Opinion
I. Introduction and Background
This аppeal is but one round in the complex, bitter legal battle between the defrauded investors of Technical Equities Corporation (Technical Equities) and its insurer—appellant National Union Fire Insurance Company of Pittsburgh, Pa. (National Union). At stake are millions of dollars in insurance proceeds to pay for claims which the investors pursued against the officers and directors of Technical Equities and over $140 million in damages later assessed against National Union.
Plaintiffs’ action 2 is for declaratory relief to determine the scope of coverage under the “Directors and Officers Liability and Corporation Reimbursement” policy of insurance which Technical Equities took out with National Union for the three-year period from August 1, 1984, to August 1, 1987. Technical Equities prepaid its $30,290 premium in return for $10 million in coverage for each policy year.
National Union concedes there is $10 million in coverage for the second policy year. At issue is whether there is coverage under the first and third policy years, and whether the policy itself is a wasting asset, so that defense costs are included within the policy limits of $10 million per year.
The trial court ruled against National Union on all three issues. The judgment in this case and in the companion case of Chatton v. National Union (Super. Ct. Santa Clara County, 1991, No. 600306*) (involving coverage under a comprehensive general liability (CGL) policy) set the stage for two insurance bad faith suits against National Union brought on a coordinated basis by over 500 investors. McLaughlin et al. v. National Union (Super. Ct. Santa Clara County, 1991, No. 666839), combining seven plaintiff groups on a test case basis, resulted in judgment against National Union for $48,943,165.45, including $43 million in punitive damages for all plaintiffs. Abelson v. National Union (Super. Ct. Santa Clara County, 1991, No. 666840), in which National Union was found liable to all remaining plaintiffs, resulted in judgment of $120,500,181. (Both McLaughlin and Abelson are also on appeal, albeit not yet fully briefed.)
We conclude that (1) defense costs reduce the policy’s liability limits and (2) there is $20 million available under the policy to pay for second and third year claims. Accordingly, we reverse in part and affirm in part.
A. Introduction
National Union’s first challenge is to the trial court’s ruling that defense costs do not deplete the limits of liability available under the policy to pay for claims. Upon reconsideration of its summary adjudication ruling, the court concluded: “The National Union 1984-1987 D&O policy is not ‘wasting’ or ‘self-consuming,’ and National Union is obligated to pay the reasonable costs, charges and expenses of defense, including attorneys’ fees of any insured under the policy, in addition to the limit of liability.” The court reasoned that any “self-consuming” provisions were contrary to the reasonable expectations of the insureds, as a matter of law. Moreover, it concluded the policy was ambiguous, “such that a normal insured would not be aware of its ‘self-consuming’ nature.”
The defense obligations of D&O carriers typically differ in nature and scope from the defense obligations of general liability carriers. For example, D&O policies generally do not obligate the carrier to provide the insured with a defense. More likely, they require the carrier to reimburse the insured for defense costs as an ingredient of “loss,” a defined term under the policy. (See 1 Hutcheon & Thompson, Business Insurance Law and Practice Guide (Matthew Bender ed. 1992) Directors’ & Officers’ Liability Insurance, § 3.06[1]; Knepper & Bailey, Liability of Corporate Officers and Directors (4th ed. 1988) Liability Insurance § 21.09, pp. 705-709; Harley, Directors’ and Officers’ Liability Insurance (PLI ed. 1990) pp. 326-329.) This being the case, it is the insured, or the insured with the mutual agreement of the insurer, who selects defense counsel and controls the defense of the underlying case.
How the carrier’s reimbursement obligation specifically interfaces with the limits of liability in a given D&O policy can only be determined by examining the language of that policy. This we do hand in hand with the familiar tools of contract interpretation.
The overriding goal of contract interpretation is to give effect to the parties’ mutual intentions as of the time of contracting. (Civ. Code, § 1636.) Where contract language is clear and explicit and does not lead to an absurd result, we ascertain this intent from the written provisions and go no further. (Civ. Code, §§ 1638, 1639;
AIU Ins. Co.
v.
Superior Court
(1990)
A policy provision is ambiguous if it is capable of more than one reasonable construction.
(Producers Dairy Delivery Co.
v.
Sentry Ins. Co.
(1986)
B. Discussion
Our analysis of this D&O policy uncovers no ambiguity concerning its “self-consuming” nature. The plain terms of the policy make it clear that defense costs are payable against the limits of liability just like any other element of “loss” 3 as defined in the policy. We arrive at this conclusion by examining the policy as a whole and the interplay between the defined concept of “loss” and various related provisions.
First, in the insuring clause National Union promises to pay on behalf of the insured officers and directors
“against loss . .
. arising from any claim or claims which are first made against the Insureds . . . during the policy period by reason of any Wrongful Act... in their respective capacities as Directors or Officers.” (Italics added.) Next, clause 5 (titled “Limit and Retention”), paragraph (b) as amended states: “[T]he Insurer’s liability for any claim or claims made against it shall . . . be the amount stated in Item 3 of the Declarations which shall be the maximum liability of the Insurer in
Finally, endorsement No. 3, captioned “Costs, Charges and Expenses and Defense Included in Limit of Liability,” replaces the predecessor clause No. 6 (captioned only “Costs, Charges and Expenses and Defense”) in its entirety. It states in pertinent part that when payment not exceeding “the Limit of Liability has to be made to dispose of a claim, costs, charges, expenses and settlements shall be payable up to the Limit of Liability . . . .” 4
From these provisions it is apparent that the term “loss” is the dollar amount which a director or officer must pay for a claim, and that such amount embraces damages as well as the costs of defense. It is further apparent that National Union’s maximum liability for claims is $10 million in each policy year. Finally, when payment not exceeding the limit of liability must be made to dispose of a claim, costs, charges expenses and settlements are payable up to the limit of liability. We agree with National Union that these provisions are clear and reasonably mean only one thing: defense costs accrue against the policy’s limit of liability.
