A recent Law.com article by David Kroeger and Catherine Doyle of Jenner & Block LLP, “When Do Insureds’ Legal Fees Constitute Defense Expenses?,” reports on attorney fees and expenses in underlying insurance coverage litigation.  This article was posted with permission.  The article reads:

When is a defendant actually a plaintiff, and when are a defendant's legal expenses not defense expenses?  While the intuitive answer may begin with the case caption and a review of the defendant's legal bills, some courts may not stop the analysis there.

In Turner v. XL Specialty Insurance Co., the U.S. District Court for the Western District of Oklahoma recently determined that none of the legal expenses incurred by a named defendant counted as defense expenses, at least where the nominal defendant to a declaratory judgment claim purportedly stood in the same posture as the plaintiff and sought the same relief via affirmative counterclaims, cross-claims and third-party claims.  The decision was appealed to the U.S. Court of Appeals for the Tenth Circuit, and policyholders and insurance law practitioners would do well to monitor how far insurers may try to extend this argument in the future.

The federal district court in Turner v. XL Specialty reached the surprising conclusion that legal fees and costs incurred while defending against a declaratory judgment claim did not constitute covered defense expenses for purposes of a directors and officers insurance policy.  The factual scenario in Turner was detailed, complex and most certainly drove the court's unique conclusion.

The story began with American Energy Partners LP, a company founded in 2013 by oil and gas businessman Aubrey McClendon, which Forbes magazine once described as America's most reckless billionaire.  The plaintiff, Ryan Turner, served for a period as an executive of both AELP and an AELP affiliate.

While in that role, McClendon, Turner and two other AELP executives, Scott Mueller and Thomas Blalock, entered into an equity and co-investment agreement that reflected their profit-sharing agreements relating to the AELP business as well as new businesses that were not yet formed.

Under the equity and co-investment agreement, McClendon owned a 76% interest in the profit from new domestic businesses; Turner owned a 12% interest, and Mueller and Blalock each owned a 6% interest.  The individuals allegedly entered into the equity and co-investment agreement as a result of their membership in AELP's executive management team.

Shortly after signing the equity and co-investment agreement two additional AELP affiliates, SCOOP Energy Company LLC and Scoop Energy Holdings LLC (collectively referred to as SCOOP), were founded.  The parties to the equity and co-investment agreement agreed that it should apply to the sale of any SCOOP assets, and an amendment was prepared to explicitly include SCOOP within the equity and co-investment agreement.

Before the amendment could be executed, McClendon died in a single-vehicle accident on March 2, 2016, the day after he was indicted by a federal grand jury.  All surviving parties to the equity and co-investment agreement nevertheless agreed that a definitive and enforceable agreement with respect to the SCOOP assets had already been reached.

After McClendon's death, Blalock was appointed special administrator for McClendon's estate with authority to continue the AELP business.  Blalock thereafter sought an order permitting the estate to distribute the proceeds from the sale of the SCOOP assets according to the percentage interests set forth in the equity and co-investment agreement, but Blalock withdrew the application after one of McClendon's other creditors opposed it.

On the same day as that withdrawal, Mueller filed a lawsuit naming SCOOP, Blalock in both his individual capacity and as the personal representative of McClendon's estate, and Turner as defendants.

The only relief sought against Turner was a declaration of the rights and liabilities of the parties, including a determination that each of the members of AELP's executive management team was entitled to his respective share of profits from the sale of the SCOOP assets.  Turner's answer either admitted, or did not dispute, the allegations in Mueller's petition.  Turner also filed his own affirmative counterclaims, cross-claims and third-party claims seeking the same relief as Mueller.

Turner thereafter sought coverage for his legal expenses from XL Specialty under AELP's company and management liability policy.  Per the policy, XL Specialty was obligated to pay "on behalf of the Insured Person Loss resulting from a Claim first made against the Insured Person during the Policy Period ... for a Wrongful Act."

"Wrongful act" was in turn defined as a "matter asserted against, or investigated or inquired with respect to, an Insured Person by reason of his or her status as an Insured Person."

XL Specialty denied Turner's claim, asserting that Turner was sued by reason of his status as an equity holder in various businesses, rather than his status as an insured person, and therefore no claim was asserted against him for a wrongful act as defined under the policy.  XL Specialty also asserted that the policy did not provide coverage for Turner's prosecution of his affirmative claims.  After receiving XL Specialty's denial, Turner settled the litigation over the SCOOP assets and filed suit against his insurer for breach of contract and bad faith.

Applying Oklahoma law, the federal district court agreed with XL Specialty and concluded that there was no coverage because Turner was not named as a defendant in the Mueller lawsuit by reason of his status as an insured person.  In so doing, the court rejected Turner's argument that it was significant that the policy's definition of "wrongful act" used the term "status" in place of the more commonly found term, "capacity."

The court found those two terms to be interchangeable, and then concluded that Turner was involved in the action solely because of his status or capacity as an individual equity holder under the ECOIA, and not in his capacity as a former executive of AELP.

