Other examples of policy language requiring the insured and insurer to resolve the allocation problem through the use of best efforts include the following. Note that in these examples the insurers have gone beyond requiring just a best effort and provide other requirements and guidelines for achieving an allocation.

     It is hereby agreed among the Insurer, the Company, the Directors and the Officers that in the event of Claim asserted against individuals insured under this policy and parties not insured under this policy (including the Company to the extent of its own liability and defense expenses, but not to the extent it may appropriately indemnify the Directors and Officers), an issue of allocation of loss and defense expenses between the Insured on behalf of the Directors and Officers and the Company and/or other parties may exist and should be resolved in accord with the following principles.

In California and other states, the obligations of good faith and fair dealing are implied covenants in every insurance policy, including D&O policies. Such obligations extend to allocation-resolution provisions such as those cited above. If either side of an allocation dispute takes an intransigent position, the opposing side may have recourse to raise a claim of breach of the obligation of good faith and fair dealing.

In Safeway v. National Union Fire Ins. Co., 805 F. Supp. 1484 (N.D. CA 1992), a D&O insurer's refusal to pay covered attorneys fees did not constitute bad faith when a dispute existed regarding allocation of the total fees incurred between covered and uncovered parties and between covered and uncovered claims. The Safeway district court decision cited was affirmed in part and reversed in part in Safeway v. National Union Fire Ins. Co., 64 F.3d 1282 (9th Cir. 1995).

In the Safeway matter, Safeway and its directors and officers refused to suggest any allocation of defense costs paid on behalf of covered directors and officers and those paid on behalf of uncovered parties. Although the insurer refused to pay any part of the settlement of the underlying case and the underlying defense fees, nevertheless the insurer was successful on summary judgment in eliminating the bad-faith claims asserted in the ensuing lawsuit between the insureds and the insurer. There was no issue of an obligation to interim fund. Indeed, the insureds made no claim on the policy until after conclusion of the underlying case.

The underlying litigation in Safeway arose from actions taken to avoid a hostile takeover. In the underlying action, the shareholders alleged generally that Safeway's directors and officers breached duties to the corporation and its shareholders by approving a tender offer for an acquisition of Safeway by the designated “white knight,” an entity known as KKR (Kravis, Kohlbert & Roberts). The shareholder action sought to enjoin the KKR buyout, or, in the alternative, to recover damages and attorneys' fees.

Although Safeway notified National Union of the pending lawsuits in August 1986, the claim on the policy was not made until February 1988, after settlement of the underlying case. The settlement involved the payment of a dividend that the court ultimately determined was not a payable loss under the policy. The settlement also involved the payment of substantial attorneys' fees to the plaintiffs which the court did determine was a loss under the policy. Therefore, the plaintiff's attorneys' fees as well as the defense fees were the subject of the allocation dispute.

Safeway and National Union accused each other of failing to use its best efforts to negotiate an allocation, but the court noted that National Union did make some efforts to resolve the allocation issue. National Union informed Safeway of the need to allocate early in the dealings and proposed a hypothetical allocation based upon an apportionment premise. National Union invited Safeway to respond and offer a counter-proposal. Ultimately Safeway's refusal to negotiate led the court to dismiss the bad-faith claims.

A pronouncement in the Ninth Circuit on this issue is Slottow v. American Casualty, 1993 WL 498353 (9th Cir. 1993), in which the Ninth Circuit overturned a district court decision that upheld a rather extreme allocation and imposed an award of $5 million in punitive damages because the insurer refused to fund the settlement.

Fidelity National Trust (FNT), a subsidiary of Fidelity Federal Bank (FFB), was trustee for investors in loan pools administered by FNT president Ralph Slottow. The investors claimed it was a Ponzi scheme and that FNT, Slottow and FFB's failure to enforce the trust agreements was a breach of contract and fiduciary duties as well as negligence.

