
    CIRCUIT COURT OF THE CITY OF ALEXANDRIA
    Federal Insurance Co. v. The Partnership Umbrella and Steven Paulachak
    March 24, 1997
    Case No. (Law) CL960228
   By Judge Thomas A. Fortkort

Hie plaintiff in this action for declaratory judgment is Federal Insurance Company (hereafter referred to as “Federal”). The defendants arc The Partnership Umbrella (hereafter referred to as “PUI”) and Steven Paulachak. Federal issued an executive liability and indemnification policy to PUI. The policy required Federal to provide coverage for certain “wrongful acts" committed by PUI officers and directors. The policy contained two exclusionary previsions: (1) Federal would not be liable for loss in connection with any claims brought about or contributed to by foe dishonesty of foe insured if judgment or other final adjudication adverse to such insured establishes that acts of active and deliberate dishonesty were committed or attempted by foe insured with actual dishonest purpose and intent and were material to foe cause of foe action and (2) Federal would not be liable to pity any loss arising from a claim against an officer or director based upon or attributable to the officer or director having gained any personal profit or advantage to which he was not legally entitled. Paulachak, a PUI officer, was investigated and then indicted mi thirty-five counts of alleged criminal activity by a Grand Jury sitting in foe U. S. District Court for the Eastern District of Virginia. Twenty-seven counte resulted in either a dismissal or an acquittal, and foe other eight resulted in convictions. Paulachak was sentenced by foe U. S. District Court and is currently in a federal prison. Federal has instituted this action against PUI and Paulachak seeking a declaratory judgment that it is not liable under the policy it issued.

PUI filed a counterclaim. In consideration of PUPs payment of an agreed premium to Federal, Federal issued to PUI a policy whereby Federal covenanted to provide executive liability and indemnification insurance. The policy is a “claims made” policy. It covered claims made during the period from October 1, 1991, through October 1, 1992. The policy defines foe “Insured Organization* as PUI and foe "Insured person” as any PUI director or officer. The policy provides coverage under two insuring clauses: (a) Insuring Clause 2 provides foot Federal “shall pay on behalf of foe Insured Organization all Loss for which the Insured Organization grants indemnification to each Insured Person, as permitted by Urn ... .” and (b) Insuring Clause 1 provides that Federal “shall pay cm behalf of... foe Insured Persons all Loss for which foe Insured Person is not indemnified by foe Insured Organization and which the Insured Person becomes legally obligated to pay....” The policy defined “Loss” as foe “total amount which any Insured Person(s) becomes legally obligated to pay on account of each claim ... for Wrongful Acts for which coverage applies, including... damages, judgments, settlements, costs and Defense Costs.” “Defense costs” include “expenses ... incurred in defending, investigating or monitoring legal actions, claims or proceedings ... .” “Wrongful Act” is defined by foe policy as “any ... act, omission, neglect, or breach of duty committed, attempted, or allegedly committed or attempted, by any Insured Person, individually or otherwise in his Insured Capacity.... All such causally connected... acts... shall be deemed interrelated Wrongful Acts.”

Paulachak served as president for PUI during the relevant period and therefore qualifies as an insured person. Paulachak retained counsel when he became foe subject of investigation by foe government PUI gave notice to Federal’s insurance agent of legal fees and expenses that may be incurred by Paulachak. PUI requested Federal’s opinion of coverage. Several times throughout tire investigation, PUI sent letters to Federal requesting coverage for Paulachak. Each time, Federal denied coverage on tire grounds that no “claim* had been made cm Paulachak for a wrongful act under foe policy. On September 14, 1994, Paulachak was indicted on thirty-five counts. Twenty-three of foe original thirty-five counts were redacted, and of foe remaining twelve, he was convicted of eight. The Board of PUI indemnified Paulachak a portion of foe fees and expenses related to his representation from May 3, 1994 (foe date Paulachak received a letter notifying him drat he was foe target of the investigation) through any appeal.

On March 18, 1996, Federal refused coverage for any costs incurred by Paulachak at any time relating to the criminal charges, including costs incurred in defending the twenty-seven counts on which Paulachak was acquitted. Paulachak incurred in excess of approximately $165,000.00 for die coste of his representation through the date of the “target” letter. PUI paid these amounts pursuant to Va. Code § 13.1-878. Thus far, Paulachak has incurred over $1,000,000.00 in post-target letter defense costs. PUI has indemnified Paulachak for a portion of these costs. PUI claims that this amount Mis under the definition of “Loss” under the policy. All necessary conditions to Federal’s duty to pay have been satisfied. Federal has wrongfully withheld coverage to PUI under the terms of die policy.

