Federal Court Issues Injunction Requiring Insurer to Pay Defense Costs to Stanford Financial Officers for SEC and Criminal Actions Pending on Expedited Judicial Coverage Determination

March 19, 2010


On March 15, 2010, the United States Court of Appeals for the Fifth Circuit modified and affirmed the District Court’s preliminary injunction ordering an insurance company to pay the defense costs of officers in Pendergest-Holt v. Certain Underwriters at Lloyd's of London, -- F.3d ----, NO.10-20069, 2010 WL 909090, (5th Cir. March 15, 2010). The decision requires the insurer to advance defense costs in connection with the officers’ defense of covered claims until there is a judicial coverage determination as to whether an exclusion applies.

Factual Background

In February 2009, the Securities and Exchange Commission (“SEC”) initiated a civil action against Robert Allen Stanford and certain officers (collectively, the “Officers”) at the Stanford Financial Group for allegedly orchestrating a multibillion-dollar ponzi scheme. The Court appointed a receiver and froze the assets of the Officers and the Stanford entities named in the SEC action, leaving the Officers no meaningful way to fund their defense.  

The Officers made claims against a director and officers insurance policy (“D&O policy”) issued by Lloyd’s of London (“Lloyd’s”) to pay for their attorneys’ fees in defending against the SEC action. Lloyds issued a reservation-of-rights letter, agreeing to pay for the Officers’ defense subject to a final determination of coverage.  

In addition to the SEC action, a federal grand jury returned an indictment against the Officers for allegations including conspiracy to commit money laundering. After one of the defendants pled guilty, Lloyd’s issued letters to the remaining Officers declining to extend coverage for defense costs incurred in the SEC action and the criminal action claiming that it had determined that the Money Laundering Exclusion negated its obligation to pay defense costs.

The Officers filed a declaratory judgment action against Lloyd’s seeking a Court order directing Lloyd’s to pay their defense costs. 

The District Court’s Ruling

The District Court granted a preliminary injunction ordering Lloyds to pay the defense costs of the Officers in the SEC and the criminal actions until the “facts” giving rise to whether the exclusion applied were determined in either the underlying criminal or SEC proceeding.

The Court looked at the D&O policy’s Money Laundering Exclusion, which precluded payments when “it is determined” that the alleged acts did “in fact” occur. Notably, the Money Laundering Exclusion in the policy, unlike the policy’s exclusion for fraud, did not explicitly provide that the determination of whether the alleged money laundering acts did “in fact” occur was reserved for a court. Lloyd’s argued that that it was entitled to make the determination of the applicability of the Money Laundering Exclusion and that it had independently done so based upon evidence extrinsic to the complaint.

Applying the eight corners rule which precludes consideration of evidence outside the four corners of the D&O policy and the four corners of the complaint, and which must be considered without regard to the truth or falsity of the allegations is in the complaint, the Court determined that the “facts” giving rise to the exclusion could only be determined by a court in the underlying proceeding because otherwise they “could change on a daily basis as additional ‘facts’ are developed” and coverage “could be withdrawn at the insurer’s whim.”

The Fifth Circuit’s Decision

Construing the policy language under Texas law and resolving any ambiguities against the insurer and in favor of the insured, the Fifth Circuit held that, under the language of the policy, “the ‘in fact’ determination must be made by a court in a separate, parallel coverage action, in which all admissible evidence is welcome. . . .” The Fifth Circuit resolved the two legal issues it deemed predicate to that determination: “(1) whether the underwriters’ duties end when they make an ‘in fact’ determination (subject to judicial review) or whether that determination can only be made in the first instance by a court; and (2) whether a court may examine evidence in making its determination or whether it is instead confined to the underlying complaint’s allegations and the D&O Policy’s terms” (i.e., the “eight corners rule”). 

As to the first issue, the Court observed that the policy was silent as to who may make the “in fact” determination of whether the exclusion applies, the insurer or a court. The Fifth Circuit construed the policy against the insurer, holding that, for an insurer to reserve to itself the right to make a unilateral coverage decision, it must “be explicit when doing so.” The Court further held that the policy’s use of the language “determination…in fact,” as opposed to the “final adjudication” language employed in the policy’s fraud exclusion, meant that the determination of whether the Money Laundering Exclusion applies may be made in a separate coverage proceeding rather than in the underlying action. “The distinction is important because under a ‘final adjudication’ clause, some courts bar insurers, after settlement of the underlying case, from litigating ‘whether the settled claims were in fact attributable to defendants’ dishonest acts” thus “limit[ing] the insurer’s recourse if the parties settle — the most likely outcome — or if the insured is otherwise absolved of liability or guilt in the underlying action.” 

