A recent decision from the U.S. District Court for the Southern District of Texas demonstrates the serious consequences of failing to negotiate for narrow policy exclusions in directors and officers liability ("D&O") insurance coverage. In Pendergest-Holt v. Certain Underwriters at Lloyd's of London, No. H-09-3712, 2010 U.S. Dist. LEXIS 108920 (S.D. Tex. Oct. 13, 2010) ("Pendergest-Holt III"), the court ended D&O insurance coverage for R. Allen Stanford and other Stanford Financial executives based on an "in fact" determination that a money-laundering policy exclusion applied prior to a final adjudication of such executives' criminal and civil liability. The court's decision is notable because many D&O insurance policies contain similar "in fact" exclusionary language, and insurers often take the position that they can unilaterally make such an "in fact" determination at any time to preclude coverage. Although here the court rather than the insurer made the "in fact" determination, the court made that determination while criminal and civil actions against the policyholders were ongoing; thus, the court cut off defense costs coverage before the policyholders had been found guilty or liable for any misconduct.
With targeted guidance by insurance coverage counsel during placement of D&O insurance policies, this is a result that could have been avoided through negotiating for a money-laundering exclusion that, rather than applying "in fact," applied only after a "final adjudication in an underlying action."
The Pendergest-Holt III decision is the latest in a series of federal district and appellate court insurance coverage decisions stemming from government prosecutions of Stanford Financial executives. Prior to the court's decision, Stanford and other Stanford Financial executives had sought advancement of defense costs from their D&O insurers for defense of criminal and SEC actions regarding their alleged misconduct at Stanford Financial, including participation in a massive Ponzi scheme. The insurers initially advanced defense costs but -- after a Stanford Financial CFO entered a guilty plea -- retroactively denied coverage and sought reimbursement for all advanced amounts as to Stanford and other executives. The insurers based their denial on the money-laundering exclusion, which required the insurers to pay defense costs until such time that it was determined that the alleged act or acts did "in fact" occur. Stanford and other executives then sued for coverage, and, in an earlier decision, the court entered a preliminary injunction prohibiting the insurers from withholding defense costs and from making the "in fact" determination unilaterally under the money-laundering exclusion. Pendergest-Holt v. Certain Underwriters at Lloyd's of London, 681 F. Supp. 2d 816 (S.D. Tex. 2010) ("Pendergest-Holt I"). The insurers then appealed, and the 5th Circuit affirmed the preliminary injunction in part, but remanded for the district court to determine whether the "in fact" requirement of the money-laundering exclusion had been met. Pendergest-Holt v. Certain Underwriters at Lloyd's of London, 600 F.3d 562 (5th Cir. 2010) ("Pendergest-Holt II").
Upon remand from the 5th Circuit, the court in Pendergest-Holt III held an evidentiary hearing, after which it made the "in fact" determination required by the money-laundering exclusion. The court held that the insurers had proven -- by a preponderance of the evidence -- a substantial likelihood of success in demonstrating that Stanford and the other executives seeking coverage had "in fact" committed money laundering as defined in the money-laundering exclusion. Pendergest-Holt III, 2010 U.S. Dist. LEXIS 108920, at *60-*61, *71-*72.
There are five important points to take away from the Pendergest-Holt III decision.
First, the decision demonstrates the importance of negotiating for narrower "final adjudication" exclusionary wording in D&O insurance policies. While the specific money-laundering exclusion at issue in Pendergest-Holt III does not frequently appear in D&O insurance policies, the language permitting application of the exclusion "in fact" frequently does appear in so-called "conduct" exclusions in D&O insurance policies -- exclusions precluding coverage for personal profit, criminal or fraudulent acts. Instead of an "in fact" standard, policyholders should strongly negotiate for policy language that requires a "final adjudication in an underlying action" before application of the conduct exclusions. Such a standard, as pointed out by the 5th Circuit in Pendergest-Holt II, requires a final adjudication in the underlying criminal or civil proceeding rather than in a parallel insurance coverage action brought by an insurer or policyholder. Pendergest-Holt II, 600 F.3d at 572-73. Importantly, as the court noted in Pendergest-Holt III, the separate fraud exclusion in the D&O insurance policies was not at issue as to Stanford and other executives because, unlike the money-laundering exclusion, it applied only after a final adjudication had been entered against a policyholder. Pendergest-Holt III, 2010 U.S. Dist. LEXIS 108920, at *15 n.14; see also Pendergest-Holt I, 681 F. Supp. 2d at 824-25. Here, during policy negotiations, the policyholders could have sought to change the language of the money-laundering exclusion to a "final adjudication in an underlying action" standard. That simple change would have preserved coverage for Stanford's and the other executives' millions of dollars of ongoing defense costs.
