Ambac Assurance Corporation, et al., Appellants,v.Countrywide Home Loans, Inc., et al., Respondents, Bank of America Corp., Defendant.BriefN.Y.June 6, 2018APL-2017-00156 New York County Clerk’s Index No. 651612/10 Court of Appeals of the State of New York AMBAC ASSURANCE CORPORATION and THE SEGREGATED ACCOUNT OF AMBAC ASSURANCE CORPORATION, Plaintiffs-Appellants, – against – COUNTRYWIDE HOME LOANS, INC., COUNTRYWIDE SECURITIES CORP. and COUNTRYWIDE FINANCIAL CORP., Defendants-Respondents, – and – BANK OF AMERICA CORP., Defendant. BRIEF FOR AMICUS CURIAE THE ASSOCIATION OF FINANCIAL GUARANTY INSURERS DONALD W. HAWTHORNE FELIX J. GILMAN AXINN, VELTROP & HARKRIDER LLP Attorneys for Amicus Curiae The Association of Financial Guaranty Insurers 114 West 47th Street New York, New York 10036 Tel: (212) 728-2200 Fax: (212) 728-2201 Date Completed: April 20, 2018 PRINTED ON RECYCLED PAPER i TABLE OF CONTENTS STATEMENT OF INTEREST OF AMICUS CURIAE............................................. 1 PRELIMINARY STATEMENT ............................................................................... 1 FACTUAL BACKGROUND .................................................................................... 8 A. Financial Guaranty Insurers Play a Vital Role in Protecting Investors 8 B. Financial Guaranty Insurers Have Paid, and Continue to Pay, Billions of Dollars to Investors For Losses Resulting from the Fraud or Misrepresentations of Mortgage Originators and Deal Sponsors ......... 9 ARGUMENT ...........................................................................................................10 I. UNDER NEW YORK LAW, AN INSURER CAN AVOID A POLICY ON THE BASIS OF FRAUD WITHOUT PROVING JUSTIFIABLE RELIANCE OR LOSS CAUSATION .....................................................................................10 II. A FINANCIAL GUARANTY INSURER SHOULD BE HELD TO THE SAME STANDARD AS ANY OTHER NEW YORK INSURER FOR OBTAINING RELIEF FROM A POLICY OBTAINED BY FRAUD ..............13 A. The Reasons That Insurers Generally Must Be Able To Rely On the Accuracy of Applicants’ Representations Apply to Financial Guaranty Insurers ................................................................................................13 B. A Financial Guaranty Insurer, Like Any Other Insurer, Should Be Entitled To Rely On An Applicant’s Representations Without Having to Prove Justifiable Reliance ...............................................................18 C. A Financial Guaranty Insurer, Like Any Other Insurer, Should Be Entitled To Recover Losses On A Policy Issued Based on Misrepresentations By The Applicant Without Having to Prove Loss Causation .............................................................................................22 D. To Be Put In the Same Position as Any Other Insurer, A Financial Guaranty Insurer Induced to Issue a Policy Based on Misrepresentations By The Applicant Should Be Entitled to Recover All Claims Payments as Damages .......................................................24 CONCLUSION ........................................................................................................29 ii TABLE OF AUTHORITIES Cases Page(s) Am. Surety Co. of New York v. Patriotic Assurance Co., 242 N.Y. 54 (1926) ............................................................................................. 11 Assured Guar. Mun. Corp. v. Flagstar Bank, FSB, 892 F. Supp. 2d 596 (S.D.N.Y. 2012) ................................................................ 16 Barrett v. State Mutual Life Assurance Co., 396 N.Y.S.2d 848 (1st Dep’t 1977) .................................................................... 22 Cherkes v. Postal Life Ins. Co., 285 A.D. 514 (1st Dep’t 1955), aff’d, 309 N.Y. 964 (1956) .............................. 11 Colin v. Hamilton Fire Ins. Co. of City of New York, 251 N.Y. 312 (1929) ........................................................................................... 11 Geer v. Union Mut. Life Ins. Co., 273 N.Y. 261 (1937) ............................................................................... 15, 19, 22 Glickman v. N.Y. Life Insurance Co., 291 N.Y. 45 (1943) ............................................................................................. 12 MBIA Ins. Corp. v. Countrywide Home Loans, Inc., 105 A.D.3d 412, 963 N.Y.S.2d 21 (1st Dep’t 2013) ...................................... 2, 17 Met. Life Ins. Co. v. Conway, 252 N.Y. 449 (1930) ........................................................................................... 12 Mut. Ben. Life Ins. Co. v. JMR Elecs. Corp., 848 F.2d 30 (2d Cir. 1988) ................................................................................. 26 Ripley v. Aetna Ins. Co., 30 N.Y. 136 (1864) ............................................................................................. 12 Syncora Guarantee, Inc. v. EMC Mortgage Corporation, No. 09 Civ. 3106, 2012 WL 2326068 (S.D.N.Y. June 19, 2012) ...................... 16 Valton v. Nat’l Fund Life Assur. Co., 20 N.Y. 32 (1859) ............................................................................................... 12 iii Vander Veer v. Cont’l Cas. Co., 34 N.Y.2d 50, 312 N.E.2d 156 (1974).......................................................... 15, 16 Statutes New York Insurance Law § 3106 ............................................................................ 12 New York Insurance Law § 3105 ............................................................................ 12 Other Authorities 45 C.J.S. Insurance § 859 (2016) ............................................................................. 11 Jeffrey W. Stempel, Peter N. Swisher and Erik S. Knutsen, Principles of Insurance Law (4th ed.) .................................................................................. 14 Seth J. Chandler, “Visualizing Adverse Selection: An Economic Approach to the Law of Insurance Underwriting,” 8 Conn. Ins. L.J. 435 (2002) ........................................................................................................... 14 William Reynolds Vance, Handbook On The Law Of Insurance § 93 (1904) ............................................................................................................ 11, 12 Williston on Contracts § 49:51 (4th ed.) .................................................................. 