As for the second issue, “what evidence may be considered in making a ‘determin[ation] fact,’” the Fifth Circuit rejected the District Court’s application of the “eight corners rule.” Noting that the “eight corners rule” had only been applied in duty to defend cases, as opposed to claims for advancement, the Court ultimately relied upon the policy’s express terms for its conclusion. In particular, the policy provided that the underwriters must advance defense costs “until it is determined that the alleged act or alleged acts did in fact occur” which “require[s] recourse to something more than mere allegations.” Accordingly, even if the eight corners could apply in advancement cases, the Court held that “the parties chose — in plain language — to displace it and to provide for the use of extrinsic evidence.” 

Concluding that the “in fact” determination must be made by a court in a separate coverage action based upon admissible evidence, the Fifth Circuit remanded the case for further proceedings to be conducted by a judge other than the District Court overseeing the underlying action. In parting, however, the Court recognized that even a determination in a separate collateral proceeding will not be final if, following a determination of the facts on remand unfavorable to the executives, the executives are then cleared of all charges in the underlying action. “That is, the judicial decision required by this coverage action remains subject to modification.”  

Consistency With Other Decisions Favoring Advancement of Defense Costs

This decision is consistent with other decisions recognizing the importance of advancing defense costs for corporate officers and directors. In U.S. v. Stein, 435 F.Supp.2d 355 (S.D.N.Y. 2006), for example, the court held that the government violated KPMG employees’ constitutional right to counsel by pressuring KPMG to cut off defense cost reimbursement to the employees.

The Delaware Supreme Court similarly supported advancement of defense costs in Homestore, Inc. v. Tafeen, 888 A.2d 204 (Del.Supr. 2005).2 In Tafeen, a former officer sought advancement for litigation expenses related to his alleged role in inflating the company’s financial statements. The Court explained that the “focus of an advancement proceeding precludes litigation of the merits of entitlement to indemnification…[because] if it is subsequently determined that a corporate official is not entitled to indemnification, he or she will have to repay the funds advanced.” Thus, the Court held that if the litigation was related to actions within an officer’s corporate capacity, the funds should be advanced without regard to whether the officer’s motivation for his conduct was greed. The Court reasoned that advancement provides officers with immediate interim relief from the personal out-of-pocket financial burdens of paying legal defense costs.  

Recently, the Delaware Court of Chancery confirmed directors and officers’ right to advancement under a company’s charter in Barrett v. American Country Holdings, Inc., 951 A.2d 735 (Del. Ch. 2008). In Barrett, the corporation brought suit against its former directors for intentional fraud. The D&O policies covered the directors’ fees, but the directors brought suit against the corporation for advancement because the D&O policy limits were nearly exhausted. The corporation argued that the directors forfeited advancement by unreasonably refusing to settle the litigation. The corporation took this stance despite the D&O policy’s requirement that directors obtain permission from the D&O insurer prior to settling and the D&O insurer’s refusal to give permission to settle. The Court ordered the corporation to pay the directors all their defense costs stating, “Its stockholders will now endure not only the cost of honoring the corporation’s promise… but also the costs needlessly run up by the corporation because it choose to assert a baseless and illogical defense…” in refusing to advance the former director’s defense costs.

Conclusion and Implications

In the wake of Pendergest-Holt, companies, their directors and officers, and their insurers should carefully review the proposed D&O policy for language setting forth the manner in which “the facts giving” rise to an exclusion will be determined. The differences between competing versions of such exclusion language may seem minor, but the consequences arising from such seemingly minor language differences could be major. Those differences may dictate: (i) whether the insurer itself has the right to deny coverage (subject to judicial review), including the advancement of defense costs; or (ii) whether the denial of such coverage can only result from a finding of fact made by either the court in a coverage action, or the court in the underlying civil or criminal action. Given the significance of these consequences, it is advisable to seek legal and brokerage advice in negotiating D&O policy language prior to binding a D&O policy.


For more information on this alert, please contact any of the lawyers listed below:

Dale E. Barnes, Co-chair, Securities Litigation, 415.393.2522

Jordan D. Hershman, Co-chair, Securities Litigation, 617.951.8455

Michael Blanchard, Partner, 860.240.2945

1 It is worth noting that in a related decision the Court, which granted the SEC’s request for appointment of a receiver, determined that the D&O policy proceeds, even if properly considered assets of the receivership estate, could be used for the Officers’ defense because “the potential harm to [the directors and officers] if denied coverage is not speculative but real and immediate.” Sec. & Exchg. Comm’n v. Stanford Int’l Bank, Ltd., No. 3:09-CV-298 (N.D. Tex. Oct. 9, 2009).

2 See also AT&T Corp. v. Clarendon Am. Ins. Co., 931 A.2d 409 (Del. Sup. Ct. 2007) (holding that D&O carrier was obligated to reimburse majority shareholder for fees, cost and settlement costs advanced to its director designees).

This article was originally published by Bingham McCutchen LLP.