City State Bank in Wellington v. U.S. Fidelity & Guar. Co.

• Decision Date: 19 December 1985
• Docket Number: No. 84-1927,84-1927
• Citation: 778 F.2d 1103
• Parties: CITY STATE BANK IN WELLINGTON, Plaintiff-Appellant, v. UNITED STATES FIDELITY & GUARANTY COMPANY, Defendant-Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 1103

778 F.2d 1103

CITY STATE BANK IN WELLINGTON, Plaintiff-Appellant, v. UNITED STATES FIDELITY & GUARANTY COMPANY, Defendant-Appellee.

No. 84-1927.

United States Court of Appeals, Fifth Circuit.

Dec. 19, 1985.

Jones, Day, Reavis & Pogue, Thomas R. Jackson, Robert F. Middleton, Dallas, Tex., for plaintiff-appellant.

Winstead, McGuire, Sechrest & Minick, Allen W. Kimbrough, Michael L. Parham, Clifford F. Altekruse, Thanksgiving Tower, Dallas, Tex., for defendant-appellee.

Appeal from the United States District Court for the Northern District of Texas.

Before GARZA, JOHNSON, and JERRE S. WILLIAMS, Circuit Judges.

JOHNSON, Circuit Judge.

Plaintiff-appellant City State Bank in Wellington, Texas ("CSB"), sued its former bonding company, defendant-appellee United States Fidelity & Guaranty Company ("USF & G"), to recover a claim made under CSB's Bankers Blanket Bond for losses resulting from the dishonest activity of CSB's former president, Chester Long. The district court granted judgment in favor of defendant USF & G, and City State Bank appeals. This Court affirms.

I. BACKGROUND

CSB is a small state-chartered bank located in Wellington, Texas. CSB is significantly smaller than the only other bank in Wellington, the Wellington State Bank. CSB was financially troubled during much of the period discussed in these proceedings.

The vast majority of CSB's outstanding stock (96.8 percent at the time relevant to this appeal) was held by a two-bank holding company, Security Bankshares, Inc. ¹ Security Bankshares, in turn, was owned by James L. Diamond, who owned forty percent of the stock, and Chester A. Long, who owned sixty percent of the stock. Prior to this acquisition, Long had been in the banking industry for eighteen years and had served as a bank examiner with the Federal Deposit Insurance Corporation and as president of Plaza National Bank and Home Savings and Loan Association in Bartlesville, Oklahoma. Diamond, a resident of Bartlesville, and Long became close friends and business associates after Long's arrival in Bartlesville.

On January 1, 1971, CSB obtained a contract of insurance entitled "Bankers Blanket Bond" from USF & G. The bond provided CSB with coverage up to $250,000 and insured CSB against "Loss through any dishonest or fraudulent act of any of the Employees...." The bond was renewed on January 1, 1980, for a three year period.

In February 1978, the then president of CSB resigned in order to become executive vice president at the competing Wellington State Bank. Concerned that CSB might lose much of its business to its competitor, Long determined that he should take the position as CSB's president. At approximately the same time, CSB's Board of Directors elected Diamond as vice president. Diamond was re-elected vice president in 1979 and 1980 but performed no substantial services in that office for CSB. Diamond, however, served on the Board of Directors of CSB from the time of the acquisition of his interest in Security Bankshares.

In the spring of 1979, Jerry McClure approached Long, Diamond, and Don Eve concerning a possible investment for manufacturing a luxury club car or van. The name chosen for the enterprise was Laser Manufacturing, Inc. ("Laser"). Long and Diamond had previously been involved in a similar enterprise with McClure called the Sportwagon. After inspecting a prototype for the Laser club car, Diamond decided to invest. On May 4, 1979, Laser was incorporated in Texas with Diamond, Long, McClure, and Eve as directors. Three of the four directors (i.e., Diamond, Long, and Eve) invested a total of approximately $130,000.00 in Laser. Further, an investment corporation owned by Diamond, known as the Bartlesville Investment Corporation, invested $7,500.00 in Laser and loaned Laser $120,000.00. Thus, Laser began its operations with a fund of approximately $250,000.00. Laser quickly exhausted its initial funding. In June 1979 Laser borrowed an additional $100,000.00 from a new source, the National Bank of Commerce in Dallas. Diamond, Eve, Long, and McClure co-signed the note.

In November 1979, Laser was again faced with a lack of funds. Moreover, no car had been produced for sale such that Laser was in a cashflow position. On November 20, Diamond and Eve arranged a line of credit for Laser with another source, the Union Bank & Trust ("UBT") of Bartlesville. Long was authorized to draft on this line of credit as Laser required the funds up to an amount of $150,000.00. Upon being informed of Laser's needs, Long would draw the money out of UBT and send it on to Laser's account at National Bank of Commerce. On March 14, 1980, Laser executed a promissory note for a floorplan loan of $100,000.00 with yet another institution, the First Bank & Trust of Richardson. Diamond, along with the other Laser directors, signed the note.

