On July 15, MBIA Insurance Corp. in Armonk, N.Y., filed suit in Delaware federal district court, along with Wells Fargo in its capacity as trustee, against Royal Indemnity Company to enforce insurance policies that Royal issued for vocational loans originated by Student Finance Corporation.

“The way weve described this is really a tremendous misunderstanding or a clash of cultures between the traditional insurance company environment and the expectations that the capital marketplace has come to expect from policies that are issued to insure debt, backed up or supported by financial guaranty policies,” said Robert Aicher, a partner with Sidley Austin Brown & Wood in Chicago.

Mr. Aichler is not representing, or connected to, either MBIA or Royal in any way.

When investors are insured by financial guaranty insurers, they assume the insurers will pay first and then sue later if fraud is determined, he said.

However, some multiline insurers are treating the financial guaranty product like the surety market, where they regularly litigate if fraud is discovered or suspected, he said.

MBIA insured eight securitizations, which have a total gross value of $380 million, which were collateralized by SFC vocational student loans guaranteed by Royal, the U.S. subsidiary of the London-based Royal & SunAlliance.

Royal filed a lawsuit on June 11 in a bid to have its policies voided on the grounds that the Student Finance Corporation and other parties associated with the transactions “fraudulently induced Royal to issue the policies by misrepresenting the performance and quality of the loans,” said the ratings agency, Fitch, in a statement that discussed the impact of the dispute on the structured finance market.

“In the normal surety world, I think there would be almost universal agreement that if fraud is practiced by the person who is insured and entitled to payment under the policy, that that person ought not to be able to benefit by their own fraud,” Mr. Aichler said.

“That is really different than what weve got going on in the Royal Indemnity case, for example. In that case, there is no allegation that those investors who were protected by the Royal Indemnity policies did anything wrong,” Mr. Aicher said. “They just bought securities.”

“Royal does not allege that the beneficiaries of the policies or MBIA engaged in fraud, breach of contract, or any wrongdoing of any kind,” said MBIA in a statement.

One market source said it was the insured that allegedly committed the fraud, not the beneficiary, MBIA.

Royal stated in its legal pleading that its loss in the SFC deal could be as high as $600 million.

“Notably, Royal is suing even though its policies contain a waiver of defenses to payment for any reason, including fraud,” said Fitch.

“MBIA believes that it will have no ultimate loss on these transactions, since all of the Royal policies are in fact valid, unconditional and irrevocable obligations to the beneficiaries,” said Richard Weill, vice chairman of MBIA, in a statement. “We will vigorously challenge Royals claim that there is no coverage and expect that Royal will be required to make full payment under its policies.”

“The financial guaranty policies say that payment is absolute and unconditional, as do surety policies,” said Mr. Aicher, noting, however, that the difference is the expectation of the insurance buyers in the two markets.

Neither the insurance community nor the statutory framework that licenses financial guaranty insurance draws clear boundaries between surety bonds and financial guaranties, he said. “As such, there is a great deal of confusion where the surety bond market ends and the financial guaranty product begins.”

“People sometimes forget. They think that the law precedes the business expectation, but its always the other way around,” he said. “Business people create the expectations of their contracts in the marketplace in which they operate. And then the law comes along and later on enforces those expectations.”

He cautioned that, as a result of these types of disputes, the attractiveness of multiline insurance companies, unless they otherwise are absolutely committed to the business of providing financial guaranties, is going to be viewed with hesitation by the capital marketplace.

“There is absolutely no doubt that the marketplace is no longer expecting multiline guaranties in the financial guaranty setting,” said one market practitioner who didnt want to be identified. He noted that it probably has improved the perception of the monolines to institutional investors.

The market source speculated that Royal “was stretching for premium” during the soft market and got into an area of business it did not completely understand, and “they didnt give it the kind of attention it deserved.”

Fitch said the recent court disputes surrounding SFC transactions potentially have broader implications for the structured finance market. (See related story on Feb. 12, 2001, on another dispute involving Lexington Insurance Company, a subsidiary of American International Group, in the “Hollywood Funding” case.)

“Royal Indemnitys decision to pursue defenses to payment arising from assertions of fraud, even though it specifically waived fraud as a defense in its policies, underscores the critical qualitative differences that exist among various forms of third-party credit enhancement,” said Fitch.

“Letters of credit and insurance policies issued by monoline financial guarantors are underpinned by a strong legal basis and/or compelling business incentives, and have demonstrated their reliability to investors as a source of credit enhancement,” Fitch continued.

“Royals decision to seek legal protections, in addition to other precedent setting legal cases involving multiline insurers who have chosen to litigate rather than make timely payments to financial obligation holders, demonstrates that multiline insurers will not necessarily” honor their policies in the same timely manner as monoline financial guarantors, Fitch said.

Mr. Aicher affirmed that the monolines know the business and want to deliver the product that people want to buy.

Some multilines “stumbled into an area of work that they really frankly didnt understand,” said one legal source, who didnt want to be identified.

“In fact, they didnt have a clue what they were doing and got burned badly, and I dont think they care that theyre not going to be players in the financial guaranty marketplace in any real extent,” the source said. “Because once theyve really understood the business and the risks inherent in the business, they dont like it.”

“Credit is unique. Its difficult. So I think what youre going to see is that the people who want to be in the business, which are the monolines generally and a few committed multilines, will be in it and they will perform as if they had a legal compulsion to perform,” Mr. Aicher said.

Angus Jordan, a representative of RSA in London, said Royal Indemnity filed the lawsuit because “we believe we were fraudulently induced into the contract.”

“Were providing a normal insurance product, which would be pay if liable,” he said. “As an insurance company providing an insurance product, we will follow the principles of insurance.”

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, August 26, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.