On January 14, 2016, the U.S. District Court for the Northern District of Ohio released its decision in National Credit Union Administration Board v. CUMIS Insurance Society, Inc., following a trial that focused on the issue of the application of the termination provision in a fidelity bond issued to a credit union. The Court held that, based on facts known to the president of the credit union's Board of Directors, the provision applied to terminate coverage. The decision is significant in that knowledge of the manager's dishonesty was effectively imputed to the president, even though the president was not aware of any one specific dishonest act by the manager. The more traditional view is that the termination clause is triggered only by subjective knowledge of dishonesty (in contrast with discovery provisions, which are typically based on a "reasonable person" standard). The Court's decision in NCUAB v. CUMIS suggests that, in some cases, an objective standard may implicitly be applied to a supervisor's subjective knowledge for the purposes of the termination provision.
In 1989, St. Paul Croatian Federal Credit Union ("SPC") hired Anthony Raguz as a loan officer. Raguz worked his way up and became manager in 1996. SPC provided real estate, motor vehicle and other forms of secured loans. Historically, SPC had had a delinquency rate of approximately 1 to 2 per cent.
In 2000, Raguz began making fraudulent loans in exchange for kickbacks. Many of these loans quickly became delinquent. To conceal this, Raguz began to manipulate SPC's books to ensure that the loans would not be recorded as delinquent, so as to avoid having to report them to SPC's Board and to SPC's regulator, the National Credit Union Administration ("NCUA"). Raguz engaged in several forms of concealment:
- Covering Loans: to cover a loan, Raguz would create a loan for a fictional entity and then use those loan proceeds to make payments on delinquent (or imminently delinquent) loans, thus keeping them off reports to NCUA;
- Resetting Loans: Raguz would take an existing loan balance, plus accrued interest, and "reset" it as a new loan. Removing the interest component would keep the loan off certain delinquency reports; and,
- Burning Loans: making the loans appear to have been paid off by setting up another fraudulent transaction.
Raguz's concealment had the effect of ensuring that the reports provided to the Board and to NCUA recorded a delinquency rate of zero, for the entire loan portfolio, for the entire period from 2002 to 2010. Each month during that period, Raguz reported the zero delinquency rate to the Board, and provided the Board with fraudulent reports to substantiate that figure.
SPC's loan portfolio expanded at a tremendous rate, growing from $42 million in 2001 to $240 million in 2010. At some point, the Board became concerned about the rapid expansion of the loan portfolio, and asked Raguz for a breakout of each loan and the nature of the security held. Raguz refused to provide this information, and the Board did nothing to discipline him. The Board also expressed concerns with respect to the reported zero delinquency rate and asked Raguz about it "from time to time" but "never got a straight answer."
In early 2010, NCUA began to have concerns about SPC's operations. In April 2010, NCUA put SPC into conservatorship and liquidated it. NCUA then submitted a claim to CUMIS under SPC's bond. CUMIS denied the claim on several bases, including the ground that the president of the Board, Robert Calevich ("Calevich"), had been aware that Raguz had reported zero delinquencies on all loans, of all types, since 2002 and that Raguz failed to respond to the Board's repeated inquiries concerning the zero delinquency rate, the volume of loans, and specific details of particular types of loans.
The CUMIS Coverage
The CUMIS bond carried coverage for Employee Dishonesty which included a provision providing coverage for fraudulent loans in certain limited circumstances. The focus of the trial was on the bond's termination provision:
Termination Or Limitation Of Coverage For Employee Or Director
This Bond's coverage for an "employee" or "director" terminates immediately when one of your "directors," officers or supervisory staff not in collusion with such person learns of ... [a]ny dishonest or fraudulent act committed by such "employee" or "director" at any time, whether or not related to your activities or of the type covered under this Bond; ...
Termination of coverage for an "employee" or "director" ... terminates our liability for any loss resulting from any act or omission by that "employee" or "director" occurring after the effective date of such termination.
At trial, CUMIS contended that Calevich's knowledge of the historical delinquency rates (1 to 2 per cent), coupled with Calevich's failure to follow up on the Board's requests for explanations from Raguz in the face of Raguz's implausible representations, amounted to knowledge of Raguz's dishonesty.
NCUA made two counterarguments. First, NCUA contended that, as a factual matter, there were no "delinquencies" because Raguz's manipulations ensured that no loan, as recorded on SPC's books, ever went into delinquency. Thus, when Raguz told the Board that there were no delinquencies to report, he was, technically speaking, not being dishonest. The Court rejected this argument as "circular logic", holding that, irrespective of Raguz's manipulations, there were reportable delinquencies throughout the relevant time period, and that Raguz's false reports to the Board were "dishonest in every sense of the word."
NCUA also contended that, although Raguz made implausible representations to the Board, the Board did not learn of Raguz's fraudulent loans until 2010, with the result that the termination provision was not engaged until then. The Court rejected this argument as well, holding that the termination provision was broader than the indemnity provision and extended to any dishonest or fraudulent act, whether or not related to SPC's activities and whether or not covered by the bond. In this regard, the Court's reasoning mirrors the 2009 decision of the Court of Appeal for Ontario in Iroquois Falls Community Credit Union.
The Court then got to the nub of the case, i.e., whether knowledge of Raguz's dishonesty could effectively be imputed to Calevich based on what amounted to wilful blindness. CUMIS did not point to any one specific delinquent loan known to Calevich. However, the Court carefully weighed Calevich's evidence at trial and noted that:
Calevich ... testified that, during the entire seven year time period that he served as St. Paul's secretary/treasurer ... there were delinquencies at St. Paul. The Board, including Calevich, became concerned when the reported delinquencies suddenly "stopped." This was because, based on his long-time experience as a Board member, Calevich "knew in fact there had to be at least some delinquencies" at St. Paul. The Board was so concerned, in fact, that it raised this issue directly with Raguz "from time to time," which implies the Board questioned Raguz regarding the zero delinquency rate on more than one occasion. Raguz, however, never provided a "solid answer that [the Board] could rely on."
Taken as a whole, the above testimony and evidence shows that Calevich knew Raguz was falsely representing that St. Paul had a zero delinquency rate in financial reports to the Board. [citations omitted]
As a result, the termination provision applied in respect of Raguz.
The Court's decision in NCUAB v. CUMIS calls to mind the White Queen of Lewis Carroll's Through the Looking-Glass, who claimed that she could believe "six impossible things before breakfast". Although CUMIS could not point to any one specific dishonest act known to Calevich, the evidence supported the finding that Calevich had to have known that Raguz's representations and reports to the Board were implausible, to the point of impossibility. Based on this, the Court was willing to conclude that there was sufficient knowledge of dishonesty to engage the termination provision. NCUAB v. CUMIS provides fidelity claims personnel with an example of a court willing to bridge the gap between a known fact and a fact that certainly (or almost certainly) must be true, based on other available evidence. The result suggests that a court may be prepared to use an objective test to decide whether knowledge of dishonesty can effectively be imputed on this basis.
National Credit Union Administration Board v. CUMIS Insurance Society, Inc., 2016 WL 165379 (N.D. Ohio)
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