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Suffolk Federal Credit Union v. CUMIS Ins. Soc., Inc.

United States District Court, E.D. New York

December 15, 2012

SUFFOLK FEDERAL CREDIT UNION, Plaintiff,
v.
CUMIS INSURANCE SOCIETY, INC., Defendant.

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Frankfurt Kurnit Klein & Selz, P.C., by: Amelia Katherine Seewann, Esq., Jeremy Seth Goldman, Esq., Jessie F. Beeber, Esq., Patrick J. Boyle, Esq., Of Counsel, New York, N.Y., for the Plaintiff.

Sedgwick Detert Moran & Arnold LLP, by: Arthur Aizley, Esq., Brian Maurice Oubre, Esq., Of Counsel, New York, N.Y., for the Defendant.

MEMORANDUM OF DECISION AND ORDER

SPATT, District Judge.

This is an insurance coverage action in which Plaintiff Suffolk Federal Credit Union (" Suffolk" ) alleges that Defendant CUMIS Insurance Society, Inc. (" CUMIS" ) breached the terms of the parties' fidelity bond (the " Bond" ) by refusing to indemnify Suffolk for losses arising from a fraud committed by Suffolk's loan servicer, CU National Mortgage, LLC (" CU National" ).

A number of motions are pending before the Court. First, Suffolk moves to amend its Complaint to add a claim against CUMIS for its alleged bad faith denial of coverage and to allege a claim for its attorneys' fees based upon CUMIS's reliance upon arguments concerning its coverage obligations that Suffolk argues are unreasonable.

Second, CUMIS moves for summary judgment or, in the alternative, partial summary judgment, on the grounds that (1) Suffolk is not entitled to coverage under the " Employee or Director Dishonesty" coverage of the bond, because CU National was not an employee of Suffolk when it committed the alleged fraudulent acts; (2) Suffolk is not entitled to coverage under the " Forgery and Alteration" coverage of the bond, because no forgery or alteration occurred; (3) Suffolk is not entitled to coverage under the Bond because a reasonable credit union would have discovered its losses before the inception of the Bond Period; (4) Suffolk's losses constitute a " single loss" under the Bond and are therefore limited by the $10 million single loss limit of liability, subject to a $25,000 deductible; (5) in the event the single loss limit of liability does not apply, Suffolk's loss should be calculated by taking the principal amount of the subject loans, and deducting from that amount all monies received on those loans; (6) Suffolk is not entitled to unearned interest under the bond; and (7) Suffolk is not entitled to attorneys' fees.

Third, Suffolk moves for partial summary judgment on the issue of liability on its claims of breach of contract and declaratory relief and for an immediate trial on the amount of damages to be awarded against CUMIS.

Fourth, Suffolk submits a second motion for partial summary judgment on the grounds that (1) Suffolk's losses in this matter are not a single loss within the meaning of the Bond or the expectation of the parties; (2) the reduction of Suffolk's loss from the Fannie Mae Settlement

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should not " include accrued interest" amounts paid into escrow after the loss was discovered and while the ownership of the loans was in dispute, because those payments are wholly unrelated to Suffolk's loss and CUMIS's obligations under the bond; (3) Suffolk is entitled to set-off from the Fannie Mae recovery the amount of attorneys' fees it incurred to obtain its settlement from Fannie Mae; (4) Suffolk's loss should not be reduced by $4,879,945 because Suffolk reduced the principal balance on each loan, and thus the amount of the claimed loss, by applying every payment received from CU National until those payments stopped in 2009; (5) Suffolk is entitled to prejudgment interest on its claims; and (6) Suffolk is entitled to its reasonable attorneys' fees.

Lastly, CUMIS moves to strike Suffolk's second motion for partial summary judgment, while Suffolk moves to strike CUMIS's May 23, 2012 and June 22, 2012 Rule 56.1 statements.