Slottow and FNT ultimately settled with investors for $4.75 million and agreed to the following apportionment of the loss:

0% allocated to FFB
4% ($170,000) allocated to FNT
96% ($4,580,000) allocated to Slottow

The D&O insurer, American Casualty, refused to fund the settlement. The district court upheld the allocation, however, and awarded $5 million in bad-faith damages. The Ninth Circuit reversed on the bad faith and sent the allocation issue back to the district court, noting allocation must be determined on the basis of a reasonable relationship to a proportional share of comparative liability. The Ninth Circuit stated that the settled allocation was suspect since FFB faced alter-ego liability for the acts of FNT, the party “that faced the greatest exposure.”

Black's Law Dictionary, 2nd Edition, defines alter ego as “second self.” Under the doctrine of “alter ego,” the court merely disregards corporate entity and holds the individual responsible for acts knowingly and intentionally done in the name of the corporation. (Ivy v. Plyler, 246 Cal. App. 2d 678, 54 Cal. Rptr. 894, 897.) According to Black's, to establish the “alter ego” doctrine, it must be shown that stockholders disregarded the entity of the corporation, made the corporation a mere conduit for the transaction of their own private business, and that the separate individualities of the corporation and its stockholders in fact ceased to exist. (Sefton v. San Diego Trust & Savings Bank, Cal. App., 106 P.2d 974, 984.) The doctrine of “alter ego” does not create assets for or in the corporation, but it simply fastens liability on the individual who uses the corporation merely as an instrumentality in conducting his own personal business, and that liability springs from the fraud perpetrated not on the corporation, but on third persons dealing with the corporation. (Garvin v. Matthews, 193 Wash. 152, 74 P.2d 990, 992.)

The opinion in Slottow also attempts to set out guidelines for when punitive damages may be appropriate if the insured is on equal economic footing with the insurer. Although there is no precedent for the court's conclusion, the Ninth Circuit felt “oppression” cannot be found under those circumstances. A showing of malice or fraud would support sanctions, but the Ninth Circuit said the insurer's arguments were not “laughable,” so no malice or fraud was shown!

When the D&O policy contains a best-efforts clause, corporations should carefully consider the question of the allocation issue, which will likely arise upon tendering a claim. It is important to have defense counsel formulate an appropriate and well-founded allocation so that reasonable negotiations can take place. It is also important to consider other policy terms in connection with the probability of an allocation dispute.

Predetermined Allocation Percentage

One approach to the allocation problem is for the insured and insurer to agree upon an allocation between the corporation and the directors and officers on a predetermined basis prior to loss occurrence. The following example from a Chubb form illustrates such a predetermined allocation approach as respects defense costs for both covered and uncovered claims and covered and uncovered persons.

Another similar approach establishes the allocation on a predetermined basis for both defense and indemnity:

Note, however, that in this endorsement, the predetermined allocation percentage applies only to securities claims, a defined term. Questions of allocation regarding all other matters are to be resolved on a “best-effort” basis.

Endorsements such as the above are offered to ostensibly provide insureds with a known allocation percentage for defense expenses. The additional premium for such endorsements can be high—as much as 25 percent or more of the base premium.

An inherent flaw with such approaches is that the predetermined allocation may have no apparent relation to what a fair allocation may in fact be under a possible future claim where the facts are unknown. Still, predetermined allocation does establish some certainty of coverage, which reduces risk. In that sense, predetermined allocation may strike an acceptable balance for some insureds.

Allocation between Insured and Uninsured Capacity

Most D&O policies define the insured to include all persons who were, now are or shall be directors or officers of the corporation. Some definitions of the term “wrongful act” may include language that effectively restricts coverage for directors and officers by providing coverage only while they are acting in the capacity of a director or officer of the corporation. An example of such language in an older D&O policy follows.

Directors and officers, such as the firm's corporate attorney or general counsel, may not be covered while performing duties in his or her professional capacity as a lawyer unless they are specifically scheduled as an insured in that capacity. Any loss associated with their non-covered actions in a non-covered capacity may be subject to allocation.

Entity Coverage

Perhaps the most controversial approach to problems of allocation is amending the base policy to extend coverage to the corporate entity for actions directly against it. When the corporation is an insured for direct actions, the need for allocation between the corporation and the directors and officers is removed or at least substantially reduced.

