Unsettled relationships between reinsurers and the banking/capital markets.

There's no business like show business – or so the saying goes. However, Irving Berlin might have added, “Unless and until the lawyers get involved”. True to type, give the lawyers something as ‘sexy' as the film business, and the result is a line of ‘interesting' judicial authority on exclusions of the right to avoid, the relationship between the slip and the policy wording, and the incorporation of underlying warranties into reinsurance contracts.

In truth, the case law to date is not much to show for the reported $2bn of losses that the film finance insurance market has suffered over the past few years. However, the main event is still to come; 2002 should prove to be a ‘blockbuster' year for the film finance litigation, when several cases, both in the UK and in the US, come to trial. For 2002 is the year when the courts will hear evidence of just why certain underwriters were persuaded that films such as ‘Beautician and the Beast' were destined to become box office smashes.

As things stand at the moment, there are a couple of cases worthy of further consideration. However, it is of some interest to consider first the wider context of the insurance industry's involvement in, effectively, guaranteeing the success of films, and to consider also just how the purported safeguards incorporated into policies by those making use of the film finance underwriting capacity has led to the case law that has been handed down to date.

Converging markets
There is no doubt that over recent years we have seen the increasing convergence of the re/insurance and banking/capital markets. However, from a legal perspective, these markets make uncomfortable bed fellows, and this incompatibility is no more striking than when one considers their respective approaches to the taking of risk and suffering of loss.

On the one hand, the banking and capital markets seek to squeeze risk out of any deal – painstaking and expensive due diligence exercises are designed to exorcise uncertainty.

By contrast, although the analysis of risk and the structuring of its acceptance become ever more sophisticated in the insurance market, one of the fundamental elements of any insurance or reinsurance transaction has to be uncertainty. Yet no underwriter is obliged to carry out due diligence. Underwriters can rely on the legal peculiarities of the classification of the re/insurance contract as a contract of utmost good faith. A purchaser of insurance or reinsurance is under a positive duty to disclose all material facts relevant to the risk, as well as not to misrepresent material information. The only remedy under English law for breach of this duty is avoidance, whereby the insurance or reinsurance contract is unravelled as if it had never existed.

If losses arise, the capital markets expect financial guarantors to make principal and interest payments almost immediately. Protracted legal disputes over coverage issues, including the right to avoid, are not acceptable: the capital market's rule is ‘pay now, ask questions later'. This is some way from the insurance market's instinctive response to being notified of a loss. Its traditional philosophy, supported by English insurance law, is that the obligation is to indemnify valid claims made on valid policies only.

In recent years in the financial guarantee market, non-specialist insurers, facing seemingly never-ending soft conditions in their traditional markets, have seized the business opportunity of providing guarantees to improve the credit rating of bond issues by using their own creditworthiness to enhance the rating of the issue. However, in any cross-insurance/capital markets transaction, the insurance market's ability to exploit its right of avoidance significantly increases the counter-risks of the capital market. The capital market would more usually be focused on the insurer's ability to pay claims, the analysis of which would involve a consideration of the credit rating assigned to the insurer, or the rating assigned to the financial instruments secured by the approval of the insurer. It has therefore become common in cross-insurance/reinsurance and banking/capital markets transactions to include clauses purporting to restrict or exclude the duty of utmost good faith and/or the remedy of avoidance.

It is these provisions, which are designed to ameliorate the incompatibility of expectations between the insurance and capital markets in relation to an occurrence of loss, that have been brought into sharp focus recently in the context of film finance insurance.

Behind the litigation
The reason for the film finance litigation, which is now raging on both sides of the Atlantic, is the rise of cable and satellite television in the early 1990s. This sparked a surge in demand for films and television programmes. Schemes were put together for advancing funds to films that in previous years would have struggled to raise finance. Policies such as the so-called time variable contingency (TVC) insurance policies and pecuniary loss indemnity policies (PLIP), which provided security for loans advanced to film makers, were developed. In essence, the insurance was taken out to cover any gap between the cost of making and marketing a film and the revenues generated by it. If the film failed to generate sufficient revenues, the banks, which mostly provided the finance to make the films, could claim on the policy.

Although initially designed for smaller film projects, over which there was a degree of risk control, the TVC concept was taken to Hollywood, on the basis that the underwriting of films on a bigger scale would generate profits on a bigger scale. The insurance premiums generated under these policies were typically 10%. With film budgets running into tens of millions of dollars, the business opportunity seemed obvious.

Although some of the biggest players in the global insurance market were prepared to back the success of these films, the banking and capital markets did require provisions in insurance policies purporting to restrict and exclude the duty of utmost good faith and/or excluding the right to avoid. These exclusions were of fundamental importance to those markets – if valid, the insurance policies were, effectively, what it was intended that they should be: guarantees.

Exclusions and the courts
With losses reported at up to $2bn, and amid allegations of negligence and fraud, the insurance market has reacted as might be expected of it in the circumstances, and avoided the TVC and PLIP policies. The banking and capital markets have reacted as might be expected of them, and sought to enforce the clauses purporting to exclude the insurers' remedy of avoidance.

Two cases to date: HIH v New Hampshire Insurance and HIH v Chase Manhattan Bank have provided, on the basis of assumed facts, judicial guidance as to how the differently worded exclusion clauses in the respective cases should operate.

HIH v New Hampshire
A number of capital providers invested in the making of a number of films, the investment to be repaid out of the future profits to be earned by the films. By way of collateral security for the investment, a PLIP was purchased to insure against any shortfall between the amount of finance provided by capital providers and the profits ultimately to be earned by the films.

The entire direct risk was taken by HIH, which acted under a fronting arrangement for three other underwriters participating in an 80% quota-share reinsurance of HIH.

