APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF NEW JERSEY (D.C. Civ. No. 78-00357)
Before Seitz, Chief Judge, and Van Dusen and Gibbons, Circuit Judges.
Hudson United Bank (the Bank) appeals from a final order of the district court entering judgment of rescission for Fidelity & Deposit Company of Maryland (F& D) after a trial to the court. Disposition of this complex and difficult diversity action is governed by New Jersey law.
In this action, F&D seeks to rescind ab initio a fidelity bond it issued to the Bank on March 21, 1976. This bond insured the Bank against losses from many causes, including employee dishonesty, but it did not cover losses from borrower fraud or dishonesty. Prior to March 21, 1976, the Bank was insured under a fidelity bond issued by Employers Mutual Liability Insurance (Employers). The F&D bond, as well as the Employers bond, was a discovery bond: it covered losses discovered during the effective period of the bond regardless of when they were sustained.*fn1
In early 1974, the Bank hired Mr. Potter as a senior loan officer in its commercial loan department. He was made a vice president in September of that year. In July 1975, on Potter's recommendation to the Board of Directors, the Bank made loans eventually totaling $700,000 to companies owned and controlled by Mr. Mullens (Mullens loans).*fn2
In January 1976, Mr. Robertson was appointed President of the Bank. In early January, some senior loan officers told him that they questioned Potter's competence. Robertson testified that after reviewing the loan files, including the Executive Investments file, he concluded that Potter was indeed incompetent. He noted that the documentation in the Executive Investments file was poor and that the loan should not have been granted based on such documentation. He also discovered that certain financial statements had been incorrectly totaled and contained penciled corrections. However, he testified that because the loan was substantially collateralized by a $300,000 Certificate of Deposit (C.D.) and by what appeared to be valuable mortgages, he did not think at the time that the loan itself was necessarily a bad risk.
Soon after this review, Robertson began an extensive investigation of the Executive Investments file. He found that there was a warrant out for Mullens' arrest for issuing bad checks, that Mullens' references did not think highly of him, that Mullens was being investigated in a seven-million-dollar fraud scheme, and that there were several judgments and liens pending against him. When Robertson attempted to verify the financial statements contained in the Executive Investments file, he also discovered that the Certified Public Accounting firm, "A. Rosato & Co.," which had certified the financial statements, did not exist.*fn3
Finally, Robertson discovered that Potter and another loan officer had allowed some corporate checks to be cashed by the individual authorized to sign checks for the corporation. This is not in accordance with general banking practice.
Robertson suggested to the Chairman of the Bank's Board of Directors that the Bank mature and demand payment on the Mullens loans. The Bank applied the pledged $300,000 C.D. with accrued interest to the Executive Investments note, reducing its balance to $239,009.59 plus $18,783.33 in accrued interest.
On February 4, Robertson called the Regional Director of the FDIC in New York and the New Jersey Department of Banking to inform them of the loan losses. He also notified the FBI, the United States Attorney, and the State prosecutor of Mullens' actions.
On February 10, at the Board of Directors meeting, Robertson recommended that the Bank discharge Potter. Robertson has consistently maintained that this action was taken because he believed that Potter was incompetent. He based this belief upon the condition of the Executive Investments files as well as Potter's other loan files, the staffing of Potter's department, and the unprofessional appearance and manners of Potter himself.*fn4 On February 19, Robertson sent a letter to the FDIC outlining the events surrounding the Mullens loans. At the close of this letter, Robertson stated:
As of this writing, these are all the pertinent facts regarding these fraudulent loans. Although we do not have any knowledge at this time of any wrongdoings by any of the officers of Hudson United Bank, we are forwarding a copy of this letter to our insurance carrier. If we have further information regarding these fraudulent loans, we will notify you immediately.
About the same time, the "Mullens swindle," which also involved other banks, had received widespread publicity throughout New Jersey. On February 20, the Chairman of the Board issued a press release stating that the "limit of Hudson United Bank's exposure is $400,000, which is partly secured by real estate mortgages." The following week a copy of the FDIC letter was forwarded to Employers along with a covering letter which stated:
We believe that we are excluded from coverage under the exclusion section of our blanket bond policy (excluding losses not due to employee dishonesty or forgery), however, we wish that you would review the contents of this letter and inform us in writing as to whether we have a claim or (under) what conditions would this claim be allowable.
(Emphasis added).*fn5 The Bank also sent a letter informing its shareholders that the Bank was increasing its reserve for bad debts so it could write off losses. It explained the Mullens exposure of $400,000 as well as some REIT losses and a large loan write-off of $2,000,000.
During this time, the Bank had been receiving bids for fidelity insurance from carriers other than Employers. An application for insurance with F&D had been completed and returned in January 1976. On March 12, Mr. Dovico, the Bank's comptroller in charge of obtaining insurance, informed Mr. Hay, the F&D representative, of a "possible pending fraud claim" that had been reported to Employers. Later that day, Hay wrote the Bank a letter confirming this telephone conversation. In this letter, Hay stated: "(Y)ou mentioned the fact that there was a possible pending fraud on which you have notified your present insurance carrier. Since the premiums quoted by our agent, Mr. Irwin, are based on a no loss experience, I would appreciate a letter from you regarding the possible fraud and the facts surrounding the same." No reply was received by F&D.*fn6 Nevertheless, when Employers decided not to renew its bond with the Bank, F&D issued a policy effective March 21.*fn7
In November 1976 the Bank filed with both Employers and F&D proofs of loss covering the Mullens loans. In December 1977 the Bank filed suit against Employers for the Mullens-related losses, and it obtained a default judgment. However, this judgment was later vacated and the case eventually settled before trial. A stipulation of dismissal was entered. The loans that were the subject of the Employers settlement were withdrawn from the F&D claim.
On January 31, 1977, Hay informed the Bank that F&D was cancelling the bond effective April 2, 1977. Hay's letter indicated that the decision to cancel was based on the fact that the Bank had notified Employers of a potential loss prior to the effective date of the policy. On April 1, the Bank requested a thirty-day extension, but F&D granted only a seven-day extension. Subsequently, the Bank purchased from F&D an additional twelve-month rider, an option provided in the original bond.
During 1977 the Bank discovered many other losses unrelated to Mullens, some of which also involved Potter, and it filed proof-of-loss claims on these losses with F&D. On January 13, 1978, F&D attempted to rescind the bond ab initio and it tendered the premium payments to the Bank. The Bank refused the tender, and F&D filed this action seeking rescission.
The district court found for F&D. In holding that F&D was entitled to rescission, the court relied on several grounds. It held that under New Jersey law, the doctrine of equitable fraud controlled the disposition of this case. See Fidelity & Deposit Co. v. Hudson United Bank, 493 F. Supp. 434, 440-42 (D.N.J.1980). Although it found no evidence of an intent to conceal ...