E&O/Professional Liability » Court Construes Fraud Exclusion In Favor of Insureds

Professional liability policies often exclude coverage for certain conduct of the insured - e.g., criminal, intentional, malicious, fraudulent acts, etc. - but provide that the exclusion is not applicable until it is established that such conduct has occurred. The wording of this exception can be critical because it can determine whether an insurer has an obligation to fund defense costs through trial. For example, some policies provide that such conduct must be established by "final adjudication" for the exclusion to apply, while others provide that it must be established "in fact", by "admission or plea" or some other standard. On March 15, 2010, the Fifth Circuit issued an important interpretation of this wording in a case involving D&O policies applicable to executives of Stanford Financial Group, who face criminal and civil charges for allegedly defrauding investors in a $7 billion Ponzi scheme centered around certificates of deposit issued by Stanford's Antiguan bank. See Pendergest-Holt v. Lloyd's of London, et al., No. 10-20069 (5th Cir. Mar. 15, 2010).

The policies had a fraud exclusion, which excluded any "Claim .... brought about or contributed to in fact by ... any dishonest, fraudulent or criminal act or omission by the Directors or Officers or the Company ... as determined by a final adjudication." The policies also had a separate money laundering exclusion, which was worded differently. That exclusion barred coverage for loss (including defense costs) resulting from any claim "arising directly or indirectly as a result of or in connection with any act or acts (or alleged act or acts) of Money Laundering," but then stated that "Underwriters shall pay Costs, Charges and Expenses in the event of an alleged act or alleged acts until such time that it is determined that the alleged act or alleged acts did in fact occur" (emphasis added).

One of the defendants struck a plea deal, and the insurers took the position that money laundering had "in fact" occurred and that coverage for defense costs would be discontinued. (They conceded that the separate fraud exclusion had not been triggered.) The other insureds sued, seeking an injunction requiring the insurers to pay their defense costs pending a judicial determination as to whether money laundering had "in fact" occurred. The Fifth Circuit sided with the insureds, rejecting the insurers' claim that they had the right to make the "in fact" determination unilaterally. The court decided that the "in fact" determination should be held in a separate coverage proceeding.

In light of this decision, insurers and insureds may be more focused on the wording of applicable coverage exclusions and the procedure that needs to be followed by an insurer seeking to invoke such an exclusion. It also highlights the danger that an executive could be left without D&O coverage precisely at the time it is most critical.