Insurance Coverage and the Subprime Mortgage Crisis Steven M. KaplanGregory S. Wright Partner, Washington Partner, Washington David P. SchackPhilip H. Hecht Partner, Los Angeles Partner, Washington
Outline of Presentation • Types of investigations, lawsuits and losses faced by companies in the subprime lending industry • Coverage afforded by D&O policies to the officers and directors of companies in the subprime lending industry • Coverage afforded by E&O policies for acts, errors or omissions in rendering or failing to render professional services • Strategies for pursuing coverage under both D&O and E&O policies, or any other relevant coverages
What is the Subprime Crisis? • Increased delinquencies, defaults and foreclosures • Inability to make new loans to “subprime borrowers” • Contraction of mortgage finance industry • Margin Calls • Change in price for loans or no secondary market for loans • Bankruptcy of lenders and conduits • Credit crunch • Losses for all participants
Who are the Participants? • Borrowers • Mortgage brokers • Mortgage lenders • Conduits
Who are the Participants? (continued) • Servicers • Issuers • Rating agencies • Investors of whole loans • Underwriters
Who are the Participants? (continued) • Purchasers of mortgage backed securities (individuals, lenders, brokers, private equity funds, hedge funds, mutual funds, pension funds, insurance companies) • Insurers • Credit enhancers
What are the Actions? • Administrative enforcement actions • Consumer class actions • Individual consumer actions • “Commercial” disputes between industry participants
Administrative Enforcement Actions • State Attorneys General • FTC • DOJ • Federal banking agencies • State banking and consumer credit departments • SEC
Consumer Class Actions • Shareholder suits for alleged violations of securities laws • Unfair and deceptive lending practices • Option ARM loan cases (including claims under TILA) • Discriminatory lending practices (claims under ECOA/FHA) • Advertising practices (FCRA firm offer on credit cases) • Servicing practices
Individual Consumer Actions • Predatory lending • Wrongful lending • Fraud • Option ARM loans • Appraisal practices
“Commercial” Disputes Between Industry Participants • Claims by whole loan purchasers against originators / sellers. • Claims by institutional investors against underwriters / issuers, lenders and / or servicers. • Claims by individual investors against institutional investors. • Claims by warehouse lenders against borrowers (lenders / conduits). • Claims by mortgage lenders against warehouse lenders and banks. • Claims by investors against rating agencies.
D&O Coverage • PART A: • The Company shall pay, on behalf of the Insured Persons, Loss for which the Insured Person is not indemnified by the Organization and which the Insured Person becomes legally obligated to pay on account of any Claim first made against the Insured Person during the Policy Period for a Wrongful Act. • PART B: • The Company shall pay, on behalf of the Organization, Loss for which the Organization grants indemnification to an Insured Person, as permitted or required by law, and which the Insured Person becomes legally obligated to pay on account of any Claim first made against the Insured Person during the Policy Period for a Wrongful Act. • PART C: • The Company shall pay, on behalf of the Organization, Loss which the Organization becomes legally obligated to pay on account of any Securities Claim first made against the Organization during the Policy Period for a Wrongful Act.
Private Company D&O Insurance Coverage • Part C—“Entity Coverage”—may be expanded to cover all “Claims” as defined by Policy. • Part C coverage may not be limited “Securities Claims.”
Definition of “Wrongful Act” Wrongful Act means: (a) any error, misstatement, misleading statement, act, omission, neglect, or breach of duty committed, attempted, or allegedly committed or attempted by an Insured Person in his or her Insured Capacity, or for purposes of coverage under Part C, by the Organization; or (b) any other matter claimed against an Insured Person solely by reason of his or her serving in an Insured Capacity.
Potential Subprime Mortgage Claims That May Trigger D&O Insurance Coverage • Investigations by SEC, Attorneys General or other governmental agencies. • Investor lawsuits alleging omissions or misrepresentations relating subprime mortgage problems. • Claims or actions by employees relating to investments in subprime mortgages by the company in connection with retirement plans/401k’s. • Claims or actions by borrowers against directors/officers (or entities under private D&O insurance) for allegedly improper lending activities.
Definition of Claim Claim means: (a) a written demand for monetary damages or non-monetary relief; (b) a civil proceeding commenced by the service of a complaint or similar pleading; (c) a formal civil administrative proceeding commenced by the filing of a notice of charges or similar document or by entry of a formal order of investigation or similar document; or (d) a criminal proceeding commenced by the return of an indictment against an Insured Person or the Organization under Part C for a Wrongful Act.
Key Issues Under Definition of Claim • “formal” vs. “informal” investigation • Expand to include “subpoenas” and “target” letters • Expand to include “investigations” without limitations
Definition of Loss • Loss means the amount the Insured Person (for purposes of Part A and B) or the Organization (for purposes of Part C) becomes legally obligated to pay on account of any covered Claim, including but no limited to damages, judgments, settlements, pre-judgment and post-judgment interest and Defense Costs. • Typically “Loss” will not include punitive damages, taxes, fines, penalty and the multiplied portions of damage awards. To the extent these items are insurable, they may be included by negotiation. Restitution may not be insurable.