For the reasons set forth below, the Court (1) denies CUMIS's motion to strike Suffolk's second motion for partial summary judgment; (2) denies Suffolk's motion to strike CUMIS's May 23, 2012 and June 22, 2012 Rule 56.1 statements; (3) denies Suffolk's motion to amend its complaint; (4) denies Suffolk's motions for partial summary judgment; and (5) denies in part and grants in part CUMIS's motions for summary judgment.

I. BACKGROUND

A. Factual Background

1. The Fraudulent Scheme Committed Against Suffolk

CU National was a New Jersey Limited Liability Corporation, and a subsidiary of U.S. Mortgage Corporation (" U.S. Mortgage" ). Both CU National and U.S. Mortgage were headquartered in Pine Brook, New Jersey. Michael McGrath (" McGrath" ) served as CU National's President and Chief Executive Officer and was also the President, Chief Executive Officer and major shareholder of U.S. Mortgage.

On or about February 1, 2003, Suffolk and CU National entered into a " Mortgage Services Agreement (" the Agreement" ) whereby CU National agreed to perform various services in connection with Suffolk's residential mortgage business. In this regard, CU National assumed the following duties: " (1) collecting mortgage payments from borrowers and remitting the payments to Suffolk; (2) reporting to Suffolk regarding the mortgages; (3) remitting tax and insurance payments to appropriate entities from the borrower payments; (4) providing monthly statements to borrowers; (5) ensuring that the mortgages complied with statutory and regulatory requirements; (6) reporting mortgage information to the appropriate regulatory entities on a periodic basis; (7) maintaining all necessary and appropriate documentation for mortgage payments, balances and activity; (8) commencing mortgage collection and enforcement proceedings against borrowers as necessary; and (9) managing and maintaining real property acquired by Suffolk in foreclosure." (Dkt. No. 84, pg. 3.) In addition, CU National also facilitated the sale to the secondary market of certain mortgage loans that Suffolk no longer wished to keep in its portfolio.

For approximately five years, from 2004 until January 2009, McGrath directed a fraudulent scheme in which he and others at CU National and U.S. Mortgages sold 189 of Suffolk's mortgage loans (" the subject loans" ) to the Federal National Mortgage Association (" Fannie Mae" ) without Suffolk's knowledge or authorization and then pocketed the proceeds. These loans were worth more than $42 million.

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The fraudulent scheme was committed in the following manner. First, McGrath or one of his employees would select a loan that Suffolk had not authorized CU National to sell. Second, they would prepare an Allonge and Assignment which they used to assign the loan from Suffolk to U.S. Mortgage, which was an authorized loan seller to Fannie Mae. On the Allonge and Assignment, McGrath or one of his employees would sign their own names, but falsely represent that they were a Suffolk " AVP" or employee. Third, after completing the assignment of the loan from Suffolk to U.S. Mortgage, McGrath or one of his employees would execute a separate Allonge and Assignment in order to assign the loan from U.S. Mortgage to Fannie Mae. Fourth, McGrath or one of his employees would submit the underlying promissory note and the fabricated Allonge and Assignment to Fannie Mae, thereby accomplishing the sale of the loan to Fannie Mae. Lastly, instead of forwarding the proceeds from the sale of the loan to Suffolk, McGrath kept the money and used it for himself and his companies without Suffolk's knowledge or authorization.

To conceal the fraud, CU National continued to service Suffolk's loans, including those that had been sold without authorization. Thus, CU National prepared monthly trial balance reports for Suffolk, which listed the loans that were currently in Suffolk's portfolio and being serviced by CU National. Some of these trial balance reports falsely indicated that the subject loans were still in Suffolk's portfolio, even though they had been sold to Fannie Mae. For example, the monthly trial balance report submitted at the end of December 2008 indicated that CU National was servicing 599 loans in Suffolk's portfolio, when, in fact, 189 of these loans had already been sold to Fannie Mae. CU National also continued to send Suffolk monthly principal and interest payments for the subject loans after they had been sold to Fannie Mae, again in an effort to make it seem as if those loans were still in Suffolk's portfolio.

