HNRK Coverage Corner

This week at the Coverage Corner, we discuss Flextronics Int’l, Ltd. v. Allianz, 25-CV-1511(PAE)—a recent decision out of the Southern District of New York that examines an often disputed, but less-frequently litigated, issue in the realm of D&O coverage:  the allocation of a settlement payment between covered and non-covered loss.  Settlements often resolve a mix of claims against the insureds, some of which (such as securities fraud) may be subject to coverage and others of which (such as breach of contract claims) may not be.  Alternatively, the same settlement might be made on behalf of insured and non-insured parties.  But D&O insurers are typically only required to pay the covered portion of any loss—whether from a settlement, judgment or defense costs.  How is the loss allocated to determine the insurer’s coverage obligation? 

As with any insurance question, the answer starts with the policy language.  Some policies have express provisions mandating a particular allocation methodology or requiring the insurer and the insureds to use “best efforts” to negotiate a reasonable allocation.  In the absence of an express policy provision, the courts have taken two main approaches. 

The Larger Settlement Rule

The first allocation method—originally articulated by the Seventh and Ninth Circuits and later adopted by the Delaware Supreme Court—is the so-called “larger settlement rule.” Under this approach, the insurer must pay for the full loss, unless it can demonstrate that non-covered claims, or the conduct of non-covered parties, increased the amount of the loss.  See Harbor Ins. Co. v. Cont'l Bank Corp., 922 F.2d 357, 367 (7th Cir. 1990) (“To the extent that the amount for which Continental settled was larger than it would have been but for the misfeasance of these other persons—either noninsured persons or persons against whom no claim was made—Continental's entitlement to reimbursement in this suit would be cut down.”); Nordstrom, Inc. v. Chubb & Son, Inc., 54 F.3d 1424, 1433 (9th Cir. 1995) (“Only if the corporation were liable for a claim for which the directors and officers lacked any responsibility, or if the corporate liability increased the amount of loss, would the amount of liability exceed that amount for which Federal was ‘legally obligated’ to pay.”); RSUI Indem. Co. v. Murdock, 248 A.3d 887, 908 (Del. 2021) (“broadly speaking, a loss is fully recoverable unless the insurer can show that the liability for non-covered conduct increased the insurer’s liability”).  Under this approach, if the settlement amount would have been the same whether or not the underlying complaint named non-covered individuals or asserted non-covered theories of the liability, the insurer must fund the entire settlement.  

The Relative Exposure Rule

Other courts have apportioned the insurer’s responsibility for a settlement involving covered and non-covered parties “according to the relative exposures of the respective parties” in the underlying litigation.  See, e.g., PepsiCo, Inc. v. Cont'l Cas. Co., 640 F. Supp. 656, 662 (S.D.N.Y. 1986); see also Clifford Chance Ltd. Liab. P'ship v. Indian Harbor Ins. Co., 41 A.D.3d 214 (1st Dep’t 2007) (“insurer is only required to pay a portion of its insured's claim for reimbursement of the settlement amount based on a determination of the insured's and the uninsured’s relative exposures in the litigation and the benefits received from the settlement.”).  Again, the insurer must “bear the ultimate burden of proving what amount of the settlement cost should be excluded from the policy coverage.”  PepsiCo, 640 F. Supp. at 662.

The Flextronics Case

The Flextronics case arose from a $42 million settlement of an underlying trade secrets litigation.  The insured negotiated allocation with its primary insurer and two of its excess insurers, but proceeded to arbitration with Allianz.  The matter ultimately came before Judge Engelmeyer of the SDNY on Allianz’s motion to vacate the arbitral panel’s award.  The panel applied the relative exposure rule, but nevertheless made a 100% allocation to covered loss, finding that the insurer failed to meet its burden to prove the amount that should be excluded from coverage.  Applying the deferential standard for judicial review of arbitration awards, Judge Engelmeyer held that the panel “did not manifestly disregard the law or the parties’ agreement.”  Even under the relative exposure rule, a 100% allocation to covered loss was appropriate because Allianz “‘failed to produce any credible evidence’ to exclude any of th[e] loss from coverage.”  Allianz’s expert applied a “per capita” allocation method:  that is, he “simply took the number of parties, namely six, and since four were covered persons, he allocated one-third of the loss” to the uninsured entities.  But the same expert “readily admitted” that this approach was “not based on industry custom or practice.”  The Court held that the panel properly rejected the per capital methodology, and since Allianz bore the burden of proof, none of the loss was excluded from coverage.

Allianz was also unsuccessful in its argument that Flextronics failed to comply with a policy provision requiring the parties to “use their best efforts to determine a fair and proper allocation of loss.”  Judge Englemeyer upheld the panel’s determination that Flextronics had satisfied this obligation, which requires “doing a reasonable job to accomplish allocation,” and is necessarily “a very subjective standard that “depends on specific facts.”  While Flextronics did not extend the same allocation offers to Allianz that it made to other insurers, the Court agreed with the panel that it had no obligation to do so. Flextronics engaged in “an iterative negotiation process” with Allianz that satisfied the “best efforts” standard.

The Flextronics decision is major win for policyholders and offers a useful primer on loss allocation in complex D&O coverage matters.  The outcome underscores that it is the insurer’s burden, under the relative exposure rule, to articulate a principled allocation theory.  And if the insurer fails to satisfy that burden, the insured is entitled to full coverage.