Earlier this year, in K2 Investment Group v. American Guaranty & Liability Ins. Co., 983 N.Y.S.2d 761 (N.Y. 2014), New York’s highest court adopted—but then decided against—a rule under which a liability insurer that has breached its duty to defend would be prevented from asserting coverage defenses in connection with the duty to indemnify.  That rule is settled law in Montana, however, and last month, in Tidyman’s Management Services, Inc. v. Davis, 330 P.3d 1139 (Mt. 2014), the state’s Supreme Court elaborated the harsh consequences that flow from it.

• To decide whether an insurer has breached its contract by refusing to provide a defense, a court need not consider whether an exclusion to coverage applies.
• If there was a breach, the insurer may be liable for the full amount of any judgment and defense costs incurred by the insured, without regard to policy limits.
• Where the judgment against the insured was the result of a settlement, the insurer bears the burden of proving the amount of the settlement is unreasonable or collusive.
• To establish collusion, the insurer must prove that the parties to the settlement “aimed at defrauding another or otherwise breaking the law.”
• Evidence that the insured agreed to pay seven times what the plaintiff had previously demanded, and that the insured stands to benefit financially from the settlement, is not sufficient to establish collusion. The Tidyman’s opinion commented on that evidence in this way:  “[T]he Court can only say, so what.“

In the end, the court sent an unmistakable message:

[W]here an insurer refuses to defend the insured, it does so at its peril. …[T]he prudent course of action is to defend the insured under a reservation of rights and file a declaratory judgment action to discern coverage.

The Messy Facts Behind Tidyman’s

Tidyman’s Management Services, Inc. (TMSI), was a corporation that operated supermarkets and grocery stores, and it had been employee-owned since 1986.  In the late 1990s, the company’s financial advisor, Zachary Scott, recommended that it be sold, estimating that the owners could realize more than $28 million.  Instead, in 1998, management recommended a merger with SuperValu, Inc., and the employees approved the transaction.  The merger resulted in the creation of Tidyman’s, LLC, a Delaware entity that held the assets of the two merger partners.  TMSI, which was still employee-owned, owned 60% of the LLC, and SuperValu owned 40%.  Several officers and directors of TMSI assumed management positions with the LLC.

In 2006, partly as a result of a damages award in a sex discrimination suit, TMSI and the LLC both went out of business.  In 2007, a group of former employees filed an action in federal court against TMSI and five of the company’s officers and directors, charging that the defendants had violated ERISA and breached their fiduciary duty by recommending and consummating the merger.

The individual defendants were now officers and directors of the LLC, and they were insureds under a directors and officers liability insurance policy that had been issued to the LLC in 2006 by National Union Fire Insurance Company of Pittsburgh. Even though the suit was based on acts the defendants had committed in their capacity as officers and directors of TMSI, before the LLC had been created, National Union agreed to pay for the officers’ and directors’ defense under that policy, subject to a reservation of rights.

After mediation, the plaintiffs reached a settlement that resolved their ERISA claim, and, as part of the settlement, they agreed to dismiss the breach of duty claims against three of the five officers and directors for $100,000.  In the course of seeking court approval for the settlement (which was required under ERISA), the plaintiffs argued that it was “reasonable in light of the likelihood of recovery, the risks and costs of litigation, and the value of the claims foregone.”

Following the settlement, the remaining defendants challenged the plaintiffs’ standing to bring derivative claims against directors of TMSI and the LLC.  Before that issue had been finally resolved, the court dismissed the action, without prejudice, for lack of subject matter jurisdiction.  In May 2010, the plaintiffs—now joined by TMSI—filed a new action against the two remaining officers, Michael Davis and John Maxwell, in a Montana district court.  In addition to TMSI, which owned a 60% share of the LLC, the plaintiffs included five current members of the LLC’s board of directors.  The new action added allegations that Davis and Maxwell had committed breaches of duty in their capacity as officers and directors of the LLC—allegedly, by conducting “business as usual at the initial meeting of [the] Tidyman’s LLC Directors.”  At some point, plaintiffs offered to settle with Davis for $4 million, but their offer was refused.

In August 2010, National Union advised the defendants’ counsel that “there [was] no longer any coverage for this matter under the Policy,” because coverage was barred by the “Insured v. Insured” exclusion—an exclusion that applied to claims brought “by any Insured … or … by any security holder of the Company.”  Insured v. Insured exclusions are standard features of D & O policies; their purpose is to “bar[] coverage for internecine corporate warfare” and to “prevent[] a company from suing its own officers and directors in order to have the insurer pay for business loss.”  23-146 Appleman on Insurance § 146.6.  A week later, the plaintiffs amended their complaint to add the insurer as a defendant and request a declaratory judgment that the claims against Davis and Maxwell were covered under the LLC’s policy.

