D&O Liability - Seventh Circuit Holds that Failure to Seek Consent to Settlement Bars Coverage
On April 9, 2008, in Federal Insurance Company v. Arthur Andersen LLP, et al., Nos. 07-1245 and 07-1464, the United States Court of Appeals for the Seventh Circuit ruled in favor of Federal Insurance Company (“Federal”),
finding that the failure by the insured, Arthur Andersen, to seek Federal’s consent before settling barred coverage under the policy. Judge Easterbrook, writing for the Court, also concluded that Federal was not estopped from
denying coverage because Arthur Andersen never tendered to Federal the defense of the lawsuit at issue.
In the wake of the Enron scandal, Arthur Andersen had difficulty paying its retirees under its pension plan. In July 2002, certain retirees filed a lawsuit against Arthur Andersen asserting that every retiree was entitled by contract
to immediate distribution of their retirement funds (the “Waters suit”). Arthur Andersen hired Mayer Brown to defend it. In September 2002, Arthur Andersen notified Federal of the Waters suit. Arthur
Andersen did not request a defense but instead asked Federal to consent to Mayer Brown as defense counsel. Two months later, Arthur Andersen sought Federal’s $25 million policy limit to help fund a settlement with its retirees.
Federal denied coverage on the basis that the Waters suit sought retirement benefits due under contracts between Arthur Andersen and the retirees. The policy excluded claims for retirement benefits due under contract. Subsequently,
in February 2003, Federal filed a declaratory judgment action seeking a declaration that it was not required to defend or to indemnify Arthur Andersen in connection with the Waters suit. Arthur Andersen counterclaimed seeking
indemnity for the retirees’ lawsuit under the policy’s terms. Arthur Andersen also counterclaimed on a theory of estoppel based on Federal’s failure to participate in the defense of the Waters suit and
an earlier pension lawsuit.
The District Court concluded that the Federal policy did not require Federal to indemnify Arthur Andersen for payments to its retirees. However, the court concluded that there was an issue of fact as to whether Federal’s failure
to provide a defense, coupled with its delay in filing the declaratory judgment action, might require Federal to provide coverage under Illinois law under an estoppel theory. Following a jury trial, the District Court granted judgment
to Federal as a matter of law on all issues except as to the Waters suit. It ordered Federal to pay $5 million to cover the cost of settling the claims of the retirees in Waters.
On appeal, the Seventh Circuit affirmed in part and reversed in part, finding in Federal’s favor on all issues including the Waters suit. The court concluded that there was no duty to indemnify for three separate
reasons. First, the Waters action did not allege loss caused by negligence or a breach of fiduciary duty. Rather, the Waters suit was a contract action and the retirees’ “problem stemmed from Arthur
Andersen’s business and legal difficulties.” Second, the policy’s exclusion for pension benefits barred coverage. In this regard, the Court noted that allowing a company to shift its obligations under a pension
plan to its insurer would create a “moral hazard [that] would wipe out the market.” Third, Arthur Andersen breached the policy’s consent to settlement provision, which provided that it could not settle any claim
for more than $250,000 without Federal’s “written consent, which shall not be unreasonably withheld.” Arthur Andersen never sought Federal’s consent to the settlement. Rather, Arthur Andersen “presented
the deal…as a fait accompli.” The court stated that“[b]y cutting Federal…out of the process, Arthur Andersen gave up any claim to indemnity – unless state law makes the policy’s
coverage clauses and exclusions irrelevant.”
The Court next analyzed whether Illinois law on estoppel rendered the policy’s terms and conditions irrelevant. Illinois law requires an insurer either to provide a prompt defense on the insured’s demand or to initiate
a declaratory judgment action. If an insurer does neither, it forfeits any right to benefit from limitations on the policy’s scope. The Court set aside whether Federal’s seven to eight month delay in filing its declaratory
judgment action was excessive – a proposition that the Court considered “questionable.” Instead, the Court focused on an exception to Illinois’ estoppel doctrine that applies when “the insured indicates
that it does not want the insurer’s assistance or is unresponsive or uncooperative.” Because Arthur Andersen never tendered its defense to Federal, Arthur Andersen “gave up any basis for demanding immediate action
by the insurer.” The Court reasoned: “When the insured does not want the insurer to supply a defense (lest the insurer also control the defense), it has no complaint if the insurer takes a while to
contemplate the question of indemnity. The urgent need is for a defense to the pending suit; liability for indemnity (the coverage question) can safely be decided later.” Moreover, because the allegations in the Waters claim were “transparently outside the scope of the policy,” there was not a duty to defend in the first place. Accordingly, the Court held that Federal’s delay in filing the declaratory judgment action did not
prevent Federal from enforcing the policy’s terms and conditions.