Much has been made of the potential fallout from the subprime crisis on the insurance industry. Simon Goldring and John Bruce examine some of the existing and potential litigation targets.
Subprime is big news at the moment. It is estimated that the losses in the financial markets will exceed $100bn and, rather ominously for the insurance market, there are already numerous class actions in the US against the directors of affected financial institutions. Some of these are no doubt reinsured in the London Market.
Even in the UK’s more benign litigation environment, shareholders in Northern Rock, an indirect subprime casualty, are forming an action group ostensibly to bring proceedings against the directors, claiming the creation of a false market. Claims are also apparently being developed against the investment managers of various stricken hedge funds.
So, how will the subprime crisis affect the direct insurance markets and thereby reinsurers? Although the financial institutions may have lost up to $100bn, Lehman Brothers’ equity research team have estimated the impact of subprime on the direct market may be limited to around $1bn. The exposure might be relatively contained as a result of limited exposure to each potential insured, and because of a tightening of policy terms and conditions over the past few years.
Further, there should be reduced damages claims by shareholders, to the extent that the share prices of those listed companies which are involved in the subprime meltdown continue to recover.
Coming over the pond?
As mentioned, there are numerous class actions against financial institutions in the US. This begs the question of whether there will be a similar incidence of claims in Europe. At the moment, property prices have held up in Europe. This means there is a lower incidence of direct subprime losses, so any potential claims are likely to focus on the European financial institutions that invested in and advised upon US mortgage-backed securities. The answer probably has two parts – first dealing with civil claims and the second dealing with regulatory investigations.
As for civil claims, it is likely that there will be fewer “mega-claims” in Europe compared to the US. This is partly because the subprime losses are currently concentrated in the US. But this would remain the case even if there were more direct subprime losses in Europe because the European litigation landscape is more benign than in the US. The reasons are well known. It is down to the differences in culture, litigation funding, the availability of (opt-out) class action procedures, and substantive law.
While there is no need to scaremonger, there are reasons to believe this litigation landscape in Europe could change over time. The European Commission unveiled proposals earlier this year to boost group litigation across the EU. Coupled with this, there has been increased interest from European pension funds in litigating to recover their losses. In the past, this was manifest by European pension funds actively pursuing class actions in the US. For example, the Avon Pension Fund recently became the first UK lead plaintiff in a securities class action lawsuit against GlaxoSmithKline.
“There is already evidence of substantial claims brought in the US, although the frequency and severity of these claims may be lower than initially anticipated
There is no reason to suppose these institutional investors will not bring claims in Europe and this is evidenced by the well-publicised European class settlement of the investors’ claims against Royal Dutch Shell for $450m.
Finally, funding was typically seen as one of the barriers to such actions in Europe, but there is increased evidence of creative funding. In the UK, a number of law firms are considering offering third-party funding options to clients after the sector's first specialist broker, Calinius Capital, secured approval from the Financial Services Authority (FSA) to act in litigation and general dispute risk.
That said, these changes to the cultural propensity to bring class actions in Europe will take time to materialise, and so probably will not be relevant to the current subprime issue. In any event, the differences in substantive law between the US and Europe remains marked, and these alone act as a barrier to large claims. Take D&O claims as an example. A drop in a company’s share price will precipitate, usually within a matter of days, a securities class action in the US. This does not happen in the UK because UK directors owe their primary duties to the company and not to shareholders or investors.
The result is that in the UK, there have been no common law judgments against directors in favour of shareholders arising from misstatements contained in company reports. Further, there is no English statute equivalent to the Exchange Act of 1934, which is the foundation of the majority of US securities class actions. The closest UK statutory provision is s463 Companies Act 2006, but this only creates a liability to the company and not to shareholders, and essentially only where the statement was dishonestly made.
The road ahead
As a possible counterbalance to the legal difficulties in sustaining such claims, a new derivative action procedure in the UK became effective on 1 October 2007. This is intended to make it easier for minority shareholders to bring a claim in the company’s name (and for the benefit of the company) against directors. Although there may be some early tests of this new procedure, our view remains that there will not be a floodgate of new claims, although this procedure will inevitably have a long-term effect.
As for regulatory investigations, these will be relevant to European financial institutions, and could trigger directors’ & officers’ notifications. The FSA had conducted research into the direct subprime market long before the resulting credit crunch hit the newspaper headlines last month. Indeed, the FSA has already investigated and fined the CEO of a subprime mortgage broker concerning the implementation of risk management procedures. This regulatory activity can be expected to increase over the coming months.
Arguably there are mixed messages concerning the likelihood and magnitude of claims arising from the subprime crisis in both the US and Europe. There is already evidence of substantial claims brought in the US, although the frequency and severity of these may be lower than initially anticipated. The litigation landscape in Europe is more benign and will remain so in the short term, but there will be claims and regulatory investigations that will have a cumulative affect, and much will depend on whether the property and stock markets continue to hold up.
Simon Goldring is a partner and John Bruce a lawyer with Reynolds Porter Chamberlain