Defence Costs Clauses in Liability Insurance Policies

Modern liability policies almost always include clauses by which the insurer agrees to pay legal costs of the insured in respect of any claim against it.  The wording varies.  The relevant clauses might read, for example:

Elsewhere in the policy there is usually found a condition which permits the insurer to take over the conduct of the defence or settlement of any claim in the name of the insured.

Where circumstances are such that the claim against the insured falls plainly within the risk covered, and where there is no suggestion that the insured’s conduct might be such as to bring it within one of the exceptions to cover, the insurer is likely to take that option.  Where, however, the insurer’s obligation to indemnify may depend upon events which are yet to become clear, and hence upon preparation for and conduct of the case, the insurer may decline to conduct the case and may also refuse to consent to the incurring of any defence costs.

It is in the latter situation where issues arise as to the meaning, and effect, of defence costs clauses.3

Before considering specific issues of construction which have arisen recently in relation to such clauses, it is useful to state some general propositions.  First, although the insurer has a right to take over the conduct of the action, it is generally not obliged to do so.4  Secondly, although once liability is found to exist the insured’s liability in law dates from the moment when the events occurred and the damage was suffered, “liability to pay damages” within the meaning of the policy means liability upon a finding, or a settlement.5  Thirdly, neither consent to the settlement of a claim by an insured (where consent is required), nor one would think consent to the incurring of legal costs, may be arbitrarily withheld.6

The specific questions to be addressed are these:

1. How wide is the defence costs clause and, more particularly, do defence costs clauses extend to costs outside the principal risk insured?
2. Can an insurer, during the course of the case between the third party and the insured, be compelled to pay the legal costs of the insured?
3. What happens if the insured overlooks the requirement that it obtain the insurer’s consent before incurring legal costs?
4. Can an insurer who wrongly refuses written approval for the incurring of defence costs subsequently argue it should not be liable to pay them because written approval was never obtained?
5. Where costs are incurred by one insured, being one of a number of defendants, and the incurring of those costs assists the case of the other defendants, is there some implied term in favour of the insurer that it pay only a proportion of the costs incurred by its insured?
6. If a corporation pays the defence costs of its directors can the corporation claim indemnity for those costs from the insurer pursuant to a defence costs clause in a company directors and officers liability insurance policy?

Do defence costs clauses extend to costs outside the principal risk insured?

The issue has arisen as to whether the defence costs extension clause in a liability insurance policy can operate independently of the primary cover afforded by the policy: is the insured only entitled to its defence costs if they are ultimately entitled to recover under the policy in respect of a claim made against them by a third party.  This clearly depends upon the wording of the policy in question.  However, policy wordings are similar so an analysis of relevant cases is useful.  Further, the cases illustrate different approaches to the construction of such policies.  Some cases have held the defence costs extension clause is to be read independently of the primary cover clauses7 while other cases have held that the liability of the insurer to pay defence costs is linked to the obligation to indemnify the insured for a claim made against it by a third party8, (that is, that the obligation to pay defence costs rises and falls with the obligation to pay a “claim” within the meaning of the policy).

In Sherlex Pty Ltd v Thornton (t/as Medical Plumbing Services),9 the plaintiff was the bailee of a helicopter destroyed by fire as a result, it alleged, of faulty workmanship by the first defendant on its oxygen supply system.  The first defendant held an insurance policy with AMP General Insurance Ltd.  AMP refused indemnity, and refused to pay the first defendant’s costs of defending the action.  The action was at an early stage.  The first defendants sought to have AMP’s obligation to indemnify it for its costs of defending the proceedings determined as a preliminary point.

The relevant policy terms were as follows:

Later in the policy there is an exclusion clause relevantly for present purposes in the following terms:

In order to have the matter determined at a preliminary stage the first defendant conceded that the factual elements of the exclusion clauses were satisfied and, consequently, that AMP was not liable to indemnify the first defendants in respect of the subject matter of the plaintiff’s claim10.

Thus, the first defendant’s contention was that on the proper construction of the policy the clause relating to the payment of defence costs was broad enough to apply irrespective of the fact that the liability of the insurer for the principal risk was excluded.

