Under a typical commercial general liability policy, the insurer agrees to defend a claim even if it is “groundless, false or fraudulent.” Numerous courts have held that the duty to defend is broader than the duty to indemnify. As a result, courts have developed a variety of familiar duty-to-defend rules for determining whether the defense obligation is triggered and the scope of that obligation. First, the insurer must defend if the underlying complaint asserts claims for damages potentially covered by the policy (sometimes referred to as the “potentiality standard”). Second, in determining whether the defense obligation is triggered, many jurisdictions confine the inquiry to the claims asserted in the complaint and the insurance policy language (sometimes referred to as the “four corners” or “eight corners” rule, or “pleadings” test). Finally, in many jurisdictions, if some of the claims in the underlying complaint are covered and some are not covered (a “mixed” action), the insurer has a duty to defend the entire action (sometimes referred to as the “one claim-all claims” principle).
Many types of insurance do not contain a duty-to-defend obligation; rather, the defense costs are advanced or reimbursed by the insurer. This is particularly common in umbrella/excess, directors and officers (D&O), errors and omissions (E&O), and fiduciary liability policies. Consequently, there may be an issue as to whether the traditional duty-to-defend standards apply to duty-to-reimburse policies. Few courts have addressed the scope of the insurer’s defense obligation in a situation where the policy provides only for the advancement or reimbursement of defense costs. This article evaluates the current case law on how and to what extent the duty to advance defense costs differs from the duty to defend.
The Scope of the Duty to Advance Defense Costs Equals the Duty to Defend
As noted above, most jurisdictions apply different rules in determining whether the insurer must defend a claim as opposed to indemnify the insured for damages. Many courts, for example, apply the “four corners of the complaint rule” in determining whether the insurer must provide a defense. Although a few older cases drew a distinction between the duty-to-defend and the duty-to-reimburse obligations, a clear majority of the more recent cases have applied the traditional duty-to-defend standards in determining whether the insurer’s obligation to advance defense costs is triggered.
Most recently, the Eighth Circuit Court of Appeals addressed this issue in Liberty Mutual Insurance Co. v. Pella Corp. The underlying litigation involved a number of class actions claiming that Pella defectively designed and manufactured windows. The coverage litigation involved excess general commercial liability policies, which expressly disclaimed any duty to defend the policyholder. An endorsement to the policies, however, required the insurer to reimburse the insured for expenses incurred in defending lawsuits that the policies covered, including reasonable attorney fees. The insurer argued, among other things, that the policies did not require reimbursement of defense costs if the underlying suits only alleged an occurrence. Rather, it contended that there was no defense reimbursement obligation unless and until the existence of an occurrence had been established (as opposed to alleged). The court rejected this argument, holding that under Iowa law “unless otherwise stated in the policy, the duty to reimburse defense costs, like the duty to defend, is determined by the facts alleged in the complaint.” Applying that standard, the court concluded that the plaintiffs in the underlying actions did not allege an occurrence and that the insurer therefore did not owe the insured a duty to reimburse the policyholder’s costs of defending the claims.
Similarly, in Julio & Sons Co. v. Travelers Casualty & Surety Co. of America, the court considered whether the allegations in the underlying complaint triggered the insurer’s obligation to advance defense costs under a D&O policy. The underlying complaint alleged claims for breach of contract, breach of fiduciary duty, fraud, and negligent misrepresentation. After the insurer denied coverage, the insured commenced a declaratory judgment action and moved for summary judgment on the insurer’s obligation to advance defense costs for defending the underlying complaint.
The policy at issue provided that the insurer would “advance Defense Expenses for which such Liability Coverage provides coverage.” As a threshold matter, the court addressed the universe of evidence that could be considered in determining whether the defense obligation had been triggered. The insured contended that the Texas “eight corners” rule governed whether the insurer must defend, thus limiting the evidence used in making that determination to the four corners of the policy and the four corners of the underlying complaint. The insurer, on the other hand, argued that the eight corners rule did not apply because the policy at issue imposed only a duty to advance defense costs and expressly did not impose on the insurer a duty to defend. The court rejected this argument.
