Insureds May Not Sue Excess Insurers Before Exhaustion of Underlying Limits

On September 5, 2024, the California Court of Appeal held that insureds must establish the exhaustion of all underlying limits before they may bring suit against excess insurers. Fox Paine & Co., LLC v. Twin City Fire Ins. Co., ___ Cal.Rptr.3d ___ (Sept. 5, 2024), 2024 WL 4093921. The Court affirmed dismissal of plaintiffs’ third amended complaint (“TAC”), in which they asserted claims for breach of contract, declaratory relief, bad faith, and aiding and abetting breach of fiduciary duty. In its discussion of all four of these causes of action, the Court clarified California law on several points, including that: (1) a breach of contract claim may not lie without exhaustion of underlying limits; (2) a claim for declaratory relief requires that a plaintiff plead facts establishing all elements of the cause of action at issue; and (3) an excess insurer does not waive policy terms by participating in a settlement.

In Fox Paine, Partners to a private equity management firm, originally called Fox Paine & Company (“FPC”),[1] sued each other and related entities in a series of suits in Delaware, New York, and then California. Several insurers provided FPC with $50 million of private equity professional liability insurance in vertical layers of $10 million each. Houston Casualty Co. (“Houston”) issued the primary insurance and paid policy proceeds to settle the initial Delaware action in 2012. 

In 2014, certain insureds sued Houston in New York state court for wrongfully distributing policy proceeds to other insureds as part of the Delaware settlement. This action settled as well. 

In 2017, several FPC entities sued the excess insurers in California, alleging damages, including interest, within the excess layers. The trial court granted the demurrers, without leave to amend, filed by the second, third and fourth level excess insurers, as to all four causes of action. 

The Court of Appeal affirmed the trial court.

Breach of Contract: The Court of Appeal held that plaintiffs had not asserted a valid breach of contract claim against the second, third, and fourth level excess insurers. Exhaustion of the underlying limits was an essential term of the excess policies, and the TAC did not allege facts supporting exhaustion of the first excess layer. Id. at *17, citing Iolab Corp. v. Seaboard Sur. Co. 15 F.3d 1500, 1504 (9th Cir. 1994) (excess insurers should not bear cost of litigating claim that may never trigger their coverage). The insurer that issued the first layer was not dismissed because the primary limits had been exhausted.

Plaintiffs asserted that interest charges increased the amount in controversy, but the Court noted that the policy at issue specifically excluded coverage for interest. Furthermore, it held that, on demurrer, a court assumes only the truth of facts pleaded, not conclusions of law. The allegation that interest is “covered loss” was a conclusion of law. 

Declaratory Relief: Plaintiffs argued that, even without alleging exhaustion, they had alleged a valid claim for declaratory relief with allegations of an actual controversy relating to the legal rights and duties of the respective parties. Id. at 22-23, citing Ludgate Ins. Co. v. Lockheed Martin Corp. (2000) 82 Cal.App.4th 592. In Ludgate, another Court of Appeal had stated: “Exhaustion is merely an issue of proof and entitlement to recovery, not of pleading.” However, the Fox Paine Court noted that the Ludgate plaintiffs had actually alleged facts demonstrating exhaustion. Therefore, the statement relied upon by plaintiffs was dictum and incorrect. Thus, Fox Paine held that a declaratory relief action requires that a plaintiff plead all elements of the underlying breach of contract claim, including exhaustion of underlying insurance. 

Waiver: The insurer that issued the second excess layer had paid some proceeds toward settlement of the earlier litigation. Plaintiffs argued that the insurer waived its right to assert exhaustion. The Court disagreed, noting that public policy favors settlements and parties may negotiate for peace without prejudicing their rights. Id. at *29, citing Western Steamship Lines, Inc. v. San Pedro Peninsula Hospital (1994) 8 Cal.4th 100, 110 (the law favors settlements); Potter v. Pacific Coast Lumber Co. of California (1951) 37 Cal. 2d 592, 600.

Furthermore, the Court held that the insurer’s settlement payment could not waive a policy term because the policy included an integration/merger clause. That clause stated that the terms of the policy shall not “be waived or changed except by written endorsement or rider issued by the insurer to form a part of this policy.” Therefore, oral statements or conduct could not modify the clear language of the policy. Id. at 31, citing Haggard v. Kimberly Quality Care, Inc. (1995) 39 Cal.App.4th 508, 521. 

Aiding and Abetting Breach of Fiduciary Duty: Plaintiffs asserted this cause of action against one of the insurers for paying policy proceeds toward a settlement, and thereby funding further litigation. In addition to other analyses, the Court noted that this cause of action requires a conscious decision to participate in the tortious activity. The Court concluded that the settlement payment did not demonstrate participation. In any event, the parties to the underlying disputes were no longer fiduciaries by the time of the settlement. 

Leave to Amend: In denying further leave to amend, the Court noted that a plaintiff must meet the burden of showing a reasonable possibility that an amendment will cure the defect. It is not enough to state that such a possibility exists. Id. at *39, citing, Campbell v. Regents of University of California (2005) 35 Cal.4th 311, 320; Schifando v. City of Los Angeles (2003) 31 Cal.4th 1074, 1081; Fuller v. First Franklin Financial Corp. (2013) 216 Cal.App.4th 955, 962. Plaintiffs had not met that burden here, as they merely cited the boilerplate rule. 

Overall, the Fox Paine Court’s analysis clarified existing law on exhaustion and waiver issues. One might argue that a split in authority remains as to whether a plaintiff must allege exhaustion of underlying limits to assert a declaratory relief claim against an excess insurer. However, the Fox Paine Court noted that the contrary language in Ludgate was dictum. It remains to be seen whether the California Supreme Court will grant review and weigh in on the issue.