Bill Perry says the Destination film finance case reveals some important lessons for back-to-back insurance and reinsurance, contractual terms and retention clauses.

Destination Films was a new concept in film financing insurance. It took the basic idea of gap financing insurance to what was in many ways its logical conclusion. Here, the insured loan note holders were to finance an entire studio, until such time as revenue from its film output was capable of taking over the general financing.

Setting the scene
Inevitably, such an audacious new concept required a good name to get it off the ground. Destination's good name was Steve Stabler. Steve Stabler had been the producer of Dumb & Dumber, and was a bankable, highly respected Hollywood producer. He wanted to strike out on his own. Destination was the result. He was to be chief executive officer, and work with another respected figure, Brent Baum, who would look after the financial side of the operation.

The trustees for the loan note holders were Northwest Bank, Minnesota, subsequently part of Wells Fargo Bank. The insurance was, as usual, to ensure that the loan note holders would put up their money. Ultimately, it was an insurance that the loan note holders would get their money back, at the end of the specified five-year loan period, and that they would be paid the agreed rate of interest in the interim, regardless of what happened to Destination and its films. The principal was $100m.

Destination's investment bankers, Donaldson, Lufkin & Jenrette (DLJ) - now part of Credit Suisse First Boston - approached brokers Willis in Chicago and London, even though Willis had comparatively limited experience in the film finance field. However, they were familiar with contingency, and time variable contingency, insurance.

Originally, Willis approached a number of significant companies in the London market. These were AXA, New Hampshire (part of American International Group and represented as its agent by AIG Europe (UK) Ltd), Sphere Drake, Royal & SunAlliance (R&SA), Deutscher Lloyd, Gen Star and GE Re (or Kemper Re as it was at the time). All indicated an interest in the business, and went so far as to put down a promised line as insurers. In the end, Great Lakes was retrospectively substituted for Deutscher Lloyd.

However, it became apparent to DLJ that in order to attract the loan note holders, they needed triple-A rated security, which some of these companies did not provide. Accordingly, it was decided to ask AXA and New Hampshire alone to underwrite the insurance. They agreed to this, and the other companies participated by way of a reinsurance of part of New Hampshire's proportion of the cover. (From this point, AXA plays no part in our story).

Willis handled the reinsurance as well as the original insurance. In the normal way, they prepared both an insurance slip and a reinsurance slip. The insurance prescribed New York law and jurisdiction. The reinsurance had no law or jurisdiction clause. It did have an `as original' clause.

Willis also prepared, in consultation with DLJ and Destination itself, an `operating agreement' and an `information package'. The operating agreement was a New York law contract between the insurers and Destination. It specified how Destination could operate and when it had discretion on the spending and handling of its money, both that initially raised and that accruing by way of film receipts. It also contained a clause that required Destination to "have executed an employment contract" for the term of the loan notes (i.e. of the insurance) with Steve Stabler and Brent Baum. The information package said that such contracts "will be required".

Both these documents were seen by New Hampshire and the reinsurers, who had also seen them in draft form when it was proposed that they be co-insurers.

In the end, and as is common in such circumstances, the reinsurers signed the reinsurance slip before the insurers signed the insurance. In particular, the reinsurance slip gave reinsurers the right to approve the wording of the underlying insurance policy, which they did.

The plot thickens
All did not go well for Destination. Its artistic ventures were not as successful as had been expected or hoped. As a result of the measures taken within Destination to try to correct matters, life became less harmonious. Mr Stabler's employment as chief executive was "terminated by mutual consent", as they say. Destination struggled on, but shortly thereafter became insolvent, a mere couple of years into the five-year term of the bond holders' loans.

Unsurprisingly, when the first interest payment anniversary came round, Wells Fargo made a claim on the insurance. New Hampshire paid, and sought immediate reimbursement - under a simultaneous settlements clause in the reinsurance - from its reinsurers. The reinsurers declined to pay. New Hampshire sued.

New Hampshire chose to sue in New York. It did so on the basis of its rights as a US corporation. The reinsurers disputed that jurisdiction. They issued three actions (which were heard together) in London in which GE Re and Great Lakes, Sphere Drake and R&SA respectively were claimants, seeking declarations of non-liability. The reinsurers were successful in persuading both the London and the New York courts, at first instance (and in New York on appeal), that London was the appropriate forum for the hearing of the dispute.

