Is Any Company Safe from Subprime Related Lawsuits?

Insurance companies that write Director and Officer's (D&O) and Errors and Omission (E&O) insurance are debating what the future holds in the way of class action litigation against their policy holders.

Writing in Business Insurance, Dave Lenckus outlines the pros and cons of whether insurance companies such as Liberty Insurance Underwriters could be hit hard should the subprime crisis begin to impact companies outside the financial services sector.

One school of thought, according to Lenckus, is that "errors and omissions liability litigation could envelope companies that facilitated home purchases by subprime risks who eventually defaulted," and by extension, directors and officers at non-financial services sector that shareholders think failed to disclose how they would be affected by the credit crisis.

He cites as examples appraisers, "fee hungry" mortgage brokers, and real estate agents who participated in putting home buyers into subprime mortgages they could not afford.

There may also be, as Lenckus puts it, an unknown number of "widget manufacturers" which bought various mortgage-backed financial instruments as investments that must now be devalued. This will impact the company's bottom line and provide an impetus for shareholder suits.

Even companies that did not invest in subprime instruments may be vulnerable. Companies that turned to other investments still face lower values, because the subprime mess has weakened the bond insurers that covered the issuers of those instruments.

Even the economic downturn could create a D&O liability threat, experts say.

"Toll Brothers Inc., a Horsham, Pa.-based builder of luxury homes that did not have a lending operation, already is defending against such a claim. Investors charge that they were misled by Toll's assertions that its business model was immune to the credit crisis. Demand for the builder's homes did shrink, however, and its stock price nosedived."

Other experts, however, say that, apart from those hundreds of people who have been arrested by the FBI in the last few months for various forms of mortgage fraud, shareholder victims will mostly blame the companies that created the problems rather than the directors and officers or the employees that carried out corporate orders. So far, plaintiffs are doing that, principally targeting the financial institutions.

The subprime mortgage situation, by most accounts, is expected to cost financial institutions as much as $400 billion in credit losses and write-offs of subprime mortgage securities.

Lenckus quoted Kevin LaCroix, a partner with OakBridge Insurance Services L.L.C. in Beachwood Ohio as saying "The question for underwriters is, "How far afield will this spread?"

In setting rates for D&O and E&O policies, insurers weigh current rather than expected losses, so any expectations for future losses would not be factored into the rate calculations and rates for these policies are falling as much as 15 percent for companies outside the financial services sector. But underwriters are asking applicants a lot of questions about their exposures to mortgage-related risks and restricting policies to existing coverage by "beefing up the pending and prior claims provisions in renewed policies."

But reality has hit home for financial sector companies, including real estate companies, which are looking at 100 to 200 percent premium increases and trouble finding coverage.