Sub-prime crisis raises claims risk

Marsh warned that the European financial services sector - including insurance companies, hedge funds, banks and ratings agencies - may be exposed to greater directors’ and officers’ liability (D&O) and errors and omissions (E&O) liability claims in the wake of the sub-prime mortgage crisis in the United States.

Higher interest rates and falling property prices have contributed to rising mortgage delinquencies among high-risk, or sub-prime, borrowers in the United States. This, coupled with increased relaxation of underwriting standards, has led to the bankruptcy of several US mortgage lenders and to increased regulatory scrutiny.

With trading in collateralised debt obligations (CDO), collateralised loan obligations (CLO) and mortgage backed securities (MBS) as financial investment instruments growing globally, so concern is rising in the European and international financial markets about their impact on the investments held by companies in US assets.

Potential litigation, and arising out of D&O and E&O liability, include:

• Lenders’ lawsuits versus the banks: Since lenders are unable to do business without capital, many have been forced to file bankruptcy when they were asked to buy back loans. It is likely that there will be claims of improper margin calls and flawed valuation of underlying collateral on the part of banks and other institutions that purchased or financed the loans.

• Shareholders’ lawsuits versus lenders, accountants, trustees, and underwriters: Sub-prime lenders that have gone into bankruptcy may well face extensive accusations. Shareholders could make claims of misrepresentation and omission related to accounting for residuals, as well as claims of bad valuation and poor underwriting standards.

• Insurers’ lawsuits versus lenders: Large insurance claims on failed sub-prime collateral may lead to accusations of poor underwriting (misrepresentations and omissions) on the part of lenders.

• Investors’ lawsuits versus trustees: To the extent that bondholders are not paid, there will be claims of breach of fiduciary duty on the part of the trustees responsible for the distribution of cash-flow.

• Trustees’ lawsuits versus lenders and underwriters on behalf of investors: Trustees might seek damages from lenders and underwriters. The claims are likely to be along the lines of fraudulent conveyance and breach of contract related to loan servicing.

• Individual investors’ lawsuits: If and when the investors in mortgage-backed securities post poor returns as a result of failing sub-prime backed investments, the individual investors may accuse the funds of not taking on suitable and prudent investments and failing to follow investment guidelines and standard risk management procedures. There will also be claims of misrepresentations, omissions, bad pricing and mark-ups.

(Source: Dr Faten Sabry, NERA Economic Consulting, ‘The Subprime Meltdown’)

Commenting on the D&O risks arising from sub-prime, Siobhan O’Brien, a senior vice president in Marsh’s financial institutions practice said: “The European financial services sector is increasingly realising the implications for the sub-prime issue outside the United States. Some European banks have frozen certain funds and the European Commission has also announced that it will review the credit ratings industry’s voluntary code of practice after reports that it has been to slow to advise clients on the crisis.”

“European insurance companies, hedge funds, banks and ratings agencies must continually assess the risks raised by the sub-prime crisis and examine their D&O and E&O exposures. Potential claims are likely to arise from wrongful acts by the company and the directors and officers in the form of allegations of mismanagement with respect to sub-prime lending or their investment portfolios, their lending and foreclosure practices and the suitability of the products sold. The potential of regulatory investigations may bring about claims by shareholders or borrowers.”

“In recent times the European D&O market has been largely stable. However, if there is a high number of costly claims under D&O and E&O insurance, this trend is likely to reverse and costs may begin to rise.”