By Ashley Jordan

Law360 (August 19, 2020, 5:57 PM EDT )

Ashley Jordan

With the number of insurance claims steadily rising across the private equity space even before the onset of the pandemic, and carrier profits bearing the brunt of the COVID-19 fallout,[1] rising costs of legal defense are expected to become a primary area of concern for insurers in the private equity market.[2] Private equity firms may experience increasing pushback, with insurers refusing to defend and advance defense costs across lines of coverage for liability claims.

Various lines of coverage may respond to liability claims against the firm, portfolio companies, and/or managing members, general partners and directors and officers, including: general partnership or directors and officers liability/management liability; employment practices liability; cyber liability; and professional liability/errors and omissions. Claims may also implicate general, environmental and other liability coverages at the portfolio level.

Known as litigation insurance,[3] an insurance company's duty to defend or advance defense costs is a valuable firm asset that serves as the first line of defense against costly liability claims. Private equity firms can implement several risk management strategies in connection with policy renewals to stave off the impact of this anticipated trend and optimize this essential protection.

1. Negotiate a 100% defense costs allocation endorsement.

Liability insurance policies impose on the insurer either a duty to defend or a duty to advance defense costs, requiring the carrier to pay costs on an ongoing basis.[4] The duty is very broad, attaching whenever a claim is potentially covered by the insurance policy.[5][6]

Generally, if there is a potential for coverage, insurers must defend the entire lawsuit, even if it includes some uncovered claims.[7] The duty is thus excused only when the third-party complaint can by no conceivable theory raise a single issue that could bring it within coverage.

Some liability policies contain clauses that alter these well-established ground rules. Allocation clauses in duty to advance policies, for example, allow the carrier to allocate up front between covered and uncovered claims and require the insurer to advance only those defense costs it "believes to be covered" or "believes to be fair and equitable" unless and until a different allocation is required.

Private equity firms should consider consulting with their brokers regarding a 100% defense costs allocation endorsement, which will require the insurer to advance defense costs if any claim triggers the duty to advance defense expenses. Obviating the need for allocation disputes in mixed actions, these endorsements include an iteration of the following language:

If both Loss covered under this policy and loss not covered under this policy are incurred by the Insureds on account of any Claim because such Claim against the Insureds includes both covered and non-covered matters, then coverage under this policy with respect to such Claim shall apply as follows: One hundred percent (100%) of Defense Costs incurred by the Insured on account of such Claim will be considered covered Loss.[8]

2. Include an endorsement stipulating to preferred defense counsel and rates.

To avoid protracted disputes with insurers over desired counsel and rates, private equity firms may be well served by requesting the insurer agree in advance to the firm's preferred law firm and rates via an endorsement to the policy.

3. Reject any extrinsic evidence endorsements.

Since the litigation insurance component of a liability policy is designed to protect the insured from paying to defend itself against suits potentially seeking covered damages regardless of the merits, the duty turns on the allegations of the underlying complaint. The allegations within the four corners of the underlying complaint are compared to the four corners of the insurance policy to determine whether potential coverage exists.[9] This is known as the four-corners rule or eight-corners rule.[10]

States are divided on whether extrinsic evidence may be used by an insurer to defeat its defense obligation. Some states including New York, Connecticut, Maryland and Massachusetts allow extrinsic evidence to establish, but not negate, the duty.[11]

Others including California and Illinois permit extrinsic evidence to both establish and negate the duty under certain circumstances.[12] Yet others like Texas do not permit such evidence to establish or negate the duty.[13]

Seizing on this split, some liability insurers are including manuscript language in their policies that expressly grants carriers the right to look beyond the four corners of the underlying complaint to evaluate their duty to defend or advance defense costs. One such extrinsic evidence clause provides as follows:

We may look to and consider extrinsic evidence outside of the allegations and/or facts pleaded by any claimant to determine whether we owe a duty to defend or indemnify against any claim or suit.[14]

Enforceability aside, firms should look out for this language in any proposed liability policies and discuss the possibility of removing it with their brokers.

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Ashley B. Jordan is a senior associate at Reed Smith LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] See COVID-19 Loss Estimates, Marsh (July 15, 2020) (estimating insurers' COVID-19 losses for Q1 and Q2 2020 will total $13.8 billion to $15.1 billion).

[2] See Private Equity and Transactional Risk Insurance Trend Report: 2020, Woodruff Sawyer, available at https://woodruffsawyer.com/mergers-acquisitions/2020-trends-complicated-market/.

[3] S. Lamden, Triggering the Duty to Defend, 3 New Appleman on Ins. Law Library Edition § 17.01 (2020) [hereinafter Lamden].

