Federal Court Rejects Insurer’s Discretion in Terminating the Duty to Reimburse Defense Costs Under a Directors and Officers Liability Policy

Federal Court Rejects Insurer’s Discretion in Terminating the Duty to Reimburse Defense Costs Under a Directors and Officers Liability Policy

   By Brett Wheeler, Associate, Farella Braun + Martel LLP

Last month, the Fifth Circuit reaffirmed what has been axiomatic in California since at least Gray v. Zurich, 65 Cal. 2d 263, 278 (1966):  People buy liability policies for peace of mind, expecting to be defended in case they are sued.   Any potential for coverage at all, therefore, triggers the duty to defend, and the duty is not dependent on the "malleable, changeable and amendable" pleadings in the underlying action.  In Pendergest-Holt v. Lloyd's, 600 F.3d 562 (2010), the Fifth Circuit extended this principle to the duty to reimburse defense costs under a D&O policy.   It held that insurers may not make unilateral factual determinations about the merits of the underlying case to justify terminating their duty to reimburse defense costs unless policy language expressly grants them that right.  Nor may they terminate their defense duties based solely on allegations in the underlying complaint.

The Fifth Circuit was deciding whether to uphold a preliminary injunction issued by the district court ordering the insurer Lloyd's of London to continue reimbursing defense costs under a D&O policy.  The insureds were officers of a company founded by R. Allen Stanford.  The SEC had brought a civil action alleging the officers orchestrated a Ponzi scheme involving sham certificates of deposit.  All but one officer pled not guilty.  But the former CFO, James Davis, pled guilty to mail fraud and stated under oath that the remaining defendants had also engaged in fraud associated with the Ponzi scheme.  After initially advancing defense costs for several months, Lloyd's changed course.  The insurer contended the allegations arose out of actions connected to a money-laundering scheme excluded by the policy and denied coverage retroactively to the date Davis pled guilty.

Lloyd's policy covered the officers for liabilities stemming from activities in their official capacity.  As is common for D&O policies, the language did not impose a direct duty to defend, but required the insurer to reimburse defense costs.  The policy also excluded coverage, including for defense costs, for any loss "arising directly or indirectly as a result of or in connection with any act or acts (or alleged act or acts) of Money Laundering."  However, this broadly formulated exclusion had a proviso that Lloyd's would pay defense costs "in the event of an alleged act or alleged acts until such time that it is determined that the alleged act or alleged acts did in fact occur." 

The Fifth Circuit's decision would turn on this phrase.  First, the court had to ask the same question asked of every schoolchild who first uses the dreaded passive voice:  By whom is "it determined?"  Did the policy envisage a particular decision maker?  Second, the court was left wondering about the evidentiary basis for determining what "in fact" occurred, regardless of who was doing the determining.   Was the decision maker limited to the pleadings or could it look at extrinsic evidence as well?  The insurer had a simple answer to both questions:  the insurer determines what occurred based on its own finding of facts in the underlying action. 

For the most part, the court disagreed.  Instead, with regard to who determines what in fact occurred, the court found the policy language ambiguous and construed it in favor of the insured.  The court looked to various definitions of what "determines" means, and concluded that they favored a judicial decision maker, but were ultimately inconclusive.   Because under Texas law ambiguities must therefore be construed against the drafter and for coverage, the court held that the policy language did not permit an insurer to end its coverage obligations based on its own determination of fact in the underlying action.   Additionally, the court noted pointedly that an insurance policy leaving the insurer with such "unfettered discretion ... might be difficult to sell," concluding that any agreement with that intent must be expressly stated "rather than leaving the reader to ponder the word 'it.'"  Finally, the court found that the "in fact" language did nothing to change the requirement for a judicial adjudication.  Instead, it held that the facts pertaining to coverage did not have to wait for a final adjudication in the underlying action, but could be resolved in a separate coverage action.  The Court's decision that the factual determination could be made in a separate, parallel proceeding, rather than awaiting determination in the underlying case itself (or afterwards) is questionable.  The insurer then effectively becomes an ally of the underlying plaintiff against the insured it has promised to protect.  Many other courts have reacted to this problem by requiring that the coverage determination be stayed until the underlying case is concluded.  Montrose Chem. Corp. v. Superior Court, 6 Cal. 4th 287, 301-302 (1993).

As to the second issue regarding what evidence should be considered for factual determinations, the court concluded that the policy itself resolved the matter.  The policy stated that the insurer must advance defense costs "until it is determined that the alleged act or alleged acts did in fact occur."  The court found that language clearly sought to contract around the "judge-made" eight-corners rule limiting any determination to the policy provisions and allegations made in the underlying complaint.  The policy language manifested an unambiguous intent by the parties to "determine" in a separate coverage action whether the duty to advance defense costs should be terminated based on the money laundering exclusion.  Such a proceeding would, of course, include any relevant evidence and not be limited to the underlying complaint.

The insurer was thus contractually bound to continue reimbursing defense costs - regardless of who was more likely to win on the merits - until the merits were actually judicially determined.   The circuit court found that the insurer, for its part, was entitled to relief in court in a separate coverage action.   But, as the court noted, few policyholders would buy a policy where the insurer also adjudicates the facts of the underlying action to determine whether it may terminate its duties to the insured.  There would be little or no peace of mind in that.

See Farella Braun + Martel's  Farella's Policyholder Perspective blog at http://www.farellacoveragelaw.com/2010/05/federal-court-rejects-insurers-discretion-in-terminating-the-duty-to-reimburse-defense-costs-under-a.html.