11 iv CORPORATE DISCLOSURE STATEMENT Amicus the Association of Financial Guaranty Insurers (“AFGI”) is a trade association whose members are ACA Financial Guaranty Corporation, Ambac Assurance Corporation, American Overseas Reinsurance Company Limited, Assured Guaranty Corp., Assured Guaranty Municipal Corp., Financial Guaranty Insurance Company, MBIA Insurance Corp., Municipal Assurance Corp., National Public Finance Guarantee Corp., and Syncora Guarantee Inc. AFGI does not have any parents or subsidiaries. 1 The Association of Financial Guaranty Insurers (“AFGI”) respectfully submits this amicus brief in support of Plaintiffs-Appellants Ambac Assurance Corporation and the Segregated Account of Ambac Assurance Corporation (collectively, “Ambac”). As set forth more fully below, AFGI urges this Court to reverse the decision of the Appellate Division, First Department, dated May 16, 2017. STATEMENT OF INTEREST OF AMICUS CURIAE AFGI is the national trade association of the leading insurers and reinsurers of municipal bonds and asset-backed securities. The decision and order of the First Department, from which Ambac appeals in this case, imposes unprecedented hurdles on an insurer’s ability to recover when it is induced by a misrepresentation into issuing an insurance policy. This ruling, if it stands, would have a significant impact on AFGI and its members, as well as on financial markets and the public in general. Accordingly, and because this case raises questions of fundamental significance to the financial guaranty insurance industry, AFGI respectfully submits this brief amicus curiae. PRELIMINARY STATEMENT In the decision from which Ambac appeals here, the First Department held that in order for Ambac to prevail on its claim against Defendants-Respondents Countrywide Home Loans, Inc., Countrywide Securities Corporation, and 2 Countrywide Financial Corporation (collectively “Countrywide”) for fraudulent inducement of the financial guaranty insurance policy it issued, Ambac must prove both “justifiable reliance” and “loss causation.” In so doing, the First Department abandoned its own recent precedent and well-settled principles of New York insurance law and ignored the long-recognized understanding of the conditions necessary to permit insurance markets to operate that underlays that authority. See MBIA Ins. Corp. v. Countrywide Home Loans, Inc., 105 A.D.3d 412, 963 N.Y.S.2d 21 (1st Dep’t 2013) (“MBIA II”) (holding that, in a claim by a financial guaranty insurer against a securitization sponsor, courts are “not required to ignore the insurer/insured nature of the relationship between the parties,” and should apply the principles of New York insurance law). The First Department’s order has potential implications for all insurers, but is of particular significance to financial guaranty insurers, including AFGI’s members, as the First Department held that financial guaranty insurers, contrary to the ordinary principles of insurance law, cannot rely on the truthfulness of an insurance applicant’s representations. This limitation on the rights of financial guaranty insurers potentially threatens fundamental aspects of their business model, as well as the viability of many municipal bond and secured asset offerings. As it stands, the First Department’s ruling also has the perverse result that large financial institutions like Countrywide are held to a lower standard of truthfulness 3 when applying for financial guaranty insurance policies than ordinary individuals when they apply for life, health, fire or property insurance. Until that erroneous ruling is corrected, the First Department’s decision leaves the law of insurance in New York in a state of confusion and uncertainty. AFGI seeks to be heard as amicus, not to repeat legal arguments that have been set out in Ambac’s briefs, but to underscore the public policy considerations underlying those arguments, which apply no less in the context of financial guaranty insurance than any other kind of insurance. * * * * * It is a bedrock principle of New York insurance law that an insurer that is induced to issue a policy by an insurance applicant’s material misrepresentation is entitled to avoid the policy. The burden is on the applicant to tell the truth, not on the insurer to ferret out the applicant’s misrepresentations. The insurer has the right to avoid recovery on the policy without proving that the insurer’s reliance on the misrepresentation was “justifiable” or that the misrepresentation “caused” a particular loss to the insurer. These principles of insurance law reflect policy judgments made over a century ago in New York about the nature of insurance and the legal framework necessary to sustain it that remain true to this day. Insurers price policies based on predictions about risk based on disclosures made by insurance applicants. Insurers 4 have expertise in evaluating risk based on a given set of circumstances and price accordingly based on a variety of facts, including the experience of pools of similarly-situated insureds. Were insurers only able to avoid recovery where they could prove that the insurer justifiably relied on an applicant’s misrepresentations in issuing a policy and that the misrepresentation “caused” the loss, they could neither price policies nor accurately assess the risks they are asked to assume. This is because the insurer would no longer be pricing based on the circumstances stated by the applicant; the insurer would be asked to price based on its assumptions about the applicant’s willingness to misrepresent the risk and to rely on the legal challenges facing the insurer in proving justifiable reliance and loss causation were its misrepresentation discovered by the insurer. The litigation risks involved are extremely difficult to price: the concept of “loss causation” poses particular challenges in the context of insurance, where applicant misrepresentations demonstrably increase the risk of loss, but may be difficult to establish as the particular cause of a loss. The propensity of an insurance applicant to attempt to obtain coverage through misrepresentations, and assume the risk that it could maintain that coverage by taking a gamble on the insurer’s ability to prove justifiable reliance and loss causation, is essentially impossible to assess, and well beyond any established insurance practice. It is for 5 that reason that insurance