Monoline Insurer Legal Battle: SCA vs Merrill Lynch

I think there may be some solid lawsuits that monoline insurers may launch against mortgage bond issuers accusing them of fraud (I don't know if they will win and it will take many years--monolines' fate will have been settled long before). However, there will be some legal challenges by some in an attempt to win something without any ethics on their side. That is, a lawsuit trying to weasle your way out of your obligations on some technicality. I personally don't view this as ethically sound since you are simply using the letter of the law. However, that's how the legal system works so these cases are to be expected.

The first attempt by a monoline insuer to avoid paying damages is SCA. SCA is trying to void its CDS-type insurance contracts that it underwrote for Merrill Lynch. Today, Merrill Lynch sued SCA in court. Here is some background from Bloomberg:

Hamilton, Bermuda-based SCA, stripped of its AAA bond insurer ratings this year by the three major ratings companies, said last week it was seeking to void the contracts, responsible for $427.4 million of the new reserves for losses set aside last quarter. SCA declined to name the counterparty, which Chief Executive Officer Paul Giordano said on a March 14 conference call failed to meet requirements ``in a fundamental way.''

``We believe that the terminations are appropriate and effective and we expect to defend against any challenge by Merrill,'' Michael Gormley, a spokesman for SCA, said in a telephone interview today.

The debt that Merrill bought protection on from XL last year includes classes of: West Trade Funding II Ltd., Silver Marlin CDO I Ltd., and Jupiter High-Grade CDO VI Ltd. The credit-default swaps offer payments if the securities aren't repaid as expected, in return for regular insurance-like premiums.

Merrill's complaint said that XL this year sought to cancel the contracts by arguing that Merrill isn't ready to exercise the ``voting rights'' as the holder of the insured CDOs classes in ways that reflect XL's written instructions, as agreed upon by Merrill in the contracts.

The complaint says that XL based the assertion on public information from Standard & Poor's that says Armonk, New York- based competitor MBIA has written protection on classes of the CDOs senior to what XL is providing protection on and is the ``sole controlling party'' for the CDOs.

Merrill responded that it hasn't entered into contracts with another party on the CDOs that would preclude it from acting in the way specified in XL's contracts, according to the complaint.

It looks like SCA is trying to get out of the insurance contract by arguing that Merrill Lynch isn't following the contract since it also has taken insurance from MBIA on more more senior tranches. I am neither a lawyer nor an expert on insurance so I have no idea what the courts will say. From a layman perspective, I think SCA should lose this case. If Merrill Lynch committed fraud in presenting its bonds, that's another story; but when SCA is simply trying to get out because of some legality, it seems quite lame.

Even though I am a shareholder in Ambac, I personally don't like to see insurers get out of paying claims unless it is clearly fraudulent. There is nothing worse than a company that you paid money to protect an adverse event backing out precisely when the event occurs.