Entity coverage for associations, not-for-profit corporations and some health-care operations has been available for many years. The approach of making entity coverage available to for-profit organizations is more recent. The first such “entity” coverage to be widely marketed is the Entity Coverage Endorsement introduced in 1993. The endorsement reads in part as follows:

Coverage for direct actions against the corporation is limited to “Open Market Securities Claim,” which the endorsement defines as follows:

Securities-based lawsuits, especially open-market securities claims, almost always name the corporation as a co-defendant. While entity coverage applicable only to securities actions is somewhat limited in scope, such coverage can nonetheless provide important protection and alleviate the problem of allocation, at least in the context of the coverage provided.

Entity coverage limited to specific types of claims, such as securities actions described in the above examples, does not eliminate the possibility of an allocation with other uncovered persons or for uncovered claims or with persons performing duties in some uncovered capacity.

Like endorsements offering a pre-determined allocation, entity coverage can be expensive. Depending on the co-insurance option selected, the additional premium for the coverage extension can be 125 percent or more of the base policy premium. In addition to the hefty additional premium and limited scope of coverage, there are other factors insureds would be wise to consider.

Because the courts sometimes have ruled against insurers allocating loss in actions against both the corporation and its directors and officers, some insureds might question the logic of paying an additional premium for coverage that may already be available. Because of the fact-specific nature of the few cases reviewing allocation, there is no guarantee of how any subsequent individual case will be judged.

Also, unless additional policy limits can be provided, entity coverage dilutes coverage available for the directors and officers.

Allocation Based on Relative Legal and Financial Exposures

Another allocation methodology found in many newer D&O policies is to allocate loss based on relative legal and financial exposures. This approach requires the insureds and the insurer to consider both the factual and legal strengths and weaknesses of the case and the financial impact of the defendants as well as benefits derived by each defendant.

This approach to allocation is generally viewed as being more favorable to insurers.

Conclusion

With the rise in popularity of D&O entity coverage in the mid-1990s, the number of allocation disputes involving public companies has diminished. Public companies purchasing entity coverage have a greatly reduced potential for allocation disputes because the entity is a covered party under the policy. The presence of entity coverage, however, does not eliminate the potential for problems with allocation to occur.

Although most D&O policies today do contain some form of allocation of loss language, this is not universal, and the issue of how allocation is to apply can be ambiguous. Without clear policy language describing the applicable allocation methodology, many courts will apply the reasonably related test for allocating defense costs and the larger settlement rule for allocating settlements.

Although such approaches may have merit, they will likely not prove to be long-term solutions, and it is preferable for the insured to have a understanding of how allocation is to apply prior to loss. Because of wide variation in the way D&O policies address the issue of allocation, and evolution in the courts, aggressive ongoing education among buyers, brokers and agents, and insurers of the issues surrounding allocation may be the best method for avoiding conflict over allocation. In particular, policyholders should be aware of the choice of law provisions and become educated on the allocation provisions, if any, in D&O policies.

Case Study in Allocation: Nordstrom Court Drives Stake through Heart of Insurers' Argument for Allocating Loss

Only where a corporation's liability is separate and apart from its directors' and officers' liability, and actually increases the amount required to settle, is the D&O insurer entitled to an allocation of loss. Where the corporation's liability is concurrent with the liability of its officers and directors, as is the case in most securities fraud suits, there is no required allocation!

On April 14, 1995, the United States Court of Appeal for the Ninth Circuit issued this opinion in Nordstrom, Inc. v. Chubb & Son, Inc., No. 93-35495, DC No. CV 92-141-BJR.

In 1990, Nordstrom shareholders brought class action suits alleging securities fraud against Nordstrom and its directors and officers. In these lawsuits the shareholders alleged that Nordstrom fraudulently concealed from its investors the existence of materially adverse risks arising out of a companywide policy requiring Nordstrom employees to work “off the clock.”

In 1989 the union for some of Nordstrom's employees challenged the policy, but in a January 1989 Annual Report and subsequent quarterly reports, Nordstrom made no mention of the potential liability that might arise due to its wrongful labor practices. In late 1989 and early 1990, Nordstrom consistently denied that the union's allegation had any merit and Nordstrom spokespersons issued numerous public statements and press releases downplaying the importance of the allegations. On February 15, 1990, following an investigation, the Washington Department of Labor and Industries issued a report concluding that Nordstrom was in violation of state wage laws. On February 16, 1990, Nordstrom's stock price dropped 10 percent and fell again the following day.

