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NCUA encourages credit unions to purchase additional coverage when circumstances warrant it.
One of the most important services credit unions provide is extending loans to their members. These loans, however, are accompanied by the unavoidable risk that the borrower will default and the collateral will not cover the loss. How do credit unions protect themselves from such loan losses? The answer lies in fidelity bond coverage. If handled properly, fidelity bond coverage can insure credit unions from losses incurred as a result of bad loans—even where no fraudulent intent or criminal conduct exists.
According to laws governing federal credit unions, federally-charted and federally-insured credit unions must obtain “adequate fidelity coverage for officers and employees having custody of or handling funds.” (12 U.S.C. § 1761b) The minimum amount of required coverage for any particular credit union is determined by the credit union’s total assets. (12 C.F.R. § 713.5(a)) However, the National Credit Union Administration encourages credit unions to “purchase additional or enhanced coverage when [their] circumstances warrant.” (12 C.F.R. § 713.5(b)) Where a credit union is engaged in extending large loans, it may wish to purchase additional coverage to ensure it is sufficiently compensated in the event one or more of those loans goes south.
A credit union’s fidelity bond “must . . . cover fraud and dishonesty by all employees, directors, officers, supervisory committee members, and credit committee members.” (12 C.F.R. § 713.3) Indeed, fidelity bonds are generally viewed as protecting from losses incurred as a result of fraud, theft, forgery and other similar crimes. Fidelity bond coverage, however, can be broader than that.
For example, credit unions may purchase “faithful performance” coverage to supplement their fidelity bond coverage. Although NCUA does not require credit unions to purchase this type of coverage, those credit unions frequently engaged in extending large loans should carefully consider doing so. This is so because faithful performance coverage protects from losses resulting from an employee’s failure to faithfully perform his or her trust—for example, by failing to comply with the credit union’s established and enforced lending policies. Thus, if an employee (or an officer or loan committee) approves a large loan in violation of the credit union’s lending policies, the credit union could have coverage for any resulting loan loss.
Courts have broadly interpreted faithful performance coverage in the credit union context. For example, in a 1982 case, the Fourth Circuit held that such coverage applies to the negligent approval of a loan. In that case, a credit union’s general manager unilaterally approved a $225,000 real estate loan to fund a member’s purchase of property for only $72,000. More importantly, the general manager “recommended the loan . . . without any evidence of the value of the real estate” and “directed another employee to process the loan as required, knowing that it had not been approved by, or even submitted to, the Credit Committee.” The member defaulted on the loan, and the credit union was only able to sell the property for $64,000, resulting in a six-figure loss. Fortunately for the credit union, “[t]he jury found [the insurer] liable on the bond due to the negligence of [the general manger]” in approving the loan. The insurer appealed, arguing that the credit union did not prove “intentional or willful misconduct” surrounding the general manager’s loan approval. The Fourth Circuit upheld the jury verdict because the credit union had purchased faithful performance coverage. The Fourth Circuit said that fraud or dishonesty coverage is different from faithful performance coverage, and “if the latter . . . is to have any independent significance, it must mean something other than fraud or dishonesty.” Thus, a credit union’s fidelity bond can cover a loss caused simply by an employee’s negligent loan approval.
Some insurance companies, however, now specifically exclude general negligent acts from faithful performance coverage. In many instances, such coverage is limited to acts done in “conscious disregard” for the credit union’s “established and enforced” policies. Courts have interpreted such language to mean the credit union must prove the loan loss was the result of an employee’s “intentional disregard” for established and enforced policies, such as in a 2008 credit union case. Consequently, it is imperative that credit unions draft clear lending policies and ensure employees sufficiently understand those policies. This is so because an employee’s unintentional policy violation—such as where the employee misinterprets an ambiguous provision—will likely not give rise to fidelity bond coverage.
In short, a credit union can largely mitigate the inherently risky nature of loans by (1) purchasing faithful performance coverage as part of its fidelity bond; and (2) drafting robust lending policies and periodically reviewing and discussing those policies with all personnel responsible for the underwriting and administration of loans. First, strong lending policies should generally prevent loan losses. Second, where employees violate those policies and approve a bad loan, credit unions can insure the resulting loan loss via faithful performance coverage
John Guin is a commercial litigator with Chamberlain Hrdlicka, Atlanta. Guin represents businesses, officers, directors, and shareholders in complex business and construction disputes, including cases involving claims for breach of contract, fraud, and breach of fiduciary duty. He may be reached at 404.588.3574.
