CMBS/Subprime Financial Crisis: E&O And D&O Insurance Issues May 16, 2008 Carl Schwartz Elliott M. Kroll

1 Property Sales (properties over $5 mm only) $425 billion 2008 Q1 $40 billion 2007

2 Index Performance Comparison (From ING Clarion Real Estate Securities, U.S. Real Estate Securities, Market Commentary)

3 Holders of Commercial & Multifamily Mortgage Leases ($ billions) (From Commercial Mortgage Securities Association, Compendium of Statistics)

4 CMBS Issuance ($ billions) (From Commercial Mortgage Securities Association, Compendium of Statistics)

5 CMBS Weekly Spreads to Treasuries and Swaps (From Commercial Mortgage Securities Association, Compendium of Statistics)

6 Insurance Coverage Issues Who is suing whom? What is the nature of claims asserted? What are the potential E&O and D&O coverage issues?

7 Categories of Real Estate-Related Claims Subprime mortgage sales to homeowners and bundling of groups of mortgage loans CMBS market disruptions Rating, securitization and insurance of real estate debt Distribution of securitized debt

8 Real Estate Related Securities and Mortgage Claims/Defendants Consumer actions (including class actions) v. Mortgage lenders, title insurers, mortgage brokers: Mortgage insurers v. Subprime lenders: Shareholder derivative suits Lenders v. Banks Suits by State Attorney Generals against Investment banks and investment advisors Hedge fund investors against Asset managers Claims against rating agencies Suits against Bond insurers, loan originators, Actions against debt securities underwriters for alleged SEC violations. Claims by Plan beneficiaries against Plan fiduciaries Criminal and regulatory investigations into subprime mortgage sales practices:

9 Real Estate Related Securities and Mortgage Claims/Defendants Borrowers (likely class actions) v. Mortgage lenders: –Inadequate disclosure of terms of loans (e.g. failure to properly disclose points, pre-payment penalties, “teaser” rates and adjustable nature of loan –Failure to investigate brokers or supervise employees –Improper reporting to credit agencies –Discriminatory/predatory lending/advertising practices –Statutory violations (Truth in Lending Act/Unfair Competition Act) Mortgage insurers v. Subprime lenders: –force lenders to buy back or replace loans that insurer insured and that were made fraudulent or in violation of lender’s standards Lenders v. Banks –improper margin calls and flawed valuation of underlying collateral by banks that purchased or financed the loans Criminal and regulatory investigations into subprime mortgage sales practices: –FBI investigations of companies that participated in subprime lending

10 Rating, Securitization and Insurance Claims/Defendants Claims against Rating agencies –failure to properly rate CDOs Regulatory investigations into anticompetitive conduct in debt rating industry Claims against bond insurers unable to make contractually-obligated payments Borrowers v. Investment banks –providing financial backing to an aggressive lender despite its questionable business practices Shareholders v. Lenders –misrepresentation and omission related to accounting for residuals; bad valuation; poor underwriting standards Investors in mortgage backed securities v. Funds –misrepresentation, bad pricing, failing to follow investment guidelines Bond purchasers v. bond issuers and affiliates Bond issuers and affiliates v. Loan originators Loan originator shareholders v. Underwriters and auditors of loan originators.

11 Distribution of Securitized Debt Claims/Defendants Plan beneficiaries v. Plan fiduciaries Clients v. Investment advisors Shareholders v. Public companies with substantial subprime securities holdings Institutional Investors v. Underwriters/Banks who securitized and sold mortgages (e.g. misrepresenting quality of underlying loans, covering up delinquencies, misrepresenting coverage available for foreclosures)

12 Estimates Of E&O/D&O Exposure To Subprime Losses $2 -3 billion in D&O losses (Guy Carpenter Specialty Practice Briefing, Nov. 2007) $3.6 billion for D&O losses (Advisen Ltd. 2/08) $8-9 billion for both E&O and D&O losses (National Underwriter P&C, Jan 28, 2008 referring to January 2008 Bear Stearns analyst report) Estimates do not include investment losses incurred by insurers through investment of their premium dollars Basis for estimates unclear –Valuation of loss entirely problematical at this point Insured v. uninsured losses Who are the actual defendants? –What is the actual impact on D&O - Side A Coverage?

