Citations
- 176 Cal. App. 4th 172
Full opinion text
Opinion
SILLS, P. J,
I. INTRODUCTION
At first we did not know what to make of this case. There was a $10 million judgment obtained by a nationwide groundwater pumping and control company against its liability insurer. The compensatory damages—all of which consisted of the attorney fees and costs incurred to sue the insurer for the $10 million—were about $1 million. What foul deeds had the insurer committed, we wondered, that merited such punishment?
At first the answer seemed simple.
At a meeting in Houston in May 1997, representatives of the insurer had, in order to induce the insured to renew its CGL (that is, “third party” liability) policy, orally promised representatives of the insured that the insurer would cover any “future” liability claims based on the release of sewage, even though the insurer, to that point, had steadfastly maintained that any liability based on sewage releases was excluded under the insurer’s “total pollution exclusion.” The Houston meeting had arisen out of the insurer’s disavowal of any coverage, or potential for coverage, for liability arising out of a certain sewage overflow in Laguna Beach. In particular, the insurer had disclaimed any coverage for the damages to the Laguna Beach home of Dr. and Mrs. Waters about a year and one-half before arising out of an allegedly faulty sewer bypass constructed by the insured for a water district.
(In this opinion we will refer to that sewage backup as the “Waters claim” and the (alleged) promise made by the insurer in Houston as the “Houston Oral Promise.”)
When the district on whose behalf the insured had built the bypass settled the Waters claim, the district sued the insured to get its money back. But the insurer refused to defend this latter suit against the insured for about 11 months even though it had promised the insured that it would cover any “future” claims.
Hence, it initially looked to us like this case might indeed warrant punitive damages. After all, coming to us after a jury trial, the ambiguity in the word “future” (could it encompass the district’s post-May 1997 suit against the insured?—or, because it originally surfaced in the form of an informal claim by the district sometime earlier, was it a “past” claim?) would have to be construed in favor of the prevailing party—the insured.
But then we started digging into the voluminous record with the help of able counsel on both sides who provided two rounds of supplemental briefing plus a second oral argument. And it was only after the second oral argument in April of this year that the case finally unfolded itself. The whole theory of liability based upon the Houston Oral Promise turned out to be an illusion that dissolved under scrutiny. Two items in particular made liability based on the Houston Oral Promise untenable:
First, the complaint never actually mentioned the oral promise made in Houston at all. Rather, the complaint was predicated on a straightforward coverage question based not on some oral promise made in Houston in May 1997, but on the written insurance policy as it stood in 1996. Essentially, the complaint said: We, the insured, had a sewage claim against us, and the insurance company denied our request for a defense of that claim because it interpreted the written insurance policy, with its total pollution exclusion, unreasonably.
Second, the complaint was never amended to include any cause of action based on the oral promise made in Houston in May 1997. In fact, before the trial, the insured’s counsel expressly dropped an attempt to amend the complaint to state a claim based on that promise as a “stand alone” cause of action.
Why? The answer came out in the second oral argument. Rather than expose the merits of the issue to the jury, the insured’s counsel wanted to rhetorically exploit the promise as a simple “concession” (his word at oral argument) by the insurer that its coverage position had been unreasonable all along.
But absent an amendment to the complaint, the Houston Oral Promise could not serve as a basis for recovery. It is elementary that a party cannot recover on a cause of action not in the complaint. (E.g., Mondran v. Goux (1875) 51 Cal. 151, 153 [“In other words, the cause of action, if any, established by the findings, is wholly different from that averred in the complaint, and is foreign to any issue raised by the pleadings. The rule is well settled that a plaintiff must recover, if at all, upon the cause of action set out in his complaint, and not upon some other which may be developed by the proofs.”]; Walker v. Belvedere (1993) 16 Cal.App.4th 1663, 1670 [20 Cal.Rptr.2d 773] [“ ‘It is a fundamental principle of pleading that “a plaintiff must recover, if at all, upon the cause of action set out in the complaint, and not upon some other which may be developed by the proofs.” ’ ”].)
That left the breach of the written contract (the insurance policy) which was, after all, the actual basis for the jury’s punitive damage assessment. But that assessment turned out to be the result of an error of law in a motion in limine in favor of the insured. Specifically, the trial court had ruled, in an in limine motion, that, as a matter of law based on the written contract and totally independent of the Houston Oral Promise, the insurer had breached the contract unreasonably so as to expose the insurer to tort, and maybe even punitive damages.
However, that theory would not hold up either. The ruling on the in limine motion (as we explain in probably too much detail below) was clear error, as shown by this court’s opinion in Morris v. Paul Revere Life Ins. Co. (2003) 109 Cal.App.4th 966 [135 Cal.Rptr.2d 718], a case which turns out to be directly on point. The trial court erroneously thought that because the case law was “unsettled” when the insurer first turned down the claim, that unsettledness created a potential for a covered claim. Morris, however, explained that if an insurance company’s denial of coverage is reasonable, as shown by substantial case law in favor of its position, there can be no bad faith even though the insurance company’s position is later rejected by our state Supreme Court.
Exactly that had happened in the case before us. Back in the late 1990’s, at the time this insurer denied a request for a defense, there was ample case law and policy language to support the insurer’s position. On top of that, this insurer changed its mind in favor of the insured more than six months before the California Supreme Court settled the question of correctness of the insurer’s original position in MacKinnon v. Truck Ins. Exchange (2003) 31 Cal.4th 635 [3 Cal.Rptr.3d 228, 73 P.3d 1205],
And finally, there was the matter of damages for the insurer’s initial and incorrect denial of coverage. It turned out, there weren’t any. As to contract damages, the insurer had, long prior to the MacKinnon case, (a) settled all the litigation against the insured and (b) paid all the insured’s attorney fees incurred in that litigation. As to tort damages, the insured’s claims for attorney fees foundered on the reasonableness of the insurer’s initial and incorrect denial. Because the denial was reasonable, no tort damages were available, including attorney fees—often called “Brandt fees.” (See Brandt v. Superior Court (1985) 37 Cal.3d 813 [210 Cal.Rptr. 211, 693 P.2d 796]; Cassim v. Allstate Ins. Co. (2004) 33 Cal.4th 780, 808 [16 Cal.Rptr.3d 374, 94 P.3d 513] [“without a tort judgment, there could be no Brandt fees”].)
