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SAN FRANCISCO-California courts may receive some long-awaited guidance on punitive damages when the state Supreme Court reviews an insurance bad faith case.

The eventual decision in West American Insurance Co. vs. Freeman, which is not expected for another year or two, might also influence courts in other states.

In accepting the case for review, the California high court said it would focus on the $12 million punitive award made by a jury and later upheld on appeal. It is the largest punitive award to be upheld by a state appellate court in a published decision.

Previous high court rulings on punitive damages do not give lower courts adequate rules to apply when juries are trying to determine whether to award punitive damages and how much to award, some attorneys say.

"Further guidance in this area is desperately needed," said Ellis Horvitz, an insurer attorney with Horvitz & Levy in Encino, Calif., who had urged the Supreme Court in a letter to take the case. Right now, "It's like doing brain surgery with a meat ax."

Even the U.S. Supreme Court, in a series of constitutional cases spanning several years, has not given U.S. businesses the clear, concrete guidance that they have been looking for on punitive damages.

The California suit involves Mark A. Freeman, a contractor who sold a Palo Alto house he built to Edward and Rhonda Pierce in 1985. The Pierces sued Mr. Freeman in 1987 for fraud and other charges after complaining of a defective foundation.

His insurer, West American, an Ohio Casualty Corp. unit in Hamilton, Ohio, provided a defense for Mr. Freeman, but reserved its right to seek reimbursement of payments made on his behalf for defense and indemnity.

The case was eventually settled for $56,500 despite Mr. Freeman's complaints about his lawyer's conduct and his allegations that the insurer had threatened to stop funding his defense unless he agreed to the settlement.

In 1991, following up on its reservation of rights, West American filed suit to limit or deny coverage as well as for reimbursement of its costs. Mr. Freeman countersued, charging the insurer with bad faith. A jury, which heard Mr. Freeman testify that he had lost his business because of the insurer's actions and had incurred more than $323,000 in attorney's fees, then awarded him $1.3 million in compensatory damages and the $12 million in punitive damages.

Four years later, upholding the award, a state appeals court in San Francisco found "substantial evidence in the record of its bad faith conduct, including forcing Freeman to settle the Pierce claim through the threat of withdrawal of defense counsel, ignoring the expert opinions on the Pierce matter, refusing to join other liable parties, refusing to turn over the defense file on the Pierce claim and putting its interests ahead of those of Freeman."

In addition, the theory that the insurer had "attempted to create new law at Freeman's expense and that this was further conduct evidencing bad faith is not without merit," the court said.

In its review, the high court said it will focus on three questions:

"Were punitive damages impermissibly awarded on the grounds that West American Insurance Co. had acted in bad faith in advancing a novel legal theory?"

"Was the punitive damage award excessive because it was based on passion and prejudice?" This refers to inaccurate statements by Mr. Freeman's attorney at trial that another Ohio Casualty unit had paid $8 million in punitive damages; the actual amount had been $5 million.

"Was the punitive damages award excessive in light of West American's financial condition?" The $12 million award represented nearly 28% of West American's net income in 1991.

Insurer attorneys say if the appellate decision is left to stand it could seriously disrupt the normal insurer practice of providing policyholders with a defense while reserving the right to later seek reimbursement.

All insurers, particularly liability insurers, would be "walking on eggshells" about whether to seek declaratory judgments on coverage issues, said Alister McAlister, a Wilton, Calif.-based attorney who is California counsel to the National Assn. of Independent Insurers.

Mr. McAlister had sent a letter to the Supreme Court urging it take the case.

What's more, a ruling that insurers which advance novel legal theories are acting in bad faith would make insurers second class citizens, say some attorneys.

That means that insurers, unlike any other participants in civil litigation, could be held liable in tort for advancing arguments that are not frivolous but are merely "incorrect and novel," said Elliot L. Bien, of Bien & Summers in San Francisco, who represents West American.

Such a ruling would threaten insurers' "ability to participate in their own disputes in a court of law," he added.

"I don't understand how the law could say an insurer is not entitled to pursue their rights in court like any other party," agreed Peter Davis, an insurer attorney with Crosby, Heath, Roach & May in San Francisco.

But policyholder attorneys have a different characterization of the case. "The insurance company believes that they can insulate themselves from bad faith liability with the issue of reservation of rights when there was no good faith belief that their legal position was tenable.*.*.and I think the court of appeals saw through that," said Walter Lack, of Engstrom, Lipscomb & Lack in Los Angeles.

This is a good case that further confirms that "bad faith is alive and well in the state of California on behalf of policyholders, not just individuals, but small businesses, who buy liability insurance and expect insurers to stand behind them," according to Charles Mazursky, of Mazursky, Schwartz & Angelo in Los Angeles. "Too often people take out liability insurance and pay premiums and find a piece of paper instead of a promise to defend them and stand behind them and stay on the same team as them."

Even some insurer attorneys say that West American's conduct makes this a poor case to use to evaluate the standards for punitive damages.

"The insurance company could have acted a little more reasonably, there's no doubt about that, and I'm sure insurance companies would prefer to see the issue tested on facts different from these," said Kirk G. Forrest, of Carroll, Burdick & McDonough in San Francisco, who represents insurers.

"I think there's a couple of lessons that insurers can learn from this case, whether the punitive damage amount is upheld or not, or whether they strike down part of it and reduce the amount, " said Linda Dakin-Grimm, a partner with Chadbourne & Park in Los Angeles who specializes in representing insurers in construction defect claims.

"The case really stands for the proposition that if you provide a defense for the insured, you have to provide a real defense. You can't provide a partial defense or a defense aimed at minimizing fact gathering and settling a case," she said.

Aside from the bad faith issues, the case could provide some important guidance on punitive damages.

The state court's decision to grant review "offers some hope and encouragement that it is ready to give much more careful definition and much better guidelines to the lower courts and the litigants and to the business community generally about what criteria should be applied in determining whether to grant punitive damages and how much to award," he said.

"I think it's very significant in that the Supreme Court is reviewing the issue of punitive damages for the first time really in any serious fashion" in five years, said Julia Molander, an insurer attorney with Bronson, Bronson & McKinnon in San Francisco.

"It could well have national impact because there's generally a truism that where California goes everyone else walks," Ms. Molander added.

Mr. Horvitz agreed. "What the California Supreme Court does is very likely to influence what other states do," he said. "I would say some other states are likely to go along with the California Supreme Court" even if they do not entirely agree with its decision.

But other disagree. "Each state deals with this issue on its own," said Bob Schiff, of Fisher & Hurst in San Francisco, an insurer attorney. Other state courts are "not going to look at California. They don't care."

It may not even influence other California cases, said Dick Barger, of Barger & Wholan in Los Angeles, an insurer attorney. "It occurs to me the court may review the case on its own merits, do whatever they do re punitive damages and decertify it" so that it is not published and does not become precedent.