Ninth Circuit Holds That Diamond Heights Represents Controlling California Law On The Duty Of An Excess Insurer To Accept A Reasonable Settlement

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In Teleflex Medical Inc. v. Nat’l. Union Fire Ins. Co. of Pittsburgh, PA (March 21, 2017) 2017 WL 1055586, the Ninth Circuit affirmed a jury verdict in a bad faith case against an excess insurer for rejecting a settlement approved by insured and primary insurer, and refusing to take over the insured’s defense.

In Teleflex, CNA issued a primary policy with a $1 million limit and National Union issued an excess policy with a $14 million limit.  CNA was defending counter-claims against the insured for trade disparagement and false advertising.  National Union did not dispute that the counter-claims were covered under its policy.  Notably, the insured’s potential damages exposure, excluding uncovered treble damages, was within National Union’s excess limits.

At the time of mediation, which National Union attended but CNA did not, the insured committed to a conditional settlement of $4.75 million, subject to approval and funding from both CNA and National Union.  CNA promptly agreed to contribute its full $1 million primary limits to the settlement.  National Union requested an updated liability and damages analysis from defense counsel.  After receiving that analysis which, like a previous analysis, reflected an exposure of up to $10 million, excluding treble damages, National Union declined to consent to the settlement and did not offer to take over the defense.  After several unanswered requests by the insured that National Union take over the defense, and after three months had passed since the mediation, the insured accepted the settlement.  National Union subsequently agreed to assume the defense if the settlement agreement could be undone.  The insured responded that the settlement could not be undone.  The insured paid the unfunded amount of the settlement, then sued National Union for breach of contract and bad faith, seeking recovery of the $3.75 million the insured contributed to the settlement,  punitive damages, and attorneys’ fees.

The jury returned a verdict for breach of contract and bad faith against National Union, but declined to award punitive damages.  National Union’s motion for entry of judgment after the verdict was denied by the district court.  National Union appealed, arguing that the district court erred in applying Diamond Heights Homeowners Association v. National American Ins. Co. (1991) 227 Cal.App.3d 563 and not applying a clear and convincing evidence standard as to whether the insurer waived the right to assert the “no action” clause of the policy as a defense to payment of the settlement by the insured without its consent.

On appeal, the Ninth Circuit concluded the district court did not err in refusing to grant judgment to National Union as a matter of law, but instead allowing the matter to be tried to a jury under the authority of Diamond Heights.  According to the Ninth Circuit, Diamond Heights holds that an excess insurer has three options when presented with a proposed settlement that meets approval of the insured and the primary insurer:

1)   approve the proposed settlement;

2)   reject the proposed settlement and take over the defense; or

3)   reject the proposed settlement, decline to take over the defense, and face a potential lawsuit for contribution and bad faith.

In the event the insurer chooses the last option, the excess insurer waives the “no action” clause and may only challenge the settlement on the grounds that it is unreasonable or that it is the product of collusion between the primary insurer and the insured.

After discussing, with approval, the policy rationales for the rule in Diamond Heights, the Ninth Circuit agreed that Diamond Heights was controlling.

The Ninth Circuit rejected National Union’s argument that Diamond Heights does not reflect current California law and has been somehow discredited by or is inconsistent with the California Supreme Court’s decision in Waller v. Truck Ins. Exchange (1995) 11 Cal. 4th 1, which established a “clear and convincing” standard of proof with respect to the issue of an insurer’s waiver of a policy defense by failure to assert it in a reservation of rights letter.

The Ninth Circuit concluded that the California Supreme Court in Waller failed to mention Diamond Heights and that subsequent California appellate courts, including Fuller-Austin Insulation Co. v. Highlands Ins. Co. (2006) 135 Cal.App.4th 958, 987, have cited Diamond Heights with approval, thus demonstrating the continued vitality of Diamond Heights.

The Ninth Circuit also rejected the contention that Diamond Heights is incompatible with Waller’s holding  as to whether an insurer waives policy defenses by failing to mention them in a letter, finding the issues in the cases to be different.  The Court  explained that  Diamond Heights establishes a rule that reconciles the existence of the “no action” or “no voluntary payments” clause of a policy where the insurer first breaches its contractual obligations or the implied covenant of good faith and fair dealing by rejecting a settlement.  Interestingly, although the implied duty to accept a reasonable settlement is generally said to emanate from the duty to defend afforded by a primary insurer, the Court rejected National Union’s argument that an excess insurer, which has no duty to defend, is in a different position than a primary insurer which charges a higher premium for the duty to defend.  According to the Court, the imposition of the rule of liability against an excess insurer under Diamond Heights is supported by other sound policy considerations and insurance principles, including the policy favoring settlements and the unfairness of allowing an excess insurer to reject a settlement and “get a free ride” at the expense of the primary insurer.

The Ninth Circuit thus concluded that National Union had failed to present convincing evidence that the California Supreme Court would not follow Diamond Heights.

The Ninth Circuit also refused to distinguish Diamond Heights on its facts.  The Ninth Circuit explained that, like in Diamond Heights, the primary insurer had committed its limits to the settlement and had funded the defense through settlement, and the insured faced no exposure above the excess limits.  The Ninth Circuit noted that the uncertainty of liability and the status of litigation were merely factors that were potentially relevant to the reasonableness of the settlement amount.

California cases have long held that a primary insurer may not “cede” its limits to the excess insurer and avoid the duty to defend.  (See, e.g., Chubb/Pacific Indem. Group v. Insurance Co. of North America (1987) 188 CA3d 691, 698.)  However, the Teleflex decision will undoubtedly give rise to an increase in the number of cases in which a primary insurer will agree to contribute their limits to a proposed settlement, potentially early in the litigation, and in effect cede the defense of the litigation to the excess insurer even in cases where there are sufficient excess limits to avoid any potential uncovered exposure to the insured.   Excess insurers operating in California should be aware that they may no longer be able to sit on the sidelines at the time of settlement and merely await the outcome of trial, but instead may be faced with the Hobson’s choice – pay a settlement which they view as inflated – or take on a defense obligation they may never have anticipated and which their underwriters may not have considered in calculating premiums.

Cheryl A. Orr is a partner with Musick, Peeler & Garrett in its Los Angeles office.  Her full bio and contact information can be found at: