Should a directors and officers (D&O) insurance policy cover derivative claims? And should a D&O insurance policy advance defense costs? A recent decision from New York’s Appellate Division, First Department, reaffirmed that the answer is “yes” to both questions, and rejected an insurance company’s arguments to the contrary. In Trustees of Princeton University v. National Union Fire Insurance Co. of Pittsburgh, Pa., 15 Misc. 3d 1118A (Table), 839 N.Y.S.2d 437 (Table), 2007 N.Y. Misc. LEXIS 2350, (Sup. Ct. Apr. 10, 2007), aff’d, 52 A.D.3d 247, 859 N.Y.S.2d 174 (1st Dep’t 2008) (“Trustees of Princeton”), an insurance coverage dispute, AIG, through its insurer National Union, tried to escape from providing D&O insurance coverage for direct and derivative claims under its D&O policy and had refused to advance defense costs.
The court decided properly that the insured versus insured exclusion did not preclude coverage
Like many directors and officers insurance coverage disputes, the insurance coverage case revolved around an underlying dispute that involved “direct and derivative claims.” 2007 N.Y. Misc. LEXIS 2350, at *3. National Union and AIG argued that the policy provided no coverage for the derivative claims, which were brought against the officers (who were individual insureds under the policy) on behalf of the organization (which was the named insured), due to the so-called “insured versus insured” exclusion that is found in countless directors and officers insurance policies. See id. at *3-*4.
The trial court denied National Union and AIG’s argument. Adoption of the insurers’ position by the court could have gutted D&O coverage for derivative claims in general, potentially wiping out unfathomable amounts of insurance protection. In support of its ruling, the trial court noted that “[t]he purpose of the ‘insured versus insured’ exclusion is to prevent collusive lawsuits that corporations bring against their officers and directors to recoup consequences of business mistakes, effectively transforming liability insurance into business loss insurance.” Id. at *5-*6 (citing Bodewes v. Ulico Cas. Co., 336 F. Supp. 2d 263, 272-77 (W.D.N.Y. 2004)). AIG had asked that the standard exclusion be applied to all claims that it deemed to be “derivative in nature,” but the court refused to do so. Id. at *6.
The trial court’s decision was eminently correct in light of the second argument that National Union and AIG advanced: that all costs arising from an occurrence—some of which were subject to policy limitations and some not—are subject to the policy limitations. Had the trial court accepted National Union and AIG’s arguments in full, the insurers likely would have asserted in other cases that coverage is excluded for all claims that involve any underlying derivative-based causes of action. The Appellate Division affirmed, “reject[ing] the contention that the policy’s ‘insured versus insured’ exclusion applies to claims brought against the insured entities by individual insureds acting in their individual capacities.” 52 A.D.3d 247, 247, 859 N.Y.S.2d 174, 175 (1st Dep’t 2008). The decision follows the long standing rule in New York and other states that an insurer may refuse to pay defense costs only after meeting the heavy burden of showing that no claim possibly is covered. See, e.g., Frontier Insulation Contractors, Inc. v. Merchs. Mut. Ins. Co., 91 N.Y.2d 169, 175, 690 N.E.2d 866, 868-69, 667 N.Y.S.2d 982, 984-85 (1997).
The insurer had to advance defense costs, without an allocation, until the underlying litigation was completed
Another significant point in the Appellate Division’s decision is that National Union had to advance defense costs, in full, until the underlying litigation was resolved. See Trustees of Princeton, 52 A.D.3d at 247, 859 N.Y.S.2d at 175. That decision is critical, as it allows the insured to recover defense costs, without being forced to allocate between covered costs and those that the insurer believes are not covered. Indeed, it is not appropriate for a court to address the question of allocation of defense expenses while the underlying claims are pending. See id.
The Trustees of Princeton decisions correctly rejected National Union and AIG’s attempts to have limited exclusions and limitations apply to coverage and defense costs for all claims, without, at a minimum, an allocation to determine whether the claims were covered or not. Moreover, the appellate court explained that the insured may recover its defense costs, in full. As AIG is one of the largest insurers issuing D&O insurance (often through its insurer, National Union), it is not unlikely that National Union and AIG will raise similar arguments in other cases, and these decisions are instructive as to why such arguments should be rejected.