Insurance Coverage and the Subprime Mortgage Crisis
Steven M. Kaplan
Partner, Washington
Gregory S. Wright
Partner, Washington
David P. Schack
Partner, Los Angeles
Philip H. Hecht
Partner, Washington
1
Outline of Presentation
 Types of investigations, lawsuits and losses faced by
companies in the subprime lending industry
 Coverage afforded by D&O policies to the officers and
directors of companies in the subprime lending industry
 Coverage afforded by E&O policies for acts, errors or
omissions in rendering or failing to render professional
services
 Strategies for pursuing coverage under both D&O and E&O
policies, or any other relevant coverages
2
What is the Subprime Crisis?
 Increased delinquencies, defaults and foreclosures
 Inability to make new loans to “subprime borrowers”
 Contraction of mortgage finance industry
 Margin Calls
 Change in price for loans or no secondary market for loans
 Bankruptcy of lenders and conduits
 Credit crunch
 Losses for all participants
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Who are the Participants?
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Borrowers
Mortgage brokers
Mortgage lenders
Conduits
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Who are the Participants? (continued)
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Servicers
Issuers
Rating agencies
Investors of whole loans
Underwriters
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Who are the Participants? (continued)
 Purchasers of mortgage backed securities
(individuals, lenders, brokers, private equity funds,
hedge funds, mutual funds, pension funds,
insurance companies)
 Insurers
 Credit enhancers
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What are the Actions?
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Administrative enforcement actions
Consumer class actions
Individual consumer actions
“Commercial” disputes between industry
participants
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Administrative Enforcement Actions
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State Attorneys General
FTC
DOJ
Federal banking agencies
State banking and consumer credit departments
SEC
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Consumer Class Actions
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Shareholder suits for alleged violations of securities laws
Unfair and deceptive lending practices
Option ARM loan cases (including claims under TILA)
Discriminatory lending practices (claims under ECOA/FHA)
Advertising practices (FCRA firm offer on credit cases)
Servicing practices
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Individual Consumer Actions
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Predatory lending
Wrongful lending
Fraud
Option ARM loans
Appraisal practices
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“Commercial” Disputes Between Industry Participants
 Claims by whole loan purchasers against originators / sellers.
 Claims by institutional investors against underwriters /
issuers, lenders and / or servicers.
 Claims by individual investors against institutional investors.
 Claims by warehouse lenders against borrowers (lenders /
conduits).
 Claims by mortgage lenders against warehouse lenders and
banks.
 Claims by investors against rating agencies.
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D&O Coverage

PART A:
 The Company shall pay, on behalf of the Insured Persons, Loss for which the
Insured Person is not indemnified by the Organization and which the Insured
Person becomes legally obligated to pay on account of any Claim first made
against the Insured Person during the Policy Period for a Wrongful Act.
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PART B:
 The Company shall pay, on behalf of the Organization, Loss for which the
Organization grants indemnification to an Insured Person, as permitted or
required by law, and which the Insured Person becomes legally obligated to pay
on account of any Claim first made against the Insured Person during the Policy
Period for a Wrongful Act.
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PART C:
 The Company shall pay, on behalf of the Organization, Loss which the
Organization becomes legally obligated to pay on account of any Securities
Claim first made against the Organization during the Policy Period for a
Wrongful Act.
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Private Company D&O Insurance Coverage
 Part C—“Entity Coverage”—may be expanded to
cover all “Claims” as defined by Policy.
 Part C coverage may not be limited “Securities
Claims.”
13
Definition of “Wrongful Act”
Wrongful Act means:
(a) any error, misstatement, misleading statement, act,
omission, neglect, or breach of duty committed,
attempted, or allegedly committed or attempted by
an Insured Person in his or her Insured Capacity, or
for purposes of coverage under Part C, by the
Organization; or
(b) any other matter claimed against an Insured
Person solely by reason of his or her serving in an
Insured Capacity.
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Potential Subprime Mortgage Claims That May Trigger
D&O Insurance Coverage
 Investigations by SEC, Attorneys General or other
governmental agencies.
 Investor lawsuits alleging omissions or misrepresentations
relating subprime mortgage problems.
 Claims or actions by employees relating to investments in
subprime mortgages by the company in connection with
retirement plans/401k’s.
