MBIA Inc.’s attempt to shield its public finance business from its more toxic structured finance guarantees hit a roadblock Thursday as the U.S. District Court for the Southern District of New York denied a motion to dismiss a lawsuit charging MBIA with fraud and breach of good faith.

A number of hedge funds, led by Aurelius Capital Master Inc., sued bond insurer subsidiary MBIA Insurance Corp. last March after the company transferred $5.4 billion of capital to a new domestic public finance insurer. The plaintiffs argued the transfer of capital was a fraudulent conveyance and “a breach of the implied covenant of good faith and fair dealing,” according to the court ruling.

The plaintiffs also alleged the restructuring “split an already-distressed MBIA Insurance company into two entities” — a healthy and well-capitalized unit, MBIA Illinois, and “a moribund and insolvent” unit, MBIA Insurance, which was “left largely with guaranty exposures to toxic securities and instruments and no prospect of writing new business.”

Before the financial crisis, MBIA Insurance was the largest municipal insurer in the market.

MBIA announced the restructuring on Feb. 18, 2009, a day after receiving approval from the New York Insurance Department. When the restructuring was announced, rating agencies slashed the credit quality of MBIA Insurance. Moody’s Investors Service, for instance, immediately cut the company eight notches to B3, well into junk status territory.

In Thursday’s ruling, District Judge Richard J. Sullivan noted that “the parties disagree significantly about the scope of the [NYID] superintendent’s approval.”

Sullivan wrote that while MBIA maintains the superintendent “stands in the shoes of the policyholders,” the hedge funds maintain that the approval letter did not discuss the “overall fairness of the transaction,” nor did the superintendent “make any finding with respect to whether defendants intended to defraud the policyholders.”

MBIA spokesman Kevin Brown released a statement following the court ruling:

“We disagree with Judge Sullivan’s ruling. The New York Insurance Department has argued that a similar case against MBIA is nothing more than a disguised challenge to the superintendent’s approval of transformation and should be dismissed. We expect the New York state courts to reach the same conclusion, at which time we will ask Judge Sullivan to reconsider his decision. In the meantime, we will continue to vigorously defend cases challenging our transformation, and strongly believe that we will ultimately prevail on the merits.”

Three other lawsuits against MBIA’s restructuring are still pending.

Sullivan ordered the parties to submit a case management plan by March 9.

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.