National Insurance Law Forum : Insurance Litigation Lawyer & Attorney : National Insurance Law Forum : Insurance Coverage, Bad Faith Litigation

Great American’s coverage lawsuit arose out of an underlying environmental pollution case.  Great American and several other insurers agreed to defend the insureds.  Great American filed its declaratory relief action for a determination that its policy limits were exhausted and therefore there was no further duty to defend.  The legal issues presented by this claim were two fold: (1) whether there was only $500,000 per occurrence available in applicable limits; and (2) whether there was an additional annual limit available because the insured had paid for an additional couple of months of coverage.  The insured argued the policy limits question necessitated determination of facts in the underlying case, including whether there was more than one occurrence and what caused the pollution.  The insured also argued it might assert a bad faith claim which would create factual issues that should be stayed.

The appellate court made short shrift of these arguments.  The possible bad faith claim was speculative.  No proposed claim had been presented to the court and, therefore, none could be considered.  On the issue of the amount of policy limits available, the court concluded these were contract interpretation issues that did not require discovery of or determination of the facts in the underlying case.  So a stay was not appropriate on those grounds.

However, the appellate court held another factor had to be considered - the prejudice of the insured being compelled to fight a “two-front war.”  The court indicated this factor must be considered “every time an insured seeks to stay a declaratory relief action while the underlying action is still pending.”  Thus, the trial court was instructed to balance the insured’s interests in not fighting a two-front war against the insurer’s interest in not being required to continue to pay for the defense where it may not owe a defense and may not be able to recoup that money.  The appellate court noted this issue is “circumstance-specific” and suggested it could depend on factors such as:

• the anticipated duration of the underlying litigation,
• whether the insured has separate counsel in the two actions, and
• availability of other insurance to cover the costs of defense.

Certainly the appellate court’s consideration of the relative burdens/prejudice is based in part on that, in California, an insurer has a right to reimbursement from the insured and contribution from other insurers if the insurer defends or indemnifies and later is found to have had no obligation to defend or indemnify.  See Buss v. Sup. Ct.(1997) 16 Cal.4th 35, 48-49.

The appellate court directed the trial court, on remand, to balance “the prejudice to the insureds if they are required to litigate both cases at once against the prejudice that Great American will sustain if it is forced to continue to provide a defense until the underlying action is resolved.”  What may help Great American in this particular case is that there are other solvent insurers defending.  This certainly is not always the case.  The court also indicated the trial court should consider alternative methods to achieve a fair balance of the interests of insurer and insured – suggesting there may be legal issues that could be determined on demurrer or motion for summary judgment at no great expense to either party.

In the earliest Minnesota case to address this issue, a federal district court ruled in Knapp v. Commonwealth Land Title Insurance Co., 932 F. Supp. 1169 (D. Minn. 1996) that a title insurer could recoup defense costs that it had paid pending a determination that it did not, in fact, owe coverage for the underlying title dispute. The court focused on the fact that the insurer had expressly reserved a right of recoupment when it agreed to defend and that the insured had not protested this claimed right. The court concluded, “Under these circumstances, the Court finds it appropriate to determine that Knapp’s silence in response to Commonwealth’s reservations of rights letter, and subsequent acceptance of the defense provided by Commonwealth, constitutes an implied agreement to the reservation of rights.”

The Eighth Circuit seemed to follow this line of reasoning a decade later in a Texas case. Despite the insured’s argument that Texas law, as exemplified by the Texas Supreme Court’s opinion in Matagorda County v. Texas Association of Counties Risk Management Pool, 52 S.W.3d 128 (Tex. 2000) precludes insurers from unilaterally asserting a right to recoupment of defense costs, the Eighth Circuit ruled in St. Paul Fire & Marine Ins. Co. v. Compaq Computer Corp., 457 F.3d 766 (8th Cir. 2006) that St. Paul’s assertion of a right to recoupment was not “unilateral” but rather was impliedly agreed to by Compaq when it accepted St. Paul’s partial payment of its defense costs after the insured itself had demanded a defense beyond that provided for under the policy. As a result, the court found that the insured had, in effect, created a supplemental agreement that required payments beyond those contemplated in the original agreement but that also gave St. Paul both rights asserted in the reservation of rights letter pursuant to which it had agreed to make any such payments.

Since then, however, it appears that the Eighth Circuit has gotten cold feet (or been taken aback by emerging case law in other jurisdictions rejecting a right of recoupment). In any event, the court’s recent opinion in Westchester Fire Ins. Co. v. Wallerich, No. 07-3624 (8th Cir. April 24, 2009) declined to find a right of recoupment and narrowly distinguished Knapp and Compaq.
In Wallerich, a directors and officers carrier agreed to provide a defense under a reservation of rights but stated that it would seek reimbursement for any sums advanced if a court later ruled that it did not have a duty to defend. Westchester Fire proceeded to bring a DJ and ultimately obtained a ruling that the “insured v. insured” exclusion in its policy precluded any duty to defend. The Minnesota District Court ruled that Westchester Fire was entitled to recoup the defense costs that it had paid in the interim.

