Insurer Has No Duty to Defend Insured in “Defensive” Arbitration Proceeding

Applying Illinois law, the United States District Court for the Central District of Illinois has held that an insurer had no duty to cover defense costs for affirmative claims that involved, but were not brought by, its insured.  Marquis Energy LLC v. Federal Ins. Co., 2020 WL 853503 (C.D. Ill. Feb. 20, 2020).

The insured, an Illinois-based energy company, is owned by three members.  In 2018, one of the members (H&H) filed suit against the company in Illinois state court.  Specifically, H&H sought to invalidate a series of resolutions considered by the company’s management committee.  The company’s D&O insurer agreed to defend the suit subject to a reservation of rights.

Later in 2018, the two other members filed a demand for arbitration against H&H.  The members argued that the issues raised in the state court lawsuit were subject to mandatory arbitration as set forth in the insured’s Operating Agreement.  The demand also sought a declaration that the resolutions considered by the management committee were valid.

About four months later, the two members filed an amended arbitration demand that added the company as a “nominal claimant,” i.e., neither a necessary nor an indispensable party.  The insurer denied coverage for costs incurred in connection with the arbitration.

In the ensuing coverage action, the company sought a declaration that the insurer was obligated to advance defense costs to the company for the arbitration.  The essence of the company’s argument was that the arbitration demand by the two members represented an affirmative claim that was “solely defensive in nature” by insureds for the purpose of putting H&H’s claims in the proper forum.  Because the affirmative claims asserted in the arbitration were ostensibly “defensive” and served to reduce its liability, the company argued that the insurer was obligated to fund the arbitration.

The court disagreed with the company for two reasons.  First, the court found that the arbitration proceeding was not a defensive claim, as the insured was “not a substantive claimant in the arbitration proceedings,” and the arbitration “was entirely unnecessary to defend against the allegations” made in the state court action.  It noted that all the company needed to do was argue for a dismissal in the state court action based on the mandatory arbitration clause.  Second, the court ruled that the insurer did not need to fund the arbitration because neither of the members that initiated the demand were Insureds under the D&O policy.  The court noted that the policy afforded coverage for the company and its subsidiaries, but not the company’s owners.  The court also held that because the company was simply the subject of a dispute between its owners, rather than of a suit “on behalf of or against” the company itself, the insurer had no duty to defend the company in the arbitration proceeding.