With the eyes of the financial world fixed squarely on the regulatory debate taking place in Washington, D.C., a New York David, in the form of a state assemblyman from Rochester, flung a big rock at the Washington regulatory Goliath, by introducing comprehensive and bi-partisan legislation to regulate credit default swaps at the state level. Assembly Insurance Chair, Joseph Morelle, (D-Irondequoit) and 34 other sponsors, including William Barclay (R,C,I-Pulaski), the ranking minority member of the Insurance Committee, have joined to require New York Insurance Department oversight of the financial product which many people believe was the cause of the financial market’s collapse in the fall of 2008. The bill (A. 10783) purports to address the lack of public oversight with respect to the $26 trillion credit default swaps (CDS) market. The bill contains a definition of “credit default insurance” which is as follows,

 

“A surety bond, or other contract, and any guarantee which is payable upon occurrence of financial loss, as a result of the failure of any obligor on or issuer of any debt instrument or other monetary obligation to pay when due to be paid by the obligor or scheduled at the time insured to be received by the holder of the obligation, principal, interest, premium, dividend or purchase price of or on, or other amounts due or payable with respect to, such instrument or obligation, when such failure is the result of a financial default or insolvency, or other credit event, or, provided that such payment source is investment grade, any other failure to make payment, regardless of whether such obligation is incurred directly or as guarantor by or on behalf of another obligor that has also defaulted;” (A. 10783, Sec. 1 the proposed new Sec. 6901)

 

Some of the key points of the legislation are:

 

• The bill also mandates licensing of credit default insurers and imposes solvency standards, such as minimum capital and surplus requirements;

 

• An insurer issuing credit default insurance shall be subject to all the provisions of the Insurance Chapter are applicable to property casualty insurers.

 

• Contingency, loss and unearned premium reserve requirements.

 

• Strict limitations on permissible credit default insurance, restricting the writing of the product to purchasers with a material interest in the underlying obligation.

 

• Single and aggregate risk limits.

 

• Authorization for the Superintendent to prescribe minimum policy and rate standards and certain restrictions on acceleration payments.

 

• Provides credit for reinsurance placed with credit default insurers or with property-casualty insurers or reinsurers meeting certain restrictions.

 

• Civil and criminal penalties for selling impermissible credit default insurance.

 

• Provides transition provisions that would permit financial guaranty insurers to continue to issue credit default insurance.

 

The sponsor’s memo states that CDS “played a pivotal role in the recent financial crisis by allowing banks and other institutions to operate like insurance companies but without the regulations that control insurance companies.”

 

The memo further states that “This legislation protects New York State’s financial services sector, and the broader economy, from the harmful effects of the complex, risky and unregulated CDS market. By firmly placing the selling and buying of CDS under the insurance law, this legislation ensures that sellers of CDS be licensed by New York State as insurance companies and that they have adequate capital and reserves to pay claims.”

 

The legislation is based on a model bill promulgated by the National Conference of Insurance Legislators (NCOIL) in which Morelle is the Chair of the Financial Services and Investment Products Committee. He said, “Insurance has traditionally been the province of state governments, and therefore states have the experience and institutional capacity to best fold CDS into that regulatory model.”

 