The whole purpose of advancing legal expenses rather than reimbursing them at the conclusion of the litigation is that insured organizations may not have the cash on hand to finance their own defense. If the insurer is permitted to look beyond the policy and the pleadings to the merits of the claim, the insured is placed in the position of choosing between seeking reimbursement at the conclusion of the underlying litigation and risking its defense by challenging the insurer in court. The former destroys any value advancement had, and the latter poses the exact same risk the eight corners rule seeks to eliminate in the duty-to-defend cases. Accordingly, there are no material differences between a duty to defend and a duty to advance defense costs.
In short, the court concluded that Texas would apply the eight corners rule to both duty-to-defend and duty-to-advance policies. Thus, in determining whether there was an obligation to advance defense costs, the court declined to consider an agreement between the parties in the underlying litigation because any interpretation of that agreement would necessarily resolve issues relevant to the underlying claim. It ultimately determined that some of the underlying claims were covered and some were not; thus, the insurer was required to advance defense costs.
A similar result was reached in Aspen Insurance UK, Ltd. v. Certain Underwriters at Lloyd’s, in which the court interpreted a professional liability policy that provided that the insurer could, in its discretion, advance defense costs prior to the disposition of the underlying claim. The underlying claims included four class action lawsuits and two arbitration proceedings alleging that the insureds had breached their duties as custodial trustees by investing in Bernie Madoff’s failed and insolvent brokerage firm. The insurers denied the policyholders’ requests to advance defense costs.
Citing Julio & Sons, the court held that there are no material differences between a duty to defend and a duty to advance defense costs. The court therefore applied a “four corners” review “pursuant to which courts look only to the four corners of the underlying complaint and the insurance policy to determine if the insurer’s duty has been triggered.” Applying the four corners test, the court concluded that the insurers were required to advance defense costs on a contemporaneous, as-incurred basis.
In the absence of policy language to the contrary, other courts agree that in determining the insurer’s defense obligation, there is no difference between the duty to defend and the duty to reimburse.
Where the Policy Provides Otherwise, Courts Have Not Applied the Duty-to-Defend
The terms and conditions of the policy control the scope of the insurer’s obligations, and a court will not rewrite the policy if the terms are clear and unambiguous. Thus, where the policy provides otherwise, courts have not applied the broader duty-to-defend standard.
A recent illustration of this principle is found in Pendergest-Holt v. Certain Underwriters at Lloyd’s of London, in which the Fifth Circuit Court of Appeals concluded that the duty-to-defend standard did not apply to a D&O policy. The underlying claims related to civil and criminal allegations arising out of the R. Allen Stanford Ponzi scheme. The coverage dispute largely turned on whether coverage was barred by a money laundering exclusion, which provided for the qualified reimbursement of defense costs “until such time that it is determined that the alleged act or alleged acts did in fact occur.”
As in Julio & Sons, the insureds contended that, among other things, the Texas eight corners rule prohibited the insurers from attempting to rely on extrinsic evidence in support of an “in fact” determination that the money laundering exclusion barred coverage. The court noted that no Texas state court has applied the eight corners rule in a case involving a duty to advance defense costs. The court reached a different result from the one reached in Julio & Sons:
Whatever the Texas Supreme Court might do to resolve the issue in a future case, however, we need not venture a guess in this one: the D&O Policy’s terms plainly state that the underwriters must advance defense costs “until it is determined that the alleged act or alleged acts did in fact occur” and, in so doing, require recourse to something more than mere allegations. The terms contemplate the use of extrinsic evidence in making the determination. . . . Assuming but not deciding the eight corners rule would have applied, the parties chose—in plain language—to displace it and to provide for the use of extrinsic evidence.
The court therefore remanded to the trial court for the “in fact” determination as to whether the exclusion applied and thus required insurers to advance defense costs, subject to reconsideration in the event that the insureds were exonerated in either the criminal or administrative proceedings. Significantly, the court further held that the insurers were required to reimburse defense costs until a decision on the “in fact” determination had been reached. Thus, the specific language of the policy may preclude application of traditional duty-to-defend law.