13 Number of Subprime-Related Lawsuits According to Navigant Consulting Study: –As of 12/31/ subprime related lawsuits –As of 3/31/08 – 478 subprime related lawsuits

14 E&O/D&O Coverage Is there a “Claim”? –Does definition expressly include administrative/regulatory proceedings and investigations? E.g. “... a civil, administrative or regulatory proceeding against any Insured Person commenced by the filing of a notice of charges, investigative order or similar document.” –“formal” vs. “informal” investigation – some definitions only cover “formal” investigations –Some definitions expressly include: subpoenas target letters “investigations” without distinguishing between “formal”/”informal”

15 “First Made And Reported During Policy Period” Claim Must Be First Made And Reported During Policy Period –Did the insured become aware, prior to the policy period, of a Claim, or notice of facts and circumstances that may give rise to a Claim, concerning alleged subprime-related losses?

16 Who Is An “Insured” E&O policies often define “insured” more broadly to include the company itself, as well as directors, officers, employees and third parties for whose actions the insured is legally responsible. D&O policies typically include directors and officers and, in some circumstances, the company and/or employees –Does policy provide “entity coverage” (Part C Coverage)? –Is Part C Coverage limited to “Securities Claims”

17 Definition of “Loss” Typically excludes: –Punitive damages –Taxes –Fines –Penalties (civil or criminal) –Multiple Damages –Restitution

18 “Professional Services” E&O policies expressly afford coverage for “professional services” Definitions can vary depending upon industry: –Lenders (“the origination, sale, pooling and servicing of mortgage loans secured by real property...) –Financial services firms (“services that an Insured renders pursuant to an agreement with a customer or client, as long as the customer pays a fee, commission, or other compensation...” D&O policies generally exclude claims related to rendering of “professional services”

19 “Professional Services” (cont.) –Investment Banks (“those services performed... by the Insured (or by any other person or entity for whose acts, errors, or omissions the Insured is... legally responsible for), for the benefit of, or on behalf of a Customer... for a fee, commission or other consideration”).

20 E&O/D&O Exclusions Dishonesty/Fraud Violation of Statutes predatory lending claims exclusion Fiduciary liability

21 Dishonesty/Fraud Exclusions Did the insured act in a fraudulent manner/ engage in intentional conduct/obtain a profit or advantage to which it was not legally entitled: –Improper mortgage sales practices, including discriminatory lending practices –Improper property valuation practices –Improper waiver of financial requirements applicable to borrowers –Reckless/intentional misrepresentations to: homebuyers buyers of securitized subprime loans Investors regarding exposure to housing/credit crisis Final adjudication v. “in fact” standard

22 Violation of Statutes Some policies only exclude “willful” violation of statute Some policies exclude only certain statutory violations (e.g. civil rights laws, antitrust laws and/or unfair competition statutes) Some policies do not exclude statutory violations

23 Specific Endorsements Some policies have an endorsement excluding predatory lending claims. Some policies contain exclusions barring claims arising from any investor’s interest in mortgage-backed securities or the filing of any registration statement therewith, unless the claim results from the rendering of “Professional Services.”

24 Fiduciary Liability Insurance Most D&O/E&O policies exclude fiduciary liability exposures and those exposures pertaining to the ERISA Fiduciary liability policy may apply if a pension/retirement fund is largely invested in subprime securities. Under ERISA, plan fiduciaries can be held personally liable for losses to a benefit plan incurred as a result of their alleged errors, omissions, or breach of fiduciary duties.

25 Fiduciary Liability Insurance (cont.) Insureds: –trust or employee benefit plan –any trustee, officer or employee of the trust or employee benefit plan –employer who is sole sponsor of a plan –any other individual or organization designated as a fiduciary.

26 Fiduciary Liability Insurance (cont.) Alleged “wrongful acts” may include: –Improper advice or disclosure –Inappropriate selection of advisors or service providers –Imprudent investments –Lack of investment diversity –Breach of responsibilities or fiduciary duties imposed by ERISA –Negligence in the administration of a plan –Conflict of interest with regard to investments

27 CONCLUSION Litigations will be prevalent The list of target defendants will be wide Plaintiff attorneys will be “imaginative” –New types of claims should be expected by state agencies, regulators, investors and consumers Policyholders need to promptly cooperate and coordinate with their insurers –Choice of counsel –Response to investigations/pre-suit claims Compliance with policy terms regarding notice to insurer (in writing, within policy period, specific address, etc.)

CMBS/Subprime Financial Crisis May 16, 2008 Carl Schwartz Elliott M. Kroll Herrick, Feinstein LLP 2 Park Avenue New York, N.Y