The ensuing shareholders' suits, which were consolidated, set forth allegations of securities fraud and common law misrepresentation. There was also a fifth count against only the directors and officers, alleging they were “controlling persons” under section 20(a) of the 1934 Securities Act and as such liable for all of the acts of the other Nordstrom employees involved in the alleged fraud. In securities law, a person who has power or control over acts that violate the law is considered a “controlling person” and can be held secondarily liable for the actions of others.

The D&O Insurer's Actions

After suit was filed, Nordstrom gave timely notice to its D&O insurer, Chubb Group, which agreed to reimburse Nordstrom for defense costs subject to, as the court noted, “an appropriate allocation as between covered and noncovered defendants and potentially non-covered claims, and satisfaction of the deductible amount.” Thereafter, beginning in March 1991, Chubb conducted an inquiry into the merits of the class action suits.

The investigation revealed that, although there were alleged isolated instances of wrongdoing, Nordstrom managers and directors and officers consistently confirmed that there was little if any validity to the charges made by the union. All the public statements, including the press disclosures, were reviewed and approved by the corporation's directors and officers, including members of the Nordstrom family.

In April 1991 settlement negotiations began before District Court Judge William L. Dwyer, with the insurer present and represented by counsel. The parties eventually agreed to a settlement figure of $7.5 million with the corporate entity and the individual directors and officers jointly and severally liable.

Chubb consented to the settlement as being reasonable, but conditioned its consent on the specific understanding that Chubb and Nordstrom reserved their rights regarding allocation. Chubb only agreed to provisionally fund one-half of the settlement, $3.75 million, subject to the outcome of any subsequent allocation.

Defense costs were not allocated at the time of the settlement. However, Chubb subsequently agreed to fund half of Nordstrom's defense costs after auditing the statements and deducting a relatively nominal amount, which it claimed was not reimbursable under the policy. After the deduction, the defense fee still exceeded $1 million and Chubb agreed to pay $536,000.

The policy wording at issue alluded to an appropriate allocation of defense costs when both the corporate entity and the directors and officers are named as defendants.

The Coverage Litigation

In January 1992, Nordstrom brought suit against Chubb, seeking payment under the D&O policy for the full amount of the settlement and defense fees. There was substantial discovery in the coverage suit, and Nordstrom produced over 100,000 pages of documents to Chubb as well as a list of documents requested by Chubb which Nordstrom claimed to be privileged and protected from disclosure. Chubb asserted that among the documents withheld from production were documents that set forth Nordstrom's attorneys' analysis of the corporation's exposure in the underlying suit at the time that the settlement was reached.

Nordstrom ultimately moved for partial summary judgment on its claim for full indemnification of the settlement and defense costs. The motion was granted by the district court. The district court found that Chubb was liable for the entirety of the settlement over the deductible contained in the policy and for all of the defense costs other than the small amount deducted after Chubb's audit. The Court also determined that Chubb was not entitled to further discovery. Chubb appealed the district court decision.

The Ninth Circuit Analysis

Applicable State Law. The Ninth Circuit determined that under Washington law, insurance policies are to be construed as contracts, and thus interpretation is a matter of law. In Grange Insurance Company v. Brosseau, 776 P.2d 123, 125 (Wash. 1989), the court determined that policies are to “be given a fair, reasonable, and sensible construction” that reflects how the average purchaser of insurance would view the policy. Under Waite v. Aetna Casualty and Surety Company, 467 P.2d 847, 850 (Wash. 1970), the court noted that in an action involving an indemnity policy, the burden to show the loss suffered comes within the terms of the policy is on the plaintiff.

The Chubb Position Supporting Allocation. Chubb's primary stance was simply that the policy did not provide coverage for claims asserted against the corporate entity and that it was thus necessary to determine whether any portion of the settlement sum was the exclusive responsibility of the corporate entity. (See Harbor Insurance Company v. Continental, 992 F.2d 357 [7th Cir. 1990].) Chubb advocated that the allocation should be according to “the relative exposure of the respective parties.” (See Pepsico v. Continental Casualty Company, 640 F.Supp 656, 662 [S.D.N.Y 1986].)