We therefore reverse the approximately $11 million judgment, with directions to enter a judgment in favor of the insurer.
H. BACKGROUND
Because this is a bad faith case, perspective is best attained if the story is told in a timeline fashion. In particular, noting the time that specific events occurred is important here because it shows that:
(a) the insurer denied the requested defense long before the MacKinnon case came down;
(b) the insurer actually changed its mind and provided a defense relatively quickly after it had first denied it, and did so before the Supreme Court handed down the MacKinnon decision;
(c) the insurer changed its mind with sufficient speed that the insured never really paid anything in defense costs. Those costs were picked up by the insurer before the insured was ever billed for them.
Also, because this is a bad faith case, we quote the precise and full language of a number of important documents, so readers can easily see the “source materials” which reveal how the parties were dealing with each other.
A. Events Prior to Litigation
1. November 1995 to February 1996: The insured’s work and the origin of the Waters claim.
In early November 1995, Griffin Dewatering Corporation (usually referred to in this opinion as “the insured,” sometimes as “Griffin”) agreed to fix a 75-foot manhole feeding into the main sewer line for the South Coast Water District.
The insured worked on the job sometime between November 1995 and February 1996. On February 6 and February 21, sewage backed up into the Laguna Beach home of Dr. and Mrs. Ron Waters, obviously resulting in extensive damage.
In late February 1996, the Waters submitted a claim form to the district. The claim form submitted by the Waters said that the “sewer line under construction by South Coast Water District backed up causing massive flow of raw sewerage [sic] into ground floor of our home on two occasions.”
The Waters, however, never sued, and never would sue, on their claim.
2. March to April 1996: The insurer is requested to cover a claim not yet reduced to a lawsuit, and denies the request.
In March 1996 (about March 8), the insurer received notice of the Waters claim. It is not clear from the record precisely from whom the notice first came—from the district or from the insured—though it is clear that at least the insured had brought the matter to the insurer’s attention in March 1996.
The next month, in April 1996, the insurer denied the claim in a letter dated April 11. The insured’s broker immediately disputed the conclusion in a letter sent on April 15, 1996.
3. May 1996 to May 1997: The Waters claim is still a possible suit against the insured, and a bone of contention between the insurer and the insured.
There is not much in the record about events in the May 1996 through May 1997 time period, except that the policy had come up for renewal in early February 1997 and the earlier denial of coverage for the Waters claim was clearly a sore spot for the insured.
4. May 1997: The Houston meeting.
In May 1997, there was a meeting between representatives of the insurer (including members of its environmental claims unit) and the insured (including its president, its in-house attorney, and its insurance broker) in Houston.
This is the origin of the Houston Oral Promise mentioned above. The insured was unhappy with the denial of the Waters claim, and the insurer was apparently eager to retain the insured’s business.
There is no dispute that there was some sort of oral promise made at the May 1997 meeting, but there is a dispute as to the precise nature of the promise. According to one of the insurer’s underwriters who was at the meeting (as he would later testify at trial), the promise was that the insurer would consider sewage claims under a reservation of rights “and in many instances” make payments as a “business consideration.” This same underwriter would also later testify that by the time of the Houston meeting, the decision on the Waters claim could not be altered but “similar-type claims” would be covered in the future.
In contrast to the resolute quality of the insurer’s decision that there was no coverage at all for the Waters claim as described by one of the insurer’s underwriters, the insured’s president would later testify that he asked the same underwriter “if anything comes from South Coast are we covered, and the answer was yes.” The insured’s in-house attorney also testified that he “understood” the underwriter to be promising that “if the Waters claim suddenly had come back to life” that the insurer would “pay” it. And the insured’s broker testified that he understood Griffin would be receiving something in writing to confirm Northern’s new coverage position. (There is no dispute that nothing was ever received afterwards except a change in the pollution exclusion in the renewed policy to remove the phrase “in whole or in part” from the pollution exclusion.)
5. May 1997 to May 1999: The district settles the Waters claim on its own and begins to think about looking to the insured for reimbursement.
Around May 1999, the district paid the Waterses nearly $417,000 to settle their claim against the district for the sewage backup. Now the district wanted to recoup that money from the insured.
6. Late September 1999 to October 1999: The district sues the insured, the insured wants coverage from the insurer, the insurer denies the request.
In September 1999, the district sued both the insured and the insurer to recoup its expenditures to settle the Waters claim. The insured was served with the suit “within a day or two” of September 29, 1999, and, in a letter dated October 1, 1999, the insured’s broker enclosed the lawsuit brought by the district against the insured (as well as the insurer itself), requesting coverage (presumably a defense or settlement, since no judgment had been entered against the insured at that point).
A representative of the insurer telephoned with a “verbal response,” to the effect that there would be no coverage for the suit. The insurer did not think a written response was necessary because there had been three prior denials.
As it turned out, though, the insured was never “out of pocket” for any defense costs during the pendency of the suit. The insured had an excess insurance policy with another insurance company (AIG—yes, that AIG), and AIG agreed to hire a defense firm to defend the insured against the district and “invoice” the bills to the insured. Essentially the excess insurer would be fronting money for the defense. The insured’s in-house counsel would later admit on cross-examination that the district’s case against it was settled (as we shall soon see, it was settled by the insurer) prior to the insured receiving any invoices from the excess insurer for the hiring of the defense firm.
B. Events After the Litigation Began
1. October 1999 to April 2000: The insured prepares and files its bad faith complaint against the insurer.
About six months after the October verbal denial, in April 2000, the insured filed a complaint against the insurer for bad faith breach of insurance contract. (The other causes of action listed were breach of contract, fraud, intentional misrepresentation, and declaratory relief.) As we have mentioned, the complaint made no reference to the Houston meeting in May 1997. The insurer filed an answer in June 2000.
2. September 2000: The insurer changes its mind, settles the district suit against the insured, and unsuccessfully attempts to give up its right to seek reimbursement in exchange for the insured’s dropping of the bad faith suit.
Less than three months after it had filed its answer, in a letter of September 8, 2000, the insurer agreed to defend the district’s suit against the insured.
In a letter of September 28, 2000, to the insured’s counsel, the insurer’s counsel stated that it had settled all the liability of the insured asserted by the district. There was a confirmation of the settlement in a letter to the insurer from the insured’s defense lawyers the next day, acknowledging that the insurer had provided $350,000 to settle the case.
