In the following guest post, Peter Selvin and Ben Clements take a look at the legal principles involved in the allocation of defense expense under a D&O insurance policy. Peter Selvin is a member of TroyGould PC, and Ben Clements is an associate at the firm. I would like to thank Peter and Ben for allowing me to publish their article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this site’s readers. Please contact me directly if you would like to submit a guest post. Here is Peter and Ben’s article.
Lawsuits involving directors and officers often include claims or parties covered by a D & O policy, as well as claims or parties the D & O carrier deems to be uncovered. Frequently, these policies include allocation provisions directing the carrier and insured to use their “best efforts” to allocate defense costs incurred in an underlying lawsuit.
In coverage disputes, carriers commonly argue that such provisions limit their obligation to fund these costs. Indeed, the general utility of an allocation provision is its ability to delimit the scope of a carrier’s liability. For this reason, at least one court has characterized an allocation provision as “in effect a partial exclusion of the insurer’s liability.” Owens Corning v. Nat’l Union Fire Ins. Co. of Pitt., 257 F.3d 484, 493 (6th Cir. 2001).
With time, “best efforts” provisions have evolved, often in response to court decisions resolving such arguments. See, e.g., In re WorldCom, Inc. Sec. Litig., 354 F. Supp. 2d 455, 466 & n.12 (S.D.N.Y. 2005) (liability policy requiring D & O carrier to advance defense costs prior to the final disposition of a claim “is an explicit repudiation of prior law”). In this evolving landscape, it is therefore important to remember a key principle: the language of the policy controls. See Nordstrom, Inc. v. Chubb & Son, Inc., 54 F.3d 1424, 1432 (9th Cir. 1995) (“[W]e consider the particular policy in question to determine which rule best effectuates the reasonable expectations and intentions of the parties under the insurance contract.”).
For example, the Ninth Circuit has held that a “best efforts” allocation provision “‘requires an allocation analysis,’ but not necessarily an allocation.” Safeway Stores, Inc. v. Nat’l Union Fire Ins. Co., 64 F.3d 1282, 1289 (9th Cir. 1995); accord Silicon Storage Tech., Inc. v. Nat’l Union Fire Ins. Co., 2015 WL 7293767, at *6 (N.D. Cal. Nov. 19, 2015); see also Nat’l Bank of Cal. v. Progressive Cas. Ins. Co., 938 F. Supp. 2d 919, 936 (C.D. Cal. 2013) (finding genuine issue of material fact whether D & O carrier undertook allocation analysis required by policy). Some courts, however, have held that a “best efforts” provision may mandate an allocation in the circumstances. See, e.g., Endurance Am. Specialty Co. v. Lance-Kashian & Co., 2011 WL 5417103, at *25 (E.D. Cal. Nov. 8, 2011) (finding that provision stating “there must be an allocation between insured and uninsured Loss” “mandates an allocation under the circumstances here”).
Likewise, “best efforts” provisions sometimes incorporate the “relative legal exposure” rule as the contemplated method of allocation. See, e.g., Dobson v. Twin City Fire Ins. Co., 2015 WL 12698443, at *9 (C.D. Cal. Aug. 5, 2015) (holding that allocation provision specifying “relative legal exposure” rule controlled over default rule). Under this rule, allocation generally concerns “the relative exposures of the respective parties to the [suit].” PepsiCo, Inc. v. Cont’l Cas. Co., 640 F. Supp. 656, 662 (S.D.N.Y. 1986). Often, these allocations turn on “some notion of relative fault.” Id.
But this was not always the case. And even today there exist D & O policies that do not specify a particular allocation method. In this circumstance, the nature of the analysis will depend on the law of the forum.
In the Ninth Circuit, the “reasonably related” rule remains the default test for allocating defense costs under a D & O policy. Under that rule, a D & O policy covers defense costs that “are reasonably related to the defense of the insured [parties], even though they may also have been useful in defense of the uninsured [parties].” Safeway Stores, 64 F.3d at 1289; see also Raychem Corp. v. Fed. Ins. Co., 853 F. Supp. 1170, 1182 (N.D. Cal. 1994). This rule applies, not only where there are covered and uncovered parties, but also to allocate costs among covered and uncovered claims. See Pan Pac. Retail Props., Inc. v. Gulf Ins. Co., 471 F.3d 961, 970-71 (9th Cir. 2006) (“Appellants must show that the expenses at issue were related to claims that actually fell within the basic scope of coverage.”).
The following scenario illustrates the breadth of the “reasonably related” rule. In a lawsuit against a company and its Ds and Os, a single firm represents both sets of defendants. Counsel must represent one of the Ds and Os at his or her deposition, but the policy covers only the company, not the Ds and Os. May the carrier insist that counsel allocate its time as between the defense of the (insured) company and the (uninsured) Ds and Os?
The answer should be no, in part because the company’s potential liability derives from the acts or omissions of its Ds and Os. See Safeway Stores, 64 F.3d at 1287-89. Deposition testimony by the (uncovered) D and O will be germane to the liability of the (covered) company. Therefore, counsel’s attendance at the deposition, and representation therein of one of the Ds and Os, is “reasonably related” to the defense of the company. This is because it is often impossible, especially before resolution of the underlying matter, for counsel or the carrier to differentiate work done strictly on behalf of the company from work done on behalf of the Ds and Os.
