7th Circuit Addresses Insured vs. Insured Exclusion

In its recent decision in Miller v. St. Paul Mercury Ins. Co., 2012 U.S. App. LEXIS 13298 (7^th Cir. June 29, 2012), the United States Court of Appeals for the Seventh Circuit, addressing Illinois law, had occasion to consider the application of an insured vs. insured exclusion in a D&O policy.

St. Paul’s insured, Strategic Capital Bancorp, Inc. (“SCBI”), was sued by five plaintiffs for alleged fraud, civil conspiracy, and violation of the Illinois Consumer Fraud and Deceptive Business Practices Act.  Of these plaintiffs, three qualified as “insureds” under the St. Paul policy as former directors of SCBI.  The other two plaintiffs were never directors or officers of SCBI, nor did they otherwise qualify as insureds.  St. Paul denied coverage to SCBI for the lawsuit on the basis of an insured vs. insured exclusion barring coverage for “Loss on account of any Claim made against any Insured : … brought or maintained by or on behalf of any Insured or Company in any capacity … .”  On motion to dismiss, the United States District Court for the Central District of Illinois held in favor of St. Paul.

On appeal, the Seventh Circuit noted that insured vs. insured exclusions are standard in D&O policies and that were the underlying suit brought solely by former SCBI directors, the exclusion would operate to bar coverage.  Alternatively, were the underlying suit brought solely by non-insureds, it would not apply.  The dilemma presented to the court, therefore, was “how to apply the policy when insured and non-insured plaintiffs join their individual claims in one lawsuit.”

The court identified three potential ways to resolve this question.  The first would be that as long as at least one non-insured plaintiff is not part of the lawsuit, then the exclusion is inapplicable.  The court acknowledged that this “rule would produce arbitrary results depending on whether insured plaintiffs did or did not have a non-insured plaintiff join in the same lawsuit.”  Moreover, this rule “would also make it easy for insured plaintiffs to evade the terms and purposes of the insured vs. insured exclusion by recruiting just one non-insured plaintiff to join an otherwise collusive or intramural lawsuit.”  The second alternative, proposed by St. Paul, would be that the presence of one insured plaintiff voids coverage for the entire lawsuit, regardless of how many non-insured plaintiffs were in the lawsuit.  St. Paul, at oral argument, conceded that under this rule if a lawsuit is brought by ninety-nine non-insured plaintiffs, and just a single insured plaintiff, then coverage would be unavailable.  The court found this proposed resolution unavailing as well, explaining that it too invited “arbitrary results depending on whether many people with similar claims file one consolidated lawsuit or many separate lawsuits.”

In light of the arbitrariness of these two potential approaches, the court revisited its reasoning as set forth in Level 3 Communications, Inc. v. Federal Ins. Co., 168 F.3d 956 (7^th Cir. 1999), wherein the court required an allocation of indemnity and defense costs for a lawsuit brought by both insured and non-insured plaintiffs.  The Miller court found that this approach:

… minimizes the risk of arbitrary results and discourages efforts to manipulate the result by the ways in which individual claims happen to be combined or separated. This answer also has the advantage of conforming to the parties' reasonable expectations: the insurer owes no duty to indemnify for claims brought by insured plaintiffs but does owe that duty for claims brought by others.

The court observed that the St. Paul policy, similar to the policy in Level 3, required allocation of defense and indemnity costs between covered and non-covered claims.  A lawsuit brought by insureds and non-insureds, explained the court, presents a claim “that includes both covered and uncovered matters, depending on the status of the different plaintiffs” and thus, under the reasoning in Level 3, St. Paul owed a coverage obligation to SCBI for the claims brought by non-insureds, but not for those brought by insureds.

St. Paul argued that Level 3 was distinguishable on several grounds, none of which were persuasive to the court.  First, St. Paul argued that in Level 3, the insured plaintiff did not join the underlying suit until well after it had been filed.  The court, however, concluded that issues of timing, and which plaintiffs are part of the original pleading, are not valid considerations under Level 3.  St. Paul also advocated for a “majority” rule, under which the insured vs. insured exclusion would apply to an entire suit if the damages claimed by insured plaintiffs outweighed those claimed by non-insured plaintiffs.  The court rejected this theory as well, explaining that:

This proposed additional requirement for a majority of non-insured claimants or dollars has no basis in the St. Paul policy language. It would also invite similarly arbitrary results, depending again on whether insured and non-insured plaintiffs filed separate or joint complaints. What would happen if one or more plaintiffs settled so as to shift the balance one way or the other? And should the relevant majority be the number of claimants or the number of dollars? By contrast, the allocation provision in the St. Paul policy gives us a fairly clear answer: coverage is not all-or-nothing based on one of these (perhaps unstable) majorities. Coverage is allocated based on "the relative legal exposure of the parties to covered and uncovered matters."

Finally, St. Paul argued that certain exceptions to the insured vs. insured exclusion as stated in the policy, by negative implication, operated to bar coverage of an entire claim when it includes the “active” participation of any insured plaintiff, regardless of whether the other plaintiffs are insured or not.  The court rejected this argument as well, finding that the “exceptions provide no guidance on how to treat claims by non-insured plaintiffs who were never subject to the exclusion.”