When Markham General Insurance Co. went into liquidation in 2002, its current and former officers and directors, including Cassels Brock & Blackwell LLP lawyers Gordon Goodman and Brian Reeve, were sued for $40 million.
Markham General had directors and officers insurance with AIG Commercial Insurance Co. of Canada. Cassels Brock had an outside director liability policy with Lloyd’s Underwriters.
Everyone agreed that the company’s policy was an underlying policy within the definitions of the firm’s policy and that both covered defence costs.
The matter settled within the underlying policy limits. The narrow issue before the courts recently was whether Goodman and Reeve’s defence costs, which their firm had paid, were to be reimbursed by AIG under the company’s policy or by Lloyd’s under the firm’s policy.
The courts at both the trial and appellate levels (see
Goodman v. AIG Commercial Insurance Co. of Canada) held that reimbursement of the defence costs was the responsibility of Lloyd’s under the firm’s policy.
The decisions turned on a narrow contractual interpretation of the “follow form” language of the firm’s policy and the contrast between the company’s policy which, like most directors and officers policies, provides that the insurer pays defence costs, and the firm’s policy that had Lloyd’s assuming the defence under certain circumstances.
The decisions acknowledge that they may be a surprise to the insurance marketplace. Law firms purchase outside director liability policies to protect their lawyers serving on boards in the event that both the corporate indemnity fails and the corporate directors and officers insurance is exhausted or doesn’t exist.
Until this decision, neither the firms nor the outside director liability insurers would have thought that the two policies could interact in the way that the courts found.
Since outside liability coverage is a part of most directors and officers policies, the implications of this decision are much broader and include:
• The right and duty to defend: The ability to defend claims is an important protection feature of all insurance policies and a fundamental feature of directors and officers policies.
For these policies, being able to mount an effective defence is the best way to avoid or minimize the exposure to a claim against the insured director. Most personal lines policies have the insurer assuming the defence. For directors and officers policies, the insureds want to control the defence.
These policies normally provide that once the insurer has approved the counsel chosen by the insured, it pays the defence costs.
Courts have held that the duty to defend is broader than the indemnification provisions in that they are determined at different points in time, with the former based on the pleadings and the latter based on the findings of the trial.
However, both ultimately depend on and are inextricably linked to the indemnity provisions of the policy.
The Court of Appeal’s treatment of the duty to defend as distinct from the insuring agreements seems inconsistent with what the Supreme Court of Canada held
in Non-Marine Underwriters, Lloyd’s of London v. Scalera.Most insurance companies have sizeable boards. Markham General, for example, had seven directors and a number of former directors.
This case suggests that rather than having a unified defence even when directors have a common interest, there are likely to be multiple counsel. In the simplest iteration of the Markham General case, Goodman and Reeve would be required to have Lloyd’s provide them with a defence with Lloyd’s picking the counsel.
The other directors of Markham General would have the right to pick their own counsel and have AIG pay for it. The situation becomes even more fractured if other directors of Markham General also had similar outside director liability policies.
The result is multiple counsel while Goodman and Reeve, who paid an extra premium, get less control over the defence than the other directors of Markham General.
• Notices and preliminary actions: When directors get sued, they should and normally do give notices under all policies that may respond.
As a practical matter, if one insurer provides a defence or agrees to pay defence costs, even if it does so under a reservation of rights, insureds will accept other insurers declining to do so.
But this decision raises questions about this approach and appears to require the resolution of disputes dealing with the obligation to defend at the beginning.
If Goodman and Reeve hadn’t notified and given Lloyd’s an opportunity to defend, then presumably Lloyd’s and AIG could argue the insureds breached their obligation under the Lloyd’s policy, meaning both AIG and Lloyd’s could refuse to reimburse them.
If notice was given and Lloyd’s refused to provide a defence, the lawyers would have to challenge that decision rather than look to their indemnity rights. In light of the importance of defence costs, the challenge is likely to occur at the beginning, at which point no one is willing to fund the defence.
The insureds will have to fund the costs of the challenge. Even if they win, they’ll only get reimbursed for a portion of those costs and their defence of the main action may be delayed and disrupted. It’s another curious result of paying for what was thought to be additional coverage.
• Policy limits: All insurance policies have policy limits. The company’s policy had a $10-million limit and the firm’s policy a $5-million cap. Most policies provide that the defence costs paid by the insurer erode the policy limits.
Especially in the directors and officers and outside director liability field, the erosion or cannibalization of policy limits is of central concern.
Directors and officers policies frequently cover inside and outside directors, former directors, officers, former officers, and the company for its indemnity obligations to directors and officers and for employment, securities, and whatever other indemnities may be provided under what’s called side C coverage.
Outside director liability policies frequently cover many insureds and many directorships. Defence costs in complicated cases can quickly mount.
In this case, the policy limits of the firm’s policy were eroded by the amount of Goodman and Reeve’s defence costs to the detriment of the firm and its partners. Again, it’s a surprising result for paying the extra premium.
Equally perplexing is that if AIG tendered less than its remaining policy limit to effect the settlement, it and its group of insureds got the benefit of Lloyd’s having to pay part of the directors’ defence costs.
Overall, these decisions suggest a broad interpretation of the duty to defend, a narrow reading of “provide a defence,” and a restrictive approach to the impact the business context or layers of risk will have on the interpretation of a policy and restrictions on an insurer’s subrogation rights.
This suggests that insureds, insurers, and underwriters must reconsider how outside director liability and primary directors and officers policies will respond.
The decisions also suggest that the policy wording could be changed to make the outside director liability coverage inapplicable if there’s unused underlying insurance or by converting the duty to defend to a duty to pay defence costs.
Alternatively, outside director liability insurers may increase their premium to reflect any perceived additional risk. The underwriters, insurers, and their customers can determine which is necessary or preferable.
In the interim, insureds, insurers, and their lawyers will have to assume that a duty to defend is separate coverage that may supersede an indemnity obligation to pay defence costs and therefore act accordingly in drafting, underwriting, and purchasing policies and in responding to claims.
Frank Palmay and R. Nairn Waterman are both partners at Lang Michener LLP.
