Insurance Coverage for the Economic Crisis:

Insurance Coverage for the Economic Crisis:

Hedging Your Financial Losses

Steve Gilford, Proskauer Rose LLP [email protected] Marc Rosenthal, Proskauer Rose LLP [email protected] Jeff Nielsen, Navigant Consulting, Inc. [email protected] John Failla, Proskauer Rose LLP [email protected]

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Topics & Panelists

ƒ Litigation from Financial Crisis

ƒ Insurance Coverage for Key Exposures

ƒ Notice and Renewal Issues

ƒ Proactive Approach to Policies

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Availability of Coverage

ƒ Many of the exposures inherent in litigation from

financial crisis are covered by insurance

ƒ Historic coverage may be relevant

— Claims made (D&O/E&O/EPL) vs. occurrence (CGL) vs. discovery (Fidelity/Crime)

ƒ Need to review carefully and creatively

— The factual allegations are more important than the captions on the counts or complaints

Category #1: Borrowers Class Actions

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Category #1: Borrowers Class Actions

Geneva M. Spicer, et al. v. IndyMac Bank, FSB, et al.

U.S. District Court, Central District of California

(Case No. CV07-3456 AHS)

ƒ Date filed: May 25, 2007

ƒ General allegation(s):

— Alleges IndyMac failed to disclose material information related to option ARMs, concealing that the loan repayment schedule was designed to result in negative amortization

ƒ Claim(s):

— TILA, 15 U.S.C.A. § 1601 & 12 C.F.R. § 226 — California Business & Professions Code § 17200 — California Business & Professions Code § 17500 — Breach of contract

— Breach of the implied covenant of good faith and fair dealing — California Financial Code § 22302

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ƒ Time period at issue: June 1, 2003 – May 31, 2007

ƒ Status:

— Order granting substitution of FDIC as receiver on August 19, 2008

— Stayed until April 13, 2009

ƒ Two types of coverage potentially applicable

— Errors & Omissions (“E&O”)

— Comprehensive General Liability (“CGL”)

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Category #1: Borrowers Class Actions

ƒ E&O insurance

— Covers professional negligence of a lender (bankers, mortgage company or broker)

ƒ Indemnity for claims made during the policy period against the insured for wrongful act in professional capacity

— Claims made coverage

— Wrongful acts broadly defined

ƒ “any act, failure to act, error, omission, breach of contract or duty or libel or slander” committed or allegedly committed in the insured’s professional capacity

ƒ Generally will not cover ministerial acts

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Category #1: Borrowers Class Actions

ƒ Key E&O exclusions

— Fraud

ƒ Typically applies only on final adjudication

— “This policy excludes any Claim alleging the fraud or dishonesty of any Insured, if a final judgment or other final adjudication shall establish, or the Insured shall admit in writing, that such fraud or dishonesty was committed”

— Return of fees

ƒ “This Policy excludes claims for return, withdrawal or reduction of

fees”

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— RESPA cases for failure to properly disclose fees

ƒ Insurer claimed return of fees not covered

ƒ Court held return of fees was part of compensatory damage arising

from insured’s breach of fiduciary duty and therefore covered

— “For” vs. “arising out of”

ƒ Language in exclusion may determine whether negligence or

derivative liability claims are excluded

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Category #1: Borrowers Class Actions

ƒ CGL

— Occurrence based so may reach back in time — Triggered by time of the act

ƒ Not date of claim or discovery

— CGL policies are generally limited to coverage for liability due to “bodily injury”, “property damage”, “personal injury” or “advertising injury”

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Category #1: Borrowers Class Actions

ƒ Advertising injury under CGL policy

— Must be advertising

— Some cases require injury to a competitor

— Most modern forms limit coverage to copyright and trademark infringement or misappropriation of advertising idea

— Some policies are not so limited and may cover liability for falsehoods in advertising

ƒ Personal injury

— Some CGL policies, particularly older ones, include coverage for “discrimination” as part of “personal injury”

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ƒ For example:

