The individual defendants in the various Stanford Financial-related SEC enforcement and criminal proceedings have been engaged in a long-running and procedurally complicated battle over whether the firm’s D&O insurers must advance the individuals defense expenses. In a sweeping January 26, 2010 opinion (here), Southern District of Texas Judge David Hittner rejected the grounds on which the insurers sought to avoid coverage and ruled that the insurers must advance the individuals’ defense costs.

 

Background and the January 26 Opinion

The defense fee dispute has a complex procedural history but for purposes of the January 26 opinion the critical fact is that on November 16, 2009, the insurers sent the individuals letters "retroactively declining to extend coverage for costs." The insurers contended that coverage was precluded by the Policy’s "money laundering" exclusion. The exclusion precludes coverage for loss "arising directly or indirectly as a result of or in connection with any act or acts (or alleged act or acts) of Money Laundering," as that term is defined in the policy.

 

In his opinion, Judge Hittner noted that the carrier’s were not seeking to avoid coverage based on the exclusion precluding coverage for fraud or criminal misconduct, because that exclusion has a requirement of an "adjudication" that the precluded conduct had occurred. The money laundering exclusion has no "adjudication" requirement, leaving, the insurers’ argued, the determination that money laundering has in fact occurred, to the insurers.

 

Judge Hittner also noted parenthetically that the insurers urged this position even though only one of the twenty-one counts in the criminal action alleges money laundering or conspiracy to commit money laundering. (The insurers argued that the policy’s definition of money laundering was broad enough to encompass all of the allegations.)

 

The plaintiffs first opposed the insurers’ position based on the "eight corners" rule, arguing under Texas law that in determining an insurer’s defense obligations, a court may not consider anything beyond the four corners of the policy and the four corners of the complaint. Judge Hittner found that despite the insurers’ arguments to the contrary, the Supreme Court of Texas "never has recognized an exception to the eight corners rule."

 

Judge Hittner was in any event strongly against a broader view of what a court properly might consider in determining the insurers’ obligations.

 

If a contemporaneous duty to advance or reimburse defense costs were judge on an "actual facts" basis, an insurer’s contractual 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. 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 discretion. That would leave directors and officers in an extremely vulnerable postion , as any allegation of dishonesty, not matter how groundless, could bring financial ruin on a director or officer. Essentially an insurer could act as judge and jury and convict its own insureds, thus avoiding any further financial responsibility for the insureds’ defense. This simply cannot be the case. (Citations omitted.)

 

The court found in applying the eight corners rule that the allegations were insufficient to establish that the precluded conduct had occurred. The insurers nevertheless sought to argue that the individuals refusal to testify in support of the application for a preliminary injunction is proof enough that the allegations against the individuals are true. The insurers sought to argue that the refusal to testify supported an inference that money laundering did in fact occur.

 

Judge Hittner held that the "given the magnitude, complexity and nature of the charges," he declined to draw the inference, and that in any event, because of the eight corners rule, the insurers’ reliance on the supposed inference from the individuals refusal to testify is "misplaced."

 

Judge Hittner, applying the standard required for a preliminary injunction motions ruled that though the money laundering exclusion does not require a judicial determination to apply, the exclusion’s requirements "also may mean much more than an insurer’s own determination." He said that he need not decide what level of factual determination must be made, and instead ruled only that plaintiffs have a substantial likelihood of succeeding on the merits at trial, satisfying the standard for awarding preliminary injunctive relief.

 

The court, in further consideration of the preliminary injunction standard, noted that the plaintiffs would suffer "irreparable harm" if the relief they sought was withheld. He noted that it is "unmistakable and cannot be seriously disputed" that the harm the individuals will suffer is "real, immediate and irreparable." He rejected the insurers contrary position that, he said, would "essentially require [the individuals] to prove their innocence." Judge Hittner commented that
 

 

Underwriters’ position is absurd because these circumstances are precisely why corporations procure D&O insurance on behalf of their directors and officers. Indeed, it would contravene the very purpose of the Policies – as well as the policy language itself – to require Plaintiffs to prove their innocence before being entitled to funds for their defense.

 

Judge Hittner found the harm to the insurers from granting the preliminary injunction was relatively slight and that public interest also weighed in favor of granting the preliminary injunction. He finally held that the individuals did not have to post a bond.

 

Discussion

Given the nature of the allegations against the individuals and the notoriety of the circumstances, as well as the number of people who lost money as a result of the collapse of Stanford Financial, the tone and temperature of Judge Hittner’s words are a little surprising. If nothing else is clear, Judge Hittner was certain that individuals needed to be able to defend themselves, and the insurers were obliged to provide the defense. The depth of Judge Hittner’s discussion of these defense cost issues are such that his words may prove useful for other individuals who are seeking to have their defense expenses paid under their policies.

 

You do get the sense that Judge Hittner ducked the hard issue – that is, if the money laundering exclusion, unlike the fraud exclusion, doesn’t have an "adjudication" requirement, then an adjudication can’t be required, so what is sufficient? Given Judge Hittner’s certainty that the eight corner rule is absolute under Texas law, there might be no way to meet the requirement. It does make you wonder whether it matters from a practical perspective whether or not there is an "adjudication" requirement.

 

Even though the usefulness of Judge Hittner’s determinations for others seeking insurance coverage arguably might be limited to those jurisdictions that also absolutely enforce the eight corners rule, the breadth of his pronouncements about the limitations on insurers’ ability to make preclusive coverage determinations virtually guarantees that his phrases will appear in the legal briefs of other individuals who are seeking defense cost coverage. His unwillingness to allow the individuals’ refusal to testify on their own behalf in the preliminary injunction proceeding may also prove helpful to other policyholders.

 

Because of the tone of Judge Hittner’s rhetoric and the high profile nature of the case, I suspect there may be some strong views about this decision. I invite readers who have thoughts about this decision to add their views to this post using the blog’s comments feature.

 

A January 26, 2010 Bloomberg article about Judge Hittner’s ruling can be found here.

 

Special thanks to Bill Schreiner of the Zuckerman Spaeder law firm for providing me with a copy of the decision.

 

Vivendi Watch: The Vivendi securities class action case went to the jury on January 11, 2010, but still no verdict. The parties are anxiously awaiting the verdict and in the meantime debating what the length of the jury deliberations may mean, according to a January 26, 2010 article by Andrew Longstreth on AmLaw Litigation Daily (here). The article also reports that almost regardless of the verdict, there will likely be an appeal, if for no reason that because of the potential jurisdictional implications of the National Australia Bank case now pending before the Supreme Court. Stay tuned (to the second power, apparently).