Policyholders Take Heed: Reimbursement of Defense Costs Should Not Be Taken for Granted

Who doesn't remember the old saw about the squeaky wheel getting the grease? It is unlikely that whoever coined this axiom was thinking about the reimbursement of defense costs under D&O and other management and professional liability insurance policies. But the lesson is particularly apt in this context. These policies do not, as a rule, require that an insurer actually defend the insured against claims. Instead, they generally require that the insurer reimburse the insured for the costs of defending itself, as well as for defense costs that the insured pays when it indemnifies other insureds. Not surprisingly, disagreements about reimbursement frequently arise between insureds and insurers. It is easy to put off dealing with these issues because an insured typically is busy defending itself and paying for its own defense, as well as the defense of individual defendants. But failing to address reimbursement issues when they arise can be dangerous. With a little preventative maintenance, a well-informed insured can plan ahead and avoid disputes or, at least, protect its interests in many situations.

Recurring Defense Reimbursement Disputes

A common point of disagreement involves the selection of counsel. Although these insurance policies sometimes contain panel counsel requirements, they more typically state that the insurer must consent to counsel retained to defend an insured. The consent requirement may take a number of forms, but consent generally cannot be withheld unreasonably. Insurers, however, often construe the consent requirement to mean that they also have the authority to approve individual members of a defense team. But the composition of a defense team may change during the life of a claim as the skill sets evolve with the case. In addition, during the course of a claim, an insured may want to retain new or additional counsel. Sometimes, additional counsel may be retained because a conflict arises, particularly when an insured organization indemnifies individual insured persons. It is important, however, to always inform an insurer of changes in a defense team in advance.

Another recurring issue is the reasonableness of defense costs. Subject to the other policy conditions, these insurance policies typically state that the insurer will reimburse the policyholder for "reasonable" defense costs based on rates that are consistent with those charged for similar matters or by similar attorneys. There may be varying formulations of what constitutes "reasonable" or "similar." What is reasonable to a policyholder as part of a zealous defense might be viewed by an insurer as excessive. For example, insurers regularly equate reasonableness with their litigation management guidelines. These guidelines, which generally contain limitations on the time that can be spent on internal meetings and research or on the attendance of more than one attorney at hearings or depositions, might be acceptable for routine matters but unsuitable for complex claims. Furthermore, insurers may use panel counsel rates as a benchmark, which can skew toward the low end of the spectrum if those rates are influenced by the economies of scale afforded by handling a large number of similar claims. From the perspective of an insured facing bet-the-company litigation or potential criminal prosecution, however, aggressive representation is not just reasonable; it is necessary. In that context, an hourly billing rate that is adequate for routine litigation may be inconsistent with the market rates for defending complex claims.

Another set of issues turns upon the allocation of defense costs and who gets to decide what is covered (and therefore paid by the insurer). A claim may include a mix of causes of action, some of which are covered and some of which are not. When a lawsuit includes both covered and uncovered claims, the same counsel likely will defend the insured for the entire lawsuit. In this situation, it can be difficult to apply defense costs to particular causes of action. The issue of allocation between covered and uncovered matters may also arise when an insured defendant files a counterclaim or takes similar affirmative action. Similarly, a claim may include causes of action against multiple parties, some of whom are not insured but are indemnified by the insured organization. If the same counsel is retained to defend multiple defendants, it can be difficult to determine which defense costs apply to which defendant or claim. For both situations, the question remains how defense costs that apply across the board—to the defense of covered and uncovered causes of action or to the defense of insured and non-insured parties—should be allocated. Standard policy forms often state that the policyholder and the insurer should agree to an allocation of defense costs, but in the event of a deadlock, the insurer can allocate defense costs until the parties can agree to a final allocation at the conclusion of the underlying claim. But a policy provision like this may mean that the insured will be reimbursed for only a portion of its defense costs.  Plus, waiting until the conclusion of an underlying claim does not make it any more easy to reach an agreed allocation of defense costs.  Endorsements are available that state that for some types of claims involving covered and uncovered matters, all of the defense costs will be allocated to covered matters. But these endorsements may still raise issues if there are multiple defendants or if there are counterclaims, third-party claims or cross-claims.

What Not to Do

The following fact pattern illustrates some of the ways that these issues can arise:

XYZ Corp. and QRS, Inc. are joint-venture partners in ABC LLC. XYZ has the authority to appoint three of the five managing directors in ABC, and its appointees are all officers of XYZ. The D&O policy covering XYZ does not include joint ventures (such as ABC) as insured entities, nor does it have an endorsement specifically identifying ABC as a named insured. All of XYZ's officers are insured persons to the extent that claims brought against them relate to wrongful acts that they allegedly committed solely in their capacities as officers of XYZ.