The insurer’s letter did not specifically state, however, that National Union would stop paying defense costs, and the defendants continued to be represented.  In September, Davis’s attorney sent two letters to the insurer, asking “whether the carrier is going to continue to pay for the costs of defense in this matter.”  National Union did not respond until October 28, when it stated clearly that it “[was] not going to continue paying the costs of defense in this matter.”

The Settlement and the Judgment

In the meantime, Davis and the plaintiffs had negotiated a “stipulation resulting from insurer’s refusal to provide coverage,” based on Davis’s alleged inability to pay for a defense and need to protect himself.  The stipulation was filed with the court on October 25—that is, three days before National Union confirmed its unwillingness to pay further defense costs.  An identical stipulation with Maxwell was filed a month later.  The stipulations provided for (i) entry of a judgment against the individual defendants in the amount of $29 million, (ii) plaintiffs’ agreement not to seek to execute the judgment against those defendants’ personal assets, and (iii) assignment of all the individual defendants’ rights against National Union.  On November 19, in between the two stipulations, National Union reversed its position and stated that it would continue to advance defense costs, subject to a reservation of rights.

Several motions followed.  In January 2013, the court approved the plaintiffs’ stipulations with Maxwell and Davis and granted plaintiffs’ motion for summary judgment against National Union—resulting in an award of $29 million.  In doing so, the court denied National Union’s request for an evidentiary hearing on the reasonableness of the settlement, and it dismissed as “speculative” the argument that the settlement was collusive.

The Supreme Court’s Decision

Over a stinging dissent by Justice Laurie McKinnon, the Montana Supreme Court affirmed most of the trial court’s rulings.  The majority’s analysis had several disturbing features.

Addressing the Duty to Defend

In Montana, the duty to defend arises “when a complaint against an insured alleges facts which, if proved, would result in coverage.”  On appeal, National Union argued that the trial court had erred by (among other things) failing to consider whether the Insured v. Insured exclusion applied.  Although not alleged in the complaint, it was, after all, undisputed that the plaintiffs included directors of the LLC, and the complaint did allege that directors were insureds under the LLC’s policy.  It was also undisputed that TMSI was a 60% security holder in the LLC.

The majority rejected this argument. In effect, the court held that the duty to defend vests with the filing of a complaint by which coverage is “potentially implicated,” and that the sole recourse of an insurer that wishes to challenge coverage is to file a declaratory judgment action. According to the majority, the fact that National Union had agreed to provide a defense to the original action in federal court (albeit subject to a reservation of rights) was sufficient to establish that coverage was “potentially implicated” in the state court action.  Consequently, the majority contended it “d[id] not matter” that the state court action differed from the original suit in ways that potentially triggered the Insured v. Insured exclusion:  “all that matters is whether [National Union] was on notice that the Policy was potentially implicated.”  Once a complaint implicates coverage, the insurer may contest coverage only in a declaratory judgment action.

The dissent pointed out that the majority’s ruling actually had the effect of “deny[ing] the insurer the right to contest a duty to defend in” a declaratory judgment action—one that had been brought by the plaintiffs, and which was already pending before National Union stated definitively (in October 2010) that it would not pay future defense costs. Justice McKinnon saw no practical difference between National Union’s motion to dismiss the plaintiffs’ suit for coverage and a separate declaratory judgment action brought by the insurer.  For the majority, however, National Union’s express disclaimer of its duty to pay for the defense was dispositive:

If we were to hold the District Court in error for failing to analyze coverage, … we would be providing insurers with an avenue to circumvent the clear requirement … that where the insurer believes a policy exclusion applies, it should defend under a reservation of rights and seek a determination of coverage through a declaratory judgment action.

National Union, the majority said, “took its chances by refusing to defend.”

Justice McKinnon (and National Union) also contested the significance of that supposed “refus[al].”  Like many other D & O policies, the policy at issue in Tidyman’s created an obligation “only to reimburse expenses incurred in [the] defense,” not to provide a defense to the insureds.  The attorneys for Maxwell and Davis represented them without interruption between October 28, when National Union stated it would not reimburse expenses, and November 19, when it agreed to continue paying defense costs subject to a reservation of rights.  At a minimum, the dissent argued, the question of whether National Union had breached its duty under the policy raised a disputed issue of fact that precluded summary judgment.

The majority rejected the factual premise of that argument, finding that National Union had “agreed only to pay for a motion to dismiss, … and while that motion was pending, failed to defend its insureds or advance defense costs.”

