PENDERGEST-HOLT v. CERTAIN UNDERWRITERS AT LLOYD’S OF LONDON (5th Cir., Mar. 15, 2010)

It has been widely reported that about a year ago the SEC sued three companies founded by R. Allen Stanford and three individual defendants alleging that Stanford and his cohorts had engaged in a Ponzi scheme through the sale of sham certificates of deposit evidencing billions of dollars of investments. The government subsequently brought a parallel criminal action against these same executives and James Davis, a former executive.

On August 27, 2009, Davis entered a guilty plea to charges of mail fraud, conspiracy to violate the mail, wire and securities fraud law, and conspiracy to obstruct a proceeding before the SEC. In doing so, he signed a sworn plea agreement and stated under oath that he and the other named defendants engaged in various acts to further the Ponzi scheme. On November 16, 2009, the defendant insurer advised the policyholders that it was denying coverage as of August 27, 2009 based on the Money Laundering exclusion included within the D&O policy. The exclusion, which defines money laundering in much broader fashion than the criminal charges, states the defendant shall pay costs “in the event of an alleged act or alleged acts until such time that it is determined that the alleged act or alleged acts did in fact occur.” The plaintiffs obtained a preliminary injunction stopping the insurer from retroactively withdrawing coverage. The Fifth Circuit granted the insurer’s request for an expedited appeal.

The Circuit Court determined that the insurer must pay legal costs incurred by the policyholders in defending against the allegations “until such time that it is determined that the alleged act or alleged acts did in fact occur.” Consequently, the insurer could not immediately withdraw coverage based upon money laundering claims being levied against the policyholders.

The court stated that two questions arose out of this dispute. First, whether the insurer’s duties ended when it makes an “in fact” determination or whether that determination can only be made, in the first instance, by a court. Second, whether a court may examine evidence in making its determination or whether it is instead confined to the allegations made in the underlying complaint and the policy terms.

The court noted that the policy is silent as to “who” makes the “in fact” determination. The insurer argued that it is entitled to make the determination in the first instance, and the obligation to advance defense costs ends when it does so. The plaintiffs countered that the “in fact” determination must be judicially made.

The court stated that where a policy requires a “final adjudication” to trigger an exclusion, “courts have consistently held that the adjudication must occur in the underlying D&O proceeding.” In contrast, the phrase “in fact” has been interpreted as having a broader scope than “final adjudication.” The “in fact” language does not require a final adjudication by the fact finder in the underlying case, but instead creates an opportunity for a “coequal alternative.” By using this language, the insurer reserves the right to litigate the coverage question outside the underlying action for which insurance coverage is sought. In short, the court concluded that the exclusion does indeed leave the decision for the judiciary in the first instance. The insurer need not wait for the resolution of the underlying action, but can affirmatively seek a decision in declaratory judgment action.

With respect to the second question, the court concluded that the decision was not dependant upon the application/interpretation of the eight corner rule. Here, the policy states that the insurer must advance costs “until such time that it is determined that the alleged act or alleged acts did in fact occur.” This language contemplates recourse to something beyond the mere allegations contained in the complaint. The court stated, “[t]he terms contemplate the use of extrinsic evidence in making the determination.”

The court remanded the matter to the district court and dictated that the coverage dispute be assigned to a separate judge to avoid any “awkwardness.” The court advised that on remand this action would be a collateral vehicle for the “determination….in fact” that the policy contemplates. Accordingly, the court held that the insurer was required to reimburse defense costs until the merit of the coverage defense was determined. Finally, the court noted that the exclusion is silent as to the insurer’s burden of proof (preponderance of evidence vs. clear and convincing) and would leave this issue to the trial court.

Impact: There seems to be no dispute that the Money Laundering Exclusion precludes coverage when “it is determined that the alleged act or alleged acts did in fact occur.” The court’s struggle and hence ultimate interpretation of “in fact” is cause for concern because it fervently discounts an insurer’s determination of the facts based on its investigation and also states that it must be something more than sworn statements admitting the very facts that would trigger the exclusion. It is unclear what effect, if any, this decision will have on coverage action as a whole, but the insurer here certainly had sufficient information to deny coverage. However, the court interpreted the policy language as adding an additional step.

For a copy of this decision, click here: http://insurancecoverage.typepad.com/insurance_and_reinsurance/2010/04/cases-for-professional-liability-monthly-april-edition.html