policies in New York have, for over a century, been subject to rescission upon proof of an applicant’s misrepresentations. The First Department’s rule also exacerbates the problems of adverse selection and moral hazard. Insurance applicants with the greatest potential risk have the greatest incentive to make misrepresentations in policy applications. Were the First Department’s rule to be implemented across the insurance industry, insurers, with greatly reduced ability to screen out higher-risk applicants – as no applications could be relied on – would be confronted with an escalating but also undefinable risk that their losses would be inflated by the most risky applicants gambling on their ability to maintain coverage, despite their misrepresentations, by prevailing on loss causation or justifiable reliance in litigation. That would not only impose a burden on insurers; because the risk is undefinable, it could not be priced. The First Department’s decision has the potential to increase insurance costs for many insureds. The long-time New York presumption that insurance applicants’ representations can be relied upon is a basis for transactional efficiencies that reduce the cost of all insurance. Were insurers required to perform more extensive due diligence to confirm the accuracy of information provided to them by policy applicants, it would significantly increase the cost of insurance coverage in all markets. 6 The First Department’s decision also has the potential to increase the cost of capital formation, increase the difficulties of municipalities seeking to raise capital to address their concerns, and decrease the attractiveness of New York and New York law as a center for securitized transactions. Increased cost of financial guaranty insurance – due to burdens imposed uniquely on financial guaranty insurers, that are not imposed on any other insurers in New York – would (i) limit the viability of securitizations governed by New York law, by increasing the costs imposed on securitizations and decreasing their relative attractiveness to investors; and (ii) increase costs on municipal issuers, and therefore reduce the attractiveness to investors of municipal offerings. The latter result is of particular significance at a time when cash-strapped municipalities must increasingly rely on bond markets, and the current administration in Washington has announced plans to rebuild America’s infrastructure through public/private partnerships, many of which will doubtless rely on debt financing by municipal issuers. The First Department’s justification for diverging from the ordinary principles of insurance law in this case turns on the fact that in the context of financial guaranty insurance there is a difference between the party that purchases financial guaranty insurance and the party that benefits from it. In most insurance policies, these two roles are the same. In the case of financial guaranty insurance, one party – typically the sponsor – contracts for the policy and makes the 7 representations on which the policy is issued, while the policy is for the benefit of the investors in the issuance. The sponsor obtains the policy in order to make the securitization more attractive to investors, and therefore to increase its own returns from the securitization. Because the investors make no representations themselves and the only representations inducing the insurance contract are made by the sponsor, the financial guaranty insurer contracts absolutely to pay the investors if the securitization results in shortfalls to their expected payments. The financial guaranty insurer cannot limit its obligation to pay investors no matter how egregious the extent of the misrepresentations on which the policy was obtained by the sponsor. This is a necessary feature of financial guaranty insurance, for the obvious reason that the policy would have little value to investors if they knew that they could be deprived of its protection based on misrepresentations by the sponsor – an entity over which they have no control and into which they have no special insight. A financial guaranty insurer therefore assumes an absolute obligation to pay securities holders that cannot be abrogated even if the policy was obtained by fraud. Financial guaranty insurers have made payments on their policies throughout the years after the credit crisis, despite the fact that their policies were obtained by the fraud of many sponsors. But the absolute liability of financial guaranty 8 insurers to insured investors provides no reason to diminish sponsors’ liability to financial guaranty insurers for the misrepresentations made by those sponsors, based on which the financial guaranty insurers issued their irrevocable policies. By holding that before Ambac can recover its claims payments, it must show what the First Department characterized as the “elements of a common-law fraud cause of action,” including justifiable reliance and loss causation, and by burdening Ambac’s ability to recover its full claims payments, the order appealed from diverges from the settled principles of insurance law, to the detriment of public policy and the functioning of the financial guaranty insurance market. AFGI respectfully urges this Court to reverse the First Department’s order. FACTUAL BACKGROUND A. Financial Guaranty Insurers Play a Vital Role in Protecting Investors Financial guaranty insurance originated in the municipal bond market, in the early 1970s. In the years leading up to the 2008 financial crash, financial guaranty insurers moved into the expanding RMBS market, offering the same unconditional guarantees that were the hallmark of their municipal bond business. The irrevocable guaranty provided by an AFGI member confers substantial benefits on sponsors and investors alike. It provides credit enhancement for a security, which reduces the sponsor’s borrowing costs, improves market access, and facilitates deal execution. Investors in a security insured by an AFGI member 9 receive an unconditional and irrevocable guaranty that interest and principal will be paid on time and in full – regardless of any misrepresentations on the part of the deal’s sponsor. Investors thus obtain additional protection against a potential default by the issuer. As a result of the insurance policy, investors also benefit from reduced exposure to price volatility