Unintended Consequences, Impact Of The Financial Crisis On Insurance Coverage

M I C A H S K I D M O R E

A M Y E L I Z A B E T H S T E W A R T

1 6 T H A N N U A L I N S U R A N C E L A W I N S T I T U T E

N O V E M B E R 3 - 4 , 2 0 1 1

A U S T I N , T E X A S

Unintended Consequences :: An Update on the Impact of the Financial Crisis on

Your Insurance Coverage Practice

Litigation arising out of the “Financial Crisis”:

Securities litigation

Bankruptcy litigation

Regulatory/government enforcement actions

Insurance coverage litigation

The Financial Crisis

“Credit Crisis” Related Securities Litigation:

2007—40 (20%) 2008—103 (41.7%) 2009—58 (26.7%) 2010—36 (15%)

Securities Litigation

Source: NERA Economic Consulting, Recent Trends in Securities Class Action Litigation: 2011 Mid-Year Review

Settlements of subprime and credit crisis litigation have been few, but large

As of September 2011, settlements totaled $3.4 billion

Average $116 million per settlement

Source: Kevin LaCroix, The D&O Diary, http://www.dandodiary.com/.

Securities Settlements

http://www.dandodiary.com/

Countrywide shareholders sett lement —$624m

Wachovia bondholders sett lement —$627m

Merri l l Lynch shareholders sett lement —$475m

WaMu—$208.5m

Wells Fargo mortgage backed securit ies —$125m

National City—$168m

Lehman Brothers—$9om

Staggering Settlements



Defense Costs Estimates

Source: J. Robert Brown, US v. Stockman and the Burn Rate on the D&O Policy, THERACETOTHEBOTTOM.ORG (June 2, 2008), available at www.theracetothebottom.org/stockman/us -v-stockman-and-the-burn-rate-on-the-do-policy.html (detailing the exhaustion of a $50 million tower of D&O insurance through defense costs accruing at a rate of $1.67 million per month).

In many cases, defense costs alone may exceed the limits of the defendants’ D&O coverage or other available insurance

Business Bankruptcy Filings:

2007—28,322 2008—43,546 2009—60,837 2010—56,282

Corporate Bankruptcy

Source: American Bankruptcy Institute, U.S. Bankruptcy Filings 1980-2010 (Business, Non-Business, Total)

Total bank failures since Jan 2008—406

87 bank failures this year alone

FDIC has initiated 15 lawsuits to date

FDIC has authorized lawsuits involving 34 failed banks and 308 directors and officers for liability of at least $7.3M

Litigation expected to increase

Failed Bank Litigation



Regulatory Enforcement

Source: SECURITIES AND EXCHANGE COMMISSION, PERFORMANCE AND ACCOUNTABILITY REPORT 36 (2009).

SEC ENFORCEMENT ACTIVITY 2007 2008 2009

Investigations Opened 776 890 994

Cases Filed 656 671 664

Derivative of underlying “financial crisis” litigation

Direct actions on first-party financial guaranty insurance, i.e., mortgage insurance, trade credit insurance

Insurance Coverage Litigation

The “fortuity doctrine,” “known loss” or “loss in progress” defense

Rescission and the “fraud in the application” defense

Priority of payments among insured defendants

Coverage for non-traditional “claims”

Coverage Issues

CASE STUDY: Chase Manhattan Bank v. N.H. Insurance Company

Insured $96.5 million in loans to film production company

No foreign distribution required by Chase

Coverage for default denied as not “fortuitous”

Fortuity Doctrine


Fortuity Doctrine

Q. If the terms of the financing transaction were equally known to the insurer, is the “fortuity doctrine” a defense?

A. No.


Fortuity Doctrine

“Given the underlying basis of the doctrine, and the right of the parties to agree to cover existing losses, it has been recognized that the known loss doctrine does not apply if the insurer also knew of the circumstances on which it bases the defense.”


Fortuity Doctrine

Q. Does the “fortuity” defense apply to risks that were not investigated prior to issuance of the policy?

A. Probably not.


Fortuity Doctrine

N.H. waived voluntary disclosure for Chase.

Other cases have inconsistently addressed the insurer’s obligation to investigate potential risks as a prerequisite to the “fortuity” defense.


Fortuity Doctrine

Q. If the insured subjectively was unaware but objectively should have known of a “loss in progress,” will the “fortuity” defense apply?

A. It depends on the jurisdiction.


Fortuity Doctrine

In Texas, “the fortuity doctrine precludes coverage for known losses and losses the insured knows, or should know, are ongoing at the time the policy is issued.”

In other jurisdictions, the standard is “subjective” only.