Plaintiffs first counter that the issue whether the D&O policy is self-consuming is moot because defense costs have been paid from and allocated to the CGL policy, and the D&O policy expressly excludes coverage for payment on claims insured by another policy. They rely on testimony and a colloquy betwеen the court and National Union’s counsel during the Chatton trial. This testimony showed that some $23 million apparently was booked to the CGL policy. However, prior to the court’s ruling on the self-consuming issue in this case, some $1.5 million was charged against the D&O policy, and all costs of defending directors against criminal proceedings have been charged against the D&O policy. More importantly, National Union deserves appellate review of the self-consuming issue because the jury in McLaughlin was instructed that the D&O policy was not a wasting asset, and presumably those instructions were taken into account when the jury found National Union liable for bad faith.
Plaintiffs further contend that the endorsement No. 3(a)(i) language that costs of defense “shall be payable up to the Limit of Liability” is ambiguous. They posit that it could mean that these costs would be paid separately up to the limit, i.e., there is a $30 million cap on coverage for claims and an additional $30 million cap on defense costs. This is an absurd interpretation-—one which could not possibly, let alone reasonably, stem from a policy which defines defense costs as an element of loss and which states in the capitalized title to the endorsement that defense costs are “included in limit of liability.”
Then, in their response to the amicus curiae brief of Continental Casualty Company, plaintiffs also argue that endorsement No. 3 completely removes the original paragraph’s restriction on defense costs in the present circumstances where payment to dispose of a claim will exceed the policy’s limit of liability. 5 The original clause provided that in such cases National Union had to pay defense costs over and above the limit of liability, but only on a pro rata basis. The new clause per endorsement No. 3 does not specifically address the situation where losses exceed the limit of liability. Thus, plaintiffs urge that the broad language of endorsement No. 3, paragraph (a) applies, requiring National Union to pay 95 percent of all defense costs, there being no other cap.
But there is another cap. Plaintiffs ignore the fact that the broad endorsing language of paragraph (a) also subjects National Union’s obligation to pay defense costs to the provisions of clause 5(b), which state that the insurer’s
Plaintiffs also maintain that National Union knows how to be clear when it wants to, quoting from a revised D&O policy used after 1984: The following notice appears at the top of the declarations page: “Notice: The Limit of Liability Available to Pay Judgments or Settlements Shall Be Reduced by Amounts Incurred for Legal Defense. Further Note That Amounts Incurred for Legal Defense Shall Be Applied Against the Retention Amount.” We agree that this statement is simpler and clearer than the statement in question. However, the policy, read as a whole, is not legally ambiguous on whether defense costs apply against coverage limits.
Plaintiffs next argue that case law supports their conclusion that defense costs do not deplete policy limits. (Citing
Planet Ins. Co.
v.
Mead Reinsurance Corp.
(9th Cir. 1986)
It is true that the reviewing court in each case rejected the insurer’s argument that defense costs diminished the insured principal sum. However, it is equally true that in each case there was a linguistic basis for interpreting the policy in favor of the insured on this key point.
6
We do not have an ambiguous policy here, and the language plainly provides that defense costs
III. First Year Claims
National Union next attacks the trial court’s ruling that $10 million was available under the policy for first year claims. Its argument is threefold: There were no claims made in thе first year because (1) no investor demanded money or services on account of a wrongful act; (2) no investor asserted liability against an individual officer or director; and (3) no one gave notice to National Union of any claim.
A. Findings and Judgment Below
The trial court referred the factual issue of first year claims to a special master who heard testimony from 24 investors. Each testified that he or she attempted to liquidate an investment during the first policy year. Typically, the investor contacted the officer 7 familiar with the account and instructed that officer to liquidate. Typically, the investors had been assured by an officer of the company that their investments were liquid and could be cashed out easily. In some cases the investors wanted to liquidate for personal reasons; many were displeased with the company and/or the performance of the particular security. Repeated attempts were made to move the officer to liquidate. In a few cases the investor obtained partial liquidation but in most cases none.
B. “Claims Made” Policy
The National Union policy is a “claims made” policy, 8 identified as such on the declarations page. The insuring clause specifically commits National Union to pay (1) against loss, (2) arising from any claim or claims first made against the insureds during the policy period, and (3) by reason of any wrongful act in their capacities as officers or directors.
The parties strongly disagree on whether there is substantial evidence to support the finding that claims were made against directors and officers during the first policy year. We need not resolve this conflict because we agree with National Union that there can be no compensable first year claims absent notice thereof by the insureds or the company in that year. No one—not the company, the directors or officers, or the investors— reported a claim to National Union during the first policy year.
Clause 7(a) of the policy, captioned “Loss Provisions,” states: “The time when a loss shall be incurred within the meaning of this рolicy shall be the date on which the Company ... or the Insureds shall give written notice to the Insurer as hereafter provided.” It further provides that as a condition precedent to the insureds’ right to be indemnified, the company or the insured must “give to the Insurer notice as soon as practicable in writing of claims made upon the Insureds.” Finally, the declarations page and limit of liability clause set National Union’s maximum liability for any claim or claims at $10 million each policy year.
From these provisions, National Union asserts there is no insured loss until notice is given and, thus, whether there is coverage in any one policy year depends upon when or if that notice is given. 9
Plaintiffs counter that nowhere does the policy say that the insureds must give notice to National Union during a policy year in order for coverage to apply for that year. They insist the policy language does not shed light on the importance of the timing of when a loss is incurred, nor does it link that time with the $10 million limit of liability per policy year or explain the significance of that limit. They point out that the insuring clause provides coverage for losses arising from claims made during the policy period against the insured, not for claims reported to the insurer during the policy period, although written notification at some unspecified point in time is a condition precedent to indemnification.