New Hampshire also asserted that since the reinsurance slip contained no express choice of law, but incorporated the underlying as original, it was subject to New York law itself. Faced with the authority of its own group's cases including AIG v The Ethnicki, it is not surprising that New Hampshire failed to persuade the Commercial Court that New York law, as well as jurisdiction, applied to the reinsurance contract.

In London, the actions evolved into the consideration of two essential points of construction in the reinsurance contracts. These were:

  • the status and meaning of a clause in the reinsurance providing that contracts of employment for Steve Stabler and Brent Baum were to be maintained, in effect, for the duration of the reinsurance. The questions were whether this was a warranty, whether it meant what it said and/or whether it had in some way been abandoned or contradicted by the reinsurers' agreement to the (supposedly back-to-back) underlying insurance policy, which contained no such clause, or by reference to the operating agreement, which required that such contracts were executed but said nothing about maintaining them in force; and

  • whether a clause in the reinsurance slip, under "Sum Insured Hereon" providing that "Ceding Company retains 20% (with Reinsurance)", was a warranty, and eliminated or reduced reinsurers' exposure, granted that:

    (a) the form of the reinsurance was specified to be "J1 NMA 2037 or companies equivalent" and form J1 NMA 2037 and the LIRMA equivalent contain a warranty providing that "in the event of the retention being less than that stated the Reinsurers participation to be proportionally reduced"; and

    (b) New Hampshire had (more or less) reinsured its entire retained line in another contract with Gen Star.

    Court room drama
    The action came to trial before Mr Justice Langley in the Commercial Court on 10 February 2003. In a reserved judgment handed down on 27 February 2003, Mr Justice Langley found in favour of the reinsurers on the Stabler point, but against them on the retention point. He refused permission to appeal.

    New Hampshire was not, it should be said in parenthesis, unduly unhappy about this finding. It had early on joined Willis as a Part 20 defendant, claiming an indemnity if the reinsurers were found not to be liable, on the basis that it had been Willis's duty to ensure that the insurance and reinsurance contracts were back-to-back, and that Willis should not have agreed wording which resulted in the retention point. Mr Justice Langley found Willis 100% liable to New Hampshire for negligence in failing to arrange for the contracts to be back-to-back.

    The retention point was a tricky one. Both J1 and the LIRMA equivalent have the same provision. There was originally an attempt to argue that the LIRMA equivalent was not in fact the "companies' equivalent" but that a companies' collective policy without a similar provision was. This was not in fact seriously pursued at the hearing, since it was plain that in the absence of such a provision it could not be "equivalent".

    Ultimately the construction question was: what was meant by the words "with reinsurance" in this context? The reinsurers argued that it could not mean more than normal excess of loss protections that a company such as New Hampshire carries, and, to be specific, that it could not mean that New Hampshire was entitled to reinsure all (or almost all - a small mistake was made in computation) its liability, since to do so was to negate the statement that 20% was retained.

    New Hampshire and Willis argued that it meant exactly what it said, namely that this did no more than state the (obvious) fact that the line New Hampshire had retained after the reinsurances by GE Re, Great Lakes, Sphere Drake and R&SA, was 20% and that New Hampshire were entitled to reinsure it to any extent it pleased. The reinsurers retorted that if it were indeed no more than the obvious, there would be no point in stating it. Thus it must have a different meaning, namely that "with reinsurance" was a safety net to ensure that (only) excess of loss protections were allowed; alternatively it meant simply "with this Contingency Reinsurance of 40%". In either case it did not permit New Hampshire specifically to reinsure its 20%, so that the J1 NMA 2037 reducing provision applied if it did.

    Mr Justice Langley found for New Hampshire/Willis on this point. He was not prepared to find that this case paralleled Kingscroft v Nissan Fire & Marine (1999), Lloyd's Rep 1R 249 (at pp 621-624), where Mr Justice Moore-Bick had held that "with reinsurance" should be read as acknowledging New Hampshire's general right to have excess of loss protection. His view was that in this context it meant no more than that the 60% line which was once to be co-insurance was now being insured by New Hampshire alone but with 40% of it reinsured on the terms of the slip. He conceded that this was close to the reinsurers' alternative submission, deprived "retains" of its normal technical meaning, and was no "more elegant than its rivals", but added that whatever it meant, he was satisfied that it did not have the meaning contended for by the reinsurers!

