The October 8, 2008 Ontario Court of Appeal decision in Hanis v. Teevan definitively sets out and clarifies the principles that now apply in Ontario to the issue of defence costs allocation for covered and uncovered claims. The decision confirms that in most cases it will be difficult for an insurer, in the absence of specific policy language, to allocate defence costs in a “mixed” claim to the insured.

The following key points from the Hanis v. Teevan decision are noteworthy:

1. The question of defence costs allocation is a matter of contract interpretation and notions of fairness or equity (i.e., there should be some allocation where the defence of covered claims benefits the defence of uncovered claims) are not relevant. The court essentially overturned, or at least rejected, earlier cases that determined allocation on the basis of “fairness” without regard to the policy language. The court summarized as follows:

For the reasons set out above, I do not think that the nature and extent of the insurer’s obligation to pay defence costs is a question of fairness or unfairness. Rather, it is a question of what the insurer has agreed to do in the policy. The answer to that question lies in the language of the policy, not in judicial notions of fairness.

2. If the policy provides for an unqualified obligation to defend covered claims, then the general principles are as follows:

I would hold that the question of apportionment of costs should be determined by the operative language in the policy. Where there is an unqualified obligation to pay for the defence of claims covered by the policy, as in this case, the insurer is required to pay all reasonable costs associated with the defence of those claims even if those costs further the defence of uncovered claims. The insurer is not obliged to pay costs related solely to the defence of uncovered claims.

In other words, where defence costs have any connection to the covered claims, the insurer has to pay 100% of those costs, with only costs solely related to uncovered claims being outside that obligation.

3. The latitude that a court will apply to the allocation exercise is demonstrated by the 95/5 allocation in favour of the insured in this case notwithstanding the covered claim of malicious prosecution was only one of many causes of action and claims asserted (the others included wrongful dismissal, conflict of interest, infringement of copyright, misappropriation of property and interference with contractual relations), all of the rest of which were assumed by the court to be uncovered claims. The court accepted that it was impossible to pin down the defence costs solely related to the uncovered claims, largely because the claims arose out of a single ongoing “story” about the plaintiff’s 14 year relationship with the insured, the factual underpinnings of which were all in some way related to the covered malicious prosecution claim.

4. The court stressed that it is open to an insurer to include specific policy language that addresses allocation between covered and uncovered claims, but that a court will not read in such language where the insurer fails to include it in the policy. In the directors and officers context, of course, it is now customary for policies to include specific allocation provisions.

5. Although the court did not have to decide the issue of whether allocation should be applied where the defence of covered claims benefits an uninsured defendant, there is a strong indication from the court’s approval of the contract interpretation approach espoused in the directors and officers context in the Privy Council decision in New Zealand Forest Products Ltd. v. New Zealand Insurance Co. Ltd., that the Ontario Court of Appeal would have applied the same principles to find that no allocation would be appropriate unless there were defence costs solely related to the defence of the uninsured defendant that would not also have been associated with the defence of the covered claims against the insured. The court approved the following passage from the Privy Council decision, which dealt squarely with the issue of an uninsured defendant:

On the ordinary meaning of the words which have been used it is reasonable to understand that the cover would extend to the whole costs incurred in the defence where the officer was the sole defendant. Why then should the meaning of the words change simply because there is another defendant who is not covered by the policy? Moreover if an uninsured co-defendant was bankrupt or otherwise without means it would seem an odd result of the insurance that it should not cover the whole of the officer’s costs even though some of them related also to the defence of the co-defendant. Once it is accepted that the costs are not confined to those which relate solely and exclusively to the officer it is hard to find anything in the language which prevents the cover extending to all the costs which also relate to another defendant. On the contrary the language points to the conclusion that all such costs are covered … In contrast to such general terms there is no provision generally requiring the kind of allocation to be made for which the [insurers] contend. It cannot be assumed that the insurers would not have anticipated the likelihood of the company being joined as a defendant along with one of its officers and if provision of the kind contended for was intended that could readily have been included … The obvious inference is that where, as here, the other defendants are not covered by insurance there is to be no restriction in the extent of the loss covered by the policy provided that it reasonably relates to the claimagainst the officer…

[Emphasis in original]

In the end result, where the costs to defend the uninsured defendant would also have reasonably been incurred to defend the covered claim against the insured defendant, all of those costs will fall to the account of the insurer under the defence obligation.

6. A specific allocation provision could be included in the policy language not only to address covered and uncovered claims, but also covered and uncovered defendants.

7. One “bright” spot from the decision is the court’s rejection of the principle in the Alberta decision in Modern Livestock v. Kansa that where an insurer wrongfully refuses to defend, it will be obliged to pay all defence costs, both for covered and uncovered claims. In reliance on the contract interpretation approach, the court stated that “I can see no justification for imposing upon the insurer, as a consequence of its breach of contract, an obligation to pay defence costs that are clearly not covered by the contract.”

8. One last observation of note concerns the onus of proof. Many earlier cases have held that the onus is on the insurer to demonstrate the portion of defence costs that relate exclusively to uncovered claims. The court notes, without deciding the issue: “I question whether there is any compelling reason to depart from the general rule that the party claiming damages bears the ultimate or legal burden of proof on that issue, including proving the quantum of damages suffered.”