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September 29, 1977


The opinion of the court was delivered by: WHIPPLE

 This is a civil action brought by the plaintiff, The Midland Bank and Trust Company (Midland) seeking indemnity under a bankers blanket employee fidelity bond and an excess bank employee dishonesty bond issued to the plaintiff by the defendant, Fidelity and Deposit Company of Maryland (F & D). Although originally instituted in state court, this diversity action was removed to this Court, the jurisdiction of this Court being premised upon 28 U.S.C. ยง 1332. The cause was tried to the Court without a jury and the following constitutes this Court's findings of fact and conclusions of law.

 Effective August 19, 1968, F & D issued to Midland its Standard Form # 24 Bankers Blanket Bond providing primary coverage in the amount of $750,000 and standard form # 28 providing the Bank with excess coverage of $1,000,000. The bonds, which contain virtually identical provisions, seek to indemnify the Bank against any loss sustained through any "dishonest, fraudulent or criminal act" *fn1" of an "Employee", *fn2" "sustained . . . at any time but discovered . . . prior to the termination . . . of this bond."

 The Bank, which lost a considerable sum of money through a series of transactions which will collectively be referred to as the "ship loans", contends such loss was suffered as a result of the dishonest, fraudulent and/or criminal acts of two of its former employees, John Pensec and Peter Moraites, and the Bank therefore is entitled to recover under the bonds.

 The defendant, in addition to contending that the Bank has failed to establish the existence of even a single dishonest act, within the meaning of the bonds, argues (1) that Moraites was never an "Employee" of the Bank and (2) assuming arguendo, that the plaintiff has sustained a loss through dishonest and fraudulent acts, the Bank failed to comply with the notice provisions of the bonds, thus releasing the defendant from liability thereunder.

 It is undisputed that John Pensec was an "Employee" of the Bank within the meaning of the bonds. Pensec joined Midland sometime in 1962 as an assistant vice president. Two years later, on October 19, 1964, he was named as a director of the Bank and was also appointed as vice president, chief administrative officer, secretary of the Board of Directors and made a member of the executive committee. On May 16, 1966 Pensec became president of the Bank, which position he held until his resignation on May 7, 1969.

 Peter Moraites was a member of Midland's Board of Directors from the time of the Bank's inception in 1957 until April 30, 1969 when he resigned from the Board. During this time Moraites, an attorney, was a partner in the New York based law firm of Hill, Betts, Yamaoka, Freehill and Longcope, which firm specialized in admiralty law and maritime financing. Presumably because of his background in the field of maritime financing, it was Moraites who first suggested in 1962 that Midland involve itself in the making of ship loans. The Board, accepting Moraites' suggestion, considered these loans a good investment because they generally command a higher rate of interest than any other commercial loan. Initially, Midland's involvement in making ship loans was minimal, limiting itself to what are known as "participation loans." In a participation loan there is always a lead bank, which puts up the major portion of the loan and further handles all of the documentation. Midland's role in these transactions consisted solely of contributing its share of the money.

 In 1965, however, Moraites suggested to the Board of Directors that Midland begin to make direct loans to foreign ship companies, independently of other participating banks. Specifically, Moraites recommended the Bank involve itself with three separate categories of ship loans. These three types of loans included: (1) ship mortgage loans which would be secured by taking first mortgage liens on the ships; (2) charter party loans secured by assignments of the charter hire which meant that no cargo could be unloaded before the Bank was paid; and (3) letters of credit which were to be secured by cash on deposit in the Bank equal to the full amount of the letter of credit. The Board, upon accepting Moraites' proposal, initially set a lending limit of $500,000 on each of the three ship loan categories and, further, through an informal agreement, gave both Moraites and Pensec blanket authority to make loans without prior Board approval. The Board, thus, placed its reliance upon both Pensec and Moraites to administer these loans efficiently.

 Every ship loan which came into the Bank was introduced by Moraites and placed on the books at the specific direction of Pensec, virtually each time without either the prior approval or authorization of the Board of Directors or the executive committee.

 In addition to bringing every ship loan to the Bank, it was understood by all that it would be Moraites' responsibility to see that all the necessary documentation in connection with the loans was properly prepared. It is clear that Midland looked solely to Moraites and his law firm as the counsel for the Bank in connection with the ship loans. *fn3"

 Although the Board was under the impression that no ship loan would be booked unless it complied with the requirements for the three types of loans set forth above, this clearly was not the case. Almost immediately Pensec and Moraites ignored the lending limits established by the Board and further booked loans which did not satisfy the Bank's requirements for collateral. In fact, in most instances, no collateral whatsoever was obtained at the time the note was put on the books. Despite this absence of collateral, Pensec instructed the tellers to credit the loan proceeds to the borrowers. When advised by a teller that the collateral Pensec had stated would be obtained was not forthcoming, he on several occasions instructed the teller to contact Moraites, who would often have some type of security instrument delivered to the Bank by a courier from his office.

