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November 19, 1992



The opinion of the court was delivered by: ROBERT W. SWEET

Sweet, D.J.

The plaintiff Joint Venture Asset Acquisition ("JVAA") seeks to enforce promissory notes in favor of First City National Bank and Trust Company ("First City") (the "Notes") against the defendants and counterclaimants Michael J. Zellner ("Zellner"), Joseph Krader ("Krader"), Zellner Plastering Co., Inc. ("ZPCI"), and James R. Wilcox ("Wilcox"). After a bench trial and upon the following findings and conclusions, the amended complaint will be dismissed.

 The Parties

 First City had offices in New York City and its principal officers and majority stockholders were two brothers, A. Frederick Greenberg and Richard Greenberg (the "Greenbergs"), who founded First City. Neither of the Greenbergs had prior banking experience. First City at its inception in October 1985 was incorporated as a savings and loan association known as First City Federal Savings Bank with a capitalization of $ 3 million. Its purpose was to make loans to borrowers with high net worth to enable the borrowers to invest in limited partnerships. First City utilized a network of brokers to that end and in the first year of its operation 70-75% of the loans it made were utilized to make investments in limited partnerships. During the first year three or four limited partnerships were financed by First City.

 In 1986 First City became a national bank and known as First City National Bank and Trust Company and on or about December 20, 1989 the Comptroller of the Currency declared First City insolvent, and appointed the Federal Deposit Insurance Corporation (the "FDIC") as Receiver.

 JVAA, in which the Greenbergs have an interest and whose general partner Stanley Abel ("Abel") was a former director and shareholder of First City, acquired its interest in the Notes by a Memorandum Agreement dated April 7, 1988 and in 1989 JVAA acquired the Notes.

 Zellner and Krader are California residents and co-owners of ZPCI. Zellner was the founder and principal administrator, and Krader the outside man. Both immigrated from Eastern Europe and together built ZPCI into a successful million dollar enterprise. Wilcox is a registered representative and a Nevada resident.

 The Defendants obtained loans from First City in 1986 in order to invest in a tax-advantaged limited partnership known as Beam Systems Income Fund I ("Beam"), which purported to involve high technology digital facsimile document transmission equipment.

 Prior Proceedings

 After learning that the proceeds from the Notes never reached Beam, the Defendants refused payment on the Notes. In August and September 1987, First City sued the Defendants to recover unpaid principal and interest accrued on the Notes, together with the costs of collection, including attorneys' fees. Counterclaims were filed in February 1988. An amended complaint and amended counterclaims were subsequently served. The cases were consolidated in February 1989.

 The stay expired on April 25, 1990. Prior to that date, upon payments by JVAA, the FDIC and JVAA entered into an agreement under which FDIC acknowledged that JVAA had assumed First City's rights in a number of defaulted loans, including those at issue here and would intervene in all pending actions to seek enforcement. JVAA intervened in this litigation by stipulation on August 14, 1990. In the stipulation, JVAA claimed whatever holder in due course status First City previously enjoyed.

 Oral argument was heard on JVAA's renewed motion for summary judgment on September 26, 1991. By opinion dated January 14, 1992, this court denied the motion, concluding that there were genuine issues of fact as to the extent, if any, of First City's "actual knowledge of some fact which would prevent a commercially honest individual from accepting the Notes."

 The trial commenced on June 10, 1992, continued on June 11, 16, 17, and 18, 1992, and concluded on June 25, 1992. Final submissions were filed by agreement of the parties on October 30, 1992, at which time the action was considered finally submitted.

 The Issue

 This case is but one of many involving failed and fraudulent limited partnerships financed by First City in the decade of the eighties. *fn1" The issue framed for trial was set forth in the denial of the JVAA motion for summary judgment as set forth above.

 Because the officers of First City had knowledge of the purpose of the Notes and uncertainty concerning the propriety of the payment of the proceeds, First City was not a holder in due course. The Defendants were defrauded, their claim for fraud was not waived, and judgment will be entered dismissing the amended complaint with costs.

 The Facts

 Zellner and Krader from time to time prior to the end of 1985 had purchased limited partnerships at the suggestion of their accountant. In late 1985 the accountant suggested meeting with Richard McNamee ("McNamee") and Tom Devaney ("Devaney"), officers of MPA Associates, Inc. ("MPA"), who were seeking investors in the Beam limited partnerships.