Now we come to what appears to be a case of mistaken purposes. The letter of September 28, 2000, from the insurer’s lawyer to the insured’s lawyer also stated that the insurer had “agreed” to give up any right to reimbursement and further stated that the insurer was willing to pay the insured’s fees incurred to sue the insurer in the bad faith case up to that point, which then were the relatively small sum of $8,921.40. On the other hand, the letter made an ambiguous reference to “mediation,” which suggests that the insurer still entertained a wistful hope of getting some of its money back, at least in an alternative dispute resolution forum. We quote the totality of the letter in the margin.
The insured’s counsel didn’t like the offer one bit, and rejected the offer in a letter dated October 2, 2000. Basically, the insured’s counsel did not perceive the insurer to be really giving up the chance to seek reimbursement, though it may be significant that the phrase “rights to seek reimbursement later” or something like it was not the phrase used in the rejection letter. Rather, counsel for the insured (also lead counsel in this appeal) used the phrase “withdrawal of all coverage defenses.” We note this because there might be a substantive difference in the two thoughts: The phrase “withdrawal of all coverage defenses” suggests the possibility of the bad faith case continuing on, but in the posture of: “We the insurer now admit we were wrong in denying coverage—we now throw ourselves on the jury’s mercy, punish us as you see fit.” The thought of “dropping any claim to reimbursement” suggests: “We were right all along, but even so we won’t seek our money back.”
On the other hand, perhaps the insured wasn’t demanding unconditional surrender at that point. We also note that the insured’s in-house counsel, as he would testify later, perceived the September 28, 2000 letter as one simply leaving open the possibility of reimbursement in a way that money might still come out of the insured’s pockets. The in-house counsel testified he would. have been “interested” in settlement if the insurer had given up its right of recoupment.
The October 2, 2000 rejection letter made one arresting point, namely that the insured’s counsel didn’t like the fact that the insurer had paid $350,000 to settle the case on its behalf. He thought $350,000 paid on behalf of his client might have an adverse effect on future premiums. (No action would come of this thought, though, and the idea of increased future premiums as a result of the insurer’s settling the case played no role in this suit.)
The insured’s counsel also made it quite clear (as the italicized passages in the margin demonstrate) that he viewed the case as warranting punitive damages regardless of whether his client suffered any actual damages, including any attorney fees incurred to sue the insurer up to that point. As is the case with the September 28 letter from the insurer’s counsel to the insured’s counsel, we quote the entirety of the October 2 rejection letter from the insured’s counsel to the insurer’s in the margin.
3. October 2000 to April 2002: Case law temporarily turns in favor of the insurer, and the insurer goes for a quick win in the bad faith case with a summary judgment motion.
The case had not settled. Two events in the period October 2000 through summer 2002 are worth recounting:
(1) If the insurer had been willing to drop its reservation of the right to seek recoupment in its September 2000 settlement offer, it apparently had not been willing to do so unilaterally. The insurer had not filed a cross-complaint for reimbursement when it filed its answer, but in a letter dated March 2, 2001, it floated the idea of obtaining leave to file such a cross-complaint, and asked opposing counsel if he would be amenable to stipulating to such a filing.
(2) Two decisions of the Court of Appeal came down in early 2002, both of which supported the insurer’s position as to the scope of the total pollution exclusion; one case involved the Bechtel Petroleum Corporation, the other would become MacKinnon v. Truck Ins. Exchange, supra, 31 Cal.4th 635 (MacKinnon) when it was taken by the Supreme Court.
4. May 2002 to October 2002: The insurer loses the first battle and unilaterally withdraws any right to seek reimbursement.
The insurer’s two allies in the appellate case law proved false when, in May 2002, the California Supreme Court granted review in both of them. The Bechtel Petroleum case and MacKinnon were dead—at least as far as they might have helped the insurer’s legal position. It is not surprising, then, that the insurer’s motion for judgment or adjudication in its favor failed in a ruling of July 2002. The minute order gave no explanation.
On October 8, 2002, a few months after the insurer’s failure to gain a quick victory, the insurer unilaterally withdrew any right to seek reimbursement of any of the funds expended to defend or settle the Waters claim.
5. Summer 2002 to September 2004: A series of inconclusive battles and a big change in the case law in favor of the insured.
For the next two years, the parties battled in a series of discovery fights plus motions for summary judgment and summary adjudication, none of which are worth retelling now, except to make two points; (1) While the insurer would, in these motions, press something called the “genuine dispute doctrine” as one of the reasons the insurer was not vulnerable to tort damages, there is also no question that the insurer also argued that its denials of coverage in the period 1996 through 2000 were objectively reasonable.
In this opinion, we do not address at all any arguable applicability of the “genuine dispute doctrine” to this case. We have nothing to say on that subject We need only point out here that the insurer did not waive the right to prevail in this appeal on an objective reasonability theory, as distinct from the genuine dispute doctrine. There is no question that the insurer did raise the issue of the objective reasonability of its denial in the trial court, so the issue of objective reasonability was not waived.
(2) The record discloses that the Houston Oral Promise was not the basis of any motion by the insured. Nor was it the basis of any defense by the insured to any motion of the insurer.
The big event in the period was in August 2003, when our Supreme Court handed down MacKinnon, supra, 31 Cal.4th 635. We explore MacKinnon in detail in part III.B.3. of this opinion. For the moment, suffice to say that no longer could the insurer even hope for a decision that its initial coverage denial had been correct. Now all it could hope for was that that denial would be adjudged reasonable.
6. October 2004 to October 2005: In limine battles culminate in a big breakthrough for the insured when the trial court ruled in an in limine motion that the insurer’s denials of coverage under the policy were unreasonable as a matter of law.
Trial was now looming, and beginning in October 2004 the parties began filing a series of in limine motions. The one we are concerned with was “plaintiff’s number 5,” heard on the afternoon of October 5, 2005. The trial court had just concluded that the insurer had breached the contract (which, given the Supreme Court’s ruling in MacKinnon, was no great revelation). It then turned to the issue of the “reasonableness” of the breach.
