Earl Zimmerman examines the current state of the law on waivers.
We've seen too much fraud lately. No one likes it and most want the frauds punished. But some people are willing to promise to pay others even if defrauded. Why? Because they get something out of it and will go elsewhere for reimbursement if defrauded.
For example, a lender may require a loan to be guaranteed and insist that the guarantor repay the loan if the borrower does not - even if fraud is involved. The guarantor would then look to the borrower for reimbursement. When I bought my first car, my father guaranteed the auto loan. He didn't care if the finance company lied to him, because I wouldn't be borrowing his car any more and he knew where to find me if I didn't make my car payments. Likewise, a person will incidentally become a guarantor because they stand to benefit from the borrower receiving the loan and are in a position to influence the borrower to make payments on the loan and avoid default.
Some guarantors do it just for the money. They are professionals, organised as insurance companies,1 that make it their business to ensure lenders don't have to deal with defaults. These pros promise to promptly pay the lenders if the borrowers do not. Experience has shown that with patience and perseverance, many defaulted loans are largely repaid. Nevertheless, lenders usually do not want to expend the time and effort for collection. The professional guarantor is paid to indemnify the lender and instead deal with collection hassles. Professional guarantors will lower their costs by guaranteeing many unrelated borrowers (i.e. risk diversification) and they will ask others to share in their risk (i.e. reinsurance).
Because lenders want guarantors, both incidental and professional, to pay promptly and without contention, they require guarantors to waive defences to payment. Until recently, waivers were broad and standardised statements where the guarantor agreed that its obligations to the lender were irrevocable and unconditional, and agreed not to raise any defence or counterclaims, including fraud. As a result of recent case law, both in New York and England, what constitutes an effective waiver of a fraud defence has been questioned. Therefore, waivers are now being extensively negotiated, often with the emotion, drama and meanness of a Tarantino film instead of a reasoned and informed discussion leading to a meeting of the minds as reflected in a specific and negotiated waiver of defences.
New York case law
The current state of New York law with respect to waivers of fraud is essentially, "You can lie to me, but only when I say it's OK. The rest of the time you have to be straight with me." In a personal relationship, this may sound dysfunctional, with one partner's head buried in the sand. In a business relationship, it strikes an elegant balance between the freedom to contract and the duty to bargain in good faith.
Until last year, when our financial, legal and value systems were tested by acts of hatred and discoveries of lying on unprecedented scales, the case law on waiving fraud was fairly clear. Specificity has been and still is the `touchstone' in the law of New York regarding waiving fraud. But we have seen alleged fraud of such dimensions that it seems impossible for anyone drafting a waiver a few years ago to include all of the specifics that have been discovered lately. "How specific?" is the new question that is fiercely debated by the parties negotiating fraud waivers.
It is worth a brief pause to specify what is meant by fraud in New York. Generally, it is the intentional misrepresentation (or concealment when there is a duty of disclosure) of a material fact by one party with the intent of inducing another party to act or refrain from acting, where the defrauded party has reasonably relied on the material misstatement or omission to its detriment. In the insurance context, a `material fact' is generally one that affects the defrauded party's appreciation of the risk involved in issuing the policy.
The New York case law on waivers of fraud generally does not involve professional guarantors, i.e. insurance companies issuing financial guarantee policies. The cases generally involve individuals who are giving guarantees to a bank as an incidental part of their business. For example, in Citibank v Plapinger,2 several corporate officers guaranteed the debts of their corporation. They agreed to the guarantee, including a waiver of defences provision, on the understanding that the bank would later extend additional credit to the corporation. When the corporation sought additional financing, the bank refused. When the corporation eventually defaulted, the bank looked for payment from the guarantors, who claimed they were fraudulently induced to make the guarantees by the bank's promise of further financing and refused to pay. The court found that the guarantors had waived this defence and the waiver in the guarantee, which was the product of long negotiations between sophisticated parties, defeated this fraud defence.
In Manufacturer's Hanover Trust Co v Yanakas,3 the court went the other way due to the absence of specificity and negotiation. Yanakas guaranteed a commercial loan to a corporation of which he was a major shareholder. The bank told Yanakas that his guarantee was a prerequisite because the loan was unsecured. Unknown to Yanakas, the corporation later gave the bank security for the loan. When the corporation defaulted and the bank looked to Yanakas for payment, he refused to pay, claiming that he had been defrauded. The bank sought to dismiss this claim, arguing that Yanakas, by agreeing that the guarantee would be "absolute and unconditional," had waived all defences to payment, including fraud. The court held that the general disclaimer language in the guarantee was not sufficient to waive the defence of fraud in the inducement, because it did not specify the defences being waived and, since there were not extensive negotiations, was merely "a generalised boilerplate exclusion."
Last December, the JPMorganChase4 case involved surety bonds issued by eleven insurers to an offshore entity called Mahonia. The surety bonds guaranteed Enron's obligations under several forward sales contracts. Under these contracts, Mahonia pre-paid Enron for the future delivery of oil and natural gas at scheduled intervals. If Enron failed to make a delivery, it was to pay Mahonia a fixed amount instead. When Enron defaulted on its obligations, the insurance companies refused to pay claims on the bonds, claiming that material information regarding the nature of the transactions underlying the surety bonds was fraudulently withheld from them. The insurers alleged that the transactions were structured to provide financing to Enron, i.e. Mahonia's prepayment constituted the original `loan' and Enron's payments constituted the repayment of principal and interest, and this was withheld from them. The court found that the waiver given by the insurers was insufficient to waive fraud of the type allegedly made by the insured due to its lack of specificity.
