9th Circuit confirms that insurers bear heavy burden to avoid defense duty

Under California law, an insurer may not shirk its duty to pay for a policyholder's defense of underlying litigation unless it meets a heavy burden and establishes that no potential for coverage exists with respect to any aspect of the underlying lawsuit against the policyholder.

With respect to the duty to defend, "[t]o prevail, the insured must prove the existence of a potential for coverage, while the insurer must establish the absence of any such potential. In other words, the insured need only show that the underlying claim may fall within policy coverage; the insurer must prove it cannot." Montrose Chem. Corp. v. Superior Court, 6 Cal. 4th 287, 300 (1993).

The 9th U.S. Circuit Court of Appeals recently reconfirmed this fundamental principle in Hanover Insurance Co. v. Paul M. Zagaris, Inc., 17-15477 (9th Cir. March 2, 2018) [unpublished opinion attached below], when it upheld the district court's decision that the insurer failed to establish that an exclusion for deceptive business practices applied to an entire proposed class action for an alleged kickback scheme.

In Zagaris, the underlying lawsuit alleged that the insured real estate brokerage company received undisclosed kickbacks from the sale to its clients of natural-hazard disclosure reports. According to the 9th Circuit's opinion, the underlying lawsuit "alleged claims for breach of fiduciary duties, aiding and abetting such breaches, violations of Section 1710(3) of the California Civil Code (prohibiting 'deceit' by omission when obligated to disclose), violations of Section 17200 of the California Business and Professions Code, constructive fraud, unjust enrichment, civil conspiracy, and accounting."

The insurer agreed to defend under a reservation of rights and then sued the insureds for declaratory relief on the grounds that it had no duty to defend or indemnify because of a purported deceptive business practices exclusion contained in its policy. As quoted in the 9th Circuit's opinion, the exclusion addressed claims "arising out of false advertising, misrepresentation in advertising, antitrust, unfair competition, restraint of trade, unfair or deceptive business practices, including but not limited to, violations of any local, state or federal consumer protection laws." (Internal quotations omitted.) The insurer argued against coverage for the entire underlying action by claiming that "each cause of action therein arises out of 'deceptive business practices.'"

The 9th Circuit invoked well-established California law and rejected the insurer's effort to avoid its defense duty. In particular, the court reconfirmed that "[d]oubts concerning the potential for coverage and existence of [a] duty to defend are resolved in favor of the insured" and that an insurer has a heavy burden to prove there is no potential for coverage for any of the allegations in the underlying complaint. (Internal quotations omitted.)

If any of the allegations are potentially covered, even when other allegations are clearly within the exclusion, the insurer must defend the entire action. The insurer failed to meet its burden to prove "that there is no possible scenario" for coverage where the causes of action for breach of fiduciary duty and constructive fraud were potentially outside the deceptive business practices exclusion because they "rely on the Insureds' omissions -- whether or not fraudulent or deceptive." The court reasoned "it remains possible that the Insureds could be found not to have engaged in deceptive business practices even if they are found to have breached their fiduciary duties by failing to disclose their interest in the sales of the NHD reports, or engaged in constructive fraud via the same omission."

Zagaris follows California's fundamental precepts that the duty to defend is broad, exclusions are to be narrowly interpreted, and even a small portion of an otherwise excluded complaint can trigger the duty to defend. As the California Supreme Court held in MacKinnon v. Truck Insurance Exchange, 31 Cal. 4th 635 (2003), "insurance coverage is interpreted broadly so as to afford the greatest possible protection to the insured, [whereas] ... exclusionary clauses are interpreted narrowly against the insurer." (Internal quotations omitted.) As a result, a few words in a complaint that is otherwise excluded are enough under California law to trigger the duty to defend. See Pension Trust Fund for Operating Eng'rs v. Fed. Ins. Co., 307 F.3d 944, 951 n.4 (9th Cir. 2002) (discussing a California case that approvingly cited a New York case that had "rejected the insurer's argument that 'two solitary, unsubstantiated words' buried within a 'completely unrelated federal antitrust cause of action, which was, itself, undisputedly not covered' could not trigger the duty to defend.").

Accordingly, a policyholder denied a defense from its insurer on the grounds that an exclusion applies should not simply take no for an answer. As Zagaris demonstrates, a detailed review of the allegations in the complaint may establish that at least a small portion of the complaint is potentially covered and, therefore, the insurer must defend the entire lawsuit.