NEW ORLEANS—Two directors and officers liability insurers must pay the legal expenses of executives accused of operating one of the nation's largest Ponzi schemes—at least until a lower court rules on their coverage dispute, a federal appeals court has ruled.

The 5th U.S. Circuit Court of Appeals in New Orleans ruled last week that Lloyd's of London syndicates and Arch Specialty Insurance Co. are bound contractually to reimburse the defense costs of R. Allen Stanford and three other executives accused by federal authorities of operating the Houston-based Stanford Financial Group Co. as a $7 billion Ponzi scheme.

The decision, which affirmed a January ruling by U.S. District Court Judge David Hittner, means the underwriters must seek a separate ruling from another judge on the dispute over defense costs.

The ruling is significant because the company's primary and excess D&O policies can be used to pay claims against the company or individual executives. Stanford Financial's court-appointed receiver has argued that the $100 million D&O tower belongs to the bankrupt company and its funds should be reserved to reimburse bilked investors. Attorneys for Mr. Stanford and the other accused executives have said they would have to leave the case if they could not secure payment from the underwriters.

The Securities and Exchange Commission filed civil and criminal charges against the Stanford Financial executives early last year. Last August, former Chief Financial Officer James Davis pleaded guilty and stated in court that he and the other executives operated the company as a Ponzi scheme. Subsequently, the underwriters denied coverage and the executives sought an injunction.

Most D&O policies stipulate that insurers will pay defense costs, except in cases of outright fraud. But the fraud exclusion typically is contingent on a “final adjudication” by a court. Because most such cases settle before a final verdict is reached, D&O underwriters usually end up paying defense costs.

Stanford Financial's policies had that type of fraud exclusion, which Lloyd's and Arch conceded was not applicable. But Stanford Financial's policy had an unusual exclusion for money laundering—defined broadly as the use or possession of criminal property—which was not contingent on a final adjudication. The policy bars coverage if “it is determined” the policyholders “in fact” committed money laundering, but does not specify who makes that determination.

Judge must decide

Lloyd's and Arch argued they were entitled to make that determination and that they had done so based on the various SEC charges and Mr. Davis' admission. The executives, however, argued that a judge would have to make that decision.

The appeals court found that Texas law requires a judge to interpret ambiguities in a policy against an insurer where multiple interpretations are reasonable. The underwriters could have avoided the confusion, the court said, by explicitly stating in the policy that insurers could unilaterally withdraw coverage, but “a policy with such a draconian power (might be) difficult to sell.”

Instead, the court said, the “in-fact” determination must be made by a judge in a separate case. It remanded that question to the Southern District of Texas and asked that someone other than Judge Hittner, who is hearing criminal charges, rule in the coverage dispute. Any decision could be reconsidered if the executives are exonerated, the appeals court said.

“By the bargain, (the underwriters) are not compelled to remain aboard an aircraft that has lost its wings,” the court wrote in its decision. “Still...the judicial decision required by this coverage action remains subject to modification.”

Laura Pendergest-Holt et al. vs. Certain Underwriters at Lloyd's of London and Arch Specialty Insurance Co.; 5th U.S. Circuit Court of Appeals, No. 10-20069; March 16, 2010