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.