The policy is not crystal clear, and plaintiffs are right that it does not expressly state what National Union contends it means, namely, that there is $10 million of coverage per policy year for claims made against the insured and reported to the insurer. The surface lack of clarity lies in the fact that the insuring clause defines National Union’s liability in terms of loss (the insurer must pay “against loss” arising from claims “made during the policy period”), whereas the limit of liability endorsement is phrased in terms of maximum liability in a policy year for claims made against it. Tacked on in clause 7 is the concept that loss is incurred upon notice to National Union.
Nonetheless, the policy, taken as a whole, is not ambiguous. First, we have already explained that the policy definition of “loss” directly links covered
D. Notice-prejudice Rule
Plaintiffs also invoke California’s “notice-prejudice” rule, arguing that in order to avoid coverage on notice grounds, National Union must (but did not) demonstrate actual and substantial prejudice arising from delay in receipt of notice. The notice-prejudice rule operates to prevent an insurance comрany from denying coverage based on a breach of the policy’s notice requirements unless the insurance company shows actual prejudice from the delay. (See
Campbell
v.
Allstate Ins. Co.
(1963)
California courts are of two minds as to whether the “notice-prejudice” rule applies to claims-made policies. In 1970, this district said it did, relying on
Campbell
and refusing to analytically distinguish occurrence from claims-made policies.
(Northwestern Title Security Co.
v.
Flack
(1970)
Flack and Mt. Hawley do not concern the interplay between notice and coverage, and do not discuss the notice-prejudice rule in terms of the special features of a claims-made policy or the type of policy language at issue here. Rather, they deal with whether the insurer can defend on the basis of breach of the notice provisions.
Plaintiffs characterize the policies in Slater and Pacific Employers as “claims made and reported” policies, as contrasted with a pure “claims made” variety which they contend accurately reflects the National Union D&O policy. Whatever label one wishes to use, we have resolved that this policy contains a reporting element essential to coverage because, according to its terms, a loss, which triggers coverage, does not occur until notice of the underlying claim is given.
In any event, we line up with the reasoning expressed by the courts in Pacific Employers and Slater. Clause 7(a) makes notice an element of coverage; the issue is not one of failure to give timely notice. Subjecting this policy to the notice-prejudice rule would materially alter the insurer’s risk. The hallmark of a “claims made” policy is that exposure for claims terminates with expiration or termination of the policy, thereby providing certainty in gauging potential liability which in turn leads to more accurate calculation of reserves and premiums. The benefit to the insureds is that the insurer can make coverage more available and cheaper than occurrence policies. (See Pacific Employers Ins. Co. v. Superior Court, supra, 221 Cal.App.3d at pp. 1359-1360.)
E. Coverage for Potential Claims
Under National Union’s pоlicy, coverage also extends to actual claims arising from potential claims which are reported to the insurer during the
Plaintiffs maintain that by classifying subsequent, actual claims arising from a reported occurrence as claims “made during the currency” of the policy period—rather than during the policy year in which notice was given—clause 7(c) eliminates the concept of distinct policy years and the attendant limit of liability per policy year. In its place steps the broader concept of the policy period. Under their analysis, the second year notice of potential claims converts the annual limit of liability into an aggregate $30 million in coverage for the three-year period and, thus, it becomes irrelevant whether actual claims were made in the first year. They remind us that Technical Equities prepaid a three-year premium of $30,290 for coverage during the three-year policy period and that the insuring clause guarantees coverage against loss “arising from any claim or claims which are first made against the Insureds . . . during the policy period . . . .” (Italics added.)
Plaintiffs highlight as supporting their position the only reported decision discussing National Union’s clause 7(с)
language—National Union Fire Ins. Co.
v.
Ambassador Group
(E.D.N.Y. 1988)
The court in
Ambassador Group
rejected National Union’s contention that clause 7(c) restricted its liability to $3 million for one policy year rather than the $6 million plaintiffs claimed was available. It explained: “This paragraph thus provides for certain limited instances in which a claim that is subsequently made will relate back to prior notice of an occurrence. If the Company becomes aware of and gives the Insurer written notice of an occurrence that may give rise to a claim, then any claim subsequently made ‘will be treated as a claim made during the
currency hereof
(italics added). Significantly, this provision does not indicate that the claim will relate back to the specific policy year during which notice of an occurrence was given, but, rather, more generally provides that the subsequent claim will be treated as a claim made during the currency of the policy. Thus, the provision appears to be designed to protect the insureds. If they notify the insurer of an occurrence that may give rise to a claim, and the claim is not actually asserted until after the Policy expires, then the claim will relate back to the ‘currency’ of the Policy, [ft] The construction that National Union attempts to give this provision is strained and inconsistent with the plain terms of the Policy. . . . [Its] interpretation, taken to an extreme, would effectively permit National Union to limit its maximum aggregate liability to three million dollars rather than the nine million dollars provided for in the Policy.”
(Ambassador Group, supra,
Plaintiffs charge that clause 7(c) at best is ambiguous because it leaves open the question of how to allocate claims made after a notice of occurrence, echoing the
Ambassador Group
court. (“The language in paragraph 7(c), however, is at best ambiguous. In such a situation, it is axiomatic that the Policy is to be construed against the insurer.”