Rulings of Law

Today’s hearing deals with two issues of law. The parties agreed to stay die proceedings until the court had an opportunity to rule on these two issues. The issues are as follows.

1. If PUI cannot recover under Insuring Clause 2 because of a determination that its indemnification of Paulachak was not “as permitted ... by law,” may PUI recover under Insuring Clause 1 either die amounts it has paid for Paulachak’s defense or the amounts Paulachak was “legally obligated topay?"

2. Can Federal argue to the jury in this case, based on the substantive merits of PUI’s decision to indemnify Paulachak, that the indemnification did not meet the statutory standards governing indemnification (including those attorney’s fees for counte on which Paulachak was not convicted)?

Law and Analysis

Question 1

This question deals with the interpretation of Clause 1 of die insurance contract Both parties agree that the Clause covers only situations where an officer has not been indemnified by the company. The argument is over what “indemnify” means in this context Federal argues that indemnify is a single decision. When the company decides to indemnify, it is bound by drat decision. Federal argues drat once the decision is made to indemnify, coverage cannot be had under Clause 1, even if the decision to indemnify was illegal and repayment is later sought from Paulachak.

PUI argues feat indemnification is determined by fee conditions existing at trial. PUI looks to what fee ultimate obligations of fee parties will be. If fee company ends up seeking repayment from Paulachak for improperly indemnifying him, then there is no indemnification under the terms of fee policy. Thus, Clause 1 would apply after indemnification is voided.

There is no case law discussing indemnification in this context The best approach to this problem is to determine the coverage of fee contract The contract places the two clauses at issue next to each other. They are entitled "Executive Liability” (Clause 1) and "Executive Indemnification” (Clause 2). These titles and fee feet that they are set out together suggest feat fee purpose of fee contract was to provide coverage to whomever was paying the bill for the losses incurred. Thus, coverage should be had under one of the two clauses (providing that none of the exceptions limiting coverage apply). This intent suggests that whether indemnification has occurred must be read as of the end of fee case. Thus, if fee court finds that fee indemnification was wrongful and sets it aside, the company may be able to bring its claim under Clause I.

The alternative way of reading die policy is to assume that fee parties woe not attempting to provide total coverage. Coverage was designed to exist only where (1) indemnification took place and was proper or (2) where no indemnification ever took place. Under this reading of fee policy, coverage was specifically excluded where fee company made a mistake and improperly decided to indemnify fee officer. If this had been fee intent, it would have been easy to require fee party to elect coverage under Clause 1 or 2. Tire policy does not have such an election; in feet, it recognizes that fee coverage of Clauses 1 and 2 could overlap in § 5.5 of fee contract, which sets the maximum deductible for claims occurring in part under 1 and in part under 2. This suggests that fee coverage provided in each clause was meant to be complimentary rather titan exclusive. Furthermore, if Federal had intended to exclude situations where fee indemnification decision would later be legally changed, it could have incorporated this exclusion into fee policy. Its failure to do so supports PUI's reading of fee policy.

Assuming that fee reading favorable to PUI is adopted and coverage exists under Clause 1 where indemnification was unlawful (barring coverage under Clause 2), the next question is whether PUI can recover fee fees it has already paid. The terms of Clause 1 provide feat tire officer or director will be paid by Federal Federal argues that only Paulachak, fee officer, can recover against Federal under Clause 1. PUI argues that it has a vested interest in fee policy and is a subrogee of Paulachak’s rights because it paid some of fee amounts owed by Paulachak. PUI argues that it is a promisee in fee insurance contract and that this gives it the right to recover under Clause 1. Clause 1 provides that Federal is obligated to pay “on behalf of each Insured Person” die losses for which they become liable. It does not state who can enforce this provision. The general rule is that a promisee (PUI) can enforce a contract even where the contract is made for the benefit of a third party (Paulachak). Am. Jur., Contracts, § 426. Thus, PUI can maintain this action against Federal, at least for the monies still owed.

