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January 12, 1976;

ROYAL NATIONAL BANK OF NEW YORK and Merrill Lynch, Pierce, Fenner & Smith, Inc., Defendants

The opinion of the court was delivered by: WERKER

WERKER, District Judge.

 This is an action to recover damages for the conversion of certain United States Treasury Notes arising under the following circumstances.

 On May 15, 1966, W. E. Hutton & Company (Hutton) had in its possession the Treasury Notes which are the subject of this action in a vault room in the Bankers Trust Company at 14 Wall Street, New York, New York. Late in August 1966 when the cashier of Hutton conducted an in-house audit it was discovered that these Treasury Notes were missing. Thereafter Hutton made a physical search of the vault in order to assure itself that the notes had not been misplaced. As early as September 24, 1966 James Barbi, a partner in Hutton, learned of the missing notes.

 United States Fidelity and Guaranty Company (USF & G) was formally notified by Hutton of the loss by letter dated September 28, 1966 to its agent William H. Kreidler Agency which contained a list of the numbers and values of the notes. This letter was written from the Cincinnati office of Hutton by its assistant operations officer, Thomas A. Rockafeller, who obtained the information by Telex from the New York office. The only record which Hutton had of the numbers of the Treasury Notes was a handwritten list of certificate numbers prepared in May 1966 by the Clerk who clipped the coupons from the Treasury Notes. That list was never produced. The list was essential because it was the beginning point from which Hutton then reviewed its records of Treasury Note transactions from May 15, 1966 to September 1966 to determine which certificates were delivered and received in order to determine which certificates should have been in the vault. The fact that Hutton was required to go through this process in order to determine what securities it had on hand indicates that its system was, to say the least, casual and careless and hardly a secure system. The activity in Treasury Notes was then minimal and the process was not as laborious as it might seem. Those records which were used for this process were never produced although those and the original list were requested by defendants. The records should have been in existence at least until 1974.

 There were no safeguards built into Hutton's method of investigation to safeguard against a clerk's error in reviewing the records for purposes of identifying the missing certificates. It is apparent that at least one such error did occur with respect to Treasury Note 31606 in the amount of $5000 which had been received by the Federal Reserve Bank of New York on denominational exchange from Hutton on May 27, 1966.

 Although Hutton knew these were bearer securities the title to which passes by delivery they did not report the loss to anyone other than USF & G until November 2, 1966. On that date, at the urging of James E. Bills, USF & G's claims examiner, the loss was reported to the Federal Bureau of Investigation and the police. This failure was deliberate in order to avoid the bad publicity which might result if the loss was reported.

 As long as Hutton did not report the loss to the FBI or police any inquiry as to the notes would have been fruitless. It should be noticed that USF & G although it was informed of the loss made no report to any authority either.

 USF & G paid the claim of Hutton under the insurance policy and is here as the assignee of Hutton.

 This action was commenced on May 22, 1968. The complaint alleges that the Treasury Notes which Hutton found to be missing were stolen sometime between May 16, 1966 and August 5, 1966. Some of those notes were presented for sale at the 149th Street branch of defendant Royal National Bank (Royal) by one Frank Mazzochi, Jr. (Mazzochi). In accordance with Mazzochi's request Royal sold the notes to defendant Merrill Lynch, Pierce, Fenner & Smith, Inc. (Merrill Lynch) and deposited the proceeds into a personal checking account of Mazzochi which he had opened for that purpose and from which he withdrew the proceeds in cash. The basis for liability is that neither Royal nor Merrill Lynch negotiated the Treasury Notes in good faith or observed reasonable commercial standards so as to gain the exemption from liability contained in § 8-318 of the Uniform Commercial Code. Further with respect to Merrill Lynch it is alleged that it violated Rule 405 of the New York Stock Exchange Rules. This is the so called "know your customer rule" which requires investigation to identify the customer before negotiating securities.

 The defendant Royal admits in its answer that it sold certain Treasury Notes for Mr. Mazzochi and deposited the proceeds into his personal checking account from which he subsequently withdrew them. Royal sets up as an affirmative defense § 8-318 of the Uniform Commercial Code. At the trial Royal moved to amend its answer to include defenses of estoppel, failure to mitigate damages and contributory negligence. That motion is granted since in the opinion of the court all of the parties were aware of the facts in this case and neither the plaintiff nor the codefendant Merrill Lynch are prejudiced by these affirmative defenses.

 Merrill Lynch admits that it purchased certain Treasury Notes from Royal, but denies any liability to USF & G. Its answer also contains a cross claim against Royal based upon a breach of warranty which Royal has denied in its answer to the cross claim.

 This case was tried without a jury on August 6, 7, 8 and 11, 1975. Six witnesses appeared in open court. The parties stipulated that the pretrial depositions of 15 others would be submitted to the court. The last papers were received on December 11, 1975.

 On August 4, 1966 Frank Mazzochi, Jr. came into the 149th Street branch of Royal and approached Rudolph Santoro, one of Royal's employees, for the purpose of selling a $10,000 United States Treasury Note. Santoro was then acting head of the loan department at that branch. Mazzochi identified himself as an officer of the Mutual Credit Union (Mutual). Mutual had been a customer of the bank since around 1950. Its members and officers were customers of the bank and some of its officers had previously in 1965 identified Mazzochi as the new president of Mutual. Mutual was also a frequent borrower at the bank. Mazzochi thus came to the bank upon good recommendation. He was well dressed and presented a neat and gentlemanly appearance.

 Santoro's responsibilities at this time were clerical in nature. He did not make decisions or judgments and was not an officer. When Mazzochi told him of the nature of the transaction it was the first such transaction Santoro had handled as acting head of the loan department. He gave Mazzochi a receipt for the note dated ...

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