(Ambassador Group, supra,
Note, however, that we do not agree with the use to which National Union wishes to put this clause, namely, that all losses stemming from actual second and third year claims would be tunneled into the second policy year because that is when Technical Equities gave comprehensive notice of occurrences. Thus, National Union asserts there is no third year coverage because the second year report attributes all subsequent claims and losses to that year. 12
National Union loses this argument because it imposes a hierarchy on the notice provisions that defeats coverage. Clause 7 details the notice requirements for actual and potential claims. We have both in this case—second year notice of potential claims, and second (and third year) 13 notice of actual claims.
Is the notice of occurrence provision superior to the notice of claim provision? Clause 7(a) tells us to attribute loss to the date of notice, but does not tell us how to resolve competition between the two types of notice. We must resolve this ambiguity in favor of the insureds. Therefore, we conclude the concept of subsequent claims developed in clause 7(c) for all practical purposes refers only to claims made
after
the policy expires and, thus, this provision is inapplicable to claims made during the policy period. (See
Ambassador Group, supra,
Finally, National Union, trying to argue fairness and common sense, explains that by assigning all claims to the policy year in which notice of the occurrence was given, the policy limits of subsequent years are preserved for unrelated claims. Thus directors and officers who are vicariously liable or who are not involved in a reported occurrence are assured that their coverage will not be reduced or eliminated by the wrongful acts of other directors and officers who reported occurrences in a prior policy year. In certain limited situations this might be the case, depending on whether claims are actually made based on the reported occurrence, whether those claims are lodged before other directors and officers can lodge their claims, and whether those claims absorb all the coverage. The policy, however, simply does not attempt to establish a “per occurrence” cap on losses or otherwise ration coverage among the various insured directors and officers. Needless to say, National Union’s apparent concern about preserving coverage for other directors and officers is self-serving—the impact of its argument in this case is to eliminate an entire year of coverage—not to preserve it for someone else.
IV. Third Year Coverage
National Union finally protests the trial court’s ruling on third year coverage. It advances several theories. We have already rejected the contention that all lawsuits filed in the third year are subsumed under the second year because they were preceded by a comprehensive notice of occurrences in that year. The remaining arguments center on the proposition that the policy was properly cancelled in the bankruptcy proceeding before inception of the third policy year, therefore precluding any scrutiny here of the propriety or effect of cancellation.
A. Factual Background
The policy gives National Union the right to cancel upon 30 days’ written notice to Technical Equities. The policy also directs the company to act on behalf of the insured directors and officers with respect to the giving and receipt of notice of cancellation.
In May 1986—three months after Technical Equities filed for protection under the Bankruptcy Code—National Union gave written notice of cancellation effective the following month. At that time it also denied the existence
Counsel for National Union and Technical Equities then struck a deal whereby National Union wоuld cancel the existing policy and issue a new policy covering postbankruptcy acts of directors and officers of the DIP. National Union would also provide coverage for a period of extended discovery for prepetition acts as provided, upon election, under the original policy. The premiums for the new policy and for extended discovery would equal the unearned premium on the cancelled policy.
Counsel for the two entities then moved for an order approving the compromise and served notice of the hearing to the directors and officers of Technical Equities (or their attorneys) and others.
On July 28, 1986, the Honorable Lloyd King of the United States Bankruptcy Court, Northern District of California, held a short hearing on the motion and two other Technical Equities matters. None of the directors or officers appeared personally or through counsel at this hearing. Counsel for Technical Equities briefly described the compromise and asked for the court’s approval. The court asked about coverage for claims based on prepetition conduct. Counsel explained that claims made until cancellation would be covered under the old policy and subsequent claims based on prepetition acts made within a year of cancellation would be covered under the extended discovery clause. 14 However counsel did not explain that under the policy, these postcancellation claims would be allocated to the liability limits for the second policy year. On August 5 the court filed its order approving the compromise.
Thereafter, National Union went to federal district court in an unsuccessful attempt to halt enforcement of any judgment that might be entered against it in this case and the coordinated bad faith actions. National Union claimed the bankruptcy order barred entry of any judgment against it for bad faith to the extent the judgment was predicated on coverage for the cancelled policy period. The Ninth Circuit Court of Appeals summarily affirmed the district court’s decision.
National Union launches a broad-based attack on the trial court’s decision on third year coverage. Its opening assertion is that we should honor the “consensual” cancellation between itself and Technical Equities, DIP. It then argues that none of the injured investors have vested rights in the liability limits of the third policy year because the policy was cancelled before any third year claims could be made and reported. Third, National Union maintains the present declaratory relief action is an impermissible collateral attack on the bankruptcy court order approving the compromise. Finally, it asserts that any party who received notice of the July 28 hearing, including any officer or director, could have challenged the compromise but did not. As to these people and their privies, including plaintiffs, National Union contends the bankruptcy order is res judicata. We take these arguments in order and conclude with an analysis of the plaintiffs’ claim that National Union pursued cancellation in bad faith.
B. “Consensual" Cancellation
National Union first maintains that we should respect the “consensual” cancellation between itself and Technical Equities, DIP because it comported with all policy requisites. It reminds us that the policy gives the carrier and the insured company the mutual right to cancel—the company at any time by written notice or surrender of the policy, the carrier by 30-day written notice. Since nowhere is notice to the directors and officers called for, National Union contends that should end this matter.
Not so. Compliance with contractual provisions governing cancellation does not seal the legal validity of National Union’s actions in pursuing cancellation.
C. Vested Rights
National Union next urges that plaintiffs and other injured investors have no standing to question the order approving the compromise because they have no vested rights in the policy’s third year coverage. This is so, it argues, because the policy was cancelled during the second year, before anyone could assert, let alone report, a claim which would tap the liability limits of the third policy year. National Union’s argument is flawed. It is the directors and officers who have standing to raise the issue of third year coverage, the ultimate question being whether the compromise and cancellation cut off their rights to the liability proceeds for that policy year. If, as is the case, the answer is no, then the former directors and officers have $10 million in third year coverage which is available to pay for losses of third year claimants.
