In an interesting opinion, the Fifth Circuit has set aside a settlement and related bar order that had been approved by the district court in litigation arising out of the Stanford Financial Ponzi scheme scandal. The appellate court said that the district court lacked authority to approve the settlement in light of several of its features, including its provisions cutting off the claims of several former Stanford Financial employees and managers to the defunct firm’s insurance policies’ proceeds. As discussed below, the circumstances surrounding the settlement raise serious questions about the intended purpose of D&O insurance. The Fifth Circuit’s June 17, 2019 opinion in the case can be found here.

 

Background

As recited by the appellate court, the Stanford Financial Ponzi scheme defrauded more than 18,000 investors who collectively lost more than $5 billion. Following the first revelations of the scandal, the district court appointed a receiver to take control of the receivership estate. Among other things, the receiver filed numerous lawsuits against hundreds of former Stanford directors, officers, and employees, alleging fraudulent transfers, unjust enrichment, and breach of fiduciary duty.

 

At the time the scandal emerged, Stanford maintained a variety of different insurance policies: a D&O insurance policy; a Financial Institutions Crime and Professional Indemnity policy, which included both first party fidelity coverage and third party coverage for professional indemnity; and an excess blended wrap policy. The maximum amount of coverage available under these policies is in dispute between the receiver and the insurers. The insurers also dispute that there is coverage under their respective policies for the various claims.

 

The Insurance Settlement

After years of litigation, the receiver and the insurers submitted the various insurance disputes to mediation. The mediation resulted in a settlement (the “initial settlement”) in which the insurers agreed to pay a total of $65 million and the receiver agreed “to fully release any and all insureds under the relevant policies.”

 

A dispute arose regarding this initial settlement and the parties returned to mediation, pursuant to which a new settlement was negotiated. The new settlement also contemplated a $65 million settlement, which would effectively exhaust the remaining insurance proceeds. However, while the new settlement released claims against 16 former Stanford directors and officers against whom the receiver had already obtained judgments, the remaining former Stanford directors and officers are not released but remain subject to ongoing or potential future litigation by the receiver.

 

In addition, and even though these other former officers and directors were not party to the settlement negotiations between the receiver and the insurers, the settlement included a “bar order” prohibiting them from suing the insurers for their costs of defense or indemnity, and even barring their claims against the insurers for extra-contractual or statutory claims.

 

The District Court Order

In a May 16, 2017 order (here), Northern District of Texas Judge David C. Godbey approved the settlement, including the bar order, over the objections of the former directors and officers whose claims to the insurance proceeds was precluded by the bar order.

 

Judge Godbey concluded, despite the objections, that the settlement and bar orders are fair, equitable, and reasonable and in the best interest of the receivership estate. Judge Godbey cited the perceived necessity of a settlement, together with the bar orders, to resolve fairly and efficiently the competing claims of the receiver and the insurers about policy coverage and to assure the maximum recovery for Stanford’s defrauded investors. Without the bar order, Judge Godbey noted, the insurers would not have settled.

 

The former directors and officers whose claims against the insurer were barred (hereafter, the Appellants) appealed the district court’s approval of the settlement and rejection of their objections.

 

The June 17, 2019 Opinion

In a June 17, 2019 opinion written by Judge Edith H. Jones for a unanimous three-judge panel, the Fifth Circuit vacated the district court’s order approving the settlement and bar orders and remanded the case to the district court for further proceedings.

 

The appellate court noted that “although we sympathize with the impetus to settle difficult and atomized issues of insurance coverage rather than dissipate receivership assets in litigation, the settlement and bar orders violated fundamental limits on the authority of the court and the Receiver.” The appellate court specifically noted a number of problems that “cast grave doubt on the fairness and equity of the settlement and bar orders reached without Appellants’ participation.”

 

Among other things, the appellate court noted that the court and the receiver could not “abrogate contractual claims” of the Appellants to the policy proceeds, at least without some allowance for the Appellants to be able to make claims to the receivership estate, and could not extinguish the Appellants extra-contractual claims against the insurers, which were completely independent of the estate’s interests.

 

The appellate court also rejected the district court’s suggestion that the settlement would not have been possible without the inclusion of the bar order, noting that in the initial settlement the receiver had agreed to release all of the claims against the former directors and officers; it was only in the new settlement, in which the receiver had insisted on its right to continue its claims against the former directors and officers, for which the insurers insisted on the order barring the former directors and officers claims against the insurer.

 

Discussion

There are a number of legal principles at play here, including in particular the extent of and limitations on a district court’s authority in supervising a receivership and in approving settlement of receivership claims. There are also a host of legal issues relating to settlements of liability claims when the amount of insurance is insufficient to resolve all claims. I leave the analysis of these issues to others, in order to focus here on a more basic issue, which has to do with the purpose of D&O insurance in the first place.

 

Before I explain my position on this issue and how I think it relates to this particular dispute, I note that there is another perspective on this situation that differs from mine. In that regard, I note that the June 17, 2019 Law 360 article about the appellate court’s ruling quotes counsel for the receiver as saying of the Fifth Circuit’s decision that “Yet once again, recovery for the Stanford victims, which has been delayed for years, is being subjected to yet more lengthy delays, and it is especially regrettable that the interests of the former executives and financial advisors have been elevated over the rights of the Stanford victims.”

 

Counsel for the receiver has expressed a worthy and principled sentiment, that the victims of the fraud should be compensated, and the sooner the better.  I cannot argue with the idea that the fraud victims are entitled to quick recompense. As fine as this sentiment is, the fact is that the settlement here effectively stood the basic proposition of D&O insurance on its head.

 

The purpose of liability insurance is not to compensate victims. Companies don’t pay thousands of dollars for D&O insurance as some sort of charitable act in order to create a fund for prospective future claimants. Companies buy D&O insurance to protect their directors and officers. The whole point of the insurance – the reason the product exists – is so that there is money available to fund the defense of directors and officers in the event claims are asserted against them. The absolutely most fundamental purpose of the insurance is to provide that defense where, as here, the company itself no longer exists and thus cannot fund the individuals’ defense. To cut off the insured persons’access to the funds to defend themselves runs absolutely counter to the very purpose of the insurance contract.

 

For the receiver and the insurer to rig up a settlement  –in a settlement negotiation that did not include the directors and officers whose interests were involved – in which the directors and officers rights to try to seek the policy proceeds were barred, is not only fundamentally unfair, it violates the very purpose of the D&O insurance contract. Yes, of course, there is an undeniable urge to try to provide the fraud victims with compensation, but this objective should not be at the expense of the individuals’ rights under the insurance contract.

 

There is an easy solution here. The receiver can agree to give up its remaining claims against the former directors and officers, as it did in the initial settlement agreement. The receiver’s subsequent insistence on pursuing these claims, while at the same time trying to cut of the defendants’ claims to the insurance policy proceeds, represents an act of basic, fundamental unfairness.

 

The Fifth Circuit was right to question the district court’s approval of this settlement. Although the appellate court’s ruling has to do with the limitations on the district court’s authority, I hope that the lessons from this situation having to do with the basic purpose of D&O insurance are not lost.