Merit Ins. Co. v. Colao
| Decision Date | 07 August 1979 |
| Docket Number | No. 78-1460,78-1460 |
| Citation | 603 F.2d 654 |
| Parties | MERIT INSURANCE COMPANY, an Illinois Corporation, Plaintiff-Appellant, v. Anthony COLAO et al., Defendants-Appellees. |
| Court | U.S. Court of Appeals — Seventh Circuit |
Charles J. O'Laughlin, Jenner & Block, Chicago, Ill., for plaintiff-appellant.
Thomas J. Weithers, Chicago, Ill., for defendants-appellees.
Before SWYGERT, LAY * and WOOD, Circuit Judges.
This diversity suit was started in 1975. The complaint, as amended, contained three counts. Count I alleged negligence; Count II gross negligence; and Count III fraud. At the pretrial stage, the district court dismissed the negligence counts for failure to state a claim and proceeded to try the fraud issue to a jury. For four months, November 1, 1977 to February 28, 1978, the plaintiff presented its case. On March 1, 1978 the trial judge granted motions for directed verdict in favor of all the defendants. From these adverse rulings, plaintiff appeals.
Merit is an Illinois casualty insurance company. It and its predecessor have been engaged in writing automobile liability insurance since 1968. The defendants are being sued individually and also as partners in Joseph Froggatt & Co., an accounting firm located in New Jersey but also operating in Philadelphia and New York City.
Two other entities are involved: General Auto Placement, Inc. and Leatherby Insurance Company. General Auto was, before it became bankrupt, a New Jersey corporation selling automobile insurance policies to high risk drivers. It did not issue the policies; rather, it marketed policies that were written by licensed casualty insurance companies. Leonard Lebowitz, owner of eighty-five per cent of General Auto's stock, was president of the company and controlled its operations. Leatherby Insurance Company, a California-based casualty insurance company, started to underwrite policies for General Auto in May 1969. It was replaced by Merit in 1972.
The instant dispute centers on General Auto's financial arrangements with its underwriters. A distinctive feature of these arrangements was that General Auto was paid commissions by the underwriter on a "retrospective" basis. Rather than receiving a flat percentage of the policy premiums as its commission (the ordinary practice), General Auto earned its commission on a fluctuating scale; that is, after a review of its loss experience on the policies it had sold, General Auto received a profit (if any) gauged on the difference between the premiums paid by policyholders and amounts paid on claims. The underwriter received a fixed percentage of the premium as an "underwriting fee." Thus, General Auto functioned in large part as an insurance company without actually being one. It assumed most of the risks even though the underwriters were ultimately liable to the policyholders.
In general terms, General Auto's business was conducted as follows:
(1) General Auto agents received a commission of 15-20 percent of the premium collected by them on the policies sold.
(2) General Auto would report to the underwriter the policies it had sold and remit the premiums, less the agents' commissions.
(3) General Auto would give notice to the underwriting insurance company of any claims on the policies it had sold along with estimated settlement costs. The underwriter would place on its books the estimated settlement costs as "claim reserves," awaiting the actual amount of the claims paid.
(4) When the claims were settled, General Auto would issue drafts drawn on the underwriter to those entitled to share in the settlement.
(5) Every four months, General Auto would be paid by the underwriter a retrospective commission calculated on the basis of its earned premiums. General Auto was paid the total of earned premiums less:
(a) the fixed underwriting fees,
(b) the loss reserves, and
(c) the amounts paid on closed claims.
By virtue of this formula the lower the loss reserves were the more General Auto was paid on each quarterly settlement between General Auto and its underwriter.
In order to evaluate the financial well being of General Auto at any particular time, it was necessary to look at the "loss ratio" of the total policies it had sold. This ratio could be calculated by comparing the combined amount of reserves and losses paid against the total amount of earned premiums. If General Auto had too high a loss ratio, the premiums would be insufficient to cover the losses on claims filed on the policies and the underwriter would be required to cover the deficiency. To protect itself against such a contingency, the underwriter required a guarantee from General Auto to cover any deficiency in premiums available to pay claims. Thus, so long as General Auto's loss ratio was low enough or was able to make up any deficiency, the underwriter had a guaranteed profit from its fixed fee.
