A California federal court recently attempted to clarify the interrelationship between extrinsic evidence, potential for liability and the duty to defend under California law. Storek v. Fidelity & Guar. Ins. Underwriters, Inc., No. C-06-06810-CRB, 2007 WL 2403363 (N.D. Cal. Aug. 20, 2007).

In the case, the insurer issued a duty to defend policy that covered claims for, among other things, personal injury from slander and wrongful eviction. The insureds later submitted a claim concerning a lawsuit in which a relative had asserted cross-claims for economic losses pertaining to alleged financial mismanagement. The insurer denied coverage.

The insureds then brought suit in federal court, arguing that the insurer had a duty to defend. The insureds based their argument on the theory that the cross-claims, when considered in light of extrinsic evidence, raised the potential for liability for covered claims. In support of this theory, the insureds presented emails from the cross-claimant accusing the insureds of being untruthful in their allegations, as well as evidence of a prior incident in which the cross-claimant claimed to be improperly excluded from a building.

The court first concluded that, on its face, the cross-claim contained no specific allegations suggesting even the potential for liability in connection with a covered claim. Then, despite California law permitting extrinsic facts to establish a duty to defend, the court rejected the insureds’ attempts to present such evidence

Plaintiffs take these two distinct principles of law and combine them. Their argument proceeds as follows. First, an insurer must consider extrinsic evidence, and second, an insurer has a duty to defend when there is merely a potential for liability. Thus, Plaintiffs argue, insurers have an obligation to provide a defense whenever extrinsic evidence raises the potential for liability.

This syllogism is perhaps supported by the dicta of numerous California cases, but only when the courts’ statements are viewed out of context. Placed in its proper context, Plaintiffs’ argument is simply contrary to the law. As to the first line of decisions, the cases make it clear that extrinsic evidence is sufficient to compel an insurer to defend only when the evidence pertains to claims actually asserted by the third party.

As to the second line of cases regarding the insurer’s duty to defend whenever there is the “possibility” or “potential” for coverage, the decisions make clear that this concept, too, is restricted to the nature of the lawsuit actually asserted by the third party. Contrary to Plaintiffs’ assertion, an insurer owes no duty to defend based upon mere “speculation” as to claims that a third party might have brought. “An insured may not trigger the duty to defend by speculating about extraneous ‘facts’ regarding potential liability or ways in which the third party claimant might amend its complaint at some future date. This approach misconstrues the principle of ‘potential liability’ under an insurance policy.” Thus, “the insured may not speculate about unpled third party claims to manufacture coverage.”

(All citations omitted). (Emphasis in original). The court then concluded that, although “[t]he duty to defend is broad, [it is] not so expansive that it requires an insurer to undertake a defense as to claims that are both factually and legally untethered from the third party’s complaint . . . Simply put, there is no evidence to impose a duty to defend when the underlying lawsuit sets forth neither the facts nor the legal claims necessary to bring the lawsuit within the terms of the policy.”

The full text of the Storek opinion can be found here.