But the court did not end its analysis after finding that there was no wrongful act asserted against Turner. It instead continued, and found (given the initial part of its ruling, arguably in dicta) that Turner did not incur defense expenses in the Mueller lawsuit, and therefore had suffered no loss.

The XL Specialty policy defined loss as "damages, judgments, payments, settlements, relief or other amounts ... and Defense Expenses."  The term "defense expenses" was defined as "reasonable legal fees and expenses incurred in the investigation and defense of any Claim."

In explaining its conclusion, the court first noted that the XL Specialty policy did not define the term "defense," and found persuasive a definition of that term from Black's Law Dictionary:

 A defendant's stated reason why the plaintiff or prosecutor has no valid case ... that which is alleged by a party proceeded against in an action or suit, as a reason why the plaintiff should not recover or establish that which he seeks by his complaint or petition.

Viewing the situation from this prism, the court concluded that Turner's legal expenses were incurred for purposes other than demonstrating why Mueller had no valid case or should not recover the relief he sought.  The court further concluded that the declaratory judgment claim — the sole claim asserted against Turner in the Mueller lawsuit — did not place Turner in a defensive posture: "Rather, it appears that Mr.Mueller asserted the claim for the benefit of himself and Mr. Turner."

Indeed, the court found significant that Turner's answer did not dispute any of Mueller's material facts, nor did it dispute or oppose any of Mueller's requested relief. Instead, both Mueller and Turner, in his affirmative claims, requested entry of the same relief. Thus:

While Mr. Turner was nominally pleaded as a "defendant" in the Mueller lawsuit, the pleadings demonstrate clearly that he stood in the same posture as Mr. Mueller … Accordingly, the legal expenses Mr. Turner incurred are not "Defense Expenses," and as such they are not covered "Loss" under the insurance policy at issue here.

Notably, the court also rejected Turner's argument that at least some of the costs for which he sought recovery had to have been incurred in connection with the defense of the Mueller lawsuit, no matter how "defense" was defined.  Had the court accepted that argument, Turner arguably would have been able to invoke a very pro-policyholder allocation provision entitling him to coverage for the full amount of his legal expenses:

If a Claim covered in whole or in part under the Policy results in both Loss covered under this Policy, and loss not covered by this Policy, because such a Claim includes both covered and uncovered matters ... the Insureds and the Insurer shall allocate 100% of such amounts to covered Loss.

The court thus granted summary judgment in favor of XL Specialty on both Turner's breach of contract claim and bad faith claim, and denied Turner's motion for partial summary judgment on the breach of contract claim.  Turner appealed the decision to the Tenth Circuit.

While the Turner decision was no doubt heavily influenced by the district court's perception of the specific parties and facts before it, the path it traveled ought to give rise to at least some level of concern.

Policyholders, insureds and many others commonly think of defense costs as being synonymous with the attorney fees and expenses that they have to pay counsel who represent them when they get sued; they do not parse that term so finely as to include within the concept only those costs incurred to specifically oppose allegations made or relief sought by the plaintiff.

Turner did not file the Mueller lawsuit, but upon being served with the petition he had to retain counsel and incur defense costs.  It seems highly, if not extraordinarily, unlikely that a party in Turner's position would not have incurred at least some measure of defense expenses — even under the narrow definition of that term the district court read into the policy.  Indeed, Turner presumably incurred legal fees to have his counsel prepare the answer that the court cited repeatedly in its opinion, and answers are a classic example of a defense expenditure.

By interpreting the policy in a manner that allowed it to recharacterize a uniquely situated defendant as effectively being a plaintiff, the court overlooked these issues and may have unintentionally opened the door to future arguments that other, less similarly situated, insureds should be denied coverage for some or all of their defense costs on the same logic.  It is common for plaintiffs and defendants to jointly request court approval of a securities class action or derivative settlement; those defendants are incurring defense costs in so doing.

Similarly, individual defendants to a securities class or derivative action may, for strategic reasons, want to agree with the plaintiffs in placing blame on other individual defendants; they, too, are incurring defense costs in all meaningful senses of the term. Yet the analysis used in Turner could be argued to require a contrary result.  For these reasons, it will be important for policyholders to monitor Turner as it makes its way through the Tenth Circuit.  In the interim, Turner may well produce an increased focus on the definition of "defense costs" in a D&O or similar policy.

Many definitions of that term define "defense costs" by reference to "defense" of or "defending" a claim, without much further elaboration. Other definitions also add the concept of "investigation" or "investigating," like the definition at issue in Turner.  And yet others include additional concepts, such as "opposing," that arguably make the result in Turner more difficult to justify, because they make more clear that "defense" and "defending" must mean something different than "opposing."  These differences in language could become very important, depending on the outcome at the Tenth Circuit.

David M. Kroeger is a partner at Jenner & Block LLP and co-chair of the firm's insurance recovery and counseling practice and its reinsurance practice.  Catherine L. Doyle is an associate at the firm.