News - October 2008

• "Genuine Dispute" Rule Does Not Bar Complaint for Bad Faith Where Insurer Allegedly Conducts Biased, Incomplete Investigation
• Insurer Has Duty to Defend Subcontractor Who Allegedly Installed Damp Drywall in Houses, Leading to Mold

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"Genuine Dispute" Rule Does Not Bar Complaint for Bad Faith Where Insurer Allegedly Conducts Biased, Incomplete Investigation

The California Court of Appeal has ruled that the “genuine dispute” rule does not bar a complaint for bad faith where the insured alleges, in detail, that the insurer knowingly conducted a biased and incomplete investigation for the specific purpose of minimizing the insured’s claim. (Brehm v. 21st Century Insurance Company (2008) 166 Cal.App.4th 1225)

Facts

Stuart Brehm filed a bad faith suit against 21st Century Insurance Company arising out of 21st Century’s handling of a claim for underinsured motorist (UIM) benefits. Brehm’s parents were named insureds (and Brehm qualified as an insured) on a policy issued by 21st Century. The 21st Century policy provided underinsured motorist (UIM) benefits of $100,000 per person.

Brehm alleged that he, his father and his mother all were injured in a traffic accident caused by a third party, who had liability insurance with a limit of $30,000 per accident. The third party’s insurance carrier exhausted its limit by paying $10,000 to Brehm, $10,000 to Brehm’s father and $10,000 to Brehm’s mother.

In addition, Brehm alleged he made a UIM claim against 21st Century, and submitted medical reports, bills and diagnostic test results that showed he had suffered “a severe shoulder injury that would require costly surgery and related costs and expenses.” Brehm further alleged that he initially demanded $85,000 under the UIM coverage and that, in response, 21st Century arranged for a biased doctor, who was a professional expert witness, to examine Brehm. According to Brehm, 21st Century’s expert concluded that Brehm had only suffered “soft tissue” injuries and that surgery was not necessary. Based on this examination, 21st Century offered to pay Brehm only $5,000 under the UIM coverage.

Brehm also alleged that he then submitted to “a truly independent medical examination” by another doctor. That doctor concluded that Brehm had indeed suffered a shoulder injury and that it was “more likely than not” that Brehm would require surgery. Based on this report, Brehm demanded that 21st Century pay $90,000 (i.e., the $100,000 UIM limit less the $10,000 the third party’s insurer had paid). However, Brehm alleged, 21st Century again offered only $5,000. Brehm ultimately obtained an arbitration award of $90,000, which 21st Century paid.

The trial court ruled that, at most, the allegations in Brehm’s complaint showed the parties’ experts had differing views regarding the extent of Brehm’s injuries, and that there was a “genuine dispute” about the issue. Thus, the trial court sustained 21st Century’s demurrer to Brehm’s complaint and entered judgment in favor of 21st Century. Brehm appealed.

Holding

The Court of Appeal reversed, holding that Brehm’s allegations, although not yet proven, were sufficient to at least state a cause of action for bad faith. Among other things, the Court reiterated that “[t]he genuine dispute rule does not relieve an insurer from its obligation to thoroughly and fairly investigate, process and evaluate the insured’s claim,” and that “an expert’s testimony will not automatically insulate an insurer from a bad faith claim based on a biased investigation.” In essence, the Court held that, if Brehm could actually prove that 21st Century had knowingly selected a biased expert for the specific purpose of minimizing the amount Brehm could collect, then the “genuine dispute” rule would not apply.

Comment

Although the existence of a “genuine dispute” about coverage or damages often negates “bad faith,” the dispute must in fact be genuine. In this case, the insured alleged that the insurer knowingly chose a biased expert for the specific purpose of minimizing the insured’s claim. Among other things, this case reinforces the notion that insurers must honestly and fairly select their experts, must reasonably evaluate their experts’ opinions and must otherwise conduct thorough investigations.

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Insurer Has Duty to Defend Subcontractor Who Allegedly Installed Damp Drywall in Houses, Leading to Mold

The United States District Court for the Eastern District of California has concluded that a liability insurer had a duty to defend its insured, a drywall subcontractor, against allegations that the insured installed damp drywall in houses which eventually led to mold in the houses. (McGranahan v. Insurance Corp. of New York (E.D.Cal. 2008) 544 F.Supp.2d 1052)

Facts

Dunmore Homes, LLC (Dunmore) was the general contractor for a residential subdivision in Ceres, California. In May 2002, Dunmore entered into a subcontract with Jeff Stewart Drywall, Inc. (JSD) for the installation of drywall at the project.

