Thinking about D & O Claim Expense

In their perceptive and thought-provoking article, “The Missing Monitor in Corporate Governance: The Directors’ & Officers’ Liability Insurer” (here), Professors Tom Baker of Connecticut Law School and Sean Griffith of Fordham Law School, among other things, examine the consequences of the standard D & O policy feature whereby D & O insurers (by contrast to other liability insurers) do not control the claim defense. Under this D & O policy provision, the insured chooses its own counsel, the costs for which are reimbursed by the D & O carrier, subject only to the policy’s limits and the requirement that defense costs be reasonable and necessary. The authors found that the “predictable effects” of this arrangement are that “D & O insurers are unable to control the costs of defending the claim,” and that D & O insurers are “pressured” to settle claims “at greater expense than an insurer in full control of defense and settlement would allow.” (A prior post where I discuss the professors' article at much greater length can be found here.)

The D & O insurers’ general inability to control the defense can present a significant issue, because the costs of defending D & O claims are substantial. According to the 2006 Towers Perrin Survey of Insurance Purchasing and Claims Trends (here), the survey respondents’ average cost of defending a shareholder claim in 2006 was $2,798,404, up from $2,140,343 in 2005. (If anything, these numbers are understated since the 2006 survey response incorporated an increased number of smaller and private company respondents.) The increasing magnitude of defense expense is one of several factors escalating general perceptions of D & O limits adequacy, a development that ultimately drives up the aggregate cost of D & O insurance transaction as buyers feel compelled to acquire higher limits. Because defense expense erodes the limits that would otherwise be available to settle claims, escalating defense expense is contrary to the interests of both carriers and policyholders.

Carriers often try to manage defense expense through counsel guidelines and similar means, but all too often these efforts add friction to the claims process. In the end, carriers and the policyholders are still left to argue over whether a disputed expense was or was not reasonable.

An April 30, 2007 opinion from the Southern District of New York sheds some interesting light on the issue. In a coverage dispute arising from two claims filed in connection with bankruptcy proceeding relating to entities associated with Indotronix International Corp., Judge Charles Brieant held (here) that the carrier did not have to pay certain defense fees incurred that were “facially excessive.” The Court had previously held that the plaintiff insured was entitled to recover its reasonable and actual fees incurred in defending the two claims. Both of the claims had been dismissed due to the claimants’ lack of standing. (The procedural history surrounding the underlying claims is somewhat complex; for simplicity’s sake, I have not attempted to reproduce it here.)

The plaintiff insured sought to recover from its insurer $443,496 in fees and $75,772 in disbursement amounts, amounts which the Court found that the plaintiff insured, “a sophisticated business organization with a competent in-house lawyer,” had “willingly paid…without any assurance of disbursement.” The Court looked at the work the attorneys had done while the various motions to dismiss were pending; the Court found numerous occasions “when nothing was happening and all papers due had been filed,” and found that the defense lawyers were “spending an awful lot of time looking at documents” and “days on end sitting at Indotronix.”

Based on this review, the Court found that the amount of fees was “facially excessive,” and that “far too much work was done at too great a cost to be visited on the insurer.” The Court found that defense counsel had continued to work (and to bill) during a lull in litigation when no action was required; that the legal research “should not have required a great investment of time”; and that the “number of hours spent looking at documents appears to be highly excessive.”

In addition, the Court also looked at the hourly rates charged by the defense firm, a Manhattan law firm, for work done in Westchester County. The Court observed that the firm’s blended rate of $357.69 an hour “while perhaps reasonable in Manhattan is in excess of rates reasonably charged for similar work” in Westchester County. The Court took judicial notice that $300 an hour was a reasonable rate in the relevant judicial district.

Based on its review and applying the $300 per hour rate, the Court reduced the requested fees from the requested $443,496, to “a reasonable award of $141,153,” leaving the plaintiffs with an unreimbursed fee expense of $302,343.

Whether or not this case represents a significant development in the ability of D & O insurers to control D & O claims expense of course remains to be seen, as it will be relatively rare that courts will be willing to undertake any kind of review of defense expense, much less the kind of detailed review that Judge Brieant undertook in this case. Nevertheless, the case does at least establish that because defense fees must be reasonable in order to reimbursed, defense fees that are not reasonable are not reimbursable, and that the defense efforts must be proportionate and relevant to the defense issues in the case.

While the Court’s holding undoubtedly will provide some comfort to D & O insurers, it does not assure that disputes over fees will be any less prevalent or intense, and indeed there is some risk that carriers emboldened by this decision will agitate even more vigorously to contest fee reimbursement requests. But in addition to any comfort it may give the D & O carriers, Judge Brieant’s opinion also provides some clues about the steps that policyholders can take to try to avoid or reduce disputes.

First, Judge Briant not only examined the defense firm’s activities, he also reviewed the firm’s billing practices. It clearly did not help the insured plaintiff’s reimbursement request that “some hourly records are missing from the record and some services involved attending at proceedings [that were] not directly related to the Adversary Proceeding.” Policyholders’ will greatly improve the prospects for success of their reimbursement request by assuring that the substantiating documentation is complete, accurate and reflects only relevant charges.

Second, while the plaintiff insured had in fact paid the fees for which it sought reimbursement, it does not seem to have subjected the fees or the attorneys’ work to review or oversight. The Court’s finding that the fees were “facially excessive” and reflected "far too much work" implicitly suggests that the insured itself could have done more to monitor and control the attorneys’ work. The first step toward convincing a carrier that requested fees are reasonable and necessary is for the policyholder to first subject the fees to its own review, before even seeking reimbursement. All parties in the claims process (except perhaps defense counsel) have a stake in ensuring that defense fees incurred are reasonable and necessary, and the policyholder does have an important role to play in the process. Indeed, because defense expense depletes the policy limits, the policyholder has every incentive to ensure that the defense goes forward efficiently.

Finally, the key ingredient to avoid fee disputes is communication. The hourly rate charged, the amount of work done, and even the completeness of the bills are all issues that should have been sorted out during the unfolding of the claim, not afterwards, when it was too late to alter the circumstances. In this case, the existence of potential coverage dispute with the carrier clearly did not help communications; coverage uncertainty can often prove an insurmountable barrier to effective communication between the policyholder and the carrier. But timely and accurate communication between the policyholder and the carrier, when possible, can frequently avert or minimize issues that can lead to significant defense expense disputes. The involvement of a skilled claims advocate can help facilitate these communications, even where coverage remains uncertain.

Special thanks to a loyal reader for a copy of the opinion.