Insurance Strategies
History tells us that a softening real estate market presents
specific risks to banks and other mortgage holders.
Insurance is one way to mitigate the risks.
Insuring Against the Potential Real Estate Bubble:
Steps a Bank Can Take Now to Mitigate Future Risk
Jeffrey A. Kiburtz
Everyday, in the popular and financial media, there is talk of a housing bubble and related financial phenomena. There are discussions of "pervasive" fraud, loose lending standards, moral hazard, "exotic" mortgages, excess liquidity, and speculation by amateur real estate investors - which make it sound as though anyone with exposure to real estate is desirous of losing money. At the same time, the real estate establishment is countering the "bears" with equally fantastic stories of a fundamental shift in investor demand toward hard assets, a strong national economy, a well-developed secondary mortgage market, diversification by foreign sovereigns from Treasuries to real estate, and just about anything to justify the sustainability of the current market.
Regardless of which side a bank executive is inclined to agree with, it is not his or her job to pinpoint what will actually happen. Rather, the challenge is to identify potential risks and take precautionary measures to mitigate the risks, taking into account both the likelihood of an occurrence and the magnitude of the potential loss. As a key player in the organization, a bank executive must accept that there is, at a minimum, a potential for a decline in real estate values and consequent market distress.
History tells us that a softening real estate market will be accompanied by an increase in the number of defaults on mortgages, inflicting loss on everyone from the defaulting homeowner to the investors holding mortgage-backed securities. History also tells us that the aggrieved parties will thereafter begin seeking ways in which to mitigate their losses, and that finger-pointing will ensue: the borrower will sue the broker, mortgage company, or retail lender for allegedly "predatory" practices.1 The lender, engaged in wholesale (using a broker) or correspondent (using a mortgage company) lines, will sue the broker, the mortgage company, or both for misrepresenting the credit quality of loans or aiding and abetting fraud committed by the borrower. The investors will sue the lenders and underwriters for misrepresenting the credit quality of loans or aiding and abetting fraud committed by the borrower, broker, and mortgage company. Around and around the lawsuits will go, making for a big game of "hot potato" in which the lenders - being wedged between consumer advocates, insolvent borrowers, brokers, and mortgage companies, and well-heeled, litigious investors - are most likely to end with the burnt hands.
Even if you believe the foregoing paragraph is overstated (it is), the point remains: a softening real estate market presents potential risks for banks that go beyond traditional business risks such as decreased loan production and defaults in portfolio loans. This article focuses on the foreseeable risks to lenders presented by the purported housing bubble2 and how those risks might be mitigated with a strong insurance portfolio.
At this point, we need to differentiate between insurable risk and noninsurable risk in the banking industry. In general, "ordinary" loan loss arising from default is considered inherent business risk and not insurable,3 as is decreased loan production. Risks such as fraud and employee dishonesty can, however, be mitigated with an adequate insurance portfolio. The line between noninsurable, "ordinary" loan loss and potentially insurable loan loss is far from clear-cut, and a detailed investigation of any significant loan loss should always be undertaken to identify any facts that might support a valid insurance claim.4
Fraud and Employee Dishonesty
A recent report by the Mortgage Asset Research Center indicated that, although the exact number of fraudulent transactions in the $3 trillion mortgage market is unknown, fraud is a "serious" problem in 26 states.5 The FBI, in May 2005, reported that "mortgage fraud is pervasive and growing."6 More recently, the FBI announced that reported loss caused by mortgage fraud exceeded $1 billion in fiscal 2005, up from $429 million in 2004. More troubling for mortgage lenders, the FBI believes that 80 percent of mortgage fraud is committed by industry insiders.7
There is furthr indication that lenders, even if not directly involved in the fraud, may be turning a blind eye to fraud being committed by borrowers, brokers, and mortgage companies in the wholesale and correspondent context.8 In November 2005, at a Texas Mortgage Bankers Association event in Dallas, it was reported that mortgage companies, concerned that production might be affected by questioning potential fraud, are "not going to slow anything down."9 Although this reported statement likely does not reflect the industry as a whole, it underscores the potential for "moral hazard" created by a situation where the party handling the direct relationship with the borrower is a party whose short-term financial interest lies in getting the loan funded, not in ensuring credit quality.
Insuring Against Fraud and Employee Dishonesty
There are two distinct types of loss that can arise from fraud: loss caused by third-party suits brought against a lender for alleged fraud committed directly by the bank or complicity with fraud committed by the borrower, broker, or mortgage company; and first-party loss caused by default on a fraudulently obtained loan being held by the lender. A directors and officers liability (D&O) policy is the most likely source of coverage for loss arising in the third-party context, while a Standard Form 24 Financial Institution Bond (FIB) is the type of insurance most likely to cover the first-party loss.
