All Aboard! Accused Fraudster Allen Stanford Rides the D&O Train, Courtesy of Lloyd's

(MoneyWatch)  It's never a good sign for the prosecution when the judge starts weeping for the defendant. But the case of R. Allen Stanford, who stands accused of masterminding a $7 billion investor-fraud scheme, could fare even worse for the insurance industry.
Insurers such as Chubb, Ace and American International Group provide Directors and Officers insurance, in shorthand, "D&O." Its purpose is to protect corporate board members, chief executives and other top officials who can be subjected to malicious lawsuits. Their companies buy it for them so they'll be productive and happy.

But insurers aren't stupid. They always include a clause that says if the insured knowingly commits fraud or other crimes, the policy is void.

Stanford made headlines when his Stanford Group Co. allegedly bilked investors using an Antigua-based bank that also bore his name. In February the court froze more than $2 billion in assets following a Securities and Exchange Commission lawsuit.

A shame for Stanford, but even more so for his high-priced lawyers, including Houston criminal attorney Dick DeGuerin and Robert Luskin of Washington-based Patton Boggs. When they begged off the case Stanford was forced to accept the common man's representation: public defender.

But this week U.S. District Judge David Godbey took pity on the one-time billionaire. No, he didn't unfreeze his assets. Instead, he laid Stanford's legal fees on the doorstep of the insurer who provided the alleged fraudster with his D&O policies, Lloyd's of London. Lloyd's will have to come through with up to $50 million for Stanford & Co.'s management, and the potential cost could reach as high as $90 million.

One could say Godbey made a bad decision. Most insurers would. But the Stanford case isn't the only one where a judge has taken insurance companies to the cleaners and ignored the fact that those who bought this insurance may have knowingly committed crimes before they did.

Earlier this month class action attorney Milberg LLP won its case against Lloyd's, Zurich and Ace. The law firm collected $4.8 million, despite the fact that its principals, including four partners, had committed fraud between 1978 and 2005, indicating that Milberg knowingly lied on its application for professional liability coverage.

Obviously courts and lawyers view insurers as deep pockets that they can dip into whenever alleged criminals can't pay. As for insurers, they may want to rethink their D&O coverage as they teeter on the edge of this judicial sinkhole.