[4] Typical duty to defend policy language reads as follows: "We will pay those sums that the insured becomes legally obligated to pay as damages because of 'bodily injury' or 'property damage' to which this insurance applies. We will have the right and duty to defend the insured against any 'suit' seeking those damages."; or "[t]he Company shall have the right and duty to defend any Claim covered by this Coverage Part. Coverage shall apply even if any of the allegations are groundless, false or fraudulent. The Company's duty to defend any Claim shall cease upon exhaustion of the applicable Limit of Liability." See Insurance Services Office, Inc. Commercial Gen. Liability Coverage Form CG 00 01 04 13, §I, 1.a.; Chubb ForeFront Portfolio 3.0 Directors & Officers and Entity Liability Coverage Part, Form 14-02-17271 (04/2011), §VIII, (A). Duty to advance defense costs policies are marked by the following or similar language: "[T]he Insurer shall advance excess of the applicable retention amount, at the written request of the Insured, covered Defense Costs every ninety (90) days."; or "[t]he Insurer shall advance covered Defence Costs on an ongoing basis prior to the Final Adjudication or settlement of any Claim and shall advance covered Legal Representation Expenses." Acacia Research Corp. v. Nat'l Union Fire Ins. Co. , No. CV 05-501 PSG (MLGx), 2008 WL 4179206 (C.D. Cal. Feb. 8, 2008) (setting forth duty to advance defense costs language in D&O policy); Chubb Elite V Directors and Officers Liability Insurance, Form Version ELITE V 2-2016, §5., F.i.

[5] Insurers often argue the scope of the duty to pay defense costs is coextensive with, not broader than, the duty to indemnify. Many courts, however, do not differ in their treatment of the duty to advance defense costs and the duty to defend. See, e.g., Acacia Research, 2008 WL 4179206; Liberty Mut. Ins. Co. v. Pella Corp. , 650 F.3d 1161 (8th Cir. 2011); Great Am. Ins. Co. v. Geostar Corp. , Nos. 09-12488-BC, 09-12608-BC, 09-14306-BC, 2010 WL 845953 (E.D. Mich. Mar. 5, 2010); Lowy v. Travelers Prop. & Cas. Co. , No. 99 Civ. 2727(MBM), 2000 WL 526702 (S.D.N.Y. May 2, 2000); Brown v. Am. Int'l Grp., Inc. , 339 F. Supp. 2d 336 (D. Mass. 2004); Aspen Ins. UK, Ltd. v. Fiserv, Inc. , No. 09-cv-02770-CMA-CBS, 2010 WL 5129529 (D. Colo. Dec. 9, 2010); Fed. Ins. Co. v. Sammons Fin. Grp., Inc. , 595 F. Supp. 2d 962 (S.D. Iowa 2009); Westpoint Int'l, Inc. v. Am. Int'l S. Ins. Co. , 899 N.Y.S.2d 8 (N.Y. App. Div. 2010); HLTH Corp. v. Agricultural Excess & Surplus Ins. Co. , No. 07C-09-102 RRC, 2008 WL 3413327 (Del. Super. Ct. July 31, 2008); Am. Chem. Soc'y v. Leadscope, Inc. , No. 04AP-305, 2005 WL 1220746 (Ohio Ct. App. May 24, 2005).

[6] Lamden, supra note 3.

[7] Id.

[8] Hiscox Management Liability Insurance Policy, Directors & Officers Liability Coverage Part, Form NFP P002 CW (03/09), §VIII.

[9] Lamden, supra note 3.

[10] Lamden, supra note 3. The rule is also known as the "complaint allegation" rule, "comparison test," and "exclusive pleading" rule.

[11] See Fitzpatrick v. Am. Honda Motor Co., Inc., 575 N.E.2d 90 (N.Y. 1991); Hartford Cas. Ins. Co. v. Litchfield Mut. Fire Ins. Co. , 876 A.2d 1139 (Conn. 2005); Aetna Cas. & Sur. Co. v. Cochran , 651 A.2d 859 (Md. 1995); Herbert A. Sullivan, Inc. v. Utica Mut. Ins. Co. , 788 N.E.2d 522 (Mass. 2003).

[12] Montrose Chem. Corp. v. Superior Court , 861 P.2d 1153 (Cal. 1993); Pekin Ins. Co. v. Wilson , 930 N.E.2d 1011 (Ill. 2010).

[13] Pine Oak Builders, Inc. v. Great Am. Lloyds Ins. Co. , 279 S.W.3d 650 (Tex. 2009).

[14] Preferred Contractors Insurance Company Manuscript Commercial General Liability Coverage Form, Form PCIC GL 00 02 0818, §I, 1.a.(5); see also Dev. Sur. & Indem. Co. v. Alis Homes, LLC , No. C17-0707JLR, 2018 WL 1792182 (W.D. Wash. Apr. 16, 2018) (extrinsic evidence endorsement stated carrier "may look to extrinsic evidence outside of the allegations and/or facts pleaded by any claimant" and may "rely on extrinsic evidence to deny the defense and/or indemnity of a 'suit'").

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