CHICAGO — CIFG Assurance North America Inc. on Monday sued Assured Guaranty Corp., charging it with breach of contract violations for reneging on its obligation to cover the policy on $83.3 million of Xenia Iowa Rural Water District bonds as part of its 19-month-old reinsurance agreement.

The lawsuit — filed in New York State Court in Manhattan — followed Assured’s refusal to cover a shortfall in debt service owed to Xenia bondholders on June 1. CIFG honored the claim to make up the $69,000 shortfall in the $1.88 million interest payment.

Assured in May formally decided to exclude the Xenia policy from its pact with CIFG. Assured agreed to reinsure $13 billion of CIFG-backed bonds — the bulk of CIFG’s public finance bond portfolio — in a reinsurance agreement executed in January 2009.

Assured has based its position regarding the Xenia policy on a provision in the reinsurance agreement that allows it to exclude from the agreement any policy for a bond that was below investment grade as of Oct. 31, 2008.

The bonds were rated investment grade at the time by Standard & Poor’s and internally by CIFG, but Assured appears to have a dispute with those ratings as Xenia had already begun to draw on its reserves.

Assured said it had not yet seen the complaint, but believes it is without merit. The bonds “were not eligible for inclusion in the CIFG portfolio reinsured by Assured Guaranty because they were not investment grade as of the effective date of the agreement. Assured Guaranty continues to work with CIFG to novate the other bonds in the assumed portfolio, a process which is being led by CIFG,” an Assured statement read.

CIFG and Assured on Oct. 31, 2008, reached a master agreement outlining what policies would be reinsured and part of a future novation process. The reinsurance agreement and a services agreement under which Assured would act as CIFG’s agent were formally signed in January 2009.

The complaint alleges that Assured agreed to reinsure the Xenia policy only after extensive due diligence on all of CIFG’s public finance portfolio and only after it had “cherry-picked” the most profitable policies.

Assured’s final bid submitted on Sept. 24, 2008, required CIFG to pay more for the reinsurance than a competing bid but CIFG chose it because Assured was willing to reinsure a larger number of policies — about 92% of CIFG’s public finance portfolio — than the competing bid. CIFG sought to reinsure its bonds after it lost if triple-A ratings.

CIFG asserts in its lawsuit that the Xenia bonds were rated investment grade based on its internal scale and separately by Standard & Poor’s.

“Assured’s refusal to honor its contractual reinsurance obligation was made in bad faith and without any reasonable basis whatsoever. Assured arbitrarily asserted, purely as a pretext for avoiding its obligation, that the Xenia bonds did not meet the criteria for reinsurance because, according to Assured, they were not 'investment grade,’ ” the lawsuit reads.

Xenia began drawing on its reserves in December 2007 to make debt-service payments but those draws were permitted under its bond covenants as long as the district adhered to a repayment schedule. Xenia disclosed the draws, its plans to replenish the fund, and its overall financial condition in its fiscal 2007 statements that were available to Assured during its due diligence leading up to the reinsurance agreement, CIFG argues in the lawsuit.

Xenia’s financial condition continued to deteriorate, and in March 2009 it filed a material event notice saying it had failed in February to make its required monthly payment to replenish the reserves following a December 2008 draw.

Standard & Poor’s in August 2009 stripped the bonds of their investment-grade rating, lowering the credit to BB-plus from BBB due to the district’s “deteriorating financial position.” The agency said it did not act sooner in part because the reserve draws were permitted under the bond resolution.

At the time, Assured continued to act as CIFG’s agent and gave no indication it planned to reverse its position on the policy, the lawsuit states. Standard & Poor’s lowered the rating to D following the June default.

By March 2010, Assured had determined a claim likely would be made under the Xenia policy to fully cover the upcoming June 1 payment. It was then that Assured began exploring whether the Xenia policy was indeed a covered policy under the reinsurance agreement, the lawsuit asserts.

“The timing of Assured’s flip-flop was not random. It occurred shortly after it became clear to Assured that Xenia’s financial condition, which had been unstable for some time, had deteriorated to the point that a claim on the Xenia policy appeared likely,” the lawsuit reads

On May 10, Assured sent CIFG a letter stating that the Xenia policy was not a covered policy under the reinsurance agreement. Assured did not provide an explanation. Assured received a request from the Xenia bond trustee on May 27 to cover the June 1 debt-service shortfall. Assured notified CIFG the next day it would not honor the obligation, so CIFG made the payment.

“It’s very disappointing to have an insurer go back on what was a clear agreement,” said CIFG Chief Executive Officer Larry English. “The language is very clear. It says the risk can be excluded if not rated investment grade. You can look back at our internal documents and at Standard & Poor’s and it’s a historic fact that the bonds were rated investment grade.”

If CIFG had not entered into the reinsurance agreement, English said the bonds would have been stripped of their investment-grade rating internally sometime after March 2009 after the district failed to make its monthly payment to replenish its reserves. 

English said he had not encountered a similar situation on a reinsurance contract in his four decades working in the insurance industry. “Assured had all the opportunity to do its due diligence. People had the right to expect this was a done deal” when the documents were executed, English said, adding he is concerned Assured could further “cherry-pick” the portfolio if future credit issues arise.

The lawsuit alleges a breach of contract of the reinsurance agreement, the services agreement, and the master agreement that deprives CIFG and Xenia policyholders of the benefits of reinsurance and novation. It asks the court to order Assured to make good on the reinsurance pledge by covering all claims and to novate the policy — the process by which all covered policies would be transferred and become directly guaranteed obligations of Assured. CIFG is being represented by Debevoise & Plimpton LLP.

CIFG General Counsel Michael Knopf said: “CIFG’s dispute is with Assured Guaranty. Notwithstanding our issues with Assured, CIFG stands 100% behind its obligations to the Xenia bondholders and will continue to fund any policy draws so long as they are needed. In addition, we continue to work with the district, through Assured as our agent, to help find a solution to Xenia’s financial difficulties.”

Xenia is seeking debt relief as part of a workout plan that includes a sale of its assets to restore its solvency.

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