Is it Raining in the Garden of Financial Institutions? · Is it Raining in the Garden of Financial Institutions? Liability Academy 2009 Nilam R. Sharma, Esq. Michelle A. Jones,

Privileged and Confidential

Presentation to

Is it Raining in the Garden of Financial Institutions?

Liability Academy 2009

Nilam R. Sharma, Esq.Michelle A. Jones, Esq.Patricia Connally, Esq.

Privileged and Confidential 2

“Is It Raining in the Garden of Financial Institutions?”

1. Overview of the U.S. – Regulatory Reforms and Claims Activity.

2. Overview of the Non U.S. – Regulatory Reforms and Claims Activity.

3. Developments and Trends in FI/D&O/E&O Wordings.

4. Claims Scenario.


Overview of the U.S. Markets:Regulatory Reforms and Claims Activity

Presented by Patricia M. Connally, Esq.

October 2009


U.S. Financial Regulatory Bodies

BANKS

FEDERAL RESERVE DEPARTMENT

of TREASURY

Restrain InflationAnd Promote

Economic GrowthManage Federal Finances

Regulate Banks


Duties of the SEC

» Interpret federal securities laws;» Issue new rules and amend existing rules;» Oversee the inspection of securities firms, brokers,

investment advisers, and ratings agencies;» Oversee private regulatory organizations in the

securities, accounting, and auditing fields; and» Coordinate U.S. securities regulation with federal, state,

and foreign authorities.


SEC Enforcement Areas

» Misrepresentation or omission of important financial information about securities;

» The manipulation of the price of a security;» Stealing from customer funds or securities;» Violation of broker/dealer obligation to treat investors

fairly;» Insider trading; and» The selling of unregistered securities.


What are the Hot Claim Areas?

» Ponzi Schemes» FCPA – U.S.» F-Cubed Litigation» Credit Crisis Litigation

– Bankruptcies– Bank Loan Loss Reserves– Auction Rate Securities– Misstatement/Misrepresentation

» Options Backdating


Ponzi Schemes

“Only when the tide goes out do you discover who’s been swimming naked.” -- Warren Buffet

» SEC filed 40 Ponzi scheme investigations from January to August 2009

» 20% of private securities actions filed in first half 2009 raise Ponzi allegations

» Wide pool of defendants» Coverage litigation has begun with policyholders

advancing claims for coverage under wide range of policies


Bernard Madoff

Madoff losses now estimated near $65 billion


Madoff Fallout: Private Class Actions

» Numerous class action lawsuits filed against Madoff and BMIS.

» Theories of recovery include:– RICO – Violation of Securities Exchange Act Section 10(b) – Violation of Securities Act Section 12– Fraud, Negligent misrepresentation– Breach of fiduciary duty– Violations of general business law – Conversion– Unjust enrichment


Madoff Fallout: Feeder Funds Litigation

» SEC, state regulators and the public have filed suit against the “feeder funds” that invested clients’ money with Madoff.

» SEC or state regulators have filed securities complaints against the largest feeder funds:– Fairfield Greenwich (Walter Noel)– Massachusetts Action– Ascot Feeder Fund (Ezra Merkin)– NY Attorney General Action– Stanley Chais – SEC Complaint– Cohmad (Sonny Cohn and Robert Jaffe) – SEC Complaint

» Private Suits (shareholder class action and derivitive suits) allege that defendants:– Breached their fiduciary duty by failing to protect and manage investors’

assets “with care, diligence and the highest degree of good faith” and by failing to conduct even minimal diligence in the face of red flags.