General Auto was formed in 1969 and soon thereafter entered into a retrospective commission contract with Leatherby. The contract provided that General Auto was to be paid by Leatherby the amount of earned premiums generated by General Auto less (1) 17.5 percent as a fixed underwriter fee, (2) the amount set aside as reserves on open claims, and (3) the amounts paid out on claims. The retrospective commission was to be calculated by Leatherby on a quarterly basis. The contract gave General Auto the right to suggest the amount of loss reserves, but Leatherby retained ultimate control over setting the amount of these reserves.
By August, 1970, Leatherby and General Auto were in dispute over the amount of loss reserves. Leatherby maintained that the reserves set by General Auto were forty percent less than what they should have been. General Auto thought thirty percent was more accurate. Leatherby insisted that the reserves should be increased by at least $85,000. An increase of that size would have created a severe cash flow difficulty for General Auto. President Lebowitz decided to find a replacement for Leatherby. Accordingly, he met in September 1970 with William A. F. Smith, head of the Philadelphia office of Joseph Froggatt & Co. They discussed the possibility of Froggatt providing General Auto with an audited financial statement which Lebowitz could use either to obtain public financing for purchase (or formation) of an insurance company or to induce another insurance company to supplant Leatherby. 1
Smith said that a financial statement would aid in dealing with other insurance companies and indicated an interest in making such an audited statement. During the meeting Lebowitz told Smith about his policy of setting reserves as low as possible. Smith agreed that Froggatt would furnish the audited statement and in February 1971 telephoned Lebowitz, saying the audit for the year 1970 would start soon and that he would provide "the best looking statement he possibly could."
In March 1971 two Froggatt employees, Lotman and Cable, started the audit. During the course of their audit, they discovered a variety of disturbing situations: (1) one of the expenses claimed by General Auto in its book of accounts was "Manager's Expense." An audit of this account revealed that more than half of the $64,045 listed consisted of personal, rather than business, expenses of Lebowitz. (2) General Auto did not report or transmit all premiums due Leatherby within the time required by the agency contract. Upon questioning by Cable, Lebowitz conceded that he deliberately engaged in late reporting to enhance the cash position of General Auto. (3) Cable and Lotman discovered that General Auto was keeping two different sets of policy records. One set, for General Auto's use, was complete. The other set, for Leatherby's use, did not include the endorsements which required the payment of additional premiums. After Lotman and Cable had completed their field audit, they turned over their work product to Smith.
In late June or early July 1971 Smith talked with Lebowitz several times about the drafts of the audited financial statement. The first draft submitted by Smith contained entries based on a loss ratio of approximately sixty-six percent. Lebowitz told Smith this was "totally unacceptable." Smith said he would review the matter. Several days later a new draft was produced showing a fifty-six percent loss ratio. Lebowitz said this corresponded to Leatherby's calculations which contained some "fat." A week later Smith submitted a third draft of a financial statement based on a fifty percent loss ratio. Lebowitz expressed satisfaction and said that with that kind of statement General Auto could either obtain an agency agreement with a different company or form its own company. (The trial judge excluded all testimony of conversations between Lebowitz and Smith concerning the draft statements.)
In September 1971 Lebowitz wrote a letter to Jerome Stern, president of Merit, saying that while General Auto was satisfied with its "present carrier," it had a "capacity problem" and that General Auto was "looking for an additional company so that our expansion can continue." On April 4, 1972 Lebowitz sent a copy of the Froggatt audit statement for 1970 to Stern and an in-house unaudited financial statement for the first nine months of 1972. On June 22, 1972 Merit and General Auto entered into an agency agreement similar to the Leatherby agreement, and General Auto began selling Merit policies in July 1972. In October 1972 Merit entered into a contract with Leatherby and General Auto whereby Merit assumed Leatherby's outstanding policies sold by General Auto.
In November 1972 General Auto ceased issuing policies for Merit. It did continue to adjust claims it had issued for Merit and on the assumed Leatherby policies. By the end of July 1973 General Auto owed Merit $250,000 on promissory notes and $72,000 in premiums, and on August 8, 1973 Merit terminated its business relations with General Auto. Soon...
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