Directors' and Officers' Liability Insurance

Dr Adolfo Paolini and Deepak Nambisan

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8 D&O DEFENCE COSTS COVER AND ALLOCATION

I. INTRODUCTION: DEFENCE COSTS COVER

8.01 A D&O policy’s primary function is to offer financial protection to directors and officers.1 Defence costs cover is one of the most important aspects of D&O insurance and is a topic of major importance to both assureds and insurers. The availability of such cover means that assureds are guaranteed access to (hopefully good) lawyers to fight or settle the claim if the company does not come to their rescue. Meanwhile, insurers benefit from the fact that the fund in respect of defence costs may assist directors in avoiding liabilities in respect of which the insurer would otherwise be obliged to provide indemnity. There is a close relationship between liability insurance and defence costs insurance, to the extent that some jurisdictions take the view that liability insurance cover automatically embraces defence costs cover unless the parties agree otherwise.2 8.02 In this chapter we consider whether defence costs cover is offered as an independent undertaking or as forming part of the core insuring clause. This is of fundamental importance to the operation of D&O cover: if defence costs cover is offered independently, the fact that insurers are in a position to avoid providing an indemnity under the main insuring clause may not affect their liability for defence costs.3

II. INTRODUCTION: ALLOCATION

8.03 In this chapter we also consider the allocation of legal costs, a topic of great significance to insurers, assureds and practitioners. In particular, the following questions arise:

(1) What portion of defence costs should be allocated between insured and uninsured directors?

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(2) What portion should be allocated between insured directors and the insured company if the insurance offers entity cover?
(3) How are defence costs are to be apportioned between insured and uninsured claims?

III. DEFENCE COSTS COVER: ONE UNDERTAKING OR TWO DIFFERENT UNDERTAKINGS?

(a) General

8.04 D&O policies usually offer cover not only to meet a director’s or officer’s liability, but also to provide financial assistance in respect of the costs of defending against such liability. This is the natural result of the D&O policy being a liability policy. Such policies usually impose upon insurers the obligation to meet the costs of defence without waiving their rights to recover from the unsuccessful third party, in accordance with well-established principles of subrogation.4 8.05 Nevertheless, the existence of defence costs cover raises a number of questions which deserve consideration:

(1) Is the assured entitled to recover under the defence costs provisions of the policy even if the underlying liability claim is excluded from cover?5
(2) Is the assured entitled to recover defence costs in any event once the insurer decides to contest the claim against the director?
(3) Is the assured entitled to recover defence costs where the insurer wrongfully repudiates its liability?
(4) Is the assured entitled to recover defence costs when the insurer forces a settlement and an admission of liability upon the director?

(b) Recovery of defence costs where the underlying claim is excluded from cover

8.06 The first point to consider is whether the policy covers both directors’ and officers’ liability for wrongful acts and defence costs incurred in contesting such liability. This depends upon whether: (i) liability and defence costs coverage form a single undertaking preventing costs recovery when the subject-matter of the underlying claim is excluded from the insuring clause; or (ii) the defence costs cover is independent and separately enforceable. 8.07 In Wyeth v. Cigna 6 the Court of Appeal held that, in the absence of clear wording to the contrary, the obligation to indemnify the insured for defence costs only arises when the claim against the insured falls within the terms of the primary insuring cover. Applying this reasoning to D&O insurance leads to the conclusion that insurers are bound to indemnify in respect of defence costs only if the claim for damages for a wrongful act is covered7 and does not fall outside the relevant period of insurance. This outcome may not always be satisfactory

