A recent ruling in the case Village Northridge Homeowners Association v. State Farm Fire and Casualty Co. could prove to be a nightmare for insurers. To find out more about the case and its implications, Claims spoke with Barry Zalma, a California attorney who has been following the case.

Could you give our readers a brief summary of Village Northridge Homeowners Association v. State Farm Fire and Casualty Co.?

An insurer and its insured, a homeowners' association, settled disputed claims arising from the 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 insists that the Association cannot pursue its claim unless it rescinds the settlement agreement and returns the $1.5 million, relying on 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, insists it has the option of affirming the settlement agreement and recovering damages for the fraud.

The trial court granted summary judgment for State Farm, ruling that 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 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 whether the insured's release was valid and enforceable, the Court of Appeal held summary judgment was improper.

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 “affirmed 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 that 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.

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. The fraud alleged is 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 their own policy.

What are some of the effects insurers should expect if the California Supreme Court affirms this ruling?

Insurers will not be able to close files when releases are signed, since they can be forced to litigate further if an insured alleges fraud. There will be no certainty that settled claims are truly settled and more cases will be forced to trial.

Insurers rarely receive sympathy from judges and juries. Do you think this ruling was affected by a negative public perception that has come back to bite the insurance industry?

It seems so. As the language quoted makes clear, the court believes that insurers will defraud those with whom it settles as a business practice. Insurers are no different than other litigants and a mere allegation by a plaintiff should not be sufficient to allow a court to assume that the defendant insurer would only be interested in defrauding those with whom it deals.

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