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SIMILARITIES BETWEEN THE SAVINGS & LOAN CRISIS AND TODAY'S CURRENT FINANCIAL CRISIS: WHAT THE PAST CAN TELL US ABOUT THE FUTURE
This article originally appeared in the September 2009 Fidelity and Surety Committee Newsletter.
It goes without saying that the financial industry, along with numerous other sectors of the United States and global economies, are currently in peril. According to statistics posted on the Federal Deposit Insurance Corporation's (FDIC's) website, in 2008, twenty-five financial institutions failed in the United States; and as of July 7, 2009, 52 financial institutions already have failed in 2009. (1) By comparison, in 2007, only three banks failed, and in 2005 and 2006, no banks failed. (2) Along with this significant increase in bank failures, it is no surprise that financial institutions have been the main focus of litigation by both private parties and the government.
Despite what some could refer to as sensationalism in the media regarding the unprecedented nature of the current crisis, this country weathered a similar collapse of its financial sector during the Savings & Loan (S&L) crisis of the 1980s. From 1986 through 1995, 1,043 S&Ls, holding $519 billion in assets, were closed, and the number of federally-insured S&Ls decreased from 3,234 to 1,645. (3) As of December 31, 1999, losses from the S&L crisis totaled approximately $153 billion, costing U.S. taxpayers $124 billion and the S&L industry $29 billion. (4) Notwithstanding these staggering figures, there is very little debate that the current financial crisis is more widespread than the S&L crisis of the 1980s. In any event, the S&L crisis provides a roadmap for the types of claims and insurance disputes we can expect to see arising from today's bank failures and bailouts.
II. The Savings & Loan Crisis
From somewhat modest beginnings (historically, S&Ls or thrifts, were community-based institutions that provided two types of services to their customers: retail savings deposits and lending of those deposits for residential mortgages), S&Ls were allowed to grow and expand beyond their means and abilities. Through a combination of speculative lending, greed, lax oversight, and reactionary legislation, the bubble grew and burst, resulting in significant losses and litigation. Although the S&L crisis is, by and large, behind us, it offers many lessons as to the bases of today's crisis. The similarities as to the causes, responses, and fallout are striking. Even a broad examination of what gave rise to the S&L crisis and governmental and public response causes one to quickly realize that the litigation that follows today's crisis is, and will be, no different, nor will the similar targets of the litigation be a mere coincidence. Consequently, the S&L crisis provides a blueprint as to what we can expect to see, and are seeing, by way of litigation.
Federally-chartered S&Ls were first created in the 1930s to promote home ownership after the Great Depression. During the Great Depression, thousands of commercial banks failed--with 4,000 banks failing in 1933 alone. (5) In response, Congress established: (1) the Federal Home Loan Bank Board (FHLBB), which regulated the S&L industry; (2) the Federal Savings and Loan Insurance Corporation (FSLIC), which insured deposits in S&Ls; and (3) the Federal Deposit Insurance Corporation (FDIC), which regulated federally-chartered commercial banks and provided a federal deposit insurance program. (6)
In the late-1960s, inflation and interest rates increased sharply. Congress applied "Regulation Q" interest-rate caps, which previously applied only to commercial banks, to S&Ls. Regulation Q capped the interest rates that S&Ls could pay depositors and helped to control S&L's costs. (7) During the late-1970s and early-1980s, interest rates once again skyrocketed, and inflation increased as a result of government deregulation of interest rates. However, Regulation Q no longer provided a solution to S&Ls because money-market mutual funds emerged in 1972 as a safe and fairly liquid investment alternative to S&L deposits. Because money markets were not subject to Regulation Q, they could pay higher interest rates to investors, and depositors began to pull their deposits from S&Ls and invest in money markets, causing the S&L industry to suffer massive withdrawals and losses beginning in late-1979. (8)