Before JSD installed the drywall at the project, the drywall was stacked inside the houses. During that time frame, fog or rain got into some of the houses and some of the drywall got damp. JSD claimed that it replaced the damp drywall with new drywall and then proceeded to install the drywall in the houses. After installation of the drywall, Dunmore inspected and approved JSD’s work.

Later, mold was identified on some of the drywall in the homes. With Dunmore’s approval, JSD attempted to repair the damage by treating the moldy drywall with bleach. The drywall was then texture coated and painted. Apparently, however, the mold problem persisted or resurfaced. The general contractor, Dunmore, ultimately hired an expert who recommended removing the drywall from the houses; removing and cleaning interior fixtures such as cabinets, tubs and toilets; removing exposed insulation; cleaning the heating and air conditioning ductwork; and removing residual traces of mold from floors, walls and ceilings.

Subsequently, in August 2003, Dunmore initiated arbitration proceedings against JSD, alleging a single claim for breach of contract. JSD tendered the defense of the arbitration proceeding to its general liability insurer, The Insurance Corporation of New York (INSCORP). However, in January 2004, INSCORP denied JSD’s tender of defense.

In March 2004 the arbitration between Dunmore and JSD occurred. The arbitrator found that JSD was aware of a potential mold problem both while the drywall was stacked and after it was installed, and that JSD’s subsequent attempt to bleach to the moldy drywall was “insufficient.” The arbitrator concluded that JSD was liable to Dunmore for approximately $350,000 in damages, plus approximately $50,000 in attorney’s fees. In July 2004, judgment was entered in favor of Dunmore and against JSD.

Eventually, JSD filed for bankruptcy. In April 2006, as part of the bankruptcy proceedings, JSD’s bankruptcy trustee sued INSCORP for breach of contract and bad faith. The bad faith case was then transferred from the bankruptcy court to the federal district court. Thereafter, JSD’s bankruptcy trustee filed a motion for partial summary judgment, and INSCORP filed a cross-motion for summary judgment.

Holding

The federal district court, applying California law, held that INSCORP had a duty to defend JSD against the underlying arbitration proceeding brought by Dunmore. The district court noted that, at the time of JSD’s tender to INSCORP, there was a factual dispute as to whether JSD had intentionally or unintentionally hung damp, moldy drywall in the houses. Since it was possible that JSD had unintentionally hung damp, moldy drywall, it was possible that JSD’s alleged liability arose from an “occurrence,” or “accident.” Further, at the time of JSD’s tender, there was evidence that JSD’s work may have caused property damage to portions of the homes other than drywall itself. Thus, the exclusion for property damage to “that particular part of the property” on which JSD worked did not bar coverage for all the damages sought. Since Dunmore was potentially seeking damages from JSD that were covered by the policy, INSCORP had a duty to defend JSD against Dunmore’s claim.

With respect to the duty to indemnify, the court noted that when an insurer erroneously fails to defend an action against its insured, the insurer is bound by all material findings of fact essential to the underlying judgment against the insured. However, the insurer is not bound by issues not adjudicated in the underlying action and can present defenses that are consistent with the judgment against the insured. Here, the arbitrator in the underlying case did not make any findings regarding (1) whether JSD intentionally installed damp, moldy drywall in the houses or (2) whether any property damage extended beyond the drywall itself. Thus, INSCORP was free to litigate those issues in the bad faith case. However, since there were triable issues of fact regarding the extent to which INSCORP might have a duty to indemnify JSD, neither INSCORP nor JSD’s bankruptcy trustee was entitled to summary judgment on that issue.   

Last, with regard to the issue of bad faith, the court rejected INSCORP’s argument that JSD’s bad faith claim against INSCORP was barred by the two-year statute of limitations. The court reasoned that although INSCORP denied JSD’s tender of defense in January 2004, the underlying judgment against JSD was not entered until July 2004. The court held that the two-year statute of limitations on JSD’s bad faith claim was “equitably tolled” until entry of the underlying judgment. Since the judgment in the underlying arbitration proceeding was not entered until July 2004, and since JSD’s bankruptcy trustee filed the bad faith action in April 2006, JSD’s bad faith action against INSCORP was not barred by the two-year statute of limitations.  

Comment     

At least based on what is in the court’s written opinion, it is somewhat difficult to see how INSCORP did not at least defend JSD in the underlying arbitration proceeding. Given the factual disputes about whether JSD knew it was hanging damp, moldy drywall, and whether property damage extended beyond the drywall to other portions of the houses, it seems clear that Dunmore was potentially seeking covered damages against JSD, thus triggering INSCORP’s duty to defend.   

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