Filed Under:Markets, E&S/Specialty

Escalating D&O Defense Costs Fuel Disputes Between Carriers, Insureds

Securities class actions, and to a somewhat lesser extent shareholder derivative litigation, have historically presented the largest class of claims exposures to directors and officers liability insurers.

Defense expenditures frequently exceed $1 million in these litigations that are not subject to an early dismissal or settlement, and often extend into the tens of millions of dollars in the more protracted actions. In the so-called "mega cases," such as Enron, defense expenses have even topped the $100 million--a threat to exhaust most, if not all, available excess layers in a typical tower of insurance.

There is little in the way of hard data in this area, but it is not unusual for something in the range of 15-to-20 percent of D&O insurance loss dollars spent in securities litigation to be attributed to defense expenses. In the Enron situation, over 35 percent of the available D&O limits were exhausted by defense payments.

Insurance policy language generally gives little practical guidance as to what defense expenses must be paid by the insurer, generally referencing solely an obligation on the part of the insurer to pay "reasonable and necessary" defense expenses.

Insurer litigation management guidelines may be of some assistance, but their enforceability is frequently disputed by insureds and their counsel.

Although there are occasionally disputes over the reasonableness of rates, many skilled securities litigation firms can command rates for the most senior partners at $750 per hour and higher.

Other areas of dispute may lie in whether multiple counsel are necessary in the absence of clear and present conflicts of interest, and whether certain items are more coverage related, and thus not covered defense expenses.

Putting those specific areas of dispute aside, perhaps the most vexing problem in this area is inherent in the insurance structure itself.

The program structure varies according to the size of the risk, but many public companies will bear a self-insured retention of at least a few hundred thousand dollars and then layers of primary and excess insurance which can range anywhere from $1 million or $2 million to as high as $25 million per layer. Layers of $5 million and $10 million are fairly commonplace.

The primary insurer will generally receive defense bills while they are still within the retention amount so that they can ensure the retention is being properly eroded. They will continue to receive, review and ultimately pay bills as the amounts exceed the retention and impact their layer of coverage.

However, in most instances, these bills are not submitted to the excess insurers for review, and these insurers typically defer to the primary to examine the bills and pay what they deem to be appropriate under the primary policy.

In cases that begin to move into a settlement mode, an unfortunate dynamic begins to develop--the insurer that is reviewing the bills often realizes that its limits will become exhausted by any combination of defense expenses and settlement amount.

This creates a disincentive for that insurer to vigorously review and cut the bills (typically this review would be done by counsel for the insurer and therefore at incremental cost to them) when any "savings" will only inure to the benefit of an insurer higher in the tower.

Although it did not involve D&O insurance but rather a multilayered employment practices liability insurance program, a decision last year by a Minnesota appellate court, Royal Indemnity Co. v. C.H. Robinson Worldwide, Inc., addressed some of the problems that are inherent in these insurance structures. (Minn. Ct. App., July 21, 2009).

This decision was not officially reported and received scant attention, but the court there held that an excess insurer was entitled to dispute the reasonableness and necessity of defense expenses already paid by an underlying insurer, and thus question whether the underlying limits were properly exhausted.

While the policyholder in that case argued strongly against this insurer being allowed a second bite at the apple, it appeared that the court appreciated the unfortunate dynamics and inappropriate disincentives that would result if it did not so rule.

A special master had been involved in reviewing bills in C. H. Robinson, and it is uncertain as to what took place after the court remanded to the trial court for further proceedings.

Notwithstanding this decision, what then are some practical steps that can be taken by insurers and insureds alike in these situations to avoid unnecessary and costly disputes over legal fees?

o First, defense invoices should be submitted to all insurers--both primary and excess--in the tower of insurance.

This is not especially burdensome on the law firms involved, particularly when the invoices are sent electronically.

Not every insurer will take the opportunity to review the bills, with most deferring that task to the primary insurer or whoever may be the "working layer" for paying the invoice at issue.

Nonetheless, if any excess insurer may have doubts that an insurer below them is adequately scrutinizing the bills, they will be free to voice any objections and seek a potential resolution, as discussed further below.

o Second, as soon as there is a settlement agreement in principle, all invoices should be submitted solely to the top-most layer of insurance impacted by the settlement.

That is the only layer that should have any real interest in vetting the bills for reasonableness and necessity, as the layers below will be exhausted regardless of reductions in defense expenses.

This may result in the top layer paying defense expenses before a settlement is actually funded, but it is actually in that layer's interest to not stand on their legal and contractual right not to pay in order to gain appropriate control over the defense fees and expenses.

It should be noted that, in the absence of a settlement in principle, it would not be a workable solution to simply have one or more excess layers attempt to dictate to the insureds and lower layer insurers what should or should not be paid as covered defense expenses.

Unless the insureds and all insurers consent to such an arrangement, an insurer cannot delegate its responsibility under the policy to an insurer in a layer above them.

o Third, insurers often overlook the notion of approaching the general counsel or other key contact at the policyholder's organization to attempt to reach an agreement on how to deal with defense expense issues.

Although general counsel will want the best defense counsel available for the corporation and its management, they should not be insensitive to the need to control defense expenses and preserve available limits for a potential settlement, judgment and even other claim matters under the same policy.

In instances where agreement unfortunately cannot be reached on where to reduce a bill, a possible solution would be to mutually agree to have the corporation bear any disputed amount uninsured.

This effectively removes the outside defense counsel from the equation and leaves them to focus solely on the defense of their clients and not their bills.

o Lastly, where fees are in dispute, insurers and the policyholder should consider the retention of a third party to act as an arbiter in those disputes.

Ideally, this neutral will be a lawyer with a well-developed understanding of the issues in the underlying litigation and D&O insurance coverage. Such a procedure is frequently employed in bankruptcy proceedings. In fact, in the ongoing Lehman bankruptcy, fee disputes involving a number of prominent law firms have been submitted to the present federal bailout pay czar, Kenneth Feinberg, for resolution.

The cost of such an arbiter should be borne as an additional defense expense to be paid by the appropriate insurer, but the benefit of that work would be enjoyed by all insurers through the reduction of the ultimate loss exposure, as well as by the insured's in the elimination of an item of contention.

Joseph P. Monteleone is a partner in the New York office of Tressler LLP. He has practiced extensively over the past twenty-five years, both in-house as a claims executive and in private practice, in the area of D&O and other professional liability insurance. He may be reached at JMonteleone@tresslerllp.com.

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