(Reuters) – A Manhattan federal judge has ordered an insurer to keep advancing legal fees of a hedge fund implicated in a criminal insider trading probe, saying the insurer was not excused because a fund analyst knew there might be a fraud when the policy was taken out.

Wednesday’s decision by U.S. District Judge Paul Engelmayer is a defeat for XL Specialty Insurance Co, which had sought to rescind its $10 million policy for Level Global Investors LP and recoup more than $7.3 million already advanced, including to co-founder Anthony Chiasson.

Lawyers involved with the hedge fund industry have said a ruling favoring XL could have forced hedge funds to review their insurance policies. Level Global had claimed it would cause irreparable harm.

The case stemmed from a secret April 2011 guilty plea by former Level Global analyst Spyridon Adondakis, who unbeknownst to XL and Level Global admitted to fraud over activities that predated the policy and had begun cooperating with prosecutors.

XL, a unit of Dublin, Ireland-based XL Group Plc, said this triggered a policy exception that excused it from providing coverage for the Greenwich, Connecticut-based fund.

Level Global countered that the fund’s general counsel, who signed the policy application a year earlier, did not know about any alleged wrongdoing, despite having made an appropriate internal inquiry prior to signing.

In a 46-page decision, Engelmayer said the defendants raised “sufficiently serious” claims that XL’s interpretation of its exclusion was improper and would deprive them of the coverage for which they bargained.

Engelmayer also said “the balance of hardships tips, not only decisively but lopsidedly” in favor of coverage.

The judge said XL’s maximum remaining exposure was just $2.7 million, while the defendants might lose access to coverage in an amount several times larger.

“From a human perspective, they stand to lose much that is far more consequential, including their liberty,” he wrote.

Engelmayer delayed his order for 14 days, to give XL a chance to appeal. The specialty insurance unit has offices in Stamford, Connecticut.

XL spokeswoman Christine Weirsky declined to comment, citing the ongoing litigation.

James Sottile, a lawyer for Level Global, said: “We are gratified about this victory and were also pleased that XL’s attorney told the court the insurance company does not claim in this case that Level Global did anything wrong.”

At a court hearing last month, a lawyer for XL said that XL was not suggesting that Level Global committed any fraud, or did anything wrong in its application. Instead, the policy exception put Level Global on notice that it could lose coverage if an insured party knew of a fraud that later resulted in a lawsuit, the lawyer said.



Lawyers and people familiar with hedge fund insurance said they were surprised by XL’s stance and said the case had caused hedge fund managers to question their own policies and insurers.

“XL must have thought they had misrepresentation from the insured at a very high level in order to deny coverage — they must have thought they have ‘the smoking gun,’” said Richard Canter, president ofSKCG Group in White Plains, New York, which specializes in hedge fund insurance.

Hedge funds are already facing greater U.S. regulatory scrutiny and have been at the center of a wide-ranging federal insider trading probe that has since October 2009 resulted in criminal charges against several dozen people.

Prosecutors in January accused Chiasson and six others, who collectively worked at five hedge funds, of forming a “circle of friends” that reaped a $62 million profit from inside tips on computer maker Dell Inc.

Four of the seven defendants in that case have pleaded guilty. Chiasson has pleaded not guilty.

Level Global no longer manages money, but still exists for legal matters surrounding Chiasson’s case.

Canter said XL is large enough to afford to lose some insurance business from hedge funds “as long as they think they have sent a message to the hedge fund industry: that hedge funds can’t misrepresent themselves on their applications.”

The case is XL Specialty Insurance Co v. Level Global Investors LP et al, U.S. District Court, Southern District of New York, No. 12-01598.