Suffolk neither recorded nor kept track of those loans it authorized for sale. Rather, Suffolk relied upon CU National to monitor those loans that Suffolk wished to sell. To that end, CU National prepared monthly pending sales reports, which listed the loans that U.S. Mortgage would be selling on behalf of Suffolk.

However, although the trial balance reports and the pending sales reports were designed to conceal the fraud, discrepancies existed within some of these reports that may have indicated that the subject loans were missing from Suffolk's portfolio. For example, the monthly trial balance reports from August 2005 to April 2006 do not list 44 of the subject loans, but these loans are then listed in the May 2006 monthly trial balance report. In addition, CU National was often late in providing Suffolk with monthly remittances and monthly service reports, thus creating problems for Suffolk when it tried to properly close its books each month. Also, U.S. Mortgage frequently delayed in remitting the proceeds from those loans CU National was authorized to sell; these delays lasted between 30 days to up to one year.

According to Suffolk, it closely monitored monthly principal and interest payments and would often notify CU National if payments were received late. However, CUMIS contends that Suffolk did not review either the monthly trial balance reports or the monthly pending sales reports. CUMIS further asserts that Suffolk did not audit CU National or U.S. Mortgage, even though it was required to obtain an SAS-70, which is an independent audit of the internal controls of third-party vendors. Lastly, CUMIS alleges that when Suffolk's Executive

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Vice President John Klag tried to investigate U.S. Mortgage's delays in remitting the proceeds for the authorized sales, McGrath complained and Suffolk subsequently fired Klag.

In January 2009, the United States Attorney's Office informed Suffolk that CU National had sold Suffolk loans to Fannie Mae without Suffolk's authorization. Suffolk claims that this is when it first discovered McGrath's fraudulent scheme. However CUMIS disputes this and argues that Suffolk was aware of facts that would have made a reasonable person assume that a loss had occurred prior to January 2009.

On June 11, 2009, in the United States District Court for the District of New Jersey, McGrath pled guilty to one count of mail and wire fraud conspiracy in violation of 18 U.S.C. § 1349 and one count of money laundering conspiracy in violation of 18 U.S.C. § 1956(h).

2. The Fidelity Bond

In 2008, Suffolk purchased the Bond from CUMIS. The Bond was effective from April 1, 2008 until April 1, 2009 and protected Suffolk against all " covered losses" discovered during that period. At issue in this case is the coverage provided under (1) Coverage A, Employee or Director Dishonesty and (2) Coverage S, Forgery and Alteration. Also at issue are the Bond's terms with respect to its " Single Loss Limit of Liability" and " Discovery of Loss" conditions.

Under Coverage A, Employee or Director Dishonesty, the Bond provides in relevant part:

We will pay you for your loss resulting directly from dishonest acts committed by an " employee" or " director," acting alone or in collusion with others.
Such dishonest acts must be committed by the " employee" or " director" with the intent to:
a. Cause you to sustain such loss; or
b. Obtain an improper financial benefit for the " employee," " director," or for any other person or entity.
However, if some or all of your loss resulted directly or indirectly from a " loan" or " trade," that portion of the loss is not covered unless you establish that the portion of the loss involving a " loan" or " trade" resulted directly from dishonest acts committed by the " employee" or " director," acting alone or in collusion with others, with the intent to:
1) Cause you to sustain a loss; and
2) Obtain an improper financial benefit for the " employee" or " director," or a financial benefit for any other person or entity.

(Dkt. No. 83-1, pg. 25.)

The bond explicitly excludes from its definition of " employee" " independent contractors" and " agents, meaning persons authorized by you to act for you." (Dkt. No. 83-1, pg. 44.) However, the Bond's definition of " employee" does include, for the purposes of Coverage A, " servicing contractors." Specifically, the Bond states that " [a]ll persons employed by any ‘ servicing contractor,’ including its partners, officers and employees, will collectively be considered one ‘ employee’ for all purposes of this Bond, except for the Termination Or Limitation Of Coverage For Employee Or Director Condition." (Dkt. No. 83-1, pg. 44). In turn, the bond defines " serving contractor" as follows:

Any person or entity duly authorized by you to perform any of the following services and only while ...

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