The following is a discussion of provisions in the respective policies to which bank executives should pay close attention in the current market.
Directors and Officers Liability Policies
When analyzing coverage under D&O policies, it is critical to keep in mind that these policies are not standardized; very substantial differences exist from policy to policy, and the specific terms must be closely scrutinized. Accordingly, the following discussion speaks only in generalities, and exceptions to these statements will almost certainly exist.
Fraud Exclusions
D&O policies typically provide coverage for "loss" arising from "claims" first made during the policy period10 against the "insured person" or "insured entity"11 for a "wrongful act," with each of these terms usually defined. "Wrongful act" is typically defined broadly and will include claims for fraud and fraud-related claims such as negligent misrepresentation. However, every D&O policy will exclude fraud at least in part, with some policies providing no coverage for fraud claims and other policies providing coverage for "defense costs" incurred defending fraud claims.12
It is critical to examine the specific language by which fraud is excluded under a policy. Many policies exclude coverage for fraud, but only if and until the insured is actually found liable for fraud.13 Express language to this effect has been watered down in many policies, with coverage excluded for fraud "in fact," which - while arguably requiring an "in fact" determination of fraud, thereby providing the same amount of coverage as the first example listed above - creates unnecessary ambiguity, to the ultimate detriment of the policyholder. A third iteration of the fraud exclusion commonly found in D&O policies excludes coverage for any "actual or alleged"14 fraud, effectively acting as an absolute fraud exclusion, unless the exclusion contains additional qualifying language.
Although the differences in the foregoing iterations may appear merely semantic to many, the effect of having a policy with one iteration or another - with the first iteration, expressly requiring a finding of actual fraud, being the most favorable for a policyholder - may be the difference between which party, the bank or the insurer, pays the substantial defense costs incurred defending a fraud claim.
Allocation Provisions
Unlike policies containing a "duty to defend" provision, most D&O policies do not give the insurer the right and duty to defend the insured. Rather, the insured retains its own defense counsel and controls its own defense, with the insurer reimbursing defense costs as incurred. The lack of a "duty to defend" frequently gives the insurer the right to allocate defense costs between covered and noncovered claims and covered and noncovered parties, reimbursing only the portion of defense costs incurred in connection with covered claims brought against covered parties.
The method by which this allocation is made can have substantial effect on the amount of coverage available to the insured. In general, courts interpreting D&O policies rule that the insurer is obligated to pay defense costs that are "reasonably related" to the defense of the insured claims. Settlements or judgments are allocated according to the "larger settlement rule," whereby allocation is appropriate only if the amount of the settlement is increased by virtue of the uninsured claims.
To avoid these rules of interpretation, many insurers include allocation provisions in the D&O policy that purport to require allocation under a "relative exposure" theory. These provisions will typically be included in the Conditions section of the policy and require an allocation be made, taking "into account the relative legal and financial exposures, and the relative benefits obtained in connection with the defense and/or settlement, of and between the covered and non-covered parties and matters involved in the Claim."
Although the enforceability of these "relative exposure" allocation provisions is questionable, they are not favorable to the insured and should be avoided, if possible.
Subsidiary Past Acts Exclusions
With the recent wave of bank mergers and acquisitions, another important provision to be aware of is the subsidiary past acts exclusion found in most, if not all, D&O policies. These exclusions bar coverage for claims arising from wrongful acts of the target bank and its former directors and officers that occurred prior to the merger or acquisition.
Because such exclusions are standard and generally not subject to negotiation, the primary source of insurance coverage for the acquiring bank will be the "tail" purchased for the target by the acquiring bank at the time of the merger or acquisition. However, because the acquiring bank typically is not an insured under the "tail," accessing insurance assets will require the acquiring bank to make a claim against the target's former directors and officers.15
Other Exclusions
D&O policies are frequently packaged with other types of coverages, such as bankers professional liability or lender liability coverage. With these specialized coverages come specialized exclusions such as exclusions for loss arising from "underwriting, securitizing, [or] syndicating debt or equity securities." Although the potential variations of coverages and exclusions are far too numerous to discuss here, the importance of closely scrutinizing the terms of a policy in the context of the particular lines of business in which the bank is engaged cannot be understated.
Financial Institution Bonds
Most financial institutions are required by law to carry Standard Form 24 Financial Institution Bond coverage. As the name suggests, FIBs are standardized policies drafted by the Surety Association of America (SAA) with input from the American Bankers Association (ABA).16
FIBs are first-party indemnity policies that provide coverage for loss sustained by the insured bank. For this reason, FIBs are unlikely to respond to loss caused by a third party bringing suit against the bank. However, the distinction between what is a covered first-party loss and a noncovered loss caused by a third-party suit is not clear in many situations. A thorough investigation and analysis of any sizeable loss should be conducted to determine whether facts implicate coverage under the FIB.