caused by changes in the credit quality of the underlying securitization. Investors also benefit from the ongoing surveillance and remediation performed by financial guaranty insurers, whose interests (unlike those of other industry participants such as trustees or rating agencies) are aligned with those of investors. Moreover, like all forms of insurance, financial guaranty insurance provides a societal benefit by spreading risk. B. Financial Guaranty Insurers Have Paid, and Continue to Pay, Billions of Dollars to Investors For Losses Resulting from the Fraud or Misrepresentations of Mortgage Originators and Deal Sponsors The financial guaranty insurance industry collectively has made and is projected to continue to make billions of dollars of payments to investors as a result of the breaches of representations and warranties by Countrywide and other sponsors of RMBS securitizations who are defendants in the many pending RMBS cases. A number of insurers have been forced into statutory rehabilitation in order 10 to make sure that the claims of certificate-holders are paid to the maximum extent feasible given the assets available for such claims payments. The significance of an AFGI member’s guaranty is well-illustrated by the facts of this case. Wide-spread borrower default in loans originated by Countrywide led to huge shortfalls in the mortgage revenues received from the securitized loans, which are needed to make payments of principal and interest to investors in those securities. Where Ambac’s insurance was present, however, investors in the Countrywide-issued securities that are the subject of this litigation have been spared the full consequences of that shortfall by virtue of Ambac’s irrevocable policies guaranteeing payment of scheduled principal and interest payments to investors. A recovery in this case would materially improve Ambac’s claims-paying ability, which would redound to the benefit of investors in securities insured by Ambac. ARGUMENT I. UNDER NEW YORK LAW, AN INSURER CAN AVOID A POLICY ON THE BASIS OF FRAUD WITHOUT PROVING JUSTIFIABLE RELIANCE OR LOSS CAUSATION It has long been settled that an insurer’s claim for fraudulent inducement of an insurance policy does not require a showing of “justifiable reliance.” The insurer “has the right to rely upon representations made by an applicant for a policy,” and “is under no duty to make further inquiry or investigation as to the 11 accuracy or veracity of the application.” 45 C.J.S. Insurance § 859 (2016). The “burden of truthfulness” is on the insured, and the applicant “may not shift” that burden “into a burden of distrust and additional inquiry on the part of [the insurer].” Cherkes v. Postal Life Ins. Co., 285 A.D. 514, 516 (1st Dep’t 1955), aff’d, 309 N.Y. 964 (1956). This rule has been recognized by the courts of New York for a century, see, e.g., id.; Am. Surety Co. of New York v. Patriotic Assurance Co., 242 N.Y. 54, 64-66 (1926); Colin v. Hamilton Fire Ins. Co. of City of New York, 251 N.Y. 312, 314-15 (1929). It has also long been settled that an insurer is entitled to avoid or defeat recovery under a policy upon a showing that it was induced to issue the policy by a material misrepresentation, regardless of whether the risk that was misrepresented actually eventuated or resulted in a loss to the insurer. The insurer must show only that the misrepresentation was “material” – that is, that it “affected the insurer’s decision to issue the policy or assume the risk for the stated premium.” Williston on Contracts § 49:51 (4th ed.). There is no “need for the insurer to prove that the misrepresented condition contributed to the particular loss that was eventually sustained by the insured.” Id. “If the knowledge of a fact would cause an insurer to reject the risk, or to accept it only at a higher premium rate, that fact is material, though it may not even remotely contribute to the contingency upon which the insurer would become liable.…” William Reynolds Vance, Handbook On The 12 Law Of Insurance § 93 (1904). This rule too has been followed for over a hundred years in the courts of New York, see, e.g., Valton v. Nat’l Fund Life Assur. Co., 20 N.Y. 32, 36-38 (1859); Ripley v. Aetna Ins. Co., 30 N.Y. 136 (1864); Met. Life Ins. Co. v. Conway, 252 N.Y. 449, 452-53 (1930); Glickman v. N.Y. Life Insurance Co., 291 N.Y. 45 (1943). These common law rules are also recognized in the New York Insurance Law statutes. New York Insurance Law § 3105 provides that “no misrepresentation shall avoid any contract of insurance or defeat recovery thereunder unless such misrepresentation was material,” and defines a material misrepresentation as one where “knowledge by the insurer of the facts misrepresented would have led to a refusal by the insurer to make such contract.” Similarly, New York Insurance Law § 3106 provides that “[a] breach of warranty shall not avoid an insurance contract or defeat recovery thereunder unless such breach materially increases the risk of loss, damage or injury within the coverage of the contract.”1 Neither statute imposes any requirement on the insurer to probe the truth of an applicant’s representations before relying on them. Under either 1 As Ambac notes in its opening brief, the principle purpose of these statutes and their predecessors was to modify the pre-20th century rule that a breach of warranty (but not a misrepresentation) could defeat recovery even if it was immaterial. See Ambac Br. 32-33; Ripley v. Aetna Ins. Co., 30 N.Y. 136 (1864) (“The effect of the breach of the warranty is to annul the policy without regard to the materiality of the warranty, or whether the breach had any thing to do in producing the loss.”) 13 statute, an insurer may defeat recovery on a showing that the applicant’s misrepresentations were material, in the sense that they caused the insurer to issue a policy it otherwise would not have issued, or that they materially increased the risk of loss under the policy. There is no requirement that the insurer show that the concealed risk actually eventuated. II. A FINANCIAL GUARANTY INSURER SHOULD BE HELD TO THE SAME STANDARD AS ANY OTHER NEW YORK INSURER FOR OBTAINING RELIEF FROM A POLICY OBTAINED BY FRAUD A. The Reasons That Insurers Generally Must Be Able To Rely On the Accuracy of Applicants’ Representations Apply to Financial Guaranty Insurers Insurance markets, as