In a move that recapitulates a classic dispute that has been brewing in bankruptcy court for years, the Stanford Financial Group receiver has asserted that the proceeds of Stanford’s D&O insurance policies are "receivership assets" and that his right to the proceeds "supersedes" the rights of insureds under the policy. Moreover, he has specifically threatened the insurer with "contempt" if it were to advance the individual insureds’ defense expenses. This sequence raises some fundamental issues about the D&O insurance structure and coverage and could highlight the importance of certain policy provisions that have recently become prevalent. It also raises some questions about some coverage structures.

 

Let me just say at the outset that I am not involved in this case and I do not intend in this post to express my opinions on the merits of the parties’ respective positions. Rather, the purpose of this post is simply to note the parties’ dispute and to make some observations.

 

According to a June 30, 2009 motion filed in the Stanford Financial SEC proceeding pending by former Stanford CEO Laura Pendergest-Holt (here), Stanford’s D&O insurance carrier had advised her that it would begin advancing her defense expense, subject to a reservation of its rights to deny coverage under the policy, on July 1, 2009. However, on June 25, 2009, the receiver sent the carrier a letter claiming that the D&O policy proceeds are "Receivership Assets" and that the receiver’s right to the proceeds "supersedes" the right of the other insureds under the policy. The carrier has withheld payment.

 

Pendergest-Holt’s motion seeks clarification that the receivership order does not apply to the D&O policy proceeds, and alternatively seeks authorization for disbursement of the D&O policy proceeds for payment of her defense expense. A host of other individuals claiming also to be insureds under Stanford’s D&O policy have sought to join in Pendergest-Holt’s motion, as reflected, for example, in the August 6, 2009 motion (here) filed by two former Stanford brokers. UPDATE: The receiver’s response to Pendergest-Holt’s motion can be found here. Special thanks to a loyal reader for providing a copy of the response.

 

The question of ownership and entitlement to D&O policy insurance proceeds is a long-standing question in the bankruptcy context. This recurring question became even more troublesome after so-called "entity coverage" was added to most D&O policies in the mid-90s. This coverage extension provides liability protection for the company itself. In public company policy’s, the coverage is limited just to securities claims. However, for private companies, like Stanford, the entity coverage is usually more extensive.

 

As reflected in a memo (here) by my friend Kim Melvin of the Wiley Rein firm, courts have continued to struggle with these issues in bankruptcy, with some courts finding that the policy proceeds are not a part of the bankruptcy estate and therefore not subject to the stay in bankruptcy, and others reaching a contrary conclusion.

 

But these questions may take on a different light in the context of the question of the advancement of defense expenses subject to a carrier’s reservation of rights. In these circumstances, policy funds are advanced without a final determination of coverage (one that might, in fact, never come, if the claims are compromised). When it comes to the entitlement to advancement of defense expense, it could be argued that, all else equal, the various insureds’ rights — including the bankrupt company’s rights – under the policy could be regarded equivalent.

 

These issues could be even further complicated where, as here, the bankrupt company faces a likelihood of its own third-party liability claims, in which the company will likely incur its own defense expense.

 

One critical element of this dispute may be the question whether Stanford’s policy has a priority of payments provision, which predetermines the order of payment under the policy. This type of provision has become fairly standard in recent years. These provisions generally specify that payment of loss will first be made under the policy’s A Side coverage (which provides individual protection in the event the corporate entity is unable to indemnify them due to insolvency or legal prohibition). These provisions confirm the parties’ intent that the D&O policy serves primarily to protect the individual directors and officers.

 

Whether Stanford’s policy has this type of provision, and if so how the court will interpret and apply it here remains to be seen. The court’s interpretation of this provision (assuming it is in the policy) could be determinative of the parties’ dispute.

 

While the outcome of this dispute remains to be seen, the receiver’s position caused me to reflect on an auxiliary D&O insurance policy that many insureds have acquired in recent years, the so-called Excess Side A/DIC policy. The "difference in condition" coverage extension under this type of policy provides that the policy will "drop down" and provide first dollar coverage under certain circumstances.

 

Although these policies vary significantly, one of the relatively standard features of the DIC coverage is a provision specifying that the policy will "drop down" and provide first dollar coverage if the insured company is in bankruptcy and the proceeds of any traditional underlying insurance cannot be paid because the proceeds are subject to the automatic stay.