In 2004, SAA and ABA unveiled the most recent version of the FIB, replacing the prior version drafted in 1986. As with the earlier versions, the 2004 FIB is offered with many choices for the riders an insured can procure. The following insuring agreements are the most likely to respond to a claim arising from mortgage-related fraud.
Insuring Agreement A
Insuring Agreement A generally provides coverage for loss resulting directly from "dishonest or fraudulent" acts committed by an employee with the "active and conscious purpose"17 to cause the insured loss. However, with respect to "loan loss," the dishonest employee must have received in conjunction with the dishonest act an "improper financial benefit," which does not include salary, bonuses, commissions, or other compensation paid by the employer.
With respect to risk related to mortgage fraud, Insuring Agreement A provides coverage under limited circumstances. The dual requirements that the dishonest employee must act with the "active and conscious purpose" to cause the insured loss and must receive an "improper financial benefit" will likely eliminate coverage for situations where the employee - seeking to earn commissions, meet production goals, or even receive an improper "kickback" - assists a real borrower in preparing fraudulent loan documents. Coverage under Insuring Agreement A is more likely to be found when the dishonest employee participated in more elaborate fraudulent schemes involving, for example, fictitious borrowers or nonexistent property serving as collateral.
Insuring Agreement E
Insuring Agreement E generally provides coverage for loss resulting directly from a bank having given value for a security, including a mortgage, that contains a "forgery" or is a "counterfeit." Both "forgery" and "counterfeit" are defined somewhat narrowly and in a way that does not necessarily comport with the ordinary usage of those terms.
Insuring Agreement E likely does not cover loss resulting from ordinary mortgage fraud involving borrower misrepresentations in loan documents. Insuring Agreement E is more likely to respond to loss arising from a lender distributing loan proceeds to the perpetrator of an identity theft scheme in which the perpetrator grants a security interest in property not owned by him. Another example of a claim potentially covered under Insuring Agreement E is loss arising from a portfolio lender acquiring a mortgage that is identical to a legitimate mortgage in all respects except that it is a counterfeit.
Insuring Agreement G
Insuring Agreement G had, until the 2004 version of the FIB, been offered only as a rider. It generally provides coverage for a bank having extended credit or otherwise having acted upon a mortgage (or similar instrument) that is defective because it contains the signature of a person who, although the proper party, signed the document under false pretenses or because of fraud.
Insuring Agreement G is an important backstop to Insuring Agreement E. In recent years, there have been increasing reports of schemes in which the perpetrator convinces the homeowner to sign over certain rights to the perpetrator, allowing the perpetrator to "drain" equity from the victim's home (through loans given by a bank). Insuring Agreement E would likely not respond to loss arising from this variety of fraud because the instruments were originals and bore the proper party's signature, thus not meeting the requirement that the security be a counterfeit or contain a forgery. However, Insuring Agreement G would likely respond to this variety of fraud.
Other Sources of Insurance
In addition to insurance policies under which the bank is directly insured, the insurance available to parties against which a bank is likely to have a claim can serve to mitigate the bank's loss. Lenders in the wholesale and correspondent segments of the market that have incurred, or face potential, fraud-related loss likely will have a claim against the broker or the mortgage company that handled the front-end borrower relationship. If a lender pursues a claim against the broker or the mortgage company, the insurance available to these parties will likely be important. Brokers, who are typically individuals, and mortgage companies, which are typically thinly capitalized, are unlikely to have assets sufficient to satisfy a large judgment in favor of the lender.
A second scenario under which a lender may be able to recover under insurance available to a third party is when a lender is sued for the wrongful acts of an acquired bank's former directors and officers that occurred prior to the acquisition. Due to the subsidiary past acts exclusion (discussed above), the bank's own insurance will likely not cover the claim. However, the bank likely will be able to make a claim against the acquired bank's former directors and officers that will trigger insurance coverage under the prior D&O policy's "tail" purchased at the time of the acquisition.There two steps that should be taken now to mitigate future risk. A bank should ensure that all brokers or mortgage companies that the bank deals with on a regular basis carry sufficient insurance and should obtain copies of those policies, if possible. For banks looking to, or in the process of, acquiring a lender or mortgage company, the D&O policy of the entity being acquired should be carefully scrutinized and a "tail" should be purchased. Under either scenario, the importance of having the policy that may be called upon for coverage in place prior to the necessity of making a claim cannot be overstated.
Act Now to Avoid Future Problems
Although the "hard" insurance market of a few years ago has "softened" some, insurers are still taking a very hard line on claims. If banks and their insurers begin incurring losses arising from a downturn in the real estate market, insurers' positions will undoubtedly harden more. Steps that can and should be taken now to mitigate future risk necessarily involve understanding the nuances of insurance.
