In an article appearing in the April 12, 2010 editions of the Los Angeles and San Francisco Daily Journals, I discuss the impact of the California Fourth Appellate District’s Intergulf Development, LLC. v. Superior Court (Interstate Fire & Casualty Company). Here it is:

In an important vindication of a California policyholder’s right to a jury trial to enforce an insurer’s duty to defend, the California Fourth Appellate District recently held that a liability insurer that fails to promptly acknowledge its insured’s right to independent counsel and begin funding that defense forfeits its rights to binding arbitration under Civil Code section 2860.  Intergulf Development, LLC. v. Superior Court (Interstate Fire & Casualty Company), __ Cal.App.4^th __, 2010 WL 1052745 (March 24, 2010).  In Intergrulf, the court ruled that the insured may proceed first to a jury trial, and, if successful, recover contract and tort damages against the insurer.

The Duty to Defend Under California Law

Under California law, a liability insurer must defend its insured if the underlying complaint alleges the insured’s liability for damages potentially covered under the policy or if the complaint might be amended to give rise to a liability that would be covered under the policy.”  Montrose Chem. Corp. v. Superior Court, 6 Cal. 4th 287, 299 (1993).  The duty to defend arises at the time the insured tenders defense of the third party lawsuit to the insurer.  Imposition of an immediate duty to defend is necessary to afford the insured what it is entitled to: the full protection of a defense on its behalf. Montrose Chem. Corp., supra, 6 Cal. 4th at 295; Buss v. Superior Court (Transamerica Ins. Co.), 16 Cal. 4^th 35, 49 (1997) (“To defend meaningfully, the insurer must defend immediately”); 10 Cal. Code Regs., section 2695.7(b).  On occasion, an insurer will delay its decision to defend outright, defend under a reservation of rights, or deny coverage altogether while it “investigates” coverage, leaving the insured to its own devices.

An unreasonable delay in paying policy benefits or paying less than the amount due is an actionable withholding of benefits which may constitute a breach of contract, as well as bad faith, giving rise to tort damages. Wilson v. 21st Century Ins. Co., 42 Cal. 4th 713, 720, 723 (2007);  Major v. Western Home Ins. Co., 169 Cal. App. 4th 1197, 1209 (2009).  The general measure of damages for breach of the duty to defend consists of the insured’s cost of defense in the underlying action, including attorney fees.  Major v. Western Home Ins. Co., 130 Cal. App. 4th 1078, 1088-1089 (2005).  Breach of the duty to defend also results in the insurer’s forfeiture of the right to control the defense of the action or settlement, including the ability to take advantage of the protections and limitations set forth in Civil Code section 2860.  Fuller-Austin Insulation Co. v. Highlands Ins. Co. 135 Cal. App. 4th 958, 984 (2006); Atmel Corp. v. St. Paul Fire & Marine Ins. Co., 426 F.Supp. 2d 1039, 1047 (N.D. Cal. 2005).

An Insurer’s Right to Invoke Civil Code Section 2860 Fee Arbitration

Under Civil Code section 2860, when a liability insurer reserves its rights to contest coverage for a third party’s suit against its insured, and defense counsel could manipulate the suit in a way that could impair the insured’s coverage, section 2860 requires the insurer to pay for independent counsel to defend the suit.  For example, defense counsel may be in a position to hire expert witnesses with particular perspectives, and guide their testimony on issues such as when damage occurred or whether particular damage was expected or intended—steering claims in or out of coverage.  Notably, section 2860(c) limits the hourly rates that the insurer must pay independent counsel, and requires the insured to submit any fee dispute to binding arbitration.

An Insurer’s Unreasonable Delay Forfeits its Right to Invoke Civil Code Section 2860

In Intergulf, Intergulf developed a condominium project in San Diego, California. Intergulf was an additional insured on policies issued to one of its subcontractors by Interstate Fire & Casualty Company, a division of Fireman’s Fund Insurance Company.  The policies provided that Interstate had the right and duty to defend any lawsuit seeking damages because of property damage.  While Interstate’s policies were in effect, the homeowners association sued Intergulf for alleged construction defects.

Intergulf promptly tendered its defense to Interstate.  Two weeks later, Interstate responded, not with an acknowledgment of its defense obligation, but by requesting information and reserving all of its rights.  Interstate wrote that, if it determined it had a duty to participate in Intergulf’s defense, it would impose “litigation handling guidelines,” and it would typically not pay hourly rates of more than $ 150 for partners, $135 for associates, and $ 75 for paralegals.  Intergulf defended with its own counsel—Luce, Forward, Hamilton & Scripps, LLP—billing at a blended rate of $250 per hour.