At first instance, Fryberg J concluded that there was no compelling reason why the ambit of the actions for which the indemnity as to costs was provided should necessarily be the same as the ambit of those for which cover against liability was provided.11  Consequently, the indemnity provided in respect of costs was available notwithstanding the assumed application of the exclusions.  His Honour focused on the expression in the second paragraph “in connection with any claim for Compensation”, and held:

An appeal was allowed.  The Court of Appeal defined the issue as follows:13

Having determined that “referred to above” refers to “Compensation”, the Court continued:14

The Court made the point that it was not only costs in connection with a successful claim which were payable under the second paragraph.  The claim may fail notwithstanding it was for compensation which satisfies the positive requirements of the first paragraph, and the negative requirements of the exclusions clause; for example, because the insured was not negligent or not in breach of contract.16

The Australian Association of Social Workers Ltd v AMP General Insurance Ltd17, the Supreme Court of the Australian Capital Territory considered the following circumstances.  A policy was issued by AMP to the plaintiff on 2 March 1999.  Clause 1 was the insuring clause and provided:

Indemnify the Insured against Loss arising from any Claim by reason of any Wrongful Act in the course of professional duty rendered or which should have been rendered first made against them jointly or severally and notified to the Insurer during the Period of Insurance. In addition the Insurers agree to pay defence costs incurred with the written consent of the lead Insurer.

(c)     Association Reimbursement

The claim against the insurer arose because Mr Robinson, a member of the Association, commenced proceedings against it seeking a declaration that it had breached its own bylaws and acted beyond its power in investigating a complaint made against him.  In addition to the declaration he sought an injunction restraining the Association from further investigating or proceeding to determine the complaint.  The Association gave to AMP notice of the proceedings but AMP refused indemnity on the grounds that there had been no claim against any “Office Bearer” of the Association and that, because the relief sought was of a declaratory and injunctive nature, there was no “Loss” to which the policy would respond.

The Association defended the proceedings.  The trial judge made the declaration sought by Mr Robinson although he lost other issues.  Mr Robinson was ordered to pay half of the plaintiff’s costs, and appealed the decision in the costs order to the South Australian Supreme Court.

The Association had incurred legal costs and charges and expenses in defending the District Court proceedings in the sum of $71,198.54, and had paid Mr Robinson a further $7,000.00 in satisfaction of the order for costs made by the Appeal Court.  The Association claimed indemnity from the insurer in respect of those amounts, or alternatively an award for damages for a failure to provide such indemnity.

The insurer argued that proceedings for a declaration or an injunction were not “Loss” within the insuring clause, as defined by cl 12(j).  The costs referred to in cl 2(j)(ii) were recoverable only if they related to a liability covered by cl 12(j)(i), and proceedings for an injunction or a declaration did not fall within “legal liability to pay damages or judgments or settlements”.  That is, the claim for costs was unrelated to monetary claims.

His Honour determined the case on the basis that “judgment” in cl 12(j)(i) included an order for costs.  He also held that the claim against the Association was a claim by reason of “any Wrongful Act” within the meaning of the policy.  It followed that there was an obligation to indemnify.  Consequently, it was unnecessary for him to determine the issue of whether, where costs unrelated to the insuring clause were incurred, they could yet be recoverable.

In Sherlex Pty Ltd v Thornton, the Court had adopted a construction which meant that costs incurred in respect of a claim made within the ambit of the insuring clause were not payable by the insured under the costs indemnity clause in circumstances where the policy, because of an exclusion clause did not respond to the risk.

Similar reasoning was applied in a different context in Intergraph Best (Vic) Pty Ltd v QBE Insurance Ltd.18  There the issue of the advancement of defence costs arose in the context of a company directors and officers liability insurance policy.  There the Victorian Court of Appeal held:

Recently, in Power v Markel Capital Ltd20 the Queensland Court of Appeal held that Mr Power was entitled to indemnity in respect of his legal costs notwithstanding that the costs were incurred by him in relation to a charge which could only have led to a criminal prosecution rather than to a claim against him for civil liability by way of a money claim.  In that case the approach to the construction of the policy was evident in this statement by Fryberg J:

Jerrard JA, who with Fryberg J comprised the majority, similarly held:

The primary cover was expressed to be as follows:

