Applying Montana law, the Montana Supreme Court has held that an insurer breached its duty to defend where the insurer was on notice that a policy was “potentially implicated” and “unjustifiably” refused to provide a defense.  Tidyman’s Mgmt. Svcs. Inc. v. Davis, 2014 WL 3778481 (Mont. Aug. 1, 2014).  In so doing, the court declined to analyze coverage by examining the applicable D&O policy and the allegations in the underlying complaint.  Also, the court reversed the trial court’s entry of summary judgment concerning the reasonableness of the underlying $29 million stipulated settlement, holding that an evidentiary hearing was necessary on the reasonableness of the amount of the settlement but rejecting the insurer’s argument that the hearing should address potential collusion among the parties to the settlement.

Employee shareholders brought an action in federal court against certain directors and officers of the insured company alleging Employee Retirement Income Security Act violations and breach of corporate fiduciary duties arising from a merger.  The shareholders alleged that the directors and officers misrepresented the merit of the merger after receiving advice prior to the transaction that the company should be sold.  After multiple settlements, and with only claims for breach of corporate duty against two directors remaining, the federal court dismissed the action.  The shareholders then filed a state court action against the two remaining directors, adding the company, a Washington corporation created by the merger, as a plaintiff.  Soon thereafter, the insurer, which had provided a defense in the federal court action under a D&O policy, sent a declination letter to the directors’ counsel, stating that based on the policy’s “Insured v. Insured” exclusion, “it appears that the [state court] Complaint . . . does not implicate the Policy.”

The plaintiffs amended their complaint, adding the insurer as a defendant and seeking a declaratory judgment that the D&O policy provided coverage for the directors.  After three attempts by counsel for the directors to clarify whether the insurer would continue to pay their defense costs, the insurer sent a second letter affirming its coverage denial and stating that “there is no longer any coverage for this matter” and that it was “not going to continue to pay the costs of defense.”  Before the insurer sent the second denial letter, it filed a motion to dismiss the amended complaint for lack of coverage.  Subsequently, one of the insured directors filed a “stipulation resulting from the insurer’s refusal to provide coverage” with the court.  The stipulation, an identical version of which the other insured director filed a month later, provided for a settlement releasing the directors from personal liability for the damages sought in exchange for assigning all of their rights against the insurer to the plaintiffs.  Three weeks after the first defendant filed his stipulation, the insurer sent a third letter to the insureds’ counsel advising of “changes to [its] coverage position” and providing that it would advance defense costs subject to a reservation of rights.  Ten days later and on the same day that the second director filed his stipulation, the plaintiffs moved for summary judgment, alleging that the insurer was liable for the stipulated settlement for breaching its duty to defend.  The district court ultimately granted that motion and motions to approve the stipulations for entry of the $29 million judgment and declined to hold a hearing on the reasonableness of the stipulated settlement.  In so doing, the court also rejected the insurer’s collusion argument related to the settlement as speculative and, relying on an opinion and affidavit prepared as part of the previous federal court litigation, noted that the settlement amount was based on the estimated value of the company at the time of the merger.

On appeal, the court first considered the insurer’s argument that Washington law should govern the contact dispute because Montana was only an anticipated place of performance of the contract.  Applying the “most significant relationship” test set forth in Mitchell v. State Farm Insurance Co., 68 P.3d 703 (Mont. 2003), instead of a “materially greater interest” test, which the court concluded would apply when an insurance contract contained a choice-of-law provision, the court affirmed the trial court’s application of Montana law.  The court reached that conclusion “because the contract did not contain a choice-of-law provision, Montana was an anticipated place of performance, and this action involved Montana workers who brought suit in Montana and a stipulated settlement in Montana.”

