First American State Bank v. Continental Ins. Co.

• Decision Date: 22 February 1990
• Docket Number: Nos. 89-1154,89-1155 and 89-1230,s. 89-1154
• Citation: 897 F.2d 319
• Parties: FIRST AMERICAN STATE BANK, Appellee, v. The CONTINENTAL INSURANCE COMPANY, Appellant. FIRST AMERICAN STATE BANK, Appellee, v. Robert S. MILNIKEL, Appellant, The Continental Insurance Company. FIRST AMERICAN STATE BANK, Appellant, v. The CONTINENTAL INSURANCE COMPANY, Appellee.
• Court: U.S. Court of Appeals — Eighth Circuit

Page 319

897 F.2d 319

15 Fed.R.Serv.3d 1270

FIRST AMERICAN STATE BANK, Appellee, v. The CONTINENTAL INSURANCE COMPANY, Appellant.

FIRST AMERICAN STATE BANK, Appellee, v. Robert S. MILNIKEL, Appellant,

The Continental Insurance Company.

FIRST AMERICAN STATE BANK, Appellant, v. The CONTINENTAL INSURANCE COMPANY, Appellee.

Nos. 89-1154, 89-1155 and 89-1230.

United States Court of Appeals Eighth Circuit.

Submitted Oct. 12, 1989.

Decided Feb. 22, 1990.

Richard P. Moore, Cedar Rapids, Iowa, Robert S. Milnikel, Chicago, Ill., for appellant.

Edward J. Gallagher, Jr., Waterloo, Iowa, for appellee.

Before ARNOLD and MAGILL, Circuit Judges, and LARSON, ^* Senior District Judge.

MAGILL, Circuit Judge.

The Continental Insurance Company (Continental) ¹ appeals from a final judgment in favor of appellee, First American State Bank (First Bank), ² in a breach of contract diversity action involving a bankers fidelity bond (the Bond). ³ Robert S. Milnikel, Continental's trial counsel, appeals the district court's ⁴ imposition of Fed.R.Civ.P. 37(b)(2) personal monetary sanctions. First Bank cross-appeals the district court's application of the Bond's potential income exclusion to deny coverage for future interest forfeited as a result of the restructuring of third party debt. We affirm.

I. BACKGROUND

A. Facts

From April 2, 1976 through July 2, 1982, Robert Clawson, First Bank's chief agricultural loan officer, ⁵ operated fraudulent loan and commodity/cattle schemes ⁶ involving two First Bank clients, Gilbert Hood and William Secor. False financial statements, falsified loan documents and elaborate withdrawal methods were used to conceal the nature of the transactions. First Bank lost $826,794.38 ⁷ as a direct In 1976, Clawson informed Hood that Hood had unused credit at First Bank which Clawson wanted to employ in borrowing money to solve a cash flow problem. ⁸ Hood agreed to borrow money from First Bank, utilizing this pre-approved credit line, and loan some of the proceeds to Clawson. Clawson assured Hood that the proposed arrangement was not improper or illegal. However, Clawson requested that Hood keep the transactions secret and Hood complied. A similar arrangement was made with Secor.

result of the dishonest and fraudulent acts of Clawson in processing fraudulent loans.

The fraudulent transactions took two forms. In Method I, Clawson prepared promissory notes representing loans from First Bank to Hood for "farm operating expenses." Hood executed the notes and deposited the loan proceeds into his First Bank checking account. Then Hood issued checks to Clawson. Clawson deposited the checks in his account and ultimately delivered promissory notes to Hood. In Method II, Clawson completed notes, signed by Hood in blank, without Hood's knowledge and deposited the proceeds directly into his own account.

First Bank's annual financial statements indicated that Hood borrowed $663,000.00, evidenced by promissory notes from First Bank on various occasions from April 2, 1976 to July 2, 1982, under the guise of drawdowns against a pre-approved credit line for "agricultural expenses." During the same period, Hood loaned Clawson money on twelve different occasions amounting to $373,308.17, evidenced by checks, and an additional $57,500.00, evidenced by notes signed in blank by Hood and completed by Clawson. Clawson executed promissory notes for $412,500.00 and $15,000.00. First Bank's annual financial statements, dated January 5, 1979, January 10, 1981 and January 8, 1982, disclosed that from December 2, 1977 through May 18, 1982, eighteen loans were made by Secor to Clawson totaling $572,378.56 and at approximately the same time that Secor borrowed money from First Bank.

Clawson also managed commodity accounts and cattle feeding operations in Secor's name with Secor's money. Secor believed the funds were being utilized as a hedging account for the cattle business. However, Clawson traded commodities (i.e., invested in pork bellies and hog futures), against bank policy and without a license. Clawson received commissions entitled "management fees," amounting to one-half of the profits realized in the cattle and commodity transactions. Secor was never compensated for losses which the parties agreed to share.