As a result, S&Ls began to lobby Congress for deregulation of the industry, and Congress responded. In 1980, and again in 1982, Congress reduced the net-worth requirements for federally-chartered S&Ls, and S&Ls were allowed to meet this requirement by using more liberal regulatory accounting principles instead of generally accepted accounting principles. (9) In 1982, restrictions on the requirements regarding the minimum number of stockholders in S&Ls were eliminated, and individuals and small groups of investors, who often were not qualified, began to own and manage S&Ls. (10) During the federal deregulation of the 1980s, S&Ls also were allowed to offer adjustable-rate mortgages; take risks by extending their lending activities into other areas like commercial real estate loans, construction loans, etc.; offer loans not backed by collateral; and take direct ownership positions in a limited number of enterprises. Regulation Q interest-rate caps also were lifted, and the amount of federal insurance on an individual S&L deposit was increased from $40,000 to $100,000. (12)
State deregulation followed suit with states relaxing lending rules to keep their state-chartered S&Ls competitive. This deregulation, coupled with a peak in oil prices and a booming real estate market in the Southeast and Texas, caused the S&L industry to grow exponentially. Between 1982 and 1986, S&L industry assets increased 56%. (13) Most S&Ls in Texas and California grew by more than 100% each year. (14)
Much of the legislation and deregulation passed in the early-1980s essentially was reactionary. It was not designed to address the ever-increasingly apparent problems with the S&L model, but merely to mask those inherent weaknesses with the hope that ultimately the S&Ls would recover through the market. However, sweeping the problems under the rug did not solve the problems, and by the mid-1980s, the S&L crisis began to emerge as a significant number of S&Ls were crippled when the Texas oil and real estate markets entered into a deep recession, which caused increasing rates of default and decreased the value of collateral-backed loans provided by S&Ls. (15)
The FHLBB also began to tighten regulations for S&Ls by increasing net-worth requirements, improving accounting standards, limiting direct investments, and doubling the number of examiners on its staff. But, the changes could not remedy the damage that had been done. The tightened regulations exposed bad investments, and S&Ls begin to fail; In 1986, 54 thrifts were rendered insolvent, and the FSLIC insurance fund became insolvent. (16) From 1986 to 1988, the FHLBB disposed of more than 300 insolvent S&Ls by liquidating them or finding acquirers. (17) By 1988, the FSLIC had a negative net worth of $50 billion. (18)
B. Causes of the S&L Crisis
Various factors contributed to the S&L crisis, including the government's failure to seize control of insolvent S&Ls earlier. By the early-1980s, hundreds of S&Ls were insolvent. However, instead of closing the banks, Congress began to deregulate S&Ls in order to encourage competition with commercial banks and money markets. For example, the increase in the federal deposit insurance for an individual S&L deposit allowed S&Ls to take greater risks with deposits as investors were less concerned with losing their savings if the S&L failed. (19) The increased insurance, combined with the elimination of interest-rate caps, also made it easier for S&Ls to attract depositors, including brokered deposits. In 1980, and again in 1982, the FHLBB lowered the net-worth requirements for S&Ls, which kept S&Ls that were on the verge of insolvency in business, and S&Ls were allowed to extend their lending activities into more risky areas--with minimal oversight, as the FHLBB lacked capacity to identify insolvent institutions because the number of field examiners at the agency was reduced significantly between 1981 and 1984 due to budgetary cuts and deregulation. (20) This left S&Ls to rely upon internal-risk management practices, which often were insufficient and led to underestimated and unrecorded economic risk. Moreover, the FHLBB revised accounting standards, which allowed S&Ls to create false assets or "supervisory goodwill" to increase their net worth. (21)
Volatile interest rates and the faulty structure of S&Ls also contributed to the crisis. S&Ls historically were structured on the model of borrowing short (via short-term deposits) and lending long (via 30-year fixed-rate mortgages). If interest rates remained stable or declined, S&Ls were safe. However, if interest rates increased, problems arose because long-term mortgages were based on lower-fixed rates, which would be inadequate to pay depositors. (22) State usury laws also capped the amount of interest an S&L could charge for a residential mortgage. High-interest rates during the late-1970s and early-1980s exposed S&Ls to significant losses because they could not compete with money markets that could pay market rates of interest. When Congress eliminated the Regulation Q interest-rate caps in the early-1980s, S&Ls were free to meet or exceed interest rates paid by money markets, but a gap emerged between the costs of an S&L's short-term interest-rate payments and the income generated by its assets (long-term, fixed-rate mortgage payments). (23) As interest rates increased, the economic value of mortgages also moved lower, which also threatened S&Ls with insolvency.
