Obtaining Advancement of Defense Costs in D&O Insurance Policies

October 2004

Directors and officers liability insurers continue to be the deep pockets that finance business litigation and pay hefty judgments. The cost of settlements continues to soar, with the average cost per claim more than doubling in recent years to just over $3 million. A major part of that cost is defense expense. This article discusses what happens when directors and officers turn to their liability insurance companies for payment of defense costs during litigation.

Must D&O Insurers Pay Defense Expenses as Incurred?

A fundamental question for defendants in directors and officers liability lawsuits is, at what point is the insurer obligated to pay defense fees? With defense costs continuing to rise dramatically (the average cost to defend a D&O claim is approximately $536,000), this issue is of increasing importance.

An insurance policy with a duty-to-defend provision, such as a CGL policy, typically contains wording that allows the insurer to choose the attorney and control the strategy of the litigation. The courts in most jurisdictions agree that in the absence of specific language imposing a duty to defend, a duty will not be imposed.

The typical directors and officers liability policy does not include duty-to-defend language. In fact, D&O policies usually specify that it is the insureds who choose the attorney. Choice of counsel must be agreed to by the insurer, and the insurer cannot unreasonably withhold its consent.

Most directors and officers policies specifically disclaim any obligation to defend and, in the face of such strong policy language, the courts generally will not impose such a duty.

A few directors and officers liability insurers do not specifically disclaim a duty to defend, but assert that their policies are indemnity policies only and thus they have no duty to defend or to pay defense costs as incurred. In California , however, unless there is very specific policy language to the contrary, the insurer does have an obligation to enter into an interim expense-funding agreement during the litigation.

Other directors and officers liability policies, while still not imposing an obligation on the insurer to defend, may provide that the insurer will advance legal fees as those fees are incurred.

Historically, D&O insurers writing indemnity policies were not obligated to pay defense costs until the conclusion of the underlying litigation. Today, given the enormous legal fees involved, the courts are split on the question of whether the insurer must pay defense fees as incurred.

It is interesting to note that New York and California courts have issued opinions on this subject that are diametrically opposed. In California an insurer is obligated to pay defense costs as incurred unless there is explicit policy language to the contrary. New York courts have found in recent cases that an insurer has no duty to advance defense costs unless the policy requires it.

In the Ninth Circuit case of Gon v. First State Insurance Company, the directors and officers of a savings and loan, defendants in a suit by the FSLIC, tendered their defenses to the insurer. The insurer responded that it had no duty to pay the legal expenses as they were incurred. But the court held that the insurer did have such a duty. The court reasoned that although the insured was entitled to apportion the legal expenses, under the facts of the case at hand this was not feasible. Defense expenses were also to be paid as incurred because that was when the directors themselves were legally obligated to pay.

While historically New York agreed with the Ninth Circuit's determination, that perspective changed recently. In Pepsico, Inc. v. Continental Casualty, a federal court in New York held that an insurance company was obligated to pay defense costs as incurred. However, courts in two subsequent cases came to opposite conclusions. In both Board of Education v. CNA Insurance Company, a 1986 case, and Ambassador Group, Inc. v. National Union, a 1990 decision, the courts held that due to the specific language of the particular policies, the insurer had no duty to pay defense costs as incurred.

In the Pepsico decision, Judge Brieant, United States District Court Judge for the Southern District of New York, ruled that the insurer was obligated to pay the defense costs contemporaneously because the policy did not require the entry of final judgment as a prerequisite for payment of defense costs. Indeed, the policy definition of loss included any amount which the directors and officers were legally obligated to pay, including amounts the company might be required or permitted by law to pay as indemnity to the directors and officers.

Such amounts naturally include defense fees. Accordingly, Judge Brieant concluded that once “loss” or “attorneys' fees” were incurred by the directors and officers, the insurer's responsibility to reimburse the directors and officers attached.

Judge Brieant determined that the insurer could be excused from the contemporaneous duty to pay defense fees only if the insurer could establish as a matter of law that there was no possible factual basis on which it might be obligated to indemnify the directors and officers. Under the factual circumstances at hand, the insurer conceded that even if final judgment had been entered, a conclusion that would include a finding of material dishonesty by the directors and officers (an excluded claim) was highly unlikely. Consequently, the insurer did have the obligation to pay the directors' and officers' defense costs as they were incurred.

In Board of Education v. CNA, Judge Brieant came to a different conclusion, ruling that the School Board's D&O insurer, CNA, did not have a duty to pay defense costs incurred during the pendency of the underlying lawsuit. The court reached this result because the policy provisions said it would indemnify defense costs payable as of the date of disposition of the claim against the insured or the date of determination of the insurer's liability under the insurance contract, whichever occurred first.

The Board of Education policy contained an endorsement that provided CNA an option, but not an absolute obligation, to advance fees, costs and expenses incurred by the insured. Any amounts paid prior to the disposition of such claims were to be secured by the insured's obligation to repay if it were ultimately determined that such fees and costs were not payable under this policy. This policy provision was not contained in the policy at issue in Pepsico v. Continental Casualty. Judge Brieant construed the CNA provision as meaning that CNA's obligation to pay defense costs arose either at the date of the disposition of the claim or the date of determination of the insurer's liability under the contract of insurance, whichever occurred first.

In Ambassador Group, Inc. v. National Union, Judge Dierie reviewed New York substantive case law and determined that under that law, D&O insurers have no automatic duty to defend. The National Union policy included a specific endorsement which set out a priority of claims. The endorsement provided that if a payment not in excess of the limit of liability has to be made to dispose of a claim, then costs, charges and expenses are payable up to their remaining limit of liability applicable under the policy. Thus, if a settlement or judgment payment were required, that payment would be made first, and defense costs would be paid with whatever funds remained under the policy limit.

National Union argued, and the court agreed, that under this endorsement, the claims of third parties for injuries caused by the acts or omissions of the insured are superior to the insured's claims for legal fees. Payment of the insured's costs, charges and expenses is required only to the extent that payment of the third party claims had not exhausted the policy's proceeds. As an interim reimbursement of defense fees could exhaust the proceeds available to satisfy third party claims, requiring such a reimbursement contemporaneously would contravene the plain meaning of the policy.

In a 1992 New York decision, Kenai Corporation v. National Union, New York District Court Judge Kimba Wood determined that, absent a specific provision requiring contemporaneous payment of defense fees, National Union had no obligation to pay defense fees as incurred and could await the outcome of the case to make a coverage determination. In coming to this conclusion, Judge Wood ignored language in the Ambassador opinion, which appeared to require specific policy language contravening interim reimbursement of defense costs. The natural implication of this conclusion is that absent such language, interim funding should be available.

Judge Wood reasoned that if the court required insurers to advance defense costs before resolution of the underlying action, insurers would be prejudiced since they would inevitably pay some losses that were not covered under the policies. This conclusion is contrary to the long-standing body of law in the State of California , which clearly places the burden of establishing uncovered claims on the insurer.

Because of widely varying interpretations of this most critical provision of directors and officers liability policies, insureds should examine their own policy language for any priority of payments or disclaimer of an obligation to pay defense fees as incurred. The insured should also determine whether there is a choice-of-law provision in the directors and officers policy.

Policies with choice-of-law provisions often require the insurance contract to be interpreted pursuant to New York law. Many policies also contain mandatory arbitration clauses requiring policy disputes to be resolved pursuant to binding arbitration. These can sometimes be overly restrictive, requiring arbitration to be held in New York and to proceed before arbitrators who have been employed by a directors and officers insurance company. Because such unfair and limiting provisions sometimes can be negotiated out of the policy, they should be scrutinized carefully.