Insurance Company Not Liable for Losses Resulting from Downgrade if it Never Agreed to Maintain a Certain Credit Rating
Fanni Koszeg | Bloomberg Law
The U.S. District Court for the Southern District of New York rejected claims by Adelanto Public Utility Authority (Adelanto) for, among others, breach of contract against Ambac Assurance Corporation (Ambac). The Court held that Ambac complied with its contractual obligations to Adelanto and had no additional, non-contractual duty to maintain a certain credit rating it never agreed to maintain, even if Adelanto suffered certain losses attributable to Ambac’s credit downgrade.
The dispute stems from the early termination of an interest rate swap agreement (Swap Agreement) between Piper Jaffray & Company (Piper Jaffray) and Adelanto for which Ambac acted as surety pursuant to a surety bond (Surety Bond) issued on September 7, 2005. Adelanto entered into the Swap Agreement to hedge its risk as the issuer, in September 2005, of two series of variable rate bonds underwritten by Piper Jaffray and insured by Ambac. The Surety Bond provided that if Adelanto failed to make certain payments, including termination payments, under the Swap Agreement, Ambac would make the payments on its behalf. The Swap Agreement also permitted Ambac to seek from Adelanto a reimbursement of any amounts paid under the Surety Bond resulting from Adelanto’s breach of the Swap Agreement. In December 2007, the variable rate bonds were converted into auction rate bonds (Auction Rate Bonds) with Ambac’s consent.
Events Leading to the Dispute
— Ambac’s Credit Downgrade
Ambac, as a provider of financial guaranty insurance, became active in issuing guarantees for structured financial products, including mortgage-backed securities. According to Adelanto, following the issuance of the variable rate bonds but prior to their conversion into Auction Rate Bonds, Ambac’s new business in the mortgage-backed securities market caused it to deviate from its “historical underwriting standards.” In fact, between January and November 2008, the three major rating agencies all downgraded Ambac’s credit ratings.
— Failing Auctions and Adelanto’s Default under the Swap Agreement
According to Adelanto, the rating downgrade resulted in steadily higher interest rates for the Auction Rate Bonds and when the auctions started to fail, Adelanto was forced to pay additional interest costs. In addition, the Swap Agreement provided that in the event of Ambac’s rating downgrade, Piper Jaffray would be entitled to terminate the Swap Agreement unless Adelanto replaced Ambac or obtained other credit enhancement within 30 days of the downgrade. Adelanto failed to do so and in June 2009, Piper Jaffray eventually decided to exercise its rights and demanded an early termination payment amounting to $4,524,000.
— Ambac’s Payment under the Surety Bond
Ambac made the termination payment under the Swap Agreement pursuant to the terms of the Surety Bond and then initiated the instant action to recover from Adelanto. In its counterclaim, Adelanto brought its claim for breach of contract, breach of an implied covenant of good faith and fair dealing, and certain other claims including fraud and unjust enrichment. Ambac then submitted a motion to dismiss these counterclaims, which is the motion that the Court granted in this case for the reasons discussed below.
No Breach of Contract Imputable to Ambac
Adelanto alleged that Ambac breached the contract between the two parties by failing to inform it of the insurance company’s “true financial condition,” as required by California insurance law, which in turn subsequently led to the credit downgrades. The documents forming the contract between the two parties include the trust indenture for the notes, the bond insurance policy, and others, which both parties entered into, but the Court pointed out that none of these documents required Ambac to maintain a particular credit rating. It is undisputed that at all times Ambac complied with the express terms of the contract. Adelanto attempted to alter the clear meaning of the contracts by asserting that the parties understood that without Ambac’s high-quality credit rating, the insurer’s participation in the transactions would be economically meaningless.
The Court agreed that California law permits courts to look past the four corners of the contract, and to use extrinsic evidence to clarify the parties’ intentions at the time of contracting, but only to the extent necessary to clarify ambiguity in the contract. The Court found that in this case the language of the contract is unambiguous and the insurance law requirement to disclose a party’s true financial condition attaches at the time of the contract formation. Consequently, even if Ambac knew that its subsequent financial guaranty activities for subprime mortgage-backed securities and other highly structured transactions would potentially negatively impact its credit ratings, it was under no obligation disclose this to Adelanto.
Other Claims Also Dismissed
The Court also dismissed Adelanto’s claims that Ambac committed fraud or negligent misrepresentation by not disclosing its exposure under certain risky financial instruments. Adelanto did not claim that Ambac made untrue statements to induce it to enter into the bond insurance policies. In fact, the alleged failure to disclose occurred after the parties entered into the contracts. The Court found that the negligent misrepresentation claim fails in any event since, under California law, such a claim must be based on a “positive assertion” as opposed to an omission. The allegation of fraud based on a material omission failed, because the Court found that even assuming that Ambac had a duty to disclose all material information at the time of the transaction, this duty does not continue to apply thereafter.
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