One of the increasingly critical features of the current D & O claims environment is the growing likelihood of disputes arising over defense fees. A June 20, 2007 decision in Delaware Superior Court for New Castle County in connection with coverage litigation arising out of the Hollinger International claims reflects many of the recurring aspects of these disputes and underscores the growing significance of issues surrounding defense fees.

The insurance coverage case in Delaware was brought by Sun-Times Media Group, the successor in interest to Hollinger International (hereafter, referred to herein as Hollinger), and by nine former outside directors of Hollinger. During the relevant period, Hollinger had purchased a total of $130 million in D & O insurance. The $130 million was arranged in four basic layers. The first two layers totaled $50 million. The third layer consisted of $40 million excess of $50 million, and the fourth layer consisted of $40 million excess of $90 million.

As a result of the now infamous corporate scandal involving Lord Conrad Black and several other Hollinger insiders (including David Radler, Hollinger’s former President, Chief Operating Officer and director, who ultimately pled guilty to participating in a scheme to defraud Hollinger’s shareholders), Hollinger shareholders filed a number of lawsuits against Hollinger, its corporate parents, the insiders, and the outside directors, Among the lawsuits was a shareholder derivative suit filed on Hollinger’s behalf in the Delaware Court of Chancery by Cardinal Value Equity Partners. Shareholders also filed several securities class action lawsuits, later consolidated, in Illinois (about which refer here).

The Cardinal derivative lawsuit settled in May 2005 (refer here). As part of the settlement, the carriers in the first two layers of the Hollinger D & O insurance program agreed to pay a total of $50 million, exhausting all of the insurance below the third layer in the Hollinger D & O insurance program.

In November 2006, Hollinger and the nine outside directors initiated a declaratory judgment action in Delaware Superior Court against the third layer insurers, who had denied coverage for the Illinois Class Action. Hollinger has been funding the outside directors ongoing litigation costs in the Illinois Class Action. In the coverage action, Hollinger and the outside directors, who are the plaintiffs in the coverage action, claim to have “incurred over $20 million (and expect to incur over $40 million) in defense costs” in defending the various shareholder lawsuits. The plaintiffs in the coverage action filed a motion for partial summary judgment seeking an order declaring that the third layer insurers have a duty to pay the coverage action plaintiffs’ past and future defense costs in the Illinois Class Action.

Although the defendant insurers opposed the motion on a number of grounds, the most substantial ground was based on the conduct exclusions in the operative policy language. The carriers argued that because Hollinger is advancing the outside directors’ fees, only Hollinger has a “ripe claim” for reimbursement of defense costs. The carriers further argued that Hollinger was not entitled to recover amounts it had incurred in defense of itself and others, because of Radler’s guilty plea. The defendants argued that the operative policy language imputed Radler’s conduct to Hollinger and triggered the conduct exclusions.

Specifically, the carriers argued that Hollinger was not entitled to defense cost coverage because coverage is precluded under the personal profit exclusion and the fraud/dishonesty exclusion. They argued that Radler’s fraudulent and dishonest acts are imputed to Hollinger under the operative policy language, relieving the carriers from their duty to advance defense fees. The carriers further argued that because Hollinger is paying their fees, the outside directors have no present claim to recover their fees from the defendants.

In its June 20, 2007 opinion (here), the Court quickly moved past preliminary issues to find that the defendants were obligated to advance both Hollinger’s and the outside directors’ defense costs. The Court ruled that because the Illinois Class Action is within the D & O policies’ coverage and “potentially could result in indemnity, the duty to advance is triggered.” With respect to the outside directors, the Court reasoned that “the fact that [Hollinger] has paid some or all of the costs does not relieve the Third Layer Insurers from their duty under the policy to address defense costs.” The Court held that the fraud implicit in Radler’s guilty plea could not be imputed to the outside directors under the policy’s imputation language.

The Court further held that the conduct exclusions did not preclude advancement of defense fees for Hollinger, notwithstanding the possible imputation to Hollinger of Radler’s misconduct. The Court found that the Policy “contains an unequivocal duty to advance defense costs prior to the final disposition of a claim.” The Court ruled that

the personal exclusions do not override a present contractual duty to advance defense costs unless the Defendants can unequivocally now show that all of the allegations in the Illinois Class Action complaint fall within the personal conduct exclusions. Defendants have failed to show at this juncture that any of the exclusions are definitely imputed to [Hollinger] Even though the Defendants argue that Radler’s guilty plea imputes the transactions to [Hollinger], the Illinois Class Action includes transactions that were not part of Radler’s guilty plea….Because the Defendants have failed to show at this time the applicability of the exclusions to [Hollinger], the Court need not decide the potential applicability of the exclusions at this time.

Finally, the Court noted that the Policy “provides that the Insured must pay back amounts they received but were not entitled to.” The Court reasoned that because of this repayment provision, “the plain language of the policy guaranteeing an advancement of defense costs is not precluded by any implication of exclusions” to Hollinger. The Court quickly disposed of the carriers’ other coverage objections, and granted the coverage plaintiffs’ partial motion for summary judgment on the duty to pay defense costs.

This ruling is clearly just the first of several rounds. Among other things, the July 13, 2007 convictions of Conrad Black and the other insider defendants (refer here) adds relevant facts and underscores the need for the court to address the potential imputation to Hollinger of the criminal misconduct and the consequences for the ultimate coverage determination. There will eventually have to be a day when the convictions and the guilty plea will have to be compared and contrasted with the allegations in the Illinois Class Action to determine what is covered and excluded, and it is entirely possible that some portion (if not all) of the defense fees the court ordered to be advanced in the June 20 opinion will have to reimbursed to the carriers.