– Intentionally concealed their relationship with Madoff from clients.– Breached agreements by placing a substantial portion of clients’ funds

with a single investment company


Ensuing Litigation: Auditors» KPMG, Ernst & Young and BDO Seidman have also been sued for

their failure to discover the Madoff fraud in the course of their audits of feeder funds

» Allegations against KPMG include:– KPMG was required to review and consider risk factors for fraud, but

had no controls for evaluating Madoff’s returns– KPMG relied excessively on management representations – KPMG was grossly negligent in failing to perform due diligence in

audits – KPMG failed to comply with Generally Accepted Auditing Standards

» Maxam Absolute Return Fund, a feeder fund created solely to invest in Madoff, has sued its own auditors (Mcgladrey & Pullen) for failing to detect the Madoff fraud


Ensuing Litigation:Madoff Coverage Litigation» Four suits filed so far but more to be expected.» Two seek to recoup Madoff losses under crime/theft provisions of

policies» One seeks to recoup Madoff losses from employee pension fund

under company E&O policy (as well recoup Company’s own losses under crime policy)

» Mass Mutual (parent company of several feeder funds) most recently filed suit in Delaware seeking coverage under D&O policies (for individuals) and under fidelity bond policies (for corporate entities)

» Surprisingly, first coverage class action filed against insurers was recently filed against AIG/Chartis under homeowners’ insurance policies relating to claims for “loss of money, securities or other property. . .resulting from fraud, embezzlement or forgery. . . .”


Stanford Ponzi Scheme

» After Madoff, most significant is the Ponzi Scheme run by Allen Stanford.

» Ponzi was operated using an Antiguan bank owned by Stanford and losses are estimated at $8 billion

» SEC charges Stanford scheme survived because Stanford bribed Antiguan officials to look the other way

» Brokers have been named as defendants for vouching for Stanford scheme and for issuing “safety and soundness” letters

» Pendergest-Holt, Stanford Chief Investment Officer, filed declaratory judgment and breach of contract action against Stanford D&O carrier, Lloyd’s.

» Separately, Stanford Receiver has moved to freeze D&O policies claiming proceeds are estate assets

» Pendergest-Holt and Stanford brokers, who claim they are named insureds, have moved that D&O policy proceeds fall outside estate assets


Additional Ponzi Schemes

Other Schemes

Took $13m in a Ponzi scheme which lasted from 2004-2007Hayim Regensberg

Accused of $17m theft from client accounts and devising classic Ponzi scheme

Danny Pang

Accused of diverting $131m to themselves and issuing false promissory notes worth $545m

Paul Greenwood and Stephen Walsh

Accused of running $413m Ponzi schemeNicholas Cosmo

Faked his own death but when found, admitted to allegations of fraudulent selling of insurance and annuity plans to investors through his company, Heritage Wealth Management

Marcus Schrenker

Accused of running alleged $13m Ponzi scheme defrauding Haitian immigrants

George Theodule

Between 2002 and 2008, he sold $700m of forged notes to 13 hedgefunds and 3 individuals

Marc Dreier


FCPA: Things to Remember

» Active Enforcement

» SEC and DOJ Expanding Scope of Coverage

» Global Coordination

» Investigation Expenses High

» Risk of Follow-On Law Suits


Overview – Who is Covered?

» U.S. Issuers – whether U.S. or foreign companies

» Other U.S. persons and agents

» Certain foreign persons


Overview – What is Covered?

» Bribery of foreign government officials

» An issuer under the Securities Exchange Act of 1934 must:

– Maintain accurate books and records; and– Maintain a system of internal controls adequate to

ensure accurate books and records


Elements of an FCPA Bribery Offense

» Corruptly offering or paying» “Anything of value”» To a “foreign government official”» Either directly, or indirectly with knowledge» To influence or secure an improper advantage through

an act or omission» To obtain or retain business


Anything of Value


Foreign Government Officials

Foreign Governments Employees International Organizations Agencies and Officials

Universities

Hospitals

State-Owned Enterprises


Knowledge – No Willful Blindness


Living with the FCPA

» How U.S. Companies Assess Risk - Location


Enforcement – Some Recent Examples

» 2009 – Guilty Plea ($18.2 million)– 2 individuals pleaded; 6 under indictment

» 2009 – Guilty Plea & civil settlement ($579 million)– Former president pleaded & agreed to 7 years jail +

forfeiture– UK agent + former employee under indictment

» 2008 – US/German Guilty Pleas & civil settlements ($800 million & €596 million)

» 2008 – Deferred Prosecution & civil settlements ($32.3 million)– 2 individuals pleaded; 2 under indictment


Increase in Enforcement Action

» Globalization of business.