In each of the PLIP wordings, the capital providers insisted on the insertion of an exclusion clause, as follows:

“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 misrepresentation by any person or any other similar grounds. The Insurer irrevocably agrees not to assert and waives any and all defences and rights of set-off and/or counterclaim (including without limitation any such rights acquired by assignment or otherwise) which it may have against the Assured or which may be available so as to deny payment of any amount due hereunder in accordance with the express terms hereof.”

The film productions were not a success. HIH was presented with claims in excess of $31m. Having made payment, HIH sought to recover the 80% reinsurance from the defendant reinsurers. The reinsurers raised two broad defences. First, HIH had no liability under the direct policies, which, in turn, meant that the reinsurers had no liability to HIH. Second, the reinsurers alleged breaches of warranty and of the duty of utmost good faith in relation to the reinsurance itself.

In May this year, the UK Court of Appeal, in determining various preliminary issues, held that the original slip policy was not superseded by the policy wording, that terms in the reinsurance contract as to the number of films to be made did operate as warranties, and that the exclusion clause was incorporated into the reinsurance contract.

As regards the ambit of the exclusion, it was held that the clause did not extend to breach of warranties – had the parties intended the exclusion to so apply, they could have expressly extended it in that way. However, the Court of Appeal also held that the clause did extend to exclude the insurer's right to avoid for both innocent and negligent misrepresentations and non-disclosures, even though there was no express reference to the exclusion of ‘negligence'.

HIH v Chase Manhattan Bank
The bank had participated in a syndicated loan. The loan had been made to Phoenix, a film production company, on the basis that the outstanding sum would be repaid out of revenues to be generated by a number of films to be produced by Phoenix. TVC insurance was procured to cover the risk of insufficient film revenues. The relevant policies all contained ‘truth of statement' clauses, which, in part, read as follows: “the insured…will not have any duty or obligation to make any representation, warranty or disclosure of any nature, express or implied…shall have no liability of any nature to the insurers for any information provided by any other parties...including, but not limited to, Heath North America & Special Risks Ltd...”

“…and any such information provided by or non-disclosure by other parties including, but not limited to, Heath North America & Special Risks Ltd...shall not be a ground or grounds for avoidance of the insurers' obligations under the Policy or the cancellation thereof”.

Very significant losses were incurred under the TVC policies. HIH claimed the right to avoid by reason of fraudulent or negligent non-disclosures and/or misrepresentations by the broker, Heath.

In largely overruling Aikens J at first instance, the Court of Appeal considered the impact of the truth of statement clause on HIH's purported right of avoidance, and, in summary, decided that:

  • A clause which excluded the insured's or the insured's agent to insure's duty to make a disclosure would protect the insured, if there was an innocent, a negligent or even a fraudulent non-disclosure.

  • A clause which excluded the insured's duty to make a disclosure was sufficient to also exclude the insured's agent to insure's separate duty of disclosure.

  • There was no reason why ‘information' could not cover representations, and therefore misrepresentations.

  • A generally worded exclusion of an insurer's remedy of avoidance would be sufficient to exclude that remedy in cases involving innocent and/or negligent misrepresentations by either the insured or his broker, but absent clear and express wording, not a fraudulent misrepresentation by the broker. Public policy precluded an insured from excluding liability for the consequences of its own (as opposed to its broker's) fraudulent misrepresentation in any circumstances.

  • A generally worded exclusion of an insurer's remedy of avoidance would be sufficient to exclude that remedy in cases involving an innocent and/or negligent and/or fraudulent non-disclosure.

    The Court of Appeal's judgment has been appealed to the House of Lords. After the HIH v Chase case, if appropriately worded exclusions have been included in the relevant policies, proving that the film finance risks were negligently presented by the brokers will not be good enough to establish a right of avoidance. It is interesting to note that since the Court of Appeal's ruling, several other film finance insurers have made allegations of fraud against brokers and some insureds.

    Other consequences
    The effect of the insurance market's refusal to pay up in respect of unsuccessful films has also had consequences away from the courts. A special purpose vehicle, Hollywood Funding No. 6, issued $100.7m of notes secured by revenues to be generated from a number of films. Based on Lexington Insurance's guarantee of two film finance instruments, Standard and Poor's rated the notes AAA. In February 2001, however, the ratings agency announced that the paper was to be re-rated to CCC – reported to be the largest single downgrade ever of a European bond – after S&P had learned that Lexington had told the trustee of the bankrupt Hollywood 6 that, due to a breach of policy warranties, it was not liable to meet its commitments. Lexington's decision not to pay, and a similar decision by New Hampshire in the HIH case, has led some to comment that the insurers are participating in the financial guarantee business without following the rules. Whilst monoline financial guarantee companies are well versed in the rules of the capital markets, and understand what such clients and bondholders expect of them, multiline insurers consider that they are writing conventional insurance business and therefore expect to explore whether or not a claim should be paid.

    The banking and capital markets will undoubtedly now capitalise on the lessons to be learned from the on-going film financial litigation, and ensure that future arrangements are drafted in such a way so that the expected performance of the obligation to pay claims is truly ‘guaranteed'. Clauses inserted to exclude the duty of disclosure and the remedy of avoidance will inevitably become more sophisticated, as lawyers seek to cover ‘all the angles' in the light of developing judicial comment and scrutiny.

    In these circumstances, and given the inevitable hardening of rates following the terrible events of 11 September, insurers may well decide to pull out of this class of business. However, assuming that some insurers will wish to continue to build on the inflow of premium from this form of alternative risk transfer product, a movement away from the traditional approach of relying on the burden imposed on insureds by the duty of utmost good faith may be necessary. Instead, investing in undertaking detailed and costly due diligence exercises will have to be contemplated. Alarming as that may sound to some insurers, such exercises are, of course, commonplace in most other areas of commercial transactional life.