Fortuity Doctrine

Q. Is the “fortuity” doctrine inconsistent with or preempted by statutory provisions addressing “fraud” in an insurance application?

Texas Insurance Code Section 705.004

“Fraud in the Application”

Policy provisions voiding coverage on the basis of false statements in an application

No effect and will not bar coverage, unless:

Shown at trial

Material to the risk

Contributed to the event for which coverage is sought


Master mortgage insurance policy

Insured Combo 100 loans

AIG denied coverage defaults and rescinded the policy

Allegations that ST misrepresented the underwriting standards for the subject loans

CASE STUDY: Suntrust Mortgage, Inc. v. AIG United Guaranty Corp.

CASE STUDY: Suntrust Mortgage, Inc. v. AIG United Guaranty Corp.


Q. Will knowledge of past “misrepresentations” or a failure to investigate impair the insurer’s “fraud” defense?

A. Yes.


“Armed with a sweeping right to audit ST’s loans and being in possession of information that would have alerted a reasonable insurer (especially a sophisticated insurer like UG) to the prospect of material, wide-scale misrepresentations by ST years before UG raised its fraud defense, UG cannot now claim that it was duped by ST into covering the loans.”

CASE STUDY:

Suntrust Mortgage, Inc. v. AIG United Guaranty Corp.


Master mortgage insurance policy

Claim for rescission as to all insured loans

Allegations that Countrywide misrepresented the underwriting standards for some loans

CASE STUDY: United Guaranty Mortgage Indemnity v. Countrywide Fin. Corp.


Q. Do “misrepresentations” as to some loans justify rescission of coverage for all loans?


A. No.


“United Guaranty cannot articulate any limiting principle for when misrepresentations as to some loans would entitle it to global rescission for all loans. . . . [T]he parties spelled out the procedures and remedies for misrepresentation or fraud—and those procedures apply on a loan-by-loan basis.”


CASE STUDY: IndyMac Bank 16 insurance policies

$160 million in policy proceeds

Bank’s failure prompted numerous lawsuits

IndyMac subsidiary sued the insurers

Sought declaration regarding priority of proceeds

Asked court to determine its entitlement

Numerous Claimants :: Limited Proceeds

CASE STUDY: IndyMac Bank

Case dismissed

D&O policies with ABC coverage prioritized payment to individuals before entities

Individuals’ entitlement could not be determined prior to adjudication of the claims against them

Subsidiary did not have an adequate injury; so, no justiciable dispute

Subsidiary had no interest in proceeds of Side-A policies


CASE STUDY: Lehman Brothers

Claims arising out of the largest bankruptcy in American history ($691 B)

$250 million insurance program

Single primary D&O policy; 16 layers of excess

Substantial defense costs eroding policies


CASE STUDY: Lehman Brothers

August 2011—former CEO and other D&Os reach $90 million settlement funded entirely by insurance

Would nearly exhaust remaining limits

D&Os of a different Lehman entity also facing significant litigation/exposure

Objection to settlement—inequitable

Court approved settlement October 19, 2011


CASE STUDY: Creative Problem Solving

Coverage defenses => leverage for negotiating reduced settlement

Saving partial limits (consider impact)

Release policy (consider impact), except carve-back for SEC/DOJ defense costs—could ultimately erode policy completely notwithstanding coverage defenses

When there’s not enough money, outcome will be short of perfect


CASE STUDY: MBIA, Inc. v. Federal Ins. Co.

Bond insurer seeking coverage for regulatory investigations and follow-on shareholder litigation

Three challenged transactions

$29.5 million in defense costs

Coverage for Non-Traditional “Claims”



Q. Does a regulatory subpoena constitute a “Claim” as defined by the subject policies?

A. Yes.



A subpoena is an “order” or “similar document” triggering the policies’ coverage for “a formal or informal administrative or regulatory proceeding or inquiry commenced by the filing of a . . . formal or informal investigative order or similar document.”



Q. Is coverage for the investigation of a shareholder derivative demand limited to the costs incurred until the demand is accepted or rejected?

A. No.



Costs incurred to investigate, and if necessary reject, the shareholders’ demand are covered, but further costs expended by the Special Litigation Committee to continue to investigate the shareholders’ claims are also covered irrespective of the primary policy’s $200,000 sublimit for investigation costs on account of all Shareholder Derivative Demands.

Questions?

THANKS!

16TH ANNUAL INSURANCE LAW INSTITUTE NOVEMBER 3-4, 2011

AUSTIN, TEXAS

Unintended Consequences :: An Update on the Impact of the Financial Crisis on

Your Insurance Coverage Practice

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Unintended Consequences, Impact Of The Financial Crisis On Insurance Coverage

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