The most recent case is Caiola.5 This does not involve a guarantee or an insurance company, but an action for securities fraud where the reasonable reliance element was examined under New York state law. According to the facts of the case, a client of a bank wanted to implement a hedging program that involved synthetic trades using swaps rather than through actual marketplace purchases, and in several discussions was assured of this implementation. The client and bank entered into swaps using standard ISDA (International Swaps and Derivatives Association) forms, which included text to the effect that the client was not relying upon the bank but was making his own investment decisions. When the bank did not follow the synthetic strategy, causing the client to lose money, the client brought suit for fraud. The bank claimed that the client could not have reasonably relied on the bank's assurances of implementing his strategy because of the ISDA disclaimers. Citing Yanakas, the court held that the disclaimers were not specific enough to establish that the client's reliance was not reasonable in light of the facts.
The conclusion to be drawn from these cases is that fraud waivers must be specific to be effective. Unfortunately, the necessary degree of specificity has not been laid down by the courts. Insureds that are aware of these cases are now actively negotiating waivers seeking the specificity required by Yanakas and its progeny. The relevant financial insurance contracts are those governed by New York law. This comprises not just contracts issued by a New York insurer but also those issued by insurers in other jurisdictions, such as Bermuda, where the contact specifies New York law as the governing law.
Next wave in waivers
Currently, some prospective insureds under financial insurance policies are negotiating extensively with their insurers in an effort to arrive at a set of waivers that will satisfy the somewhat nebulous standards of the case law discussed above. These specific waivers are sometimes received like death by insurers - denial and anger precede bargaining and acceptance. In the denial stage, there may be a reluctance to negotiate, with the insurer and its counsel arguing that specific waivers are `not market', alluding to regulatory burdens relating to policy forms or appealing to the administrative need for standardised contract forms, including waivers of defences. In the anger stage, impassioned rhetoric often follows.
Then comes the bargaining. This is often not an exercise in imagining all of the worst case scenarios that lawyers, bankers and depressives do so well. In an experience reminiscent of teen films set in the 1950s, some guarantors do not want to go all the way and waive every fraud, but are afraid of dissuading their insured/suitor by saying so. As the parties negotiate in good faith, the need for specificity can become a springboard for a fruitful exploration of the boundaries of the guarantor's willingness to give up its rights to sue for fraud. This is done against the backdrop of recent allegations, indictments and arrests involving extremely creative fraud allegedly perpetrated by highly creative, intelligent and, before the indictments, respected individuals and institutions.
As the negotiations proceed, underwriters and other business people usually provide valuable insight into the risk assessment process and whether any information provided by the proposed policyholder was actually relied upon (e.g. documents containing disclosure about the guaranteed obligation that were prepared by the policyholder). If appropriate, these documents can be excluded from the negotiated fraud waiver. Specific waivers often include a waiver of all misrepresentations and non-disclosures in specified documents and elsewhere, as well as a waiver of all duties of disclosure on the part of the policyholder (including the duty of utmost good faith).
It is also advisable to seek representations from the insurer as factual support for the fraud waivers. These are similar to `big boy' representations given by `accredited investors' in the context of private placements of securities. After Caiola, these representations also need to be specific and negotiated. If accurate, the insurer may represent that it has performed its own, independent due diligence and underwriting investigation, it has made an informed decision to issue the policy with the assistance of any advisors it deemed appropriate, and that it is aware that the insured may have performed its own analysis and arrived at a different conclusion. Other representations should be considered as appropriate.
In some circumstances, some guarantors simply do not want to waive certain types of fraud. For example, some prefer to be able to deny payment if a fraudulent claim is made by the policyholder, while others seek a competitive advantage by not doing this. In other instances, a guarantor is willing to pay the policyholder, but wants to reserve certain negotiated rights after payment of claims.
Nothing is expected to be cleared up soon. The Mahonia case goes to trial in December and a final decision may be years away. No relevant legislation is pending, as far as I am aware. It is unlikely that the National Association of Insurance Commissioners (NAIC) or any regulator or legislator will take interest in the matter without the prompting of any industry group, which is unlikely. Guarantors will risk anti-trust violations if they agree on a position on waivers.6 What we have left is the need for educated parties to negotiate in good faith to arrive at a specific set of waivers in their contract.
1 This article does not address bank letters of credit.
2 Citibank NA v Plapinger, 66 NY2d 90 (NY 1985).
3 Manufacturers Hanover Trust Co v Yanakas, 7 F3d 310 (2nd Cir 1993).
4 JPMorgan Chase Bank v Liberty Mutual Insurance Co et al, 189 F Supp 2d 24 (SDNY 2002).
5 Caiola v Citibank NA, 295 F3d 312 (2nd Cir 2002).
6 To my knowledge, the issues discussed above have not come to the attention of purchasers of letters of credit from banks. This is probably because there have been no recent high profile cases where a bank refused to pay on a letter of credit because of fraud.