A similar result based on the specific wording of the policy was reached in Jeff Tracy, Inc. v. United States Specialty Insurance Co., which involved a D&O policy that disclaimed any duty to defend. The policyholder argued that the broader duty-to-defend or potential-for-coverage standard applied in determining when the insurer is obligated to pay defense costs on an as-incurred basis. The court rejected this argument on the grounds that, among other things, the policy specifically provided for allocation of defense costs involving both covered and uncovered losses. The court held that these, and other conditions in the policy, were “not consistent with the broader duty to defend standard.” Instead, the court held, the insured must establish that the underlying claims are within the basic scope of coverage. Here again, the specific policy language trumped application of the duty-to-defend standards.
The Insurer’s Obligation to Advance All Defense Costs in a Mixed Action
Apart from the standards for triggering the defense obligation, a related issue is whether the insurer must advance all costs associated with defending a “mixed” action. The few reported cases that have considered this issue have concluded that the insurer has an obligation to advance all of the defense costs, subject to later recoupment.
The court in American Chemical Society v. Leadscope, Inc., interpreted a D&O policy that provided for advancement of defense costs. The underlying claims alleged misappropriation of trade secrets, common-law unfair competition, and implied license under the shop-right doctrine. The insureds brought a third-party action against the insurer seeking a determination that it was required to reimburse the insureds for defending all of the claims. The trial court ruled that because one of the claims in the underlying suit was covered, the insurer owed a duty to defend against all of the underlying claims, regardless of whether they were covered. On appeal the insurer argued that the policy contained no duty to defend and that the insureds were therefore entitled only to advancement of defense costs incurred in defending claims that were individually covered. The court rejected that argument:
[W]e conclude that, when a policy imposes a duty to advance defense costs but no duty to defend, the pleadings test and the one claim-all claims principle apply to determine the duty of the insurer to advance defense costs. We see no reason to make a distinction between duty to defend cases and duty to advance defense costs cases with respect to application of the one claim-all claims principle and pleadings test.
In an attempt to avoid the one claim-all claims principle, certain policies may contain an allocation provision that requires the insurer to pay only certain defense expenses allocated to the covered loss. The results here have been mixed.
In Federal Insurance Co. v. Kozlowski, the court recognized that under a defense reimbursement policy, “the insurer is entitled to differentiate between covered and uncovered claims” but concluded that “[s]ince this allocation cannot be made at this juncture and the duty to defend is broader than the duty to indemnify, Federal must pay all defense costs as incurred, subject to recoupment when Kozlowski’s liabilities, if any, are determined.”
The court in Commercial Capital Bankcorp., Inc. v. St. Paul Mercury Insurance Co. came to a much different result in interpreting a D&O policy that contained an allocation provision. The underlying claims for misappropriation of trade secrets and confidential customer information involved both covered and uncovered claims. The insured asked the insurer to pay 100 percent of the defense costs. The insurer refused and offered to pay 50 percent of the defense costs. The insured subsequently brought a declaratory judgment action seeking 100 percent of the defense costs and also asking the court to declare the allocation provision unenforceable. The court rejected this argument, finding the allocation provision valid and enforceable under California law. It also rejected the policyholder’s argument that the duty-to-defend rule required the insurer to defend an entire mixed action of covered and non-covered claims. In particular, the court held as follows:
[R]ather than paying premiums for the right to a defense of all potentially covered claims, Plaintiff in this case paid (presumably lower) premiums for a lesser right. . . . To require Defendant to advance all of Plaintiff’s defense costs on a current basis despite [the allocation provision’s] clear indication of the parties’ contrary intent would give Plaintiff an un-bargained-for windfall.
Accordingly, the insurer was required to advance only 50 percent of the defense costs.
Conclusion
In the absence of policy provisions to the contrary, a clear majority of courts that have addressed the issue treat the duty to advance or reimburse defense costs the same way as the duty to defend. As a result, they generally apply the traditional duty-to-defend standards. This is expressly or implicitly grounded on the idea that defense costs, regardless of how they are characterized, are part and parcel of the insurer’s defense obligation. However, the actual terms and conditions of the policy govern the trigger and scope of the defense obligation. For that reason, a number of policies are structured so as to substantially narrow the defense obligation, particularly with respect to mixed actions.
