The United States Court of Appeals for the Eighth Circuit, applying Federal procedural and Minnesota substantive law, affirmed a district court’s conclusion that insured corporate directors failed to carry their burden to establish that their insurer was responsible for 100% of the fees and costs incurred in connection with a suit against the directors, the corporation, and other parties.  Brand v. Nat’l Union Fire Ins. Co. of Pittsburgh, Pa., 2019 WL 3850592 (8th Cir. Aug. 16, 2019).

The coverage litigation arose out of an underlying federal lawsuit and arbitration involving a wind turbine supplier’s claims against four directors of an energy company and several uninsured entities.  The turbine supplier claimed that the energy company had violated the terms of a finance agreement for the sale of turbines and that the directors had fraudulently induced the wind turbine supplier to enter into the finance agreement.  The energy company asserted a product-defect counterclaim against the turbine supplier. The directors tendered all matters to their D&O insurer.

In the coverage dispute, the parties focused on allocation.  The D&O insurer had initially offered to cover 20% of the costs related to the turbine supplier’s claims (based on the rough percentage of those claims that were asserted against the insured directors) but refused to cover any portion of the affirmative product-defect claim against the turbine supplier.  The D&O insurer ultimately offered to cover 40% of the lawsuit costs (based on the ratio of insured defendants to non-insured defendants) and 10% of the costs of the arbitration.  This offer was also refused.

In the district court, the insured directors sought a declaration that they were entitled to 100%, and nothing less, because all costs to defend the federal action were “reasonably related” to defending the insureds, and the arbitration was an extension of the federal action.  However, the directors cited only out-of-state authority that involved policies without allocation provisions for this standard.  The policy at issue provided for allocation on the basis of the “relative legal and financial exposures” and the “relative benefits obtained” by insured and non-insured entities.  The district court found that the “reasonably related” standard and caselaw did not apply as a result of the contractual allocation provision and that the directors had not met their burden to show that they were entitled to 100% under the applicable standard.

On appeal, the insured directors argued that the district court should have decreed the appropriate allocation – whether that was 82%, as they had argued in their reply brief to the district court, or even 40% as the insurer had offered before litigation – not merely found they weren’t entitled to the 100% they sought.  The district court should have done this, the directors argued, based on Fed. R. Civ. P. 15(b)(2), which provides that “[w]hen an issue not raised by the pleadings is tried by the parties’ express or implied consent, it must be treated in all respects as if raised in the pleadings.”

But the appellate court found that the claim of entitlement to some allocation less than 100%, appearing for the first time in the directors’ reply brief before the district court, did not provide the insurer with “actual notice of an unpleaded issue” sufficient to allow an “adequate opportunity” to respond to the change in pleadings.  The appellate court further noted that the necessary “implied consent” to a Rule 15(b)(2) pleading modification will only be found where the parties would have understood particular evidence to be “aimed at the unpleaded issue.”  The court concluded that the insurer would not have understood references to the pre-litigation email chains discussing the proper allocation, cited in the reply brief below, to be “evidence … aimed at any particular allocation.”