Ambac and the New World Order

December 03, 2013

The controversial rehabilitation plan for the Segregated Account of Ambac Assurance Corporation (“Ambac”) was recently upheld on appeal in a decision that reached some rather revolutionary conclusions on a wide range of issues affecting various policyholders. The decision by the Court of Appeals of Wisconsin should caution policyholders that they may not have certain basic rights and protections they might expect — including with respect to claims priority — and highlights the great deference given to the insurance commissioner to formulate a plan of rehabilitation.

Ambac, a Wisconsin insurance company headquartered in New York, is one of the largest insurers of financial guarantees in the world. It provides insurance and guarantees for municipal bonds, various asset backed securities, and credit default swaps. Due to financial challenges, Ambac stopped writing new insurance in mid-2008 and by early 2010, Wisconsin’s Commissioner of Insurance (the “Commissioner”) decided to take formal regulatory action to forestall Ambac’s apparently imminent demise.

The Commissioner chose to conduct a targeted rehabilitation of parts of Ambac by establishing a Segregated Account and transferring to it approximately 1,000 of the policies that the Commissioner believed represented Ambac’s greatest potential liabilities. A partial rehabilitation was chosen to isolate the claims-paying resources in Ambac’s General Account in order to avoid various contractual default triggers that might have triggered massive losses for Ambac. The Segregated Account was capitalized by a secured note in the amount of $2 billion and an aggregate excess of loss reinsurance agreement against Ambac’s General Account. The Segregated Account may call upon the General Account to pay claims allocated to the Segregated Account as long as such payment does not cause Ambac’s surplus to fall below $100 million, giving the Segregated Account access to the bulk of Ambac’s claims-paying assets.

Under the Rehabilitation Plan originally proposed by the Wisconsin Insurance Commissioner, holders of claims related to policies allocated to the Segregated Account would receive 25% of their claims in cash and 75% in surplus notes1. The surplus notes mature in 2020, but the commissioner could assess the need to modify that date to allow for the continuation or reissuance of surplus notes after 2020. It is projected that the surplus notes may not be paid until 2050, if not later.

In March 2010, the Commissioner submitted a petition for rehabilitation of the Segregated Account in the Dane County Circuit Court. The Circuit Court entered an order for rehabilitation, and granted a temporary injunction preventing anyone from prosecuting claims related to the rehabilitation or that have the potential to lessen Ambac’s assets. Approximately six months later, the Commissioner filed a rehabilitation plan, which was approved by the Circuit Court following a five-day evidentiary hearing. Written objections were allowed, but objectors were not allowed to conduct discovery prior to the hearing or to formally intervene in the rehabilitation proceedings.

Various “interested parties” (the term used by the Court of Appeals to refer to the objectors/appellants) appealed to challenge the approval by the Circuit Court of the decisions made by the Commissioner in formulating the rehabilitation plan.

The Court of Appeals rejected all objections to the Circuit Court’s review of the rehabilitation plan, finding that the insurance rehabilitation statutory scheme was designed to be “flexible and informal and conferred substantial power to the rehabilitator to effectuate rehabilitation.” The court applied an “erroneous exercise of discretion standard, in line with other jurisdictions that follow the Insurers Rehabilitation and Liquidation Act” in reviewing the Circuit Court’s rulings, and also found that the Commissioner’s determinations are entitled to great deference. The Court of Appeals decision rejects, in the insurance rehabilitation context, many of the rights and protections that counterparties have traditionally expected to have in insolvency proceedings and at common law, both in substance and process. The Court of Appeals has rejected the belief of many practitioners that the best interests of creditors test would apply in insurance rehabilitations (as it does in bankruptcy), that statutory priorities apply in rehabilitation, that novation of contracts prior to formal proceedings is prohibited, and that contracts between third parties (for example bond indentures) are outside of the reformation powers of rehabilitation proceedings. In addition, the effect of the rehabilitation plan is to allow Ambac’s holding company to retain its full equity interest in the insurer, in apparent violation of the absolute priority rule, which would ordinarily strip equity holders of any value until debt holders are paid in full. The effect of the holdings of the Court of Appeals is a broad-based assertion that whole-heartedly endorses an admonition by the receiver to “trust me” to protect policyholder interests.

