D&O Insurance Marketplace Entering a Transitional Phase

As Credit Crisis Ripples Through Economy, Competitive Conditions Could Be Shifting

The growing wave of subprime-related litigation is among the many side effects of the subprime mortgage meltdown. The litigation wave has changed, too, as the subprime crisis evolved during the past two years and as new and different litigants became involved. But as a result of the dramatic, recent headline events in the financial marketplace, the economic crisis entered a dark new phase that has already produced its own distinctive round of lawsuits. Like the underlying circumstances, the new litigation phase also seems darker and more threatening. And the events indicate the directors and officers (D&O) insurance marketplace is entering a new phase.

The first subprime-related securities class action securities lawsuit was filed in February 2007, just as the subprime meltdown began. Since then, as the problems developed into a general credit crisis, the associated litigation also has grown to a huge wave of lawsuits. As of Oct. 10, 2008, 124 subprime and credit crisis related securities class action lawsuits had been filed, in addition to 25 derivative lawsuits and 18 ERISA lawsuits.

Events took a dramatic turn in September 2008. Within the span of a few weeks, the government assumed control of Fannie Mae and Freddie Mac; Lehman Brothers filed for bankruptcy; Bank of America agreed to acquire Merrill Lynch; the government engineered a massive bailout of American International Group (AIG); regulators took control of Washington Mutual; and Citigroup sought to acquire Wachovia, only to have its bid topped by Wells Fargo. On top of those events came the massive $700 billion bailout.

Any one of the events alone would have been significant and disruptive. Taken collectively, the developments represent a massive reordering of the entire financial market. It will be months or even years before all of the consequences become apparent.

Shareholder lawsuits have already been filed against the directors and officers of the companies caught up in those events. For example, Fannie Mae and Freddie Mac shareholders have filed securities class action lawsuits alleging that they were misled about the companies’ financial condition. Merrill Lynch shareholders have sued alleging that the company’s planned merger with Bank of America is the result of a “flawed process and unconscionable agreement.” AIG shareholders are alleging that the defendants should be held accountable for the company’s “exposure to and grossly imprudent risk taking in the subprime lending market and derivative instruments.”

These lawsuits are perhaps inevitable. But there also has been other litigation that suggests the litigation wave may now have entered a new, more complex and perhaps more dangerous, phase.

The Primary Fund of the Reserve Family of Funds “broke the buck” when its net asset value fell below $1 per share. On Sept. 18, 2008, plaintiffs’ counsel filed a securities class action suit against the Fund’s underwriters, investment advisor, and officers and directors. The complaint alleges that the Fund’s offering documents failed to disclose “the lack of diversification of the Fund’s assets and exposure to, at a minimum, now largely worthless debt securities valued at $785 million of the now defunct Lehman Brothers Holdings Inc.”

In addition, on Sept. 22, plaintiffs filed a securities class action against Constellation Energy Group that alleges the company’s “exposure to credit problems of trading partners was much greater than represented” and that “in fact, one of Constellation’s key trading partners, Lehman, was having severe financial problems.”

The Constellation Energy suit demonstrates that the reverberations are spreading far beyond high-profile financial services companies. They are encompassing a broad array of participants — many of whom have little or no direct exposure to subprime. However they have exposures to other companies that had exposures to mortgage-related assets and investments. The subprime and credit crisis-related litigation wave not only has much further to run, but also may have entered a new phase involving a broad spectrum of litigants.

These events also mark a new phase in the D&O insurance marketplace. D&O insurance for financial institutions, which already was under pressure, has become even more challenging. In addition, it is clear that the broader D&O insurance marketplace has entered a transitional phase. The larger trends continue to develop. However, insurers generally are proceeding more cautiously. Whether these events will result in a market hardening remains to be seen. But these events have introduced the possibility that the competitive conditions that prevailed in the marketplace in recent years could be shifting.

Topics Lawsuits New Markets