Loss Control: Lessons from Losses

  • July 23, 2024
  • 6 min read

Written by: Debra McManigle

Outlined below are recent losses caused by fraud perpetrated by customers and against customers of our financial institution clients. Whether there is insurance coverage or not, financial institutions should examine their procedures to be sure that controls are in place to avoid similar losses.

CHECK KITE LOSS EXAMPLE

Recently, a bank had a 7-figure check kiting loss. The bank was disappointed to learn at the time of the loss that they did not have coverage because the kite was one customer (auto dealership) that had two accounts at their bank. Check Kiting coverage does not respond to claims unless the kite was between an account at one bank and one or more accounts at another institution.

The application for Financial Institution (FI) Bond coverage includes questions about check kite mitigation controls (i.e. does the bank review a check kite suspect report on a daily bias). Many times, an institution will answer “yes” to having controls in place only to find out that exceptions are made, even when suspicious activity is detected. Ignoring such activity can result in a denial of coverage, as well as, kiting activity that involves accounts within the same institution. There is no absolute safeguard against check kiting or any other type of bank fraud. But there are account activities that can signal the need for greater scrutiny.

Establishing adequate controls to identify fraudulent activity, and periodic review and assessment of those controls, is essential to reducing your bank’s risk of loss or scandal caused by fraudulent check-kiting schemes. Here are a few suggestions that will help reduce Check Kiting Losses:

  1. Clearing Checks Internally through the bank’s core system vs. “on us” which can create a float to hide rolling and increasing overdrafts between multiple customer accounts
  2. Review of a daily Check Kite Suspect Report and such review should be the task of someone with knowledge and experience and the authority to act on suspicious activity
  3. Flagged activity must be reviewed, investigated and acted upon vs. relying on assurances from the customer that nothing is awry and allowing the fraudulent activity to persist.
  4. Once there is suspicion of “check kiting”, avoiding steps to mitigate loss may cause denial of coverage for the portion of loss post suspicion.

NON-SUFFICIENT FUNDS (NOT FINALLY PAID) LOSS EXAMPLE:

Over the past few months, claims involving fraudulent Cashier’s Checks have caused financial institutions to suffer large losses. Below are two examples of recent claims that were not covered under the institution’s FI Bond. Institutions that are at greater risk to these types of claims tend to be near the Canadian border, however this type of fraud does not discriminate as our recent experience was with institutions in Florida, Ohio and California. A recent Google search on “check fraud schemes against attorney trust accounts” resulted in 146 million results. Scams targeting lawyers and trust accounts have cost financial institutions hundreds of thousands of dollars in loss, including legal fees.

These scenarios are noteworthy because they are large and oftentimes not covered. Banks that are typically of greater risk to these claims tend to be near the Canadian border, however the two recent claims were banks far from the California border.

EXAMPLE 1:

A bank’s long-time customer, who is an attorney that had an IOTA (Trust Account), deposited a Canadian Draft (bank drafts or cashier’s checks) for $200,000 into his trust account at the bank. Since the bank knew their customer, the bank did not place a hold of any type on the check and allowed the customer to immediately wire the money to another bank. Many issues exist leading up to this loss being denied under the FI Bond:

  1. Insufficient funds exclusion in the FI Bond policy – Exclusion O.
  2. No effort to place a hold on the check, call drawer bank to determine if the check was good, etc.
  3. The bank did not believe that the check had cleared since they never gave it a change by placing a hold, therefore no provisional credit or false sense of reliance that the draft was legitimate.
  4. The item was returned as “fraudulent”. The bank could not determine if there were any other fraudulent characteristics on the draft (i.e. forged signatures, counterfeit, unauthorized signatures, etc.).

EXAMPLE 2:

A bank’s long-time customer, who is an attorney that had an IOTA (Trust Account), deposited a Canadian Draft (bank drafts or cashier’s checks) for $250,000 into his trust account at the bank. In this case, the bank sent the check for collection via a correspondence bank. Prior to receiving notice from the Canadian drawer that the draft was fraudulent, the bank allowed the attorney to wire the funds. The check was returned, and the bank is out $250,000. Many issues exist with this being a covered claim and will likely be denied:

  1. Customer’s account did not have adequate funds to cover charging this fraudulent item back to them, therefore the Insufficient funds exclusion in the FI Bond policy – Exclusion O will apply.
  2. The bank allowed the funds to be wired prior to learning the draft had not cleared.
  3. The item was returned as “fraudulent”. The bank could not determine if the draft was forged, counterfeit, unauthorized, etc.

Despite the slight differences in the two scenarios above, Exclusion O, which is found in all FI Bond policies, reads: loss resulting directly or indirectly from payments made or withdrawals from a depositor’s account involving items of deposit which are not finally paid, for any reason, including but not limited to Forgery or any other fraud, except when covered under Insuring Agreement (A).

Had either bank waited to determine if the funds were good in these cases, they would have prevented the loss to the bank and potentially their customer, should the bank take legal action against the customer. IOTA accounts also bear fiduciary responsibilities that differ from regular deposit accounts; thus, we have seen the customer file suit against banks triggering the bank’s liability coverage.

Steps that should be in place to avoid losses due like the two above:

  • Place proper holds on drafts, checks, etc.
  • Send items for collection, call the drawer bank
  • Never allow wires on accounts that lack the funds to cover such amounts being wired
  • Ensure that there are proper Written Funds Transfer Agreements in place with the Customer / Bank prior to wiring funds
  • Adhere to the bank’s policies and procedures for wire funds – the banks above had written procedures that were not followed, but the “we know are customer trust” trumped their procedures

For more information please reach out to me:

Debra R. McManigle
Senior Vice President, CFSO
HUB Financial Services
Mobile: 847-420-9136
debra.mcmanigle@hubinternational.com