The trial court specifically referenced CalFarm Ins. Co. v. Krusiewicz (2005) 131 Cal.App.4th 273 [31 Cal.Rptr.3d 619] (CalFarm), which rejected a bad faith claim because the insurance company had been objectively reasonable in its denial. The CalFarm opinion arose out of a contractor’s failure to properly seal certain retaining walls, which allowed water to permeate the walls and damage their exterior paint. The insurance company, said this court, “could make an objectively reasonable determination” that the costs of “removing and replacing” certain backfilled dirt and landscaping in the course of repairing the walls fell within a policy’s “ ‘own work’ ” exclusion; thus there could be no bad faith liability. (Id. at pp. 291-292.)
The trial court and counsel thoroughly discussed the CalFarm opinion. Unfortunately (as shown anon) the trial court misapplied it. The trial court held that the insurer’s denials had been unreasonable as a matter of law. Why? The trial judge said that the issue of the scope of the total pollution exclusion was “unsettled” when the insurer had disclaimed coverage. The trial judge indicated that he thought CalFarm inapplicable because in the case before him, there had been no defense pursuant to a reservation of rights.
7. October 5, 2005: The insured unequivocally drops the attempt to predicate a separate claim based on the Houston Oral Promise.
A little while thereafter during the same hearing, the trial court moved on to the problem of the Houston Oral Promise, which had been lurking in the background in the case, but had never been squarely presented as a cause of action At one point in the proceedings—and one must remember this point was after the trial court had ruled that the insurer had been unreasonable in denying coverage under the written contract—it appeared that the insured’s counsel wanted to offer an amendment to the complaint based on the Houston Oral Promise (referred to by the parties at that point as the “Gentleman’s Agreement”) and the insurer’s counsel was prepared not to oppose it.
The trial court readily grasped the essence of the problem for the insurer posed by the Houston Oral Promise. As the judge said at one point, it was like the insurer promising coverage and then pointing to an integration clause in the contract and saying “ ‘neener, neener.’ ”
After some more colloquy, the insured’s counsel made it very clear that he was withdrawing any attempt to include the Houston Oral Promise as a “stand alone cause of action.” Rather than do that, he said, he planned to use the Houston Oral Promise in the context of the causes of action that already were in the complaint. And in supplemental briefing to this court, the insured has also made it abundantly clear that its case at trial was premised on the tortious breach of the 1996 written policy and not the Houston Oral Promise.
8. Late 2005 to March 2006: The insurer loses big at trial, brings the usual posttrial motions, then files this appeal.
There are no issues in this appeal regarding the conduct of the trial (at least, given our determination of the objective reasonability of the insurer’s denials of coverage as explained in pt. HI.B.4. below). The major point about the trial for our purposes here was the insured’s emphasis on the insurer’s reservation of rights to recoup monies paid to settle the Waters claim. The reason is that much of the trial was devoted to establishing the rather large amount of attorney fees incurred by the insured to bring its bad faith case against the insurer to trial in the first place, so as to obtain fees under Brandt v. Superior Court, supra, 37 Cal.3d 813, 817 (“When an insurer’s tortious conduct reasonably compels the insured to retain an attorney to obtain the benefits due under a policy, it follows that the insurer should be liable in a tort action for that expense. The attorney’s fees are an economic loss— damages—proximately caused by the tort.”).
In early January 2006, the jury came back with its verdicts. The jury found that the insured had paid about $1 million (all in legal fees and costs) to “collect the benefits due under the contract.” It found that the insurer had acted with “oppression or fraud or malice in doing the acts that caused” the insured to incur those fees and costs, denominated “damages” in the special verdict form. It then proceeded to award $10 million in punitive damages.
After a futile round of postjudgment motions for new trial or judgment notwithstanding the verdict in late January, the insurer filed this appeal. As noted above, the case has taken two oral arguments and two rounds of additional briefing, largely because it has taken us some time to ascertain the true nature of the Houston Oral Promise, and how it fit into the rest of the case. Indeed, counsel for the insured did not make that clear until the second oral argument in April 2009, when he candidly explained that he saw the Houston Oral Promise as a “concession” by the insurer that its original coverage position was unreasonable. (The insurer disputed that characterization.)
m. DISCUSSION
A. The Basic Three-part Paradigm for Analyzing Bad Faith Cases
By the time the trial court entertained the October 2005 motion in limine that essentially won the case for the insured, the MacKinnon case was already two years old. Accordingly, there was no question that the insurer had indeed breached the written contract of insurance when, in October 1999, it had denied the insured’s request for a defense of the district’s lawsuit stemming from the Waterses’ sewage damage claim. The trial court’s predicate ruling on which the in limine motion was based—that the insurer had breached the contract—was indeed correct.
But a breach of an insurance contract does not automatically subject an insurer to tort damages for bad faith breach. Bad faith cases are analyzed in a three-step process: First, was there a breach at all so as to warrant contract damages? Second, was the breach unreasonable so as to warrant tort damages? Third, was the breach so egregious that there is evidence of “oppression, fraud, or malice” under Civil Code section 3294, subdivision (a) so as to warrant punitive damages?
It is important to recognize the reason for the possibility of tort, and perhaps even punitive damages on top of regular tort damages, for an insurance company’s unreasonable breach of an insurance contract. Insurance contracts are unique in that, if the insurance company breaches them, the policyholder suffers a loss (often a catastrophic loss) that cannot, by definition, be compensated by obtaining another contract. (E.g., Cates Construction, Inc. v. Talbot Partners (1999) 21 Cal.4th 28, 44 [86 Cal.Rptr.2d 855, 980 P.2d 407] [“Unlike other parties in contract who typically may seek recourse in the marketplace in the event of a breach, an insured will not be able to find another insurance company willing to pay for a loss already incurred.”]; Medina v. Safe-Guard Products, Internat., Inc. (2008) 164 Cal.App.4th 105, 111 [78 Cal.Rptr.3d 672] [“The reason that insurance contracts may be enforced by tort (bad faith) as well as ordinary contract damages is that, unlike all other contracts, a policyholder who is wrongfully denied a claim cannot, by definition, obtain a substitute in the marketplace. Once it is known that the insurable loss has occurred, the insured will not be able to obtain insurance for that loss.”].)
Thus, without the possibility of tort damages hanging over its head when it makes a claims decision, an insurance company may choose not to deal in good faith when a policyholder makes a claim. The insurance company could arbitrarily deny a claim, thus gambling with the policyholder’s “benefits of the agreement.” (E.g., Major v. Western Home Ins. Co. (2009) 169 Cal.App.4th 1197, 1209 [87 Cal.Rptr.3d 556] [“The fundamental purpose of the implied covenant of good faith and fair dealing is ‘ “that neither party will do anything which will injure the right of the other to receive the benefits of the agreement.” ’ ”].) If the insurance company gambled wrong, it would be no worse off than it would have been if it had honored the claim in the first place. In effect, if the law confined the exposure of the insurance company under such circumstances to only contract damages, it would be pardoned and still retain the fruits of its offense.