» DOJ and SEC targeting specific industries.

» Regulatory authorities focus on high risk countries.

» US authorities show willingness to cooperate with foreign governments in foreign jurisdictions in joint investigations e.g. Siemens.

» Increased M & A activity – anti corruption due diligence.


FCPA as a Source of D&O Exposure

» Although no private right of action under FCPA, investigations involving FCPA enforcement can give rise to follow-on securities claim.

» Investigation/Defense expenses can erode limit of indemnity.


Examples of Follow-On Lawsuits

Two Types:» Securities class action lawsuit.

– Filed on behalf of company shareholders.• Titan Corp - $61.5 million• FARO Technologies - $6.8 million• Immuncor - $2.5 million • Nature’s Sunshine Products - ongoing• Panalpina World Transport - ongoing

» Shareholders’ derivatives lawsuit.– Filed on behalf of company itself. Plaintiffs allege that the

company was harmed as a result of the defendants’ failure to have appropriate safeguards in place or to appropriately supervise company practices.

• Siemens


Financial Crisis

» Failed banks in the US

– Bank “stress-tests” results treated as good news, but:• As of mid-September, 92 failed banks since

January 1, 2009 (114 in all of 2008)• FDIC increased number of problem banks from

305 to 416– FDIC expected to begin filing actions– Shareholder class actions are beginning to be filed


US Subprime and Credit Crisis Securities Lawsuits

Both Dismissed (notably on grounds of failure to plead economic loss causation)

MisrepresentationsInvestor/Student Loan Servicing Co.Luminent/First Marblehead

$32 million settlement (funded by insurance)

Misrepresentation of exposure to subprime debt

Investment TrustRAIT Financial Trust

Dismissed, but with leave to amend MisrepresentationLoose lending practices

Subprime lender Fremont General

Dismissed Misrepresentation Bank Downey Financial

DismissedBreach of fiduciary dutiesMisrepresenting that Citigroup stock was sound investment

BankCitigroup ERISA suit

Dismissed Investing in subprime mortgagesFailure to disclose exposure to subprime debtInsider trading

Bank Citigroup subprime suit

Dismissed Inadequate internal controlsMaterial misstatement of financial results and condition

Real estate investment trust NovaStar Financial

$30.5 million settlement (funded by insurance)

Violation of federal and state regulationsAccounting and financial reporting irregularities

Home builders Beazer Homes Inc

$37.25 million settlement (auditors and offering underwriters contributed as well as D&O insurers)

Exposure to subprime debt Real estate investment trust American Home Mortgage Investment

$22 million settlement (funded by D&O insurers)

Misrepresentation Failure to disclose exposure to subprime debt

Mortgage banking Accredited Home Builders

Dismissed/SettledAllegationsType of CompanyCase


Financial Crisis

» Bankruptcies are up 64% from June 2008 to June 2009» Of public companies that seek bankruptcy protection,

77% are named in securities class action lawsuits» Coverage Implications:

– Automatic Stay– Insured v. Insured– Ownership of Policy proceeds


F-Cubed Litigation

» Foreign investors who buy shares of a foreign company on a foreign exchange and seek access to U.S. courts to pursue claims against foreign company

» No bright line rule on jurisdiction» National Bank of Australia: jurisdiction exists “only if the

defendant’s culpable [actions] within the United States directly caused losses to foreign investors abroad”

» Petition for Certiorari Pending and Supreme Court action closely watched


F-Cubed Litigation

» Vivendi– In absence of bright line rule, F-Cubed litigation

continues– Vivendi shareholder class action trial began October

6, 2009 in federal court in New York– Only the second shareholder class action to go to trial

in 2009– Closely watched for substance as well as

jurisdictional reach– If successful, may attract more F-Cubed Plaintiffs


Regulatory Reform

» Structural Reforms– The Fed– Treasury– SEC– One “Super” regulator?– Financial Consumer Protection Agency

