Feb.01, 2010

Insurers for directors and officers accused by federal authorities of operating a $7 billion Ponzi scheme must pay defense costs for the criminal defendants, a federal judge has ruled.

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Last February, the Securities and Exchange Commission charged R. Allen Stanford and four other executives at Stanford Financial Group Co. of securities fraud and various other charges, alleging they operated the Houston-based company as a Ponzi scheme that bilked investors out of more than $7 billion through fake certificates of deposit from a subsidiary bank in Antigua.

On Nov. 16, the company's D&O underwriters—syndicates at Lloyd's of London and Arch Specialty Insurance Co.—denied coverage for the former executives' criminal defense costs because of a policy exclusion for money laundering. The defendants filed suit, asking the U.S. District Court for the Southern District of Texas to force the insurers to pay defense costs.

In a Jan. 26 ruling, Judge David Hittner sided with the defendants and ordered the insurers to pay all submitted legal expenses for the defendants within 10 days.

D&O policies have exclusions for deliberate fraud, but most such exclusions are triggered by a “final adjudication,” which courts have interpreted to mean a judicial verdict of guilt or liability. Most cases settle before that stage, which in effect means that D&O insurers must advance defense costs even in cases where directors are accused of deliberate fraud.

But Stanford's insurers denied coverage based on a separate money laundering exclusion, which would be triggered by a determination that money laundering “did in fact occur.” The policy does not say who would make that determination. The underwriters argued that they had made such a determination based on evidence in the SEC's case and the guilty plea of another former executive, and therefore denied coverage.

Judge Hittner ruled that the underwriters' conclusion that money laundering occurred was based on “mere allegations” and allowing underwriters to deny coverage based on those kinds of facts would mean insurers' obligation “to pay defense costs could change on a daily basis as additional "facts' are developed.”

“Essentially, coverage that directors and officers relied upon and expected when the policies were purchased on their behalf could be withdrawn at the insurer's whim,” he wrote in his ruling. “If, as underwriters suggest, the policies afford underwriters absolute discretion to withhold payments whenever charges of intentional dishonesty are leveled against directors and officers, then insurers will be able to withhold payment in virtually every case at their sole discretion. That would leave directors and officers in an extremely vulnerable position, as any allegations of dishonesty, no matter how groundless, could bring financial ruin.”

“Essentially, an insurer could act as judge and jury and convict its own insureds, thus avoiding any further financial responsibility for the insureds' defenses,” he added.

Previously, the trustee overseeing the insolvent company's assets had asked a judge to prevent the insurers from paying defense costs for the former executives, so that he could tap the D&O policy proceeds to compensate bilked investors and defend the company against lawsuits. The judge ruled it was permissible for D&O underwriters to pay defense costs for individual defendants.

According to Judge Hittner's decision, the primary D&O policy had a $5 million limit. The decision said that the limit of the excess policy was “unclear,” but that insurers maintained they faced an exposure of nearly $100 million in the case.

The former executives each face up to 375 years in prison.