In the course of discharging their coverage obligations, insurers often benefit from bargains they strike with service providers.  Healthcare insurers pay in-network caregivers rates that are dramatically lower than the prices charged to the uninsured.  Automobile insurers frequently make payments for repairs based on the rates charged by body shops in Direct Repair Programs.  In many cases, the insurers enjoy discounts that are not available to individual insureds.  But the process can also work the other way: in some cases, a homeowner who can purchase repairs at below-market rates, or who performs the repairs herself, can pocket a portion of the claim settlement—even including the amount that would otherwise go to a general contractor as “overhead and profit.”

Recently, the insured under a commercial general liability policy tried to get a similar benefit in connection with a claim for the costs of defending a copyright infringement action.  But in Lexington Insurance Company v. MGA Entertainment, Inc., No. 12 Civ. 3677 (SAS) (S.D.N.Y. June 10, 2014), the United States District Court for the Southern District of New York, applying California law, ruled that an insured “is owed no more than … it actually paid” to defend a covered claim.

The MGA Entertainment Case

MGA Entertainment, Inc., manufactured a line of “Bratz” dolls—“a group of four young friends who are very cool and popular, wear trendy clothing, and have a ‘we can do anything, we’ve got a lot of power, we believe in ourselves’ attitude.”  While working on the initial design of the dolls, a sculptor employed by MGA hung on her wall a photographic image, known as “Angel/Devil Girl,” that had originally been designed by a Brooklyn photographer to advertise a line of shoes.  The photographer sued MGA for copyright infringement.

MGA tendered the defense of the copyright case under its CGL and commercial umbrella liability policies.  The insurers denied coverage and brought an action for declaratory judgment.  Meanwhile, MGA defended the underlying suit.  In 2011, the court awarded summary judgment to MGA, finding that the finished “Bratz” product was not “substantially similar” to the plaintiff’s original images.  Belair v. MGA Entertainment, Inc., 831 F.Supp.2d 687 (S.D.N.Y. 2011).  In 2013, the same court awarded MGA partial summary judgment in its litigation against the insurers, finding that the insurers had a duty to defend the underlying claim.  Lexington Ins. Co. v. MGA Entertainment, Inc., 961 F.Supp.2d 536 (S.D.N.Y. 2013).

MGA used two different law firms to defend the copyright suit, and the lawyers submitted bills in a total amount of $2,823,992.34.  MGA disputed those charges, and, in April 2012 and June 2013, it concluded settlements with both firms.  In the coverage litigation, MGA stipulated that the total amount it actually paid to its defense counsel for the copyright action was $2,408,914.02.  The insurers agreed to pay that amount, plus prejudgment interest.

Under California law, the proper measure of damages for an insurer’s breach of the duty to defend “is the reasonable attorneys’ fees and costs incurred by the insured in defense of the claim.”  Marie Y. v. General Star Indem. Co., 110 Cal.App. 4th 928 (2003).  In this case, MGA argued that it had “incurred” the entire $2.8 million its attorneys had originally billed, and that its subsequent settlements with the law firms were “irrelevant.”  It contended that any discount obtained from defense counsel by the insured should not inure to the benefit of an insurer that has been found to have breached its duty to defend.

You Get What You Paid For

MGA’s argument relied on a single decision from the California Supreme Court, which also presented unusual facts.  In Arenson v. National Auto. & Cas. Ins. Co., 48 Cal.2d 528 (1957), the court held that that the insurer was obligated to pay the full amount an attorney had billed, even though the attorney testified that he had not expected his clients to be able to pay those fees.  The Supreme Court reasoned that the duty to defend is not modified, just because the insured is in financial straits.

Judge Scheindlin, however, declined to apply this logic to the facts of MGA Entertainment, in which the client had already paid its attorneys in full.  Finding no other authority on point, the court ruled that “MGA is owed no more than the $2.4 million it actually paid.”  The court acknowledged that “MGA did, at some time, incur $2.8 million in legal bills,” but emphasized that “this is not the amount it ultimately spent defending the action.”

It probably helped the insurers’ case that MGA was asserting a claim for damages for breach of contract.  It is conceivable, that is, that a court could arrive at a different conclusion if called upon to interpret the language of a coverage provision in a claim for specific performance or declaratory judgment.  While the facts of MGA Entertainment are unusual, it will probably be worthwhile for insurers to review their policy language if they want to avoid paying anything other than actual defense costs in the future.