the law has long recognized, are different from many other markets. Insurers sell protection against risk. Unlike most industries, where the seller’s costs of producing a product or providing a service depend primarily on facts about the seller, such as its manufacturing costs, the cost of providing protection against risk depends crucially on information regarding the consumer. It is the insurance buyer’s characteristics and conduct that determine their risks, and the cost of providing insurance to them. Therefore, while in most markets a seller’s costs depend on information in the seller’s possession and control, the cost of providing insurance depends fundamentally on information that is solely in the applicant’s possession. As a result, insurers are uniquely exposed to the risk of 14 systematically underpricing their product due to asymmetry of information between insurers and insurance applicants. The asymmetry of information between insurer and insured gives rise to two of the central problems that face insurance markets: “adverse selection” and “moral hazard.” The problem of “adverse selection” is that those individuals with the greatest risk – those who impose the greatest costs on insurers – have the greatest motivation to obtain insurance, and the greatest motivation to conceal their risks. The related problem of “moral hazard” is that insureds have greater incentives to take on risk to the extent that they know insurance will protect them from any loss. The result of these problems is that if insurers cannot control their risk by obtaining reliable information from applicants, they will not merely end up taking on random or uncontrolled risk, but the worst risk. See Jeffrey W. Stempel, Peter N. Swisher and Erik S. Knutsen, Principles Of Insurance Law (4th ed.) § 1.05 (“Adverse selection and moral hazard … provides perhaps the greatest threat to fortuitous underwriting by the insurer”); Seth J. Chandler, “Visualizing Adverse Selection: An Economic Approach to the Law of Insurance Underwriting,” 8 Conn. Ins. L.J. 435, 437 (2002) (describing the “powerful torque” exerted on insurance prices by adverse selection, and its capacity to “shrink insurance markets”). Legal doctrines of misrepresentation and breach of warranty, which create incentives for applicants to honestly disclose the information insurers 15 require to assess risk, are critical to controlling these problems and equalizing information asymmetries between insurer and applicant. Insurance markets are also unusual in their systemic importance to society. If an ordinary seller of goods or services collapses, its stakeholders suffer – its employees, shareholders, and counterparties – but its existing customers by and large do not, as they have already obtained whatever benefit they bargained for. Insurers are different. Insurers provide their insureds with protection against the risk of future losses; their contracts may last for decades, and their benefits may not be felt unless and until a loss occurs, far in the future. If an insurer is induced by a misrepresentation to take on excess risk and collapses as a result, it is not only the insured who caused the loss who suffers, but also all of the insurer’s other insureds, who may be left without protection, or with large uncompensated losses. This is well illustrated by the circumstances of financial guaranty insurers; the losses that AFGI’s members have suffered due to the misrepresentations of sponsors such as Countrywide have severely impaired their ability to protect all of their insureds. For insurance markets to be sustainable, and to continue to provide their social benefits, including protection against risk and risk-pooling, insurers must be able to control their risk. The law has long recognized this. See Geer v. Union Mut. Life Ins. Co., 273 N.Y. 261, 265 (1937) (an insurer “is free to choose the risks 16 which it will assume”). The ability of insurers to control their risk in turn depends on their ability to accurately assess it – which is to say, on their ability to rely on the representations of insurance applicants, and to avoid recovery where they are induced into taking on excess risk through misrepresentations. See Principles of Insurance Law § 6 (representations and warranties exist “in order to control the kind and degree of risk to be insured.”); Vander Veer v. Cont'l Cas. Co., 34 N.Y.2d 50, 53, 312 N.E.2d 156, 157 (1974) (applicant’s misrepresentation “deprived [insurer] of freedom of choice in determining whether to accept or reject the risk.”). All of these reasons, which explain why insurers must be able to rely on the accuracy of policy applicant representations, apply equally to financial guaranty insurers. Courts have repeatedly recognized that the principles underlying the insurance law generally are applicable to financial guaranty insurers. See, e.g., Syncora Guarantee, Inc. v. EMC Mortgage Corporation, No. 09 Civ. 3106, 2012 WL 2326068, at *4 (S.D.N.Y. June 19, 2012) (“Insurance is the business of pricing risk; and it cannot function efficiently if the insured conceals or misrepresents the risks a policy covers.”); Assured Guar. Mun. Corp. v. Flagstar Bank, FSB, 892 F. Supp. 2d 596, 602 (S.D.N.Y. 2012) (“New York law … provides that an insurer has an interest in receiving complete and accurate information before deciding whether to issue a policy. Moreover, New York law recognizes that an insurer may 17 rescind a policy where an insurer has relied on a material misrepresentation… While this is not a rescission case, plaintiff’s immediate contractual remedy— repurchase—is closely akin to rescission.”) (citations omitted). Indeed, the problems posed by informational asymmetry are likely to be especially acute in contexts such as financial guaranty insurance, where the applicants are highly sophisticated financial institutions who are better able to assess their risk than ordinary individuals such as applicants for life or property insurance, and therefore better able to take advantage of their superior access to information. Moreover, applicants for financial guaranty insurance have powerful financial incentives to exploit informational asymmetries, by consciously increasing the risk of their operations and therefore their profits while passing off the risk to insurers – and to the markets generally. In 2013, the First Department