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In a ruling that could prove to be worth nearly $400 million for a pair of banks, a federal appeals court has ruled that Royal Indemnity Co. must honor insurance policies that covered defaulted student loans despite Royal’s argument that the policies were “procured through fraud.” When combined with an undisclosed settlement Royal struck with a third bank in the midst of the appeal, the total cost to the insurer could approach $500 million. In its 27-page opinion in MBIA Insurance Corp. v. Royal Indemnity Co., a unanimous three-judge panel of the 3rd U.S. Circuit Court of Appeals found that Royal was the victim of a “spectacular fraud” perpetrated by the now-bankrupt Student Finance Corp. of Newark, Del., to hide the fact that SFC’s student loans were defaulting at a rate of more than 80 percent. Nonetheless, the 3rd Circuit found that Royal had waived any rights to assert any fraud-based defenses due to the plain language in its policies, and therefore must reimburse the banks for all of the defaulted loans. The appellate panel concluded that the trial judge, U.S. District Judge Joseph J. Farnan Jr. of the District of Delaware, had properly ruled that such waivers would be deemed enforceable under Delaware law. “When sophisticated parties include a broad but unambiguous anti-reliance clause in their agreement, the Delaware Supreme Court will likely indulge the assumption that they said what they meant and meant what they said,” U.S. Circuit Judge Samuel A. Alito Jr. wrote in an opinion joined by Judges Theodore A. McKee and D. Brooks Smith. But Royal won a partial victory when the court concluded that Farnan must reconsider his calculation of the awards to the banks to account for the possibility that some of the banks’ losses may have resulted from looting of SFC’s coffers by the company’s founder, Andrew N. Yao. Royal — the American subsidiary of the London-based insurance giant Royal & SunAlliance — pointed to evidence that, prior to SFC’s bankruptcy, Yao was receiving distributions at the rate of about $1 million per month while serving as its director, treasurer and chief executive officer. Alito concluded that, under a reasonable interpretation of Royal’s policies, the insurer may not be liable for losses due to SFC’s “misappropriation,” and that “further development of the record is necessary to determine the extent of this misappropriation before Royal may be ordered to pay the beneficiaries’ claims.” But Alito emphasized that the remand was a limited one, saying “We caution that this remand is not an opportunity for Royal to revive its rejected fraudulent inducement defense. The proceedings should be limited to deciding which of the losses claimed by the beneficiaries are covered under the policies.” On remand, Alito said, Farnan “must first decide whether or not the policies cover losses attributable to SFC’s alleged conversion.” If not, Alito said, Farnan “must then determine the extent to which SFC’s misappropriation contributed to those losses.” Royal’s lawyers — Michael H. Barr and Kenneth J. Pfaehler of Sonnenschein Nath & Rosenthal in New York — could not be reached for comment. But lawyers for the two banks — Wells Fargo Bank and Wilmington Trust of Pennsylvania — said they are confident Royal will not succeed in its efforts to persuade Farnan to reduce the awards. In a series of decisions handed down between October 2003 and March 2004, Farnan awarded nearly $400 million to three banks. Only two banks remain in the case because PNC Bank — which was awarded more than $110 million — settled its claims against Royal soon after the January 2005 oral argument before the 3rd Circuit. PNC’s lawyers, David H. Pittinsky and Lawrence D. Berger of Ballard Spahr Andrews & Ingersoll, said the terms of the settlement are confidential. In October 2004, Farnan awarded nearly $270 million to MBIA Insurance Corp. and Wells Fargo Bank. In March 2004, Farnan awarded more than $12.9 million to Wilmington Trust. Wells Fargo’s lawyer, Ronald S. Rauchberg of Proskauer Rose in New York, said the judgment in favor of Wells Fargo is likely to swell to more than $380 million due to pre- and post-judgment interest and because Farnan also ruled that Royal must continue to cover new claims as they arise. Rauchberg said Wells Fargo has continued to submit new claims since Farnan’s ruling, and that Royal’s escrow account to cover those claims now exceeds $383 million. Wilmington Trust was represented in the appeal by attorneys Joseph H. Huston Jr. and Thomas G. Whalen Jr. of the Wilmington, Del., office of Stevens & Lee. Huston said the $12.9 million judgment in favor of Wilmington Trust has also swelled with interest and additional claims. In the 3rd Circuit appeal, Royal’s lawyers argued that SFC had procured the insurance for hundreds of millions in loans from the banks by perpetrating a complex fraud scheme. Those arguments echoed claims made in a suit filed in U.S. District Court in Tennessee in which Royal accused SFC and the Commercial Driver Institute Inc., a Nashville-based chain of truck driving schools, of operating a “loan mill” that churned unqualified students through trucking schools. The Tennessee suit alleged that the loans defaulted “at an astonishing rate of over 80 percent” — a statistic that Royal claims was masked by SFC when it obtained credit-risk insurance from Royal. According to Royal, SFC misrepresented the creditworthiness and employment history of its student borrowers, and conspired with schools to generate as many loans as possible by altering or forging loan documents. As loans went into default, Royal said SFC created a smokescreen by surreptitiously diverting the proceeds of later loans to make payments of some of the defaulted loans. By making such “forbearance payments,” Royal said SFC masked the default rates of the older loans, and induced Royal to insure still more loans. As Alito described it, the proceeds of the new loans “then had to be applied in Ponziesque fashion to pay down the earlier ones.” Royal also says some of the proceeds were diverted to Yao’s personal accounts. According to court papers, the scheme collapsed in March 2002 when Yao allegedly confessed to Royal that SFC had been making payments on defaulted loans. Royal said it launched an investigation and discovered that the default rate for SFC’s loans was more than 80 percent. Within three months, SFC was in Chapter 7 bankruptcy, where it still remains. Royal was soon hit with a trio of lawsuits brought by the banks alleging that the insurer was illegally repudiating its policies. In a summary judgment decision, Farnan ruled in favor of the banks and rejected Royal’s argument that the policies were procured through fraud. On appeal, Royal argued Farnan erred in finding that the text of its policies unambiguously waived its defense to payment based on SFC’s fraud. The 3rd Circuit disagreed, saying “the policies plainly strip Royal of a defense to payment based on fraud.” Alito noted that the policies explicitly said Royal’s liability will be unaffected by “fraud with respect to the student loans” and also “expressly” waived any other right or defense Royal could marshal to avoid payment. “In the face of this clarion language,” Alito said, “Royal contends that the phrase ‘with respect to the student loans’ contemplates only the microfraud of individual schools or students, not the macrofraud of SFC.” Royal’s lawyers, he said, argued that the waivers were designed only to protect the banks from “obstreperous litigation over the validity of individual loan documents.” Alito rejected that argument, saying “no reasonable interpretation can be teased from this language that would preserve Royal’s defense. The policies all declare that, after payment of the premium, Royal’s liability will become ‘absolute’ and ‘unconditional’ and ‘subject only to the limit of liability.’” Such language, Alito said, “might not contemplate a fraud that induced the policies in the first place,” but the policies also provided that Royal’s liability would be unaffected by “a breach of any representation.” That clause, Alito said, proved fatal to Royal’s main argument in the appeal. “Since a misrepresentation is an essential element of a fraud, it follows that fraud cannot affect Royal’s liability,” Alito wrote.

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