In the mid-1980s, the price of oil plummeted, causing real estate projects in Texas and their investors, including S&Ls, to lose money. (24) The real estate market and the farming industry also experienced a downturn, which caused farmers to default on loans issued by S&Ls. (25)
Finally, fraud and insider abuse caused the S&L crisis. In 1982, the FHLBB eliminated various regulations concerning S&L ownership, allowing individuals and small groups of shareholders to control S&Ls. (26) Often the wrong type of owners and managers assumed control of S&Ls because an opportunity existed to grow an S&L quickly with minimal capital base. This fraud and insider transaction abuse contributed to a large number of S&L failures. (27)
C. Legislative Response
In response to the S&L crisis, Congress passed the Financial Institution Reform Recovery and Enforcement Act of 1989 (FIRREA), which abolished the FHLBB and FSLIC, and transferred regulatory power over S&Ls to the Office of Thrift Supervision and the FSLIC's insurance role to the FDIC. (28) FIRREA also established the Resolution Trust Corporation (RTC), which was controlled by the FDIC and managed and resolved failed S&Ls until its sunset on December 31, 1995. (29) Upon dissolution of the RTC, the RTC's assets and liabilities were transferred to the FDIC. When an S&L failed, the FDIC or RTC stepped in as receiver for the thrift. Because S&L's failed, in part, due to the negligence and fraud of their directors, officers and outside professionals, in an effort to recover losses, the FDIC and RTC investigated and pursued litigation against these individuals.
D. S&L Litigation
In connection with the widespread failures of S&Ls, various civil and criminal actions were filed. For example, the FDIC and RTC filed hundreds of civil actions against D&Os of failed-S&Ls alleging breach of the duties of loyalty and care, negligence, fraud, waste, and mismanagement in connection with imprudent investments, the offering of bad loans, and undisclosed conflicts of interest. Shareholders or bondholders also filed securities class actions for violations of securities laws or breach of fiduciary duties against D&Os. From October 1988 to March 31, 1995, 1,119 D&Os were charged with fraud against their S&Ls, and 92% (1,033) of the D&Os were convicted. (30) For example, the infamous Charles Keating, CEO of Lincoln Savings and Loan Association in Irvine, California, and David Paul, CEO of CenTrust Federal Savings Bank in Miami, Florida, both were convicted of bank fraud.
Regulators sued accountants for failed-S&Ls for malpractice in connection with breaching duties to perform competent audits in compliance with GAAP, failing to review adequate samples of delinquent loans, failing to write-off permanently impaired loans, failing to identify internal control deficiencies in annual management letters, and allowing readily-marketable securities to be reported at book value instead of their lower-market value. The FDIC and RTC recovered more than $1.15 billion from accounting firms with a majority of the recovery coming from global settlements with the "Big Six" accounting firms, who audited more than one-thousand S&Ls from the 1980s to the early-1990s. (31)
Regulators also sued attorneys for malpractice in connection with failing to record liens, aiding and abetting CEOs in criminally deceiving shareholders and regulators, and failing to advise thrifts about regulatory violations and statutes in connection with imprudent loans. The FDIC and RTC filed 205 attorney malpractice actions, and recovered more than $500 million from law firms. (32)
E. Coverage Issues
Given the enormity of losses arising from the S&L crisis, regulators were eager to pursue claims for insurance coverage. These losses also motivated insurers to limit their exposure by litigating the applicability of key exclusions and policy provisions. Generally, litigation arising from the S&L crisis triggered D&O policies and financial institution bonds issued to failed-financial institutions. (33)
i. D&O coverage issues
D&O insurers often relied upon the following defenses to deny coverage for claims arising from the S&L crisis: the insured vs. insured exclusion, the regulatory exclusion, the bad acts exclusion, and rescission for misrepresentations in the application for the policy.
Most D&O policies contain an insured vs. insured exclusion precluding coverage for claims made against a director or officer by any other director or officer or by the insured company. During the S&L crisis, insurers invoked the insured vs. insured exclusion to preclude coverage for actions asserted against directors and officers by the FSLIC, FDIC, or RTC, reasoning that the regulators stepped into the shoes of the failed S&L. (34) Therefore, the insurers argued that the claims were being asserted against the insured directors and officers by the insured company. However, most courts held that the insured vs. insured exclusion did not preclude coverage for claims brought by the FSLIC, FDIC, or RTC against former officers and directors of a failed thrift, reasoning that: (1) the true intent of the insured vs. insured exclusion is to prevent collusion between insureds; therefore, because the FDIC is more than a successor-in-interest to a failed S&L, the FDIC is a genuinely adverse party to the D&Os; and (2) the FSLIC does not only stand in the shoes of the failed S&L, but also acts on behalf of depositors, creditors, shareholders, and the federal insurance fund. (35)
During the 1980s, most D&O policies issued to financial institutions also included a regulatory exclusion, which precluded coverage for claims brought against an insured by or on behalf of any governmental or regulatory agency. Therefore, when the RTC, FDIC, or FSLIC filed an action against the D&Os of a failed thrift, D&O insurers often denied coverage for the claims under the regulatory exclusion. (36) Regulators often would argue that regulatory exclusions should not be enforced because: the exclusions were ambiguous, the exclusions did not comport with the reasonable expectations of the insureds, and the exclusions were contrary to public policy. (37) Prior to the enactment of FIRREA, regulators had greater success striking down the regulatory exclusion. (38) However, after FIRREA was passed, courts generally upheld the regulatory exclusion reasoning that: (1) Congress' silence regarding regulatory exclusions in FIRREA indicated that Congress did not believe that regulatory exclusions were contrary to public policy; and (2) the parties' freedom to contract overrode the regulators' right to file suit against individual insureds. (39)
Insurers also relied on so-called "bad acts" exclusions to preclude coverage for claims of fraud, criminal acts, or intentional conduct. However, such exclusions generally required an adjudication, which would not relieve an insurer of its obligations to advance defense costs pending the outcome of the underlying suit. Courts have held that the final adjudication must occur in the underlying action, as opposed to during coverage litigation. (40)
Finally, applications for D&O policies often ask whether the insured is aware of any facts that may give rise to a covered claim. During the S&L crisis, directors and officers often were accused of making bad loans. In response, insurers would attempt to rescind D&O policies based upon misrepresentations made in the application for the policy.