On the other hand, if the coverage decision is reasonable, no lawyer has power to charm a jury into awarding any tort damages against the insurance company based on that coverage decision. As Justice Bedsworth wrote for this court in Morris v. Paul Revere Life Ins. Co., supra, 109 Cal.App.4th at page 977 (Morris): “As long as the insurer’s coverage decision was reasonable, it will have no liability for breach of the covenant of good faith and fair dealing. An insurer which denies benefits reasonably, but incorrectly, will be liable only for damages flowing from the breach of contract, i.e., the policy benefits.” (Italics added.) We therefore now turn to the question of the reasonability of this insurer’s coverage decision in October 1999.
B. The Reasonableness (or Lack Thereof) of the Insurer’s Denial of a Defense to the Waters Claim
A CGL policy (remember that the L in CGL stands for “liability”) such as the insured carried in this case typically provides two benefits: One, it will pay for liability a policyholder incurs by virtue of a lawsuit against the policyholder, at least up to a certain limit, and assuming that the terms of the policy (the risks covered) otherwise provide for such payment. The technical word for this benefit is called “indemnification.” Two, the CGL contract will also pay for a defense of any lawsuit which even might potentially result in the insurance company indemnifying, in whole or in part, the policyholder. (See generally Croskey Rutter Insurance Treatise, supra, ¶ 7:4, pp. 7A-1 to 7A-2 (rev. # 1, 2008) [“A liability insurer generally has two basic obligations to its insured: [¶] • Indemnification: First, the insurer promises to pay on the insured’s behalf (i.e., to indemnify the insured), up to the policy limits, the sums the insured shall become legally obligated to pay on account of specified risks, [¶] • Defense: Second, the insurer promises to defend any suit against the insured alleging damages payable under the terms of the policy.”].)
Since insurance companies don’t have law degrees, in practical effect the “duty to defend” means a duty to hire competent counsel to conduct the defense of a lawsuit against the policyholder. (E.g., Kroll & Tract v. Paris & Paris (1999) 72 Cal.App.4th 1537, 1542 [86 Cal.Rptr.2d 78] [“In the usual tripartite insurer-attomey-insured relationship, the insurer has a duty to defend the insured, and hires counsel to provide the defense.”].)
The big question in this case, of course, was whether the insurer’s denial of a defense to the district’s lawsuit against the insured was reasonable. But to answer this question, we must address three interrelated problems: First, do we gauge the reasonableness of the insurer’s denial on an objective standard as a matter of law (which is what the trial court here did, holding the decision unreasonable as a matter of law), or should the matter simply have been committed to the jury? Second, what is the impact of subsequent case law upon our evaluation of the insurer’s denial? In the present case, for example, the insured pointed to the subsequent MacKinnon decision which, to say the least, invalidated the rationale behind the insurer’s denial. Third, what is the nature of the “potentiality rule” that formed the basis of the trial court’s reasoning that the insurer’s denial was not reasonable?
1. A Primer on the Potentiality Rule
There is no better place to understand the potentiality rule than the nearly half-century-old fountainhead case that gave us the rule: Gray v. Zurich Insurance Co. (1966) 65 Cal.2d 263 [54 Cal.Rptr. 104, 419 P.2d 168]. There, a policyholder was sued for assault and battery—classic intentional torts not covered by insurance policies—after an altercation arising out of an auto accident. The policyholder claimed, however, that he acted in self-defense. The insurance company denied a defense of the lawsuit, reasoning that liability for intentional torts was not covered by the policy. But—insurance law’s most cited opinion ever went on to explain—there was a potential that the policyholder might be found liable not for assault and battery, but merely for the negligent use of unreasonable force in the altercation. That potential liability thus created the possibility of a judgment for a negligent tort, not an intentional one, and if the judgment came down that way, the insurance company would have to pay for it. And because the insurance company might have to pay for such a judgment, it definitely had an obligation to defend.
The next logical question is: From what facts precisely is such a potential gauged? The answer is: (a) The facts alleged in the complaint, and (b) facts known to the insurance company at the time of the coverage decision (usually the inception of the suit). (See Scottsdale Ins. Co. v. MV Transportation (2005) 36 Cal.4th 643, 654 [31 Cal.Rptr.3d 147, 115 P.3d 460] (Scottsdale).) It must be remembered in that regard, though, that the precise causes of action are not determinative of coverage. If, under the facts alleged, the complaint could be fairly amended to state a cause of action alleging a covered liability, there will be a duty to defend. (See ibid. [“Determination of the duty to defend depends, in the first instance, on a comparison between the allegations of the complaint and the terms of the policy. . . . But the duty also exists where extrinsic facts known to the insurer suggest that the claim may be covered. . . . Moreover, that the precise causes of action pled by the third party complaint may fall outside policy coverage does not excuse the duty to defend where, under the facts alleged, reasonably inferable, or otherwise known, the complaint could fairly be amended to state a covered liability.” (Citations omitted.)].)
However, the facts do not include speculative facts not in the complaint, or otherwise unknown by the insurance company. (See Friedman Prof. Management Co., Inc. v. Norcal Mutual Ins. Co. (2004) 120 Cal.App.4th 17, 34—35 [15 Cal.Rptr.3d 359] [“the universe of facts bearing on whether a claim is potentially covered includes extrinsic facts known to the insurer at the inception of the suit as well as the facts in the complaint, it does not include made up facts, just because those facts might naturally be supposed to exist along with the known facts”]; Westoil Terminals Co., Inc. v. Industrial Indemnity Co. (2003) 110 Cal.App.4th 139, 154 [1 Cal.Rptr.3d 516] [refusing to consider scenario not in facts of complaint]; Low v. Golden Eagle Ins. Co. (2002) 99 Cal.App.4th 109, 114 [120 Cal.Rptr.2d 827] [refusing to consider possibility of amendment of third party’s complaint against policyholder because it would speculate “about unpled causes of action”]; Hurley Construction Co. v. State Farm Fire & Casualty Co. (1992) 10 Cal.App.4th 533, 538-539 [12 Cal.Rptr.2d 629] [refusal to consider hypothetical amendment to third party’s complaint against policyholder]; Gunderson v. Fire Ins. Exchange (1995) 37 Cal.App.4th 1106, 1114 [44 Cal.Rptr.2d 272], quoting Hurley.)