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in the sense that directors or officers might find themselves without defence costs cover purely because the claimant has pleaded their claim on uninsured grounds even though the nature of the wrong, correctly analysed, is in fact covered. 8.08 The authors take the view that the enforceability or otherwise of an insurance agreement cannot depend solely upon the manner in which a claimant chooses to put their claim. Similarly, if insurers were entitled definitively to assess the nature of the wrong in order to repudiate liability,8 irrespective of how the claimant has framed the plea, assureds would be placed in a highly disadvantageous position with no right to establish that the claim was in fact covered and thus no right to recover defence costs. 8.09 As was highlighted in Wyeth, the parties are free to agree that the right to recover defence costs may arise whether or not the claim unequivocally falls within the scope of the insuring clause. 8.10 In Thornton Springer v. NEM Insurance Co Ltd,9 special condition 1 of the insurance policy provided that “Underwriters shall in addition indemnify the assured in respect of all costs and expenses incurred with their written consent in the defence or settlement of any claim made against the assured which falls to be dealt with under this Certificate … ”.10 Colman, J held that as long as the third party claim was in substance capable of coming within the policy and the insurer gave its consent the clause was activated, thus providing its benefits to the assured. The judge went on to say that “in order to ascertain whether the claim is in substance within the scope of the insuring clauses it may be necessary to investigate what basis of the claim really amounts to, as distinct from the manner in which it is expressed in the claimant’s pleadings … ”.11 8.11 In Poole Harbour Yacht Club Marina Ltd v. Excess Insurance Co,12 Thomas, J held that the claimant boatyard was entitled to an indemnity in relation to the costs and expenses of litigation commenced against it in relation to works done on a yacht’s engines and incurred with the insurers’ written consent, in the absence of express exclusions in regard to such costs and expenses. The policy contained three different indemnities against: “(A) all sums which the Assured shall become legally liable to pay for compensation and claimants costs and expenses; (B) all costs and expenses of litigation incurred with the written consent of the Companies in respect of a claim against the Assured; and (C) the payment of the solicitor’s

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fee incurred with the Companies written consent for representation of the Assured at proceedings in an Court of Summary Jurisdiction arising out of any alleged breech of a statutory duty or at any Coroners Inquest or Final Accident Inquiry” resulting from the activities or matters enumerated in sub-clauses 1 to 7 of the indemnity clause.13 8.12 The yard contended that as a matter of ordinary and simple language, the policy provided indemnity under sub-clause (B) for costs and expenses of litigation as long as the claim resulted from one of the matters set out in sub-clauses 1 to 7. The insurers argued that this construction produced an absurd result which the parties could never have intended and which did not arise on the ordinary language of the indemnity clause, thus giving cover for legal expenses under an ordinary policy of indemnity insurance.14 It was suggested instead that the natural reading of the words in sub-clause (B) “in respect of a claim against the insured” referred to what was covered by sub-clause (A). 8.13 The judge held that the language of the policy was clear and that sub-clause (B) contained nothing specifying that the claim in respect of which the costs and expenses were incurred had to be a claim under sub-clause (A): the insurer was bound to provide indemnity for defence costs where the assured’s liability arose in connection with any activity in subclauses 1 to 7 of the indemnity clause. The judge also took the view that sub-clause (B) read naturally as a wholly independent form of cover similar to the cover in sub-clause (C) but instead referable to civil litigation against the yard. Furthermore, although it was clear that the policy exclusions had been drafted so that they could in principle apply to the whole of the coverage provided by the policy, most of them by their clear terms did not apply to the coverage under sub-clause (B).15 8.14 Although this case involved the interpretation of a particular policy wording, its impact in relation to D&O policies is potentially very significant: directors and officers might be entitled to indemnity under the defence costs provisions of the insurance policy where the third party’s claim arises in connection with an activity carried out in their capacity as directors or officers of the company and regardless of the fact that the claim alleges, for example, fraud or an excluded peril. It may be observed that this, of course, is the rationale for the requirement that the assured obtains, as a condition precedent to the provision of indemnity, the insurer’s consent for costs to be incurred. From a practical perspective, this means that the insurer can take control and, as a result of being kept well-informed, assess the nature of the insurance claim in advance and agree either to provide indemnity or challenge it. 8.15 One of the leading policies in the market seems to follow the above approach in Poole Harbour. Lloyd’s Form LSW 736: “Definitions”, section (g) provides:

“ ‘Costs and Expenses’ shall mean all reasonable and necessary fees and expenses incurred by or on behalf of the Directors or Officers with the written consent (such consent shall not unreasonably be withheld) of Underwriters resulting solely from the investigation and/or defence and/or monitoring and/ or settlement of any Claim and appeals therefrom.

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