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A liability insurer cannot assert the comparative bad faith of its insured in the underlying third-party litigation as an affirmative defense in a bad faith action brought against it, the California Supreme Court held June 22 in a split decision ( Kransco v. American Empire Surplus Lines Insurance Co., No. SO62139, Calif. Sup). “Because an insured’s breach of the covenant does not sound in tort, the insured’s contractual breach of an express policy provision cannot be raised by the insurer as a defense in a bad faith action brought against it by the insured. It would be illogical to allow the insurer in such a suit to instead interpose as a defense the insured’s contractual breach of an implied policy provision (i.e., the covenant of good faith and fair dealing) based on those same express policy terms,” the high court said. Toy manufacturer Kransco was hit with a $10 million punitive damages verdict and $2.35 million in compensatory damages after its primary insurer, American Empire Surplus Lines Insurance Co. (AES), failed to settle for $750,000 a product liability action filed by Michael Hubert, who became paralyzed while using one of Kransco’s Slip ‘n Slides. The offer was within policy limits and was made during trial. UNDERLYING SETTLEMENT Kransco settled with Hubert for $7.5 million, with AES and the excess insurers paying their policy limits, and Kransco kicking in $3.1 million of its own funds. A stipulated judgment for $12.5 million was entered with an agreement not to execute. Kransco then sued AES for bad faith failure to settle within the $900,000 policy limits and agreed to split the net proceeds of the insurance litigation with Hubert. During discovery in the underlying case, Kransco denied any knowledge of other adult injuries with its product. It later amended its response and admitted it was aware of two such injuries, including a fatality. AES argued during the bad faith trial that Kransco’s lying about the previous injuries inflamed the jury and resulted in the record punitive award. Specifically, AES claimed the Wisconsin jury in the underlying Hubert action assessed $10 million in punitive damages to punish Kransco for its false and incorrect interrogatory responses made during pretrial discovery. At the bad faith trial, the jury found Kransco 90 percent responsible for the underlying verdict and AES 10 percent responsible. On Kransco’s motion for judgment notwithstanding the verdict, the court said its comparative fault instructions to the jury were overly broad and found AES 100 percent responsible for the Hubert damages. The appeals court affirmed the judgment and said the jury should not have been given the comparative bad faith instruction at all. The Supreme Court noted its prior holdings that the scope of the insured’s duty of good faith and fair dealing, and the remedies available to the insurer for a breach of that duty, are fundamentally and conceptually distinct from the insurer’s reciprocal duty, and the remedies available to the insured for breach of that duty. An insurer’s breach of the covenant of good faith is governed by tort principles. An insured’s breach of the covenant is not a tort. CALIFORNIA CASUALTY REJECTED AES relied on California Casualty Gen. Ins. Co. v. Superior Court (173 Cal. App. 3d 274 [1985]), in which an appeals court held for the first time that in a bad faith action, the insurer could interpose as a defense the tort concept of comparative fault. The court ruled that the insured’s undue delay in submitting information necessary to process her claim, which contributed to the insurer’s failure to pay the claim, may reduce the insured’s recovery for damages resulting from the insurer’s bad faith nonpayment. “As the Court of Appeal below recognized, the California Casualty court’s holding is grounded on the faulty premise that the obligations of insurer and insured – and thus their bad faith – are comparable. They are not,” the high court said. “We agree with the analysis and holding in Agricultural ( Agricultural Ins. Co. v. Superior Court, 70 Cal.App.4th 385 [1999]), and disagree with the California Casualty court’s extension of tort comparative fault principles to an insured’s contractual breach of the covenant of good faith and fair dealing,” the court said. “By allowing an insurer to assert a defense of comparative bad faith, California Casualty’s holding misleadingly equates an insured’s contractual breach of the reciprocal covenant of good faith and fair dealing with an insurer’s tortious breach of the covenant. HOLDING ‘CONFUSING, INCONSISTENT’ “The holding is confusing and inconsistent insofar as it acknowledges an insured’s breach of the covenant is not actionable