Insurer Must Go to Trial on Allegations of a Fraudulent Settlement

The Facts of the Case

In this case, an insurer and its insured, a homeowners association, settled disputed claims arising from the 1994 Northridge earthquake, with the insurer paying $1.5 million, and the insured releasing the insurer from all claims or causes of action it had or may have arising out of its earthquake claim. Two years later, the association sued the insurer, and still later discovered the limits of its insurance policy were almost $7 million greater than had been represented by the insurer. The insurer insisted that the association could not pursue its claim unless it rescinded the settlement agreement and returned the $1.5 million, relying on California Supreme Court precedents holding that a plaintiff cannot avoid a fraudulently induced contract of release without rescinding the contract and restoring the money paid as a consideration for the release. The association, which long ago used the $1.5 million to repair earthquake damage, insisted it had the option of affirming the settlement agreement and recovering damages for the fraud.

The court agreed with the association.

The lawsuit arose from the Northridge earthquake in January 1994, and was filed in December 2001, after the California Legislature revived insurance claims otherwise barred by the statute of limitations. Village Northridge Homeowners Association (the Association or the insured) sued State Farm Fire and Casualty, alleging breach of contract and breach of the implied covenant of good faith and fair dealing. The complaint alleged State Farm improperly undervalued the Association's loss, inducing it to forego proper repairs and to forego payment of amounts properly owed under the policy.

The Association further alleged it "was required to sign a release and did so under compulsion and with no other option afforded to secure partial benefits owed," and that it did not agree "that the partial payments provided fully compensated [the Association] for the actual damages and loss sustained…."

The trial court granted summary judgment for State Farm, ruling the Association had not demonstrated the release agreement was a product of undue influence or fraud, and that it was binding on the parties. The California Court of Appeal reversed the judgment, concluding material issues of disputed fact existed concerning the limits of the earthquake policy and whether the policy limits were misrepresented by the insurer during the adjustment process. Because a resolution of these issues was necessary to a determination of whether the insured's release was valid and enforceable, the court of appeal held summary judgment was improper and must be resolved at trial.

When the case was returned to the trial court, State Farm filed a motion for judgment on the pleadings. State Farm asserted the complaint did not state a claim upon which relief could be granted, because the Association's claims were barred by the settlement agreement and release, and the Association could not rescind the settlement agreement without first offering to restore to State Farm the consideration it paid under the agreement. The trial court granted the motion, with leave to amend, observing that the complaint did not allege fraud in the inducement or rescission, and that the Association "need[s] to either rescind the agreement or affirm the agreement and sue for damages."

The Association amended the complaint twice, alleging a cause of action for fraud in addition to its original claims for breach of contract and breach of the implied covenant of good faith and fair dealing. The Association alleged it had spent the $1.5 million on partial earthquake repairs and was not offering to return the $1.5 million; acknowledged a credit in that amount in State Farm's favor against the damages sought in the lawsuit; did not seek to rescind the release; and "'affirm[ed]' the Release, as requested by the Court, and [sought] damages …," contending the release was unenforceable as the product of fraud.

The trial court sustained the demurrer without leave to amend, observing the Association chose to affirm the settlement agreement and keep the money paid by State Farm, but not to release the claims, and "[t]hey can't have it both ways."

The general principle that, if a defrauded party is induced by false representations to execute a contract, the party has the option of (1) rescinding the contract and restoring any consideration received under it, or (2) affirming the contract and recovering damages for the fraud. The court of appeal allowed the Association to affirm the settlement agreement and recover damages for the fraud.

Other Rescission Holdings

The circumstances of this case are not unlike those in rescission cases where courts have applied an exception to the rule requiring restoration of the consideration paid: "A restoration is not necessary, in order to avoid the bar of a release, where there is no question as to the right of the plaintiff, arising independently of the release itself, to retain what he received." (Sime v. Malouf, 95 Cal. App. 2d 82, 111, 112 (1949) ["[r]escission and restoration are required only under equitable principles and to prevent the taking of unfair advantage"]; see Denevi v. LGCC, LLC, 121 Cal. App. 4th 1211, 1220 (2004) [victim of fraud cannot be required to undo the transaction in its entirety; "he has the right to 'retain the benefits of the contract …, and make up in damages the loss suffered by the fraud'"; "he may affirm the contract, and simply sue for damages for the fraud"].)

The Ruling

In support of its decision, the California Court of Appeal said:

Simply as a matter of policy, this cause of action [alleging a settlement procured by fraud] should be deemed to exist. First, insurance companies would have everything to gain and nothing to lose by systematically defrauding tort claimants into accepting low settlement offers. In such cases the company gambles that the deceit will not be uncovered. If the fraud is uncovered, then the company only faces litigation, or the costs of reimbursement, that it would have had to confront without a settlement. … Moreover, such a rule would enforce a higher standard of care among insurance agents, thus helping to prevent cases of merely negligent misrepresentation." (Citation omitted)

The court of appeal concluded that the principle applicable to ordinary contracts—that a party induced by fraud to execute a contract has the option of rescinding it or affirming it and recovering damages for the fraud—applies to the case. Any other conclusion would leave a defrauded insured with no practical remedy and would do nothing to discourage fraud in the settlement of insurance claims. Accordingly, it concluded that the trial court erred in sustaining State Farm's demurrer to the Association's second amended complaint. Again, the case will be returned to the trial court for trial.

The fraud alleged was that State Farm failed to advise the proper limits available to the insured. Since the insured received—in the normal practice of insurance companies—a copy of the policy, it is difficult to understand how an insured could be deceived by its insurer about the limits of its policy. Further, the amount of damages is a finite amount that can be ascertained by physical evidence and expert testimony and cannot be effected by the amount of insurance available. A $1 million loss is not made larger by a $10 million policy.

The Association, probably hopefully with legal advice, signed a general release of all claims, known and unknown, and should not have been allowed to force lengthy litigation on such a thin claim of fraud. Insurers who settled with their insureds with a general release may not be able to close their books on the claim.