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MORGAN v. FEDERAL INS. CO.

June 20, 1986

MORGAN, OLMSTEAD, KENNEDY & GARDNER INCORPORATED, Plaintiff, against FEDERAL INSURANCE COMPANY, Defendant; FEDERAL INSURANCE COMPANY, Third-Party Plaintiff, - against - VICTOR SCHIPA (a/k/a VITTORIO SCHIPA), GIRARD WILDE & COMPANY, INCORPORATED, CARLISLE INSTITUTIONAL SERVICES, INC., MOSELEY, HALLGARTEN, EASTABROOK & WEEDEN, INCORPORATED, SECURITIES SETTLEMENT CORPORATION, UNITED STATES TRUST COMPANY OF NEW YORK, and BRUCE HINTZE, Third-Party Defendants


The opinion of the court was delivered by: CONNER

OPINION AND ORDER

CONNER, D. J. :

 Plaintiff Morgan, Olmstead, Kennedy & Gardner, Incorporated ("Morgan Olmstead") brought this action against Federal Insurance Corporation ("FIC") seeking indemnity under a fidelity bond for losses Morgan Olmstead sustained as a result of the allegedly fraudulent and dishonest acts of one of its employees. This matter is now before the Court on FIC's motion for judgment on the pleadings, or in the alternative for summary judgment, and Morgan Olmstead's cross-motion for summary judgment. For the reasons set forth below, FIC's motion for summary judgment is granted; *fn1" I need not and do not address Morgan Olmstead's cross-motion.

 Background

 The parties agree, at least for purposes of these motions, on the following facts; hence, there is no dispute as to any material fact that would prohibit a grant of summary judgment.

 Morgan Olmstead is a securities broker-dealer. In 1982, in addition to buying and selling securities, Morgan Olmstead was engaged in the apparently lucrative business of lending securities to other broker-dealers and financial institutions. Morgan Olmstead's stock loan transactions typically Worked as follows: Morgan Olmstead would loan stock to a borrower with the understanding that the stock had to be returned upon Morgan Olmstead's demand. In exchange, the borrower would deliver to Morgan Olmstead cash collateral equal to 100% of the market value of the stock at the time of the loan. During the period of the loan, Morgan Olmstead would pay the borrower an agreed rate of interest on the collateral. This interest rate was usually lower than the rate Morgan Olmstead could otherwise obtain from other sources, such as commercial banks. Thus, in this way Morgan Olmstead could obtain funds at a discount to make other investments and to cover its operating costs.

 If during the life of a loan the market value of the stock fluctuated, the collateral would be adjusted so that it always equalled 100% of the market value. If the market value rose, Morgan Olmstead would request additional collateral from the borrower. By the same token, if the market value dropped, the borrower would request that Morgan Olmstead return part of its collateral. This process of adjustment is known in the securities industry as "marking to market."

 From April 1981 to November 1982, Bruce Hintze ("Hintze") was a vice president of Morgan Olmstead and the manager of its stock loan department. His compensation was based solely on a profit-sharing formula whereby Morgan Olmstead was to receive 60% and he was to receive 40% of the net profits of the stock loan department. Several expenses were charged against the stock loan department's gross revenues in computing its net profits; among those expenses was the interest paid on cash collateral Morgan Olmstead held on stock loans.

 In the summer of 1982, Morgan Olmstead experienced a decline in its stock loan business and the profits of its stock loan department fell accordingly. As a consequence, Hintze's compensation dropped as well. During this period, a stock loan finder *fn2" named Victor Schipa ("Schipa") approached Hintze and offered to furnish Morgan Olmstead's stock loan department with approximately $20 million of business on the condition that the loans not be marked to market. Hintze agreed to participate in this plan.

 Morgan Olmstead alleges that Hintze accepted Schipa's offer in order to increase the profits of the stock loan department and his own compensation under the profit-sharing formula. It contends that Hintze knew that if the stock loaned at Schipa's request increased in value during the life of the loans and the loans were not marked to market, Morgan Olmstead would be required to pay out less interest because the amount of the cash collateral deposited with it would be smaller; consequently, the amount of interest charged against the stock loan department's revenues in computing its net profit would also be smaller. Of necessity, Hintze's income under the profit-sharing formula would be greater.

 Morgan Olmstead also contends that Hintze knew that while he would benefit from the undercollateralization of the loans made at Schipa's request, Morgan Olmstead would suffer. Without the full collateral available as operating capital, Morgan Olmstead would borrow additional funds from other sources, such as commercial banks, at substantially higher interest rates. Since the higher cost of such money would not be charged against the revenues of the stock loan department, Hintze's income under the profit-sharing plan would be enhanced. In short, the scheme shifted the expense of paying interest on collateral held as security on stock loans from the stock loan department to Morgan Olmstead's other divisions. This made the stock loan department's net profits appear greater and increased Hintze's compensation under the profit-sharing formula.

 Unfortunately for all concerned, Schipa's scheme allegedly did not stop there. Hintze apparently believed that Schipa intended to re-lend the stock he had borrowed from Morgan Olmstead to other borrowers. However, Morgan Olmstead alleges that Schipa instead used the stock for his own benefit to cover short sales he had made. After the stocks had been used in this way, Morgan Olmstead was unable to retrieve them, and since Hintze had directed that the loans not be marked to market, the collateral held by Morgan Olmstead was less than the market value of the stock. Consequently, when Morgan Olmstead was required to purchase replacements on the open market, it suffered a loss of approximately $4 million.

 Morgan Olmstead seeks indemnification for this loss under a fidelity bond issued by FIC that covers losses sustained as a result of dishonest acts by Morgan Olmstead's employees. Morgan Olmstead contends that the following provision of the bond covers ...


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