When a liability insurer wishes to avoid all coverage obligations with respect to a claim against its insured, it may seek an adjudication that it has no duty to defend or indemnify the policyholder. If the insurer files for such declaratory relief while the underlying litigation is still pending, California insureds will frequently move to stay the coverage action, pursuant to Montrose Chemical Corp. v. Superior Court, 6 Cal. 4th 287 (1993) (“Montrose I”). The purpose of such a Montrose stay is to avoid the risk of prejudice to the insured in the underlying action, if it is simultaneously forced to litigate an insurance coverage dispute.

In these situations, the insured faces a dilemma: Should it immediately move to stay the coverage litigation, or wait until it has filed an answer and cross-complaint? The more principled position might be to minimize any public filings which could force the insured to take positions on factual matters at issue in the underlying litigation. However, a recent California Court of Appeal decision, Great American Insurance Company v. Superior Court, 178 Cal. App. 4th 221 (2009), suggests that the better practice may be to answer and cross-complain before moving to stay.

In Montrose I, the California Supreme Court stated: “To eliminate the risk of inconsistent factual determinations that could prejudice the insured, a stay of the declaratory relief action pending resolution of the third party suit is appropriate when the coverage question turns on facts to be litigated in the underlying action.” 6 Cal. 4th at 301. Otherwise, the insured faces a very real risk that “if the declaratory relief action proceeds to judgment before the underlying action is resolved, the insured could be collaterally estopped to contest issues in the latter by the results in the former.” Haskel, Inc. v. Super. Ct., 33 Cal. App. 4th 963, 979 (1995); see also Montrose Chem. Corp. v. Super. Ct., 25 Cal. App. 4th 902, 909-10 (1994) (“Montrose II”). Thus, “[i]t is only where there is no potential conflict between the trial of the coverage dispute and the underlying action that an insurer can obtain an early trial date and resolution of its claim that coverage does not exist.” Haskel, 33 Cal. App. 4th at 979. The courts have also explained that the carrier’s declaratory relief action may unfairly “require[] the insured to fight a two-front war, litigating not only with the underlying claimant, but also expending precious resources fighting an insurer over coverage questions.” Montrose II, 25 Cal. App. 4th at 910. Thus, even where there is no factual overlap between the coverage dispute and the underlying litigation, the court must weigh this issue when deciding whether to stay the insurer’s declaratory relief action. The court must balance the insured’s interest in not fighting a two-front war against the insurer’s interest in being relieved from paying any further defense costs. Id.

Great American is the most recent California Court of Appeal decision applying the test for entry of a Montrose stay. In Great American, the Court actually reversed the trial court’s stay order. The Court noted that, on the face of the insurer’s complaint, the only apparent coverage issues involved interpretation of the policy terms. These were issues of law. They did not require the parties to resolve any of the same disputed factual matters at issue in the underlying litigation. The Court therefore concluded there was no risk of prejudicial factual findings if the coverage action were permitted to go forward.

The insureds argued one additional ground for entry of a stay: a possible counterclaim for breach of the implied covenant of good faith and fair dealing. The insureds indicated that this potential counterclaim would turn on disputed factual issues being adjudicated in the underlying litigation. However, the only pleading before the court was the insurer’s complaint; the insured had demurred and had not yet filed any answer or cross-complaint. With no responsive pleading on file, the Court of Appeal held that the insured’s argument was simply too speculative. The court vacated the stay order and remanded the case to the trial court.

Finally, it is interesting to note that the Court of Appeal ordered the trial court on remand to consider whether a stay might still be warranted, on the ground that it would unfairly force the insured to fight a “two-front war.” Under the circumstances of this particular case, the Court of Appeal strongly implied, the insured would not suffer any undue prejudice. Nevertheless, it is noteworthy that the Court of Appeal refused to vacate the stay outright. Insureds seeking a Montrose stay should remember to thoroughly brief the “two-front war” issue; it remains an important component of the analysis a trial court must perform when deciding whether to grant such a stay.

Ultimately, however, the lesson of Great American is: Where the risk of prejudice is not apparent on the face of the insurer’s complaint, but may lie in the counterclaims the policyholder intends to assert, the insured should answer and cross-complain before moving to stay. Although the more principled position may be to refrain from doing so until the underlying litigation is resolved, it may not be without risk. A court could very well reject the policyholder’s arguments in support of its Montrose stay motion, on the ground that they are too speculative.