A federal judge ruled that, under a professional liability insurance policy, an insurer had to keep advancing to hedge fund managers their costs of defending themselves against parallel SEC and federal criminal investigations into alleged insider trading until a judicial decision on the insurer’s request for declaration that, under the prior knowledge exclusion, the insurer had no duty to cover any of the hedge fund manager’ costs in defending the Government actions. XL Specialty Insurance Company v. Level Global Investors, L.P., SD NY, No. 12 Civ. 1598, June 13, 2012.
As publicly reported, these steps were part of a broad criminal investigation into alleged insider trading within the securities industry. As described in news reports, the Government was investigating allegations that hedge funds, mutual funds, and other financial firms had obtained material inside information regarding public issuers, including from so-called expert networks or third-party consultants, and traded on this information, in violation of the federal securities laws.
The court found that if the insurer is not directed to resume paying their defense costs the hedge fund managers are likely to suffer extreme or very serious damage, the highest of the standards the Second Circuit uses to measure irreparable harm. The insureds are confronted by criminal charges, noted the court, and the termination of payment came at a critical juncture for the defense. As of the time that the insurer ceased paying their legal fees, the insureds were each either the subject of a broad and ongoing criminal investigation, or, in the case of one of them, an indicted defendant awaiting trial. Noting that, to date, the Department of Justice's investigation into insider trading on Wall Street has resulted in the indictments of nearly 60 people, the court found that the Government actions present a real risk, not only of monetary liability, but also of prosecution and a loss of liberty. Moreover, the parallel SEC investigation may result in serious civil charges presenting the added risk of serious regulatory sanctions, including a potential bar from the securities industry.
In addition, the charges in the complex underlying matters are by their nature unusually costly to defend against. A diligent defense counsel can be expected to investigate numerous potential defenses when the client is facing charges of alleged insider trading, including whether information about the security was communicated to the client in advance of the particular trade; whether that information was material; whether it was non-public, as opposed to known or fairly ascertainable through legitimate means; and whether it had been obtained by the expert network or other third-party intermediaries in breach of a duty.
The court also found that the insureds demonstrated that there are sufficiently serious claims going to the merits on the question of whether the prior knowledge exclusion in the policy, based on an unsealed allocution by mid-level research analyst at the hedge fund, is ambiguous as applied here. The hedge fund managers correctly stated that the carrier's construction would put insureds in jeopardy of losing the insurance protection for which they bargained because they could, as here, suddenly lose their professional liability coverage deep into a litigation if it later came to light that a renegade employee had once engaged in, but never disclosed, misconduct that gave rise to the litigation. The court noted that the carrier’s position is that if anyone insured under a policy like the one at issue here, even a secretary in a corporation with thousands of employees, knows of facts that might give rise to a valid claim, then coverage is barred for all other insureds even though none of them knew, should have known, or even could have known such facts.