‘Best efforts’ and allocation provisions in D&O policies

Many, if not most, directors and officers liability policies contain allocation clauses. Commonly, these clauses provide that when an insured is sued for a covered loss with someone who is not covered for the claim, or the insured is sued for both covered and uncovered loss, the insureds and the insurer agree to use their "best efforts to determine a fair and proper allocation of covered Loss." In addition, these provisions commonly provide that "the parties shall take into account the relative legal and financial exposures of the Insureds in connection with the defense and/or settlement of the Claim."

If the parties, as a result of their "best efforts," are able to agree to an allocation between covered and uncovered loss, all is well. However, an insured may end up in litigation with its insurer regarding coverage for defense costs or the settlement of claims involving one insured and multiple claims, some of which are covered and some of which are not, or involving multiple defendants, some of whom are insureds and some of whom are not. In this situation, insurers invariably will argue that the allocation language quoted above mandates that a court allocate the settlement or defense costs between covered and uncovered loss. They further argue that this provision mandates that the allocation be based upon the "relative legal and financial exposures of the insureds." However, relevant authorities and principles of insurance policy interpretation reveal the weakness of this argument, particularly in California.

First, the 9th U.S. Circuit Court of Appeals adopted the "larger settlement rule" in Nordstrom, Inc. v. Chubb & Son, Inc., 54 F.3d 1424 (9th Cir. 1995), and Safeway Stores, Inc. v. National Union Fire Insurance Co., 64 F.3d 1282 (9th Cir. 1995). In Nordstrom, a corporation and certain of its directors and officers, all defendants in a securities class action, agreed to a settlement with the plaintiffs. Because the corporation's D&O policy covered the directors and officers, but not the corporation, the insurer refused to pay more than half the settlement. The 9th Circuit held that the insurer must pay the full settlement amount. It adopted the "larger settlement rule," holding that "responsibility for any portion of the settlement should be allocated away from the insured party only if the acts of the uninsured party are determined to have increased the settlement." In other words, the full amount of an insured's settlement is covered unless the settlement was increased by the presence of uninsured parties or non-covered claims. Nordstrom was followed in Safeway. The 9th Circuit stated there that allocation is appropriate "only if, and only to the extent that, the defense or settlement costs of the litigation were, by virtue of the wrongful acts of uninsured parties, higher than they would have been had only the insured parties ... settled." It also held that the burden of proving that the uncovered defendant's liability had increased the amount of the settlement.

Second, the 9th Circuit has applied the larger settlement rule even when the policy at issue contains a "best efforts" provision. In Safeway, the insurer argued that the best efforts language mandated an allocation. The 9th Circuit held that this language was not mandatory -- it required only that the parties use their best efforts. The clause "requires an allocation analysis," but not necessarily an allocation." 64 F.3d at 1289. See also Silicon Storage Tech., Inc. v. Nat'l Union Fire Ins. Co., 2015 WL 7293767, at *6 (N.D. Cal. Nov. 19, 2015) (following Safeway).

Third, basic principles of insurance policy interpretation would indicate that the above allocation provision does not require an allocation. As one court has held, an allocation is in effect a partial exclusion of an insurer's liability. Owens Corning v. Nat'l Union Fire Ins. Co., 257 F.3d 484, 493 (6th Cir. 2001). If this is the case, then the allocation provision must be "strictly construed against the insurer and liberally interpreted in favor of the insured." Delgado v. Heritage Life Ins. Co., 157 Cal. App. 3d 262, 271 (1984). In addition, "the burden rests upon the insurer to phrase exceptions and exclusions in clear and unmistakable language." MacKinnon v. Truck Ins. Exch., 31 Cal. 4th 635, 648 (2003). An ambiguous exclusion is not plain and clear. Haynes v. Farmers Ins. Exch., 32 Cal. 4th 1198, 1211 (2004).

In Owens-Corning, the court stated that a similar provision calling for the parties to use their best efforts to determine a "fair and proper" allocation was ambiguous. The court stated that "[a]llocation is in effect a partial exclusion of the insurer's liability," and therefore any allocation provision must be clear and exact to be given effect. Because the above language was not clear, Ohio law supported "coverage of the settlement except to the extent that uninsured claims have actually increased the insured's liability." The same result should be reached under California law.

Finally, an insurer's failure to use available language to exclude coverage gives rise to the inference that the parties intended not to so limit coverage. "After all, if [the insurer] had really intended to limit coverage ... [it] was free to draft a policy with qualifying language that expressly implemented that intention." Fireman's Fund Ins. Cos. v. Atl. Richfield Co., 94 Cal. App. 4th 842, 852 (2001). As the Fireman's court held, if an insurer chooses "not to include limiting language," then the words it uses will not "support [the insurer's] position regarding an intent to limit coverage." See also Pardee Const. Co. v. Ins. Co. of the W., 77 Cal. App. 4th 1340, 1358-60 (2000) ("the insurers' failure to use available language expressly excluding completed operations coverage implies a manifested intent not to do so. ... 'If the parties had intended coverage to be limited to the [extent] suggested by the [insurers], language clearly embodying that intention was available.'"). In other words, if the insurer intended to require an allocation between covered and uncovered loss, and intended that a specific methodology be used to perform that allocation, it could and should have said so.

This is particularly true when there is available language in the marketplace that would have accomplished the insurer's goals, but the insurer did not use it. With respect to the allocation, there is currently language in the marketplace providing that "if in any Claim the Insureds incur both Loss covered by this policy and loss not covered by this policy because such Claim includes both covered and uncovered matters, the Insureds and the Insurer shall allocate such amount" and that the loss "shall be allocated between covered Loss and uncovered loss based upon the relative legal and financial exposures of the parties to covered and uncovered matters." Therefore, any insurer that could have used this language has manifested its intent not to require an allocation, and not to require that a specific allocation methodology be used.