Nordstrom's Arguments against Allocation. Nordstrom offered three independent grounds to justify affirming the district courts ruling:

1.  Nordstrom initially argued that because the Chubb policy did not contain an express allocation clause, Chubb's only remedy was an action in subrogation. (Nordstrom's subrogation argument was vague but referred to third parties who may be held liable. As the court noted, this made little sense because, to the extent that the settlement costs are attributable to uninsured persons or entities, they are not covered and subrogation is irrelevant.)

2.  Nordstrom argued that the joint and several liability provision of the settlement rendered the directors and officers legally obligated to pay the entire sum, and therefore precluded any allocation of loss.

3.  Nordstrom argued that Chubb was estopped from asserting any right to allocation because it violated its duties under Washington law to investigate Nordstrom's claim promptly and provide a reasonable explanation for the facts and law supporting its denial of coverage. Estoppel is a principle that prevents a person or entity from denying or alleging a certain fact or stating facts because of that individual's previous conduct, allegation, or denial.

The Ninth Circuit rejected each of Nordstrom's contentions as without merit, stating that Washington law does not prohibit allocation despite the absence of an express allocation clause regarding indemnity. The court further noted that allocation is not required where the covered and noncovered claims of a single insured party “consist of the same facts.” (See Public Utility District No. 1 v. International Ins. Co., 881 P.2d 1020 [Wash. 1994].) Under Washington law, allocation may not be permitted if an insurer has improperly refused to defend an insured against claims or made no attempt to separate out a portion of the settlement amount for which it was liable. (See Waite v. Aetna Casualty & Surety Co., 467 P.2d 847, 852 [Wash. 1970], and Prudential Property & Casualty Co. v. Lawrence, 724 P.2d 418 at 424 [Wash. Ct. App. 1986].) However, in this case Chubb did not refuse to defend and expressly conditioned its consent on a later allocation.

The court rejected Nordstrom's argument that just because the allocation clause in the Chubb policy refers only to defense costs, the settlement amount cannot be subject to allocation. This is simply because the policy “unambiguously covers only losses which `the insured person has become legally obligated to pay.'” The Ninth Circuit noted that if the corporate entities' independent exposure accounts for a settlement sum, that part of the sum would not constitute a covered loss within the meaning of the policy.

Nordstrom argued that the joint and several liability provision of the settlement agreement makes the directors and officers legally responsible for the entire sum, and therefore coverage of the entire sum. This argument raises the question of what actually constitutes a covered loss. The Chubb policy provided indemnification for wrongful acts committed by an insured person during the policy period. Under the joint and several liability provision of the settlement agreement, the Nordstrom directors and officers were legally obligated to pay all sums, including those which may not have resulted from their own wrongful acts, but rather from acts attributable solely to the corporate entity. These sums were simply not covered under the policy, and therefore a joint and several settlement provision by itself did not obligate Chubb to fund the entire settlement amount.

Finally, with regard to Nordstrom's estoppel claim, the court determined that there was no proof that Chubb delayed investigating Nordstrom's claim, but simply that Chubb and Nordstrom disagreed about the scope of coverage under the policy. Chubb reserved its rights to seek later allocation in order to facilitate the ongoing settlement negotiations.

Ninth Circuit's Allocation Analysis

Under general principles of insurance law, a D&O insurer is responsible only for the loss attributable to liability imposed by law upon the named insureds and has no responsibility for liability imposed on the corporation for its wrongful acts. While the court was not required to resolve all fact and legal issues in the underlying case, it was obliged to determine what reasonable allocation should have been made considering uncertainties in both fact and law known at the time of the settlement. (See Nodaway Valley Bank v. Continental Casualty Co., 715 F. Supp. 1458, 1465 [W.D. Mo. 1989], aff'd, 916 F.2d 1316 [8th Cir. 1990].)

