No Reimbursement of Defense Costs for Liability Insurer While Defending Insured Under Reservation of Rights

By:  John A. Carleton

         On an issue of first impression, the Superior Court of Pennsylvania has held there is no reimbursement of defense costs for a liability insurer defending an insured under a reservation of rights letter, absent a provision in the insurance policy allowing for such reimbursement.

In American and Foreign Insurance Co., et al. v. Jerry’s Sport Center, Inc., et al., 2008 Pa.Super. 94, Jerry’s Sport Center, Inc. and several subsidiaries (collectively, “Jerry’s Sport”), appealed from a July 7, 2006 judgment entered by the Court of Common Pleas in favor of its commercial liability insurer, American and Foreign Insurance Company, Royal Insurance Company of America, Safeguard Insurance Company, and Royal Indemnity Company (collectively, “Royal”).  On an issue of first impression, the Superior Court of Pennsylvania concluded the trial court erred by granting Royal’s request for reimbursement of attorney fees that Royal had paid on behalf of Jerry’s Sport while Royal undertook a defense for Jerry’s Sport in an underlying suit.
           
            Royal and Jerry’s Sport entered a commercial liability primary and umbrella insurance contract on or about October 18, 2000.  In June 2000, the NAACP filed a civil action against several firearms wholesaler-distributors, including Jerry’s Sport.  Jerry’s Sport provided notice of the suit to Royal, tendered the claim for defense and indemnification and Royal retained a law firm to represent them.

            By letter dated June 15, 2001, Royal advised Jerry’s Sport it was providing them with a defense under a full reservation of rights, including the right to seek reimbursement of all defense fees advanced in the event it was determined Royal had no duty to defend Jerry’s Sport.  On June 25, 2001, Royal informed the president of Jerry’s Sport via telephone that if Royal determined Jerry’s Sport was not entitled to coverage and Royal continued to advance the costs to defend the action, Royal would seek reimbursement of any defense costs advanced on behalf of Jerry’s Sport after the date Royal made its final determination of coverage.

                        On September 7, 2001, Royal informed Jerry’s Sport in writing of its final coverage determination that Royal had no duty to defend or indemnify Jerry’s Sport and they were going to commence a declaratory relief action in that regard.  In the interim, Royal stated it would continue to advance the defense costs but informed Jerry’s Sport if it was successful in its declaratory relief action, it might also seek reimbursement from them of any defense costs Royal advanced beginning on September 7, 2001.  On September 12, 2001, Royal commenced a declaratory judgment action arguing the terms of its policy entailed no duty to defend or indemnify Jerry’s Sport in the NAACP lawsuit because the NAACP case did not allege or involve “bodily injury” as defined in the policy.  On February 25, 2003, the trial court granted Royal’s motion for summary judgment in the declaratory judgment action but did not indicate whether it was granting Royal reimbursement of attorney fees advanced to Jerry’s Sport. 

            On May 11, 2004, Royal filed a motion for reimbursement of defense fees  expended on behalf of Jerry’s Sport from the date of the filing of Royal’s declaratory judgment on September 12, 2001.  On June 13, 2006, the trial court entered a verdict in favor of Royal and on June 27, 2006, Jerry’s Sport filed a notice of appeal to the Superior Court.

            On appeal, Royal contended the court should follow the majority of jurisdictions, such as California in the seminal case of Buss v. Superior Court, 939 P.2d 766 (Cal.1997), which have found a right of reimbursement based on the existence of an implied contract between the insurer and its insured created through a reservation of rights letter, in addition to unjust enrichment of the insured from the insurer’s coverage of defense costs for claims that were determined not to be within the coverage provided by the policy.  This was essentially the reasoning employed by the trial court when it granted reimbursement to Royal.

            Reversing the ruling of the trial court, the Superior Court held the duty to defend arises whenever the complaint filed by the injured party may potentially come within the coverage of the policy.  The court concluded Royal’s duty to defend was triggered when it was faced with what it categorized in its own letters and communications with Jerry’s Sport as “potentially covered claims” and when it activated its right to defend under the insurance contract by taking actions such as hiring counsel.  By undertaking this duty to defend, Royal benefited by preserving both its right to control the defense and its ability to take actions to mitigate any future indemnification responsibilities.  Given the benefits to Royal and its exercise of its right to defend, the Superior Court held the trial court erred as a matter of law by concluding Royal’s undertaking of the defense pursuant to its reservation of rights letters created an implied contract and that Jerry’s Sport was unjustly enriched by the provision of a defense by Royal.

            The Superior Court indicated it appeared that undertaking the defense pursuant to a reservation of right to reimbursement not contemplated in the written insurance contract was an attempt by Royal to unilaterally modify the written insurance contract.  The court further held where the insurance contract is silent on the issue, permitting reimbursement of defense costs expended by an insurer exercising its right to defend potentially covered claims prior to a court’s determination of no actual coverage or duty to indemnify would result in a retroactive erosion of the breadth of the duty to defend.

            Importantly, the court cited LA Weight Loss Ctrs., Inc. v. Lexington Insurance Co., 2006 WL 689109 (C.P. Phila.Co. 2006), which held if an insurer wishes to retain its right to seek reimbursement of defense costs in the event it later is determined the underlying claim is not covered by the policy, the insurer is free to include such a term in its insurance contract.  Absent such a provision in the policy, an insurer should not be permitted to unilaterally amend the policy by including the right to reimbursement in its reservation of rights letter.

            Royal is currently seeking an appeal to the Supreme Court of Pennsylvania.  We will continue to follow this important case, but in the interim, insurance carriers writing policies in Pennsylvania should heed the ruling in this case and include the suggested policy term to preserve the right of reimbursement.