Does the Enterprise Oil decision mean the end of Lumbermens allocation? ask Simon Greenley and Tim Bull

Justice Colman's decision in Lumbermens Mutual Casualty Co v Bovis Lend Lease is one of the most controversial English insurance law judgments of recent years. It stated that a "global" settlement agreement must allocate on its face sums in respect of specific covered claims, as a precondition to the insured recovering an indemnity. Lumbermens has been widely criticised by academics and insurance lawyers as creating unnecessary difficulties for insureds claiming under liability policies.

Justice Aikens' recent decision in Enterprise Oil v Strand Insurance has roundly criticised the Lumbermens allocation rule, and the reasoning behind it. Although Lumbermens has not yet been overruled, Justice Aikens' criticisms suggest it is unlikely to be followed by other senior English judges.

The allocation principle

Lumbermens concerned a claim under a liability policy by contractors, Bovis, arising from a dispute with its client over a construction project in Glasgow. Bovis had sued for £37.8m allegedly due under the contract, and were met with a counterclaim for £103.6m raising numerous separate causes of action. A global settlement ultimately compromised all the claims and cross claims for a total payment to Bovis of £15m without indicating how this was calculated, or which of the claims and counterclaims were treated as valid. Bovis sought an indemnity under its liability cover, claiming £19.2m which it argued was the value of the valid counterclaims covered under the policy.

Justice Colman rejected Bovis's claim for indemnity, establishing the Lumbermens allocation principle in English law. He held, following previous authority, that there was an implied term in liability policies that the insured had to show that it had incurred a liability, ascertained by means of a judgment, arbitration award, or settlement agreement. However, he added that if the settlement agreement failed to identify specifically the cost to the insured of discharging the relevant insured liability to the claimant, it failed as an ascertainment of that liability, and the insured was barred from bringing a claim under its policy.

The problem with Lumbermens

The allocation principle has been criticised for putting artificial hurdles in the path of insureds, and discouraging settlements. Essentially, Lumbermens makes fair settlements harder. Aware that an insured needs an agreement which allocates between separate covered heads of loss, claimants can use this to leverage more favourable deals. The commercial benefit of global settlements is precisely that insureds and claimants do not have to allocate specific sums to different claims.

It also creates practical drafting problems. In a construction dispute, for example, a claimant can raise a "Scott schedule" of hundreds of individual claims of inadequate workmanship. Lumbermens appears to require the settlement agreement to allocate to each claim. It may give insurers a defence even where only a single cause of action has been litigated and where the settlement sum is accepted on the conventional basis "in full and final settlement of the claim, and all other claims arising out of the subject matter of the action ...".

Lumbermens encourages artificiality in the structuring of settlements. Insureds could be tempted to collude with claimants to inflate the amounts allocated to covered claims. It is not clear whether Justice Colman intended the allocation principle to apply to judgments, jury awards, and arbitration decisions - but that would appear to follow. Whether a judgment or award allocates specific sums to individual claims may be entirely outside the insured's control.

Allocation on the face of the agreement is not the end of the story. The insured still has to prove that it was in fact subject to an insured liability, and that the allocated sum was reasonable. It is difficult to see any practical benefit in making allocation an additional requirement.

The Enterprise decision

The insured, Enterprise, and associated oil companies, had entered into a contract to hire a drilling rig, which was terminated by them early, after just over a month. The oil companies were then sued in Texas by Rowan, which had agreed to provide the rig to its leaser, BAO. Rowan claimed they had wrongfully interfered with the Rowan/BAO agreement, and sought consequential losses, and punitive damages. A settlement agreement was signed in March 2002 under which $84m was paid to settle Rowan's claim, of which Enterprise's share was $20.5m.

Enterprise claimed an indemnity in English Commercial Court proceedings. In his judgment delivered on 26 January 2006, Justice Aikens rejected Enterprise's claim. He held that, on the correct construction of the policy, to recover Enterprise had to demonstrate "that it was or would have been actually (as opposed to arguably) liable to Rowan in the Texas proceedings ...". Applying Commercial Union v NRG, he rejected Enterprise's argument that, in deciding whether it was liable, he should take account of American lawyers' predictions of what a Texas jury could have found. It was his role as judge to apply Texan law to the facts as he found them, and on that basis he ruled that Enterprise had not established its liability to Rowan. Enterprise's claim therefore failed.

Justice Aikens' critique

Justice Aikens proceeded to consider what, if Enterprise had been liable, was the consequence of the settlement failing to allocate between insured liabilities (for compensatory damages) and uninsured liabilities (for punitive damages and irrecoverable costs). He had invited specific submissions on Lumbermens, and noted that both parties acknowledged it was "very controversial".

In addition to his judgment, Justice Aikens rejected Justice Colman's allocation analysis for two reasons. First, Lumbermens was not well founded in English case law. The earlier House of Lords and Court of Appeal authorities on which Justice Colman relied did not establish that it was a precondition for recovery that the wording of a judgment, or award, or settlement "ascertained" the specific cost to the assured of discharging its insured liability. In Justice Aikens view it must be open to an insured "to assert and prove, by extrinsic evidence, that it is liable to a third party for a particular sum under a settlement (which) represents a loss covered by an insured peril ...".

Second, recognising the practical problems Lumbermens raises, Justice Aikens concluded that it should also be rejected on public policy grounds, as leading to commercial inconvenience, and to artificial statements in judgments, arbitration awards and settlements, which should not be concerned with potential claims against non-party insurers. Furthermore, parties to settlements, for very good commercial reasons, might not wish to attribute sums to individual heads of claim. Making allocation a precondition to recovery under a liability policy could "discourage settlement of disputes and create more litigation, to no advantage".

Lumbermens has not yet been overturned - the criticism added by Justice Aiken in Enterprise Oil does not create a binding contrary precedent. Lumbermens remains a decision which binds tribunals below the English High Court, including English law arbitration panels. Insureds must still take allocation into account in structuring settlements and considering their insurance recoveries.

However, Justice Aikens' criticism shows that the English judiciary generally recognises the problems Lumbermens creates, and suggests that when it does again come before the English Commercial Court, it is unlikely to be followed - and in due course will be conclusively overruled by the English Court of Appeal.

- Tim Bull and Simon Greenley are partners at Reynolds Porter Chamberlain LLP.