Simon Goldring and John Bruce look at how the US sub-prime losses will affect the insurance market
Sub-prime is big news. It is estimated that the losses in the financial markets will exceed $100bn (£49BN) and, rather ominously for the insurance market, there are already at least 10 class actions in the US against the directors of financial institutions.
Even in the UK’s more benign directors’ and officers’ (D&O) risk environment, shareholders in Northern Rock, an indirect sub-prime casualty, are forming an action group ostensibly to bring proceedings against the directors claiming the creation of a false market.
So, will sub-prime be a disaster for the insurance market? Some research suggests it may not be. Although the financial institutions may have lost up to $100bn, Lehman Brothers’ equity research team has estimated the impact of sub-prime on both D&O and errors and omissions (E&O) insurers may be limited to $1bn (£0.49bn).
The reasons are: sub-prime lenders typically purchase low D&O insurance cover, often limited to $50m (£24m); US mortgage brokers do not typically buy D&O insurance; the credit rating agencies (which seem likely litigation targets) tend to self-insure both for E&O and D&O; and, while some hedge funds purchase D&O cover, many do not.
That said, other analysts are predicting insurance losses of $5bn (£2.4bn). Either way, the sums are substantial.
Sub-prime started as a US problem, arising from certain lenders’ appetite to provide mortgages to high-risk borrowers on low incomes and with poor credit ratings.
An increase in US base rates led to an increase in repossessions and, crucially, this coincided with a fall in property values. This meant the lenders were not able to recover their loans, and therefore suffered losses.
Sub-prime has become a global problem because the losses did not rest with the sub-prime lenders. These lenders typically packaged bundles of sub-prime loans and sold them into the financial markets, raising more money to lend to more sub-prime borrowers.
Those bundles of sub-prime loans were then sliced and diced by investment banks into different mortgage-backed securities.
The credit ratings agencies were consulted on to how to structure the mortgage-backed securities to achieve the best credit rating. These securities were then sold into the secondary market, such as hedge funds, structured investment vehicles and conduits.
So, how does the sub-prime problem translate into D&O claims?
There are a number of class actions in the US against financial institutions whose share prices fell as a result of their exposure to the sub-prime market.
At the moment, these securities class actions are mainly restricted to US sub-prime lenders and certain real estate investment trusts (Reits). These class actions allege that the directors failed to disclose their companies’ exposure to losses in the sub-prime market, thereby creating a false market.
The other high profile securities class action is against Moody’s. Many commentators have suggested rating agencies will be litigation targets.
This is certainly true for claims by the investors in the mortgage-backed securities rated by the agencies, but these will not typically result in D&O claims. There cannot be securities class actions against rating agencies other than Moody’s, because none of them is publicly listed.
“A drop in a companyâ€™s share price will precipitate, usually within a matter of days, a securities class action in the US. This does not happen in the UK
As a result, although rating agencies are the focus of a lot of criticism, their most immediate D&O exposure is likely to come from regulatory investigations.
The other litigation targets are mortgage brokers, investment banks, and hedge funds, but so far there has not been a slew of D&O class actions against them.
The possible actions against mortgage brokers and hedge funds seem more likely to be E&O based, although there may be scope for D&O actions depending on the facts of each case.
Regulatory investigations will, however, be a source of woe for all the above financial institutions. The SEC in the US is investigating whether Wall Street firms pressured the rating agencies to give top ratings to sub-prime bonds. And it is also looking at allegations of mis-pricing of securities, accounting errors and insider trading. These actions may impact D&O policies and are notoriously costly to manage.
In Europe, property prices have held up, which means there is a lower incidence of direct sub-prime losses, so any potential claims are likely to focus on the European financial institutions which invested in and advised on US mortgage backed securities. The answer probably has two parts – first dealing with civil claims and the second dealing with regulatory investigations.
As for civil claims, there will be fewer D&O claims in Europe than in the US. This is partly because the sub-prime losses are currently concentrated in the US. But this would remain the case even if there were more direct sub-prime losses in Europe, because the European litigation landscape is more benign than the US litigation landscape.
The reasons are the differences in: culture; litigation funding; the availability of (opt-out) class action procedures; and substantive law. Although the first three may be gradually changing, the difference in substantive law between the US and Europe remains marked, and acts as a barrier to large claims.
Take D&O claims as an example. As mentioned above, a drop in a company’s share price will precipitate, usually within a matter of days, a securities class action in the US. This does not happen in the UK because UK directors owe their primary duties to the company and not to shareholders or investors. The result is that in the UK, there have been no common law judgments against directors in favour of shareholders arising from misstatements contained in company reports.
Further, there is no English statute equivalent to the Exchange Act of 1934, which is the foundation of the majority of US securities class actions. The closest UK statutory provision is s463 Companies Act 2006, but this creates a liability only to the company and not to shareholders, and essentially only where the statement was dishonestly made.
As a possible counterbalance, a new derivative action procedure in the UK became effective on 1 October. This is intended to make it easier for minority shareholders to bring a claim in the company’s name (and for the benefit of the company) against directors.
Although there may be some early tests of this new procedure, our view remains that there will not be a flood of new claims, but there will inevitably be a long term effect.
As for regulatory investigations, we consider these will be relevant to European financial institutions, and these could trigger D&O notifications. The FSA conducted research into the direct sub-prime market long before the resulting credit crunch hit the newspaper headlines last month.
Indeed, the FSA has already investigated and fined the chief executive of a sub-prime mortgage broker concerning the implementation of risk management procedures, and we expect this regulatory activity to increase over the coming months.
Simon Goldring is a partner and John Bruce a lawyer with Reynolds Porter Chamberlain