For purposes of standing to bring this declaratory relief action, plaintiffs have an “interest” in determination of the issue of third year coverage because they are direct assignees of a portion of the right, title and interest of certain former directors in the policy. (Code Civ. Proc., § 1060: “Any person interested . . . under a contract, or who desires a declaration of his rights or duties with respect to another . . . may, in cases of actual controversy relating to the legal rights and duties of the respective parties, bring an original action ... for a declaration of his rights and duties in the premises. . . .”) The former officers and directors, in turn, were nominal defendants in this action. Many of them cross-complained against National Union sеeking, among other relief, a declaration as to outside limits of the policy. They participated throughout the proceedings and it was efficient and proper for the court to declare the extent of coverage available to them under the policy, including the third policy year thereof.
The bankruptcy court order approving the compromise is final—no one appealed from it or brought a direct attack seeking relief from the order. National Union maintains that the instant declaratory relief action is an impermissible collateral attack on that order and an abuse of the principle of judicial comity.
We do not classify this lawsuit as a collateral attack on the bankruptcy order. Rather, plaintiffs are seeking a declaration that the insureds are entitled to the liability limits of the third policy year precisely because the bankruptcy order did not impact or determine rights as between the insurer and its insureds. 16
Bankruptcy proceedings operate in rem
(Levy
v.
Cohen
(1977)
Therefore, while the results of the order were to approve a cancellation agreed upon between National Union and Technical Equities, DIP and set in place a new policy covering the directors and officers of the DIP, the order did not cut off or determine the preexisting rights of the former directors and officers to the policy proceeds, or alter the preexisting duties of National Union to its insureds. These rights and duties have nothing to do with the debtor’s property. The insureds had a preexisting right to third year coverage absent a good faith cancellation. If, as the trial court found, National Union did not act in good faith in seeking cancellation, it follows that the directors and officers remain entitled to the benefits of third year coverage.
Recently, the Ninth Circuit, in a somewhat similar situation, rejected the argument that a third party’s declaratory relief suit was a collateral attack on
So, too, the bankruptcy court order here did not purport to determine the rights of the insured directors and officers under the policy. Thus we conclude that the real issue framed by this lawsuit is not whether it is an impеrmissible collateral attack on a final bankruptcy court order, but whether the doctrine of res judicata bars plaintiffs’ efforts to raise the issue of National Union’s bad faith.
E. Res Judicata Analysis
A judgment or order of a bankruptcy court, once rendered, is final for purposes of res judicata until reversed or modified on appeal or set aside in the rendering court.
{Levy
v.
Cohen, supra,
No one disputes that issues concerning the directors’ and officers’ rights to the third year policy proceeds, and National Union’s corresponding obligations, were not litigated at the compromise hearing. Three issues are disputed: whether the directors and officers could have litigated these matters; whether plaintiffs could have contested the compromise; and whether plaintiffs’ interests were represented by others present at the hearing.
(1) Directors & Officers
Plaintiffs assert some claims against National Union as assignees of the directors and officers and, therefore, they are privies of the insureds. (See
Woolett
v.
American Employers Ins. Co.
(1978)
The notice recited that: (1) The policy was for the period August 5, 1984, to August 5, 1987; (2) Technical Equities “paid the entire premium due for the three years covered by the Policy, which' contained a $10,000,000 liability limit, subject to specified terms and conditions”; (3) “The compromise set forth in the Motion is in the best interest of the estate and creditors”; (4) Technical Equities will agree that the policy is cancelled effective July 13, 1986; (5) National Union will agree to issue a new policy covering acts of the officers and directors of Technical Equities, DIP arising after the bankruptcy and to provide one year extended discovery under the old policy; (6) the unearned premiums would be allocated to the cost of the new policy and the discovery tail; (7) “The complete terms оf the compromise are set forth in the Motion. Copies of the Motion and the exhibits thereto, including the Policy . . . are on file with the court”; and (8) “Any interested party that objects to the Motion must file with the court . . . written notice of any objections . . . within ten (10) days after service of this notice.”
National Union first calls attention to
Matter of Gregory
(9th Cir. 1983)
The court in
Gregory
held that when a creditor “receives any notice from the bankruptcy court that its debtor has initiated bankruptcy proceedings, it is under constructive or inquiry notice that its claim may be affected, and it ignores the proceedings to which the notice refers at its peril. ‘Whatever is
Similarly, a bankruptcy court recently explained that a notice under Federal Rules of Bankruptcy Procedure, rule 2002 17 is not intended or required to fully explain the circumstances of the case—a notice is a notice, not a case history, and details can be obtained by proсuring copies of the underlying motion and agreement, as stated in the notice. (In re Lee Holding Co. (Bankr. S.D.Ohio 1990) 120 Bankr. 881, 889-890.)
Citing these and other cases, National Union asserts the directors and officers were on inquiry notice that their interests could be affected; the notice itself indicated that the motion and copies of the policy were on file with the court; had they made inquiry, they would have discovered the need to protect their interests.
Although
Gregory
contains broad language about inquiry notice from documents served in a bankruptcy case, the facts show an unsecured creditor claiming he did not realize he would receive zero payments under the debtor’s chapter 13 plan when the actual notice said: “ ‘The debtors’ plan does not propose payment of unsecured creditors.’ ”
(Matter of Gregory, supra,
Moreover, Gregory concerned the initial meeting of creditors and the confirmation hearing on the debtor’s plan, the heart of proceedings involving an individual debtor. The notice was the first notice any creditor would personally receive that its debtor had initiated bankruptcy proceedings; whatever plan that was confirmed would bind the debtor and each creditor. (11 U.S.C § 1327(a).) The confirmation hearing affords any party in interest the opportunity to object to confirmation of the plan. (11 U.S.C. § 1324.) How else would the creditor protect his or her unsecured claim but by attending the creditor’s meeting and confirmation hearing? Even if the order said nothing about payment of unsecured creditors, under these circumstances the creditor is on inquiry notice that his or her claim is potentially impaired.