The Court’s relative ease in reaching its conclusions was, it must be noted, substantially enhanced by the Court’s willingness to overlook certain considerations raised by the policy’s other terms and conditions. The Court clearly was not concerned to differentiate whether Hollinger sought reimbursement under Side B of the policy for amounts for which it had indemnified the directors and officers, or under Side C for amounts the company had incurred directly in its own defense. The Court’s analysis of the carriers’ obligation to advance the outside directors’ defense fees was unaffected by any analysis whether the outside directors’ direct coverage under Side A of the policy had even been triggered, given that the outside directors are being fully indemnified by Hollinger. The Court was unconcerned by the possibility that even if Radler’s guilty plea, as imputed to the Company, did not preclude coverage for all of the claims in the Illinois Coverage Action, it might preclude coverage for some of the claims- the fact that amounts paid that were not owed must be repaid apparently was sufficient for the Court.

In effect, the Court held that the policy does not require an allocation between covered and uncovered claims until it is possible to make the final and ultimate allocation determination, and in the interim the policyholder (rather than the carriers) gets to hold the stakes. There is a rough sort of justice to this outcome, without regard to what the Court did or did not have to say about the policy’s other requirements and provisions.

Even if the Court’s disinterest in certain features of the policy may make the opinion less instructive, the case itself nevertheless is important in larger respects, for what the underlying dispute signifies about important issues in the D & O claims context.

The first of these larger aspects is that the present dispute arises between the insureds and the excess carriers, after the underlying carriers apparently have already acknowledged and provided coverage. The existence of active coverage disputes with excess carriers after the underlying carriers have acknowledged coverage is becoming unfortunately more common. Just to mention a couple of examples, the CNL Resorts case (here) and the Conseco case (mentioned in the CNL Resorts post) both involved disputes between insureds and excess insurers after the underlying carriers had already recognized coverage. The increasing willingness of excess carriers to assert or stand upon coverage defenses that underlying carriers had not maintained is a potentially troublesome development.

To be sure, the excess carriers’ position in the Hollinger dispute may ultimately prove to be valid and I do not mean to suggest that there is anything questionable about their positions in that case. Given the significant level of criminal misconduct involved, the excess carriers’ position is certainly understandable. But in general, the phenomenon of excess carriers disputing coverage when underlying carriers do not could disrupt to efficient claims resolution. At a minimum, claims resolution becomes substantially more contentious and litigious, in a way that is contrary to the reasonable commercial expectations of insurance buyers at the time they enter into the insurance contract. Insurance buyers who purchase a multilevel program of insurance certainly do not expect to have to fight their way through each successive layer.

Another larger concern is the sheer magnitude of attorneys’ fees that increasingly are required to defend D & O claims. Without a doubt, the Hollinger claim is unusually complex, and given the criminal misconduct involved, unusually serious. The accumulation of as much as $40 million in attorneys’ fees is nevertheless arresting. Moreover, there are all too many other cases these days that do not involve near the complexity or seriousness of the Hollinger claims in which defense counsel are earnestly working to achieve the same level of defense expenditure, or as close to it as they can get. The astonishing acceleration of defense expense is one of those facts that everyone recognizes but that no one is willing to say or do anything about. The astronomical level of defense fees represents a serious problem for every participant in the claims process (except perhaps the defense attorneys themselves). The reality is that the rapid escalation of defense fees all too often may threaten to leave policyholders uninsured or underinsured for the costs ultimately required to resolve claims.

I would argue that the most significant challenge for the D & O industry right now is the dramatic increase in defense fees. (An earlier post on this same topic can be found here.) The increasing level of defense fees creates difficulties at every stage of the insurance transaction, from contract formation, when the specter of escalating fees makes limits selection increasingly challenging, to the claims process, when escalating fees complicate efficient claims resolution (and perhaps may be the real reason behind the increase in disputes with excess carriers). Moreover, the accumulated cost of escalating defense expense is undoubtedly a significant factor working against further reductions in the levels of D & O premiums.

As is well explained in a recent article (here) by noted D & O commentator Dan Bailey, controlling defense expense is in everyone’s interests, in order to maximize the protection available under the D & O insurance program. To be sure, that does not imply that carriers are justified in resisting payment for reasonable and necessary expenses that policyholders rightfully expect carriers to pay. But everyone in the industry has an interest in the development of mechanisms and controls to ensure that claims defense goes forward in the most efficient and cost effective way. Defense expenditures that exhaust or substantially deplete the available insurance are a problem for all concerned.

Very special thanks to Francis Pileggi of the Delaware Corporate and Commercial Litigation blog (here) for providing a copy of the June 20 opinion.

SOX Anniversary: The approaching fifth birthday of the Sarbanex-Oxley Act has already been the subject of extensive commentary; for example, it is the cover story of the July 2007 issue of CFO Magazine (here). The Audit Trail blog (here) wants to celebrate as well as observe the anniversary. Its site not only displays a running SOX birthday countdown clock, but also features a SOX birthday music video. The site even allows you to send a SOX anniversary eCard (here) to that special someone in your life. The next thing you know, there will be SOX anniversary decorations for sale at Wal-Mart.