Seven months later, Interstate finally informed Intergulf that Interstate recognized a “potential” for a defense obligation, but did not actually acknowledge either a duty to defend or coverage.  Interstate offered to “participate” in the defense of Intergulf through the firm of Wood, Smith Henning & Berman.  Intergulf objected that Interstate’s reservation of rights created a conflict of interest for the Wood Smith firm, and demanded the appointment of its own independent counsel under section 2860.

Intergulf then asked Interstate to reimburse its out-of-pocket defense fees and costs.  No response.  About a month later, Intergulf asked again.  No response.  Approximately one year after it had tendered its defense, Intergulf had neither a commitment to defend with conflict-free counsel nor any reimbursement for outstanding defense fees and costs from Interstate.  Intergulf then sued Interstate for breach of the duty to defend, bad faith, and declaratory relief.  Two months after Intergulf filed suit, Interstate made a first payment of approximately $ 140,000; nine months later, Interstate made a second payment of approximately $ 98,000.

Five weeks before the scheduled trial, Interstate filed a petition to compel arbitration of what it characterized as a section 2860 fee dispute.  Intergulf responded that the case was about the contract and tort damages that Interstate owed for breaching its duty to defend—not about a fee dispute.  It argued that because the questions of Interstate’s duty to defend, conflict of interest, and bad faith had not been resolved, Interstate did not satisfy the prerequisites for arbitration under section 2860(c).  The trial court, however, granted Interstate’s petition to compel arbitration and continued the trial, pending completion of  arbitration.

Intergulf challenged the trial court’s ruling by filing a petition for writ of mandate.  The appellate court summarily denied the petition. The Supreme Court granted Intergulf’s petition for review and transferred the matter back to the appellate court with directions to vacate the order denying mandate and issue an order to show cause why the relief sought should not be granted.

The appellate court agreed with Intergulf that the gravamen of the complaint was bad faith and breach of contract, not a dispute over the amount Interstate should pay independent counsel under section 2860(c).  By filing the action for breach of contract, bad faith, and declaratory relief, Intergulf gave Interstate notice that it was treating Interstate’s failure to acknowledge Intergulf’s right to independent counsel and delay in paying policy benefits as a total breach of the duty to defend.  Intergulf  at *2-3, citing  Coughlin v. Blair, 41 Cal. 2d 587, 599 (1953) (filing suit gave defendant notice that plaintiff viewed its failure to perform as a total breach of contract); and Sackett v. Spindler, 248 Cal. App. 2d 220, 229-230 (1967)(seller could treat persistent delay in payment for stock as total breach of the purchase agreement).

Intergulf’s entitlement to damages for breach of contract and bad faith turned on (i) whether Interstate owed Intergulf a duty to defend in the first instance; and (ii) whether Interstate breached that duty by failing to defend Intergulf “immediately” and “entirely” on tender of the defense.  Intergulf  at *3, citing  Buss v. Superior Court, supra, 16 Cal. 4th at 49; and Montrose Chemical Corp., supra, 6 Cal. 4th at 295.  Neither of these questions had been resolved at the time the court granted Interstate’s petition to compel binding arbitration of the purported fee dispute pursuant to section 2860(c).

As the appellate court noted, ordering fee arbitration under section 2860 under these circumstances puts the cart before the horse. If Intergulf proves that Interstate breached the duty to defend or committed bad faith by failing to acknowledge Intergulf’s right to independent counsel or failing to immediately and fully fund its defense, Interstate forfeits its right to limit defense fees and costs under section 2860(c) fee arbitration.  Instead, a jury could award contract and tort damages in the trial court.  Intergulf at *4.  The appellate court issued a peremptory writ of mandate directing the trial court to vacate its order granting Interstate’s petition to compel arbitration under section 2860(c), and to enter an order denying the petition to compel arbitration.

Sound Public Policy

The appellate court’s decision is based on sound public policy.  If an insurer could delay a full and immediate defense for its insured, and then run for cover under section 2860’s rate limits and binding arbitration, it would have an incentive to fabricate a Cumis conflict, comforted by the knowledge that the attorney fee element of its insured’s damages would be limited by Cumis rates, claim management protocols, and binding arbitration, instead of being tried to a jury.  The insured’s right to have a jury determine breach and damages is fundamental to enforcing the insurer’s duty to provide a full and immediate defense.