The possible pitfalls in ART transactions.

One of the key objectives of a lawyer advising a reinsured on an ART transaction which crosses the boundary between reinsurance and banking/capital products is to ensure that the intended integrity of the transaction is not potentially adversely affected by the legal peculiarities of reinsurance contracts compared with banking products. Unlike financial products, reinsurance contracts are contracts of utmost good faith. The result of this fundamental distinction is that a reinsured is under a duty to disclose material facts relevant to the risk and not to misrepresent material information. The only remedy for breach of the duty of utmost good faith under English law is the draconian one of avoiding the reinsurance from its beginning. There is no alternative remedy of damages or a more flexible remedy such as readjusting the premium to take into account any increased risks which arise from any material information which may have been inadvertently not included in the placing information.

A further pitfall so far as reinsureds are concerned is the principles concerning warranties. Typically, a warranty is a promissory term whereby the reinsured promises either that a given state of affairs existed prior to the inception of the reinsurance policy or that it will continue to exist during the currency of the risk. The fact that a term in a policy is not described as a ‘warranty' but, for example, as a ‘condition' is of no significance. If the clause has a material impact on the risk, this is a strong indication that the clause was intended to be a warranty. Breach of a warranty automatically discharges the reinsurer from the time of breach even though the loss which is claimed has no casual connection with the breach of warranty.

The right of the reinsurer from the reinsured's viewpoint to be able to ‘take advantage' of rights of avoidance and/or breaches of warranties adds significantly to the counter-party risks of the re/insured who would normally be primarily interested in assessing the financial soundness of a re/insurer to pay claims. These financial considerations would to a large extent be evaluated by reference to the rating of individual reinsurers or the rating assigned to the bonds or other financial instruments secured by approval of reinsurers. In view of these very real concerns, it is common in many ART transactions to include provisions which purport to restrict or eliminate the duty of utmost good faith and the right of the reinsurer to rely upon the remedy for breach of this duty. Two recent cases in the English commercial court concerning film finance reinsurances have given helpful guidance with regard to the extent to which the duty of utmost good faith and the remedy of avoidance can be excluded as well as the very real danger of not specifically excluding the remedy for breach of warranty.

Phoenix episode
The first case was HIH and Others v Chase & Heaths (31 July 2000) (the ‘Phoenix' case). This case concerned a dispute regarding a policy purchased by the Chase Manhattan Bank which was intended to guarantee reimbursement of capital and interest in respect of a loan to a film production company to enable it to produce and market a number of films. The policy indemnified the bank in the event that the films did not earn the anticipated level of revenues from sales. The relevant policy contained an elaborate ‘truth of statements' clause which purported to exclude the insurer's rights to avoid the policy for non-disclosure and/or misrepresentation by the insured and its brokers.

The judge, Aikens J, helpfully summarised the general legal principles applicable to waiver clauses. He found that:

  • a clause which excludes the duty of disclosure of the insured or its agent will protect the insured even if there is deliberate concealment or fraud;
  • a clause which excludes the duty of the insured to make disclosure is not going to be sufficient (without more) to also exclude the duty of its agent;
  • a clause which excludes the right of avoidance for non-disclosure will not protect an insured against its own fraudulent non-disclosure;
  • a clause which excludes rights of avoidance for less culpable types of non-disclosure by the insured or any type of non-disclosure by his agent will protect the insured;
  • a clause which excludes a duty to make a representation will be of no effect because there is no ‘duty' to make a representation. It is a matter of choice as to whether a party chooses to make a representation;
  • a clause which excludes ‘liability' for misrepresentation/non-disclosure is not sufficient to exclude insurer's remedy of avoidance; and
  • a clause which tries to exclude liability for the consequences of ‘information' is not apt to exclude liability for mis-information.

    The good news for re/insureds is that a carefully drafted waiver clause will be upheld by any English court except for the extreme situation of trying to exclude liability for the consequences of an insured's own fraudulent breach of duty which cannot be removed on the grounds of public policy. The bad news is that the judge found that the clause in question was largely ineffective. The message is that considerable care should be taken to ensure that the waiver clause is clearly and unambiguously worded because the courts will give the benefit of any doubts to the re/insured.

    The second case, HIH Casualty and General Insurance Ltd v New Hampshire Insurance Co (December 2000) also involved film finance insurance. In this case the films were financed through the issuance of a bond which was ‘secured' by a pecuniary loss indemnity insurance. Its purpose was to insure against any shortfall between the amount of finance provided by the bondholders and the profits ultimately earned by the films.

    The insurance policy contained a waiver clause. The insurer which wrote the original policy in turn reinsured a substantial part of the risk which it had assumed. The insured paid the bondholders under the insurance policy but the reinsurers, for a number of reasons, declined to pay the reinsured. One of the critical issues in this case was whether the waiver clause in question covered a breach of warranty with regard to the number of films to be produced. The relevant clause read:

    “To the fullest extent permissible by applicable law, the insurer hereby agrees that it will not seek to or be entitled to avoid or rescind this policy or reject any claim hereunder . . . (for) non-disclosure or mis-representation by any person on any other similar grounds”.

    The issue was whether breach of warranty could be regarded as a “similar ground” to non-disclosure or misrepresentation. The judge, Steel J, decided that this broad wording did not cover breach of warranty. He emphasised the different consequences of breach of the duty of utmost good faith and breach of warranty: the former led to the contract being voidable whereas the latter did not affect the ability of the policy but operated automatically to discharged the insurer from any liability for claim. This difference was sufficient to render the clause inapplicable for breach of warranty. This decision reinforces the concerns which have arisen from the Phoenix case about the difficulties of drafting a comprehensive waiver clause.

    Bridging the gap
    Both of these decisions are subject to appeals in the Court of Appeal and they will be followed with great interest by ART practitioners and their legal advisers. These cases have once again emphasised that from a legal and regulatory perspective, care must be taken to ensure that the differences between the insurance and banking worlds can be successfully bridged but the drafting of the documentation for such transactions must take into account the generally favourable position of reinsurers which can, if the deal turns out to be unprofitable, seek to turn the arrangement on its head and rely upon the favourable legal climate in the insurance/reinsurance worlds.