» Substantive Reforms– Executive Pay– Capital Requirements– Hedge Fund Regulation– Flash Trades– “Pay to Play”


Regulatory Reform

» Federal Reserve/Department of Treasury– Conflicting proposals to expand or restrict the power

of the Fed– Proposals to Expand Power Include:

• Broad power to prevent future financial crises, including power to take over banks

• Broader power to enter into settlements• Oversight of broker-dealers

– Proposal to Restrict Power Includes:• Create a “National Banking Supervisor” which

would consolidate power of Fed and Department of Treasury


Regulatory Reform

» Bank reform proposals focus on:– Increase Capital Requirements

• Focus of Secretary Geithner– Executive Compensation

• Will focus on long term gain• Principles rather than requirements• Difficulties exemplified by Bank of America

bonuses– Will be Global in Nature


SEC Reform

» SEC has proposed ban on “flash trading”

– Enables traders to see orders less than a second before the public at large

– SEC Chairman Shapiro: “Flash orders may create a two-tiered market by allowing only selected participants to access information about the best available prices for listed securities.”

– Believed to account for about half of the daily dealing volume in the US

– SEC has issued proposed regulations to ban flash trading


SEC Reform

» SEC has proposed reform of credit rating agencies. Proposed reforms focus on:– How they rate– Who they rate– Enhanced Disclosures– Attempts to decrease conflicts of interest


SEC Proposed Reforms

» Robert Khuzami announced the following additional proposed reforms:– Creation of five Specialized Units

• Asset Management Unit• Market Abuse Unit• Structured and New Products• Foreign Corrupt Practices Act• Municipal Securities and Public Pensions

– Streamline Management and Processes– Office of Market Intelligence– Encourage Cooperation by Individuals– Direct new Additional Resources to free up time of investigators

and hire Chief Operating Officer


Regulatory Reform Things to Remember

» Reforms will be global» Wide sweeping reforms will be slow:

– Focus remains on stabilizing economy– Global Coordination takes time

» Focus on individual accountability» Active exercise of existing enforcement powers» Broadening of enforcement powers


Impact on FI/D&O/E&O Markets

» Nature and Number of Claims

» Coverage Issue

» Policy Wordings/Pricing


Implications for D&O/E&O/FI Insurers

» Expect a proliferation of lawsuits in the wake of the Madoff/Stanford and other Ponzi schemes and the global economic crisis

» When faced with these suits, defendants look to insurance to absorb the cost of litigation and resulting damages

» Going forward, these lawsuits will test the limits of D&O and E&O coverage for companies, directors and officers, and any other policyholders– Initial estimates suggest the Madoff scandal alone may cost the

insurers of financial institutions $1 billion for legal costs expended in defense of investment managers who gave client money to Madoff

– Broadcom legal expenses estimated at $130 million


Coverage Issues

» Rescission» Definition of Claim/Trigger of Coverage» Notification» Personal Profit Exclusion» Fraud/Crime Exclusion» Insured vs. Insured Exclusion» Prior Knowledge Exclusion» Impact of Corporate Insolvency» Severability» Damages» Public Policy Considerations


Overview of Non-U.S. Markets:Regulatory Reforms & Claims Activity

Stemming from the Current Economic Crisis

Presented by Michelle A. Jones, Esq.

October 2009


Introduction

» EU Regulatory Bodies Taking Center Stage During the Economic Crisis

» Regulatory Reforms in the EU Resulting from the Current Economic Crisis

» Litigation & Claims Scenarios Arising from the Economic Crisis


EU Regulatory Bodies

» European Union MOU (2008)

» Cooperation between the Financial Supervisory Authorities, Central Banks, & Finance Ministries of the European Union on Cross-Border Financial Stability

» Recognizes need for more centralized governance and cooperation

» Guidance on steps & procedures to take in order to manage a cross-border systemic financial crisis

» Information-sharing among countries » Includes regulators from countries such as: Austria,

Belgium, Finland, France, Germany, Greece, Italy, the Netherlands, Spain, Sweden, & the UK