ii. Bond coverage issues
Congress specifically authorized the FDIC and FSLIC to require federally-insured commercial banks and S&Ls to obtain fidelity bonds to insure against "burglary, defalcation, and other similar insurable losses." (41) Because regulators automatically acquired a failed S&L's assets and liabilities upon receivership, the regulators succeeded to the failed S&L's right to pursue bond claims. While the regulators were entitled to pursue civil litigation against the S&L's former employees, the employees often were judgment proof. Therefore, the regulators only chance of recovery was to pursue bond claims.
Generally, before an S&L was closed, the S&L--prompted by federal regulators--would notify its bond insurer of any losses believed to be caused by employee dishonesty in connection with the issuance of any bad loans. After an S&L was closed, regulators would assume control of the S&L, and often would file a supplemental proof of loss detailing additional losses discovered after the regulators took over. (42) Bond insurers often relied upon the following defenses to deny coverage for bond claims submitted by the FDIC and FSLIC: (1) the bond's termination-upon-takeover clause; (2) all losses attributable to a single employee do not constitute a single loss; and (3) rescission for misrepresentations in the bond application.
Termination--upon--takeover clauses generally provide that the bond will terminate immediately upon the taking over of the insured by a receiver or other liquidator or by state or federal officials. (43) Disputes often would arise regarding whether a loss--which was first discovered after the regulators assumed control of the S&L and after the bond terminated pursuant to the termination-upon-takeover clause--was covered under the bond. Bond insurers would argue that because the bond solely provided coverage for loss "discovered during the bond period," any losses first discovered after the S&L was taken over by regulators were not covered because the bond period had expired. In response, regulators--who often filed supplemental proofs of loss seeking coverage for losses first discovered after the regulator assumed control of the S&L--would argue that the bond's termination-upon-takeover clause was contrary to public policy because it hindered the regulators' statutory obligation to marshal the assets of a failed S&L. Courts, however, rejected the regulators' public policy arguments reasoning that: (1) the FSLIC and FDIC have statutory authority to require S&Ls to purchase bonds that continue coverage after the appointment of a receiver, but have not instituted such a requirement; and (2) the compelling public policy is the parties' fight to contract freely, which should not be disturbed. (44)
Regulators also would argue that as long as "any loss" by an employee was discovered during the bond period, any subsequently discovered and reported losses--which arose from the same employee's conduct--related back to the losses discovered during the bond period, and were covered under the bond. (45) However, courts declined to adopt the FDIC's broad interpretation, and instead, looked for loans that arose out of the same pattern of conduct or scheme originally discovered during the bond period. (46)
Bond applications generally included a question regarding whether the insured was aware of any facts that may give rise to a covered claim. If the insured answered the question in the negative--even though the insured or its directors of officers knew of facts requiring an affirmative answer--the insurer arguably had grounds to void the bond. (47) Generally, facts giving rise to a loss under a bond were known by employees before regulators assumed control of the failed S&L. Sometimes, the facts were known prior to the bond's inception. Therefore, in response to coverage litigation arising under bonds, insurers often would raise misrepresentations in the bond application as a defense to coverage, and would seek to void the bond. In response, regulators argued that the insurer's defense violated the D'Oench Duhme doctrine, which was first articulated by the Supreme Court in D'Oench Duhme & Co. v. FDIC, 315 U.S. 447 (1942) and later codified at 12 U.S.C. [section] 1823(e). (48) The doctrine prohibits a party from basing a defense to a regulator's claim upon a secret agreement between the party and the failed bank. Courts are split over whether a rescission defense violates the D 'Oench Duhme doctrine. (49)
III. Today's Crisis
The origin of today's crisis, which actually is a number of interrelated crises, is complex, and likely will not be known for some time. (50) However, the most immediate and identifiable causes of the current economic crisis are increasing interest rates and declining property values. Prior to the crisis, property values increased dramatically, and interest rates remained at record lows. Accordingly, homebuyers were able to borrow larger amounts of money and still have seemingly comfortable monthly-mortgage payments. This led to an increase in real estate sales, even as prices increased. As interest rates rose, subprime borrowers with variable rate loans saw an increase in their mortgage payments, leading to defaults and foreclosures. The attendant drop in property values meant that the borrower suffered significant losses in equity and that lenders were unable to recover the full value of the losses from default.
