A recent California Court of Appeals decision sought to clarify the application of California Insurance Code Section 533.5(b) concerning the statute’s preclusion of an insurer’s duty to defend its insured in criminal actions.  In Mt. Hawley Insurance Co. v. Richard Lopez, Jr.,__Cal.App.4th___, 2013 Cal. App. LEXIS 346 (May 1, 2013) the Court of Appeals held that Section 533.5 (b) is not applicable to criminal actions brought by federal prosecuting authorities, and thus is limited to precluding the insurer’s duty to defend its insured in state criminal actions brought by the Attorney General, any district attorney, any city prosecutor, or any county counsel.  The Court importantly held that the insurer’s Motion for Adjudication of the insured’s bad faith claim should be denied given the insurer’s potentially unreasonable actions even though the insurer gave a reasonable interpretation to an insurance code section.

In Mt. Hawley, the Court of Appeals addressed the appeal of a summary judgment motion and a demurrer concerning the extent of Section 533.5 (b)’s preclusion of the duty to defend.  This case arose out of an indictment of the insured by the United States Attorney for the Central District of California for allegedly committing a criminal conspiracy, making false statements, concealing fraudulent actions, and falsifying records.  The charges were brought based upon the insured’s alleged participation in a conspiracy to falsify records to move a patient up the transplant waiting list, which consequently resulted in the death of another patient.  The Policy at issue stated that the insurer, “shall have the right and duty to defend any Claim covered by this Policy, even if any of the allegations are groundless, false or fraudulent.”  The definition of clam in the policy’s endorsement included a criminal proceeding against any insured commenced by an indictment.  However, the Insurer rejected the insured’s tender a defense based upon its belief that Section 533.5 (b) precluded the duty to defend in all criminal matters.

The Court of Appeals reversed the District Court’s grant of summary judgment.  The court first noted that Bodell v. Wallbrook Insurance Co., 119 F.3d 1411 (9th Cir. 1997) held that Section 533.5 (b) applies to criminal actions brought by the four listed state and local agencies, but does not apply to criminal actions brought by federal prosecutors.  However, in the Bodell decision, the Ninth Circuit did not engage in the three-step analysis for statutory interpretation required under California law, and did not specifically address whether or not Section 533.5 (b) precluded an insurer from providing a defense in all criminal actions, including federal criminal actions.  Thus, the Court of Appeals analyzed the statute to determine: 1) whether the plain language of the statute is susceptible to only one reasonable interpretation; 2) the purpose behind the statute; and 3) whether, “reason, practicality, and common sense to the language at hand,” mandated a conclusion that the statute required that the insurer defend and indemnify the insured.

(b) No policy of insurance shall provide, or be construed to provide, any duty to defend, as defined in subdivision (c), any claim in any criminal action or proceeding or in any action or proceeding brought pursuant to Chapter 5 (commencing with Section 17200) of Part 2 of, or Chapter 1 (commencing with Section 17500) of Part 3 of, Division 7 of the Business and Professions Code in which the recovery of a fine, penalty, or restitution is sought by the Attorney General, any district attorney, any city prosecutor, or any county counsel, notwithstanding whether the exclusion or exception regarding the duty to defend this type of claim is expressly stated in the policy.

The Court of Appeals found that Section 533.5 (b) was susceptible to three different interpretations as to the preclusion of the insurer’s duty to defend in criminal actions, and determined that the statute was therefore ambiguous and necessitated an interpretative analysis of the statute’s legislative history.  Upon review of the legislative history of Section 533.5 (b) the Court of Appeals found the statute had been intended to address a very specific problem the State Attorney General was experiencing in litigating Unfair Competition Actions (Cal. Bus. & Prof. Code § 17200) and False Advertising Actions (Cal. Bus. & Prof. Code § 17500).  The State Attorney General’s Office found itself filing actions against a business or an individual, only to proceed into litigation of the matter against a defense tendered by an insurance company, while the individual/business whose conduct violated the provision(s) was not being held directly accountable.  Therefore, the purpose of Section 533.5 (b) was to facilitate consumer protection activities, while alleviating the burden being placed on the local prosecutorial resources from the pro-longed litigation battles with insurance defense teams.

The Court of Appeals found the application of reason, practicality, and common sense unnecessary, but proceeded through the final step to provide further support of its holding that Section 533.5 (b) did not apply to criminal actions brought by federal prosecutors.  The Court of Appeals found unpersuasive the insurer’s argument that there was a strong public policy of barring insurance coverage to discourage certain types of behavior, and remarked that the public policy concerns applied to indemnification of an insured rather than the defense of an insured.  The Court Appeals rejected the insurer’s argument that the Court’s interpretation of Section 533.5 (b) would create a potential conflict with California Insurance Code section 533.5, subdivision (a), explaining that the latter dealt with indemnification of fines, penalty or restitution of in a criminal action or proceeding rather than a duty to defend.  Nor did the Court of Appeals find any merit in the insurer’s argument that its interpretation of Section 533.5 (b) would conflict with statutes in the Corporations Code and Government Code.  Instead, the Court of Appeals found that its interpretation brought harmony to the code section, and assisted in practically applying the intent the Legislature had when drafting Section 533.5 (b).

Through this in-depth analysis, the Court of Appeals recognized that the California Legislature never intended for Section 533.5 (b) to apply to criminal actions other than those brought by the state and local agencies enumerated in the statute.  However, the insurer argued that even if it were incorrect in its interpretation of the statute, it should still be entitled to summary adjudication of the insured’s bad faith claim because a general dispute exists from the insurer’s reasonable interpretation of the statute.  As discussed above, the Court of Appeals agreed that the insurer’s interpretation of the statute had been reasonable, but the Court of Appeals stated that it was doubtful that the “general dispute doctrine” applied to third party disputes such as the present matter.  Instead, the Court of Appeals found that the reasonableness of the insurer’s conduct in denying the defense of the insured was a question of fact that precluded summary judgment, especially since the insurer had agreed to defend the hospital where the insured was employed for the same criminal investigation, while refusing to defend the insured, who was covered under the policy as an employee of the hospital.

Moreover, the Court of Appeals additionally found that the insurer may have acted in bad faith by denying coverage based on a medical incident exclusion that, according to the insured, was not part of the policy.  The Court of Appeals noted that the “insurer’s continued reliance on endorsement insureds claim they never received was ‘indicia of bad faith’ and one for the jury to decide.” Tomaselli v. Transamerica Ins. Co., 25 Cal.App.4th 126 (1994).  Therefore, a triable issue of fact existed as to whether the insurer acted in bad faith by denying coverage based on an exclusion that cannot be found in the Policy and the trial court’s ruling for summary judgment was reversed.