 Claims or actions by borrowers against directors/officers (or
entities under private D&O insurance) for allegedly improper
lending activities.
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Definition of Claim
Claim means:
(a) a written demand for monetary damages or non-monetary
relief;
(b) a civil proceeding commenced by the service of a complaint
or similar pleading;
(c) a formal civil administrative proceeding commenced by
the filing of a notice of charges or similar document or
by entry of a formal order of investigation or similar
document; or
(d) a criminal proceeding commenced by the return of an
indictment against an Insured Person or the Organization
under Part C for a Wrongful Act.
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Key Issues Under Definition of Claim
 “formal” vs. “informal” investigation
 Expand to include “subpoenas” and “target” letters
 Expand to include “investigations” without limitations
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Definition of Loss
 Loss means the amount the Insured Person (for purposes of
Part A and B) or the Organization (for purposes of Part C)
becomes legally obligated to pay on account of any covered
Claim, including but no limited to damages, judgments,
settlements, pre-judgment and post-judgment interest and
Defense Costs.
 Typically “Loss” will not include punitive damages, taxes,
fines, penalty and the multiplied portions of damage awards.
To the extent these items are insurable, they may be included
by negotiation. Restitution may not be insurable.
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Definition of Defense Costs
 Defense Costs means that part of Loss consisting
of reasonable costs, charges, fees (including but
not limited to attorneys’ fees and experts’ fees) and
expenses incurred in defending any Claim and the
premium for appeal, attachment and similar bonds.
 Defense Costs in a D&O policy typically reduce the
available policy limits.
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Potentially Applicable D&O Exclusions
 Fraudulent/dishonest conduct
 Personal profit
 Known claims
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Other Issues
 Claims made feature of policies
 Self-liquidating feature of policies
 Notice of facts and circumstances that may give rise
to a claim
 Problems arising from settlement without consent
 Need for early notice
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Errors and Omissions (E&O) Insurance
 The wave of subprime litigation also may trigger coverage
under E&O insurance policies.
 The Financial Times reports:
 Companies being hit by multi-million dollar legal actions are
expected to claim on their E&O and D&O policies.
 An unnamed underwriter for a leading insurer states that there is
“D&O and E&O exposure all over the place. Wherever
someone had their fingers in the pie, someone’s going to get
sued.”
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See “US legal battles over mortgage crisis could cost London insurers,” Financial Times, August 20,
2007.
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E&O Overview
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Overview of E&O Terms
Differences between E&O and D&O
Potential Claims that May Trigger E&O Coverage
Potential Defenses
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What is E&O Coverage?
 E&O is the “general rubric” used to describe many types of
insurance that protect persons or entities that render
“professional services” for liabilities arising from errors or
omissions committed while rendering such services, usually
for a fee or commission.
 Terms vary widely by industry and often are narrowly tailored
to “professional services” of particular industry.
 Terms vary widely not only by industry, but also by insurer
within an industry group.
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Typical E&O Insuring Agreement
 “To pay on behalf of the Insured all sums which the
Insured shall become legally obligated to pay as
Damages resulting from any Claims first made
against the Insured and reported to the Insurer
during the Policy Period … for any Wrongful Act of
the Insured or any other person for whose actions
the Insured is legally responsible, but only if such
Wrongful Act … occurs solely in the rendering or
failure to render Professional Services.”
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AIG, Mortgage Bankers/Mortgage Brokers E&O Insurance, 63530 (3/96).
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Other Common Features of E&O Coverage
 Claims-Made Coverage (claim generally must be made
against insured during policy period; often claim must be
reported to insurer during policy period or set time period
thereafter).
 Defense (policies vary widely, but certain policies issued to
mortgage lenders include a duty to defend, rather than a duty
to reimburse defense costs).
 Damages (often defined broadly to include all economic
losses, but some policies limit coverage for fines, penalties,
and/or punitive damages).
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Other Common Features of E&O Coverage, cont’d.
 “Claim” – wide variation of coverage for regulatory
investigations or proceedings.
 Some policies expressly include
administrative/regulatory proceedings and
investigations.
 Some policies define “Claim” as “any demand against
the Insured for monetary Damages, and includes a
lawsuit” (silent on regulatory proceedings).
