Law360, New York (August 4, 2017, 4:35 PM EDT) -- The recent, pro-policyholder Ninth Circuit decision in Teleflex Medical Inc. v. National Union Fire Insurance Company of Pittsburgh, Pennsylvania, affirms the contractual obligation imposed upon excess insurers by the implied covenant of good faith and fair dealing to either contribute toward a reasonable settlement that invades its coverage layer or, alternatively, to take over the defense of the underlying claims. The Ninth Circuit rejects the notion that the “no voluntary payments” and “no action” provisions in an insurance policy provide the excess insurer with an absolute right to veto a reasonable settlement without taking responsibility for the defense. The well-reasoned opinion examines multiple California state cases as well as universal policy considerations in support of its holding. As the issues addressed in Teleflex are not widely addressed by settled case law in all jurisdictions, we hope to see the Ninth Circuit’s reasoning in this opinion extended and applied to other jurisdictions in favor of policyholders facing similar disputes with their insurers.

In the recent action of Teleflex Medical Inc. v. National Union Fire Insurance Company of Pittsburgh, Pennsylvania, 851 F.3d 976 (9th Cir. 2017), the U.S. Court of Appeals for the Ninth Circuit applied California law to require an excess insurer, presented with a settlement of underlying claims against its policyholder, to choose among 1) accepting the settlement where it is reasonable and not the product of collusion, 2) rejecting the settlement but taking over the defense of the underlying claims, or 3) rejecting the settlement and refusing to take over the defense, and as a result, facing breach of contract and bad faith claims.

In the underlying action, the policyholder, LMA North America Inc. (LMA), a manufacturer of laryngeal mask airway products, brought a patent infringement suit against a competitor and faced product disparagement counterclaims in return. LMA had a primary general liability policy with a $1 million limit issued by Transcontinental Insurance Company (CNA) and an excess general liability policy with a $14 million limit issued by National Union Fire Insurance Company of Pittsburgh, Pennsylvania (National Union). The primary insurer, CNA, defended LMA against the underlying action and the excess insurer, National Union, did not dispute that the product disparagement counterclaims against LMA were covered by its excess policy. The excess policy between National Union and LMA, however, contained “no voluntary payments” and “no action” provisions requiring, in relevant part, National Union’s consent to defense costs or any settlement before it would assume any obligations under the policy.

The parties in the underlying action filed summary judgment motions against each other, and LMA’s competitor prevailed on both, though LMA successfully appealed the judgment against its affirmative patent infringement claims. The parties then participated in mediation over two days. National Union did not participate in the mediation, though it received daily updates from LMA. The parties reached a conditional settlement agreement for the competitor to pay LMA $8.75 million to settle the affirmative patent infringement claims and for LMA to pay $4.75 million to settle the product disparagement counterclaims. The settlement was conditioned, however, on LMA’s obtaining approval and funding from its insurers, CNA and National Union.

The primary insurer, CNA, agreed to tender its full $1 million policy limit to LMA in connection with the proposed settlement. The excess insurer, National Union, however, did not agree to contribute a portion of its $14 million policy limit to fund the remainder of the proposed settlement. Instead, over the next few months National Union requested, and LMA provided, additional information regarding potential liability and damages. LMA concluded that the $4.75 million settlement was fair and reasonable in light of its exposure substantially in excess of $10 million, exclusive of defense costs and potential treble damages. This information and analysis was provided to National Union in addition to copies of the pleadings, discovery, an earlier case report assessing potential liability, and other reports and information LMA had previously given to National Union. 

LMA then made multiple requests for a decision from National Union. In its third request, LMA specified that National Union had the option to 1) accept the proposed settlement, 2) reject the settlement and assume the defense of LMA in the continued action, or 3) reject the settlement, decline to take over the defense, and face a future coverage action from LMA seeking reimbursement for settlement amounts paid by LMA and potential bad faith damages. National Union responded by asking for more information about the settlement. LMA again responded to National Union’s requests and advised National Union of its three options. National Union committed to a response date, but ultimately refused to agree to the proposed settlement or to assume the defense of LMA in the continued action. LMA repeatedly asked National Union to assume the defense if it would not consent to the settlement, and stated that it intended to finalize the settlement if National Union did not respond promptly.

Without receiving a response from National Union, LMA executed the settlement three months after the mediation and promptly informed National Union. Three days later, National Union offered to take over the defense if LMA could “undo” the settlement. LMA responded that the settlement agreement could not be undone and subsequently brought suit against National Union for breach of contract and bad faith in the U.S. District Court for the Southern District of California.