Endnotes
1. In some circumstances, upstream players such as the issuers and underwriters of mortgage-backed securities can be found liable for aiding and abetting fraud committed by the broker or mortgage company, as was the case for Lehman Brothers in the First Alliance matter. See Henriques, Diana B., "Lehman Aided in Loan Fraud, Jury Says," The New York Times (June 17, 2003).
2. For a discussion of the housing bubble, see BusinessWeekOnline, "Housing Bubble - or Bunk?" (June 22, 2005), available at http://www.businessweek.com/bwdaily/dnflash/jun2005/nf20050622_9404_db008.htm.
3. Financial guarantee bonds, credit default swaps, and other specialized financial instruments can provide some form of "insurance" - in a nontechnical sense of the word - against "ordinary" loan loss. However, these instruments are beyond the scope of this article.
4.Financial institution bonds and directors and officers liability policies (and, although not discussed here, professional liability policies) are the types of insurance most likely to cover the risks contemplated here. A bank's commercial general liability policies likely will not respond to the economic loss arising from fraud or employee dishonesty.
5. Iwata, Edward, "Fraud booms with mortgage market," USAToday.com, available at http://www.usatoday.com/money/perfi/housing/2005-10-04-fraud-usat_x.htm.
6. U. S. Department of Justice, Federal Bureau of Investigation, Financial Crimes Section, Criminal Investigative Division, "Financial Crimes Report to the Public" (May 2005), available at http://www.fbi.gov/publications/financial/fcs_report052005/fcs_report052005.htm.
7. Chambers, Jennifer, "Mortgage fraud soars," The Detroit News (February 21, 2006), available at http://www.detnews.com/apps/pbcs.dll/article?AID=/20060221/BIZ01/602210392/1010.
8. Lenders involved in the wholesale and correspondent segments of the market face liability for the acts of brokers and sub-originators under principles of agency law or under aiding and abetting theories. Although more difficult to prove, lenders also face liability, in limited circumstances, for aiding and abetting torts committed by borrowers.
9 Morse, Neal J., "Is real estate fraud getting the greenlight?" Inman News (November 30, 2005). Available at http://inman.com/Inmannews.aspx?ID=48992&CatType=R (subscription required).
10. Importantly, the trigger for coverage under a claims-made policy is the date on which the claim is made, not the date on which the alleged wrongful act occurred.
11. Many D&O policies issued to public companies provide entity coverage - also known as "Side C" coverage - only for "securities claims." While typically defined to include traditional types of "securities claims" (i.e., claims for wrongful acts associated with securities issued by a public company), the definition of "securities claims" might be broad enough to provide coverage for claims related to the issuance of loans.
12. As a general matter of law, a party cannot be insured for its own acts of fraud. This general legal principle often precludes coverage for payments made on account of an adverse judgment from, or in settlement of, a claim for fraud. In recognition of this, some policies provide coverage for "defense costs" incurred defending a fraud claim, even if amounts paid in settlement or satisfaction of an adverse judgment are not covered.
13. Although it is critical to ensure that the policy requires an actual adjudication of fraud before the fraud exclusion applies, the analysis does not end there. Many policies provide the insurer with the express right to seek reimbursement of funds advanced on a claim that is ultimately found not to be covered. The language of such a provision should be closely examined to ensure that it does not grant the insurer rights broader than intended.
14. The addition of the word "alleged" to the fraud exclusion substantially broadens the exclusion. For example, with "alleged" fraud excluded from coverage, no coverage would be available for meritless fraud claims alleged by overzealous plaintiffs' attorneys; whereas with only "actual" fraud excluded, coverage would be available for meritless fraud claims because there was no "actual" fraud.
15. In situations where the acquiring bank agrees to indemnify the target's former directors and officers, making claims against those persons to trigger insurance coverage becomes more complicated. The details of these complications exceed the scope of this article.
16. Insurance Services Office, Inc., (ISO) also offers a policy covering employee dishonesty.
17. In the 2004 version of the FIB, the language of the intent requirement was modified from "manifest intent" to "active and conscious purpose," which will likely require the insured to make a clearer showing that the dishonest employee intended to cause the insured loss.
Jeffrey A. Kiburtz is of counsel at Wood & Bender, one of the nation's leading law firms in the fast-growing area of insurance policy enforcement. Kiburtz devotes his practice to commercial coverage disputes involving directors and officers liability policies and financial institution bonds, among other types of business insurance. The firm is headquartered in Southern California and represents corporate clients in coverage disputes and litigation throughout the United States. He can be reached at jak@wood-bender.com.