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LOS ANGELES-In a potentially costly defeat for policyholders facing liability lawsuits, the California Supreme Court has ruled that general liability insurers' duty to defend policyholders does not mean insurers are responsible for the entire defense.

Upholding a state appellate court ruling, the Supreme Court on July 24 ruled that insurers that

defend their policyholders against all allegations in a lawsuit later may seek reimbursement from policyholders for the cost of defending claims that their policies potentially do not cover.

Policyholder attorneys said the court, normally a pro-policyholder forum, has weakened insurers' duty-to-defend obligation under comprehensive and commercial general liability policies.

One insurer attorney said the decision merely affirms a longstanding practice by insurers in California to allocate defense costs, though she was not sure how readily policyholders have swallowed some of those costs in the past.

And at least one other state, Washington, allows insurers to defend policyholders against only the portions of lawsuits that allege potentially covered claims, said the attorney, Laura Foggan, a partner with Wiley Rein & Fielding in Washington, D.C.

Several insurer attorneys, though, said the allocation process is too expensive and difficult to pursue in most cases.

And, "The reality is, insurers are not going to seek reimbursement from policyholders that can't afford it," said insurer attorney Elizabeth A. McIntyre of San Francisco-based Kaufman & Logan, which filed an amicus brief in the case.

As a result, the ruling will not open a floodgate of

defense cost allocations after underlying lawsuits

have been resolved, insurer and policyholder attorneys agree.

In the few cases in which allocations are relatively easy, however, insurers stand to recoup significant sums, insurer attorneys acknowledged.

But, policyholder attorneys fear the decision plants the seeds for a thicket of other defense problems for policyholders.

For example, merely by threatening an allocation lawsuit, insurers might coerce policyholders into agreeing at the inception of an underlying lawsuit to shoulder a portion of their defense costs.

"The much more realistic threat is the Damoclean sword that carriers will try to foist on policyholders," said policyholder attorney Dorn Bishop, head of the insurance practice at Latham & Watkins in San Diego.

"I suspect allocations could be a cottage industry in and of itself, either after the fact or before the fact," said policyholder attorney Roger W. Simpson, a partner with law firm Cotkin & Collins of Los Angeles.

Both attorneys filed amicus briefs in the case.

Policyholder attorneys also are concerned that the decision by the influential California Supreme Court could sway courts elsewhere, few of which have ruled on this issue.

The policyholder in the case has not decided whether to ask the court to review its decision, but such a request is unlikely, said David M. Roberts, a partner with Paul, Hastings, Janofsky & Walker L.L.P. in Los Angeles. Mr. Roberts represents the policyholder in the case.

The court's 6-1 decision clears up what had been a muddled position on defense cost allocation in the state. California courts, including the Supreme Court, have reviewed the issue in a handful of cases over the past three decades. But none of those decisions fully spelled out when an insurer that has provided its policyholder a defense in a case involving potentially covered and uncovered claims is entitled to a reimbursement of defense costs.

The latest case, which attracted numerous amicus briefs from policyholders and insurers, stemmed from a contractual dispute between H&H Sports Inc. and Los Angeles sports mogul Jerry H. Buss.

Attorneys think H&H was dissolved years ago, after it settled its dispute with Mr. Buss. The company is not listed in the Los Angeles phone directory.

Mr. Buss owns the Los Angeles Lakers professional basketball team and the Great Western Forum, the home arena for the Lakers and some other Los Angeles-area sports teams as well as the site of other special events.

Mr. Buss also owns cable television networks.

By contract, H&H for years had been Mr. Buss' exclusive agent for obtaining advertising for the Forum and for one of his cable networks. But in 1988, Mr. Buss terminated that exclusivity arrangement.

H&H in 1989 sued Mr. Buss and other individuals and organizations connected to him, eventually charging them with 27 allegations of wrongdoing. The allegations included breach of contract, fraud, conspiracy and conversion, which Mr. Buss' CGL policies did not cover.

But, the suit also contained one allegation-a defamation charge-that CGL policies do cover.

Mr. Buss asked three of his CGL insurers to defend him, but only Irving, Texas-based Transamerica Insurance Co., now TIG Insurance Co., consented.

One of the other insurance companies, Landmark Insurance Co., a subsidiary of American International Group Inc., later settled with Mr. Buss.

In a 1995 summary judgment, a trial court found that the third insurer, Fireman's Fund Insurance Co. of Novato, Calif., had no duty to defend Mr. Buss, because the defamation allegedly occurred after the insurer's policy had terminated.

Mr. Buss settled with H&H, which had sought $297 million of damages, for $8.5 million in December 1991.

TIG, as well as the other insurers, refused to contribute to it.

While TIG agreed it owed Mr. Buss a defense because the defamation claim was potentially covered, H&H did not provide much evidence that it had been defamed, explained TIG's attorney, James E. Gibbons.

