On certification to the Superior Court, Appellate Division, whose opinion is reported at 171 N.J. Super. 34 (1979).
For affirmance -- Justices Sullivan, Pashman, Clifford, Schreiber, Handler and Pollock. For reversal -- none. The opinion of the Court was delivered by Pollock, J.
The primary issue on this appeal is whether a corporate director is personally liable in negligence for the failure to prevent the misappropriation of trust funds by other directors who were also officers and shareholders of the corporation.
Plaintiffs are trustees in bankruptcy of Pritchard & Baird Intermediaries Corp. (Pritchard & Baird), a reinsurance broker or intermediary. Defendant Lillian P. Overcash is the daughter of Lillian G. Pritchard and the executrix of her estate. At the time of her death, Mrs. Pritchard was a director and the largest single shareholder of Pritchard & Baird. Because Mrs. Pritchard died after the institution of suit but before trial, her executrix was substituted as a defendant. United Jersey Bank is joined as the administrator of the estate of Charles Pritchard, Sr., who had been president, director and majority shareholder of Pritchard & Baird.
This litigation focuses on payments made by Pritchard & Baird to Charles Pritchard, Jr. and William Pritchard, who were
sons of Mr. and Mrs. Charles Pritchard, Sr., as well as officers, directors and shareholders of the corporation. Claims against Charles, Jr. and William are being pursued in bankruptcy proceedings against them.
The trial court, sitting without a jury, characterized the payments as fraudulent conveyances within N.J.S.A. 25:2-10 and entered judgment of $10,355,736.91 plus interest against the estate of Mrs. Pritchard. 162 N.J. Super. 355 (Law Div. 1978). The judgment includes damages from her negligence in permitting payments from the corporation of $4,391,133.21 to Charles, Jr. and $5,483,799.02 to William. The trial court also entered judgment for payments of other sums plus interest: (1) against the estate of Lillian Pritchard for $33,000 accepted by her during her lifetime; (2) against the estate of Charles Pritchard, Sr. for $189,194.17 paid to him during his lifetime and $168,454 for payment of taxes on his estate; and (3) against Lillian Overcash individually for $123,156.51 for payments to her.
The Appellate Division affirmed, but found that the payments were a conversion of trust funds, rather than fraudulent conveyances of the assets of the corporation. 171 N.J. Super. 34 (1979). We granted certification limited to the issue of the liability of Lillian Pritchard as a director. 82 N.J. 285 (1980).
Although we accept the characterization of the payments as a conversion of trust funds, the critical question is not whether the misconduct of Charles, Jr. and William should be characterized as fraudulent conveyances or acts of conversion. Rather, the initial question is whether Mrs. Pritchard was negligent in not noticing and trying to prevent the misappropriation of funds held by the corporation in an implied trust. A further question is whether her negligence was the proximate cause of the plaintiffs' losses. Both lower courts found that she was liable in negligence for the losses caused by the wrongdoing of Charles, Jr. and William. We affirm.
The matrix for our decision is the customs and practices of the reinsurance industry and the role of Pritchard & Baird as a reinsurance broker. Reinsurance involves a contract under which one insurer agrees to indemnify another for loss sustained under the latter's policy of insurance. Insurance companies that insure against losses arising out of fire or other casualty seek at times to minimize their exposure by sharing risks with other insurance companies. Thus, when the face amount of a policy is comparatively large, the company may enlist one or more insurers to participate in that risk. Similarly, an insurance company's loss potential and overall exposure may be reduced by reinsuring a part of an entire class of policies (e.g., 25% of all of its fire insurance policies). The selling insurance company is known as a ceding company. The entity that assumes the obligation is designated as the reinsurer.
The reinsurance broker arranges the contract between the ceding company and the reinsurer. In accordance with industry custom before the Pritchard & Baird bankruptcy, the reinsurance contract or treaty did not specify the rights and duties of the broker. Typically, the ceding company communicates to the broker the details concerning the risk. The broker negotiates the sale of portions of the risk to the reinsurers. In most instances, the ceding company and the reinsurer do not communicate with each other, but rely upon the reinsurance broker. The ceding company pays premiums due a reinsurer to the broker, who deducts his commission and transmits the balance to the appropriate reinsurer. When a loss occurs, a reinsurer pays money due a ceding company to the broker, who then transmits it to the ceding company.
The reinsurance business was described by an expert at trial as having "a magic aura around it of dignity and quality and integrity." A telephone call which might be confirmed by a handwritten memorandum is sufficient to create a reinsurance obligation. Though separate bank accounts are not maintained
for each treaty, the industry practice is to segregate the insurance funds from the broker's general accounts. Thus, the insurance fund accounts would contain the identifiable amounts for transmittal to either the reinsurer or the ceder. The expert stated that in general three kinds of checks may be drawn on this account: checks payable to reinsurers as premiums, checks payable to ceders as loss payments and checks payable to the brokers as commissions.
