Vincent J Vitkowsky, John F McCarrick and Maurice Pesso, Edwards Angell Palmer & Dodge
The substantial financial losses associated with subprime mortgage lending and the follow-on impact on the credit markets are already resulting in increased frequency of losses under directors and officers liability (D&O) and errors & omissions (E&O) policies. As of this date, insurance analysts have estimated the potential underwriting exposure of D&O and E&O insurers for losses resulting from subprime lending to be as high as US$8 billion. This estimate does not include or address investment losses incurred by insurers through investment of their premiums. Nor does this analysis address the related issue of D&O and E&O exposures arising from credit risk problems resulting from subprime lending.
If one outcome of the subprime lending crisis is a material reduction in the availability of bank credit for other kinds of non-residential real estate loans, such as business financing loans, there is a greater potential that smaller public and private companies will wither and die without reasonable access to bank credit and loans - increasing the potential for bankruptcy and other kinds of undesirable corporate activity that tend to generate D&O claim frequency. Thus, there is a real potential for a substantial increase in frequency and severity in the D&O and E&O insurance lines beyond companies with direct and recognisable subprime or real estate exposures to companies that have nothing at all to do with residential real estate or subprime loans.
SOURCES OF ACTUAL AND ANTICIPATED SUBPRIME CLAIMS AND THEORIES OF LIABILITY
We discuss below the sources of subprime claims already filed and the theories of liability under which such claims have been brought. We also discuss some of the insurance and reinsurance issues triggered by subprime claims. But first, we should consider the source of subprime lending-related D&O and E&O claims.
The financial losses associated with subprime lending-related losses directly result from deterioration in residential real estate values, and not from a natural or man-made catastrophe, or from a financial fraud or corrupt scheme. The absence of a specific causative event, the timing and seriousness of which was outside preventative and risk-management efforts, arguably limits the liability theories under which an insured could be alleged to have been negligent or otherwise culpable.
The origin of the subprime crisis immediately makes the resulting litigation different from prior waves of litigation, such as IPO laddering and stock option backdating litigation - both of which allegedly originated with distinct and repeated acts of corporate or individual misconduct. This is not to suggest, of course, that in the subprime lending industry, individuals or firms assiduously avoided the exploitation of buyers and investors caught up in a seemingly never-ending real estate boom, and that such exploitative conduct will not give rise to litigation or insurance issues. The point is simply that the run-up and slippage in residential real estate values were not the result of a planned or anticipated event.
This is a significant point because, in retrospect, all of the involved buyers, sellers, investors and intermediaries assumed that residential real estate values would continue to rise indefinitely. Whether or not that was a reasonable assumption, it appears, at this point, that all of the involved players shared the same misperception that residential real estate values would hold - and indeed, would continue to rise.
Thus, the litigation and regulatory investigations that have addressed subprime-related conduct to date have not focused on whether the drop in residential real estate values could have been avoided, but whether corporate managers or professional services providers conducted their business dealings fairly and reasonably although they were operating on a shared misperception about the long-term value of residential real estate.
This point is also significant when considering relevant insurance coverage issues because, to date, D&O or E&O insurers are not arguing that the underlying cause of the entire subprime lending crisis is based on fraudulent or other uninsurable misconduct, and, therefore, that such underlying conduct somehow taints coverage for all resulting D&O or E&O claims. Indeed, to the extent fraudulent or deliberate misconduct has been identified, it has been isolated to transactions surrounding the original mortgage loan transaction, such as inflated property appraisals, intentional departure from mortgage underwriting guidelines, and fraudulent mortgage applications by speculative investors. No similar conduct has been identified - or yet alleged - in connection with the securitisation, rating or sale of mortgage-backed securities.
For these reasons, we can anticipate that the coverage issues that arise in connection with subprime-related claims will be based on the unique facts of each claim, and will not be tainted by an insurer perception that the conduct at issue exists as part of a larger scheme or collusive industry-wide practice.
As of the first quarter of 2008, 448 cases had been filed relating to subprime lending. Litigation arising from economic losses associated with subprime lending can be broadly stated to come from three sources: parties who sustained economic losses in companies or securities in which they invested; parties who sustained losses through transactions with other firms; and parties who are employees of companies that sustained losses in connection with subprime lending-related activities. Although it could be said that the nature of all corporate or professional services relationships is contractual, when those relationships are recognised as creating fiduciary and other non-contractual duties too, D&O and E&O insurance policies are triggered.
Looking at the D&O and E&O exposures separately, it can be broadly said that while D&O liability involves the liabilities of corporate directors and officers for the actions or omissions in managing the affairs of their corporate principal, E&O liability involves the liability of firms and individuals in providing professional services to clients or customers, generally for a fee or commission.