Morelle received praise from a former Congressional official. “Chairman Morelle is to be congratulated for his leadership role, not only in New York, but nationwide, for insisting that the highly toxic credit default swaps be treated for they really are: insurance policies,” said Michael Greenberger, the former director of the Division of Trading and Markets for the Commodities Futures Trading Commission. One of the more interesting components of the bill is its reach. The key language appears in Section 6904, entitled “Limitations”. Subsection (a) states “Credit default insurance may be transacted in this state only by a corporation licensed for such purpose pursuant to section six thousand nine hundred two of this article.” (Emphasis added) While the term “transacted” is not defined, presumably any swap that is written and otherwise effectuated in New York would be regulated by the bill. As a result, the New York Department could be responsible for regulating swaps that insure risk anywhere in the world, as long as the swap was executed in New York. Such language is reminiscent of New York’s famous “extraterritoriality” provisions that have caused so much consternation in the insurance world. On the other hand, swaps that are not “transacted” in New York would be free of the provisions of the bill. Would the large financial businesses that develop these instruments simply move their operation to another state which had not enacted this NCOIL model? Could it be argued that this legislation’s provisions would be pre-empted by the provisions of the Federal Commodities and Futures Modernization Act of 2000? The prime sponsor says no, but the financial community may wish to raise this challenge. These questions, and many others I have no doubt, will be raised during deliberations on this legislation. Despite some questions and concerns with the legislation, there is no doubt that with this bold move, Morelle and his co-sponsors have fired a shot across the bow of federal officials who have wringed their hands and argued for nearly two years now about the future of financial regulation in general, and CDS in particular. I can only imagine that such a move is not well received by those federal officials, as well as those investment banks and other firms in the CDS business. Chairman Morelle said that the Senate Insurance Committee is examining the bill and that the Insurance Department, despite assisting with the drafting, has not taken an official position.

 

Even without endorsement by New York’s other governmental bodies, the bill has achieved one great success already. It has put New York back in the middle of the debate about the regulation of insurance and the financial markets, where it should be. All too often it seems, Federal legislative and regulatory officials ignore, either willfully or not, the effects of their actions to regulate the financial services industry on our state. This industry is our largest and most vibrant industry and it pays the brunt of the income tax needed to run our state government. It also puts the swaps where they should have been all along, under the supervision of the best insurance regulator in the country. How can I not like that?

 

Has the U.S. Supreme Court Given Guidance to NYSID on Discretionary Clauses?

 

Recently the New York Insurance Department issued a proposed regulation designed to prohibit discretionary clauses in any insurance policy in New York. The new regulation, which is to be numbered 11 NYCRR 222, reasons, in its “Purpose” section that because the courts have given wide latitude in reviewing administrator decisions made pursuant to discretionary clauses in policies under the Federal Employee Retirement and Income Security Act (ERISA), “the policy form provisions may be rendered illusory by nullifying an insurer’s responsibility to pay.” (See proposed 11 NYCRR Sec. 222.0[a]) The regulation also reads that “Discretionary clauses are therefore contrary to sections 3201(c) and 4308(a) of the Insurance Law which authorize the Superintendent to disapprove a policy form if it is ‘prejudicial to the interests of policyholders or members or it contains provisions which are unjust, unfair or inequitable, or if its provisions encourage misrepresentation or are unjust, unfair, inequitable, misleading, deceptive, or contrary to law or to the public policy of this state.” (See proposed 11 NYCRR sec. 222.0[b].

 

This move by the Department has been years in coming and is one that I was involved in back in 2006. The Department has been concerned with the discretionary clauses because they run counter to the traditional doctrine of insurance policy interpretation which holds that any ambiguity is to be resolved in favor of the policyholder. The Department sees the potential for great mischief in putting such discretion in the hands of an employer representative. In some cases, I would imagine, the Departments concern is warranted.

 

I have always questioned the Department’s effort to ban discretionary clauses for two reasons. First, in 2006, we had a lack of any significant level of complaints from claimants that the clauses were being interpreted unfairly. Secondly, I was concerned that the Department was delving into ERISA territory, which is not an area with which the department is entirely familiar. For these reasons and others, no action has been taken since the issue first arose – until now.

 

Perhaps circumstances have changed in the years since I have left. At that time the concerns with the clauses had only been raised by a small number of trial attorney firms who simply did not like the clauses. Perhaps the lack of that ERISA had its own procedural mechanisms to deal with abuse of administrator discretion? I am not sure why the Department has now decided to move forward with this measure. However, a recent U.S. Supreme Court case has raised questions about the Department’s stated reason for the regulation. On April 21, 2010, the Supreme Court decided an ERISA case that specifically dealt with administrator discretion. In the case of Conkright v. Frommert, slip op. no. 08-810 the high court ruled that the district court should have applied a deferential standard of review to the Plan administrator’s interpretation of the plan. In Conkright, the high court dealt with the issue of what standard of review should be applied to the determination of a plan administrator whose first determination was ruled to be unreasonable. The Second Circuit ruled that the District Court was correct not to apply a deferential standard to the second plan administrator’s determination on the grounds that he has erred in his first determination. The Supreme Court reversed that decision and held in favor of the deferential standard.