One of the automatic extensions of liability under the policy related to legal fees incurred in attending an Investigation.  Extension (b) provided:

“Claim” was defined as a “notice received by…the Insured…of the intention of a person or entity to hold the Insured responsible for the results of any Wrongful Act”.  At first instance McMurdo J denied the claim for indemnity on the basis that there needed to be a connection between a Claim and Loss (so much was evident from the insuring clause 1(a)).  His Honour held:

On appeal the insured was held entitled to his costs under extension (b).  The main difference in reasoning related to whether a Claim needed to be something capable of giving rise to a loss.  This was related to a wider issue being whether an insured could recover under an extension only if they were able to show an entitlement to primary cover.  Fryberg J held that the cover provided by the extension was distinct from the primary cover.24  The whole point of the extension, His Honour held, being “to provide for payment of legal expenses as they arise, at a time when it may not be clear whether some ground exists to deny the primary cover”.25

In relation to the requirement for loss His Honour held:

This issue is clearly made more difficult by the way in which these policies have been drafted.  If costs are to be provided only where the insured is entitled to primary cover under the policy then the extension clause should make this clear.  “Claim” should be defined so that it can only mean a claim against an insured which gives rise to a civil liability for damages.

Can the insurer, during the course of the case between the third party and the insured be compelled to pay the legal costs of the insured?

For an insured looking into the abyss, this is an important issue. Regrettably, the answer is generally “no”.

In two recent cases the High Court was asked to construe directors and officers policies to see whether they responded in respect of the legal costs incurred or to be incurred by the insured.  The cases were Wilkie v Gordian Runoff Ltd (formerly GIO Insurance Ltd)27 and Rich v CGU Insurance Limited; Silbermann v CGU Insurance Limited.28  The issue of the advancement of defence costs was raised by the insured in each case as a preliminary issue, that is, prior to the determination of whether the insurer was obliged to indemnify the insured under the policy in respect of its primary obligation.  The insured, faced with pending proceedings against it, claimed the insurer was bound by the policy to pay the defence costs as they were incurred.

The issue is an important one for an insured facing a lengthy court case or other proceeding. As Callinan J highlighted in Rich:

It is important to note that defence costs clauses differ from policy to policy.  It is likely, market permitting, the insurers will respond to these decisions in the drafting of future clauses.  The decisions are nonetheless of broad relevance, considering the sorts of issues likely to arise in other defence costs cases.

In Wilkie v Gordian Runoff Ltd (formerly GIO Insurance Ltd) the High Court allowed the appeal against the insurer, overturning the decision of the Supreme Court of New South Wales.  In Wilkie the insured appellant, an executive officer of FAI Insurance Ltd, brought proceedings against the insurers claiming the payment in advance of costs for defending himself in proceedings brought against him by the Australian Securities Investment Commission (“ASIC”).  The nature of the prosecution was an allegation that the insured knowingly permitted misleading information to be provided to the auditors of FAI Insurance Ltd and that he acted dishonestly in the discharge of the duties of his office.  The insured duly notified the insurer and requested consent for the advancement of defence costs.  The insurer’s immediate response in each case was to the effect that they were considering the position in relation to indemnity.

By letter dated 25 September 2003 the insurers advised the insured: 

The appellant did not contend that the Defendants acted other than in good faith in deciding to deny indemnity based upon Exclusion 7 and in writing the letter of 25 September 2003.

On 19 September 2003 Windeyer J ordered that the question whether the Defendants were entitled to decline to indemnify the Plaintiff for defence costs be determined as a separate question, the terms of which were to be agreed.  Nicholas J of the Supreme Court of New South Wales answered “yes” to the question, that is, the insurer was entitled to refuse to pay the insured’s defence costs.  The insured appealed.

The case was determined by construing the relevant directors and officers policy.  A policy of insurance was a commercial contract which was to be given a businesslike interpretation.30   The court referred to Gleeson CJ in McCann v Switzerland Insurance Australia Ltd31  where His Honour said:

The commercial purpose of this form of policy was said by the court to be, relevantly, to “afford assistance with defence costs when an insured is faced by allegations of wrongdoing, including criminal wrongdoing.”33

The resolution of the issue regarding the advancement of defence costs depended upon the relationship between Extension 9 (the “defence costs clause”) and Exclusion 7 (the “dishonesty exclusion”).

