Under California law, a liability insurer has a good faith duty to reasonably settle claims within its policy limits. In Diamond Heights Homeowners Association v. National American Insurance Co., the California Court of Appeal held that where a proposed settlement demand exceeds a defending primary insurer’s limits and has been approved by the insured and the primary insurer, an excess insurer has three options: (1) approve the proposed settlement; (2) reject it and assume the insured’s defense; or (3) reject it and face a potential lawsuit from the insured. 227 Cal.App.3d 563, 580-581 (1991). The rationale for this rule is that the excess insurer cannot force the primary insurer to continue defending a case that should resolve within the excess insurer’s limits.

In Teleflex Medical Inc. v. National Union Fire Insurance Co. of Pittsburgh, PA, National Union sought to challenge Diamond Heights in the Ninth Circuit. No. 14-56366, ___ F.3d. ___, 2017 WL 105586 (9th Cir. Mar. 21, 2017). Teleflex concerns LMA North America, Inc.’s suit against Ambu for alleged patent infringement of laryngeal mask airway products and Ambu’s $28 million counterclaim for LMA’s alleged disparagement of Ambu’s products. LMA’s primary insurer, CNA, defended LMA against the counterclaim.

In January 2010, LMA’s defense counsel opined that LMA’s potential liability on the counterclaim could be as high as $10 million, excluding potential treble damages. In January 2011, LMA and Ambu reached a conditional settlement under which Ambu would pay LMA $8.76 million for the patent claims and LMA would pay Ambu $4.75 million for the disparagement claims. The settlement was conditioned upon LMA’s ability to obtain approval and funding from CNA and National Union. CNA committed its full $1 million limit, but National Union was not convinced that the counterclaims could invade its layer of coverage.

On February 14, 2011, National Union requested an updated liability analysis from defense counsel. On March 17, 2011, defense counsel advised that damages could exceed $10 million, that $4.75 million was a fair and reasonable settlement, and LMA needed a prompt reply to the settlement demand. On March 23 and 25, 2011, LMA repeated its request for a response, setting forth National Union’s options under Diamond Heights: (1) accept the settlement; (2) reject it and defend; or (3) reject it and refuse to defend. On April 7, 2011, National Union declined to consent to the settlement without assuming LMA’s defense. The following week, LMA provided National Union with one last opportunity to defend, given that National Union had rejected the settlement. On April 18, 2011, LMA finalized the settlement and notified National Union that it had done so. Three days later, National Union advised LMA that it would assume the defense if LMA could “undo” the settlement. LMA responded that the settlement was final.

LMA then sued National Union for breach of contract and bad faith in the U.S. District Court for the Southern District of California. A jury found for LMA on its breach of contract and bad faith claims but did not award punitive damages. The district court entered judgment in LMA’s favor for $3.75 million in contract damages, more than $1.2 million in attorneys’ fees and costs, and more than $1.1 million in prejudgment interest. National Union appealed to the Ninth Circuit.

National Union argued that as an excess insurer, it had the absolute right to veto the settlement. National Union asserted that it had not intentionally waived the provisions in its insurance contract that (1) prohibited the insured from voluntarily making a payment or assuming an obligation without National Union’s consent and (2) provided an insured cannot have a right of action against National Union until the amount the insured owes has been determined with National Union’s consent or by actual trial. The Ninth Circuit rejected that argument. The court determined that while the rules regarding intentional waiver prevent an insurance contract from being expanded beyond the contracting parties’ intent, the covenant of good faith and fair dealing underlying Diamond Heights is grounded on “honoring the reasonable expectations created by the autonomous expressions of the contracting parties.”

The Ninth Circuit acknowledged that but for the implied covenant of good faith and fair dealing, the Diamond Heights rule would be contrary to the “no voluntary payments” and “no action” provisions, but found California law has long held that those provisions do not create absolute rights to veto settlements. See Diamond Heights, 227 Cal.App.3d at 581 (the insured can make a reasonable settlement “where a primary insurer wrongfully denies coverage, unreasonably delays processing a claim, or refuses to defend an action against the insured as required by the policy … even where the policy prohibits settlement without the consent of the insurer”). The Ninth Circuit determined that Diamond Heights applied because National Union failed to show that the district court erred in following the decision.

National Union challenged the bad faith claim on the ground that a genuine dispute existed regarding Diamond Heights’ application and viability. Specifically, National Union argued that the district court should have explicitly instructed the jury on the “genuine dispute” doctrine and that the jury failed to take into account that genuine dispute in rendering its decision. In a footnote, the Ninth Circuit noted that the “genuine dispute” doctrine has been applied in other contexts, but expressed skepticism that it would apply to the insurer’s duty to settle third-party claims. Regardless, the court determined that the doctrine “is subsumed” within the standard jury instruction for breach of the covenant of good faith and fair dealing, which requires that the insurer’s conduct is “unreasonable.” The court further ruled that the jury could rationally conclude that National Union acted unreasonably by refusing to take over the defense or approve the settlement and that any dispute regarding coverage was less than genuine. The court rejected National Union’s challenge to the bad faith claim.

The Teleflex decision provides persuasive authority that excess insurers in California must seriously consider settlement demands exceeding primary limits in electing whether to accept the settlement, reject it and assume the insured’s defense, or reject it and decline the insured’s defense. This is so even if the language in the excess insurance contract otherwise appears to give the excess insurer veto power over the settlement.