— Personal Injury means injury covered by an offense of:

ƒ False arrest, false detention or other false imprisonment ƒ Malicious prosecution

ƒ Wrongful entry, wrongful eviction or other violation of a person’s right to private occupancy

ƒ Electronic, oral or written publication of material that libels or slanders a person or violates a person’s right of privacy

ƒ Discrimination, harassment or segregation based on a person’s age, color, national origin, race, religion or sex

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ƒ Case law is mixed as to whether such references to discrimination

extend beyond discrimination based on race, religion, gender, etc.,

particularly in employment context

— Majority of cases are limited

ƒ Some discriminatory lending practice claims include protective class

— Some cases find coverage for price discrimination or discrimination in home maintenance under Fair Housing Act

ƒ Courts find that “discrimination” merely means “differential treatment”

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ƒ Duty to defend

— Advantage of CGL policy is that it often includes duty to defend — E&O may or may not

ƒ Duty to defend is normally based on allegations of complaint

— Claim only needs to be potentially covered

— If duty to defend, it normally extends to whole case even if some claims are not covered

ƒ Where there is a duty to defend, issuance of reservation of rights

creates conflict between insurer and insured

— Under the circumstances, in most states, insured can pick counsel and control defense at insurer’s expense

Category #2: Securities (D&O) Claims

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Category #2: Securities (D&O) Claims

Corporation, et al. U.S. District Court, Central District of California (CV 07-00931 DDP)

ƒ Date filed: February 8, 2007

ƒ General allegation(s):

— Plaintiffs (purchasers of various New Century securities) allege GAAP violations related to loan loss allowances, repurchase reserves, among others, related to the company’s whole loan sales and securitizations.

ƒ Claim(s):

— ’33 Act § 11, 15

— ’34 Act § 10(b) & Rule 10b-5, 20(a)

ƒ Time period at issue: May 5, 2005 – March 13, 2007

ƒ Status:

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ƒ Key sources of insurance coverage:

— Directors & Officers Liability — E&O

— Investment Advisor Professional Liability

ƒ Directors & Officers liability insurance

— Protects directors and officers against claims for loss arising from actual or alleged wrongful acts done in their role as directors or officers

— Public Company D&O often covers “Securities Claims” against the Company as well as numerous types of claims against the individuals — Private Company D&O often covers a wider variety of claims against

both the entity and the individuals

— Not all policies contain Entity coverage

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ƒ Although most D&O policies contain similar general provisions, their

language varies greatly and manuscripting and revisions are both

possible and very productive

ƒ Even what appear to be small and technical language changes often

pay enormous dividends in obtaining payment

ƒ D&O exclusions of concern

— Fraudulent, dishonest, willfully illegal conduct

ƒ Often requires final adjudication as discussed above

— Personal profit to which insured is not entitled

ƒ Critical language distinction

— “in fact” vs. “final adjudication”

— Professional services or E&O exclusions

ƒ “For” or “arising out of” predicate is key

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ƒ D&O coverage should address most of the securities lawsuits arising

from the financial crisis

— Stock drop cases

— Alleged misrepresentations about asset quality, exposure to risk

— Failed deals, financing issues, alleged broken investment promises or commitments

ƒ Three important points to consider at the outset

— Quality and extent of coverage for securities claims — Investigation, criminal and regulatory coverage — Defense coverage and the duty to defend

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ƒ Quality and extent of coverage for securities claims

— Two common but alternative formulations in D&O policies

ƒ Coverage only for claims involving securities issued by the insured company — Restrictive coverage – fine for stock drop cases or claims involving

misrepresentations or omissions involving insured company securities — Policies with this formulation will exclude coverage for broader securities

claim risks

ƒ Coverage for claims that involve any violations of securities laws or regulations

— Broken deal, financing, investment cases covered — Example: Apollo Hexion Huntsman Litigation

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ƒ Investigation, criminal and regulatory coverage

— Common misconception that coverage is limited or unavailable

— Key is to ensure that coverage applies as early in the investigatory process as possible