Extension 9 provided:

Exclusion 7 provided:

GIO claimed to have denied indemnity in accordance with Extension 9, stipulation (i) by it’s letter to the insured which denied indemnity for the Claim, that is, of indemnity in respect of the process alleging a Wrongful Act.  The insurer referred in it’s letter to the findings of a Royal Commission into the affairs of FAI and to the “voluminous evidence contained in the Crown brief”.

The issue was whether that denial was sufficient to disengage Extension 9, thereby disentitling the insured to indemnity under the policy for its defence costs.

The court held that it was not.  Something more than a mere denial by the insurer to indemnify the Claim was required.  As the court held:

If the insurer had wanted to leave the advancement of defence costs to it’s discretion it could have made this clear in the policy, by for example, stating that the exclusion applied “where in the opinion of the Insurer, such act, omission or breach has occurred”, or if it didn’t want to go this far, it could have stated that the issue of dishonesty was to be determined by an independent decision-maker (a “Senior Counsel clause”).35

The court referred to that part of Extension 9 which permitted the insurer a right to recover any defence costs advanced to the insured where it was eventually established that the insured had been guilty of dishonesty.  This it was held supported their construction: otherwise that part of the provision was otiose.36  The construction was also consistent with the meaning given elsewhere in the policy to the basis upon which the insurer could refuse indemnity.  The specified conduct, in order to have “in fact occurred”, means it has either been admitted or established by adjudication.37  Exclusion 7 was not established by the fact of criminal conduct, for example, but by the adjudication of criminal guilt.38   A similar interpretation should be given to the meaning of the words “denial of indemnity” in Extension 9, that is, as the court held, the insurer, must refuse indemnity “on a ground for refusal provided by the Policy, not a statement which foreshadows that indemnity will be refused if and when a ground for refusal becomes available.”39

[It is relevant in this context to refer to Mead v Allianz Australia Ltd40 where it was held that if an exclusion clause in a liability policy requires “adjudication of malicious or reckless conduct” that will usually occur where the court is considering a civil or criminal wrong that has, as an essential ingredient, an element of malicious or reckless conduct.  There should therefore be an express curial finding using those terms before such an exclusion should be relied upon.]

Rich v CGU Insurance Ltd; Silbermann v CGU Insurance Ltd41 involved a similar issue but a differently worded defence costs clause.  Unfortunately for the insured, the answers to the predetermined questions involving construction of the policy were not all the subject of appeal.

Special leave was revoked when it was realised that resolution of the question on appeal could not, because of issues determined by the intermediate court against the insured and not the subject of challenge, relevantly bring a conclusion to the dispute.

The outcome of Wilkie’s case meant that under that policy the insured had a right to payment by the insurer of its’ defence costs, notwithstanding that the insurer had denied primary liability, and liability under the defence costs extensions, on the basis of the insured’s dishonesty.  The outcome was available because the right of the insurer to refuse to do so was not established until a finding, in fact (not just alleged) of dishonesty by a tribunal.

The outcome of Rich’s case would not necessarily have been the same.  Clause 2.1 of the Automatic Extensions in that case provided, inter alia:

In Wilkie, no such discretion was conferred.  Notwithstanding the stated discretion in Rich, there also appeared there a clause of the nature of Exclusion 7 in Wilkie.  It remains to be seen whether the existence of the discretion improves the insurer’s position.  It may well do so insofar as the issue is whether it is bound to pay the costs as and when they are incurred.

Where a policy provides for the payment of defence costs with the consent of the insurer, what happens if that consent is not obtained before the costs are incurred?

The policy will generally reserve to the insurer the right to take over the conduct of the defence.  In the event it elects not to do so, another clause will generally provide that costs only be incurred in the defence of the action with the consent of the insurer.

Prudence suggests that consent may be necessary on more than one occasion, and at all important stages of the litigation.  Prudence also dictates, and the clause will usually require, that the consent be in writing.

What happens if the insured overlooks the requirement for consent?