An insurance company can thus get into trouble by refusing to consider facts it knows, but which are extrinsic to the complaint and which show, á la Gray, a potential for coverage.
The insurance company committed precisely that sort of error in Amato v. Mercury Casualty Co. (1993) 18 Cal.App.4th 1784 [23 Cal.Rptr.2d 73] (Amato I). In Amato I, the policyholder was sued by his mother-in-law for injuries arising out of an auto accident in which the policyholder was driving and the mother-in-law was a passenger. Application of a certain exclusion depended on whether the policyholder resided with his mother-in-law. The Amato I court noted the insurance company “possessed information which, if true, indicated that [he] was residing at locations other than the home of’ his mother-in-law. (Id. at p. 1789.) Despite that knowledge, the insurance company refused to defend or, after a default judgment against the policyholder, indemnify. As it turned out, though, in a subsequent bad faith action, the jury found that the policyholder did, indeed, live with his mother-in-law. (Ibid.) That fact, however, did not exonerate the insurance company. At the time of the coverage decision, the insurance company had facts in its possession, albeit extrinsic to the mother-in-law’s complaint against the policyholder, which created a potential that the exclusion did not apply, ergo there was a potential for indemnification, ergo there was definitely a duty to defend. It made no difference that a jury ultimately found that those extrinsic facts were ultimately disproven at trial.
2. The Question of an Objective Standard
Unlike Amato I, the peculiar circumstances of the case before us do not implicate any “facts known to the insurer” extrinsic to the district’s complaint against the insured, which suggest the nonapplicability of the total pollution exclusion to sewage claims. Nor has there been any attempt by the insurer to disclaim coverage based on facts outside the complaint that might establish that the liability for the sewage backup was never potentially covered in the first place, as if, for example, the insured actually “expected” the damage. (E.g., Shell Oil Co. v. Winterthur Swiss Ins. Co. (1993) 12 Cal.App.4th 715, 772 [15 Cal.Rptr.2d 815] [insurance company lawyers argued policyholder “should have known it was polluting”].)
From the beginning, the insurer’s coverage decision in this case, and the insured’s quest for a defense, was a straightforward, binary matter based on a discrete, almost pristine question of law: Did the insurer’s total pollution exclusion categorically eliminate any potential for coverage for sewage backups?
As such, we believe we are on safe ground to conclude, as indeed the trial court concluded, that the question of the reasonableness of the categorical application of the pollution exclusion to the sewage backup must be determined in this case using an objectively reasonable standard. After all, as shown especially in the MacKinnon opinion itself (see MacKinnon, supra, 31 Cal.4th at pp. 645-647 [noting multitude of court decisions in area]; cf. ACL Technologies, Inc. v. Northbrook Property & Casualty Ins. Co. (1993) 17 Cal.App.4th 1773, 1779-1783 [22 Cal.Rptr.2d 206] [canvassing decisions across country on interpretation of prior version of pollution exclusion]), the determination of the scope of the pollution exclusion in the CGL is the quintessential legal question, on which many courts in many jurisdictions opine. (See CalFarm, supra, 131 Cal.App.4th 273, 287 [“When the issue of the insurer’s objective reasonableness depends on an analysis of legal precedent, reasonableness is a legal issue reviewed de novo.”]; Chateau Chamberay Homeowners Assn. v. Associated Internat. Ins. Co. (2001) 90 Cal.App.4th 335, 346 [108 Cal.Rptr.2d 776] [reasonableness of “claims-handling conduct . . . becomes a question of law where the evidence is undisputed and only one reasonable inference can be drawn from the evidence”].) This case is not like Amato I where coverage rested on a disputed issue of fact.
The tidiest statement in the area may be found in Morris, supra, 109 Cal.App.4th 966, 973, footnote 1: “We recognize there are numerous cases reciting that ‘reasonableness’ of a defendant’s conduct is a factual question for the jury. However, the reasonableness of the legal position taken by [the insurance company here] depends entirely on an analysis of legal precedent and statutory language. Those are matters of law, not facts which can effectively be ascertained by lay jurors.”
Because it was an objective matter and thus an issue of law, the Morris court would ultimately be able to go on to affirm a summary judgment declaring that the insurance company had not acted in bad faith.
3. The MacKinnon Case
We thus determine that an explication of the MacKinnon decision is the appropriate way to determine the reasonableness of the insurer’s coverage determination under the facts of the present case.
Prior to the 2003 MacKinnon decision, there was no decision explaining the scope of either the “absolute” or the “total” pollution exclusion in California, though as we have noted in part II.B. above, for a brief few weeks in early 2002 there were two published appellate decisions which appeared to go in the insurer’s favor. The only decisions to that point had been in the context of “traditional” pollution, i.e., long-term gradual exposure. (See MacKinnon, supra, 31 Cal.4th at p. 641, fn. 1.)
MacKinnon itself arose out of the application of insecticide by a landlord. Unfortunately, the pest control company he hired failed to warn his tenant of the spraying, and her reaction to the subsequent exposure killed her. Her heirs sued the landlord, but his insurance company denied coverage, specifically withdrawing an initially provided defense after deciding that the absolute pollution exclusion precluded coverage. The withdrawal, in turn, provoked a coverage suit by the landlord. The trial court granted summary judgment to the insurance company on the strength of the absolute pollution exclusion, and the appellate court affirmed. (MacKinnon, supra, 31 Cal.4th at pp. 640-641.)
But the Supreme Court reversed. The structure of the discussion portion of the opinion bears study: First, the high court set up the problem: The scope of the absolute pollution exclusion was a big, nationwide issue: Would courts take an expansive view or a narrow view of the new pollution exclusion? The issue had generated a lot of controversy on which courts around the country were split. (See MacKinnon, supra, 31 Cal.4th at pp. 641-642, and particularly p. 642, fn. 2, noting the scoreboard as it stood to date.) The MacKinnon court surveyed the score as it stood in 2003: If we read the court’s recount correctly, it was nine jurisdictions (Illinois, Indiana, Kansas, Louisiana, Maryland, Massachusetts, New York, Ohio, Wyoming) for a narrow, i.e., propolicyholder reading of the absolute pollution exclusion, versus four jurisdictions for an expansive reading (Florida, Montana, Oklahoma, Texas) with Pennsylvania being in both camps.
