Return of Fees Exclusion Does Not Bar Coverage For Suit Arising From Client’s Payments to Law Firm Pursuant to Invalidated Contingent Fee Agreement

Applying Alaska law, a federal district court held that a return of fees exclusion does not bar coverage for a lawsuit arising out the insured law firm’s receipt of fees from a former client pursuant to a contingency fee agreement.  ALPS Prop. & Cas. Ins. Co. v. Merdes & Merdes, P.C., Case No. 14–cv–00002–SLG (D. Alaska Dec. 29, 2014).  The court also rejected the insurer’s coverage defenses based on the policy’s claims-made-and-reported condition precedent, prior knowledge provision, retroactive date limitation, and definition of “damages.”

In 1988, an attorney agreed to represent an Alaskan village pursuant to a contingency fee agreement.  After the village prevailed, a fee dispute arose between the village and the law firm to which the attorney had assigned his rights in the fee agreement.  A state court entered judgment in favor of the law firm.  The village made partial payments on the judgment from 1995 to 2001 before defaulting in 2002.  In 2009, the law firm moved for a writ of execution on the judgment.  The trial court granted that motion, over the village’s objection, and denied the village’s motion for relief from the judgment.  In February 2010, the village appealed.  Despite the pendency of the appeal, the village paid the law firm the entire remaining balance owed on the judgment ($643,760) in July 2010.  On February 1, 2013, the Alaska Supreme Cout held that the writ of execution was unlawful because the original contingency fee agreement violated the Alaska Native Claims Settlement Act.  The court further held that the village was entitled to recover the $643,760 payment it made after the writ issued.

On February 12, 2013, the village formally demanded the return of the $643,760 from the law firm.  The law firm requested coverage from its professional liability insurer that same day.  The law firm also notified its insurer that it was discontinuing operations and requested a new policy on behalf of its successor entity.  The insurer denied coverage for the village’s demand but issued a policy to the successor entity.  In May 2013, the village filed suit against the law firm, the successor entity, and one of the firm’s partners.  The village alleged that the defendants improperly transferred assets to other parties during the pendency of the appeal so that the law firm would be unable to refund the $643,760 payment.  The suit asserted counts for breach of contract, fraudulent conveyance, and violation of Alaska’s unfair trade practices statute.  The village sought compensatory damages, equitable relief and punitive damages.  The insurer denied coverage for the suit under both the law firm’s and the successor entity’s policies.

In the coverage litigation that followed, the court agreed that the insurer owed no coverage under the policy it issued to the successor entity, which had a retroactive date of April 1, 2013.

With respect to the law firm’s policy, however, the court concluded that the insurer was not entitled to summary judgment on any of its coverage defenses.  First, the court rejected the argument that the village’s claim against the law firm was first made in March 2011 – prior to the inception of the claims-made-and-reported policy period – when the village demanded restitution of its payment in a reply brief filed with the Alaska Supreme Court.  The court reasoned that, because the restitution argument was included in an appellate brief and used “conditional” language, a reasonable person would not conclude that the argument constituted a “claim,” defined by the policy as a “demand for money or services.”

The court next held that the policy’s retroactive date of January 1, 1990 did not bar coverage because the acts giving rise to the claim were those the law firm allegedly took after the  village’s payment of $643,760 in 2010 – not, as argued by the insurer, the execution of the contingency fee agreement in 1988.

The court also held that the insurer was not entitled to summary judgment on its prior knowledge defense, which relied on a policy provision barring coverage if, as of the effective date of the policy (July 18, 2012), any insured “knew or reasonably should have known or foreseen that the act, error, or omission . . . might be the basis of a claim.”  With respect to the subjective prong, the court held that genuine issues of fact existed as to whether any insured, as of July 18, 2012, actually knew that his acts might give rise to the village’s claim.  As to the objective, “reasonably should have known or foreseen” prong, the court concluded that, because there is no law or ethical rule that required the law firm to safeguard the $643,760 payment, the insureds did not have enough information to alert a reasonable person that the unrestricted use of the payment might give rise to a claim.  According to the court, this analysis was not changed either by the pendency of the village’s appeal, which challenged the legality of the writ of execution, or the village’s reply brief, which asserted an entitlement to restitution of the $643,760 payment.

Finally, the court rejected the insurer’s arguments based on the policy’s definition of “damages” and its return of fees exclusion.  The policy defined “damages” as specifically excluding the  “restitution, reduction, disgorgement or set-off of any fees, costs, consideration or expenses paid to or charged by an Insured, or any other funds or property presently or formerly held by an Insured.”  The court reasoned that, because the complaint alleged “financial damages in an amount to be established at trial,” it could not definitely be said that the complaint sought only restitution of fees paid to the law firm, and summary judgment on the duty to defend was therefore improper.  Similarly, the court held that coverage was not necessarily barred by the policy’s exclusion for “any claim that seeks, whether directly or indirectly, the return, reimbursement or disgorgement of fees, costs, or other funds or property held by an Insured.”  Although the court acknowledged that the fees paid to the law firm and the insureds’ related acts “are the primary focus” of the village’s suit, the court concluded that the return of fees exclusion did not necessarily apply because the underlying complaint sought compensatory damages in some amount greater than $643,760 (i.e., greater than the amount of fees paid to the law firm).