Thursday, August 30, 2007

D & O Underwriters Get Active in Underwriting Subprime Litigation Risk

In an earlier post (here), I commented on the D & O industry’s probable response the the litigation wave arising from the subprime lending mess, including the likelihood of increased underwriting around subprime exposures. The heightened scrutiny that I had surmised apparently is now a reality. An August 30, 2007 Bloomberg.com article reports (here) that a leading D & O insurer has created a "three-page questionnaire" to be used to determine whether applicants "make home loans to the riskiest borrowers or invest in sercurities backed by them." Other D & O insurers reporedly are inquiring about applicants' vulnerability to subprime exposure without requiring a questionnaire. (Full disclosure: I am quoted in the article).

According to the article, this effort"highlights insurers’ concerns that the rout in the subprime market could damage one of the most profitable lines of business." The article quotes an analyst from Sanford Bernstein as estimating that "subprime could add to D & O insurers’ claims by as much as $1.5 billion to $3.6 billion annually for three years" although also noting that that scenario is "extremely unlikely" and that actual losses will be 10 to 50 percent of those numbers.

The article also contains some sensible advice from my good friend Lauri Floresca, who suggests that clients should "avoid giving written answers [to any questionnaire] because they could later be used to deny coverage." (The insurer’s spokesperson is quoted in the article as saying that the written questionnaire is rarely mandatory.) Floresca also comments (as I noted in my prior post) that insurers "are really on high alert for anything that could be tangentially related to subprime."

The broad range of loss the analyst projected (that is, a three year total exposure ranging from $450 million to $10.8 billion) encompasses just about every possible outcome. Given how early we are on this story, any number that anyone would posit at this point could be nothing but pure conjecture, but I still wonder why the analyst even bothered to attempt a putative quantification of the exposure.

A final thought about the analyst's projection: If people really do get paid for coming up with that kind of, well, analysis, then there has to be some way that I can make money from this blog.

How Broadly Will the Subprime Wave Spread?: In earlier posts (most recently here), I commented that the greater risk from the subprime lending mess is that its effects could spread far beyond the subprime lending industry itself. An August 27, 2007 Financial Times article entitled "Internet Groups Brace for Subprime Fallout" (here) suggests just how broadly the subprime wave might spread. The article notes that "Internet companies are bracing for a possible fall-off in one of the biggest sources of advertising following the meltdown of the subprime mortgage market."

The article goes on to note that 16% of all online advertising comes from financial services companies, making it the second biggest source of income behind retail. Among the financial services companies advertising on the Internet, the biggest players include mortgage lenders such as Countrywide, Low Rate Source and Lending Tree.

The fact that the subprime mortgage mess could hurt the financial prospects of an industry seemingly as unrelated as the Internet suggests just how widespread and unpredictable the subprime mess potentially may be. The D& O underwriters mentioned above who are scrambling to develop underwriting tools to try to get ahead of the risk are understandably nervous, and in light of the stories about the subprime impact on Internet companies, may understandably extend their heightened underwriting well beyond the subprime lending industry itself.

Another Private Trading Platform: In earlier posts, I have taken a look at the new private trading platforms, such as the Goldman Sachs GSTrUE system (refer here) and the Nasdaq Portal (refer here), where accredited investors can trade Rule 144A shares. The attraction of these private exchanges is that they allow private companies to raise equity capital while providing investment liquidity but without assuming reporting company burdens and responsibilities. Recent news reports (here) that hedge fund giant Renaissance Technologies was considering selling an equity stake in a Rule 144A offering highlighted the fact that yet another private trading system has been launched.

According to the news reports, Renaissance is considering floating an offering on the new OPUS-5 system, announced this month by Morgan Stanley, Lehman Brothers, Citigrop, Merrill Lynch and the Bank of New York Mellon. According to the Bank of New York Mellon’s August 14, 2007 press release describing the system (here), its name is an acronym for "Open Platform for Unregistered Securities," and will "provide trade reservation, shareholder tracking and transfer management for privately offered equity securities transacted under Rule 144A." The press release goes on to state that :

OPUS-5 will support and enable an open platform with multiple market makers and is designed to provide broad liquidity to the U.S. private placement market and facilitate greater access to capital for issuers in the 144A equity market. The platform will also monitor the number of shareholders in these issuers. OPUS-5 is expected to launch in September 2007.
The reason that the platform’s managers will monitor the number of shareholder is that if the number of the issuer’s shareholders were to exceed 500, the issuer would trigger reporting company obligations.

The sudden efflorescence of these private trading platforms is clearly a part of the U.S. financial market’s response to the success of the London-based Alternative Investment Market (AIM). These platforms provide companies with ease of access to equity financing, addressing the need, noted in my prior post (here), that has driven AIM’s success. The active competition that has quickly arisen between the various private platforms will clearly be to the benefit of the issuer companies, as they will have the advantage of being able to choose on which platform they will have their Rule 144A shares traded. The more interesting question is whether these new private platforms will serve as a way station to an eventual public offering or whether they will serve as an alternative to going public. For a huge hedge fund like Renaissance, the OPUS-5 trading clearly is an alternative to going public.

In either case, as I noted in my prior post looking at the GSTrUE system, even though floatations on the private systems are less risky that an public offering, they are not risk free exercises. The D & O marketplace undoubtedly will innovate customized products to address the specific risks facing companies whose Rule 144A shares will be trading in these private systems.

Will His Retirement Attire Be Orange?: As has been well-documented in the press (refer here), Bill Lerach is resigning from his eponymous law firm, to be known after August 31 as Coughlin Stoia Rudman & Robbins. The most interesting media coverage of the resignation has been on the WSJ.com Law Blog, which not only reprinted the full text of Lerach’s resignation e-mail (here) but also posted (here) a fascinating comparison between the text of Lerach’s e-mail and Richard Nixon’s Resignation and Farewell speeches, and in addition (here) to the Godfather II movie.

But perhaps the most noteworthy aspect of the WSJ.com Law Blog’s coverage is the statement in its August 28 post (here) that Lerach "is in advanced talks with prosecutors on a plea deal that could be announced in September and involve serving time, according to two people familiar with the investigation (emphasis added)."

The law firm’s August 28, 2007 press release on Lerach’s resignation can be found here.

So Kids, That's Why You Should Do Your Math Homework: Renaissance Technologies, which has assets over $30 billion, was founded by mathematician James Harris Simons, and uses mathematically based trading strategies. Press reports commenting on the reasons why Renaissance might shun a public offering suggest that one reason was to avoid having to reveal more information about its trading strategies.

Another reason Renaissance might try to avoid a public offering is to avoid greater scrutiny of its executive compensation practices. According to Wikpedia, Simons earned an estimated $1.7 billion in 2006, after having made $1.5 billion in 2005 and $670 million in 2004. Forbes lists him (here) as the 64th richest person in America.

Speaker's Corner: I will be moderating the educational panel on "Current Issues in Directors' and Officers' Liability Insurance" at the Professional Liability Underwriting Society (PLUS) Midwest Chapter event in Cincinnati on September 12, 2007 (refer here for details). We have a distinguished panel including Dan Bailey from the Columbus law firm of Bailey & Cavalieri, Tom Reiter from K&L Gates in Pittsburgh, Jim Lash from the Hylant brokerage in Cinncinati, and Mark Lamendola from Travelers. This is going to be a great event, and I hope readers in the Ohio Valley and Great Lakes regions will try to attend.

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