Recent Regulatory Reforms

» European Union

» General concern that current financial crisis highlighted weaknesses in EU’s supervisory framework (fragmented along national lines)

» Larosiere report identified shortcomings in the existing system of financial supervision in Europe

» European System of Financial Supervisors» European System Risk Council» Draft Directive on Alternative Investment Fund Managers» Joint Network on European Private Law » Amendments to EC Market Abuse Directive



» European System of Financial Supervisors

» 2009 EC proposal to be set forth in new future legislation » Includes national supervisors & 3 new European

Supervisory Authorities for banking, securities, and insurance & occupational pensions sectors

» Supervision of individual financial institutions » National financial supervisors work in tandem with new

EU authorities» National supervisors cooperate & exchange information» No direct supervisory powers over any institutions

(simply possibility for subsequent legislation)» Evaluated after three years



» European System Risk Council (ESRC)

» Headed by president of European Central Bank & includes governors of EU’s 27 central banks

» Monitor & assess risks to stability of European financial system

» Recommendations not binding on Member States/Authorities

» Swedish Ambassador to the UK has indicated Sweden is eager to support the ESRC



» Draft Directive on Alternative Investment Fund Managers

» Create a comprehensive and effective regulatory and supervisory framework for AIFMs at European level

» Authorization & registration requirements (authorization generally for AIFMs with assets under management above €100 million)

» Enhanced monitoring & investor protection» Develop single market for AIFMs» Capital requirements» Reporting requirements» Restrictions on ability to delegate» If approved by end of 2009, could come into force in 2011



» Joint Network on European Private Law – PEICL

» Project Group on Restatement of European Insurance Contract Law

» Goal: voluntary insurance contract law regime across EU» Ability to opt out of national law regimes & agree that

insurance contract governed by stated Principles» Insured’s duty of disclosure limited to responses to clear

& precise questions; Proportionate approach to remedies (no claim denial based on innocent non-disclosure)

» EU Regulation would be required for binding effect» Committee meeting again this month



» Amendments to EC Market Abuse Directive

» European Commission review of prior Market Abuse Directive

» Harmonized approach amongst securities regulators re: surveillance & enforcement of market abuse

» Goal: strengthen EU regulatory framework for financial services & reduce administrative burdens on EU companies by end of 2012

» Reviewing: Scope of the markets/financial instruments covered by Directive; Disclosure of inside information; Authorities’ access to data; Short selling



» UK Treasury White Paper: “Reforming Financial Markets” (07/2009)

» Extensive reforms to UK banking regulation » Formalize & strengthen arrangements for institutional cooperation

– Council for Financial Stability (FSA, Bank of England, & Treasury) to meet regularly & formulate/implement policy responses

» Enhance FSA’s powers (greater rule-making, information-gathering, & enforcement powers)

» Expand role of Financial Services Compensation Scheme » New “national money guidance service” to provide better consumer

education » Possibly introduce collective legal action by consumers



» FSA Becoming More Vigilant

Failure to provide accurate transaction reports to FSA & weaknesses in systems/controls re: transaction reporting (09/2009)

£2.45mBarclays

Failure to have adequate systems & controls to protect against loss or theft of customer confidential data (07/2009)

£3m+HSBC

Systems & controls failures re: trader mis-marking (former trader also banned) (05/2009)

£1.4mMorgan Stanley

Failure to establish & maintain systems/controls to counter bribery & corruption – Bahrain, Bangladesh, Bulgaria, Burma, Indonesia, & Vietnam (01/2009)

£5.25mAon

IssueFineCompany



» Germany – Act on Adequacy of Management Board Compensation

» June 2009 change to German Stock Corporation Act » D&O insurance for executives must include personal

deductible to be borne by directors of at least 10% of relevant loss (annual cap at least 1.5x compensation)

» Applicable only to stock corporations & management board

» Can still buy separate insurance for director’s deductible exposure (director could receive increased compensation to cover premium cost)

» Effective July 10, 2009; existing policies must be amended by July 1, 2010



» September 2009 G-20 Meeting

» Again pledged to overhaul banking practices & build new global economic model

» Constraints on executive pay at financial firms (tie compensation to long-term performance, increase disclosure, & limit bonuses)