itself recognized that the principles of the insurance law apply equally in the context of financial guaranty insurance. In the context of a claim by another financial guaranty insurer against a sponsor – the same sponsor as in the present case – the First Department held that the court was “not required to ignore the insurer/insured nature of the relationship between the parties.” See MBIA Ins. Corp. v. Countrywide Home Loans, Inc., 105 A.D.3d 412, 963 N.Y.S.2d 21 (2013). Citing New York Insurance Law § 3105 and § 3106, the First Department held that the financial guaranty insurer plaintiff was not required 18 to show loss causation in order to prevail on its claim against the sponsor to recover its claims payments. In the order appealed from, the First Department acknowledged its prior ruling, but simply “decline[d] to follow it.” The only reason that Countrywide claims that Ambac is not entitled to the presumption under New York law that it should be put in the place it would have been, had it not issued insurance based on misrepresentations, is that Ambac issued irrevocable policies to investors in Countrywide’s securitizations. But that is a distinction without a difference. It was Countrywide, as sponsor, that defrauded Ambac. Nothing about the irrevocable nature of these policies provides a reason for depriving Ambac of its rights to obtain relief from a party (Countrywide) that obtained insurance based on misrepresentations. There is nothing in the contract between Ambac and Countrywide (and Countrywide has not alleged to the contrary) saying that by irrevocably agreeing to pay investors, Ambac was absolving Countrywide, as the party that obtained the insurance, from its ordinary obligations under New York law, as policy applicant, to provide truthful information relating to the policy. B. A Financial Guaranty Insurer, Like Any Other Insurer, Should Be Entitled To Rely On An Applicant’s Representations Without Having to Prove Justifiable Reliance Insurance law recognizes that an insurer is entitled to rely on an applicant’s representations in assessing risk, rather than being subject to after-the-fact second 19 guessing about whether the insurer’s risk assessment efforts were adequate. See Geer v. Union Mut. Life Ins. Co., 273 N.Y. 261, 270 (1937). Treating financial guaranty insurers differently in this respect would undermine the goals of the insurance law. Sponsors (like any policy applicant) would face strong incentives to apply for financial guaranty insurance on false pretenses. If the policy was issued and a loss occurred, the sponsor could take comfort, despite its misrepresentations, in the possibility that the insurer would be unable to carry its burden of proof that it relied on the misrepresentation, given all the other information available to the insurer at the time, and given arguments that the insured might make about the insurer’s obligation to undertake its own diligence. There is no justification under New York law or the parties’ contracts to permit applicants for financial guaranty insurance to misrepresent their risks and shift the burden of proving justifiable reliance on their misrepresentations to the insurer, when no other insurance applicant can do so under New York law. Countrywide acknowledges that “life, health [and] fire” insurers are entitled to rely on an applicant’s representations, but suggests that financial guaranty insurance is different because Ambac is not a “high-volume” insurer. Resp. Br. 22-23. The implication of this distinction is perverse – that banks like Countrywide, JP Morgan, and Bank of America, applying for billion-dollar 20 insurance policies, should be held to lower standards of truthfulness than ordinary consumers applying for life, health or fire insurance. Moreover, while financial guaranty insurers issue relatively few policies, RMBS securitizations cannot be described as “low volume.” A typical RMBS securitization may be backed by thousands or tens of thousands of mortgage loans, and the sponsor’s processes for originating or acquiring and securitizing those loans are extremely complex, often involving an enormous number of personnel and many different origination channels. If financial guaranty insurers were not entitled to rely on a sponsor’s representations, but had to investigate their truth, the costs of that investigation would increase the costs of insurance and would be passed on to investors. More importantly, no amount of due diligence could completely avoid the risk of misrepresentations. Insurers can never realistically hope to gain the same understanding of a sponsor’s operations as the sponsor itself. Requiring financial guaranty insurers to prove “justifiable reliance” would therefore require the insurer to price not only for the risks inherent in the facts as represented by the applicant, but also for the unknowable risk that the facts were misrepresented by the sponsor, and for the further litigation risk that the insurer’s due diligence efforts would be found insufficient after the fact. These costs too would be passed on to the market – raising costs for all honest market participants to prevent the fraud of bad actors among deal sponsors and policy applicants. 21 Ambac’s conduct here further demonstrates the necessity for a financial guaranty insurer of being able to rely on a sponsor’s representations. Ambac obtained extensive information from the applicant, Countrywide, regarding the characteristics of the collateral and regarding Countrywide’s operations. Ambac used this information to assess the risk it was taking on, and to determine, among other things, the premium it would charge – just as a life insurer, for example, might obtain and assess information regarding an insurance applicant’s medical history. Among other things, Ambac obtained “mortgage loan tapes” from Countrywide, containing information regarding the credit characteristics of each loan in the securitizations. Ambac obtained prospectus documents for each securitization, which included representations about the collateral and about Countrywide’s underwriting processes, and about the structure of the securitizations as a whole. Ambac met with Countrywide employees to discuss Countrywide’s operations. Ambac used all of this information to model the securitizations, assess their risk, and price its policies. See Ambac Br. 8-9. What