After the $150,000.00 line of credit at UBT had been exhausted on February 4, 1980, and during the negotiations for the floorplan loan, Long engaged in a series of actions which the district court termed as "draft kiting." Although the $150,000.00 line of credit at UBT had been exhausted, Long continued to submit drafts against it. In all, Long sent approximately $120,000.00 worth of excess drafts to UBT for payment; each draft was returned unpaid. Long, however, had CSB provide a credit for each draft and transferred the credit to Laser's account at National Bank of Commerce. UBT president Donaldson testified that he suspected a draft kiting scheme when Long submitted drafts identical to ones UBT had previously refused. Donaldson also testified that he believed that he had discussed the draft kiting with Diamond and that Diamond appeared concerned.

Long's efforts to fund Laser through CSB continued into May of 1980. On May 6, Long, without Diamond's knowledge or consent, signed Diamond's name to a promissory note with CSB in the amount of $175,000.00. Long used $120,000.00 of the note's proceeds to cover the overdraft of the line of credit with UBT. The remaining proceeds went to Laser's account at National Bank of Commerce. The note was submitted to CSB's Board of Directors on June 26, 1980, and approved by the directors attending the meeting. Although the minutes of the meeting indicated that Diamond was present, the district court found that Diamond did not attend the meeting. Throughout the summer, Diamond continued his involvement with Laser, including attending a car show in California with Long on May 28 and visiting the Laser facility in Richland Hills. By August 1980, however, Laser was near its end, and during the summer of 1980, Diamond determined to cease his involvement with Laser. ²

On November 6, 1980, and on May 6, 1981, Long again, without Diamond's knowledge or consent, signed Diamond's name to a renewal of the $175,000.00 promissory note. On May 29, 1981, CSB sold a $90,000.00 participation interest in the note as renewed to Amarillo National Bank ("ANB"). When the note became overdue, ANB contacted Long, who assured ANB that the note would be paid. When Diamond was contacted about the note, Diamond denied any knowledge of it. Diamond was concerned because he had told the Texas State Banking Commissioner at the time he acquired Security Bankshares that he would not borrow from either of its member banks. After consulting with his attorneys, Diamond reported the note to the Texas State Banking Commissioner.

The Banking Commissioner summoned Long and Diamond to Austin in late September 1981. Long was ordered to resign from CSB and did so at a meeting of CSB's Board of Directors on September 27, 1981. ³ Shortly thereafter, Long assigned his entire interest in Security Bankshares Inc. to Diamond.

On April 16, 1982, ANB filed a civil action against CSB, Long, and Diamond in state court in order to recover its $90,000.00 participation interest in the $175,000.00 promissory note. The case was settled on December 19, 1983. As part of the settlement, Diamond and CSB posted an irrevocable letter of credit to ANB. At trial, Diamond explained that, while both he and CSB were obligated to pay the letter of credit, Diamond would pay it if CSB's capital reserves were too low to permit CSB to contribute any money to pay the letter of credit. Noting this evidence, the district court in the instant case found that any recovery by CSB from USF & G would be used to reduce Diamond's obligations under the letter of credit.

In late 1981, Laser went out of business. Diamond's investment company, Bartlesville Investment Corporation, foreclosed its security interest in Laser's assets and sold them at public auction on January 19, 1983. On June 5, 1984, Long pleaded guilty to an indictment for forgery for signing Diamond's name to the May 6, 1980, note to CSB.

CSB initiated the instant suit to recover on the Banker's Blanket Bond. Following a trial to the court on August 16-22, 1984, the district court granted judgment for defendant USF & G. The district court based its judgment on three independent grounds relevant to this appeal. First, the district court held that Long was not an "employee" covered under the terms of the bond. Second, the district court held that recovery for losses suffered as a consequence of the two renewals was barred because the bond was terminated in 1980 due to Diamond's knowledge of Long's dishonest acts in funnelling money to Laser through CSB. Third, the district court held that allowing any recovery on the bond was equitably barred because it would result in a double benefit to Diamond.

CSB has the heavy burden of demonstrating that the district court erred in each of these three grounds. This Court's examination, governed by Texas law, focuses on the latter two grounds. The Court reserves the question whether Long was an "employee" under the terms of USF & G's bond.

II. THE MERITS

The district court found that Diamond, who was a principal stockholder, director and officer of CSB and a principal investor in Laser,...