 Beam was described as being in the business of developing and operating high technology facsimile document transmission equipment. At a December 30, 1985 meeting, Devaney was introduced as the CEO of MPA who was to be Beam's managing agent.

 According to Devaney, Beam's financing was in place, the fax machines to be installed in hotels were in service, only a few units were left, and they wanted to "get rid of them." Zellner and Krader decided to invest that day.

 Gene Lobato ("Lobato") arrived the following day, December 31, 1985, to loan Zellner and Krader one-half of the down payment on their investment using the names of First Cal Leasing d/b/a First California Lessors Corp. Zellner, Krader, and ZPCI purchased interests in Beam on the basis of the Private Placement Memorandum ("PPM").

 Zellner and Krader made their investment decisions in reliance on the representations of officials of MPA, the promoter/manager of Beam, and on the additional representations of Lobato that (i) Beam had equipment already in service at major hotel locations; (ii) the unpaid portion of the purchase price on their investment would be paid off out of the operating revenues of Beam; and (iii) in the highly unlikely event that this revenue stream was insufficient to pay off the unpaid portion of the purchase price, MPA guaranteed making the payment.

 Zellner and Krader each purchased 5 units and ZPCI each purchased 10 units of Beam. The purchase price per unit was approximately $ 10,000 of which approximately $ 1,300 was made as an initial payment with the obligation to pay the unpaid portion formalized by a subscription/assumption agreement. The investment was structured so that the investors would obtain certain tax benefits.

 InterDiscount Services, Ltd. ("InterDiscount"), a presently defunct corporation, had been retained by Beam to provide financing. InterDiscount, the shares of which were held 50% by Tara Cole ("Cole") and 50% by Gideon Chern ("Chern"), sought to arrange financing for Beam. Cole had been introduced by John Rice.

 Cole met the Greenbergs in January 1986 or at the very end of 1985 through another broker, John Rice ("Rice"). The Greenbergs first introduced Cole to Michael Cash ("Cash") as the person managing National Capital Corp. ("NCC") and the business of First City and InterDiscount was described. The documents were to be forwarded to NCC which Cole believed to be owned by First City. Cash was president of NCC and Harvey Hirschfeld ("Hirschfeld") its executive vice president. The office of NCC was within the suite 1101 at 60 Madison Avenue, in New York, maintained by the Greenbergs, the phones were answered "Executive Offices," and First City and NCC shared telex and cable designations. NCC paid no rent. There was no listing to NCC or its officers on any director or door at 60 Madison Avenue. First City prepared the forms for transaction which were distributed by NCC and Greenberg participated in the preparation of the financial grid and guidelines which NCC used in reviewing the applications to be submitted to First City. NCC paid First City an origination fee on loans made by it processed by NCC. Greenberg told Cole that First City's agent, NCC, reviewed the offering memorandums and checked out the syndicators. Hirschfeld testified that he had read the Beam offering memorandum and it was available for anyone at NCC to review. First City agreed to make $ 4.8 million available to qualified investors and introduced by InterDiscount. Cole was advised that NCC was responsible for assembling and evaluating the paper work on these loans, reviewing the offering memorandums and checking the syndicators.

 A second meeting was then held prior to January 13, 1986 at which Cole, the Greenbergs, Cash and Rice were present and the contents of NCC's letter of January 13, 1986 to InterDiscount were discussed at length by the participants and agreed upon.

 The second paragraph of this letter provides, in part:

 Interest received by the Lender [i.e., First City] in excess of 1% over the Reference Rate up to a maximum of 3% per annum over the Reference Rate will be disbursed to IDSL on a monthly basis.

 At this meeting it was concluded that NCC would supply the forms prepared by First City to InterDiscount for distribution to the prospective borrowers, including Promissory Notes, Borrowers Letters, Engagement and Authorization Letters, and Irrevocable Instructions To Pay Proceeds Letters.

 Cole wrote on March 24, 1986 to Hirschfeld stating:

 Enclosed please find an adjusted transaction outline for Beam. Please note that the rate is 14%. Richard and I agree that First City would accept 13 1/2%. The 1/2% of a percentage differential should be deposited in InterDiscount Services Ltd.'s account after collection on a quarterly basis.

 confirming a telephone conversation with Greenberg.