In the context of subprime-related financial losses, the most frequent sources of D&O claims are made by shareholder investors against corporate managers, alleging breaches of fiduciary duty or violations of federal or state securities laws in managing or disclosing the corporation's financial exposure to subprime losses.
With respect to E&O claims, their likely anticipated source is the customer base of service providers such accounting firms, law firms, mortgage banks or brokers, other financial institutions, residential property appraisers, and other professional services providers. These claims are likely to allege that the professional services provider failed to provide timely or complete information about the nature of services or products subject to financial fluctuation or losses based on subprime developments.
Generally, neither D&O nor E&O claims directly address the financial losses sustained by falling residential real estate prices. The losses for which the claimants seek recovery in D&O or E&O claims is limited to the financial losses sustained by the company or its shareholders through the company's investments in, or public disclosures relating to, subprime mortgage-backed securities, and by the injured client or customer in the E&O area who was not made to appreciate the risks associated with investments in securities backed by subprime loans. These customers question: whether lenders and investment banks alerted borrowers and investors to the risks posed by subprime loans or securities backed by them, and how much the lenders and investment banks were obliged to disclose about subprime loans and subprime-backed securities.
COVERAGE ISSUES FOR INSUREDS FACING SUBPRIME CLAIMS
Given the non-fraudulent nature of the underlying deterioration in residential real estate values, the coverage issues likely to be encountered and addressed in the subprime lending and credit risk area are the same coverage issues that are encountered in "garden variety" D&O and E&O claims. In this regard, the key questions that D&O and E&O insurers will want to know about their insureds include the following:
•Did the insured become aware of the potential for a claim against it arising from a claimant's alleged subprime-related losses prior to the inception of the policy period?
•Did the insured or its employees act in a fraudulent manner or engage in intentional misconduct, or did the insured obtain a profit or advantage to which it was not legally entitled, in connection with the circumstances underlying the subprime-related D&O or E&O claim?
•Is the insured being asked to repay fees and commissions or to unwind the terms of a prior transaction?
•Is the claimant seeking to enforce the insured's alleged contractual obligations?
•Is the claimant seeking punitive or treble damages from the insured?
•Is insurance coverage available for the subprime claim or occurrence under a different insurance policy that also may be applicable?
•Were the legal expenses incurred by the insured in the D&O or E&O claim incurred solely in the defence of the insured in connection with a covered claim and on behalf of insured parties?
As in other kinds of D&O or E&O claims, the extent and nature of the financial losses at issue can attract regulatory and governmental investigations in the form of SEC and US Department of Justice investigations. Whether in response to such an external investigation or in response to a demand upon a board of directors by a shareholder planning to bring a derivative lawsuit, an internal investigation or special litigation committee investigation is often commissioned by the company whose actions are being questioned.
The legal fees and related costs and expenses associated with internal or external investigations of corporate conduct are increasingly substantial in amount. Often, several sets of legal counsel are retained for numerous discrete representations without prior consideration of which legal fees and expenses are subject to insurance coverage and reimbursement. In these situations, the necessary process of sorting and parsing legal fee statements after substantial fees and expenses have been incurred often leads to disputes between D&O and E&O insurers and their insureds. Moreover, in some instances, and particularly, in connection with SEC or government investigations, insurance coverage is not triggered until the investigation is elevated to a formal status.
When these claims reach the reinsurance level, they are likely to implicate several commonly recurring issues. The first is notice. The experience thus far is that reinsureds are taking pains to make early notification, often doing so before any litigation, sometimes based only on press or other informal reports of an insured suffering a loss. Those who do not may be deemed delinquent.
In a related vein, full disclosure at the time of placement could be crucial. Similarly, reinsurers may be deemed to have a form of constructive notice.
One key issue will be aggregation, with distinctions between "event", "occurrence", "cause" and "series" wordings being significant. Distinctions may be made among individual negligent acts, fund collapses and other scenarios. Differences in the scope of retrocessional wordings may also be important.
Allocation issues may arise, especially when a factual investigation demonstrates that a number of acts have caused losses over a period of time.
As in so many other areas, the scope of the follow-the-fortunes doctrine may be implicated. A reinsured must demonstrate that settlements were made in good faith after a reasonable and businesslike investigation, and settled covered losses. This may have an impact on claims paid in response to external pressures, as those from such regulators or the media, or in attempts to buy off an investor who complains early, for the stated purpose of quietly preventing other investors from asserting similar claims.
* * *
It is already clear that the subprime-lending financial losses are generating much litigation. What is not yet clear is whether this growing flood of litigation will translate into substantial settlements or significant coverage litigation or arbitration. It is expected that the current level of litigation activity will continue unabated through the remainder of 2008, and that reinsurance issues will follow. If that is the case, the litigation frequency associated with subprime lending cases likely will be higher than IPO laddering or stock-option backdating corporate litigation, and already has surpassed the failed bank litigation era of the 1980s in terms of litigation frequency and complexity.