    Rated for language
    The effect of this ruling is that it remains necessary to be very careful of a stated retention, particularly if there is any indication that it is likely to be reinsured. There is still a large number of forms of words in the market, the precise meaning of which may be clear to the individuals who write them, but is objectively very difficult to determine. It is evidently going to be hard for the courts to impose a standard meaning on such language.

    The requirement to consider the factual nexus of each transaction seems likely to result in a lot of `one-off' interpretations of such clauses. In this particular case, Mr Justice Langley was prepared to consider as part of the factual nexus the whole background to the transaction, including the change of the reinsurers from their original status of co-insurers and the knowledge of New Hampshire's "retention" of 20% which they were therefore presumed to have.

    Equally interesting was the Learned Judge's treatment of the Stabler warranty. Applying the tests laid down by Lord Justice Rix in HIH v New Hampshire (2001) EWCA Civ 735 (at para 101) as to whether the term was a warranty, even if not so described, he had no difficulty in holding that as the basic creative mind behind Destination, which was ultimately a creative company, Steve Stabler's continuing participation in it as chief executive throughout the period of the loan note holders' interest was vital. Equally, he accepted that damages were not an adequate remedy for breach, since it would be virtually impossible for reinsurers to show the quantum of loss caused by his absence and the substitution of an alternative chief executive. If the precise number of films on the slate were to be a warranty in one case, Mr Justice Langley accepted that the continued employment as chief executive of the creative genius behind the company was a warranty in this one.

    The next issue related to the use of the word "maintained" throughout the contract. New Hampshire/Willis put it to Mr Justice Langley that to say that this meant what it said was to impose a commercially impossible interpretation. After all it was possible that Mr Stabler might drop dead, which would technically be a breach of the warranty if it were strictly interpreted. If it were once accepted that his absence due to death was not a breach, why would his absence due to company re-organisation be?

    Mr Justice Langley held that the clause did mean what it said. He saw the commercial sense in a requirement that Steve Stabler remain associated with the company throughout its operational history. He accepted that had Mr Stabler been removed by an event such as death, it might be have been necessary to put a restraining interpretation on the clause, but this was not that case. Here, Steve Stabler had throughout the term of the contract remained available to be employed in the capacity in which the reinsurers had required him to be employed, but he was not so employed. There was, on that basis, a plain breach of the warranty.

    Finally, Mr Justice Langley disposed rapidly of the argument that by approving the underlying insurance policy without the term, reinsurers were in some way relinquishing their rights to the warranty, or accepting by implication that it should be written out of the reinsurance. The warranty was an express term of the reinsurance contract. It is not possible to imply a term to overrule an express term. Nor by exercising one express right bestowed in the reinsurance contract could reinsurers be taken to be abandoning another express right.

    Thrilling conclusion
    The Destination case contains important lessons not just for film finance reinsurance but for all reinsurance. In the first place, it repeats the lesson that if insurers want back-to-back insurance and reinsurance, it has to be truly back-to-back. Mr Justice Langley specifically refused to follow the line of argument that this was a "Vesta v Butcher" (1989) 1 AC 852 case. That was a case where the wording was the same, and it was a question of reconciling different systems of law which might have resulted in the same words having a different effect. Here, the wording was different. There is no scope for the court to overlook express words, simply to bring the contracts back into line with some presumption that they should be back-to-back.

    In essence, Mr Justice Langley held that the court would not infer an objective intention that the contracts should be back-to-back from surrounding circumstances when the contracts by their terms were plainly not back-to-back. It is not for the court to rewrite the contracts. Intention is to be inferred from the contracts, and the surrounding circumstances cannot overrule the express wording of the contracts. This would be to overrule the objectively clear intentions of the contracts.

    The second lesson is the reassuring one that the Commercial Court will take a sensible view of the importance of contractual terms. The application of the HIH v New Hampshire test for warranties is welcome re-affirmation that policy clauses, which are obviously important, and where damages would be difficult to quantify, will be held to be warranties.

    Finally, Destination is another reassertion of the importance of clear wording in the field of retention. This remains a minefield. All reinsurers need to look with great care at the precise wording of retention clauses to ensure that they have in them exactly what they want as to what their insureds are doing about a retention.

    By Bill Perry
    Bill Perry is a Partner and Head of Litigation at law firm Charles Russell.