» Tougher standards on banks (raise capital requirements)» Process to correct economic imbalances, such as large

trade surpluses & deficits (peer review to examine economic policies)

» Enhance the voting power of emerging economies at IMF (ex: China)


Litigation & Claims Scenarios

» European Union

» White Paper: Damages for Breach of EC Antitrust Rules– Considering representative claims by trusted bodies & opt-in mechanism

» Green Paper: Consumer Collective Redress– Considering various options, including judicial collective redress procedure on a

pan-European basis – To ensure consumers throughout EU are able to use collective redress

mechanisms available in different Member States and/or getting Member States to establish a collective redress mechanism

» Draft law permitting private competition damages withdrawn from EC’s agenda to get more agreement from Member States– Included “opt-out” clause (those affected by anti-competitive behavior

automatically included in the action unless opt out)– Some concern re: the effect on businesses due to rise of costly antitrust actions



» UK Derivative Actions

» Statutory derivative action (Companies Act 2006)» Brought by member of a company for cause of action vested in the

company & seeking relief on behalf of the company » When director’s negligence, default, breach of duty, or breach of

trust has caused loss to the company (including breach of duty to exercise reasonable care, skill, and diligence)

» Expands range of duties owed by directors to their companies (7 codified duties including duty to “promote the success of the company for the benefit of the members as a whole”)

» Damages will still go to the company, not the shareholder» Must get court permission



» Other UK Collective Redress Options

» Group Litigation Orders– Claims that “give rise to common or related issues of fact or law”– Brought as a group, usually with at least 10 claimants & often with same lawyers– Claimants wishing to join must opt in by specified date– Often regarding product liability & tax

» Enterprise Act 2002– Consumer organizations can submit “super-complaints” to Office of Fair Trading– Some type of market feature(s) that significantly harms consumer interests– OFT may take enforcement action, launch market study, or refer complaint to

Competition Commission or sector regulator

» Litigation funding on the rise



» Italy

» Consumer code changes, effective January 2010 (no retroactive effect)

» Allow individuals to aggregate claims into one lawsuit» Brought either by individual class member or by

associations » For consumer claims based on: (1) injuries to contractual

rights; (2) injuries suffered as end consumer, or (3) injuries suffered as result of unfair business practices or unfair competition

» Opt-in process



» Sweden

» Currently: private, individual class actions by plaintiff-class member & organization/public actions; not restricted to consumer or environmental law; must involve common factual circumstances; opt-in mechanism

» Possible amendments: US-style contingency fees (up to 30% of disputed amount); improved notification process for greater participation; expediting court’s certification process



» Germany – Capital Investor Sample Proceedings (2005)

» Sample proceedings arising from certain capital markets transactions (does not apply to other civil law proceedings)

» Involving: damages due to false, misleading or omitted public capital market information, or performance based on a tender offer under the Securities Acquisition and Takeover Act (ex: prospectus liability claims)

» Only available to parties who have already filed suit » Automatically ceases November 2010 unless extended



» Hot Areas for Current/Future Claims

» Securities & shareholder claims (prospectus & public statement liability, fraud, insider trading)

» Bankruptcy» Tax issues » Environmental issues» Antitrust/Cartel Activity» Oil & gas industry



» Rise of Frequency & Severity of D&O/E&O Claims

» 400+ D&O/E&O claims outside of the U.S. since 2007 » Criminal, regulatory, and civil matters» Hot spots: Australia, Canada, China, Hong Kong, Italy,

India, Malaysia, Russia, UK» High D&O limits (over $100m): Australia, Netherlands » In 2009, majority of claims in financial services sector

(particularly high percentage in oil & gas industry)



» Forces Affecting D&O/FI Claims in Certain Countries

» Argentina – collective actions available, perhaps US-style class actions; Halabidecision allowing class actions in certain circumstances; lagging economic recovery

» Australia – securities class actions permitted; non-parties can fund litigation; GIO collapse & other major companies’ problems