 

The circumstances of the dispute involving the Stanford D&O insurance policy present a situation where the individual insureds might well find themselves unable to access the protection of a traditional D&O insurance policy, at least if the receiver’s current efforts are successful. However, even if Stanford Financial D&O insurance program included a Side A/DIC policy, the typical Side A/DIC policy would not appear to provide drop down protection to the individual insureds in this circumstance, because their inability to access the policy proceeds is not as the result of the initiation of an action under the U.S Bankruptcy Code and not as a result of the automatic stay in bankruptcy.

 

The apparent nonapplicability of the drop down coverage to these circumstances under the typical Excess Side A/DIC policy made me reflect that there could be a need for an extension of the DIC coverage’s drop down protection to circumstances like this one where the proceeds of the traditional D&O insurance policy may be unavailable for the individual insureds’ protection for reasons other than the operation of the U.S. Bankruptcy Code. There may well be some DIC policies out there that might respond in this situation, but the typical Excess Side A/DIC policy likely would not.

 

The Stanford Financial insurance dispute will be interesting to watch, although it is an extremely unwelcome situation from the perspective of the individuals involved. In any event, the specifics of the situation suggest a possible (and arguably necessary) extension of the DIC coverage in the typical Excess Side A/DIC policy.

 

I know that many readers may have much more experience with the coverage issues involved in the receiver’s actions in the Stanford Financial case, and many readers may also have views about the extent and limitations of the typical Excess Side A/DIC policy. I encourage readers to share their views with others using the blog’s "Comment" feature.

 

Quelle Surprise: The Lawyers Want to Be Sure They Will Be Paid: Among other things, the receiver’s asset freeze together with the dispute of over the D&O policy proceeds may have left the various individuals’ lawyers wondering when and how they will be paid. R. Allen Stanford’s new criminal defense lawyers want assurance they will be paid before they will take any actions.

 

As reflected in an August 10, 2009 Texas Lawyer article entitled "Stanford’s Lawyers Want Assurance on Pay" (here), Stanford’s erstwhile new legal defense team has entered an appearance in the criminal proceeding against Stanford – solely for the limited purpose of determining "whether Mr. Stanford will be granted access to monies to pay for his legal fees and expenses."

 

"Private Companies Need D&O Insurance, Too": The Stanford Group case may represent an extreme example, but it does illustrate that private companies can become involved in serious claims for which D&O insurance is required. But many private company officials remain unconvinced of the need for D&O insurance, particularly when it comes to closely held companies.

 

A recent memo by Shannon Graving and Thomas H. Bentz, Jr. of the Holland & Knight law firm entitled "Private Companies Need D&O Insurance, Too" (here) takes a look at this recurring question about private companies and D&O insurance. As the article shows, private companies and their directors and officers may be susceptible to a wide variety of claims, as a result of which, the companies – even family owned businesses – would be well advised to secure D&O insurance protection.

 

More Madoff-Related Coverage Litigation: As I noted in a prior post (here), Madoff-related coverage litigation has started to arrive, and there undoubtedly will be more to come. Along those lines, Bloomberg reported today (here) that Madoff feeder fund Tremont Group Holdings and its related organizations have filed an action in Delaware Chancery Court against its insurers for denying coverage for Madoff-related claims.

 

According to the article, Tremont is owned by OppenheimerFunds, a unit of Mass Mutual Financial Group. The article reports that the complaint alleges that Mass Mutual’s D&O insurers and its bond insurers "have ignored repeated requests to pay defense costs." The complaint apparently contends that MassMutual’s D&O insurer has taken the position that the company’s bond insurer should pay a portion of the defense expense, but that "the primary bond underwriters have refused to pay any portion of the joint defense expense." The complaint seeks a judicial declaration of coverage under the applicable policies.

 

I don’t yet have a copy of this complaint, but I will post a link as soon as I get a copy. I would be grateful if any reader that has a copy of the complaint would forward a copy to me (anonymously, of course, if necessary), so that I can post the link. UPDATE: A copy of the complaint can be found here. Special thanks to a loyal reader for providing a copy of this complaint.

 

Special thanks to a loyal reader for sending me a copy of the Bloomberg article.