The U.S. Court of Appeals for the Fifth Circuit has issued a significant decision concerning the obligation of directors and officers liability insurers to fund their insureds’ defense. In Pendergest-Holt v. Certain Underwriters at Lloyd’s of London, No. 10-20069, 2010 WL 909090 (5th Cir. Mar. 15, 2010), Allen Stanford and other Stanford Financial executives sought coverage for the costs they are incurring in defending themselves against civil and criminal proceedings alleging that they operated their company as a massive Ponzi scheme. The insurance dispute turned on whether the D&O insurers could refuse to advance the insureds’ defense costs based on the insurers’ unilateral determination to apply a “money laundering” exclusion.

Unlike a typical exclusion for fraud, which under most D&O policies explicitly applies only when there is a “final adjudication” that the excluded conduct occurred, the money laundering exclusion in the Stanford insurers’ policies instead obligated the insurers to pay defense costs “until such time that it is determined that the alleged act or alleged acts did in fact occur.” The insurers argued that they were entitled to and did make the “in fact” determination on their own, based on information and developments relating to the underlying cases, including findings of the court in the action brought by the SEC. The insureds argued for an “eight-corners” analysis akin to the duty to defend standard, under which a determination of coverage would be based solely on comparison of the underlying allegations to the policies’ insuring agreements, without considering the kind of extrinsic evidence upon which the insurers based their position.

The district court sided with the insureds. See Pendergest-Holt v. Certain Underwriters at Lloyd’s of London, No. H-09-3712, 2010 WL 317684, at **9, 14-15 (S.D. Tex. Jan. 26, 2010.) The insurers appealed, and after expedited briefing and oral argument, the Fifth Circuit Court of Appeals held that the “determination” language connoted a judicial decision, and that if the insurers really had intended to arrogate the decision-making solely to themselves, they could easily have said so explicitly in the exclusion’s wording. However, in contrast to “final adjudication” language, which courts typically interpret as meaning adjudication in the underlying proceeding, the “in fact” determination could be made in a “separate, parallel coverage action.” The court remanded the case back to the district court for that “in fact” determination.

Importantly, the court held that the insurers “are contractually bound to reimburse reasonable defense costs until that merits decision is reached,” and on that basis the court enjoined the insurers “from refusing to advance defense costs unless and until a court ‘determine[s] in fact’” that the excluded conduct occurred.

For policyholders, the court’s decision is helpful in that it rejects the notion that insurers can abandon their insureds based on what amounts to a unilateral determination that the insureds actually engaged in the wrongful conduct of which they stand accused. But the court also rejected the insureds’ argument that the coverage determination could be strictly limited to the allegations. The court’s conclusion that the coverage determination should be made in a “separate, parallel coverage action” effectively forces the insureds into a “twofront war” in which they must defend themselves against both the claimants and their own insurers, with the insurers often parroting the very allegations that the government and civil claimants are leveling against the insureds.

That situation imposes extraordinary burden and cost on insureds, and also creates unnecessary risk, due to the potential preclusive effect that early decisions on the coverage issues might have. Courts typically address that risk by prohibiting coverage cases from proceeding to decisions on the substantive merits prior to adjudication of underlying litigation. The Court of Appeals in Pendergest-Holt noted the “cart before the horse” problem created by the prospect of having the coverage issues decided during the pendency of the underlying civil and criminal cases, but downplayed that issue as mere “awkwardness,” and purported to address it by (1) directing that the coverage dispute be reassigned to a new district court judge (instead of the judge who was also handling the underlying cases); and (2) holding that the coverage decision would be subject to modification or reconsideration based on the outcome of the underlying cases.

That approach fails to adequately address the risk that parallel proceedings creates. If, for example, the Stanford insurers were to succeed on remand in establishing that the money laundering exclusion applies, the court might make findings that government and civil claimants could argue should be accorded preclusive effect in their as-yet unadjudicated underlying proceedings. If the insureds nonetheless succeeded in obtaining a dismissal or acquittal in later-tried underlying proceedings, under the Court of Appeals’ approach the insureds could at that time seek modification or reconsideration of the prior coverage adjudication. However, the practical disadvantages of that approach are manifest, and significant. Most important, the insureds will have been required to conduct their defense without insurance funding.

The lesson for policyholders is not to wait to address this issue when they are facing claims asserted by highly-motivated and well-financed securities class action lawyers and governmental agencies. We urge policyholders to address this issue in their renewal negotiations with their D&O insurers, by insisting on “final adjudication” limitations for all conduct-related exclusions, including those which bar coverage for fraud or other intentionally wrongful conduct, “unfair profit or advantage,” or statutory or regulatory violations. As the Court of Appeals in Pendergest-Holt observed, “[w]hen a D&O policy requires a ‘final adjudication’ to trigger an exclusion, courts have consistently held that the adjudication must occur in the underlying D&O proceeding, rather than in a parallel coverage action or other lawsuit.”