The decision in Acacia Research Corp. v. National Union Fire Ins. Co., 2008 WL 4179206 (C.D. Cal. Feb. 8, 2008) makes this point. There, Nanogen sued Combimatrix and its officer, Montgomery, alleging that Montgomery stole Nanogen’s technology. After settling with Nanogen, Combimatrix sued its D & O carrier for reimbursement of settlement and defense costs incurred in the Nanogen action, arguing that the costs incurred provided a common defense to (covered) Combimatrix and (uncovered) Montgomery. Id. at *1-2.
The Court held that “[b]ecause the wrongful acts alleged in the underlying action all involved the alleged wrongful acts of Montgomery, no allocation of defense costs between Combimatrix and Montgomery is needed.” Id. at *10. In other words, the costs incurred to defend the uncovered party (Montgomery) were necessarily related to the defense of the covered party (Combimatrix).
In reaching this conclusion, the Court cited testimony from Combimatrix that defense counsel “was divided by issues, not by parties.” Id. at *4. The company’s general counsel testified that counsel defended “‘both Combimatrix and [Montgomery],’” and that it was not possible “‘to discern between the defense of the two.’” Id. Defense counsel confirmed that he was “‘responsible for the patent law and trade secret law aspects of the case, and also the development of the facts relating to the technology . . . both for my client and . . . Montgomery.’” Id. Thus, because all defense costs arose out of a single and joint defense, allocation was inappropriate.
Courts in the Second Circuit have followed a similar approach to allocation. For example, at issue in Doran Jones, Inc. v. Per Scholas, Inc., 2017 WL 2197100 (S.D.N.Y. May 2, 2017), was Doran Jones’s obligation to indemnify a former officer, Klain, for claims based on his conduct as an officer of the company. The Court concluded that the company’s corporate charter required it to advance Klain’s defense costs on a current basis and rejected Doran Jones’s attempt to allocate those costs among claims based on Klain’s “individual obligations” and those arising from his official duties as an officer. Id. at *7-8. Given the “intertwined nature” of the claims, which were “premised on the same factual allegations,” the Court reasoned that permitting allocation would put form over substance. Id.
If, in the context of a “best efforts” provision, the parties’ best efforts fail to produce an agreement on allocation, the issue often arises whether the carrier must advance costs on a current basis in the underlying litigation and, if so, whether those advanced costs may be allocated.
Relevant here is the D & O carrier’s obligation to contemporaneously pay the insured’s defense costs as they come due. In both Okada v. MGIC Indemnity Corp., 823 F.2d 276, 280-82 (9th Cir. 1986) and Gon v. First State Insurance Co., 871 F.2d 863, 868-69 (9th Cir. 1989), the Ninth Circuit affirmed the “contemporaneous payment” rule, which directs a D & O carrier to fund an insured’s ongoing defense costs.
The policies in those cases were liability policies, not indemnity policies, a key distinction. “In D&O policies, there is generally no duty to defend clause. Instead, defense costs are defined as part of ‘Damages’ for which indemnification is to be paid.” Health Net, Inc. v. RLI Ins. Co., 206 Cal. App. 4th 232, 259 (2012). But not all D & O policies are reimbursement policies. Some are liability policies, which obligate insurers “to pay [the insured’s] defense costs as soon as they were incurred.” Millennium Labs., Inc. v. Allied World Assurance Co., 726 F. App’x 571, 574 (9th Cir. 2018). Thus, identifying the type of policy at issue is critical to determining whether a carrier is obligated to contemporaneously fund defense costs.
Of course, the parties may also agree there is no duty of contemporaneous funding. That scenario was illustrated in Commercial Capital Bankcorp v. St. Paul Mercury Insurance Co., 419 F. Supp. 2d 1173 (C.D. Cal. 2006), where the policy stated that, absent an agreed-upon allocation, “‘the Insurer shall advance on a current basis Defense Costs which the Insurer believes to be covered under this Policy until a different allocation is negotiated, arbitrated or judicially determined.’” Id. at 1177. The Court held that this language signified that the parties may “contract out” of the default rule and provide for a different funding mechanism. Id. at 1181.
If there is an obligation to advance defense costs on a current basis, any allocation before resolution of the underlying suit may likely be premature. Indeed, Gon declared that carriers should exercise restraint in attempting to limit or allocate the costs they pay on a contemporaneous basis. 871 F.3d at 869. The Court reasoned that “apportioning legal expenses where coverage is not yet clear, because the facts are not fully developed, may deny the insureds the benefits of the protection they purchased.” Id.; see also St. Paul Fire & Marine Ins. Co. v. Scopia Windmill Fund, LP, 2015 WL 5440694, at *13-14 (S.D.N.Y. Sept. 9, 2015) (construing “best efforts” provision as “designed to ensure that defense costs are advanced, instead of paid after the fact, even when the parties disagree about allocation”).
This reasoning should control unless the policy provides otherwise. “D & O insurance is not only designed to provide financial security for the individual insureds, but also plays an important role in corporate governance in America. Unless directors can rely on the protections given by D & O policies, good and competent men and women will be reluctant to serve on corporate boards.” In re WorldCom, Inc. Sec. Litig., 354 F. Supp. 2d at 469. This basic tenet should drive the analysis in circumstances where allocating advanced costs is at issue. By arguing for allocation of contemporaneous funding, a D & O carrier that declined to bargain for policy language permitting such an allocation deprives the insured of the policy’s full benefits. See id. at 469 (holding that the “failure to receive defense costs when they are incurred constitutes ‘an immediate and direct injury’” that deprives insureds of the “‘protection from financial harm that insurance policies are presumed to give’”).