in tort, but nonetheless can give rise to tort consequences because the insurer may assert it as a defense in a bad faith action to lessen responsibility for its own tortious conduct.” The high court observed, however, that its rejection of comparative bad faith in this context does not leave the insurer without remedies for an insured’s breach of the covenant of good faith and fair dealing. Evidence of an insured’s misconduct may factually disprove the insurer’s liability for bad faith by showing the insurer acted reasonably under the circumstances. The insured’s breach of the covenant of good faith and fair dealing is also separately actionable as a contract claim, and some forms of misconduct by an insured will void coverage altogether under the insurance policy. Without coverage there can be no liability for bad faith for the insurer. Further, an insured’s fraudulent misconduct is separately actionable and can give rise to tort damages, the high court said. “These remedies adequately serve to protect an insurer from the insured’s misconduct without creating the logical inconsistencies and troublesome complexities of a defense of comparative bad faith,” the Supreme Court said. NO DAMAGES Regarding the underlying jury verdict, the high court said the award was properly based on Kransco’s production and sale of the Slip ‘N Slide, not its erroneous discovery response. There is no indication that Hubert suffered any damage as a result of Kransco’s incorrect interrogatory responses. “As a factual matter, AES has not demonstrated that Kransco’s litigation misconduct was a proximate cause of the Wisconsin jury’s excess verdict and huge punitive damages award,” the Supreme Court said. Additionally, the record established that AES was fully aware of the false interrogatory responses prior to its rejection of Hubert’s $750,000 settlement offer. Hence, Kransco’s litigation misconduct was not a factual cause of AES’s decision to reject Hubert’s mid-trial settlement offer, the high court said. “To have any meaning, the express promise of a liability insurer to defend and indemnify the insured against injury claims, and the implied duty to reasonably and in good faith settle third-party claims within policy limits in an appropriate case, must extend to insureds that are less than perfect litigants,” the Supreme Court said. “An insured’s known weaknesses as a litigant should inform the insurer’s assessment of the likelihood of an excess judgment, not diminish the insurer’s obligation to reasonably accept settlement offers within policy limits.” DISSENTS Justices Ronald M. George and Joyce L. Kennard dissented. Justice George agreed with the majority upholding the original trial court award. However, he opted not to reject the theory of comparative bad faith in its entirety. Justice Kennard said the majority holding wrongly denies juries in insurance bad faith actions the ability to equitably apportion the policyholder’s loss according to the respective fault of all parties responsible for that loss. Bertrand LeBlanc II, Donald T. Ramsey and David M. Rice of Carroll, Burdick & McDonough in San Francisco, J. Ric Gass, Janice A. Rhodes and Caren B. Goldberg of Kravit, Gass & Weber in Milwaukee and Thomas R. Newman of Newman & Co. in New York represent AES. W. Stuart Parsons, Kevin P. Crooks and Katherine H. Grebe of Quarles & Brady in Milwaukee, James F. Thacher, Arthur R. Albrecht and Frank E. Solomon of Thacher, Albrecht & Ratcliff in San Francisco and Thomas W. Johnson of Irell & Manella in Newport Beach, Calif., represent Kransco. Jeffrey T. Bolson and Karen-Denise Lee of Hahn Bolson & Mendelson, Engstrom, Lipscomb & Lack and Nishimura & Saunders, all in Los Angeles, represent respondent excess insurers International Insurance Co. and Transco Syndicate #1. Gibbons, Lees & Conley, Gibbons & Conley of Walnut Creek, Calif., and Dolores M. Donohoe of Walnut Creek, Calif., represent Agricultural Excess and Surplus Insurance Co. Amicus curiae on behalf of Kransco are Jordan S. Stanzler and Deborah M. Mongan of Stanzler, Funderburk & Castellon of San Francisco and John A. MacDonald of Anderson Kill & Olick in Philadelphia, representing United Policyholders; James T. Linford of San Francisco; and Kristine L. Wilkes, Dorn G. Bishop and Julia E. Parry of Latham & Watkins of San Diego for Montrose Chemical Corp. Amicus curiae on behalf of AES are Richard L. Seabolt, Eve F. Lynch and Robert M. Fineman of Hancock Rothert & Bunshoft of Los Angeles for London Market Insurers and Lisa Perrochet and Stephanie Rae Williams of Horvitz & Levy of Los Angeles for Truck Insurance Exchange and Allstate Insurance Co. � Copyright 2000 Mealey Publications, Inc.

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