Next, the court considered whether the trial court had erred in finding that the insurer had breached its duty to defend without analyzing coverage under the policy.  The insurer disputed that the state and federal court actions were the “same” and argued that, in any event, the trial court was required to analyze coverage under the policy and based on the allegations in the complaint before finding a breach of a duty to defend.  According to the Montana high court, however, “all that matters” for determining whether the duty to defend is triggered “is whether [the insurer] was on notice that the Policy was implicated.”  Because the insurer defended the insureds in the federal action, the court concluded that the insurer knew the policy was “potentially implicated.”  The court found that the fact that the insurer eventually reversed its coverage position “cemented” its recognition that the policy was implicated.  Then, relying on the insurer’s letter, which stated that coverage was “no longer” available and noting the insurer’s failure to promptly respond to the insureds’ communication attempts or to pay attorneys’ fees, the court found that the insurer had declined to provide a defense.  Finding both that the insurer was on notice that the policy was “potentially implicated” and failed to provide a defense, the court affirmed that the insurer breached its duty to defend.  In reaching that conclusion, the court emphasized that the insurer should have continued providing a defense while reserving rights under the policy.

The court rejected the insurer’s arguments that fact issues precluded finding a breach because the insurer effectively sought a coverage determination by filing the motion to dismiss and because the insureds were represented at all times.  Instead, the court found a breach of the duty to defend because the insurer failed to advance defense costs while the motion was pending and failed to defend under a reservation of rights while awaiting a coverage determination.  In declining to analyze coverage under the policy based on allegations in the complaint, the court explained that a Montana court must only analyze coverage before determining whether an insurer has breached its duty to defend when there “has been an ‘unequivocal’ demonstration that a claim is not within the policy coverage.”

The court then considered the insurer’s arguments that the trial court had erred in denying a hearing and discovery on reasonableness and collusion related to the stipulated settlement.  Although the court rejected the insurer’s argument that Montana law compelled the trial court to take the procedural step of conducting a reasonableness hearing, it agreed that the trial court’s failure to consider certain facts presented by the insurer with respect to the reasonableness of the settlement was error.  Specifically, the court pointed to the trial court’s failure to consider issues with the valuation report, the lack of an identified buyer for the company at the time of the merger, the minimal discovery provided on the issue in relation to the substantial judgment, that the settlement was “magnitudes greater” than the settlements entered with other directors, and a separate valuation of the company for less than half the final judgment amount.  Concluding that “further consideration is necessary to determine whether the $29 million stipulated settlement is reasonable,” the court remanded the action to the trial court for a hearing on the reasonableness of the stipulated settlement.

Nevertheless, the court also found that the insurer had failed to demonstrate specific facts to necessitate a hearing on collusion.  The court characterized the insurer’s collusion argument as amounting only to the allegation that the directors and officers lacked any “incentive to minimize the settlement amount” and, as a result, that “the settlement was per se unreasonable because it was improperly collusive.”  In support of collusion, the insurer argued that the insureds stood to personally benefit from the large settlement, that the stipulated settlement amount was over seven times what the plaintiffs had previously offered to accept, and the timing of the stipulation—immediately following the coverage denial—was more than suspicious.  The court, however, concluded that those facts did “not rise to the level of collusion” because the term required a “sort of agreement aimed at defrauding another or otherwise breaking the law” that the insurer had not shown.  Because the court found that the settlement amount was based on a valuation conducted before the proceeding and that the insurer offered no evidence of the insureds’ participation in determining that amount, it concluded that no material facts required further inquiry by the trial court on the collusion issue.  The court also essentially dismissed the insurer’s timing argument because it could not fault the insureds for acting quickly to protect their individual interests.

In a strongly-worded dissent, Justice McKinnon primarily took issue with the court’s willingness to find a breach of the insurer’s duty to defend without considering whether the complaint alleged facts which, if proven, would result in coverage under the applicable policy.  The dissent asserted that the majority “effects a significant shift in our jurisprudence” by creating a “broad and nebulous” “potentially implicated” standard that “effectively moots any future need for analysis of the policy and the complaint.”