The court noted that in this instance the underlying complaint did allege wrongdoing by both the insured and the uninsured parties but that the settlement agreement did not include a breakdown of each parties' proportional responsibility for the liability imposed in the settlement. Nordstrom urged the court to adopt a “larger settlement rule,” which was embraced by the Seventh Circuit, according to which responsibility for any portion of the settlement should be allocated to an uninsured party only if the acts of the uninsured party are determined to have increased the settlement. This rule was first established in Harbor Ins. Co. v. Continental, 992 F.2d 357, at p. 368 (7th Cir. 1990) and permits allocation only if the corporate entity alone was liable for a particular claim, or if its liability would exceed that of the directors and/or officers on any claim for which the corporation was independently but jointly liable.

Chubb, on the other hand, espoused the relative exposure rule, which bases liability on the measure of proportional fault. (See Smith v. Mulvaney, 827 F.2d 558, at 561 [9th Cir. 1987].) Under Chubb's relative exposure argument, even if the court determined that the directors and officers were liable under all claims, there may still be an allocation allowable. The allocation would be made on the basis of the separate relative culpability of the corporation.

The Nordstrom court attempted to limit its decision by stating that it was not deciding whether any given rule is generally applicable to all settlement agreements under D&O insurance policies. Rather, the court considered only the particular policy in question to determine which rule best reflects the reasonable expectations and intentions of the parties under the insurance contract. However, the court may have failed in limiting its decision because the Chubb policy contained language similar to that found in many D&O policies currently underwritten by other insurers.

The Chubb policy expressly provided coverage for “all loss….which the insured person has become legally obligated to pay on account of any claim….for a wrongful act committed…by such insured persons during the policy period.” The court noted that under this provision the parties would expect that Chubb would be responsible for any amount of liability that is attributable in any way to the wrongful acts or omissions of the directors and officers, regardless of whether the corporation could be found concurrently liable on any given claim under an independent theory.

The Nordstrom court noted that there are uncovered allocable losses only if the corporation is liable for a claim for which the directors and officers lacked any responsibility, or only if corporate liability increases the amount of loss. The Nordstrom court cited, among other decisions, The Raychem Corp. v. Federal Ins. Co., 853 F.2d 1170 (N.D. Cal. 1994). The Nordstrom court concluded that under the Chubb D&O policy, the larger settlement rule best reflected the reasonable expectations of the parties. Thus, the court required allocation only if there is some amount of corporate liability that is both independent of and not duplicated by the liability of the directors and officers.

Application of the Larger Settlement Rule to Nordstrom

The Ninth Circuit determined that Nordstrom's corporate liability, even if based on an independent theory, would still be wholly concurrent with the directors and officers liability. In reaching this conclusion, the court rejected two arguments made by Chubb: (1) Nordstrom was exposed to vicarious liability based upon the acts of uninsured corporate employees who prepared press releases and the like, and the directors and officers were not necessarily responsible for those actions as “controlling persons” within section 20(a) of the 1934 Securities Act; and (2) the corporation could be solely and directly liable for certain acts and omissions of directors and officers because it is possible that only the corporation under a theory of collective scienter would have the intent required to establish liability. The term scienter has to do with the intent or knowledge requirement necessary to find a violation of various provisions of the securities laws. The term collective scienter refers to the knowledge or bad intent of a number of corporate employees whose intent or knowledge is then attributable to the corporation as a whole. The concept of collective scienter was essentially rejected by the Nordstrom court.

The controlling persons liability under section 20(a) of the 1934 Securities Act refers to the liability of corporate officers and directors for the actions of other employees over whom the directors and officers have supervisory or managerial authority. If the directors and officers are in fact obliged to supervise or manage or otherwise control the actions of the corporate employees and have reason to know what activities were undertaken by the corporate employees, they may be found liable as controlling persons even for action which did not involve any personal undertaking by the directors or officers. A finding of controlling persons liability often occurs where improper accounting methods are used by corporate accountants and the approving director or officer knew that the corporate accountants were using improper methods which, for example, overstated company earnings.

The importance of the controlling persons analysis is that where there is good faith defense to controlling persons liability, there may be a basis for allocation under the Nordstrom decision. That is, if the director or officer had no reason to know that a company accountant was lying about an accounting document, which overstated earnings, there may be no liability under section 20(a). The liability would be wholly corporate and thus uncovered pursuant to the directors and officers policy.

