During a session of the Professional Liability UnderwritingSociety International conference held in San Francisco earlier thismonth, George Gowen, a member of Cozen O'Connor in Philadelphia,detailed three categories of cases emerging from the subprimecrisis–against mortgage lenders, firms involved in thesecuritization process, as well as investment managers andadvisers.

An offshoot of the second category–lawsuits against securitiesissuers and underwriters–is one unusual case filed by the City ofCleveland against 21 investment banking firms in January, henoted.

The suit targets “all major Wall Street firms” as defendants,under the theory that the securitization process the investmentbanks “created and funded” had “fed the growth of predatory lendingpractices,” reported Mr. Gowen.

Plaintiffs further allege that “these lending practices … led tomassive home foreclosures in Cleveland, which in turn led to amassive loss of tax revenue for the city and some other costs,” headded.

“It's an ambitious theory,” Mr. Gowen said, noting that the cityis trying to hold Wall Street “industry leaders as a whole”responsible for creating a market of securities backed by subprimeloans.

“Cities tried this with cases against gun manufacturers someyears ago, but didn't have very good results,” the lawyernoted–referring to the fact that the Cleveland case, like the gunliability suits, hinges on the legal concept of “publicnuisance.”

In a press release announcing the subprime suit on Jan. 11,Cleveland Mayor Frank Jackson explained that the nuisance theoryallows recovery for “circumstances created by the defendant[s] thatinterfere with the public's 'rights and interests.'”

The complaint says, “Defendants are liable to the city … forpublic nuisance for their respective roles in proliferating toxicsubprime mortgages within its borders, under circumstances thatmade the resulting spike in foreclosures a foreseeable andinevitable result,” noting that defendants “chose to ignore …obvious facts in pumping hundreds of millions in subprime loans”into a city where property values never skyrocketed as they didelsewhere.

The city received no financial gain as Wall Street defendantsrode a “gravy train” that pushed loans to unqualifiedborrowers.

Cleveland was instead left to deal with the tangible costs ofrising foreclosures–”increased fire and police expendituresassociated with vacant properties and demolition,” and aproperty-tax revenue base “deeply depleted” by the severe drop inthe appraised value of real estate, the complaint says.

The public nuisance theory was also at the center of lawsuitsagainst lead paint manufacturers, but earlier this year the city ofColumbus, Ohio, dropped its lead paint suit, and the Rhode IslandSupreme Court threw out the only jury verdict that had been reachedagainst the paint makers. (See NU, July 28, page 20.)

Not all such efforts have been unsuccessful, however.

Speaking at the PLUS conference, Paul Lavelle, president of LVLClaims Services in New York, noted that he has heard talksurrounding the Cleveland subprime case, comparing it to moresuccessful efforts aimed at tobacco makers.

“Attorneys general are coordinating a little bit to see how [thetheory] works and where it works best,” Mr. Lavelle said.

“What they learned from tobacco is [to] just keep going atthis–'We only need to win once and then we win it all,'” he said.“If they think they're making progress–that the tone and theatmosphere are right for them–then they just need to find the rightjudge to try to channel [cases] through.”

Tobacco settlements reached in the early 1990s exceeded $200billion.

The Cleveland subprime case–filed against Deutsche Bank, BearStearns, Citigroup, Credit Suisse, Goldman Sachs, Lehman, and 15other financial institutions–is one of many targeting Wall Streetfirms, Mr. Gowen said.

He noted, however, that the majority of cases against securitiesissuers and underwriters are “classic shareholder claims by theentities' stockholders,” alleging that firms misrepresentedexposures or failed to write down investments in time, thereforecreating periods of inflated stock prices.

Continuing to describe what he repeatedly referred to aslitigation “crossfire,” he noted that “the securitization entitiesare in the crossfire” because they not only face lawsuits fromshareholders and others, but they also serve as plaintiffsthemselves in cases against lenders.

Mr. Gowen said another class of plaintiffs suing the investmentbanks is made up of buyers of securities backed by subprime loans,giving the example of a Florida case against Credit Suisse broughtby Bankers Life Insurance Company. The insurer alleges that theplaintiff misrepresented the nature of underlying loans, Mr. Gowensaid.

Where the securitizers are the plaintiffs in cases againstlenders, they allege breach of contract or breaches ofrepresentations and warranties–and in some cases, failure to buyback defaulting loans where provisions for buybacks were set forthin contracts, he said.

In addition to suits from securitizers, lenders face lawsuitscoming from many directions, including stock-drop suits fromshareholders if they're publicly traded and suits filed byhomeowner borrowers, he said.

“Saddled with mortgages they can't afford, they have suedlenders under various theories, including predatory lending andrace discrimination,” he said.

“The City of Baltimore brought a fairly unique case on a racialdiscrimination theory,” he noted, describing a “reverse redliningcase” against Wells Fargo Bank.

“Redlining would be where a lender uses profiling to eliminatecertain borrowers from primary credit,” he explained. “Reverseredlining, according to the theory [in this case] is the processthrough which lenders singled out geographically certaineconomically disadvantaged groups for marketing of riskier andpotentially more onerous [subprime] loans.”

The complaint charges that such unfair lending practices violatethe federal Fair Housing Act. It describes how the combination oftwo conditions–a historic practice of redlining and geographicconcentrations of people by race and ethnicity–has resulted inBaltimore's African-American neighborhoods being hit hardest byreverse redlining practices.

“The legacy of historic discrimination, or redlining, oftenleaves residents of minority communities desperate for credit,”causing them to “respond favorably to the first offer of creditmade, without regard to the fairness of the product,” the complaintsaid.

Such conditions made victims of historic redlining “especiallyvulnerable to irresponsible subprime lenders,” according to thecomplaint.