Definition of Defense Costs • Defense Costs means that part of Loss consisting of reasonable costs, charges, fees (including but not limited to attorneys’ fees and experts’ fees) and expenses incurred in defending any Claim and the premium for appeal, attachment and similar bonds. • Defense Costs in a D&O policy typically reduce the available policy limits.
Potentially Applicable D&O Exclusions • Fraudulent/dishonest conduct • Personal profit • Known claims
Other Issues • Claims made feature of policies • Self-liquidating feature of policies • Notice of facts and circumstances that may give rise to a claim • Problems arising from settlement without consent • Need for early notice
Errors and Omissions (E&O) Insurance • The wave of subprime litigation also may trigger coverage under E&O insurance policies. • The Financial Times reports: • Companies being hit by multi-million dollar legal actions are expected to claim on their E&O and D&O policies. • An unnamed underwriter for a leading insurer states that there is “D&O and E&O exposure all over the place. Wherever someone had their fingers in the pie, someone’s going to get sued.” • See “US legal battles over mortgage crisis could cost London insurers,” Financial Times, August 20, 2007.
E&O Overview • Overview of E&O Terms • Differences between E&O and D&O • Potential Claims that May Trigger E&O Coverage • Potential Defenses
What is E&O Coverage? • E&O is the “general rubric” used to describe many types of insurance that protect persons or entities that render “professional services” for liabilities arising from errors or omissions committed while rendering such services, usually for a fee or commission. • Terms vary widely by industry and often are narrowly tailored to “professional services” of particular industry. • Terms vary widely not only by industry, but also by insurer within an industry group.
Typical E&O Insuring Agreement • “To pay on behalf of the Insured all sums which the Insured shall become legally obligated to pay as Damages resulting from any Claims first made against the Insured and reported to the Insurer during the Policy Period … for any Wrongful Act of the Insured or any other person for whose actions the Insured is legally responsible, but only if such Wrongful Act … occurs solely in the rendering or failure to render Professional Services.” • AIG, Mortgage Bankers/Mortgage Brokers E&O Insurance, 63530 (3/96).
Other Common Features of E&O Coverage • Claims-Made Coverage (claim generally must be made against insured during policy period; often claim must be reported to insurer during policy period or set time period thereafter). • Defense (policies vary widely, but certain policies issued to mortgage lenders include a duty to defend, rather than a duty to reimburse defense costs). • Damages (often defined broadly to include all economic losses, but some policies limit coverage for fines, penalties, and/or punitive damages).
Other Common Features of E&O Coverage, cont’d. • “Claim” – wide variation of coverage for regulatory investigations or proceedings. • Some policies expressly include administrative/regulatory proceedings and investigations. • Some policies define “Claim” as “any demand against the Insured for monetary Damages, and includes a lawsuit” (silent on regulatory proceedings). • Some policies exclude Claims brought by any state or federal regulatory or administrative agency.
E&O v. D&O • The line between D&O and E&O is not always clear, and certain lawsuits may potentially trigger coverage under both lines of coverage. • “Professional Services” • D&O policies generally exclude claims related to rendering of “professional services.” • E&O policies expressly afford coverage for “professional services.” • “Insured” • D&O (directors and officers and, in limited circumstances, company and/or employees). • E&O policies often define “Insured” more broadly to include the company itself, as well as directors, officers, employees, and third-parties for whose actions the Insured is legally responsible.
Definition of “Professional Services” • Some policies define “professional services” generically: • One policy defines Wrongful Act as certain errors or omissions committed by the Insured “solely in the performance of or failure to perform professional services for others in the Insured’s Profession as stated in Item 1.A. of the Declarations.” London, Specimen SUA MCPL 04. • Many policies specifically define “professional services” based on industry of policyholder.
Definition of “Professional Services,” cont’d. • Lenders (“the origination, sale, pooling and servicing of mortgage loans secured by real property …”). • Financial Services firms (“services that an Insured renders pursuant to an agreement with a customer or client, as long as the customer pays a fee, commission, or other compensation …”). • Investment Banks (“those services performed … by the Insured (or by any other person or entity for whose acts, errors, or omissions the Insured is … legally responsible) for, for the benefit of, or on behalf of a Customer … for a fee, commission or other consideration”).
Claims That May Trigger E&O Coverage • Given wide array of potential claims and potential defendants, it is difficult to even begin to list the potential types of claims. • Imperative to compare specific allegations against specific policy language.
Claims That May Trigger E&O Coverage, cont’d. • Borrowers suing Mortgage Lenders (Note: policies cover claims related to the “origination, sale, pooling and servicing of mortgage loans”). • Alleged negligent failure to disclose terms of loans (e.g., alleged failure to properly disclose points and pre-payment penalties, failure to disclose teaser rates and adjustable nature of loan, etc.). • Alleged negligent failure to investigate brokers or supervise employees. • Alleged improper reporting to credit agencies. • Alleged statutory violations (Truth in Lending Act / Unfair Competition Act). • Some E&O policies only exclude “willful violations of statutes”; some exclude only certain statutory violations (civil rights laws, antitrust laws, and/or unfair competition statutes); some do not exclude.
