California Supreme Court Allows Declaratory Relief and Bad Faith Claims Against Excess Carriers to Proceed at Pleading Stage Even Though All Underlying Insurance Had Not Been Exhausted

Background

In Fox Paine & Co. v. Twin City Fire Insurance Co., the California Supreme Court held an insured could bring claims against excess carriers for declaratory relief and breach of the implied covenant of good faith even though all the underlying insurance was not exhausted.

The insurance dispute arose from the 2006 breakup of a private equity firm and related litigation between rival factions. The insurance tower at issue consisted of a $10 million primary policy and four additional $10 million excess layers, each of which “follow[ed] form” to the primary policy.

After years of litigation and incurring tens of millions of dollars of attorneys’ fees, the plaintiffs sued their excess insurers for breach of contract, declaratory relief, and bad faith. The excess insurers demurred, contending that the plaintiffs had not adequately alleged exhaustion of underlying insurance. The trial court concluded that the plaintiffs had adequately alleged exhaustion of the primary policy, permitting claims against the first excess carrier. But it sustained the demurrers of the higher-layer excess carriers because the plaintiffs had not alleged exhaustion of the first excess layer.

While the plaintiffs’ appeal was pending, the claims against the first excess carrier proceeded to trial. The first excess carrier ultimately prevailed based on the plaintiffs’ failure to give timely notice. After the First Appellate District affirmed dismissal of the higher-layer carriers, the California Supreme Court reversed and remanded.

Declaratory Relief

The court held that “a lack of exhaustion does not categorically make a coverage dispute involving an excess policy unduly abstract or hypothetical.” A blanket exhaustion prerequisite, the court reasoned, could force insureds into “onerous, time-consuming, and expensive proceedings” by requiring them to litigate coverage policy by policy through the excess tower.

To sufficiently plead a controversy over a given excess layer, “it must be adequately alleged that the insured’s covered losses are sufficient to reach that policy.” Where the total amount of allegedly covered loss is known, the insured should plead the amount and nature of that loss so it can be compared with the attachment point of the excess policy. Where the amount of covered loss or liability remains uncertain, “it must be practically or reasonably likely that the insured’s potential liability will reach into the excess coverage; absolute proof that the policies will be triggered is not required.”

The court did not hold that the plaintiffs had satisfied the newly articulated pleading standard. It found the plaintiffs’ allegations “flawed” because they commingled allegedly covered loss with recoverable interest. The court therefore remanded for consideration of whether the defect could be cured by amendment. The court also noted that, if the first excess carrier’s judgment is upheld on appeal, claims for declaratory relief against the higher excess carriers may no longer be necessary or proper.

Bad Faith

As to bad faith, the court held, “[t]he proper focus at the pleading stage is not on whether coverage under a particular excess policy has already attached and payments under that policy are already due.” Rather, an insured need only allege facts sufficient to show that coverage under the excess policy will attach or would attach, but for the excess insurer’s bad-faith conduct, and that the insurer’s misconduct impaired the insured’s recovery of policy benefits.

The court emphasized that these allegations must ultimately be proven for a plaintiff to recover for tortious bad faith. The court also made clear that it was not creating an exception to Waller v. Truck Insurance Exchange Inc., which holds that a breach of the implied covenant cannot occur unless policy benefits are eventually due.