Imagine this: an underlying tort lawsuit is being defended by the primary insurer. While the defense is underway, an opportunity arises in which the insured and the primary insurer agree that the proposed settlement of the covered claim should be accepted. However, the amount of the settlement exceeds the primary layer and therefore involves the need for the excess insured to approve the settlement. This situation recently occurred in the U.S. 9th Circuit Court of Appeals case of Teleflex Medical, Inc. v. National Union Fire Ins. Co. of Pittsburgh, PA, 851 F.3d 976 (9thCir. 2017).
In Teleflex the insured, LMA North America (LMA) sued a competitor, Ambu, for patent infringement. Both LMA and Ambu were in the laryngeal mask airway products business. In turn, Ambu filed counterclaims against LMA for trade disparagement and false advertising which focused on alleged statements made by LMA in its advertising regarding Ambu’s products. At the time of the litigation, LMA had a primary layer of insurance with CNA Insurance Company which provided $1 million of liability coverage. LMA was also insured with an excess layer of liability insurance through National Union Fire Insurance Company with $14 million in excess liability coverage. The National Union excess policy contained standard “voluntary payments” and “no action” clauses. Under the National Union excess policy the insured was prohibited from making voluntary payments, assuming any obligations, or incurring any expenses other than for first aid in tort cases without National Union’s consent. Any such nonconsensual payments were made at the “own cost” of the insured for which National Union would have no obligation or responsibility under its policy. Under the excess policy’s no action clause, it was stated that the insured would have no right of action against National Union unless the amount the insured owed in the litigation was determined with National Union’s consent or by actual trial or final judgment. The policy also recognized National Union’s right to participate in the defense of the claim and that the obligation of National Union to defend the claim under its excess policy would arise if the primary layer was exhausted.
In the pending litigation, CNA defended LMA against Ambu’s counterclaims. National Union acknowledged that the counterclaims would be covered if there was a liability finding. The underlying claims were mediated. Although CNA attended the mediation, a representative from National Union did not. During the multi-day mediation, LMA’s attorney provided daily updates to National Union regarding the progress of the mediation. On the second day of mediation an agreement was reached between LMA and Ambu under which LMA would pay Ambu $4.75 million to settle its disparagement claims. The settlement, however, was conditioned on obtaining approval and funding from both CNA and National Union. CNA agreed to pay its full policy limit the settlement. However, National Union refused, questioning the value of the claim.
During the processing of the underlying lawsuit, LMA’s attorney provided National Union with emails that suggested that LMA’s management may have intentionally engaged in false advertising and estimated that LMA’s liability could be as high as $10 million, which could then be trebled under California law. National Union’s response was to request an updated analysis of liability and damages. The update was provided by LMA’s counsel, predicting damages substantially in excess of $10 million. Thereafter, National Union refused to contribute to the proposed settlement. LMA then finalized the settlement with Ambu. A few days after the settlement, National Union advised LMA that it would assume the defense of the underlying suit if LMA could “undo” the settlement. After executing the settlement, LMA then brought litigation against National Union for breach of contract and bad faith.
The 9th Circuit Court of Appeals, interpreting California law, held in the Teleflex case that when an excess liability insurer is presented with a reasonable, non-collusive proposed settlement of a covered claim which has been approved by the insured and its primary insurer, the excess insurer is faced with a binary choice: (1) approve the proposed settlement and pay its share of the settlement amount; or (2) reject the proposed settlement and take over the insured’s defense. If the excess insurer rejects the settlement and refuses to take over the defense, the insured was then entitled to recover reimbursement from the excess insurer for the settlement if the insurer had been given a reasonable opportunity to evaluate the proposed settlement.
Central to the Teleflex court’s analysis was the California Court of Appeals decision of Diamond Heights Homeowners Association v. National American Insurance Co., 227 Cal.App.3d 563, 277 Cal.Rptr. 906 (1991). In the Diamond Heights case, the court ruled that, subject to certain conditions, “a primary insurer may negotiate a good faith settlement of a claim in an amount which invades excess coverage, “a primary insurer may negotiate a good faith settlement of a claim in an amount which invades excess coverage, and . . . enter into such settlement binding upon the excess insurer without the excess insurer’s consent, notwithstanding the ‘no action’ clause.” Id. at 580, 277 Cal. Rptr. 206. The court in Diamond Heights also found that an excess insurer could waive its rights under the no action clause if it rejected a reasonable settlement and at the same time failed to offer to undertake the defense of the insured. Id. at 581, 277 Cal. Rptr. 906. The Diamond Heights court grounded its ruling in the duty of good faith owed between the duty of good faith and fair dealing. The court in Diamond Heights explained:
Consistent with its good faith duty, the excess insurer does not have the absolute right to veto arbitrarily a reasonable settlement and force the primary insurer to proceed to trial, bearing the full costs of defense. A contrary rule would impose the same unnecessary burdens upon the primary insurer and the parties to the action, among others, as does the primary insurer’s breach of its good faith duty to settle.
Id. at 580-81, 277 Cal.Rptr. 906. The court’s ruling was tethered by several policy considerations: (1) “a contrary rule would ‘imperil the public and judicial interest in fair and reasonable settlement of lawsuits.” Id. at 581, 277 Cal.Rptr. 906; (2) “similarly, a contrary rule would have inequitable consequences for the insured in cases where liability may exceed excess limits, as well for primary insurers in cases where liability does not. Such a rule would effectively allow excess insurers to “get a ‘free ride’ at the expense of the primary insurer to the detriment of all other parties involved.” Id. at 582, 277 Cal.Rptr. 906; and (3) the rule does not result in unfairness to excess insurers “because they are ‘not without a means of avoiding a proposed settlement or challenging a final settlement.'” Id. Excess insurers could agree to under the defense and either conduct its own settlement negotiations or take the action to trial. Id. In Fuller-Austin Insulation Co. v. Highlands Ins. Co., 135 Cal.App.4th 958, 987, 11, 38 Cal.Rptrd.3d 716 (2006), the court noted that an excess insurer is not conclusively bound by a good faith settlement determination in the underlying litigation in which it did not participate.