ƒ Significant costs often incurred in early stages

— Common policy provisions contain important nuances

ƒ Most restrictive

— Formal administrative, criminal or regulatory proceeding ƒ Formal administrative, regulatory, or criminal investigation

— Can be triggered by subpoena, formal order of investigation, notice of charges, or Wells notice – substantial differences

ƒ Formal or informal regulatory investigations or inquiries — Wells notices

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Category #2: Securities (D&O) Claims

ƒ Defense coverage and the duty to defend

— Standard provisions are not optimal for policyholders

ƒ No duty for insurer to assume defense

ƒ Sometimes no obligation to advance or reimburse costs as incurred

ƒ Obligation of D&Os to return advanced defense costs if ultimately determined no coverage exists

ƒ Unfavorable allocation provisions

ƒ Positive developments for policyholders

— Language enhancements provide for contemporaneous advancement or reimbursement

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ƒ Advancement or reimbursement decided on same standard as duty

to defend

— Based on allegations of complaint — No need to wait until case concluded

ƒ Claim only needs to be potentially covered

ƒ If duty to defend, it normally extends to whole case even if some claims are not covered

ƒ Injunctive relief available to compel insurers to advance

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ƒ New York Insurance Department Office of General Counsel Opinion

No. 08-10-07 (October 16, 2008)

— Unlawful under New York law for D & O insurers to issue policies that impose the duty to defend on policyholders instead of insurers

— Unlawful to impose allocation provisions that restrict insurers’ duty to defend the entire case if an allegation potentially triggers coverage for a portion of the case — Applies to sophisticated policyholders

— Positive implications for policy negotiation and claims handling — Caution required to ensure control of the defense

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ƒ Investment management liability coverage

— Mutual fund complex, private funds, private equity, hedge funds, venture capital

— Auction rate securities, money funds, investor claims challenging disclosure, risk, investment decisions

— Broad D&O, E&O coverage

— Key issues involve program structure (combined or separate funds-only coverage) and “limits adequacy”

Category #3: Contract Claims

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MBIA Insurance Corporation v. Countrywide Home Loans, Inc., et al. Supreme Court of the State of New York

(Case No. 08602825)

ƒ Date filed: September 30, 2008

ƒ General allegation(s):

— Countrywide breached certain representations and warranties related to home equity loans sold into securitizations for which MBIA provided

credit enhancement. Countrywide subsequently refused to repurchase said loans.

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MBIA Insurance Corporation v. Countrywide Home Loans, Inc., et al.

Supreme Court of the State of New York

(Case No. 08602825) (cont’d)

ƒ Claim(s):

— Fraud

— Negligent misrepresentation

— Breach of contract – insurance agreement

— Breach of contract – sale and servicing agreement — Breach of implied duty of good faith & fair dealing — Indemnification

ƒ Time period at issue: 2005 – 2007

ƒ Status:

— Active

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Category 3: Contract Claims

ƒ E&O coverage

— Contractual liability exclusion

— Exclusion often does not apply if the policyholder would face similar liability in the absence of the contract provision

ƒ e.g., negligent misrepresentation and contract

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Category 3: Contract Claims

ƒ Fidelity bond or crime coverage

— Not limited to embezzlement

— Often broad coverage extensions in endorsements

— Endorsements covering losses for mortgage securitization or mortgage pooling and other financial instruments

ƒ Often covers losses due to forgery or alteration

ƒ Broader coverage where payor signature obtained through trick, fraud or false pretenses or where mortgage note is “for any other reason illegal, invalid, non binding or not enforceable in accordance with its terms.”

Category #4: Employee Action

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Category 4: Employee Action

Michele Viera, et al. v. Accredited Home Lenders Inc. et al. U.S. District Court, Western District of Texas

(Case No. A07CA71988)

ƒ Date filed: 8/24/2007

ƒ General allegation(s):

— Accredited Home Lenders Inc. failed to give at least 60 days advance notice prior to terminating former

employees without cause. Subsequently, said employees failed to receive wages and other employee fringe benefits for a 60-day period following their respective terminations.