We note that it is the practical effect of notice that carries constitutional significance. When the action involves possible deprivation of an individual’s property rights, due process requires that “[t]he notice must be of such nature as reasonably to convey the required information, [citation], and it must afford a reasonable time for those interested to make their appearance . . . .”
(Mullane
v.
Central Hanover Tr. Co.
(1950)
(2) Status as Unsecured Creditors
In their bad faith action against National Union, plaintiffs also pursue some claims directly against the insurer rather than as assignees of the insured directors and officers. National Union reasons that the order approving cancellation is res judicata evеn as to plaintiffs when they don their own hats because, as unsecured creditors of Technical Equities, they were parties to the bankruptcy proceedings and are deemed bound by the resulting orders. (Citing
Levy
v.
Cohen, supra,
More importantly, while plaintiffs may have claims against Technical Equities in the abstract, the record does not reveal that they have identified themselves as creditors of the company. We find nothing indicating they have filed proofs of claim or otherwise asserted their interests in the bankruptcy proceedings. Instead, they have pursued actions against the negligent corporate officers and directors. Thus, there is no substantial identity of interest between plaintiffs as injured investors and the unsecured creditors who are pursuing and perfecting a claim against the corporation. As to self-identified creditors of the corporation, the compromise would make sense because it favored the debtor’s continued existence.
(3) Privity with Others
Finally, National Union urges that res judicata bars plaintiffs’ present suit because they were in privity with others who were parties to the compromise
National Union asserts that plaintiffs were virtually represented by at least four separate parties: the trustee in bankruptcy; counsel for the unsecured creditors’ committee; counsel for an uncertified federal class of plaintiffs; and a corporate investor.
What role did these parties play in the compromise? The trustee was not present at the hearing, nor was the motion to approve the compromise spearheaded by the trustee as normally would be the case. 20 The corporate investor was not present, nor is there any indication that this investor was formally acting in a representative capacity. Counsel for the unsecured creditors’ committee and for certain federal class action plaintiffs attended the continued hearing on Technical Equities matters, but participated solely in a subhearing on an entirely different issue. Counsel fоr the unsecured creditors’ committee, however, did approve the form of the order.
As noted above, there was no substantial identity of interest between plaintiffs and the unsecured creditors’ committee. The same could be said for the plaintiffs and the trustee, who is the creditors’ representative.
(Matter of Met-L-Wood Corp.
(7th Cir. 1988)
In the federal cases concerning privity and virtual representation in the context of a prior bankruptcy proceeding, the party deemed to be a virtual
Here the settlement was between National Union and Technical Equities and none of the creditors (or the trustee) actually participated in negotiations or the hearing although by virtue of the notice they were afforded an opportunity to object.
National Union claims this lack of participation is irrelevant because these parties had the opportunity to object. However, it cites no authority for the extreme proposition that a nonparty can be bound by a judgment in an еarlier proceeding of which he or she did not have notice and notwithstanding that there was virtually no advocacy, no control, and no actual participation in the litigation by the party with “identical” interests. For example, in Medomak Canning, where the reviewing court applied the virtual representation concept to junior lienholders on grounds of adequate representation by the trustee in bankruptcy, the trustee had spearheaded the previous compromise proceeding plus the lienholders had adequate notice of the hearing to approve the compromise.
In conclusion, for all the reasons aired above, we determine that the bankruptcy court order is not res judicata to the present adjudication of the issue of third year coverage.
F. The Cancellation Violated the Covenant
Liability carriers do not have an unfettered right to cancel coverage, notwithstanding mutual cancellation clauses to that effect. Cancellation provisions in an insurance contract are subject to the implied covenant of good faith and fair dealing just like any other clause.
(Spindle
v.
Travelers Ins. Companies
(1977)
For our purposes the cancellation clause in Spindle was identical to the one at issue here. Plaintiff alleged the insurer cancelled for the purpose of making “an example” of him so as to discourage other insureds from resisting a 140 percent premium increase. He also alleged that insurance was not available at competitive rates from solvent, nonhazardous insurance carriers. The reviewing court found that this purported reason rendered cancellation a violation of the covenant. (Commercial Union Assurance Companies, supra, 26 Cal.3d at pp. 918-919.)
Plaintiffs claim National Union’s purported cancellation of third year coverage for the directors and officers breached the covenant of good faith and fair dealing. They contend its purpose was to avoid paying $10 million in coverage on third year claims—coverage which the insureds bargained for and could reasonably expect to remain intact. They recite the following facts: National Union had notice of potential claims, knew Technical Equities had filed under chapter 11, and knew that substantial claims had been made against its insureds. As early as February 12, 1986, interoffice memoranda referred to “The Problem” and “Big Problems.”
In March 1986 Christopher Cavallaro, National Union’s senior vice-president in charge of underwriting D&O insurance, made the decision to cancel Technical Equities’ policy. He knew Technical Equities was in chapter 11 and had prepaid its premiums on the three-year policy. He was also aware that there were significant lawsuits pending against the directors and officers and more were expected to be filed. He based his decision to cancel on information related to him by Attorney Ken Sagat of D’Amato & Lynch which gave him a “gut feelfing]” that some individuals at Technical Equities were “guilty of gross fraud.” His understanding concerned three to five officers; he was not aware of any information indicating that the outside directors were engaged in gross fraud. Cavallaro’s stated reason for cancel-ling was that he did not want to do business with people guilty of gross fraud. However, he also indicated that the policy did not afford coverage for dishonest acts established by adjudication. Nonetheless, he still felt a need to cancel the policy because they “weren’t sure where the corporation was going” and “what was going to occur going forward.”