PUI also argues that it is entitled to enforce the contract to recover fees already paid under a theory of equitable subrogation. Virginia recognizes the doctrine of equitable subrogation. Federal Land Bank v. Joynes, 179 Va. 394 (1942). The principal purpose of die doctrine is to secure die ultimate discharge of a debt by the party who ought in equity to pay it, notwithstanding the technical failure to take an assignment. Id. In this case, assuming that diere is coverage under Clause 1, Federal is the debtor, and PUI stands in die shoes of Paulachak under the doctrine of equitable subrogation. Virginia courts have not addressed equitable subrogation in the context at bar, but the Fourth Circuit, relying on Virginia law, has recognized die doctrine in this context. See, Atlantic Perm. Fed. Savings & Loan v. American Cas. Co., 839 F.2d 212 (4th Cir. 1988). In Atlantic, the court held that unclean hands of the directors and officers would not bar recovery by the company against the insurer undo* equitable subrogation. Id. The court noted that it would be manifestly unjust to allow the insurer not to pay the company when it had been well compensated for the policies, given Virginia's strong policy favoring liberal application of equitable subrogation. Id. Under eitiier of the above theories, PUI could recover against Federal under the insurance policy if coverage exists under Clause 1.

The court rejects Federal’s argument that the language “for which the insured is not indemnified by the Insured Organization" eliminates die common law right of subrogation. The court finds that this language is merely designed to prevent double recovery. Under the normal rules of contract construction, if the insurer desired to rid itself of the common law right of subrogation, it should have expressly stated so.

However, we do reach the same point urged by Federal through the use of this language. Since PUI under Virginia subrogation rulings steps into die shoes of the subrogee, it cannot collect for that portion of die expenses which it has already paid since it is limited to Paulachak’s right of recovery. See United Services v. Nationwide Mutual, 218 Va. 861, 241 S.E.2d 748 (1978); Erie Ins. Exch. v. Meeks, 223 Va. 287, 288 S.E.2d 454 (1982). Therefore, when PUI steps into the shoes of its officer Paulachak, it can only recover for those expenses not previously indemnified under this clause since its subrogation rights are limited by the language “for which the insured is not indemnified.”

We find that under any theory advanced by the defendant, it can only recover that portion of the expenses which it has not indemnified Paulachak.

Question 2

PUI claims that Va. Code § 13.1-870 applies to this case, not § 13.1-876. Va. Code § 13.1-870 is a codification of the “business judgment rule." PUI contends that applying the business judgment rule to this case limits the scope of toe inquiry on whether indemnification was permitted under Virginia law to whether toe proper procedures for toe indemnification decision were met

The bottom line of this issue is who decides whether toe substantive decision to indemnify comports with toe statutory requirements for lawful indemnification. PUI argues that toe Board of Directors decides this issue. PUI claims that the Business Judgment Rule prevents toe court, parties, etc., from delving into toe substance of toe decision to indemnify Paulachak. Effectively, PUI is therefore arguing that toe decision by toe Board is never subject to judicial review. The statutes dealing with indemnification suggest toe exact opposite. They set out when indemnification may occur, when it must occur, and when it may not occur. The language is mandatory. It would be counter intuitive to argue that although the company may not indemnify under certain circumstances, it is held harmless for deciding to do so anyway. Companies could ignore toe requirements of toe statute with impunity. This cannot be toe intent of toe statutes. For toe statutes to be enforced, toe decision to indemnify must be subject to review by toe courts. Therefore, evidence must be allowed to be introduced to allow toe finder of fact to determine whether the requirements of the statute have been met

Federal has toe better of toe two arguments. On its face, § 13.1-870 is entitled "general standards for conduct of directors.” It is not directed at toe propriety of a decision of a corporation to indemnify a director. Rather, it sets up toe standards to which a director is held in performing Ms duties. The main allegation in this case is that the corporation agreed to indemnify Paulachak in circumstances where indemnification would not be permissible under Virginia law. What occurred at toe meeting where toe decision to indemnify was made is relevant to determining whether toe corporation followed toe requirements of toe statute setting out when indemnification is allowed.

We conclude that defendant PUFs rights under toe contract under Clause I are limited to toe amounts of money for attorney’s fees which are due and owing but not yet paid. The amounts which PUI indemnified Paulachak cannot be reached under Clause X for the reasons stated.

Indemnification of PUI by Federal for file amounts PUI expended on Paulacliak’s legal fees will be governed by the statutory standards relating to indemnification.  