The Ninth Circuit first rejected Chubb's argument that persons other than the named directors and officers were independently liable because any such liability would be concurrent with the directors and officers section 20(a) liability. The court noted that there is a good faith defense to section 20(a) liability; however, under the facts of the Nordstrom case, there was simply no evidence to indicate that the Nordstrom employees who were not directors and officers established policy and issued unauthorized statements that contributed to the fraud. In fact, the directors and officers induced the fraud by approving the allegedly misleading public statements, precluding invocation of the good faith defense.

With regard to Chubb's second argument that Nordstrom may have had direct corporate liability for securities fraud and that senior management personnel actions were “intrinsically corporate and bear the imprimatur of the corporation itself,” the Ninth Circuit noted that such liability would be concurrent with the liability of the directors and officers in any case.

With regard to Chubb's argument that the corporation may have had more extensive liability under the “collective scienter” theory, the Ninth Circuit noted that there is simply no case law supporting such a theory of liability. There is one court decision, In re Warner Communications Securities Litigation, 618 F. Supp. 735 (S.D.N.Y. 1985) aff'd 798 F.2d 35 (2nd Cir. 1986), which noted a corporation scienter could be different from an individual director or officer. However, Warner held such scienter would require showing that one or more members of top management knew of material information but failed to stop the issuance of misleading statements, or that the Warner management had recklessly failed to set up a procedure which insured dissemination of correct information.

Again, Chubb could not show any evidence to support its collective scienter theory without a concurrent finding that an individual director or officer also had the requisite intent.

Finally, the court confirmed that Chubb was not entitled to further discovery because Chubb already had ample opportunity for discovery including reviewing over 100,000 pages of documents, yet was unable to show a single fact supporting the notion that additional discovery would lead to relevant information. Even if uninsured employees were responsible for some of the fraudulent activity, this would be largely irrelevant to the allocation issue because the insured directors and officers oversaw such activity and remained responsible as controlling persons under section 20(a) of the Securities Act.

Effects of the Nordstrom Decision on Application of the Larger Settlement Rule

The pronouncement of the Ninth Circuit in Nordstrom, Inc. v. Chubb & Son, Inc. is the majority rule in the United States today. The Nordstrom opinion has been expressly followed in the 4th, 7th, and 10th Circuits. Every court that compared the larger settlement rule with the relative culpability analysis of the decades-old Pepsico case follows Nordstrom and permits a D&O carrier to allocate “only if the acts of the insured party are determined to have increased the settlement.” This rule prevails, however, only where the corporate entity alone was liable for a particular claim, or if its liability would exceed that of the directors and officers on any claims for which the corporation was independently but jointly liable. (Nordstrom, Inc. v. Chubb & Son, Inc., 54 F.3d at 1432.)

The larger settlement rule more accurately reflects the business reality that “regardless of whether corporate liability is legally direct or derivative, a corporation must act through its agents.” (See Caterpillar, Inc. v. Great American Ins. Co., 62 F.3d 955 [7th Cir. 1995].) The Caterpillar court rejected the application of the competing rule of relative exposure in favor of the larger settlement rule. While the courts have cautioned that they were not trying to develop general canons of allocation for every conflict between D&O insurers and their insureds (Caterpillar, 67 F.3d at 961 and Nordstrom, 54 F.3d at 1432), each court that has considered both rules has applied the larger settlement rule.

Raychem Corp. v. Federal Ins. Co., 853 F.Supp. 1170 is an example where the court concluded that the best reasoned cases were those applying the larger settlement rule. Indeed, the Pepsico case, which is the 1986 New York decision pronouncing the relative exposure rule, was criticized in the Illinois Federal District Court with regard to allocation in the Caterpillar decision.

The Safeway court followed suit with Nordstrom.(Safeway v. National Union Fire Ins. Co., 64 F.3d 1282 [9th Cir. 1995].) The appellate court affirmed that the settlement dollars relating to payment of a dividend was not covered loss but reversed the trial court allocation of defense fees and instead allocated the defense costs to National Union. The underlying suits in Safeway were a series of shareholder actions claiming the directors and officers of Safeway violated their obligations to the shareholders in approving the merger with KKR. The case was settled when Safeway and KKR reworked their merger agreement to provide for an early dividend to shareholders. Thus the only loss under the policy was the incurred fees to defend the directors and officers of Safeway. The Safeway court followed the larger settlement rule, finding that the insured was entitled to reimbursement of all the defense fees because the corporation's liability was purely derivative of the liability of the insured directors and officers.