Cavallaro testified in court that he had no personal knowledge of fraud at Technical Equities until 1989 when he saw judgments in the coordinated action. His decision to cancel was informed only by allegations of fraud; he did not “think” anybody was guilty of anything, he “thought” there were some allegations. Cavallaro also expressed that fraud is alleged in “just about every D and O case . . . .” This was the only National Union cancellation he knew of where the premium had been prepaid and the company had filed fоr bankruptcy.
Cavallaro’s reason for cancelling was not communicated to anyone involved in or affected by the cancellation, including National Union’s own staff, Technical Equities, the insured directors and officers, and the insurance broker. 21 The senior underwriter for National Union indicated that in 1986 National Union did not have any policy guidelines concerning the basis for cancelling D&O policies. Technical Equities was the only cancellation he was aware of since joining National Union in 1983. It was also the only one that National Union’s underwriting manager was aware of involving a corporation which had filed for bankruptcy.
Plaintiffs asserted below and reiterate here that National Union put its own interests ahead of its insureds, cancelling the policy to avoid paying up to an additional $10 million in third year claims, at the time when the directors and officers most needed the protection that had already been paid for.
The court found that “the attempted cancellation was arbitrary and without legal justification.”
22
This finding is supported by the evidence reviewed above. The attempted cancellation was arbitrary because it was based on
An arbitrary cancellation is a breach of the covenant of good faith and fair dealing. “‘[Wjhere a contract confers on one party a discretionary power affecting the rights of the other, a duty is imposed to exercise that discretion in good faith and in accordance with fair dealing.’ ”
{Spindle
v.
Travelers Ins. Companies, supra,
V. Attorney Fees
The trial court awarded attorney fees to plaintiffs and cross-complainant Paul Kouns under authority of
Brandt
v.
Superior Court
(1985)
Plaintiffs moved for their fees after judgment in the McLaughlin case wherein National Union was found to have breached the covenant of good faith and fair dealing for denying all but $10 million in coverage under the D&O policy. Kouns’s award was conditioned on later determination that National Union wrongfully denied him coverage.
These awards must be reversed in light of our partial reversal. Plaintiffs and counterclaimant Paul Kouns may seek reevaluation of the propriety of such awards after the judgment in McLaughlin becomes final.
VI. Disposition
The judgment is reversed insofar as it declares that defense costs are payable under the policy in addition to the limits of liability and insofar as it declares there is $10 million in coverage for first year claims. The judgment is affirmed insofar as it declares there is $10 million in coverage for third year claims. The judgment awarding attorney fees to plaintiffs and cross-complainant is reversed, with the trial court retaining jurisdiction over the cause for possible reevaluation consistent herewith.
Perley, J., and Reardon, J., concurred.
A petition for a rehearing was denied November 30, 1992, and appellant’s petition for review by the Supreme Court was denied February 11, 1993. Panelli, J., was of the opinion that the petition should be granted.
Reporter’s Note: See Chatton v. National Union Fire Ins. Co., ante, page 846 for opinion on appeal.
Notes
We sometimes abbreviate “directors and officers” as D&O.
In addition to National Union, plaintiffs also named as defendants those individuals who were directors and officers of Technical Equities at the relevant times. All of the named former directors of Technical Equities and all but two of the named officers cross-complained against National Union for declaratory relief on the issues of defense costs and the policy’s liability limits.
The policy defines “loss” as “any amount which the insureds are legally obligated to pay for a claim or claims made against them for Wrongful Acts, and shall include damages, judgments, settlements, costs, charges and expenses (excluding salaries of officers or employees of the Company) incurred in the defense of actions, suits or proceedings and appeals therefrom; provided always that such subject of loss shall not include fines or penalties imposed by law or other matters which may be deemed uninsurable under the law pursuant to which this policy shall be construed.”
Endorsement No. 3 reads: “(a) No costs, charges, expenses and settlements shall be incurred without the Insurer’s consent which shall not be unreasonably withheld; however, in the event such consent being given, the Insurer will pay, subject to the provisions of Clauses 5(b) and 5(c) [relating to retentions], 95% of all such costs, charges, expenses and settlements, subject nevertheless to the following conditions: [1] (i) If a payment not in excess of the Limit of Liability has to be made to dispose of a claim, costs, charges, expenses and settlements shall be payable up to the Limit of Liability applicable under this policy. [<J] (ii) If the claim is successfully resisted by the Insureds, costs, charges and expenses shall be payable up to but not exceeding the Limit of Liability under this policy.”
In this same brief plaintiffs point out that contrary to the original policy language, this same endorsement adds a new restriction to National Union’s obligation to pay defense costs—namely, that when National Union is called upon to pay less than the limit of liability, it is no longer required to pay defense costs over and above that limit. The original language read: “If a payment not in excess of the limit of liability has to be made to dispose of a claim, costs, charges and expenses shall be payable in addition to the limit of liability otherwise applicable under this policy.” (Italics added.)
Plaintiffs’ interpretation here goes against the very argument presented in their opening brief and discussed above that the endorsement No. 3(a)(i) language is ambiguous. (The two briefs were prepared by different law firms.)
For example, in
Planet Ins. Co.
v.
Mead Reinsurance Corp., supra,
And in
Grunewald & Adams
v.