The housing crisis created a snowball effect, placing parties involved in the purchase and securitization of mortgage-backed securities (MBS) (51) and participants in credit default swaps (52) at risk. It is important to note that the vastness of the credit default swap market is staggering. According to the International Swaps and Derivatives Association, the aggregate national value of credit default swaps outstanding at the end of 2007 was $62 trillion, an amount which could exceed the value of bank deposits worldwide and is three times the value of the U.S. stock markets. (53) Therefore, the threat of litigation involving credit default swap transactions is great.
i. Increase in litigation likely
The current financial crisis already has claimed several notable "victims." Washington Mutual Bank, a bank with $307 billion in assets, failed in 2008. (54) This is the largest insured financial institution to fail in FDIC history. Other notable victims are Lehman Brothers, JP Morgan Chase (not ironically, the inventor of credit default swaps), IndyMac Bank, Fannie Mae, and Freddie Mac.
Litigation involving the current-economic crisis already is significant: Some accounts tab subprime-related lawsuits, since their inception in August 2007, as already exceeding the number of lawsuits brought during the entire S&L crisis. These figures often are misleading, as what constitutes a "subprime" lawsuit includes a much broader characterization of the actual claims and facts giving rise to the lawsuit. Regardless, the lawsuits are numerous, and insurance-cost estimates related to subprime lawsuits, which .range from $3 to $9 billion, are staggenng. (55) In one subprime case alone, the Apollo Group spent more than $25 million through trial. (56) In contrast, at the height of the S&L crisis, the combined direct and indirect payments by the FDIC and RTC to outside counsel in 1991 reached over $700 million. (57)
ii. Anticipated litigation
The body of law developed during the S&L crisis provides a good background as to what to expect with the current financial crisis, especially with regard to bank failures. During the S&L crisis, the FDIC, RTC, and OTC aggressively pursued D&Os of the failed banks and third-parties such as audit and law firms. Accordingly, likely plaintiffs arising from the current financial crisis include: the FDIC and other bank regulators, including the Office of Thrift Supervision (OTS) and the Office of the Comptroller of Currency (OCC), the SEC, the DO J, and the U.S. Treasury; (58) and private and individual parties, including shareholders of bank holding companies, employees whose retirement funds are invested in company stock, and trustees of bank holding companies. Likely defendants are: D&Os, third-party professionals, controlling shareholders, and companies that hold stock or debt instruments in failed financial institutions. As banks are highly regulated and subject to regular examination, federal regulators will be compelled to save face and allege that the banks misled regulators during examinations. Therefore, D&Os are the most identifiable defendants, and finger-pointing, especially in today's political climate, will drive many of these lawsuits. These defendants likely will be alleged to have breached their duties to investigate or supervise, and to have violated of securities laws for issuing false or misleading financial statements and disclosures regarding loan practices and exposure to the subprime market and risks.