» Canada – 2006 law permitting securities class actions (currently $3b in claims for securities class actions); U.S. class action law firms entering Canada

» Germany – strong accountability rules for supervisory board; strong shareholder rights (ex: Deutsche Telekom case with 17,000 shareholders & 800 lawyers, Hypo Real Estate Holding litigation & investigations by Munich DA & BaFin)

» Italy – new law; enhanced rights of minority investors & accountability of corporate D&Os (ex: consumer group Adusbef may bring class suits against FIs and/or institutions connected to bankruptcies)

» Malaysia – 2007 law re: director duties & statutory derivative actions; shaky economy (foreign investment plummeted & heavily reliant on exports)

» Russia – FFMS revocation of securities licenses; possible future bill re: insider trading & price manipulation; Central Bank tightening bank requirements



» Other Hot Spots & Emerging Areas

» Dubai (UAE) – real estate/construction crisis; increasingly difficult for developers & investors it to obtain any return on their money; various regulatory investigations

» Kazakhstan - one of deepest economic declines in its history; extreme indebtedness of banking sector; falling oil prices (oil is 70% of country’s exports)

» Nigeria – rising oil prices & banks overexposed when commodities prices fell; Nigerian stock market fell 60%; government pledge to reform banking industry

» Turkey – 14% decline in GNP; proposed changes to directors’duties and shareholders/creditors may bring action against boardmembers if they violate their obligations


Reinsurance Issues Stemming from the Current Economic Crisis

Presented by Michelle A. Jones, Esq.

October 2009


Current D&O/FI Reinsurance Market

» Reinsurers remain concerned about FI risks (watching the claims, the rates, & the increasing range of companies exposed)

» Demand for reinsurance remains high, but capacity is limited

» Placements typically limited to incumbent reinsurers; new capacity difficult to secure; new insurance start-ups; no new reinsurers; increased rates

» 2009 renewals reveal treaty terms favorable to reinsurers & expectation of difficult 2010 renewal season


Recent Legal Developments

» Lexington Ins. Co. v AGF Ins. Ltd. & Lexington Ins. Co. v. Wasa Int’l Ins. Co., [2009] UKHL 40

» Environmental damage at multiple sites over many years, ultimately settled

» Reinsurers not bound by U.S. court interpretation of ceded policy, even with follow form facultative reinsurance & express follow the settlements clause– Reinsurance agreement was a separate contract & there was no

choice of law clause– Under English law, reinsurers only responsible for damage that

manifested itself during reinsurance period


D&O/FI Reinsurance Issues

» Were the underlying insurance layers exhausted? (Qualcomm case from California & Comerica case from Michigan)

» Was there adequate notice?

» Was there adequate disclosure?

» How was the underlying loss allocated?

» Is the reinsurer bound to follow the fortunes/settlements?


Developments and Trends in FI/D&O/E&O Wordings

Presented by Nilam R. Sharma, Esq.

October 2009


Topics for Discussion

» What are the drivers for change?

» What are the changes?

» Can we expect the changes to last?


Drivers of Change (1)

“IT’S THE ECONOMY STUPID!”

» Nationalization;

» Insolvency/Bankruptcy;

» Regulatory Activity; and

» Pursuit of Litigation Made Easier.


Drivers of Change (2)

» Claimant.» Types of Claims.» Allegations:

– Misselling/Inadequate Disclosure/Misrepresentation;– Fraud/Dishonest Conduct;– Breach of Fiduciary Duty;– Insider Trading; and– False or Misleading Statements.


What are the Changes? (1)

» Civil Liability – Trigger of Coverage.» Loss/Mitigation of Loss.» Notification – When, Content.» Circumstances vs Claim. » Innocent Non Disclosure/Severability.» Contractual Liability.



CIVIL LIABILITY – TRIGGER

» No real definition.» Statute, regulation, tort, civil (not criminal).» Wrongful act.» Professional services.» New wording to reflect clarity.



LOSS/MITIGATION OF LOSS

» Judgment, settlement with consent.» Prevent a loss – widely accepted.» US – “cost of correction cover.”» Stress testing of banks – are costs of complying

mitigation of loss? » Internal investigation costs – mitigation of loss?