Lloyds of London, supra,
Similarly, in
Hertzka & Knowles
v.
Salter, supra,
In one case the investor dealt with an officer’s secretary because the officer would not return telephone calls. In two or three other cases, the investors dealt with an account representative who was not an officer or director.
The difference between “claims-made” and “occurrence” policies has to do with the insured risk. Under a “claims-made” policy, the insurer generally is responsible for loss resulting from claims made during the policy period no matter when the liability-generating event took place. Under an “occurrence” policy, the insurer generally is responsible for loss resulting from acts that occur during the policy period, even if the claim is made after the policy expires. (See
Bums
v.
International Ins. Co.
(9th Cir. 1991)
The trial court concluded that “[u]nder the law a claim is ‘made’ when it is made to the insured, TE, not when notice is given to the insurance company,” citing
Phoenix Ins. Co.
v.
Sukut Construction Co.
(1982)
In particular, paragraph 7(c) provides: “If during the policy period ...:[?] (i) the Company ... or the Insureds shall receive written or oral notice from any third party that it is the intention of such third party to hold the Insureds responsible for the results of any specified Wrongful Act by the Insureds while acting in the capacities aforementioned; or [5] (ii) The Company ... or the Insureds shall become aware of any occurrence which may subsequently give rise to a claim being made against the Insureds in respect of any such Wrongful Act; and [f] shall in either case, during such period give written notice to the Insurer of the receipt of such written or oral notice under (i) above or such occurrence under (ii) above, then any claim which may subsequently be made against the Insureds arising out of such Wrongful Act shall for the purpose of this policy be treated as a claim made during the currency hereof.”
Specifically, on January 30, 1986, Senior Vice-President Craig Foster advised National Union by letter that in the wake of certain disclosures set forth in a press release issued the previous week, Technical Equities received “many phone calls from disgruntled investors” and “some [may] have consulted counsel.” The letter goes on to state: “We are not aware of any lawsuits that have been filed at the present time. However, we want to give you notice of this occurrence because it may give rise to claims being made against this company, its subsidiaries, officers and directors under the policy of directors’ and officers’ liability insurance issued by National Union to Technical Equities.”
National Union also attempts to bolster its position by referring us to the “interrelated acts” provision of clause 5(c) which states that “losses arising out of the same or interrelated acts of one or more of the Insureds shall be considered a single loss . . . .” The policy declarations, as amended, provide for a $5,000 retention per director or officer, subject to a maximum of $7,500 per loss. Clause 5(c) goes on to state that the $5,000 per director/officer retention applies separately to each such person for each loss and where the “per loss” maximum retention applies, that retention is to be prorated among the insureds in proportion to their respective losses. In context it is clear that the interrelated acts provision pertains solely to calculation of the retention amount to be borne by the insureds and not to the issue of when loss is incurred for purposes of applying the annual limit of liability for a particular policy year. The court in
Ambassador Group
arrived at the same conclusion when responding to a similar argument based on similar language.
(Ambassador Group, supra,
National Union has never argued that it did not receive notice of third year claims.
In fact, the discovery clause provided for six months’ extended coverage.
National Union states: “Plaintiffs’ сontention that the cancellation was invalid because National Union acted in bad faith . . . was never raised or tried or determined in this case.” National Union must realize that the validity of its actions in pursuing cancellation was a pivotal issue below. In their pretrial statement, plaintiffs highlighted the undisputed and disputed facts going to this issue and briefed the matter in the trial court. Moreover, much of the evidence offered at trial went to this issue. Finally, National Union itself in its proposal on issues to be decided framed the question: “Was cancellation valid?”
PIaintiffs have argued that the bankruptcy order is void because it violated the automatic stay. The trial court did not decide this issue, nor do we.
This rule governs notice on hearings on approval of a compromise or settlement, among other matters.
Significantly, Judge King, who approved the compromise, consistently indicated in subsequent rulings that he did not intend the compromise to affect matters of coverage or policy limits—those issues were left to the state court. Moreover, at the initial hearing on the compromise, Judge King inquired as to coverage for claims based on prepetition conduct. Counsel for Technical Equities represented that the compromise transaction was designed so that there would be no coverage gaps—claims made up to termination of the policy would be covered under that policy; the new policy would pick up postpetition acts, and the discovery tail would cover claims based on prepetition acts made subsequent to cancellation. Nothing was said to indicate that covеrage would be diminished by one-third based on the cancellation!
Of course, as National Union points out, had the directors and officers procured a copy of the policy and put a microscope to it, they may have figured out that claims reported under the discovery tail would be attributed to the second policy year’s liability limits.
Federal Rules of Bankruptcy Procedure, rule 9019(a) provides: “On motion by the trustee and after a hearing on notice to creditors [and others] as provided in Rule 2002 . . . , the court may approve a compromise or settlement.” (Italics added.)
Under recent additions to the Insurance Code, commercial liability carriers are now required to state the reason for cancellation in the notice. (Ins. Code, § 677.2, added by Stats. 1986, ch. 1321, § 5, pp. 4669-4670.) Cancellation is not effective unless it is based on one of the enumerated statutory grounds. (Ins. Code, § 676.2, subd. (b).)
Dubbing this a finding that National Union lacked good cause, National Union states it was entitled to cancel the policy without cause, citing
Jensen
v.
Traders & General Ins. Co.
(1959)
We note that under the new statutory restrictions on cancellation, an allowable reason to cancel is “[d]iscovery of willful or grossly negligent acts or omissions ... by the named insured . . . which materially increase any of the risks insured against.” (Ins. Code, § 676.2, subd. (b)(4).) We emphasize the phrase “discovery of” because it connotes what did not happen here, namely, that awareness of the act or omission was the result of a search or inquiry.