Companies that were not even directly involved in any events leading up to the subprime meltdown and credit crisis, but are exposed to companies that have such risk, also may be named as defendants. For example, companies or banks that hold stock or debt instruments in AIG, Fannie Mae, Freddie Mac, Lehman Bros., Washington Mutual, etc. may be targets of litigation. This is especially troubling because last year, the Supreme Court held that an individual has a fight to pursue a breach of fiduciary duty claim against its plan administrator for mismanagement of the 401(k) plan. (59)
State law likely will apply regardless of whether the bank is a federally or state-chartered institution, even if the FDIC sues in federal court. (60) State law also controls the standard for breach of fiduciary duties, but federal regulators often place a heightened burden on D&Os, including a duty to investigate. For example, the OCC's manual provides that "when circumstances alert a director to an actual or potential problem, the 'duty to investigate' requires that the director takes steps to learn the facts and to resolve the situation." (61)
C. Coverage Issues
While each claim presents novel issues, several common coverage issues likely will arise in connection with lawsuits resulting from the current financial crisis. For example, insurers may try to preclude coverage for investigations made in response to a shareholder demand letter or to governmental investigations because "claim" generally is defined as a demand for money damages or the filing of a lawsuit. Policies generally define "wrongful act" as any actual or alleged act, error or omission, misstatement, misleading statement, or breach of fiduciary duty or other duty. If liability arises out of a contract or is based on intentional conduct, it may not be a "wrongful act." "Loss" often is defined as the amount an insured is legally obligated to pay as a result of a claim. Generally, multiplied damages, penalties, and fines do not constitute loss. Moreover, loss does not include corporate governance changes, equitable relief, or attempts to recoup bad investment in subprime portfolios. Neither disgorgement of ill-gotten gains nor restitution payments generally constitute a covered "loss" under an insurance policy either.
After FIRREA was passed, courts largely upheld regulatory exclusions, relying on Congress's failure to expressly state in the statute that these exclusions were contrary to public policy. However, Colorado and Maryland continue to hold that regulatory exclusions are void as against public policy. (62) Moreover, in recent years, a competitive underwriting environment has emerged making the regulatory exclusion an infrequent addition to D&O policies issued to financial institutions. (63) In light of the dearth of recent bank failures, this absence is not a remarkable development. However, given the recent trend, we may see an increase in the inclusion of the regulatory exclusion going forward.
It is unclear whether insured vs. insured exclusions will be upheld in connection with the current financial crisis, even if the FDIC steps in as a receiver for the bank and files suit against D&Os. However, as discussed above, insureds likely will be able to argue that the FDIC is not the same entity as the failed-bank, and should not be bound by the exclusion.
Most D&O policies include fraud exclusions, which preclude coverage for deliberate, dishonest, fraudulent, or criminal acts or omissions upon any such finding that such is material to the cause of action so adjudicated. However, unless the policy specifically allows the insurer to litigate the fraud exclusion in a separate proceeding, most courts hold that the "adjudication" referenced in the fraud exclusion pertains to the underlying proceeding, and the exclusion is inapplicable if there has been no fraud determination. If a finding "in fact" or a "final adjudication" is not required, an investigation as to coverage will require an analysis of internal and insider communications to determine who knew what and when. However, innocent individual insureds may argue that a policy's severability provision, which often states that the conduct or knowledge of one insured will not be imputed to another, makes such exclusions inapplicable to them.
The breach of contract exclusion also may be triggered by subprime suits if suits arise out of contracts requiring the parties to "buy back" MBS sold to investors. However, breach of contract exclusions generally preclude coverage for liability under any contract or agreement, provided that such liability would not have attached but for the existence of a contract (i.e., common law or statute).
Other insurance clauses may be invoked in connection with claims arising out of the current financial crisis because a number of different policies could apply in the typical subprime lawsuit, or other credit crisis lawsuit, such as D&O, E&O, CGL, or credit risk policies. Therefore, it is important for insurers to carefully analyze other insurance clauses to determine whether one policy will have priority or whether the policies will act as co-insurance.
Finally, as with the S&L crisis, rescission may be a valid defense to coverage because exposure to the subprime market, credit default swaps, or other investment vehicles may require review of the insured's application to determine whether its responses were forthright and accurate, as many subprime claims allege the policyholder's financial statements, which often are referenced in the policy's application, contain materially misleading statements. If false or misleading statements were made, this may give rise to a claim for rescission by the insurer. It should be noted that rescission does not necessarily require a showing of fraud.
Litigation against failed financial institutions and their outside professionals will continue to increase as more financial institutions fail and as the current economic situation continues to deteriorate. Regulators, and taxpayers, are certain to incur enormous expenses in responding to bank failures, and insurance policies may provide the only hope of recovery. Therefore, as with the S&L crisis, coverage litigation is likely to ensue. However, the cases decided during the S&L crisis are a useful guide to insurers who want to gauge the viability of their coverage defenses.
(1) FDIC, Failed Bank List, available at http:// www.fdic.gov/bank/individual/failed/banklist.html (last updated July 7, 2009).
