In a flawed opinion handed down in Carolina Casualty Insurance Co. v. Merge Healthcare Solutions, the Seventh Circuit ordered an insurance company to pay $3.15 million for attorney fees awarded to the plaintiffs who sued the company’s insured. Some shareholders sued Amicas, Inc. and its officers, who were insured by Carolina Casualty Insurance Co. under a D&O policy. The shareholders won a preliminary injunction halting Amicas’s merger with Thoma Bravo, LLC. Weeks later, the parties settled after Merge Healthcare, Inc. bought Amicas for $26 million more than what Thoma Bravo offered. Under the law of Massachusetts, where these shareholders sued, a plaintiff can recover amounts incurred in attorney fees out of the funds raised due to his efforts. Here, as the funds were raised in Merge’s more generous tender offer, the funds to be levied were the money of all shareholders. If Amicas’s shareholders had paid the attorney fees, Carolina’s policy would not cover them, at least because the policy does not insure the shareholders. Worried that paying the attorneys from the shareholders’ funds could derail Merge’s purchase, Amicas agreed to pay the fees itself. If Amicas had paid without Carolina’s consent, Carolina’s policy would not insure Amicas’s payment, because Amicas would have voluntarily assumed its shareholders’ liability.

Before Amicas agreed to pay the attorneys fees, it got agreement from Carolina that Carolina would insure “reasonable attorneys’ fees awarded by the court,” “subject to the Policy’s terms and conditions.” (Carolina’s agreement is eminently sensible: it funded Amicas’s defense, had a $26-million reason to believe that the lawsuit had merit, and thus wanted the litigation to end.) The Massachusetts court awarded the shareholders’ lawyers $3.15 million in fees, which equaled a lodestar of $630,000 multiplied by five. Carolina refused to pay for the $2.52 million added by the multiplier because the “loss” its policy covered did not include “the multiplied portion of multiplied damages.” Amicas sued, and the District Court of the Northern District of Illinois ordered Carolina to pay the $3.15 million in full.

The Seventh Circuit affirmed, giving three explanations: The court saw no reason to equate attorney fees with “damages.” Next, the court decided that the “loss” definition only guarded against the insured’s moral hazard, which the court distinguished from the risk the plaintiffs’ attorneys took in prosecuting the case. Last, the court deemed the $3.15 million equal to a percentage award of about 12%, which the court assumed would have been acceptable. Each of these explanations invites rebuttal.

First, consider the nature of the $3.15 million from the insured’s viewpoint. The policy covered attorney’s fees that were part of the “Costs of Defense.” Plainly, the plaintiffs’ attorneys fees were not incurred defending Amicas, so if Carolina were to owe the $3.15 million, they must fall within another category of loss that the policy covered. The policy covered “damages,” and to Amicas, the $3.15 million were damages it paid on the shareholders’ behalf.

Second, remember that moral hazard is not insured for fear that the insurance may induce the risk-taking. Permitting insurance of multiplied fees may induce plaintiffs’ attorneys to sue insureds. Here, the lawyers were awarded a lodestar of $450 per hour for 1,400 hours worked. The federal courts have long presumed that the lodestar is the reasonable fee. They specifically refuse to multiply the lodestar for the purpose of compensating the attorney for his risk of losing because, if in effect you pay an attorney for the cases he loses, then you tempt him to bring unworthy lawsuits. Perdue v. Kenny A., 130 S. Ct. 1662 (U.S. 2010); City of Burlington v. Dague, 505 U.S. 557 (1992). By construing the D&O coverage to cover plaintiffs’ attorneys fees, the Seventh Circuit’s ruling makes companies juicier targets for lawsuits, even bad ones.

Last, it was inapt of the court to assume that if the $3.15 million award would have been appropriate if it were expressed as 12% of the fund. Consider the qualitative difference between fees if awarded as an enhanced lodestar and the exact same amount if awarded as a percentage of a recovery. Generally, courts are reluctant to grant percentage awards in cases that settle quickly. Untethered from any market value for the attorney’s time or the amount of time the attorney worked, a percentage award entices an attorney to settle a case prematurely. Here, for example, the shareholders’ attorneys requested a mere 19% of the fund: $4.94 million for a few weeks of work. The Massachusetts court refused. $26 million may seem a terrific result for the shareholders, but perhaps a few weeks’ more work might have led to an even better offer for Amicas. Even if 12% were an appropriate percentage in the abstract, in this case it was inappropriate to award any percentage of any number.

The Seventh Circuit’s opinion in Carolina Casualty Insurance Co. v. Merge Healthcare Solutions, Inc., No. 12-2275 (7th Cir. July 16, 2013) is here.