 After investing, Zellner asked if he could view the system in operation and learned that the system was not functioning and financing had been delayed. Lobato and McNamee came to Zellner's office on April 1, 1986, appropriately enough stressing the need for immediate action and requesting Zellner, Krader, and ZPCI to execute notes and a Borrowers Letter.

 By the terms of the Notes, Zellner and Krader agreed to pay the principal sum of the Notes in equal quarterly installments, together with interest which was in blank, and upon default to pay any amount due thereunder when the entire amount of the Notes would become due and payable without notice or demand. The Defendants also agreed to waive the right to interpose any set-off or counterclaim in any action brought under the Notes. The Notes also provided that the Defendants reimburse the Bank for all costs and expenses, including reasonable attorneys' fees and disbursements, incurred by the Bank in connection with the enforcement of the Defendants' obligations thereunder.

 The Borrowers Letters executed on April 1 instructed the bank, which was not identified, to pay the proceeds of their loans directly to InterDiscount Services Ltd. ("InterDiscount"). The Borrowers Letters also provided that the bank was acting solely as a lender and not as an investment advisor, that the bank had made no representations to the Defendants to induce them to request their loans, and that the bank had made no representations concerning the partnership, its general partner, or its financial strength, prospects or integrity. The Borrowers Letter held the bank harmless, released it from any and all claims.

 The Defendants signed the Irrevocable Instructions To Pay Proceeds Letter as part of their loan documentation which provided that:

 Please make the transfer [of the loan proceeds] when required and by wire charging me any cost. Please confirm the transfer [of the loan proceeds] to me by mail to my address as set forth in the enclosed loan application.

 Only Wilcox received this written confirmation in a letter from First City dated April 23, 1986, the day after his loan application was approved.

 First City's letter did not inform Wilcox that his loan proceeds had already been disbursed to First California, InterDiscount and NCC, pursuant to the Engagement and Authorization Letter.

 Wilcox has an extensive securities and investment background, and had invested in numerous limited partnerships prior to Beam. He has been a registered representative since 1965, selling stocks and bonds with securities firms and in 1986 he also started marketing investment products. He has been employed in the securities industry for substantially all of his business career.

 Early in 1986, Wilcox learned that Beam's equipment was not in service at the end of 1985 and Polley told him that the partnership was trying to get third-party financing to purchase the equipment and place it in service.

 In March 1986, Zellner, Krader, and Wilcox were told that they would have to obtain personal loans for their respective portions of the financing with the proceeds of their individual loans going directly to Beam.

 Wilcox spoke with Lobato who represented himself as being the "lender's representative who would be orchestrating or arranging this replacement financing." Lobato informed him that "First City" was going to be the lender and that First City's official, Craig Staley ("Staley") was the person he "could contact" who was handling this situation. At this time Lobato also informed Wilcox that InterDiscount, whose name did appear in the Borrowers Letter and the Engagement and Authorization Letter, "was the disbursement arm of the bank, of the lender." On March 31, 1986, Wilcox met with Lobato and executed, among other documents, a Note, Borrowers Letter and Engagement and Authorization Letter in connection with his loan application. First City's name did not appear on any of the loan documentation.

 In April 1986, Wilcox called Staley who was the chief lending officer at First City and confirmed with him that Lobato was representing First City, that InterDiscount was the disbursing arm of the bank and "that the equipment had been placed in service." Wilcox testified that if Staley had not confirmed these specific matters that he "would have withdrawn my loan application."

 On April 1, 1986, Lobato went to Zellner's office to obtain the same loan documentation (i.e., Promissory Notes, *fn2" Borrowers Letters and Engagement and Authorization Letters, among other documents) from Zellner, Krader, and ZPCI Zellner, as the inside man at ZPCI, was directly involved with arranging for the execution of the loan documentation. During this visit, Lobato told Zellner that InterDiscount was the "disbursement arm of the lender from whence he was going to get the loan."

 The 14% and 16% interest rates now appearing on their respective Promissory Notes and Borrowers Letters were not inserted at the time of execution. At some time after the execution of the Promissory Notes and Borrowers Letters, the 14% and 16% interest rates were inserted.

 Zellner, Krader, and Wilcox had no knowledge of the efforts to promote the Beam partnership beyond the conversations with their ...

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