(3) Timothy Curry and Lynn Shibut, The Cost of the Savings and Loan Crisis: Truth and Consequences, FDIC BANKING REVIEW, Vol. 13, No. 2, at 26 (2000), available at http://www.fdic.gov/bank/ analytical/banking/2000dec/index.html (last updated Feb. 15, 2001).
(4) Id. at 33.
(5) FDIC, FDIC Learning Bank, available at http://www.fdic.gov/about/learn/learning/when/1930 s.html (last updated May 2, 2006).
(6) See, e.g., Erisk.com, US Savings & Loan Crisis Case Study, at 1 (Aug. 2002), available at http://www.erisk.com/learning/casestudies/ussaving sloancrisis.asp.
(7) Lawrence J. White, Financial Institutions and Regulations, The S&L Crisis: Death and Transfiguration Symposium, 59 FORDHAM L. REV. 57, 63 (May 1991).
(8) Id. at 64.
(9) See Erisk.com, supra note 6, at 2-3.
(10) Id. at 4.
(11) White, supra note 7, at 64.
(12) White, supra note 7, at 65.
(13) FDIC, The S&L Crisis: A Chrono-Bibliography, available at http://www, fdic/gov/bank/ historical/s&l/(last updated Dec. 20, 2002).
(15) White, supra note 7, at 67.
(16) ERisk.com, supra note 6, at 4.
(17) White, supra note 7, at 68.
(18) Scott Reed, "Superpowers" of Federal Regulators: How the Banking Crisis Created An Entire Genre of Bond Litigation, 31 TORT & INS. L. J. 817, 822 (Summer 1996).
(19) ERisk.com, supra note 6, at 3.
(20) White, supra note 7, at 64-66.
(21) See Erisk.com, supra note 6, at 2-3.
(22) White, supra note 7, at 62; Curry and Shibut, supra note 3, at 27.
(23) White, supra note 7, at 65.
(24) Id. at 67.
(25) Reed, supra note 18, at 822.
(26) ERisk.com, supra note 6, at 4.
(28) FDIC, Volume I: An Examination of the Banking Crises of the 1980s and Early 1990s, at 100, available at http://www, fdic.gov/bank/ historical/history/(last updated June 5, 2000).
(30) Reed, supra note 18, at 826 (citing U.S. DEPARTMENT OF JUSTICE, ATTACKING FINANCIAL INSTITUTION FRAUD, FISCAL YEAR 1995 (Second Quarterly Report)).
(31) FDIC, Volume I: Managing the Crisis, Ch. 11, Professional Liability Claims, at 280, available at www.fdic.gov/bank/historical/managing/history111.pdf (last visited July 7, 2009).
(32) Id. at 281.
(33) Robert M. Horkovich, Coverage for Subprime Lawsuits, RISK MANAGEMENT, Dec. 1, 2008, available at http://www.allbusiness.com/bankingfinance/ banking-lending-credit-services/11732425-1.html.
(34) See, e.g., Joseph P. Monteleone, The Insured vs. Insured Exclusion in Policies Issued to Banks and Other Financial Institutions, 623 PLI/CoMM 547, 550 (June 4, 1992).
(35) See Fidelity & Deposit Co. of Maryland v. Zandstra, 756 F. Supp. 429, 432 (N.D. Cal. 1990); Branning v. CNA Ins. Cos., 721 F. Supp. 1180 (W.D. Wash. 1989); FSLIC v. Mmahat, 1988 WL 19304 (E.D. La. March 3, 1988).
(36) Wayne E. Borgeest, The Battle Over the Regulatory Exclusion, 623 PLI/COMM 565, 568 (June 4, 1992).
(37) Id. at 573-75.
(38) See Branning, 721 F. Supp. at 1184 (holding that the D&O policy's regulatory exclusion "substantially hinders FSLIC's exercise of its federal powers and therefore is contrary to public policy"); American Casualty Co. of Reading, Pa. v. FDIC, 677 F. Supp. 600, 604 (N.D. Iowa 1987).
(39) See American Casualty Co. of Reading, Pa. v. FDIC, 944 F.2d 455, 460-1 (8th Cir. 1991); FDIC v. American Casualty Co. of Reading, Pa., 995 F.2d 471, 473 (4th Cir. 1993).
(40) See Pepsico, Inc. v. Continental Casualty Co., 640 F. Supp. 656 (S.D.N.Y. 1986).
(41) Reed, supra note 18, at 819 (citing 12 U.S.C. [section] 1828(e); 12 C.F.R. [section] 563, 190).
(42) Id. at 829.
(43) Id. at 830.