NOTIFICATION

» Timely-immediate (as soon as practicable)» Condition precedent

– (HLB Kidsons v Lloyd’s 2008 EWCA Civ. 1206)» Content of notification – specific or general (D&O policy)» Knowledge – Senior Personnel

– (Global company with worldwide losses)» Information Only» Block/Blanket Negotiations – Good or Bad?



CIRCUMSTANCES VS CLAIM

» Should the FI/E&O policy cover circumstances? (Compare mitigation of loss)

» Should the definition of either be related to an actual loss?

» Circumstances if correctly and properly dealt with may result in no claim.

» UK Civil Procedure Rules.



INNOCENT NON DISCLOSURE/SEVERABILITY

» Company vs individual.

» Who made the misrepresentation – difficulties in unraveling and applying the severability clause.


What are the Changes (7)

CONTRACTUAL LIABILITY

» Normally excluded.

» Breach of contract claims may extend definition of civil liability to claims in contract.

» Controversial but a response to the allegations which fairly could be covered.


Can We Expect the Changes to Last?

» No.

» Cycle of hard and soft markets.

» New claims, new claimants and new remedies for loss –wordings should never stand still.


Claims Scenario

Ratings Agency Company (“RAC”) is a private Danish corporation with global operations in the USA, Asia and Europe. RAC provides specialised ratings reports on financial products, such as bonds and structured finance deals. The main board of directors are appointed in accordance with Danish law. The subsidiary companies board of directors are appointed in accordance with Danish law, and where relevant and/or necessary, in accordance with the law of the country of operation.

In April 2007, RAC was commissioned by a global investment bank to rate its new bond backed by securities made up of commercial property mortgages (“the Bond”). Following a review of the legal documents and underlying securities, RAC awarded the Bond an AAA rating. On the basis of this rating, and eager to recommend alternative products that were safer than the sub-prime-backed bonds, several other investment banks and hedge funds recommended investments in the Bond to their financial institution and private individual clients. The Bond increased in value from April 2007 to May 2009.


Claims Scenario

Beginning in June 2009, there were a series of defaults on the underlying mortgages due to a decline in the US commercial property market. In July 2009, RAC issued an updated evaluation for the Bond, which downgraded the rating by several grades. The value of the Bond fell substantially.

In September 2009, a complaint was filed in a US District Court against RAC and its directors and officers by a US hedge fund and its clients alleging negligent and/or fraudulent misrepresentation in relation to the rating awarded to the Bond. The complaint also alleges a conspiracy to defraud the investors by RAC and the debt issuer who commissioned the rating.

The same week the complaint is filed, the UK’s Financial Services Authority (FSA) writes to RAC’s board requesting information about the review conducted in order to produce the 2007 rating of the Bond. The US and Danish regulatory authorities are also considering an investigation into the research activities of RAC.


Claims Scenario

RAC hires legal counsel in the US to defend all of the US legal and potential regulatory proceedings, UK counsel to respond to the FSA’s requests, and Danish counsel to respond to the potential local regulatory proceedings. RAC is also conducting an internal review.

RAC’s board notifies the US complaint, the FSA letter and comments on the potential regulatory investigations to its broker on October 1, 2009. As the current D&O policy is due to expire on October 5, RAC also considers making the following blanket notification to its insurers:

“As a result of the US complaint, the UK FSA letter and the potential regulatory investigations intimated, we believe it would be prudent to place insurers on notice of further actions that may be commenced against RAC. Our initial review suggests that investors were also advised by our subsidiary companies world wide.”

The policy has no choice of law clause.


Coverage Issues- Discussion

» Notification» Claim/Circumstance» Loss/Defence Costs/Investigation Costs» Allocation» Damages» Jurisdiction and Choice of Law

Documents

Is it Raining in the Garden of Financial Institutions? · Is it Raining in the Garden of Financial Institutions? Liability Academy 2009 Nilam R. Sharma, Esq. Michelle A. Jones,