Clawson's schemes created potential bank liability. When Hood and Secor demanded payment of the promissory notes, Clawson stated that he had no ability to pay. On January 3, 1983, Hood presented his claim to First Bank's Board of Directors. Clawson was fired on January 6, 1983 for perpetrating a fraud on First Bank and its customers, in violation of the banking laws. On January 7, 1983, First Bank became aware of the additional transactions involving Secor.

Secor, facing personal bankruptcy as a result of the fraudulent transactions, refused to make payments of interest on the notes representing loans from First Bank and threatened First Bank with suit for compensatory and punitive damages. Hood also refused to make payments on his notes and threatened to sue First Bank and its Board of Directors. ⁹ The directors were advised by counsel of First Bank's probable liability because Clawson was an employee acting on behalf of First Bank when he committed the dishonest and fraudulent acts.

First Bank filed proof of loss with Underwriter's Adjusting Company (UAC), Continental's agent, on February 4, 1983. On February 15, 1983, UAC denied coverage, on behalf of Continental.

First Bank entered into settlement negotiations with Hood and Secor which resulted in settlement agreements and mutual releases in an effort to avert potentially staggering compensatory and punitive damage awards. Clawson was required to transfer all non-exempt property, his profit sharing account and Mrs. Clawson's First American Group, Ltd. stock to First Bank in mitigation of damages.

Releases of all demands, dated May 19, 1983, were executed between First Bank and Hood, First Bank and the Clawsons (for claims arising out of the Hood notes), Hood and First Bank and its directors and officers, and the Clawsons and Hood and First Bank and its directors and officers. A conditional release, dated May 19, 1983, was executed between Hood and the Clawsons, contingent upon the material accuracy of the Clawsons' current inventory of assets and the Clawsons' acknowledgment of debt and agreement not to file bankruptcy for a ninety-one day period. The releases will be hereinafter referred to as the Hood Settlement.

On May 19, 1983, Hood settled his claims against First Bank. Hood received a check for $373,479.50 ¹⁰ which he used to repay his notes with First Bank. Hood's notes with First Bank were marked "paid." Hood received a check representing the proceeds of the sale of stock. Clawson's notes with Hood were cancelled.

First Bank suffered a loss of $373,308.17 through settlement as a direct result of Clawson's acts. First Bank's liability to Hood, incurred as a direct result of Clawson's dishonest and fraudulent scheme, totalled $373,308.17, the amount of the cancelled Clawson notes. At the time of settlement, Hood had a viable fraud claim against First Bank for the amount of the cancelled notes.

First Bank forgave Secor's notes, restructured his debt, and became assignee under Clawson's notes with Secor. On May 23, 1983, Secor settled his claims, executed notes for $375,000.00 and $172,672.14 secured by a land mortgage, and obtained a $150,000.00 line of credit subject to a crop lien. First Bank's liability to Secor amounted to $270,000.00, the amount of the forgiven Clawson-Secor notes not attributable to excludable potential income. First Bank was out $270,000.00 as a result of having to compensate Secor through settlement for the cancelled notes precipitated by Clawson's fraudulent scheme.

An Agreement and Release, dated May 23, 1983, between Secor and First Bank effected a mutual release. A Release, also dated May 23, 1983, among First Bank, Secor and the Clawsons, released all parties from liability arising out of their financial dealings. The Agreement and Release and the Release are hereinafter referred to as the Secor Settlement.

First Bank incurred $12,759.27 in attorneys' fees as a result of settlement negotiations with Hood and Secor. Continental was notified of the negotiations and the settlements.

First Bank filed final proof of loss on August 29, 1983 and Continental established a reserve ¹¹ of $600,000 indicating that it believed losses were caused by Clawson in his capacity as a bank officer. However, Continental still denied coverage.

First Bank, among other claims, brought a breach of contract action against Continental in federal district court. ¹² First Bank alleged breach of contract by Continental in denying coverage under the Bond for First Bank's losses which resulted directly from the dishonest and fraudulent acts of an employee.

B. District Court

After a ten day bench trial, the district court concluded that the settled Hood and Secor claims, if established, would have constituted valid, collectible losses under the terms of the Bond, and therefore First Bank had incurred a covered loss of $519,415.82. The district court properly calculated First Bank's covered losses as follows:

                $373,308.17  Total outstanding promissory notes from Clawson to Hood
                               evidencing transfer of fraudulently obtained loan proceeds
                k270,000.00  Total outstanding loans from Secor to Clawson, funded by
                               fraudulently obtained loan proceeds
                - 87,416.58  Monetary value of Clawson pension plan
                 - 8,000.00  Net gain from sale of Clawson corn
                - 12,975.77  Net gain from sale of Clawson real property
                - 10,500.00  Net gain from sale of Clawson vacant lot
                 - 5,000.00  Bond deductible
                -----------
                $519,415.82  COVERED LOSS
                

First Bank proved by a preponderance of the evidence that as a direct result of Clawson's dishonest and fraudulent acts, a loss under the bond of $519,415.82 ¹³ was incurred, representing the total outstanding...