(44) See Sharp v. FSLIC, 858 F.2d 1042 (5th Cir. 1988); FDIC v. Aetna Casualty and Surety Co., 903 F.2d 1073 (6th Cir. 1990).
(45) Reed, supra note 18, at 834.
(46) See FDIC v. Fidelity & Deposit Co. of Maryland, 45 F.3d 969 (5th Cir. 1995).
(47) Reed, supra note 18, at 849-52.
(48) Id. at 850.
(49) See FDIC v. Aetna Casualty & Surety Co., 947 F.2d 196, 208 (6th Cir. 1992) (holding that section 1823(e) did not preclude the insurer's rescission defense); but see FDIC v. Oldenburg, 34 F.3d 1529, 1551-52 (10th Cir. 1994) (holding that insurer's rescission defense was barred under section 1823(e)).
(50) Generally speaking, a "crisis" is described as an excess leverage in the financial system followed by a breakdown in confidence. An economic crisis becomes a recession if it blocks the provision of capital to businesses long enough to generate widespread corporate failures.
(51) MBS are loans that are purchased from banks, mortgage companies, originators, etc. and assembled into pools.
(52) A credit default swap is an agreement between two parties under which the seller agrees, in exchange for a periodic payment, to provide the buyer with protection in the event of a default or other credit event involving the underlying instrument (usually a MBS). Credit default swaps are like insurance, but the buyer does not actually hold the underlying instrument, nor does it need to actually have an interest in the underlying instrument. Credit default swaps create an incredible discrepancy between the parties.
(53) Kevin LaCroix, The Credit Default Swap Litigation Threat, THE D&O DIARY, June 5, 2008, available at http://www.dandodiary.com/2008/06/ articles/subprime-litigation/the-credit-default-swap-litigation-threat/.
(54) Eric Dash & Andrew Ross Sorkin, Government Seizes WaMu & Sells Some Assets, N.Y. TIMES, Sept. 26, 2008, at A1.
(55) Judy Greenwald, Subprime Liability Claims Could Reach $4B: Fitch, BUSINESS INSURANCE, April 9, 2008, available at http://www.business insurance.com/apps/pbcs.dll/article?AID=99992000 12687 (citing Fitch Ratings' Subprime Mortgage Exposure for Property~Casualty Insurers study, available at www.fitchratings.com).
(56) Kevin LaCroix, About Those Subprime D&O Loss Estimates', THE D&O DIARY, Feb, 10, 2008, available at http://www.dandodiary.eom/2008/02/ articles/d-o-insurance/about-those-subprime-d-oloss-estimates/.
(57) Richard D. Bernstein, John R. Oller& Jessica L. Matelis, Failed Financial Institution Litigation: Remember When, 5 NYU J. L. & BUS. 243, 243 (Spring 2009).
(58) The Bailout Plan authorizes the Treasury Secretary to purchase troubled assets from any financial institution, who may then "at any time, exercise any rights received in connection with troubled assets purchased under this Act." The Secretary may require, as a condition to purchasing any assets, an express assignment of rights.
(59) LaRue v. DeWolff, Boberg & Associates, Inc., 128 S. Ct. 1020 (2008).
(60) See Atherton v. FDIC, 519 U.S. 213, 213-14 (1997) (holding that "[s]tate law sets the standard of conduct as long as the state standard (such as simple negligence) is stricter than that of the federal statute. The federal statute nonetheless sets a 'gross negligence' floor, which applies as a substitute for state standards that are more relaxed").
(61) Bemstein, Oller& Matelis, supra note 57, at 259 60.
(62) See FSLIC v. Heidrick, 774 F. Supp. 352 (D. Md. 1991); FDIC v. American Cas. Co. of Reading, Pa., 843 P.2d 1285 (Co. 1992).
(63) Kevin LaCroix, D&O Insurance: Remember the Regulatory Exclusion?, THE D&O DIARY, July 23, 2008, available at http://www.dandodiary.com/2008/07/articles/d-o-insurance/ do-insuranceremember-the-regulatory-exclusion/.
IADC Member John J. McDonald, Jr. is a partner of Meagher & Geer PLLP. Mr. McDonald focuses his practice on complex litigation--especially in the areas of employment practices, commercial litigation, insurance coverage, professional liability, and legal malpractice claims. A member of the IADC Fidelity and Surety Committee, Mr. McDonald works with clients in the area of insurance and reinsurance coverage claims--including directors and officers, fiduciary and fidelity bond claims.
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|Author:||McDonald, John J., Jr.|
|Publication:||Defense Counsel Journal|
|Date:||Oct 1, 2009|
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