The MacKinnon court then summarized the history of the CGL pollution exclusion as told by the Illinois Supreme Court in American States Ins. Co. v. Koloms (1997) 177 Ill.2d 473 [227 Ill.Dec. 149, 687 N.E.2d 72] (Koloms), plus noted the positions taken by commentators to the effect that the exclusion was intended to be limited to “traditional environmental pollution rather than all injuries from toxic substances.” (MacKinnon, supra, 31 Cal.4th at pp. 643-645.)
Next, the MacKinnon court recapitulated the arguments for and against a narrow interpretation of the pollution exclusion. (See MacKinnon, supra, 31 Cal.4th at pp. 645-647.) Readers of that portion of the opinion will note a thorough discussion of both sides, particularly of the side it would ultimately reject. Just as the MacKinnon opinion featured the Illinois Supreme Court’s decision in Koloms, by using language from that decision to demonstrate the historical case for a narrow view of the exclusion (see MacKinnon, supra, 31 Cal.4th at pp. 643-644) so did the MacKinnon court quote what the Wisconsin Supreme Court had said in Peace ex rel. Lerner v. Northwestern Nat’l Ins. Co. (1999) 228 Wis.2d 106 [596 N.W.2d 429] (Peace) in favor of a broader view of the exclusion based on its “plain language.” (See MacKinnon, supra, 31 Cal.4th at pp. 646-647.)
After restating some principles of insurance contract construction, the MacKinnon court next came to the nitty-gritty of its decision: The literal language of the absolute pollution exclusion, particularly the words “ ‘irritant or contaminant,’ ” was just “overly broad,” and thus yielded absurd results: “The application of iodine,” wrote Justice Moreno for a unanimous court, “onto a cut through an eyedropper may be literally characterized as a discharge or release of an irritant.” (MacKinnon, supra, 31 Cal.4th at p. 650.) The MacKinnon court made it clear that “interpreting an exclusionary clause so broadly that it logically leads to absurd results,” was not the course it would follow. (Ibid.; see also id. at p. 652 [“In short, because Truck Insurance’s broad interpretation of the pollution exclusion leads to absurd results and ignores the familiar connotations of the words used in the exclusion, we do not believe it is the interpretation that the ordinary layperson would adopt.”].) The court then went on to demonstrate that the more reasonable interpretation of the exclusion was that it should be limited to injuries arising from “conventional environmental pollution.” (Id. at p. 655.)
4. “Congeries of Cerebrates’’: Why MacKinnon and Morris Show the Insurer’s Decision Here Was Reasonable
The case before us is remarkably similar to Morris. Remember that in' Morris an insurance company that issued a disability policy denied coverage based on a policy interpretation that had garnered considerable, if minority, support in various jurisdictions (there the score had been seven to nine in favor of policyholders). And, as here, the insurance company’s interpretation was rejected, years later, by the California Supreme Court in a decision that settled the matter for this state. Recognizing that “so many courts” had agreed with insurance companies about what was a pure question of law, the Morris court held that the insurance company’s position was reasonable. (Morris, supra, 109 Cal.App.4th at p. 976.) In a line that recalls Brahms’s comment on Strauss’s “Blue Danube,” Justice Bedsworth summed up its rationale: “We cannot just dismiss such a congerie of cerebrates as ‘unreasonable.’ ” (Ibid.)
Another similarity was the temporary precedent favoring the insurance company’s position. In Morris, two Court of Appeal decisions—as here—had gone with the position advocated by the insurance company. And, as here, one of those two cases would end up as the Supreme Court case on point, while the other disappeared in the wake of the Supreme Court’s ultimate position. (See Morris, supra, 109 Cal.App.4th at p. 971.) That is, as in Morris, more than just one trial judge had ruled in favor of the insurance company’s position; the majority on two appellate panels had as well, plus the majority of about seven state supreme courts outside of California. Here, as shown in MacKinnon, we also have the majority of two appellate courts, and (depending on how you count Pennsylvania) four or five state supreme courts outside of California.
Morris was not just remarkably similar to the present case. It is almost on all fours.
Ironically, whatever few significant differences that do exist between the case before us and Morris actually make the conclusion stronger that Morris requires us to conclude that the denial here was reasonable.
First, in Morris, the same disability insurance company before the court had itself been the company that had litigated the issue in jurisdictions “favoring its position.” (Morris, supra, 109 Cal.App.4th at p. 976.) The policyholder argued that the insurance company was just running around the country creating favorable precedent for itself, in effect conjuring outside precedent with a deceptively pleasing shape. The Morris court rejected that line of reasoning by pointing out that the insurance company there was “entitled to be an advocate for its own interests.” (Ibid.) Here, by contrast, we perceive no special role that this insurer has taken beyond any other CGL insurance company in establishing whatever favorable precedent there is for its position. (See MacKinnon, supra, 31 Cal.4th at p. 642, fn. 2.)
The second significant difference is that in Morris there actually was one lone standing appellate precedent against the insurance company’s position, McMackin v. Great American Reserve Ins. Co. (1971) 22 Cal.App.3d 428, 439-440 [99 Cal.Rptr. 227]. To be sure, that precedent didn’t count for much because, as Morris noted that Galanty had noted, that lone precedent was “ ‘without useful discussion.’ ” (Morris, supra, 109 Cal.App.4th at p. 971, quoting Galanty v. Paul Revere Life Ins. Co. (2000) 23 Cal.4th 368, 377 [97 Cal.Rptr.2d 67, 1 P.3d 658].) Even so, it was there. The current might have been weak, but the insurance company in Morris was still swimming upstream. Here, by contrast, there was zero precedent on point against the insurer’s position at the time it made its coverage decision.
A third difference is the degree to which one can perceive a difference in the relative strength of the insurance company’s linguistic and analytical position in the two cases. The position of the insurance company was, if anything, weaker in Morris than the insurer’s position here.