 Even when collateral was obtained initially from the borrowers, it was generally grossly inadequate. Although authorized to issue ship mortgage loans only when receiving first mortgage liens on the ships, Pensec and Moraites often granted loans when obtaining, for example, only second mortgage liens, or the personal guarantees of stockholders. As it was Moraites' duty to obtain any required security instruments and insure they were properly executed, he clearly had to be aware of the fact that anything less than a first mortgage lien would not satisfy the requirements established by the Board and further might increase the likelihood that the Bank would be exposed to a risk of loss.

 Similarly, with the other two ship loan categories, instructions re: the type of collateral to be obtained were ignored. With respect to charter party loans, the charter hire was often permitted to expire without any payments being made to Midland. On several occasions the assignment of charter parties was never acknowledged and when the charter hire proceeds came into the Bank, they were applied to the borrowers' accounts and not put towards the payment of the loan. Finally, the most flagrant disregard of the Board's security requirement came with respect to the letters of credit. More often than not, Pensec, who authorized every letter of credit but one, failed to insure there would be any money on deposit in the Bank to secure the transaction. Further, the Bank never charged or collected any fees in connection with these letters of credit.

 When loans would become past due, Pensec and/or Moraites would bring them up to date with renewal loans. Certain loans were repeatedly renewed without any payments being forthcoming. The fact that the Bank was not making any money on these loans and that all of these notes were delinquent was concealed by Pensec, who in his monthly operating reports to the Board listed renewal notes as new loans. Whenever questioned by the Board about the status of the ship loans, Pensec never indicated that he was experiencing any difficulties, when in fact he knew that many of the loans were overdue and unpaid.

 At the same time Pensec was authorizing unsecured loans to cover overdrafts in certain borrowers' accounts and similarly concealing this fact by listing such loans in his monthly operating reports as secured.

 Pensec and Moraites further concealed from the Board the fact that a group of companies identified as the "K & M Group" operated in actuality as a single entity. The significance of this is that while Midland's books were made to reflect the granting of a number of small loans to individual, non-related companies, in reality, most of the proceeds were being funneled into an omnibus account for the benefit of a single borrower.

 On several occasions, when a loan to one member of the K & M Group remained unpaid for too great a period of time, Pensec would authorize a "new" loan to another company in the K & M Group, the proceeds of which would be used to satisfy the unpaid note. When doing so, Pensec was not placing the Bank in any better position than it had been in with respect to the original loan. Rather, he was again merely concealing the fact that the ship loans were going unpaid.

 From the time of the inception of the direct ship loan program in 1965 through July 1966, the volume of the loans increased rapidly. In May 1966, even as the Board increased the ceiling placed on the amount of bank funds which could be extended in any one of the three ship loan categories, *fn4" Pensec was authorizing loans whose amount in July 1966 exceeded the newly established limits by approximately $800,000. At no time did Pensec advise the Board of Directors that the loans which he had already booked and for which he was now seeking Board approval, exceeded the limits established by them. This Court finds that Pensec was well aware of the fact that the loans he authorized exceeded the Board's specified limits, and that because of the nature of the loans, *fn5" it would be virtually impossible for the Board to know whether they were staying within their prescribed limits unless they were so advised by Pensec.

 The report and covering letter were reviewed by the Board of Directors *fn6" at several meetings at which Director Moraites and President Pensec were questioned as to the specific criticisms of the Banking Department. Both men reassured the Board that there were no problems with the ship loans and that any delinquencies mentioned in the covering letter had been taken care of. On February 14, 1967 Pensec, as President of Midland, sent the Bank's reply to the Banking Department. The letter stated in pertinent part:

". . . it is the intent and the policy of the Board of Directors and top management to maintain rather than increase and where possible decrease, our involvement, in loans and contingent credits to those firms whose primary interest is in the shipping industry."

 Despite this assurance to the Banking Department that Midland intended to at least maintain the status quo, Moraites continued to refer and Pensec continued to approve new loans. In fact, there was a steady increase in the volume of ship loans through the first half of 1967. In April 1967 the New Jersey Department of Banking and Insurance made another examination of the Bank. This 1967 report which was sent to the Bank by covering letter dated July 19, 1967 contained much stronger criticisms of the ship loans than the 1966 report.

 The letter stated in pertinent part:

"This department is seriously concerned over the expansion of risk assets in your institution and particularly in the quality of a large segment, referred to hereinafter as 'ship loans,' and furthermore, the lack of control exercised by your managing personnel over this group of loans . . . We could go on at great length reiterating the criticisms our examiner has cited in his report concerning this concentration which, with its many hazards, threatens the very existence of your institution. You have acted with extreme imprudence, and you must ...

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