Directors And Officers Liability Insurance And Subprime Mortgage Crisis Related Litigation

Thursday, May 1, 2008 - 01:00

The inevitable, and presently occurring, increase in litigation arising out of the subprime mortgage crisis will have wide-ranging effects on many businesses. One way a company can properly brace itself for this litigation onslaught - or any risk of litigation - is to understand the nature and extent of its Directors and Officers ("D&O") insurance coverage.

The Subprime Mortgage Crisis

While the current crisis is affecting all areas of lending, it is most acute with residential mortgages, and the practice of "subprime" lending, where lenders issued loans to borrowers who didn't qualify for market interest rates because they had bad credit or insufficient income for the size of the loan. The "crisis" refers to a sharp rise in home foreclosures that started in the fall of 2006 due to an increase in defaults on subprime mortgages.

The origin of the crisis is quite complex, but the most immediate and identifiable causes are rising interest rates and declining property values. For some time leading up to the fall of 2006, property values were increasing dramatically. Interest rates at this time were at record lows, allowing prospective homebuyers to borrow large amounts and still have seemingly "comfortable" monthly payments. This led to increased sales even as real estate prices continued to increase, creating massive inventories of subprime loans. Then, as interest rates rose, the subprime borrowers with variable interest rate loans saw a significant increase in their monthly mortgage payments, which often led to default and foreclosure. The concomitant drop in property values meant the borrowers suffered significant losses in equity and lenders were unable to recover the full value of the losses from defaults.

The effect of the crisis has expanded to include more than just lenders and borrowers, however. A company that purchased any mortgage-backed security is at risk to suffer - or already has suffered - significant investment losses. Mortgage-backed securities ("MBS") are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental,or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization.1

Potential exposure to the subprime mortgage crisis also exists for any company that invests in collateralized debt obligations (CDOs), which includes collateralized loan obligations (CLOs) and collateralized bond obligations (CBOs). CDOs are simply securitized interests in pools of assets. They are called CLOs or CBOs if the pool of assets is limited to only loans or bonds, respectively. Since there are many different kinds of companies that invest in MBSs and CDOs, the scope of potential exposure is expansive. Add these corporations to the borrowers, lenders, companies, and persons involved in any aspect of real estate transactions, and the subprime mortgage crisis affects the bottom line of many individuals and companies.

The Subprime Mortgage Crisis Litigation Effect

There are several different ways in which the subprime mortgage crisis has led to litigation. Examples include: borrowers and regulators suing lenders for predatory practices; financial institutions, trustees, and insurers suing lenders for issuing risky loans; lenders suing banks to recoup their losses; investors suing financial institutions and trustees to recoup losses in their investments; pension holders suing pension funds for breach of fiduciary duty under the Employee Retirement Income Security Act of 1974 ("ERISA"); and shareholders suing their corporations, lenders, accountants, trustees, and underwriters for deceptive practices.

Shareholder derivative class action lawsuits are the most significant type of subprime mortgage crisis related litigation. The potential exposure from such litigation is enormous and could have a large financial impact on the entity and individual directors and officers being sued. Further, given the focus on securities violations, such lawsuits could arise out of or lead to regulatory action. The most common lawsuits in this area involve shareholders accusing companies and their directors and officers of mismanaging MBSs, and/or for improper disclosure of MBS investments. Generally, in these cases, shareholders accuse the directors and officers of making misleading statements concerning subprime investments to artificially inflate the price of the company's stock.

Subprime related securities lawsuits have been brought against Bear Sterns Co., AIG, Inc., Citigroup, E*Trade Financial Corp., HSBC Holdings, Moody's Co., Toll Brothers, and Washington Mutual, Inc. Of the many such cases filed in the past year, almost all of them named individual directors and officers as defendants.