The court did not address the more fundamental question:  why the duties of an insurer that has agreed only to reimburse the costs of a defense, not to provide one, could not be adjudicated in a declaratory judgment action filed by the insured.  The answer appears to be that the policy of requiring insurers to defend and sue for declaratory judgment is of absolutely paramount importance.

Addressing the Reasonableness of the Settlement

National Union also faulted the trial court’s failure to conduct a hearing on the reasonableness of the plaintiffs’ stipulated judgment.  On this point, the insurer won a partial victory.  The court first held, rather confusingly, that “a trial court may hold a hearing to establish whether a stipulated judgment … is reasonable or collusive—but failing to do so is not procedural error.”  Nevertheless, the court confirmed that “we do require such settlements to be reasonable,” and it found that the trial court should have conducted a hearing in this case.

The majority explained that “a stipulated settlement is presumed reasonable,” and that “the burden is on the insurer to rebut the presumption.”  To carry that burden, the insurer must “go beyond the pleadings” and offer evidence establishing a genuine issue for trial.  The court held that National Union had established such an issue through a combination of important facts:

• Although TMSI’s financial advisor had suggested it could be sold for at least $28 million, no buyer willing to pay that price had been identified.
• In fact, the advisor had suggested that the value of TMSI as a standalone entity was only $11 million.
• Plaintiffs settled with other directors of the LLC for only $100,000, and they had previously offered to settle with Davis for only $4 million.

It therefore reversed the award of summary judgment and remanded the case for a hearing on the reasonableness of the settlement.

Addressing Collusion

National Union argued further that a stipulated judgment like the one at issue in Tidyman’s must be both reasonable and not collusive. Among other arguments supporting its claim that this settlement was collusive, the insurer pointed to the disparity between the size of the stipulated judgment and the amounts for which plaintiffs had previously been willing to settle their claims, as well as to the fact that Davis, as one of the employee-owners of TMSI, stood to receive over $500,000 from the settlement of the claims that had been asserted against him, and Maxwell  would also benefit from it.  (The plaintiffs disputed this claim, asserting that Maxwell and Davis had both assigned their rights to any proceeds of the settlement; the issue does not appear to have been finally resolved.)

The Supreme Court found, however, that “Montana precedent does not require a court to consider whether a stipulated settlement is collusive where the insurer has breached the duty to defend,” because Montana law is determined to create “strong disincentives against default in performance of the duty.”

Furthermore, and even more striking, the court found that the facts cited by National Union—including the fact “that Davis stood to be one of the largest beneficiaries of the stipulated judgment“—”do not rise to the level of collusion.”

The court declared that “the term ‘collusion’ implies the existence of some sort of agreement aimed at defrauding another or otherwise breaking the law.”  On that basis, it agreed with the trial court that the insurer’s collusion arguments were merely “speculative.”  It did note, however, that the size of the settlement relative to plaintiffs’ previous demands could be considered in connection with the issue of reasonableness.

Thus, although the Supreme Court directed the trial court to conduct a hearing on reasonableness, it found that “a collusion inquiry” would not be “relevant,” and explained, “we do not require such an inquiry here.”  Summing up the evidence about how the settlement had been reached, the Supreme Court of Montana declared:

“[T]he Court can only say, so what.  What Defendant has described is nothing other than the usual custom and practice in which parties engage in Montana as a consequence of an insurer’s failure to defend.

Conclusions

As the dissent pointed out, Tidyman’s has established a trigger for the duty to defend—it arises whenever coverage is “potentially implicated” by the allegations of a complaint—that is vague, at best. The decision in Tidyman’s further establishes that this trigger is irreversible: because the original, federal complaint had “potentially implicated” coverage, the fact that the subsequent state court complaint added allegations that implicated an exclusion could not justify a disclaimer of defense costs.  In the court’s words, it “d[id] not matter.”

At the same time, the consequences for denying coverage where this trigger has been tripped are extreme: liability for any judgment and defense costs, without regard to policy limits. If the judgment in question is the product of a settlement, the insurer will have the burden of proving the settlement is unreasonable or collusive. Either claim requires hard evidence, and a claim of collusion requires evidence that the parties “aimed at defrauding another or otherwise breaking the law.”

And remember: if those parties were merely exploiting the possibility of inflicting maximum pain on the insurer, they were engaging in nothing more than “the usual custom and practice … in Montana.”  If liability for judgments and defense costs were not sufficient incentive for insurers to pay defense costs, the license that the Supreme Court has issued to insured defendants certainly is.

Image source: Tom Palumbo (Wikimedia)