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Fraud case shows need for D&O priority clause

Alleged Ponzi leaders vie with company for coverage limits


DALLAS—The leaders of an alleged billion-dollar Ponzi scheme and the receiver of the now-bankrupt company are involved in a court battle that observers say illustrates the need for a directors and officers policy provision that has become more prevalent in recent years.

Federal authorities have accused R. Allen Stanford of operating Houston-based Stanford Financial Group Co. as a Ponzi scheme, bilking investors of more than $7 billion through fake certificates of deposit from a subsidiary bank in Antigua. Mr. Stanford and his alleged co-conspirators, who face lawsuits and criminal charges, say they need to tap the company's D&O policy to pay their attorneys; a court-appointed receiver says the bankrupt company's estate needs all proceeds of that policy to pay swindled investors and litigants. The case is being heard by the U.S. District Court for the Northern District of Texas in Dallas.

Stanford Financial's D&O policy, like many D&O policies, covers claims against the company and individual directors and officers, which can create conflicts when the corporation and individuals both face legal expenses and losses likely to exceed the policy limit.

Stanford Financial so far faces class action lawsuits alleging at least hundreds of millions of dollars in claims, while its insurers at Lloyd's of London have received indemnity requests from more than 60 former Stanford directors and officers, according to a brief filed by Stanford Financial receiver Ralph S. Janvey.

The Lloyd's policy offers at least $50 million in limits, Mr. Janvey's brief said.

To deal with these kinds of disputes, many D&O policies now have priority-of-payments provisions, which attempt to clarify the order in which the insurer will disburse funds in cases of competing claims. Stanford's policy does not have such a provision.

Observers say the provisions have become more prevalent in recent years, although such disputes are not new. Joshua Gold, an attorney and shareholder at Anderson Kill & Olick P.C. in New York, said such provisions were in about one of four policies five or six years ago; now he sees them in 80% or 90% of policies.

“D&O insurance companies have now become sensitive to the fact that, because they've made D&O policies more complicated over time and because they've added coverage (for the corporation), there is now some concern that all these different categories of insureds now have a claim to the (same) insurance proceeds,” he said. “This issue is only going to get bigger.”

Though some details vary, priority-of-payments provisions generally specify that when corporate and individual claims are likely to exceed the total policy limits, Side A claims—claims from individuals that cannot be indemnified, typically because the company is insolvent or legally barred from doing so—should be paid first.

The recent rise in bankruptcies and derivative litigation—the two primary drivers of Side A claims—make that kind of competing-claim scenario more likely. In addition, budgetary restraints prevent many companies from buying more limits, which elevates the importance of the order-of-payment provision, said Susanne Murray, a New York-based executive vp of executive risk at broker Alliant Insurance Services Inc.

“While you may be looking at the adequacy of your limits, most companies aren't buying more limits today,” Ms. Murray said. “Then what they're saying is, "If I'm not going to spend more money, how can I make what (insurance) I have provide me with the most protection?' “

Order-of-payments provisions come with some problems. Most such clauses provide instructions for insurers on how to handle competing claims likely to exceed the policy limits but do not specify what person or group determines if that is likely to happen, Mr. Gold and Ms. Murray said. Mr. Gold said many of the clauses are “inadequate and ambiguous.”

“Right now, it looks to me like a half-hearted attempt to kind of throw some provision in there without really exploring how the language is going to be interpreted and invoked in these kinds of situations,” Mr. Gold said.

Adding to the confusion is the fact that courts have differed on whether a bankrupt estate can claim the entire proceeds of a company's D&O policy, and they rarely have ruled on priority-of-payments clauses specifically, legal observers say.

In a 2002 case involving Enron Corp., the bankruptcy court allowed a D&O insurer to pay legal costs for former executives of the failed energy company because of a priority-of-payments provision, said William A. Boeck, a Kansas City-based senior vp and insurance and claims counsel at Lockton Financial Services.

“They have not been rigorously tested in the courts,” Mr. Boeck said. “Where there's a dispute over an insurer's ability to pay (Side A) loss, you end up litigating it within the bankruptcy (court). There are cases going both ways.”

Mr. Gold, who said he has been involved in several such disputes, said a court will rule on the issue eventually, whether that is in the Stanford Financial case or another case.

“Oftentimes that gets argued and negotiated before it ever reaches the court, but it will happen,” Mr. Gold said. “You'll take one of these nightmare scenarios like a Madoff or Stanford or Enron and ultimately people are going to start saying, "I've got no option but to have a judge or jury decide it.'”

Lloyd's had agreed to advance defense costs to former Stanford Financial Chief Investment Officer Laura Pendergest-Holt until Mr. Janvey wrote Lloyd's in June arguing that all of the D&O policy proceeds belonged to the Stanford Financial receiver.

Ms. Pendergest-Holt asked the U.S. District Court to clarify the situation, and Mr. Stanford and other former executives joined that motion. Ms. Pendergest-Holt's attorney has threatened to leave the case over $500,000 in unpaid expenses. Mr. Stanford is being represented by a public defender after other attorneys left his case over lack of payment.

In a brief, Lloyd's said it reserved the right to deny coverage to the estate or the former directors based on policy exclusions for being convicted of money laundering, fraud or other criminal acts.