Pendergest-Holt v. Certain Underwriters at Lloyd's of London, No. 10-20069 (5th Cir. March 15, 2010) see Decision
In this case, the Fifth Circuit considers a Director & Officers (D&O) insurer's refusal to pay defense costs to insured criminal defendants because an exclusion bars such payment when "it is determined that [money-laundering] did in fact occur." The key issue for the reviewing court is who gets to decide when the excluded conduct "in fact" occurred. Lloyd's argued that it could decide when the exclusion kicked in and why. The insureds said that only a jury in the underlying criminal case could trigger the exclusion with a guilty verdict. The court held that both sides were wrong. A court, not the insurance company, had to determine if the exclusion applied and at what point. But that determination did not have to await a final verdict of guilt or innocence. The issue could be decided by a separate court in a coverage lawsuit. Said the court, "This works a sensible construction of an awkwardly drafted instrument, aided by the equity power of the court to grasp the realities at hand."
This is a significant decision because many D&O policies have some kind of "occurred-in-fact" exclusion. Every D&O policy I have seen contains exclusions for certain kinds of bad conduct. Most exclude deliberately fraudulent or criminal acts as well as receipt of illicit, undeserved profits. Because no plaintiffs-lawyer worth her salt would draft a securities complaint that doesn't paint the directors' and officers' conduct in the blackest of terms, the bad-conduct exclusions in D&O policies are almost always potentially in play. So, if the mere allegation of excluded conduct was enough to trigger the exclusions, directors and officers would never get the benefit of any coverage.
In order to get companies to buy their D&O insurance, insurers' like Lloyd's, draft the exclusions to permit advancement of defense costs while the lawsuit is pending until the bad conduct is established in some manner, at which point, the spigot is turned off and the bad characters have to fend for themselves. Often, the policy will even require the insureds to reimbursement the insurer for costs previously advanced. Roughly speaking, the exclusions have one of two cut-off points: (1) when the bad conduct is established by a "final adjudication" (which the court in this case said always means adjudication in the underlying D&O proceeding - p. 16); or (2) it is determined "in fact" that the conduct occurred.
Here the D&O policy had a number of conduct exclusions, all but the the money-laundering exclusion to be determined after a final adjudication. Unfortunately for the defendants, the policy described money-laundering very broadly, and just about all of the conduct alleged by the government in this ponzi scheme fall within the definition. And this exclusion was triggered by an "in fact" determination. So the court held that the insurer had to advance defense costs until a court decided the cut-off point. That could already have occurred when one of the defendants copped a plea and pointed a finger at the others. Or it may be established by other evidence. Or it might have to await a jury verdict.
Interestingly, the court noted that the lower court judge who decides the issue might find that the exclusion has already been triggered, but an innocent verdict would effectively reverse that determination. That possibility is what the court had in mind when it referred to the courts' equity power.
On a final note, the appellate court held that the court hearing the criminal trial should not be the court to determine the coverage issue. By its holding here, the Fifth Circuit has relegated to a footnote the extraordinary holding by the lower court that Lloyd's payment obligation should be decided under Texas' strict 8-corners rule that an insurer's duty to defend is determined with reference only to the allegations in a lawsuit, not to actual facts established by extrinsic evidence. I say extraordinary because under this policy, and just about every D&O policy in existence, Lloyd's has no "duty to defend." Its obligation is to indemnify the insureds for their defense costs, or, at best, to advance costs. This is not the same as the more robust duty to defend.
The Fifth Circuit pointed out that if the 8-corners rule applied, then the mere allegation of money-laundering would immediately settle the issue in Lloyd's favor. The appellate court deftly characterized the 8-corner issue as a "red herring" and remanded the coverage action to some other court that was not burdened with the responsibility of rendering a fair trial in a high profile case.
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