 Some policies exclude Claims brought by any state
or federal regulatory or administrative agency.
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E&O v. D&O
 The line between D&O and E&O is not always clear, and
certain lawsuits may potentially trigger coverage under both
lines of coverage.
 “Professional Services”
 D&O policies generally exclude claims related to rendering of
“professional services.”
 E&O policies expressly afford coverage for “professional services.”
 “Insured”
 D&O (directors and officers and, in limited circumstances, company
and/or employees).
 E&O policies often define “Insured” more broadly to include the
company itself, as well as directors, officers, employees, and thirdparties for whose actions the Insured is legally responsible.
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Definition of “Professional Services”
 Some policies define “professional services”
generically:
 One policy defines Wrongful Act as certain errors or
omissions committed by the Insured “solely in the
performance of or failure to perform professional
services for others in the Insured’s Profession as
stated in Item 1.A. of the Declarations.” London,
Specimen SUA MCPL 04.
 Many policies specifically define “professional
services” based on industry of policyholder.
29
Definition of “Professional Services,” cont’d.
 Lenders (“the origination, sale, pooling and servicing of
mortgage loans secured by real property …”).
 Financial Services firms (“services that an Insured renders
pursuant to an agreement with a customer or client, as long as
the customer pays a fee, commission, or other compensation
…”).
 Investment Banks (“those services performed … by the Insured
(or by any other person or entity for whose acts, errors, or
omissions the Insured is … legally responsible) for, for the
benefit of, or on behalf of a Customer … for a fee, commission
or other consideration”).
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Claims That May Trigger E&O Coverage
 Given wide array of potential claims and
potential defendants, it is difficult to even begin
to list the potential types of claims.
 Imperative to compare specific allegations
against specific policy language.
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Claims That May Trigger E&O Coverage, cont’d.
 Borrowers suing Mortgage Lenders (Note: policies cover
claims related to the “origination, sale, pooling and servicing
of mortgage loans”).
 Alleged negligent failure to disclose terms of loans (e.g., alleged failure
to properly disclose points and pre-payment penalties, failure to
disclose teaser rates and adjustable nature of loan, etc.).
 Alleged negligent failure to investigate brokers or supervise employees.
 Alleged improper reporting to credit agencies.
 Alleged statutory violations (Truth in Lending Act / Unfair Competition
Act).
 Some E&O policies only exclude “willful violations of statutes”;
some exclude only certain statutory violations (civil rights laws,
antitrust laws, and/or unfair competition statutes); some do not
exclude.
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Claims that May Trigger E&O Coverage, cont’d.
 Issues related to securitization may result in a wave of
litigation that may trigger E&O policies.
 Investors suing Funds (e.g., misrepresentation, bad pricing,
failing to follow investment guidelines, etc.).
 Funds/Institutional Investors suing Underwriters/Banks who
securitized and sold mortgages (e.g., misrepresenting quality of
underlying loans, covering up delinquencies, misrepresenting
coverage available for foreclosures, etc.).
 Banks suing Trustees who serviced underlying loans (e.g.,
alleged breaches of fiduciary duties in servicing loans).
 Banks suing original Mortgage Lender/Originator (e.g.,
misrepresentations).
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Potential Exclusions and Defenses
 Fraud Exclusions.
 Final Adjudication standard v. “In fact” standard.
 Specific Endorsements excluding claims for
“Predatory Lending” claims.
 Exclusions barring claims arising from any
investor’s interest in mortgage-backed securities or
the filing of any registration statement therewith,
unless the claim results from the rendering of
Professional Services.
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E&O Conclusion
 Terms of Policies vary widely.
 When claims are made, it is imperative for
policyholders to review specific allegations and
specific policy terms to evaluate potential for
coverage and to take steps to preserve rights to
coverage.
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Strategies for Pursuing Coverage
KEY POLICY CONDITIONS
NOTICE
 Must be in writing
 Usually must be given “as soon as practicable” or within limited time
period, e.g., 60 days
 Actual Claim
 Wrongful Act that may lead to claim
 Circumstance that “could reasonably be expected to give rise to a
claim”
 Must be given within policy period or extended reporting period
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Strategies for Pursuing Coverage
KEY POLICY CONDITIONS
NOTICE (cont.)