As part of its defense to the insurance coverage action, National Union moved for summary judgment on the grounds that the “no voluntary payments” and “no action” clauses in its excess policy gave it an absolute right to veto the conditional settlement in the underlying action. The district court denied the motion, applying the California appellate court case Diamond Heights Homeowners Association v. National American Insurance Co., 227 Cal.App.3d 563 (1991) and holding that National Union waived its rights under the “no action” clause by rejecting a reasonable settlement and declining to undertake the defense of LMA in the continued action. Under Diamond Heights, an excess insurer is limited to three options when faced with a reasonable settlement that is not the product of collusion and that pierces its layer of excess coverage: 1) approve the settlement, 2) reject the settlement but assume the defense of the claim in the continued action, or 3) reject the settlement, decline to assume the defense, and face a potential lawsuit from the policyholder for a contribution to the settlement.

National Union ultimately lost at trial and LMA was awarded $3.75 million in contract damages, $1.2 million in attorney fees and other costs, and $1.1 million in prejudgment interest. The district court also denied National Union’s “motion for a new trial and/or judgment to be entered in its favor.”

National Union appealed to the U.S. Court of Appeals for the Ninth Circuit, arguing that Diamond Heights had been overruled and was distinguishable on its facts. The Ninth Circuit examined both the legal and policy rationales that form the basis of the holding in Diamond Heights. Diamond Heights relied upon the duty of good faith owed by an excess insurer to a primary insurer and a policyholder, finding that an excess insurer could not “arbitrarily” veto a “reasonable” settlement and force a primary insurer to bear the costs of proceeding to trial. The Diamond Heights court further noted the public interest in encouraging settlement on fair and reasonable terms, the available avenues for an excess insurer to challenge a settlement or take the case to trial, and the inequity in allowing an excess insurer to take advantage of a primary insurer at the expense of all other involved parties. In the instant case, the Ninth Circuit rejected National Union’s argument that the California Supreme Court’s decision in Waller v. Truck Insurance Exchange, Inc., 11 Cal.4th 1 (1995) overruled Diamond Heights by standing for the proposition that an insurer only waives a right by intentional relinquishment. Waller did not refer to Diamond Heights and relied upon authorities related to waiver before Diamond Heights. Moreover, California appellate courts continued to rely upon Diamond Heights after the Waller decision and declined to recognize an excess insurer’s absolute right to simultaneously withhold consent to a settlement and refuse to assume the defense in the continued action. The Ninth Circuit also reconciled Diamond Heights and Waller by framing Diamond Heights as focused on the excess insurer’s breach of the implied covenant of good faith and fair dealing, rather than focused on the waiver of the excess insurer’s “no voluntary payments” or “no action” provisions — notwithstanding the Diamond Heights court’s use of waiver terminology.

The Ninth Circuit did recognize that, unless excess insurers have increased the price for their insurance to account for costs imposed by the Diamond Heights holding, then primary insurers and policyholders have received an added benefit beyond the express terms of the “no voluntary payments” and “no action” provisions in their excess policies as a result of the holding. However, the Ninth Circuit ultimately determined that other insurance principles and policy considerations weighed in favor of applying Diamond Heights, as it is well settled that policyholders are permitted to make a reasonable settlement notwithstanding a consent provision, in analogous circumstances where the primary insurer unreasonably delays the processing of the claim, refuses to defend despite being required to under the policy, or wrongfully denies coverage. Having concluded that the California Supreme Court would be likely to continue to apply Diamond Heights, the Ninth Circuit went on to apply the same rule to the facts of the instant case in favor of LMA. In particular, the court recognized the possibility that LMA may have had the incentive to settle the disparagement counterclaims, paid by the insurers, at a higher amount in order to negotiate a larger settlement for its own infringement claims, but noted that the jury in the underlying action, supported by substantial evidence, unanimously found that the settlement was reasonable and not the product of collusion.

The Ninth Circuit also articulated the burden of proof required under Diamond Heights, namely, that the policyholder’s prima facie showing includes 1) that the insurer wrongfully withheld a defense or indemnity, 2) that the policyholder entered into a settlement, 3) that the settlement was reasonable, reflecting an informed, good faith effort on the part of the policyholder to resolve the claim, and 4) that the insurer had a reasonable opportunity to assume the defense instead of consenting to the settlement. Upon that showing, the burden then shifts to the insurer to demonstrate by a preponderance of the evidence that the settlement was either the product of fraud or collusion or that it would not reasonably resolve the claim. The Ninth Circuit went on to affirm the district court’s jury instructions related to breach of good faith and fair dealing, and to affirm the district court’s award of fees and costs to LMA.

Going forward, courts in other jurisdictions should consider the well-reasoned approach offered by the Ninth Circuit in Teleflex, holding that excess insurers cannot rely upon “no voluntary payments” and “no action” provisions to circumvent their obligations of good faith and fair dealing towards policyholders and primary insurers. While Teleflex is specific to California law, the policy considerations articulated by the Ninth Circuit should nonetheless offer a framework for other jurisdictions, whose law on these issues is unsettled, to consider applying in favor of policyholders facing similar disputes with their insurers.