On appeal, the Eighth Circuit affirmed the lower court’s ruling that Westchester Fire had no duty to defend but rejected its claims to recoup defense costs.. The court took note of the split in authority around the country and the growing number of courts that have rejected the insurers’ position and concluded that it was persuaded by the more recent state and federal court opinions from other jurisdictions that have adopted the “minority” position barring reimbursement for defense costs.
The court also distinguished the facts in Knapp and Compaq. In particular, the Eighth Circuit emphasized that Wallerich had not acquiesced in the insurer’s assertion of this right and, indeed, had loudly protested at the time that it should not have to repay Westchester Fire.

Under the circumstances, the court ruled that Westchester’s decision to still go forward with a defense despite the insured’s rejection of the terms in its reservation of rights letter constituted an implied acceptance of the insured’s terms. Furthermore, unlike Compaq, the court held that the insurer had never explicitly agreed to forego any rights that it otherwise had in return for tendering a defense.

Is Wallerich a complete repudiation of Compaq or just a refinement of the court’s earlier analysis in a different fact pattern where the insured’s objection at the time invalidates the “implied in fact” contract that insurers have argued to advantage in other cases.

From the author’s own point of view, the defense cost recoupment cases are much more difficult to prove than is the case where an insurer agrees to pay a settlement on its insured’s behalf and later seeks repayment after it is held not to owe coverage. The real issue with the defense cost recoupment cases is that courts are increasingly viewing these claims as subverting the promise to defend set forth in the policy’s insuring agreement. What value is the duty to defend, so goes this argument, if the insurer demands its money back later?

In fact, there is real merit to insurer arguments for recoupment where the absence of a defense obligation is apparent on the face of the pleadings or uncontroverted facts and the defense being provided to the insured is truly a “courtesy” defense that may minimize any liability that the insured may otherwise face. Where an insurer does have a duty to defend, however, it may only recoup defense costs that are attributable to non-covered claims (as in Buss) or that were incurred after it was found not to owe a defense.

The insureds were LA Sound, an audio equipment company, and its two officers and directors. At the time of renewing their insurance policy with St. Paul, the insureds (through their broker) answered an application indicating they were not involved in any joint ventures or in a labor interchange with any other business or subsidiary. In fact, the insureds had been involved for six months in a joint venture with Hollywood Sound to produce, market and sell audio and speaker products. The joint venture was a new corporation by the name of LSY Trading Development, Inc.

The joint venture stalled and Hollywood Sound sued the insureds and LSY for unfair competition (trademark infringement).

St. Paul agreed to defend LA Sound and its officers/directors, but only in their capacity as such, under a full reservation of rights. St. Paul specifically disclaimed any obligation to defend LSY and its (same) officers and directors. St. Paul agreed to pay the portion of the defense costs being incurred by LA Sound. St. Paul reserved the right to get the money back.  Thereafter, St. Paul settled the claim against LA Sound and its officers/directors, and the case proceeded against LSY and its (same) officers/directors until resolved.

Following conclusion of that lawsuit, LA Sound sued St. Paul for breach of contract and bad faith and St. Paul counterclaimed for rescission and reimbursement of amounts paid on LA Sound’s behalf. Trial resulted in a decision for St. Paul in all respects. The appellate court on review agreed there were grounds for rescission of the policy. Misrepresentations had been made to St. Paul about whether there was a joint venture or labor agreement. The omitted information was material to St. Paul’s assessment of the risk, underwriting, and determination of the premium to charge.

The appellate court also found St. Paul was entitled under Buss v. Sup. Ct. [16 Cal.4^th 35 (1997)] to be reimbursed for defense costs and the settlement paid on LA Sound’s behalf. However, the appellate court found St. Paul had not met its burden of showing by a preponderance of the evidence an allocation as between LA Sound and its two officers/directors. It was not fair, according to the court, to allocate all amounts to the insureds jointly and severally as there was no showing each faced the same liability and received the same benefit from the payments. As the court explained:

"[I]n the absence of proof, we decline to assume that every dollar St. Paul spent on the underlying action benefited all three insureds. Whether this is true depends on a detailed analysis of how the defense costs were spent – did any discovery or motion practice benefit one insured alone, or did all litigation costs benefit all insureds equally? It also depends on a detailed analysis of how the indemnity costs were spent – did the insureds face the same amount of liability , and was the liability settled on identical terms?" *15.

Under Buss the burden was on the insurer to prove the right to reimbursement and allocation, which the court found appropriate since the insurers were in the "best position to monitor the underlying litigation, track expenses, and allocate policy benefits among insureds.” Id.

Thus, the case was remanded for further determination on the proper allocation of restitution based upon the “respective benefits received by each” of the insureds under the rescinded policy.