Messrs. Pritchard and Baird initially operated as a partnership. Later they formed several corporate entities to carry on their brokerage activities. The proofs supporting the judgment relate only to one corporation, Pritchard & Baird Intermediaries Corp. (Pritchard & Baird), and we need consider only its activities. When incorporated under the laws of the State of New York in 1959, Pritchard & Baird had five directors: Charles Pritchard, Sr., his wife Lillian Pritchard, their son Charles Pritchard, Jr., George Baird and his wife Marjorie. William Pritchard, another son, became director in 1960. Upon its formation, Pritchard & Baird acquired all the assets and assumed all the liabilities of the Pritchard & Baird partnership. The corporation issued 200 shares of common stock. Charles Pritchard, Sr. acquired 120 shares, his sons Charles Pritchard, Jr., 15 and William, 15; Mr. and Mrs. Baird owned the remaining 50. In June 1964, Baird and his wife resigned as directors and sold their stock to the corporation. From that time on the corporation operated as a close family corporation with Mr. and Mrs. Pritchard and their two sons as the only directors. After the death of Charles, Sr. in 1973, only the remaining three directors continued to operate as the board. Lillian Pritchard inherited 72 of her husband's 120 shares in Pritchard & Baird, thereby becoming the largest shareholder in the corporation with 48% of the stock.
The corporate minute books reflect only perfunctory activities by the directors, related almost exclusively to the election of officers and adoption of banking resolutions and a retirement plan. None of the minutes for any of the meetings contain a
discussion of the loans to Charles, Jr. and William or of the financial condition of the corporation. Moreover, upon instructions of Charles, Jr. that financial statements were not to be circulated to anyone else, the company's statements for the fiscal years beginning February 1, 1970, were delivered only to him.
Charles Pritchard, Sr. was the chief executive and controlled the business in the years following Baird's withdrawal. Beginning in 1966, he gradually relinquished control over the operations of the corporation. In 1968, Charles, Jr. became president and William became executive vice president. Charles, Sr. apparently became ill in 1971 and during the last year and a half of his life was not involved in the affairs of the business. He continued, however, to serve as a director until his death on December 10, 1973. Notwithstanding the presence of Charles, Sr. on the board until his death in 1973, Charles, Jr. dominated the management of the corporation and the board from 1968 until the bankruptcy in 1975.
Contrary to the industry custom of segregating funds, Pritchard & Baird commingled the funds of reinsurers and ceding companies with its own funds. All monies (including commissions, premiums and loss monies) were deposited in a single account. Charles, Sr. began the practice of withdrawing funds from the commingled account in transactions identified on the corporate books as "loans." As long as Charles, Sr. controlled the corporation, the "loans" correlated with corporate profits and were repaid at the end of each year. Starting in 1970, however, Charles, Jr. and William begin to siphon ever-increasing sums from the corporation under the guise of loans. As of January 31, 1970, the "loans" to Charles, Jr. were $230,932 and to William were $207,329. At least by January 31, 1973, the annual increase in the loans exceeded annual corporate revenues. By October 1975, the year of bankruptcy, the "shareholders' loans" had metastasized to a total of $12,333,514.47.
The trial court rejected the characterization of the payments as "loans." 162 N.J. Super. at 365. No corporate resolution authorized the "loans," and no note or other instrument evidenced the debt. Charles, Jr. and William paid no interest on the amounts received. The "loans" were not repaid or reduced from one year to the next; rather, they increased annually.
The designation of "shareholders' loans" on the balance sheet was an entry to account for the distribution of the premium and loss money to Charles, Sr., Charles, Jr. and William. As the trial court found, the entry was part of a "woefully inadequate and highly dangerous bookkeeping system." 162 N.J. Super. at 363.
The "loans" to Charles, Jr. and William far exceeded their salaries and financial resources. If the payments to Charles, Jr. and William had been treated as dividends or compensation, then the balance sheets would have shown an excess of liabilities over assets. If the "loans" had been eliminated, the balance sheets would have depicted a corporation not only with a working capital deficit, but also with assets having a fair market value less than its liabilities. The balance sheets for 1970-1975, however, showed an excess of assets over liabilities. This result was achieved by designating the misappropriated funds as "shareholders' loans" and listing them as assets offsetting the deficits. Although the withdrawal of the funds resulted in an obligation of repayment to Pritchard & Baird, the more significant consideration is that the "loans" represented a massive misappropriation of money belonging to the clients of the corporation.
The "loans" were reflected on financial statements that were prepared annually as of January 31, the end of the corporate fiscal year. Although an outside certified public accountant prepared the 1970 financial statement, the corporation prepared only internal financial statements from 1971-1975. In all instances, the statements were simple documents, consisting of three or four 8 1/2 X 11 inch sheets.
The statements of financial condition from 1970 forward demonstrated:
WORKING CAPITAL SHAREHOLDERS' NET BROKERAGE
1970 $389,022 $509,941 $807,229
1971 not available not available not available
1972 $1,684,289 $1,825,911 $1,546,263
1973 $3,506,460 $3,700,542 $1,736,349
1974 $6,939,007 $7,080,629 $876,182
1975 $10,176,419 $10,298,039 ...