The Safeway decision was followed in Owens Corning v. National Union Fire Ins. Co., 257 F.3d 484 (6th Cir. 2001). In this case, Owens Corning sued for coverage of a $10 million settlement of a class action suit brought by shareholders regarding asbestos liabilities. In construing a 1991 policy, the appellate court found that although settlement allocation was contemplated by the policy, the method of allocation was ambiguous. The court said that Ohio law favored the larger settlement rule, citing Safeway among other cases, supporting coverage of the settlement except to the extent that uninsured claims had actually increased the insurer's liability. The Owens Corning court found that the directors had been sued on all claims, and that there were no separate claims attributable solely to employees or to the corporation.

A Seventh Circuit court also reaffirmed the discussion from that circuit's Caterpillar v. Great American case, finding in favor of the larger settlement rule. (Level 3 Communications, Inc., 1999 U.SD. Dist. LEXIS 13338 [N.D. Ill.].) But the Level 3 court cautioned that the application of the larger settlement rule depends entirely on the policy language and should not be assumed in the absence of such policy language.

Exception as to Defense Costs

With regard to defense costs, however, the prevailing rule remains the reasonably-related test, which establishes an even tougher allocation standard than the Nordstrom opinion does for settlements. Under the reasonably-related test, all the policyholder needs to show is that the defense costs were reasonably related to the defense of the insured persons or insured claims to ensure that they are covered and nonallocable. This concept dovetails with the CGL concepts reaffirmed by the California Supreme Court in Buss v. Superior Court, 16 Cal. 4th 24 (1997).

Larger Settlement Rule Not Always Followed

While the larger settlement rule has been applied in some high profile and oft-cited cases such as Nordstrom, there are still some more recent cases where courts have found that the rule in fact did not apply. For example, the Private Securities Litigation Reform Act (PLSRA) of 1995, which was enacted after the Nordstrom, Safeway, and Owens Corning opinions, may have altered the rationale behind the larger settlement rule. This is because the PLSRA eliminated joint and several liability in shareholder actions brought pursuant to that act. In the unpublished opinion, Stauth v. National Union Fire Ins. Co., 1999 U.S. App. LEXIS 14006 (10th Cir), later proceeding at 236 F.2d 1260 (10th Cir. 2001), the court vacated the trial court's decision on allocation, which held the larger settlement rule applied. The appellate court questioned the application of the larger settlement rule under the Stauth facts and the PSLRA. Further, there was not yet a settlement, and because there were facts by which the uninsured parties may have been found separately liable, the Stauth appellate court found an allocation decision was premature.

Also contrary to a trend toward the larger settlement rule, in Piper Jaffray Companies, Inc. v. National Union Fire Ins. Co., 38 F. Supp.2d 771 (D. Minn. 1999), the court did not apply the larger settlement rule because of underlying issues whether the plaintiff, who was a corporate defendant in the underlying case, was jointly but independently liable due to the actions of uninsured employees. The court concluded that the larger settlement rule would not apply, relying largely on Nodaway Valley Bank v. Continental Cas. Co., 715 F. supp. 1458 (W.D. Mo. 1989) aff'd 916 F.2d 1362 (8th Cir. 1990).

In still another case, the court refused to apply the larger settlement rule because no claim was made against an officer or director in National Bank of Arizona v. St. Paul Fire and Marine Ins. Co., 193 Ariz. 581, 975 P.2d 711 (1999). It therefore appears as though the courts are looking more at the underlying claims to determine whether to apply the larger settlement rule, rather than on the allocation language contained in the policy.

Where there is a specific allocation agreement in the policy (such as a specific ratio: 60/40, for example) or where the directive is to apply a “relative culpability” analysis regardless of joint and several liability, one would expect the courts to enforce these contractual provisions under general principles of contract law. Absent specific contractual language, however, the courts may look to whether the law would permit a finding of separate culpability on the part of the uninsured party before rejecting the larger settlement rule.