This issue was considered by the High Court in Antico v Fielding Australia Pty Ltd.42  The provisions relevant to the payment of defence costs in Antico’s case were lengthy, and complicated.  In general terms, they provided that the insured would not be liable to indemnify the insured for legal expenses unless the insured obtained the specific consent of the insurer, which the insurer was obliged to give only if the insurer had reasonable grounds for defending the proceeding or there were reasonable grounds for the successful outcome of the matter.  If the insurer did not consent, there was an elaborate procedure which followed:  the insurer would give detailed reasons and access to the insurer’s advisors; the insured was entitled to make representations to them; if the insurer still did not consent, an opinion was to be obtained from a mutually acceptable Queen’s Counsel; and the insurer would consent if the Queen’s Counsel decided there were reasonable grounds for defending the matter or upon which to anticipate its successful outcome. Another clause provided that if the insured wished to nominate his own solicitor to act he had to submit the solicitor’s details to the insurer; that bills of costs had to be forwarded to the insurer after receipt by the insured; and that the insured was not to enter into a fees agreement with his solicitor without the insurer’s prior written approval.

The insurer denied it was obliged to indemnify in respect of legal costs in circumstances where consent was not obtained to the incurring of the costs and, hence, the further procedures had not been followed.  Notice was given by the insured after some costs had been incurred.  The insurer had requested information about whether there were reasonable grounds to defend, but had not consented before the proceedings were settled.

The insured sued the insurance company, and his broker.  Because of dealings between the broker and the insurance company, the proceedings against the insurer failed.  In the suit against the broker, alleging a failure to exercise due care and in advising the insured about the policy, the trial judge found the broker had breached its retainer and duty of care.  He suggested, without deciding, that the insured’s claim against the broker would however fail because the breach had not caused loss, because the insurer would have been entitled to decline to provide indemnity on the grounds that consent had not been obtained under cl 1.

The High Court held that s54 of the Insurance Contract Act 1984 (Cth) applied to the failure to obtain the insurer’s consent to the incurring of the legal costs.  Further, s 54 also applied to the failures to give to the insurer the insured’s solicitor’s details; bills of costs, and its entry into an agreement in respect of costs without the insurer’s consent.

The extent of prejudice suffered by the insurer was the opportunity it had lost, in any event, to refuse indemnity because there were no reasonable prospects of a successful defence.  Thus, damages against the broker were to be reduced by the value of that opportunity lost.  That exercise was returned to the District Court.

What if the insurer wrongly refuses written approval required by the policy to be obtained before costs are incurred?  Can the insurer argue, in the face of its wrongful refusal, that the insured is unable to claim under the policy for its defence costs?

In Australian Association of Social Workers Ltd v AMP General Insurance Ltd,43 Crispin J held in such circumstances that the insurer could not refuse the indemnity.  His Honour reasoned it was well established that “no person can take advantage of the non-fulfillment of a condition the performance of which has been hindered by himself”.44

A wrongful refusal would also, in my view, give rise to an action for damages, either for breach of an implied term that, for example, consent not be unreasonably withheld,45 or that each party is under an obligation to co-operate to ensure the other party receives the intended benefit of the contract,46 or for a breach of the obligation of utmost good faith.

Allocation of defence costs

Allocation of defence costs issues arise where there are co-defendants, some of whom share the same interests, where defence costs benefit not only the insured, but also the other defendants.  In a simple situation, directors may be sued together with the company.  One or more of the directors, or the company, may be in a better position to recover under a policy of insurance the legal costs of defending the action. If such a director, for example, incurs the costs (and the others do not), can the insurer insist on paying only a portion of the defence costs.