ƒ Claim(s):

— WARN Act § 2101

ƒ Time period at issue: August 10-22, 2007

ƒ Status:

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ƒ CGL and D&O policies often exclude employment related claims

ƒ EPL policies

— Typically claims made, regardless of when conduct or injury took place

— Covers discrimination, harassment, wrongful termination, wrongful failure to hire or promote and other wrongs arising from the employment context

ƒ Generally includes a laundry list of offenses

— Typically includes duty to defend

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ƒ Important EPL exclusions

— ERISA and benefits claims

ƒ Claim may include wrongful termination as well as mishandling of ERISA benefits plan

ƒ ERISA claims would be covered by ERISA fiduciary liability policy

— Fines, penalties and injunctive relief

ƒ Intentional acts

— Claims of discrimination, sexual harassment and wrongful termination are frequently based on intentional acts

— General rule is that a liability policy covers unintended results of intentional acts

— Not really an intentional acts exclusion – but, rather, an intentional harm exclusion

— Intent to harm will not necessarily be inferred in discrimination and harassment type claims

Category #5: Bankruptcy Claims

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Category 5: Bankruptcy Claims

Mortgage Lenders Network USA, Inc. v. Merrill Lynch Bank USA et al. U.S. Bankruptcy Court, District of Delaware (Case No. 07-10146 PJW)

ƒ Date filed: March 31, 2007

ƒ General allegation(s):

— Merrill Lynch Bank USA received certain preferential and fraudulent transfers prior to the Chapter 11 bankruptcy of Mortgage Lender

Network USA related to mortgage collateral securing certain warehouse lines of credit.

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Category 5: Bankruptcy Claims

Mortgage Lenders Network USA, Inc. v. Merrill Lynch Bank USA et al. U.S. Bankruptcy Court, District of Delaware (Case No. 07-10146 PJW)

ƒ Claim(s):

— Uniform Commercial Code § 9-625(b)

— Uniform Commercial Code § 9-608(c) & 11 U.S.C. § 542 — Avoidance of preferential transfers, 11 U.S.C. § 547 & 550 — Breach of repurchase agreement

— Avoidance of fraudulent transfers, 11 U.S.C. § 548 & 550

ƒ Time period at issue: Chapter 11 filed February 5, 2007

ƒ Status:

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ƒ Claims like preferences and fraudulent conveyances are not usually

covered

— Case law generally holds return of moneys not entitled to are not an insurable loss

— But misrepresentations may be covered

ƒ Bankruptcy presents an array of issues, especially for creditors

— Claim by trustee vs D&Os presents issues of who owns the D&O policy

ƒ The company or the D&Os

— If the company owns the policy, it may be property of the estate and the automatic bankruptcy stay may preclude D&O access to policy even though claims against D&O continue

— Seriously complicates order of payment and ability to obtain advances for defense

ƒ Absent “order of payment” provision in the policy, normally has to be resolved by agreement or litigation

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ƒ Some of these issues may be avoided by purchase of commercially

available clauses

— Side A only coverage

— 100% allocation to D&Os where company is co-defendant

ƒ usually for securities claims

— Order of payments clause

ƒ Pay D&Os first

ƒ Next pay company for indemnity paid to D&Os ƒ Last pay claims against company

Notice and Renewal Issues

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ƒ Prompt notice is key

— Claims made and occurrence policies require prompt notice of a claim — May hinge on knowledge of risk manager or general counsel

— Failure to give notice may preclude coverage even without prejudice to insurers

ƒ Whether prejudice required varies by state

ƒ New York’s recently enacted Chapter 388 repeals state’s “no prejudice” rule for personal injury or property damage claims under occurrence-based

policies, but generally does not impact on coverages discussed today (possible exception of CGL discrimination claims)