As a result, the settlement did not consist of any insured damages, said Mr. Gibbons, a partner with Haines, Brydon & Lea P.C. in Long Beach, Calif.

In a flurry of litigation that followed the settlement, a trial-level court agreed TIG did not have to contribute to the settlement and that the insurer could seek reimbursement for most of its defense costs from Mr. Buss.

The defense costs exceeded $1 million, with only $22,000 to $56,000 attributable to defending Mr. Buss against the defamation claim, the lone potentially covered claim in H&H's lawsuit, according to TIG.

The appellate court affirmed the decision last year (BI, March 18, 1996).

The Supreme Court's decision, written by Justice Stanley Mosk, said an insurer has a duty to defend a policyholder against the entire action it faces, even when only some of the claims are potentially covered.

"To defend meaningfully, the insurer must defend immediately. To defend immediately, the insurer must defend entirely," Justice Mosk wrote.

When all of the claims are potentially covered, the insurer must pay for the entire defense, Justice Mosk wrote.

But, California courts have established that when policyholders face suits in which none of the claims are covered, their insurers have no duty to provide a defense, the justice wrote.

"It follows" that in lawsuits alleging both covered and uncovered claims that an insurer has the right to seek reimbursement for the costs that the insurer incurs defending its policyholder against uncovered claims, Justice Mosk wrote.

"With regard to defense costs for those claims, the insurer has not been paid premiums by the insured. It did not bargain to bear those costs," the justice explained.

Even if the policy language were unclear, a policyholder "could not have an objectively reasonable expectation that it was entitled to what would in fact be a windfall," he wrote.

The court also ruled that insurers must prove their defense cost allocations are sound by a preponderance of evidence.

In a 1970 ruling, the court held insurers to the much more difficult "undeniable evidence" standard. But, Justice Mosk explained that the stricter standard did not apply in this case. Among other reasons, the 1970 court invoked the standard against an insurer that wrongfully refused to provide its policyholder any defense, Justice Mosk wrote.

"What I found sort of refreshing is the extent to which the California Supreme Court said it would enforce the terms of the policy," observed Ms. Foggan, who filed an amicus brief for insurers in the case.

But, several policyholder attorneys criticized the court for "paying lip service" to CGL policy language but then not addressing two key policyholder arguments: Policies require insurers to defend "any suit," not just any potentially covered claim, and CGL policies do not explicitly allow insurers to allocate defense costs to policyholders.

"If the policy says, 'defend any suit,' I would expect that is a reasonable expectation" by policyholders, Mr. Simpson said.

"If they wanted to defend only covered claims, the policy should say that," agreed Mr. Roberts, Mr. Buss' attorney.

The court's majority "didn't seem to focus on the language of the policy, and our arguments were given short shrift," he said.

Dissenting Justice Joyce Kennard concurred, pointing out that title insurers, for example, include such language in their policies.

Ms. Foggan said the majority's detractors are taking the "defend any suit" language out of context. The remainder of the provision, as well as "common sense," dictate which defense risks insurers assume, she said.

The decision raises several potentially thorny defense-related problems for policyholders.

Mr. Roberts said insurers may use this ruling to pressure policyholders at the beginning of a liability lawsuit that alleges some uncovered claims to assume a portion of their defense costs in exchange for a waiver of their insurers' rights to seek reimbursement later.

But, in the ruling, Justice Mosk said there is nothing wrong with two parties to a contract agreeing to such a provision. However, he said that scenario is unlikely, because the court has affirmed insurers' duty to defend any lawsuit in its entirety if the action alleges at least one potentially covered claim.

Mr. Roberts and other policyholder attorneys also lamented that the court's ruling creates potential conflict-of-interest issues between insurers and policyholders.

Those issues could hurt a policyholder's defense in underlying litigation and spark additional litigation between policyholders and insurers, the attorneys said.

For example, will insurance companies direct a policyholder's attorney to focus on only covered claims? Or, to avoid paying any defense costs, will insurers direct the attorneys to focus on the uncovered claims?

Justice Mosk and insurer attorneys discounted those concerns, though.

"It's up to the insured's lawyer to provide the best case possible," said Mr. Gibbons, TIG's attorney. After that, he said, if the policyholder has to reimburse its insurer a portion of the defense costs, "that's what he bargained for in the contract."

The decision also may further complicate pollution coverage disputes, Mr. Simpson said.

For defense cost purposes, insurers typically consider pollution liability allegations against a policyholder as a single claim, even if the pollution spanned many years and the policyholder was uninsured in some years.

Mr. Simpson also questioned whether insurers in California now might break down those pollution liability claims by year of coverage and allocate to policyholders the defense costs related to the years the policyholder was uninsured.

The case now heads back to the trial court, where TIG must show it has allocated its defense costs properly.

Jerry H. Buss et al. vs. the Superior Court of Los Angeles, California Supreme Court; No. S052844