Fifth Circuit Holds That Settlement Obligations Create Legal Liability to Pay and Constitute “Loss” Under D&O Policy

The United States Court of Appeals for the Fifth Circuit, applying Texas law, held that an insurer was potentially liable for settlement payments its insured made to a claimant who had threatened legal action, even where the claimant never filed suit and the statute of limitations on the underlying action had passed.  HM Int’l, LLC v. Twin City Fire Ins. Co., 2021 WL 3928970 (5th Cir. Sept. 2, 2021).  The court rejected the insurer’s argument that the insured was not “legally liable” to make these payments, finding that contractual liability to pay a settlement constituted sufficient legal liability.

The policyholder, an investment firm, received a telephone call from a fraudster purporting to be a client instructing the firm to transfer a large sum of money out of a joint account.  The firm made the transfer without confirming the identity of the caller.  The fraudster then stole the funds, resulting in a loss to the firm’s client.  The client subsequently sent a letter accusing the firm of negligence and demanding compensation.  The client eventually reached a settlement with the insured and never filed the negligence suit.  By the time of the settlement, the statute of limitations on the negligence claim had run, so the client would have been unable to recover if the client had sued. 

The insured sought coverage for the settlement payment under its Directors, Officers and Entity Liability policy, which covered “Loss” “resulting from an Entity Claim,” where “Loss” included “Damages,” and “Damages” was further defined as “amounts . . . the Insured is legally liable to pay as a result of a Claim . . . including . . . settlement amounts.”  In later coverage litigation, the insurer argued that the settlement payment did not constitute covered “Loss” under the policy because the insured was not “legally liable” to make the settlement payments since the negligence suit was time-barred when the parties settled.  The District Court agreed, granting summary judgment to the insurer.

On appeal, the Fifth Circuit reversed, holding that the settlement payment constituted Loss resulting from a Claim under the Policy.  The Court explained that, under Texas law, “legally liable to pay” can mean contractually liable, and legal liability does not require a likelihood of prevailing in a court of law.  The Court also noted that the policy’s definition of a “Claim,” included both “a written demand for monetary damages or other civil, non-monetary relief.”  The Court observed that, while “[a] cause of action can certainly be time-barred by a statute of limitations . . . a Demand Letter . . . cannot.”  The Fifth Circuit also drew upon Comsys Info. Tech. Servs. v. Twin City Fire Ins. Co., 130 S.W.3d 181, 189 n.3 (Tex. App. 2003), in which a Texas appellate court addressed the issue of whether settlement payments created legal liability in a footnote: “[a] legal obligation can also arise out of a contract, such as a settlement.”  Having established that contractual liability was sufficient legal liability, the court also noted that the inclusion of “settlement amounts” in the definition of “Damages” “bolstered” its conclusion.  The Fifth Circuit emphasized that the insured need not “meet a threshold likelihood of losing the threatened lawsuit before a settlement can be covered,” and that “[t]he party defending the suit, threatened or filed, has the right to assess the legal risk it presents and decide whether to settle.”

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