 Often to specific address or specific outside counsel
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Strategies for Pursuing Coverage
KEY POLICY CONDITIONS
DEFENSE AND SETTLEMENT
 Defense costs count against policy limits
 Some policies require Insurer to defend any claim
 Insurer selects and pays counsel
 Some policies require Insured to defend, subject to
 (a) Insurer’s right to tender defense to Insurer or
 (b) Insurer’s option on assume defense
 If Insured defends, Insurer typically advances defense costs
 If Insured tenders claim to Insurer then Insurer chooses counsel
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Strategies for Pursuing Coverage
KEY POLICY CONDITIONS
DEFENSE AND SETTLEMENT (cont.)
 Some policies require Insured to choose from list of panel
counsel for particular types of claims, e.g., employment and
securities
 Regardless whether Insurer or Insured defends,
policies require Insurer’s prior written consent for:
 Settlement
 Admission of liability
 Incurring of any defense cost
 “Hammer” clauses may limit the Insurer’s obligations
where Insured refuses to settle
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Strategies for Pursuing Coverage
KEY POLICY CONDITIONS
ASSISTANCE AND COOPERATION
 Insured must assist and cooperate with Insurer at its
own cost, including
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Submission to examination by Insurer
Attendance at hearings, depositions, etc.
Production of all pertinent records
Negotiation of settlements
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Strategies for Pursuing Coverage
KEY POLICY CONDITIONS
ASSISTANCE AND COOPERATION (cont.)
 Some policies require additional due diligence
 Reasonable efforts to mitigate actual or potential loss
 Maintenance of customary insurance for mortgage banking
transactions
 Reinstatement or replacement of insurance that lapsed or
has been rendered invalid
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Strategies for Pursuing Coverage
KEY POLICY CONDITIONS
ACTION AGAINST INSURER
 Most policies state that Insured cannot sue Insurer for
coverage unless
 Insured fully complies with all policy terms
 Insured’s obligation to pay claim has been determined by
judgment or settlement
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Strategies for Pursuing Coverage
KEY POLICY CONDITIONS
ACTION AGAINST INSURER (cont.)
 Some policies require binding arbitration under
American Arbitration Association rules
 Some policies have more elaborate dispute
resolution provisions that give Insurer sole discretion
whether to submit dispute to ADR
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Strategies for Pursuing Coverage
WAYS COVERAGE CAN BE JEOPARDIZED
 Most policies have clause making policy application an
integral part of the policy
 All statements and information in application are part of the
policy
 All statements and information in application are “deemed
material” to the Insurer’s agreement to insure
 Any misrepresentation in application voids policy in its entirety
 Some policies are unitary contracts and not severable
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Strategies for Pursuing Coverage
WAYS COVERAGE CAN BE JEOPARDIZED
 Some policies state that misrepresentation does not void
policy as to “innocent” insureds
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Failure to provide timely notice
Failure to cooperate
Settlement without insurer’s prior written consent
Change of ownership/control
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Strategies for Pursuing Coverage
PRACTICAL POINTERS
 Locate your policies and policy applications for:
 E&O
 D&O
 Mortgage Bankers Bond
 Check that your policies are current and have not lapsed
 Establish internal procedures for notification of insurers
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Strategies for Pursuing Coverage
PRACTICAL POINTERS
 Be prepared for “No”
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Insurers are well aware of potential for significant claims
Insurers will take advantage of any “out” under the policy
Know your history with your Insurer(s)
Many Insureds have never submitted claims to Insurers
How long have you been with Insurer?
What premiums have you paid
Engage competent insurance coverage counsel at early stage
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Question & Answer
 If you are on a speakerphone, please pick up the handset before
you ask your question and follow the instructions provided below.
 To ask a question:
 Press *(star) 1 on your touch tone phone. You will hear a tone
indicating you have been placed in queue.
 The AT&T moderator will take your name and further instruct you.
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Contact Information
Philip H. Hecht
philip.hecht@klgates.com
202.778.9380
David P. Schack
david.schack@klgates.com
310.552.5061
Steven M. Kaplan
steven.kaplan@klgates.com
202.778.9204
Gregory S. Wright
gregory.wright@klgates.com
202.778.9250
49