Ruling on a matter of first impression, a California federal court held that an insurer did not breach its duty to defend when it withdrew a defense in reliance on a declaratory judgment which was subsequently reversed on appeal. National Union Fire Ins. Co. v. Seagate Tech., Inc., 2013 WL 308875 (N.D. Cal. Jan. 25, 2013).

In 2004, National Union and other insurers brought a declaratory judgment action seeking a ruling that they had no duty to defend an underlying action brought against policyholder Seagate. During the litigation that followed, National Union contributed to Seagate’s defense. In 2010, a California district court ruled that the insurers’ duty to defend terminated in 2007. In light of this ruling, National Union ceased funding Seagate’s defense. In 2012, an appellate court reversed the district court decision. Seagate then sought reimbursement from National Union of legal costs incurred in connection with the underlying claims between 2007 and 2012. Seagate argued that National Union’s 2010 withdrawal of a defense breached the insurance contract. The court held that there was no breach. The court reasoned that National Union did not act wrongfully in withdrawing a defense and “was entitled to the benefit of the (erroneous) ruling that there was no longer a duty to defend.” Thus, the court concluded, the initial decision in National Union’s favor “does provide insulation against a further claim of breach of contract.”

Although the ruling did not eliminate National Union’s obligation to reimburse the defense costs deemed retroactively due by the appellate court, the dismissal of the breach of contract claim has potentially significant financial implications under California law. Under California law, an insurer that wrongfully denies a defense may be liable for defense costs incurred by the policyholder. However, Civil Code Section 2860 allows an insurer to reduce its payment of fees and prejudgment interest to “the rates which are actually paid by the insurer to attorneys retained by it in the ordinary course of business in the defense of similar actions in the community.” The court held that because National Union’s defense denial was not wrongful, it was entitled to the benefit of Section 2860. Significantly, Section 2860 not only permits appropriate fee reductions, but also requires fee disputes (here, a $20 million discrepancy between fees demanded and amounts paid by National Union) to be resolved by arbitration.

Seagate represents a victory to insurers, but its precedential reach may be limited. First, the court contrasted an insurer’s fair reliance on a court ruling (as was the case here) with an insurer’s unilateral decision to stop defending in the absence of a court judgment. Second, the court distinguished cases in which an insurer attempts to “advance a subsequent declaratory judgment backwards in time to its decision to stop defending.” Finally, the court deemed it significant that Seagate had not sought a stay pending its appeal of the lower court duty-to-defend decision, indicating that had a stay been imposed, National Union’s withdrawal might have given rise to a breach of contract claim.