Although what follows is not a comprehensive list of the many conclusions reached by the Court of Appeals, a few of the more interesting holdings are described below:

1. Capitalization of Segregated Fund. Wis. Stat. § 611.24 compels the Commissioner to “require the corporation to have and maintain an adequate amount of capital and surplus in the segregated account.” The Court of Appeals rejected the objectors’ argument that the Segregated Account was inadequately capitalized because it consisted only of liabilities. The court noted that the Commissioner’s approach was “creative” in transferring liabilities into a Segregated Account, and “differs from the approach used by insurance commissioners in other cases where the assets of the company were transferred to a new company.” The court acknowledged that “[w]hether policyholders in the Segregated Account will receive the full cash value of their claims remains to be seen,” but found that the plan is not a de facto liquidation and that the record “demonstrates that it remains possible to preserve Ambac’s business, which ultimately is in the best interests of all involved, including those whose policies have been allocated to the Segregated Account.”

2. Priority of Claims. Wis. Stat. § 645.68 mandates certain statutory priorities in liquidation, including that policyholders are to be paid ahead of general creditors and that there be no subclasses. Interested parties argued, among other things, that the plan treats holders of claims in the Segregated Account as a subclass within the class of claims that includes claims held in the General Account. The Court of Appeals found that the statute governing order of distribution of claims from an insurer’s estate applies to liquidation proceedings but does not apply to rehabilitation proceedings, and stated that the priority system provides “inflexible and cumbersome rules” that go against the flexible and informal purpose of rehabilitation proceedings.

3. Liquidation Value of Claims. The objectors maintained that the rehabilitation plan violated the “best interests of creditors test” followed in bankruptcy proceedings under which claimants, pursuant to a plan of reorganization, must receive at least what they would receive on account of their claims in a liquidation. In response to arguments that the plan fails to provide policyholders the liquidation value of their claims, the court found that there was no rule that a rehabilitation plan is per se invalid unless it permits policy holders to receive the liquidation value of their claims or the right to opt out of the plan, again noting the legislature’s intent to “maximize the commissioner’s flexibility in formulating a rehabilitation plan tailored to the circumstances of the particular case.”

4. Made Whole Doctrine. Interested parties argued that the plan violated Wisconsin’s “made whole doctrine,” under which an insured must be made whole on their loss before the insurer may exercise subrogation rights. In essence, an insurer may not recoup from third parties (usually the insured’s only hope of full repayment) in competition with their own insured. The objectors argued that the rehabilitation plan required policyholders to assign their contractual rights to Ambac before they are fully compensated for their loss because they received surplus notes worth “cents on the dollar.” The Court of Appeals found that the “made whole doctrine is ill-suited” for rehabilitation proceedings, the purpose of which “is not to make each policyholder whole but to apportion unavoidable losses in a manner that is fair and equitable to policyholders, creditors, and the public in general.”

5. Set-Off Rights. U.S. Bank, acting in its capacity as trustee for certain residential mortgage-backed securities, argued that the trust policies are governed by New York law, which grants a right of set-off, so that any premiums that have not been paid should be reduced by the amount Ambac owes to the trusts. The Court found that Wisconsin law governs setoff in the rehabilitation proceeding and prohibits setoff when the obligation is to pay premiums. The Court also left the door open to prohibit the setoff of payments not related to premiums.

6. Control Rights. The trustees for certain securitization trusts argued that the trial court erred by entering an injunction enjoining them from exercising their control rights pursuant to the various indentures even though Ambac was in payment default. The Court rejected this argument, finding no evidence to counter the Circuit Court’s finding that allowing parties other than the Commissioner to exercise control rights would likely be damaging to the policyholders and the public in general.

7. Administrative Burdens. The Court rejected the pleas of various indenture trustees that the plan imposes unfair administrative burdens on them without compensation, supporting the Circuit Court’s finding that the alleged burdens were reasonable.

8. Novation and Takings. Certain RMBS policyholders argued that the allocation of their policies to the Segregated Account constituted a novation and that such novation was ineffective because there was no mutual consent or sufficient consideration. Objectors noted that the transfer to the Segregated Account took place before the petition for rehabilitation was entered. The Court of Appeals found that the common law doctrine of novation does not apply in rehabilitation proceedings. The court also rejected a constitutional takings argument, noting that the contract of policyholders is subject to the reasonable exercise of the state’s police power. The timing argument was dismissed as “a technicality that is ultimately irrelevant.”

1 The Office of the Commissioner of Insurance has announced that the rehabilitation plan will be substantially revised at a future date in response to various tax concerns.

This article was originally published by Bingham McCutchen LLP.