In New Zealand Forest Products Ltd v New Zealand Insurance Co Ltd,47 a company reimbursement policy covered the insured as part of the insured organisations in respect of “all loss” for which the insured had granted indemnification to any designated officer and which such officer had become “legally obligated to pay on any claim … made against him … for a wrongful act”.  “Loss” was defined as meaning the total amount of defence costs.  In proceedings commenced in California against the insured, there were a number of defendants, and allegations of fraud involved.  All of the defendants were represented by the same lawyers.  The insured granted indemnification to the director for his defence costs. Proceedings were settled but only after substantial defence costs had been incurred.  The insured made a claim under the policy.  There was an issue as to whether the insurer was obliged to pay all of those costs in circumstances where:  other defendants benefited from the incurring of the costs; the costs were in part solely for the director’s benefit, in part for the director’s benefit and for the benefit of other defendants, and in further part for the benefit of other defendants alone.  The trial judge in the High Court of New Zealand held that the defence costs within the policy were limited to those parts of the costs incurred solely in defence of the allegations pleaded in one of the causes of action.  The Court of Appeal of New Zealand allowed the insured’s appeal but held that to the extent that the costs incurred in resisting the liability of the insured and other defendants were reasonably related to the director’s liability, he was only legally obliged to pay an appropriate share to be assessed.  On appeal to the Privy Council, it was held that on the proper construction of the policy any item of cost which reasonably related to the director’s defence of the claim against him was covered by the policy, even if it also related to the defence of another defendant whose costs did not fall within the scope of the policy and thus was of use and benefit to the other defendant, and no allocation of such common costs was required by the terms of the policy.  The question of whether or not a particular item of cost was reasonably related to the claim against the director was one of fact, and the matter would be remitted to trial for such determination.  The Privy Council made clear that costs relating solely to another defendant were not recoverable; but otherwise the test was one of whether the cost was reasonably related to the claim against the director.  The Privy Council acknowledged that the true question was one of the proper contentions of the terms of the policy.48

The issue of allocation of defence costs arose again in Baycorp Advantage Ltd v Royal & Sun Alliance Insurance Ltd.49

“Defence Costs” were defined in the policy to be:

Claim Condition 6 under the “Allocation” provided, inter alia:

The principle proceedings were settled.  There were considerable costs incurred.

In relation to defence costs, three issues were raised:

1. Where legal and experts’ fees, costs, charges and expenses are incurred in defending, investigating, monitoring or settling a claim, whether RSA (the insurer) is relieved of its obligation to pay those defence costs simply because another person receives a benefit from those defence costs being incurred.
2. Whether, assuming it is valid, claims condition 6 has the effect that RSA is entitled to apportion defence costs which it is otherwise liable to pay.
3. Whether claims condition 6 is invalid because it is unenforceable as an agreement to agree and/or void for uncertainty.50

The trial judge accepted from the pleadings before the Victorian Supreme Court that many of the factual aspects of the allegations made were common to all relevant defendants.51  The judge accepted that the effect of the definition of “defence costs” and “claim” were such that costs which related exclusively to defence of the corporate defendants were not defence costs, and should be excluded from the liability of the insurer.

Otherwise, however, the clause, which referred to “all” reasonable legal and experts’ fees, costs, charges and expenses (see the definition of “defence costs”), prima facie meant that any costs which satisfied that definition were payable, whether or not some other defendant also obtained a benefit.  His Honour followed the New Zealand Forest Products case.

As to claims condition 6, His Honour ruled it unenforceable as an agreement to agree and void for uncertainty.52  His Honour found that to be so because of the difficulty inherent in all issues concerning allocation:  how to divide the costs.  As His Honour pointed out:

“Further, no method of allocation is specified in claims condition 6. Does it, as the plaintiff reminds us, require

• a comparison of the allegations made in the proceedings against the insured person with the allegations made against the uninsured person — if so, on what basis are the two to be compared (likelihood of success?, cost of refuting?, relative seriousness?, potential pecuniary outcome?, may regard be had to non-pecuniary consequences such as loss of reputation for an officer not affecting a corporate defendant?);
• a comparison between an assessment of the underlying liability of the insured person and the underlying liability of the uninsured person — if so, how is the assessment to be made (for defence costs, an allocation along these lines seems out of step with the insurer’s express obligation to pay defence costs whenever an allegation is made, regardless of underlying liability);
• allocation to the insurer of the additional defence costs which will be incurred as a result of insured person(s) being joined as defendant(s) to the proceedings in addition to uninsured person(s);
• allocation to the insurer of all but the additional defence costs which will be incurred as a result of uninsured person(s) being joined as defendant(s) to the proceedings in addition to insured person(s);
• pro rata allocation between the insurer and the insured according to the number of insured persons and the number of uninsured persons who have been named as defendants in the proceedings; or
• fifty-fifty allocation?”53

Ultimately, the clause was severed from the agreement.  The severance of claims condition 6 did not alter the “nature” or “kind” of the obligation to pay defence costs so as to cause the entire policy to be unenforceable.54  This case poses a problem for insurers:  how properly to draft with certainty a clause allocating defence costs.  The difficulty in drafting such a clause reflects the difficulty in defining, in a way which is workable a method of equitably distributing the costs obligation.