 

The case discussed herein is not directly on point as it does not deal with a discretionary clause in an insurance policy. However, what makes the high court ruling interesting is its resounding statement in support of plan administrator discretion, and its confidence that the ERISA system, as well as trust law, are more than adequate to deal with abuses of administrator discretion.

 

The high court noted that it has always recognized that ERISA “represents a ‘careful balancing’ between ensuring fair and prompt enforcement of rights under a plan and the encouragement of the creation of such plans.” Aetna Health Inc. v. Davila, 542 U.S. 200, 215 (2004). “Congress sought ‘to create a system that is [not] so complex that administrative costs, or litigation expenses, unduly discourage employers from offering [ERISA] plans in the first place” Variety Corp. v. Howe, 516 U.S. 489, 497 (1996). Further, the court wrote, “ERISA ‘induc[es] employers to offer benefits by assuring a predictable set of liabilities, under uniform standards of primary conduct and a uniform regime of ultimate remedial orders and awards when a violation has occurred.” Rush Prudential HMO, Inc. v. Moran, 536 U.S. 355, 379 (2002).

 

It is this deference to the administrator’s determinations that protects these interests and, by permitting an employer to grant primary interpretive authority over an ERISA plan to the plan administrator, preserves the “careful balancing” on which ERISA is based. Conkright at p. 9. “Deference promotes efficiency by encouraging resolution of benefits disputes through internal administrative proceedings rather than costly litigation. It also promotes predictability, as an employer can rely on the expertise of the plan administrator rather than worry about unexpected and inaccurate plan interpretations that might result from a de novo review.” Id. at p.10

 

Finally, in support of administrator deference, the high court wrote: …deference serves the interest of uniformity, helping to avoid a patchwork of different interpretations of a plan, like the one here, that covers employees in different jurisdictions— a result that would introduce considerable inefficiencies in benefit program operation, which might lead those employers with existing plans to reduce benefits, and those without such plans to refrain from adopting them. Id. at p.10, quoting Fort Halifax Packing Co. v. Coyne, 482 U.S. 1, 11 (1987) It is clear that the Supreme Court desires to maintain a clear standard of deference to plan administrator interpretations to preserve the very purpose of the ERISA statutory plan. What about the Insurance Department’s concerns that without a de novo review of plan administrator interpretations about insurance policies with discretionary clauses, policy form provisions will become illusory and work to the detriment of policy claimants? Will the use of discretionary clauses encourage plan administrators to adopt unreasonable interpretations of plans?

 

The high court answered this concern by reverting to trust law. The Court wrote that “[u]nder trust law, a trustee may be stripped of deference when he does not exercise his discretion ‘honestly and fairly.’ Conkright at p. 14. Further, the Court held “[a]pplying a deferential standard of review does not mean that the plan administrator will prevail on the merits. It means only that the plan administrator’s interpretation of the plan ‘will not be disturbed if reasonable.’” Id. quoting Firestone Tire & Rubber Co. v Bruch, 489 U.S. 101, 111 (1989) Finally, the Supreme Court held that…”far from impos[ing] [a] rigid and inflexible requirement that courts must defer to plan administrators , we simply hold that the lower courts should have applied the standard established in Firestone and Glenn.”

 

Thus, it is apparent that despite the insistence of the high court on deference to plan administrator’s interpretations, the courts may abandon such deference when presented with an administrative interpretation that is exercised improperly.

 

Will the new Supreme Court decision cause the New York Department to re-examine the necessity for the proposed regulation? If the Department does move forward with the regulation would it face a challenge under the federal pre-emption doctrine?

 

Perhaps we may get the answer to these questions and others in the next few months.