Second, in making a determination that the "in fact" standard had been met, the court examined the policy language, the underlying complaints and outside evidence presented at the evidentiary hearing, including the testimony of witnesses. Pendergest-Holt III, 2010 U.S. Dist. LEXIS 108920, at *2-*4. Thus, the court examined extrinsic evidence consistent with the 5th Circuit's decision in Pendergest-Holt II, stating that the "in fact" language in the D&O insurance policies required the use of evidence in addition to just the allegations in the underlying complaints. See Pendergest-Holt II, 600 F.3d at 574. The policyholders had argued that the "in fact" determination should be limited to complaint allegations, under which the insurers likely would be unable to demonstrate the money-laundering exclusion applied "in fact." That the court did not find this argument persuasive was favorable to the insurers because it permitted the court to examine a wealth of evidence other than just mere allegations in the complaint.
Third, Stanford and the other executives seeking D&O insurance coverage neither testified nor were deposed; they had refused based on their Fifth Amendment right against self-incrimination in the underlying actions. Pendergest-Holt III, 2010 U.S. Dist. LEXIS 108920, at *43 & n.60. Because of this, the court stated its findings and conclusions were narrow and not intended to be used in the criminal and SEC actions those individuals were facing. Id. at *60-*61, *73. This demonstrates the tension inherent in an "in fact" standard where litigation in an insurance coverage dispute of facts that may be relevant to underlying liability is proceeding at the same time policyholders are defending against criminal and civil allegations of misconduct. Despite this tension, the issues in a D&O insurance coverage action and the issues in underlying criminal and civil actions are different. The former concerns interpretation of contractual insurance policy language while the latter concerns findings as to violations of criminal or civil statutes or common law.
Fourth, the standard employed by the court was a preliminary one: whether the insurers had shown by a preponderance of the evidence a substantial likelihood that Stanford and the other Stanford Financial executives had engaged in money laundering. Id. at *4, *17-*18. Thus, the court left open the possibility that should Stanford and the other executives prevail in the criminal and SEC actions, they could seek a final determination on the merits from the court as to the applicability of the money-laundering exclusion. Id. at *75 n.106. In the interim, however, the policyholders were on their own in funding their defense. Up to that point the insurers already had spent more than $11.2 million in funding the policyholders' defense. Id. at *75. The financial ramifications going forward are thus large -- the policyholders will have to fund their own defense in the underlying criminal and SEC actions out of pocket even though they thought they were protected by D&O insurance.
Finally, the court denied a stay pending appeal; as a result the insurers -- as of the court's judgment -- no longer had an obligation to pay or advance defense costs. Id. at *74-*76. The court justified this by the fact that there was a "dwindling insurance pot" for the use of some 30 other Stanford Financial executives. Id. at *76. After its decision, on Nov. 29, 2010 the court closed the case pending the final conclusion of the underlying criminal action, after which the policyholders could move to reinstate the case.
Thus, Pendergest-Holt III highlights the consequences of failing to obtain the narrowest possible exclusionary wording -- wording that applies after a "final adjudication" rather than "in fact." The D&O insurance policies at issue in this case failed to protect the Stanford Financial executives when their need was great. Instead, their insurance policies led to a coverage action where evidence of money laundering was presented and ruled upon at the same time the executives were fighting underlying criminal and civil actions.
Lorelie S. Masters is a partner in Jenner & Block's Washington, D.C., office. She is a member of the firm's litigation department and Climate and Clean Technology Law and Insurance Litigation and Counseling Practices. Brian S. Scarbrough is a senior associate in the firm's litigation department. He is a member of the Insurance Litigation and Counseling Practice and Reinsurance Practice.