Can a corporation obtain indemnity from the insurer under a directors and officers liability insurance policy for defence costs paid by the corporation in respect of its directors?

This issue arose in Intergraph Best (Vic) Pty Ltd v QBE Insurance Ltd 55  In that case the Victorian Court of Appeal were asked to consider two preliminary questions concerning the construction of a directors and officers’ liability insurance policy. Essentially the plaintiff was seeking indemnification of legal costs it had paid in respect of the appearance of certain of its directors and staff who were compelled to attend a Royal Commission established to investigate the corporation’s activities.   Under the policy QBE agreed to provide indemnity:

1.  for loss which the insured person is not indemnified by the corporation arising from any claim made against the insured person; and
2. for loss which the corporation indemnified the insured person as permitted by law arising from any claim made against the insured person.

“Insured person” was defined to include directors and officers of the plaintiff, Intergraph.  “Loss” was defined to mean “the total amount which an Insured Person becomes legally obligated to pay in respect of a Claim made against such Insured Person for a Wrongful Act and shall include damages, judgments, settlements, legal costs and expenses awarded against an Insured Person to any claimant, and Defence Costs.”

Clause 2.3 of the policy provided “QBE agrees to pay Defence Costs arising out of any legally compellable attendance by an Insured Person at any official investigation, examination or inquiry in relation to the affairs of the Corporation ….”   The clause was construed as follows:

“It can be seen that QBE’s liability pursuant to the insuring clauses is not with respect to loss arising out of a claim against Intergraph but exists with respect to an amount which a director or officer becomes legally obligated to pay arising out of a claim against a director or officer.”56

The issue was whether QBE was liable to indemnify the corporation for the defence costs it had paid, and in respect of which the directors were not legally liable, on the basis that they were liable to indemnify in respect of an amount which a director or officer becomes legally obligated to pay arising out a claim against a director or officer.

The corporation argued that clause 2.3 did not stipulate that the defence costs be paid by the directors and officers or on their behalf by way of indemnity.  Further, it was argued, it was commercially and practically sensible for the corporation to incur those costs where it was the corporation under investigation and therefore a commercial and practically sensible construction of the policy would be that such costs were covered.

QBE argued that although the costs were “defence costs” within the meaning of the policy, they were not costs which the directors and officers were legally obligated to pay and further, that a claim was precluded in any event due to the dishonesty exclusion in the policy which provided that QBE would not be liable to make any payment for Loss arising from any Claim against an insured person directly or indirectly based upon, attributable to, or in consequence of any dishonest act.  If defence costs were held to be payable, it was argued, this would be tantamount to providing direct cover to the corporation rather than to the directors and officers of it, which would be at odds with the overall structure of the policy, and which would be alien to the common understanding of a directors and officers liability insurance policy.  Furthermore, the interests of directors and officers of a corporation may or may not overlap with those of a corporation, and often may be in conflict.

At first instance, the judge held that QBE were liable to pay defence costs notwithstanding that the costs had been incurred not by the insured person but by the plaintiffs.  However, His Honour held the indemnity was excluded by the operation of the dishonesty exclusion.  QBE appealed in relation to the first issue and Intergraph in relation to the second.