Countrywide is really saying, when it argues for the imposition of a “justifiable reliance” standard, is that Ambac’s risk assessment was inadequate because it should have done more to probe the truth of Countrywide’s representations, and to reveal their untruth. This standard, if applied, would result in a tremendous and irrational duplication of efforts, with the insurer being 22 required to duplicate the loan-level underwriting that should have been performed by the sponsor in the first place, and on which the insurer should have been entitled to rely in performing its own risk assessment of the securitizations as a whole. The costs of this duplication of efforts would have been passed on to investors. C. A Financial Guaranty Insurer, Like Any Other Insurer, Should Be Entitled To Recover Losses On A Policy Issued Based on Misrepresentations By The Applicant Without Having to Prove Loss Causation An insurer is entitled to avoid recovery when it discovers that an insurance applicant has misrepresented a risk, without the need to prove that the misrepresentation somehow “caused” a loss. See Barrett v. State Mutual Life Assurance Co., 396 N.Y.S.2d 848, 851-52 (1st Dep’t 1977) (“The test is whether failure to furnish a true answer defeats or seriously interferes with the exercise of the insurance company’s right to accept or reject the application.”); see also Geer, 273 N.Y. at 270 (an insurer may avoid an insurance contract procured by misrepresentations because “the erroneous statement deprived the company of its freedom of choice” and “if the truth had been disclosed, it might, reasonably, have acted differently.”). Indeed, the insurer does not have to wait for the misrepresentation to result in a loss before it can pursue its remedies, because it has already been harmed by having been induced to take on excess and unqualified risk. 23 That rule is unsurprising. Insurers deal in risk. A misrepresentation may well increase the risk of loss. But it may be far more complicated to demonstrate that the misrepresentation “caused” a loss. Much of the information conveyed in any application for insurance may be predictive of future loss, and material to an insurer’s assessment of risk, but it may not be straightforward that such predictive factors “cause” a loss in any particular case. For example, information about an applicant’s past conduct or claims history is often highly predictive of the likelihood of future loss, and highly material to an insurer’s assessment of the applicant’s risk; but it may not be straightforward to prove a causal nexus between a particular predictive factor and any subsequent loss that actually occurs. Applying a “loss causation” rule, as the First Department’s ruling entails, would reduce insurers’ ability to rely on such predictive factors, and therefore their ability to control their risk. At the same time, it would incentivize insurance applicants to lie about such factors, knowing that they would face no consequences unless a loss occurred, and that even then they would keep the benefits of the policy unless the insurer could meet the challenge of proving a causal connection between the misrepresented risk factor and the loss. It would exacerbate the problems of adverse selection and moral hazard that the insurance law seeks to control. 24 These complexities in loss causation explain why insurers are not required to prove causation in order to avoid recovery on policies issues based on an applicant’s misrepresentations. For the same reasons, financial guaranty insurers should be entitled to recover past claims payments based on misrepresentations by policy applicants, without having to prove that such misrepresentations caused a loss. D. To Be Put In the Same Position as Any Other Insurer, A Financial Guaranty Insurer Induced to Issue a Policy Based on Misrepresentations By The Applicant Should Be Entitled to Recover All Claims Payments as Damages When an insurer is induced to issue a policy based on misrepresentations, it is entitled to rescind the policy, thereby avoiding payment of any claims. Financial guaranty insurers cannot rescind, because they issue irrevocable policies for the benefit of investors. Hence, to be treated similarly to all other insurers, financial guaranty insurers should be entitled to recover the entirety of their claims payments as damages from the sponsor that fraudulently induced them to issue the policy. There is nothing unusual about this remedy; it merely puts financial guaranty insurers in the same position as all other insurers and provides them an equivalent remedy when policy issuance has been induced by fraud. The First Department’s holding that it would be “inequitabl[e]” to allow Ambac to recoup its full claims payments, rather than claims payments associated with particular loans about which misrepresentations were made, ignores this basic 25 insurance law principle, that insurers are entitled to avoid paying any claims on a policy obtained by misrepresentation. When an insurer has been fraudulently induced to insure a risk, it may avoid the policy as a whole, not merely a portion of the policy associated with a particular misrepresentation. Policies obtained by misrepresentation are not “blue-pencilled” in this way. Nor should Ambac’s remedy be limited to the financial equivalent of rescinding only a portion of its policy. The First Department attempts to justify imposing limitations on Ambac’s recovery by contending that Ambac had “accepted the risk” that factors other than Countrywide’s misrepresentations as to particular loans, such as a downturn in the housing market, might cause loans to default. But Ambac no more accepted that risk than any other insurer, in issuing a policy in reliance on an applicant’s representations, accepts the risk that factors other than those represented might contribute to a loss. It is well-established that an insurer is entitled to avoid a policy obtained through misrepresentation without the need to prove that the misrepresented fact actually caused or contributed to a claim on the insurer; just so, a financial guaranty insurer can recover its losses on a policy obtained by misrepresentation without the need to prove the reason that any particular loan defaulted. 