INSURERS IN THE CROSSFIRE

All the cases Mr. Gowen described–including another level ofcases against asset managers and investment advisers that steeredinstitutional money into mortgage-backed securities–are of concernto PLUS members, since liability insurers may ultimately be on thehook to pay damages and defense costs under professional liability(E&O) and directors and officers liability (D&O)policies.

The price tag for insurers could be $9.6 billion, according to atrio of reports by New York-based Advisen that were separatelyreleased during the PLUS conference.

Advisen Co-Founder David Bradford, in the reports and in apre-release interview, noted some trends that could keep a lid oninsurance losses–including economic troubles at law firms thatbring the cases, as well as coverage issues like conductexclusions. Still, the nearly $10 billion figure for insurancelosses arising from the subprime and ensuing credit crisis is muchhigher than earlier estimate by the firm.

One key difference from the $3.6 billion figure that Advisenpublished in February is that the earlier estimate was only forD&O losses. The latest reports put the D&O portion of theoverall insurance bill at $5.9 billion, while E&O losses areestimated at $3.7 billion. The $9.6 billion forecast falls in arange for combined D&O and E&O losses of $6.8-to-$12.1billion, Advisen said.

“Since February, the credit crisis has mushroomed into a globalfinancial calamity,” Advisen noted in the latest reports, partlyexplaining the $2.3 billion jump in the midrange D&O value fromthe earlier estimate.

Back in February, Advisen had tallied 181 subprime-relatedsuits–there are now 420, Mr. Bradford said at PLUS on Nov. 7,updating a figure of 418 published in the latest report on Nov.5.

The 420-suit total includes 124 securities class-actionlawsuits, which fuel part of the D&O insurance loss total.While Advisen's earlier D&O estimate only contemplated costs ofsuch class actions, the latest one:

o Adds insured losses for derivative suits (filed byshareholders on behalf of the company alleging board-level breachesof duty), and securities fraud suits brought by regulators and lawenforcements agencies.

o Adds an estimate of defense costs associated with dismissedclaims.

o Differentiates between traditional D&O coverage andSide-A-only coverage, which directly covers directors and officerswhen the company cannot indemnify claims.

As the number of bankruptcies grows, Side-A policies areincreasingly exposed, Advisen said, noting that in many cases,Side-A limits for large financial institutions, in particular, aremany multiples of traditional D&O policy limits.

Even with that methodology refinement, the estimate of theinsured portion of class-action settlements falls far short of theexpected total cost to defendants–$27 billion, according toAdvisen, which notes that the insured loss estimate specificallytakes into account average retentions and program limits, as wellas historical ratios of class-action settlements tomarket-capitalization drops.

Turning to E&O, Advisen said that unlike D&O losses,which will fall most significantly on large, publicly-tradedfinancial institutions, E&O losses will be widelydistributed–with insureds ranging from small mortgage brokers tothe largest global diversified financial services firms.

In its E&O report, Advisen derived insurance loss forecastsof $1.5 billion for mortgage brokers and $1.0 billion forinvestment banks, with mortgage lenders, securities brokers,commercial banks, rating agencies and other types of firms makingup the rest of the $3.7 billion total.

The mortgage broker category produced the greatest volume oflosses because of the very high number of lawsuits by borrowers,Advisen said, noting, however, that individual mortgage brokerE&O settlements tend to be small–typically in the tens ofthousands of dollars.

As a result, the $1.5 billion insured loss estimate is just afraction of the limits at risk, Advisen said, estimating that about21,000 brokers carry E&O insurance with average policy limitsof $1.275 million, or $27 billion in total.

In contrast, Advisen expects full policy limit losses for thebanks that buy insurance, but notes that most investment banks areself-insured. Those that do buy coverage carry an average limit of$100 million, the report said.

MITIGATING FACTORS?

In addition to self-insurance, there are other factors at workthat may serve to lower ultimate damage totals and payouts byD&O and E&O insurers, experts say.

“A lot of law firms subsidize the upfront costs for securitiesclass-actions with income from their corporate practices, and thathas fallen off dramatically,” Mr. Bradford noted. “Firms are layingpeople off, so they're probably being more selective about casesthey're going after.”

There are legal barriers for plaintiffs and their lawyers aswell. “For companies that were just caught in the domino effect ofa global financial crisis, they have to prove there was intent onthe part of the directors and officers to commit fraud ordeceive–and that may be something that will be relatively difficultto prove in a lot of all these cases,” he said.

These factors are helping to keep total securities class-actionsfor 2008 below the annual average of 234 actions for 1997-to-2005(excluding 2001, which was further inflated by cases related to ascandal involving initial public offerings), the Advisen reportnotes.

Total securities class-actions now stand at roughly 180 forsubprime and non-subprime cases combined, falling well belowmidyear forecasts by NERA Consulting and Stanford Law School of 280and 220, respectively.

Historically, one-third of securities class-action suits filedare dismissed, Advisen reported, suggesting that because of thegreater obstacles plaintiffs will encounter in pursuing subprimeand credit crisis suits, it is likely that a higher percentage ofthese suits will be dismissed.

(For more pessimistic predictions about subprime-relatedlitigation, see a related article–”No End In Sight To InvestorLawsuits Emerging From Subprime Crisis Fallout”–in NationalUnderwriter's Nov. 3 edition, on page 12.)

For additional information on D&O and E&O insurancetrends, see related articles in this issue of E&S Extra

o Mortgage-Related Claims Leave Most Players Feeling InsuranceCover Squeeze

o $9.6 Billion In Subprime, Credit D&O And E&O LossesPredicted

o D&O Market Turn Looming

o Brokers, Carriers Develop D&O Lifeboats To RescuePolicyholders If Insurer Sinks