Remember that Morris was a case where a disease (multiple sclerosis) had manifested itself before the inception of the policy but the claim was made after the first two years of the policy, in light of an incontestability clause which said, essentially, that the insurance company would not dispute any claim presented after two years had passed. Thus, in Morris the policyholder had the literal language of the policy’s incontestability clause going in his favor. The insurance company could only prevail if a court were to give precedence to the contract’s limitation of coverage to sicknesses first manifesting themselves after the inception of the policy over the clear implication of the incontestability clause that claims presented after two years would be honored without dispute.
By contrast, in the case before us, the insurer’s position was rooted in the literal language of the absolute pollution exclusion, so the insurer was going to win if a court were to apply the literal language of the exclusion. After all, pollution was defined to include “waste,” which is often a euphemism for sewage. Moreover, plain language remained (and remains today) an important principle of contract interpretation. Just two months prior to the MacKinnon decision, the California Supreme Court had enforced the plain language of a collapse provision in a homeowners insurance policy (Rosen v. State Farm General Ins. Co. (2003) 30 Cal.4th 1070, 1073 [135 Cal.Rptr.2d 361, 70 P.3d 351] [“By failing to apply the plain, unambiguous language of the policy, the Court of Appeal erred.”]) and, of course, the high court had invoked plain language as the governing rule numerous times before. (E.g., Palmer v. Truck Ins. Exchange (1999) 21 Cal.4th 1109, 1115 [90 Cal.Rptr.2d 647, 988 P.2d 568] [when language “ ‘is clear and explicit, it governs’ ”]; Bank of the West v. Superior Court (1992) 2 Cal.4th 1254, 1264 [10 Cal.Rptr.2d 538, 833 P.2d 545] [same].) MacKinnon itself had also noted that the Wisconsin Supreme Court in Peace had invoked the “ ‘plain language’ ” of the policy to uphold the insurance company’s position there. (MacKinnon, supra, 31 Cal.4th at pp. 646-647.)
To be sure, the MacKinnon court didn’t apply the literal language of the exclusion, finding it “overly broad,” and MacKinnon stands as a decision refusing to carry literal language to an absurd result. But surely the insurer here, facing no actual contrary language in the contract, was on firmer ground than the insurance company in Morris, which (in light of the incontestability clause) did.
5. The Insured’s Attempt to Distinguish Morris Is Not Persuasive
Readers may already have noted one other difference between Morris and the present case that did not make our list of “significant” differences: Morris was a “first party” case, where the policyholder’s loss was directly compensable by the insurance company—the relationship is direct between insurance company and policyholder. The present case is a “third party” case where the insurance company is to defend and if necessary indemnify a “third party’s” claim against the policyholder, so the compensation is indirect. There would be no problem if there weren’t a third party out there who wanted the policyholder to pay it money.
The insured here attempts to distinguish Morris solely on that difference. According to the insured here, the fact that Morris was first party and the present case is third party means that in Morris the insurer had the right to (and we now quote directly from the respondent’s brief): “ ‘argue for whatever interpretation of the law and policy language most benefited its own interests,’ so long as the interpretation was ‘objectively reasonable.’ [Morris, supra, 109 Cal.App.4th at p. 974.] That rule simply does not apply to third-party insurance coverage, where the insurer must construe the policy language favorably to the insured.” (Original italics.)
The insured here seems to be intimating that, because Morris was a first party case, the insurance company there had the right to pick its side of the legal issue which had divided courts as noted in Galanty, but here, since we have a third party situation, the insurer was obligated to side with the anti-insurance company side of the division in case law as noted in MacKinnon.
We beg to differ. The passage from the respondent’s brief betrays several points of confusion which need clearing up. Preliminarily, we should note that we are well aware of the differences between first and third party insurance. Readers who want to consult an extended discussion on the difference are referred to Garvey v. State Farm Fire & Casualty Co. (1989) 48 Cal.3d 395, 405-408 [257 Cal.Rptr. 292, 770 P.2d 704], which was a case where the difference between first and third party insurance actually did make a difference in the outcome.
a. Reasonability Is the Test in Both First and Third Party Cases
First, as far as bad faith law is concerned, we can divine no difference in basic doctrine between first party cases and third party cases under the facts of this case. The basic rule of reasonability of coverage decision holds for both first and third party insurance policies. In either case, tort damages are predicated on the policyholder’s being stuck with costs that an insurance company would have otherwise paid for, but which—after the event giving rise to those costs—now cannot be covered by another insurance contract. As we have already pointed out, imposition of a reasonability standard is required to prevent the insurance company from, in essence, denying its obligation under the contract risk-free. (See pt. III.A., above.)
It is illustrative of the settledness of the reasonability standard that, for example, Justices Moore and Fybel, who differed in CalFarm—a third party case—on the question of whether the issue of reasonability was a matter of law or, alternatively, should have been submitted to a jury in the case, both agreed with each other in R & B Auto Center, Inc. v. Farmers Group, Inc. (2006) 140 Cal.App.4th 327 [44 Cal.Rptr.3d 426]—also a third party case— that because the insurance company’s position was reasonable, there was no tort liability. (Compare id. at p. 354 (maj. opn. of Moore, J.) [“At the time Truck Insurance evaluated the claim, it was reasonable to deny it.”] with id. at p. 374 (dis. opn. of Fybel, J.) [“I concur in the majority’s affirmance of the trial court’s decisions in favor of defendants on the causes of action for breach of contract, breach of the implied covenant of good faith and fair dealing, and breach of fiduciary duty.”].)
b. A Third Party Insurer Has the Right to Make a Reasonable Coverage Decision Even if It “Benefits Its Own Interests”
The insured’s assertion that the insurer had no right to take a legal position on policy language that “benefited its own interests” is an attempt to set up a kind of mousetrap for liability insurance companies. The trap is that if a liability insurance company proffers a legal position regarding a matter of pure contract interpretation in its own “interest”—just like any other litigant might do in a contract—it ends up proclaiming its own bad faith.
No. As the court in Love v. Fire Ins. Exchange (1990) 221 Cal.App.3d 1136 [271 Cal.Rptr. 246] (Love), pointed out, insurance companies do not stand in a fiduciary relationship with policyholders, though the unique nature of insurance contracts may make the relationship “akin” to a fiduciary one. Thus: “Unique obligations are imposed upon true fiduciaries which are not found in the insurance relationship. For example, a true fiduciary must first consider and always act in the best interests of its trust and not allow self-interest to overpower its duty to act in the trust’s best interests.” (Id. at p. 1148, itali