26 Imposing an additional burden on financial guaranty insurers to tie losses to individual loans, as the First Department would have it, would also create an incentive for sponsors to apply for coverage on false pretenses, heightening the problems of adverse selection that affect the insurance industry. Under the First Department’s rule, a sponsor could retain the benefits of a fraudulently induced policy, except in connection with whatever subset of loans the insurer could ultimately prove – perhaps after years of litigation – that the sponsor should never have been able to sell into the securitization in the first place. Such a remedy would effectively permit the sponsor to re-write the insurance policy after the fact based on information about risk the sponsor concealed at the time of policy issuance. See, e.g., Mut. Ben. Life Ins. Co. v. JMR Elecs. Corp., 848 F.2d 30, 34 (2d Cir. 1988) (“Such a claimant could rest assured . . . that even in the event of a contested claim, he would be entitled to the coverage that he might have contracted for had the necessary information been accurately disclosed at the outset. New York law does not permit this anomalous result.”). The First Department’s rule also misconstrues the nature and purpose of financial guaranty insurance. Financial guaranty insurers do not insure particular loans against default or issue their policies based on their assessment of the risk of individual loans. Rather, they insure the payment of principal and interest on 27 securities, backed by pools of loans.2 They assess risk at the level of the security, taking into account the structure and characteristics of the securitization (which may include many other forms of internal protection, such as “over- collateralization” or “excess spread,” which would reduce the likelihood of shortfalls of principal and interest), the characteristics of the collateral pool in the aggregate, and the integrity of the sponsor’s operations generally. The scope of financial guaranty policies is reflected in the typical terms of the Insurance and Indemnity Agreements (“I&I’s”) entered into between sponsors and financial guaranty insurers. Such I&Is (including the I&I between Ambac and Countrywide) not only make representations about individual loans, they also contain representations, made only to the insurer, that go to the risks of the securitizations as a whole. For example, the I&I between Ambac and Countrywide represents that all information in the securitizations’ prospectus documents was materially accurate, and that all other “material information relating to … the operations of Countrywide … furnished to [Ambac]” was materially accurate. See Ambac Br. 9-11, 48-49. 2 There is another sector of the insurance industry that does insure individual loans against default. Mortgage insurers, unlike financial guaranty insurers, insure certain individual loans within a securitization against default, cherry-picking which specific loans within a securitization they wish to insure. The risks, pricing, and economics of this kind of mortgage insurance are for these reasons quite different from the economics of financial guaranty insurance. 28 Nor do financial guaranty insurers limit their risk assessment to the sponsor’s contractual representations. Financial guaranty insurers rely on their assessment of the sponsor’s operations and integrity as a whole. In deciding whether to do business with a particular sponsor, insurers consider, inter alia, the sponsor’s reputation in the marketplace and its public statements regarding its operations. Insurers commonly conduct on-site visits to sponsors to review their operations, meet their staff, and understand their processes and standards (as Ambac did here, see Ambac Br. at 8). As Countrywide’s own expert in this proceeding has testified, “Insurers employ onsite visits to verify the procedures used to originate and service loans and more broadly to assess the risks associated with the parties involved in originating and servicing the loans. . . .” Expert Report of Aaron B. Stern dated Oct. 1, 2014 at ¶¶ 36, 68, No. 651612/2010, Sup. Ct. N.Y. Cnty., (Dkt. No. 1621). The integrity of a sponsor’s overall processes is critical, because underwriting, originating and securitizing loans requires experienced judgment, correctly applied. From appraisal processes, to review of stated incomes, to allowance for exceptions, to selecting loans for securitization, all aspects of underwriting, origination and securitization depend on the careful exercise of experienced judgment. When a sponsor holds itself out as having rigorous, credit- focused processes, but in fact is recklessly focused on growth at the expense of 29 credit, that corruption of standards and judgment affects deals as a whole. The remedy for such pervasive misrepresentations is for the insurer to be permitted to recover as damages all claim payments to which the insurer has become exposed by virtue of having insured a transaction based on the sponsor’s misrepresentations. CONCLUSION For the reasons set forth above, amicus curiae AFGI respectfully requests that the Court reverse the decision and order of the First Department, in so far as it holds that Ambac must show justifiable reliance and loss causation in order to recover its claims payments, and in so far as it imposes unique burdens on Ambac’s ability to recover damages in the amount of its full claims payments. Dated: April 20, 2018 New York, New York AXINN, VELTROP & HARKRIDER LLP By: Donald W. Hawthorne Felix J. Gilman 114 West 47th Street New York, New York 10036 (212) 728-2200 Attorneys for proposed Amicus Curiae the Association of Financial Guaranty Insurers PRINTING SPECIFICATIONS STATEMENT I hereby certify pursuant to 22 NYCRR § 500.13(c) that the foregoing brief was prepared on a computer using Microsoft Word. A proportionally spaced typeface was used, as follows: Name of typeface: Times New Roman Point size: 14 Footnote Point size: 14 Line spacing: Double The total number of words in the brief, inclusive of point headings and footnotes and exclusive of pages containing the table of contents, table of authorities, proof of service, certificate of compliance or any authorized addendum is Co1 (n5 j ■ Dated: April 20, 2018 Donald W. Hawthorne, Esq. Felix J. Gilman, Esq. AXINN, VELTROP & HARKRIDER LLP 114 West 47th Street New York, New York 10036 (212) 728-2200 Attorneys for proposed Amicus Curiae the Association of Financial Guaranty Insurers