Claims that May Trigger E&O Coverage, cont’d. • Issues related to securitization may result in a wave of litigation that may trigger E&O policies. • Investors suing Funds (e.g., misrepresentation, bad pricing, failing to follow investment guidelines, etc.). • Funds/Institutional Investors suing Underwriters/Banks who securitized and sold mortgages (e.g., misrepresenting quality of underlying loans, covering up delinquencies, misrepresenting coverage available for foreclosures, etc.). • Banks suing Trustees who serviced underlying loans (e.g., alleged breaches of fiduciary duties in servicing loans). • Banks suing original Mortgage Lender/Originator (e.g., misrepresentations).
Potential Exclusions and Defenses • Fraud Exclusions. • Final Adjudication standard v. “In fact” standard. • Specific Endorsements excluding claims for “Predatory Lending” claims. • Exclusions barring claims arising from any investor’s interest in mortgage-backed securities or the filing of any registration statement therewith, unless the claim results from the rendering of Professional Services.
E&O Conclusion • Terms of Policies vary widely. • When claims are made, it is imperative for policyholders to review specific allegations and specific policy terms to evaluate potential for coverage and to take steps to preserve rights to coverage.
Strategies for Pursuing Coverage KEY POLICY CONDITIONS NOTICE • Must be in writing • Usually must be given “as soon as practicable” or within limited time period, e.g., 60 days • Actual Claim • Wrongful Act that may lead to claim • Circumstance that “could reasonably be expected to give rise to a claim” • Must be given within policy period or extended reporting period
Strategies for Pursuing Coverage KEY POLICY CONDITIONS NOTICE (cont.) • Often to specific address or specific outside counsel
Strategies for Pursuing Coverage KEY POLICY CONDITIONS DEFENSE AND SETTLEMENT • Defense costs count against policy limits • Some policies require Insurer to defend any claim • Insurer selects and pays counsel • Some policies require Insured to defend, subject to • (a) Insurer’s right to tender defense to Insurer or • (b) Insurer’s option on assume defense • If Insured defends, Insurer typically advances defense costs • If Insured tenders claim to Insurer then Insurer chooses counsel
Strategies for Pursuing Coverage KEY POLICY CONDITIONS DEFENSE AND SETTLEMENT (cont.) • Some policies require Insured to choose from list of panel counsel for particular types of claims, e.g., employment and securities • Regardless whether Insurer or Insured defends, policies require Insurer’s prior written consent for: • Settlement • Admission of liability • Incurring of any defense cost • “Hammer” clauses may limit the Insurer’s obligations where Insured refuses to settle
Strategies for Pursuing Coverage KEY POLICY CONDITIONS ASSISTANCE AND COOPERATION • Insured must assist and cooperate with Insurer at its own cost, including • Submission to examination by Insurer • Attendance at hearings, depositions, etc. • Production of all pertinent records • Negotiation of settlements
Strategies for Pursuing Coverage KEY POLICY CONDITIONS ASSISTANCE AND COOPERATION (cont.) • Some policies require additional due diligence • Reasonable efforts to mitigate actual or potential loss • Maintenance of customary insurance for mortgage banking transactions • Reinstatement or replacement of insurance that lapsed or has been rendered invalid
Strategies for Pursuing Coverage KEY POLICY CONDITIONS ACTION AGAINST INSURER • Most policies state that Insured cannot sue Insurer for coverage unless • Insured fully complies with all policy terms • Insured’s obligation to pay claim has been determined by judgment or settlement
Strategies for Pursuing Coverage KEY POLICY CONDITIONS ACTION AGAINST INSURER (cont.) • Some policies require binding arbitration under American Arbitration Association rules • Some policies have more elaborate dispute resolution provisions that give Insurer sole discretion whether to submit dispute to ADR
Strategies for Pursuing Coverage WAYS COVERAGE CAN BE JEOPARDIZED • Most policies have clause making policy application an integral part of the policy • All statements and information in application are part of the policy • All statements and information in application are “deemed material” to the Insurer’s agreement to insure • Any misrepresentation in application voids policy in its entirety • Some policies are unitary contracts and not severable
Strategies for Pursuing Coverage WAYS COVERAGE CAN BE JEOPARDIZED • Some policies state that misrepresentation does not void policy as to “innocent” insureds • Failure to provide timely notice • Failure to cooperate • Settlement without insurer’s prior written consent • Change of ownership/control
Strategies for Pursuing Coverage PRACTICAL POINTERS • Locate your policies and policy applications for: • E&O • D&O • Mortgage Bankers Bond • Check that your policies are current and have not lapsed • Establish internal procedures for notification of insurers
Strategies for Pursuing Coverage PRACTICAL POINTERS • Be prepared for “No” • Insurers are well aware of potential for significant claims • Insurers will take advantage of any “out” under the policy • Know your history with your Insurer(s) • Many Insureds have never submitted claims to Insurers • How long have you been with Insurer? • What premiums have you paid • Engage competent insurance coverage counsel at early stage
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