ƒ Notice of circumstances

— Most claims made policies permit notice of circumstances to tie

circumstances which have not yet resulted in a claim to an expiring policy

— Some claims made policies require such notice

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ƒ Exclusions typically preclude coverage for claims or circumstances

likely to give rise to a claim known before inception of policy

ƒ Application typically requires disclosure of claims or circumstances

likely to give rise to a claim

— Many applications require warranties of no such claims or circumstances

ƒ Unless existing claims are likely to exhaust coverage, important to

“shake the trees” to identify and notice all existing claims and

circumstances under an expiring policy by appropriate deadline

ƒ Establishment of paper trail and procedures helps to defend insurer

claims of inadequate disclosure and rescission

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ƒ Interplay of notice of circumstance and renewal application

requirements can raise significant issues

— Notice of circumstances typically requires “full particulars”

ƒ Insurers want particulars so can identify what is noticed

ƒ Insurers may contend notice of circumstance is insufficient without them

— Renewal application and required warranty may seek broader disclosure of any event which may lead to a claim

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Notice and Renewal Issues

ƒ Example

— Bank issued mortgage backed securities, but not sued or threatened with suit

— Other banks issuing similar instruments were sued

ƒ Shareholders and employee benefit plans claiming negligence or failure to disclose

— Do you disclose?

ƒ As circumstance? At renewal?

ƒ Insurers will argue insufficient particulars for notice of circumstance

on expiring policy

ƒ If not disclosed, insurers will argue for rescission based on material

omission in application leading to rescission

— May rescind as to all claims

— Particularly problematic under UK law where arguably required to disclose all material information to underwriters even if not requested

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ƒ Important to make notice decision early enough to permit insurer

response and renewal

ƒ If give notice of circumstances, easy to give notice on renewal

ƒ If notice of circumstances is not required, more pressure on

renewal disclosure

ƒ Case-by-case analysis

— Standard not same (probable/possible/likely) but need to coordinate with those responsible for securities and Sarbanes Oxley compliance

Provisions to Seek on Renewal

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Provisions to Seek on Renewal

ƒ Important Provisions to Review and Revise

— Loss definition

ƒ Contains buried exclusions

— Must ensure explicit coverage for Section 11 and 12 claims under 1933 Act to avoid disgorgement, ill-gotten gains, uninsurable as a matter of law restrictions

— Critical importance because many of latest filings in financial crisis cases are state court Section 11 and 12 cases

ƒ Conduct exclusions

— Final adjudication — Severability

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ƒ Allocation

ƒ Application and rescission protection

— Materiality threshold — Severability

— Limits on application materials

ƒ Claim cooperation, settlement approval, and hammer provisions

ƒ Exclusions of significance to particular businesses

— Professional services — Libel and defamation — Environmental

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ƒ Excess layer issues

— Follow form

ƒ Beware of inconsistent provisions and additional exclusions

ƒ Representation and warranty letters and application severability – REFCO example

ƒ Exhaustion and attachment traps

— Avoid excess policies that will not pay unless the underlying insurers actually pay their full policy limits

— Insolvency of underlying insurer or settlement with primary or lower level excess insurer for less than full limits could cause massive

program failure

— Avoid sharing of limits clauses

— Insist on language that requires excess policy to attach if underlying insurer OR policyholder pays the underlying limits and which has insolvency protection

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Provisions to Seek on Renewal

ƒ Protecting against insurer insolvency

— Often unpredictable and rapid

— Can use ratings downgrade clauses with pro-rata premium return — Better to address through program structure

ƒ Excess program with more layers and diversity of insurers — Language, cost and capacity issues

ƒ Quota share programs

ƒ Reinsurance cut-through (captive and industry insurer groups)

ƒ Flex excess policies – upper layer resembles umbrella policy and drops down to cover lower insolvent layer

ƒ DIC coverage to protect individuals against rescission, insolvency, coverage denial, exclusions

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Questions & Answers

Steve Gilford, Proskauer Rose … (312) 962-3510 … [email protected] Marc Rosenthal, Proskauer Rose … (312) 962-3530 … [email protected] Jeff Nielsen, Navigant Consulting … (202) 973-4506 … [email protected]