HOUSTON—A federal judge soon will decide whether directors and officers liability insurers must continue to pay the legal bills for executives accused of running one of the nation's largest Ponzi schemes.

U.S. District Court Judge Nancy Atlas heard arguments last week in Laura Pendergest-Holt vs. Certain Underwriters at Lloyd's of London in U.S. District Court for the Southern District of Texas.

Federal indictments have accused R. Allen Stanford and three other executives of running Houston-based Stanford Financial Group Co. as a $7 billion Ponzi scheme. The company and its executives have $100 million in D&O coverage, but the underwriters—Lloyd's of London syndicates and Arch Specialty Insurance Co.—say the coverage should be void because of a money laundering exclusion in the policies.

Before the start of the three-day trial last week, former Stanford Chief Financial Officer Laura Pendergest-Holt settled with the underwriters, the judge said.

Attorneys for Mr. Stanford and other executives have said they would have to leave the case if they could not secure payment from the underwriters. Stanford's court-appointed receiver has argued that the $100 million D&O tower is property of the bankrupt estate and should be used instead to compensate bilked investors.

D&O insurers typically advance defense costs to policyholders. Most policies exclude fraud, but most such exclusions are triggered by “a final adjudication,” and cases typically settle before reaching a final court decision.

But Stanford's D&O policies had an unusual exclusion for money laundering, defined broadly as the use or possession of criminal property. That provision is triggered not by a final adjudication but when “it is determined” the policyholder “in fact” committed money laundering, without specifying who would make that determination.

The 5th U.S. Circuit Court of Appeals ruled in March that a district court must make that determination and that the underwriters must pay defense costs until then.

But, in sending the case to Judge Atlas, the appeals court set up an unusual scenario: The underwriters are presenting evidence against their own policyholders while the executives decline to testify because of the civil and criminal trials set to begin early next year.

“I find it staggering that the 5th Circuit allowed this to happen,” said Ann Kramer, a New York-based insurance recovery attorney and partner at Reed Smith L.L.P. “The policyholder (has) to plead the Fifth—you can't engage in a trial like this before your criminal case. Normally, the coverage case is stayed, the duty to defend is honored and then after the matter at hand—whether product liability or a criminal case—you get to (insurers') rights.”

Two forensic accounting experts testified last week that Stanford executives reverse-engineered financial information and intentionally over-valued a land purchase to hide losses. They also said Stanford's bank in Antigua loaned $3.5 billion to Mr. Stanford and the company without proper disclosure. Defense attorneys argued that such misbehavior was perpetrated by James M. Davis—Stanford's ex-finance chief, who pleaded guilty last year and is cooperating with prosecutors—and without the knowledge or consent of the three executives under indictment.

Ms. Kramer said she was concerned about other courts opting to hear coverage disputes before criminal or civil trials.

“Insurers will latch onto this and use it in far less (extreme) cases, and it will be precedent and it will be very bad for policyholders if it's followed by anybody,” Ms. Kramer said. “It should be a wake-up call to everybody in this business to be careful about what kind of D&O policies they're buying.”

Judge Atlas told attorneys not to expect an immediate decision.