Understanding D&O Insurance In The Context Of The Subprime Mortgage Crisis

The subprime mortgage crisis, and the resulting litigation, identifies the need for every company, including companies that may not be affected by this specific problem, to review and understand its D&O liability insurance coverage. The anticipated increase in D&O claims raise a variety of issues, specifically related to the availability of insurance coverage. Therefore, it is important to review several common policy provisions that may affect coverage for a claim against an individual director or officer based upon "subprime" related facts.

a. Definition of "Loss"

The definition of "loss" typically includes the total amount an insured becomes legally obligated to pay as a result of a claim. The specific definition of loss in each policy is important because liability for subprime related activity often involves regulatory action against a company for violations of securities laws, resulting in the imposition of civil or criminal fines or penalties. Most D&O policies specifically except civil or criminal fines or penalties from the definition of loss, which will result in uninsured losses for the company or the individuals.

b. Unjust Profit and Criminal Acts Exclusions

Similarly, most D&O policies specifically exclude from coverage any liability for claims made against an insured arising out of the gaining "in fact" of any unjust profit, or arising out of the committing "in fact" of any deliberate criminal or deliberate fraudulent act. This is an important consideration because the securities actions likely to arise out of the subprime mortgage crisis will typically involve allegations of unjust profits, fraudulent schemes, and/or criminal violations of securities laws.

In general, the language of these exclusions states that a determination "in fact" must be made, meaning the availability of insurance coverage depends upon whether the allegations "in fact" happened. Policies typically don't define what "in fact" means, or what is required for an "in fact" determination. However, the relevant case law generally holds that an "in fact" determination requires that the issue be specifically adjudicated against an insured.

The actual impact these exclusions have on coverage must be considered in light of the allegations in the lawsuit and the conduct at issue, as well as the state law being applied when interpreting the exclusions. The availability of coverage may be significantly limited by these exclusions and should be carefully considered in the event a claim is made.

c. Continuity Date Provisions

Another factor to consider in connection with the availability of D&O coverage for subprime mortgage crisis related litigation is the Continuity Date provisions of the policy. Often, a D&O policy includes a Continuity Date, which will bar coverage for liability arising out of an incident that the insured had notice of prior to the Continuity Date. In these circumstances, coverage would be precluded even if the claim was filed within the applicable policy period. It is possible that a company involved in subprime mortgage crisis related litigation has been subject to a prior SEC proceeding or investigation, or that prior lawsuits were commenced based upon conduct now relevant or related to a claim arising out of the subprime mortgage crisis. In order to ascertain the availability of coverage under an applicable policy, an examination into whether any such proceeding or investigation took place, and the earliest date of any such proceeding or investigation, is necessary.

d. Severability Endorsements

Most D&O policies contain severability provisions that insulate one insured from losing coverage because of facts known by or committed by another insured under the same policy. Therefore, while certain insureds may not be covered, coverage for "innocent" insureds would typically be preserved. This is important because liability arising out of subprime mortgage crisis related lawsuits may involve only a few directors with knowledge of the specifics of the company's investment in or management of MBSs and/or CDOs. In order to properly determine the extent of coverage, an investigation into the actual knowledge of the relevant directors, and which directors may be within the terms of any severability provision, is essential.

e. Possibility of Rescission

There is a possibility that a D&O insurance policy could be rescinded in circumstances likely to occur in subprime mortgage crisis related litigation. For example, a Federal Appeals court recently held that the insured's misrepresentation in its latest 10k report filed with the SEC, at the time the policy was issued, was grounds for rescission of the policy.2The court found that the financial statements provided were misleading and material, and were relied upon in issuing the policy, but remanded the case to determine if the misrepresentation was intentional. Because the foundation of many subprime related cases is a misrepresentation of the company's financials by the directors and officers, a company should carefully consider what disclosures were made to its insurer at the time of the application or renewal.

Conclusion

The recent subprime mortgage crisis has already led to an increase in litigation, particularly litigation against directors and officers, which is likely to continue. As with the risk of any litigation, an understanding of the D&O policy provisions most likely to be relevant to any claim is essential to ensure that the terms, conditions, and scope of insurance coverage are consistent with expectations.

1 www.sec.gov/answers/mortgagesecurities.htm .

2See ClearOne Commc's, Inc. v. Nat'l Union Fire Ins. Co., 494 F.3d 1238 (10th Cir. 2007).

John T. Wolak, a Director in the firm's Business & Commercial Litigation Department, is the Insurance Practice Team Leader. He represents clients in a wide range of commercial matters, with an emphasis on insurance counseling and complex insurance coverage litigation. Andrew B. Smith, an Associate in the deparment, handles all aspects of litigation on a wide range of substantive matters for corporate clients.

Please email the authors at jwolak@gibbonslaw.com or absmith@gibbonslaw.com with questions about this article.