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Lessons for insurers from financial crisis litigation
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Lessons for insurers from financial crisis litigation

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Lessons for insurers from financial crisis litigation Lessons for insurers from financial crisis litigation Presentation Transcript

  • Dentons US LLP INSURANCE LITIGATION Lessons from the Financial Meltdown January 2014
  • The Fulcrum of Post-Financial Crisis Litigation We are now through 5+ years of fallout from the financial crisis Centered on both litigation between financial institutions and regulatory investigations Most matters focused on the collapse of structured financial products Many involve money center banks, investment banks, hedge funds and other financial investors But global insurers have suffered their share of actual or threatened losses from failed financial instruments which they insured or in which they invested Not surprising, given that insurers have over $6.8 trillion in invested assets January 2014 Dentons US LLP 2
  • Where Did the Exposure Come From Over the past 10-15 years we saw multi-line insurers competing with mono-line insurers and banks to offer credit enhancement for financial products as an avenue to expand premium revenue and margins Mono-line carriers also expanded their role well beyond traditional municipal finance Credit enhancement came in the form of surety bonds, credit default swaps, debt service insurance policies and other policies to ensure payments to noteholders and investors Insurers provided credit wrapper for an array of financial products, including collateralised debt obligations (CDOs), mortgaged backed securities (MBS), and other securitized and pooled assets January 2014 Dentons US LLP 3
  • What Was the Anticipated Return The attraction: Transactions insured were supposed to be overcollateralized • Even if a portion of underlying assets defaulted, zero insurance payments anticipated • So called “zero-loss” underwriting • Insurers lend their balance sheet and credit rating, with minimal risk, if at all The result: Transactions collapsed and huge insurance payments required • Some losses were perhaps inevitable due to depth of crisis • But insurers were also victimized by misrepresentations or Ponzi schemes, and other financial frauds, and broken promises January 2014 Dentons US LLP 4
  • Lessons for Insurers Who do you underwrite and who does the underwriting? How have the Courts viewed the insurer’s role and conduct? The Regulators are coming Get used to being a plaintiff January 2014 Dentons US LLP 5
  • Who Do You Underwrite and Who Does the Underwriting First principles: What is the risk the insurer is underwriting? • With credit enhancement insurance, the proper direction and focus of underwriting was less certain • Was it the risk of underlying assets defaulting or that the sponsoring entity was a fraudulent enterprise? • The legitimacy of individual assets or the credit-worthiness of the pool • The principals on a series of loans or leases, or the entity pooling and selling those obligations or income streams to third parties Insurers must be clear on where to train their sights – what is the true risk and, thus, the right entity to underwrite January 2014 Dentons US LLP 6
  • Case Study: Commercial Money Centers • Equipment leasing business, that pooled and sold the lease income streams, totaling hundreds of millions of dollars, to institutional investors • Lease payments were insured by a broad group of sureties • In typical tri-party surety relationship, surety would focus on the principals, in this case the underlying equipment lessees • But the risk in these transactions was that CMC was an illegitimate enterprise or could not properly manage the enterprise • After years of litigation, court handling multi-district proceeding decided that remaining sureties would not have to pay on their bonds if they could prove they were fraudulently induced to issue the bonds • Key issue in the fraud jury trial was whether sureties were limited to showing that underlying leases were product of fraud or that they were fraudulently induced to insure the overall program January 2014 Dentons US LLP 7
  • So Who Does the Underwriting The Corollary: Who underwrites the risk that has been identified • What you cannot understand, you cannot underwrite • As complexity of the transaction increases, demands on the underwriters increase • Need to assess both the underlying assets and the sponsor, and how the transaction is structured and managed • May require different skill sets, tools, analytic models and support • For fraud claims, reasonable or justifiable reliance will be tested based on quality of the underwriting January 2014 Dentons US LLP 8
  • The Courts Weigh In Given the locus of key players in the financial industry, not surprising that many instructive decisions are emanating from federal and state courts in New York Intensive focus on facts and documents for each case But certain trends are emerging in the rulings January 2014 Dentons US LLP 9
  • You Are Likely to be Viewed as a Sophisticated Party Bottom line: if you are an insurer or other financial institution, you are likely to be judged as a sophisticated party Rationale: Whether you have the requisite knowledge and experience, you have the financial resources to pay for outside experts HSH v. UBS, 95 A.D. 3d 185 (1st Dept. 2012) HSH, a German regional bank, had alleged it had “little relevant experience in synthetic CDO’s based upon U.S. real estate assets.” Court rejected HSH’s position: “If HSH believed that it lacked sufficient expertise to evaluate the NS4 transaction unassisted, it was free to retain qualified outside consultants to render independent advice concerning the risks of the deal.” ACA Financial Guaranty Corp. v. Goldman Sachs, 106 A.D. 3d 494 (1st Dept. 2013), involving the much criticized ABACUS synthetic CDO, Court similarly focused on its view that ACA was a “highly sophisticated commercial entity.” January 2014 Dentons US LLP 10
  • Representations Outside the Transaction Documents Corollary to concept of sophisticated parties, has been enforcement of disclaimers of duties and warnings in offering circulars and other transaction documents Difficult, but possible, to sustain fraud claims in the face of these provisions See ACA v. Goldman • Misrepresentations contradicted by written disclosures • Difficult to prove justifiable reliance in light of “no reliance” provisions • Ability to obtain truthful information elsewhere But see Dodona I LLC v. Goldman Sachs, 10 Civ. 7497 (VM), upholding both securities and common law fraud claims • Detailed factual recitation concerning transaction GS believed was doomed • "Make some lemonade from some big old lemons" Courts have also allowed cases to proceed on breach of contract claims, whether tied to offering provisions or promises in side letters or oral agreements January 2014 Dentons US LLP 11
  • The Regulatory Challenge Heightened regulatory scrutiny and investigations, as all levels of government react to the financial crisis and the failure of major institutions State Insurance Departments generally have had primary enforcement responsibilities over insurers But state Attorneys General, particularly in NY, have taken a more aggressive approach (e.g., forced placed insurance) Federal agencies such as the Consumer Financial Protection Bureau are also taking an active role (e.g., mortgage insurance) Federal Insurance Office, and its Director, Michael McRaith, charged under Dodd-Frank with monitoring all aspects of the insurance industry • December, 2013 release of Modernization Report • Hybrid State-Federal model for insurance regulation • Specific focus on changing marketplace and the financial crisis January 2014 Dentons US LLP 12
  • Insurer as Plaintiff Insurers are increasingly finding themselves on the plaintiff’s side of the equation in post-crisis litigation The reality is that in many of the failed structured products, insurers were counter-parties with exposure similar to investors • Primary difference that insurers paid off note holders • To recoup losses, insurers had to seek recompense from sponsors or counter parties In many of the seminal decisions or cases being litigated, insurers are the plaintiffs Insurers have also commenced high profile claims on their portfolio investments Need for aggressive mindset to pursue these claims January 2014 Dentons US LLP 13
  • Conclusion Insurers have learned to think twice about deals they do not fully understand No such things as a guaranteed no-lose/zero loss proposition Every potentially insured deal must be underwritten with fresh eyes and a fresh approach on its individual term and merits January 2014 Dentons US LLP 14
  • Questions? January 2014 Dentons US LLP 15
  • Contact Information Michael Barr US Senior Partner and Member of the Global Board D +1 212 768 6788 michael.barr@dentons.com January 2014 Dentons US LLP 16