XYZ and QRS have disagreements about the management of ABC. The relationship deteriorates to such an extent that QRS sues XYZ, ABC and the managing directors, who are also XYZ officers. QRS alleges that XYZ and its officers breached the duties owed to QRS as joint-venture partner, used ABC as a vehicle to misappropriate QRS's trade secrets and to disparage QRS in the marketplace, and diverted ABC's revenues. QRS also seeks the dissolution of ABC and an accounting and distribution of its assets.

XYZ indemnifies its officers and ABC, and retains the same law firm to represent itself and the other defendants. XYZ provides its D&O insurer—DEF—with notice of QRS's lawsuit. DEF reserves its rights and agrees to reimburse XYZ for its defense costs and those of its officers subject to the following qualifications: (1) DEF will only pay for services provided by law firms that it has approved and then only for attorneys in those firms that it has approved; (2) DEF will only pay hourly billing rates that it determines are reasonable; (3) DEF will only provide reimbursement for work that is consistent with its billing guidelines and is, in its estimation, reasonable; (4) DEF must pre-approve the filing of any dispositive motions or the retention of experts; and (5) DEF reserves the right to allocate defense costs between what it characterizes as covered and uncovered matters (such as QRS's theft of trade secrets claims) and between covered and uncovered defendants. In addition, DEF declines any obligation to reimburse XYZ for the defense costs it pays on behalf of ABC because ABC is not insured under the D&O insurance policy.

XYZ's risk manager tells its insurance broker that the company is unhappy with DEF's position. But XYZ does not follow up with DEF. Instead, XYZ periodically submits defense bills, and DEF makes deeply discounted reimbursement payments. Along with each payment, DEF provides an explanation for the reductions that is based on the limitations it identified at the outset. XYZ's management is preoccupied with the defense of QRS's lawsuit and decides to deal with the defense reimbursement issues once the lawsuit is over.

In the meantime, it becomes necessary to retain expensive independent counsel for the individual defendants, and a number of cross-claims, counterclaims and third-party claims are filed. In addition, members of XYZ's founding family, who are now minority shareholders, file a lawsuit against XYZ and its directors and officers because they are distressed that management is refusing to listen to their concerns about the ABC situation. Eventually, all of the litigation is settled.

XYZ now turns its attention to the defense costs that were not reimbursed. DEF reimbursed only $350,000 of the more than $2 million in defense costs that XYZ paid to four law firms and submitted for reimbursement. When XYZ presses for reimbursement, DEF invokes the original conditions—noting that there had been no objection at the outset, that XYZ did not seek consent as required by the insurance policy when it selected additional counsel or when it settled the litigation, and that a significant portion of the defense costs pertained to uncovered matters, uninsured parties and affirmative claims. When XYZ continues to request reimbursement, DEF files a lawsuit seeking a determination that it had no further duty to reimburse XYZ.

We will not predict the result of this complex dispute, but it is safe to say that these or similar issues have been litigated to varying outcomes across the United States, and XYZ made several choices that led to another round of costly litigation:

• By failing to structure its D&O coverage to more closely track its actual activities, XYZ missed multiple opportunities to prevent costly disputes;
• By failing to seek consent when it was arguably required, XYZ opened the door to DEF's arguments that XYZ breached its duties to cooperate; and
• By failing to disagree in writing with some of DEF's reimbursement positions, XYZ appeared to acquiesce to DEF's determinations and surrendered the opportunity to demonstrate why DEF was being unreasonable.

Lessons Learned

Learning from XYZ's mistakes, a well-informed policyholder can take these and other steps to protect itself and avoid a similar fate:

• When placing insurance, a policyholder should take care in making sure that entities and persons to whom it is obligated to provide indemnification are identified as insureds;
• Do not be bashful in requesting available enhancements to policy terms such as favorable consent, allocation and prompt payment provisions;
• Pay attention to the consent and cooperation provisions of your insurance policy and err on the side of caution in seeking consent; if consent is withheld, do not hesitate to record why you believe the insurer's actions are not reasonable;
• During the course of an underlying claim, remember the consent and cooperation provisions, and continue to update the insurer; and
• If you disagree with reimbursement decisions made by the insurer, be assertive in responding and establish a record showing that you have not consented to those positions.

Disagreements about the reimbursement of defense costs regularly occur. But by paying attention to your interests and the conditions of the relevant insurance policy, you can prevent those disputes or, at least, establish the strongest possible argument for reimbursement.

Daniel J. Struck, a Principal in the firm's Policyholders' Insurance Coverage group, represents corporate and individual policyholders throughout the United States in insurance coverage litigation and provides counsel regarding complex insurance advisory matters. Dan can be reached at 312.521.2736 or dstruck@muchshelist.com.

Neil B. Posner, Chair of the firm's Policyholders' Insurance Coverage group, focuses his legal practice in the area of insurance coverage, with specific emphasis on insurance recovery and dispute resolution, risk management, loss prevention and cost containment. Neil can be reached at 312.521.2623 or nposner@muchshelist.com.