On appeal it was held that QBE were not liable for the defence costs.  The nature of the cover was described as follows:

Such policies have been held in the United States not to provide cover to the company except to the extent that the company indemnifies the insured directors and officers.  Accordingly, these types of policies do not provide insurance to a company in respect of the litigation or defence costs incurred by it.58   If the company engages legal representation on behalf of its directors and officers but those directors and officers are not personally obliged to pay for such representation, then the policy will not cover the costs incurred by the company.59

Roger Traves SC and Samantha Traves

  Footnotes

1. See s 11(7) of the Insurance Contracts Act 1984 (Cth).
2. Policy, CE Heath Underwriting Agencies Pty Ltd, 1990.
3. Defence costs clauses are here intended to refer to clauses in respect of the insureds own costs, not costs of or orders which might be made against it in favour of a claimant third party.
4. As was put by Stephen J in Distillers Co Bio-Chemicals (Aust) Pty Ltd v Ajax Insurance Co Ltd (1973-74) 130 CLR 1 at 25, “… not until the insured becomes subject to a relevant liability will the insurer, for the first time, be subject to any obligation to indemnify the insured under the policy and at no time will it be under an obligation to defend actions brought against the insured by third parties.  It has a right, but no obligation, to undertake the defence of such actions”.
5. Post Office v Norwich Union Fire Insurance Society Ltd [1967] 2 QB 363 at 377.
6. Distillers Co Bio-Chemicals (Aust) Pty Ltd v Ajax Insurance Co Ltd [1973-74] 130 CLR 1 at 26 per Stephen J, referring there to a consent to settle the action.
7. Power v Markel Capital Ltd [2007] QCA 284; Sherlex Pty Ltd v Thornton (t/as Medical Plumbing Services [2003] QSC 199 per Fryberg J at first instance.
8. Sherlex Pty Ltd v Thornton (t/as Medical Plumbing Services) [2003] QCA 461
9. [2003] QCA 461; BC200306206.
10. Sherlex Pty Ltd v Thornton (t/as Medical Plumbing Services) [2003] QSC 199; BC200305188, Fryberg J at [4].
11. At [9]
12. At [7]
13. At [8]
14. At [10]
15. At [11]
16. At [12]
17. [2003] ACTSC 51; BC200303302.
18. (2005) 11 VR 548
19. Ibid at [28].
20. [2007] QCA 284
21. Ibid at [36]
22. Ibid at [4]
23. Ibid at [14]
24. Ibid at [28]
25. Ibid at [28]
26. Ibid at [29]
27. [2005] HCA 17
28. [2005] HCA 16
29. Ibid at [69]
30. Ibid at [15]
31. (2000) 203 CLR 579 at 589
32. Ibid at [15]
33. Ibid at [46]
34. Ibid at [36]
35. Ibid at [37]
36. Ibid at [39] and [41]
37. Ibid at [42]
38. Ibid
39. Ibid
40. [2006] NSWSC 366 at [64] — [65]
41. [2005] HCA 16
42. (1997) 188 CLR 652.
43. [2003] ACTSC 51; BC200303302.
44. Citing Roberts v Bury Improvement Commissioners (1870) LR 5CP 310 at 326; approved in Panamena Europea Navigacion (Compania) Limitada v Frederick Leyland & Co Ltd [1947] AC 428 per Lord Thankerton at 436.
45. Distillers Bio-Chemicals (Aust) Pty Ltd v Ajax Insurance Co Ltd (1973) 130 CLR 1.
46. See, for example, Butt v McDonald (1896) 7 QLJ 68 at 70-1; Secured Income Real Estate (Aust) Ltd v St Martins Investments Pty Ltd [1979] 144 CLR 596 at 607; Shepherd v Felt & Textiles of Australia Ltd (1931) 45 CLR 359 at 378.
47. [1997] 1 WLR 1237.
48. See the headnote to the decision.
49. [2003] NSWSC 941; BC200306250.
50. Ibid at [50]
51. Ibid at [54]
52. Ibid at [64]
53. Ibid at [71]
54. Judgment at [81], citing Humphries v The Proprietors “Surfers Palms North” Group Titles Plan 1955 (1994) 179 CLR 597 at 618 (McHugh J); McFarlane v Danielle (1938) 38 SR(NSW) 337 at 345 (Jordon CJ); State of New South Wales v Banabelle Electrical Pty Ltd at [32] (Einstein J).
55. (2005) 11 VR 548
56. At [11]
57. At [23]
58. At [24] citing Clark v General Accident Insurance Co Pty Ltd 951 F Supp 559 (D Virgin Islands 1997) per Moore J at 561: “These provisions have been interpreted to mean exactly what they purport to state, ie that the named insured is not covered except to the extent that it may indemnify its directors and officers for covered loss incurred by them.”
59. At [25]