Do choice-of-law provisions insulate insurance carriers from tort and punitive damage liability under California law?

It's no secret that California permits policyholders to assert either contract or tort remedies for an insurer's breach of the implied covenant of good faith and fair dealing.  The difference between the two remedies, available at the policyholder's election, is significant; "[i]f the insured elects to proceed in tort, recovery is possible for not only all unpaid policy benefits and other contract damages, but also extra-contractual damages such as those for emotional distress, punitive damages and attorney fees."[2]  The ability to seek punitive damages, in addition to other potential tort recovery, makes California an attractive forum for policyholders seeking to maximum damages for an insurer's unreasonable or unjustified denial of policy benefits.[3]

New York, on the other hand, does not permit tort recovery for bad faith, thereby also precluding an insured from recovering punitive damages.[4]  Because California potentially allows a broad spectrum of damages for an insurer's bad faith and New York allows much less, it is not surprising that many policyholders elect to pursue their bad faith actions in California while many insurers seek to confine any action on the policy to New York by including a choice-of-law provision in their policy.  But are such provisions enforceable with respect to claims for breach of the implied covenant of good faith and fair dealing asserted under California law?

Recently, a federal district court in California held a choice-of-law provision in an insurance policy was not enforceable with respect to a policyholder's claim for breach of the implied covenant of good faith and fair dealing.  See Tri-Union Seafoods, LLC v. Starr Surplus Lines Ins. Co., 2015 U.S. Dist. Lexis 23441 (Feb. 5, 2015).  Although federal decisions are not binding on California courts with respect to issues of state law,[5] Tri-Union raises the issue of whether California will enforce a valid choice-of-law provision where doing so would deprive a policyholder of potential tort and punitive damages for the insurer's bad faith.  In other words, do California policyholders have a public policy right to recover tort and punitive damages against an insurer for its bad faith?  The Tri-Union court answered this question in the affirmative, but would a California court do the same?

In California, insurance policies are contracts, subject to the same construction principles as other contracts.[6]  Provisions in insurance policies are given effect and are not rewritten or omitted to advance some perceived public policy.[7]  California courts acknowledge the parties' freedom to contract,[8] while recognizing the potential for disparate bargaining power between policyholders and insurers.  California courts enforce contracts as written – including policies – unless doing so violates public policy.[9]

With respect to choice-of-law provisions specifically, California has a strong policy of enforcing such provisions that satisfy the principles set forth in section 187(2) of the Restatement Second of Conflict of Laws ("Restatement").[10]

The Restatement sets forth a multi-part test; under the first part, the court determines whether the state in the choice-of-law provision has a substantial relationship to the parties, their transaction or whether there is any other reasonable basis for the law chosen by the parties.  The first part may be satisfied if one of the parties resides in the chosen state or has its principal place of business there.[11]  If the first part is met, the court then determines if the law chosen by the parties is contrary to a fundamental policy of California.[12]  If there is no contradiction, the court will enforce the choice-of-law-provision.  But if the court finds a conflict between the law of the chosen state and a fundamental policy of California, it will analyze if California has a "'materially greater interest than the chosen state'" in resolving the specific controversy.[13]

In Tri-Union, the policyholder argued a choice-of law provision, which stated "[t]he construction, validity, and performance of this Policy will be governed by the laws of the State of New York …", was unenforceable because it violated a fundamental policy of California.[14]  That fundamental policy, the insured argued, was its right to sue an insurer in tort for breach of the implied covenant, a remedy not recognized under New York law. 

Notwithstanding the California Supreme Court's conclusion that "a valid choice-of-law clause … encompasses all causes of action arising from or related to that agreement, regardless of how they are characterized, including tortious breaches of the duties emanating from the agreement …,"[15] the insured in Tri-Union successfully argued Nedlloyd did not apply to insurance contracts.  This argument was bolstered by reference to Comment (g) of Section 187 of the Restatement, which provides:  "A fundamental policy may be embodied in a statute which makes one or more kinds of contracts illegal or which is designed to protect a person against the oppressive use of superior bargaining power.  Statutes involving the rights of an individual insured as against an insurance company are an example of this sort."  Relying on Comment (g) and various California cases explaining the rationale for affording tort liability in the insurance context, the Tri-Union court concluded "a tort remedy for the [sic] an insurer's breach of the implied covenant of good faith and fair dealing implicates a substantial and thus fundamental public policy in California."[16]  And after finding California had a materially greater interest than New York, the court refused to enforce the choice-of-law provision in the policy.

In proclaiming a policyholder has a fundamental right to seek and obtain tort and even punitive damages against an insurer for bad faith, the Tri-Union court appeared to ignore several key California decisions.  For example, California courts generally express great reticence in proclaiming what is and what is not public policy.[17]  But in choosing to nullify the insurer's choice-of-law provision, the Tri-Union court appeared to express no such hesitancy.

The Tri-Union court also appeared to pay little heed to California's long tradition of enforcing policy provisions as written, confirming the parties' right to contract as they please.[18]  In finding an insurance policy "exception" to choice-of-law analysis, the Tri-Union court held that while other business entities may rely upon choice-of-law provisions, insurance companies may not.[19]

More importantly, the Tri-Union court appeared to ignore the California Supreme Court's decision in Boghos v. Certain Underwriters at Lloyd's of London, 36 Cal.4th 495 (2005), where the court rejected the notion that an insured has a fundamental public policy right to seek tort remedies for bad faith.

In Boghos, an insured brought claims for breach of contract and bad faith against a disability insurer.  The insurer moved to compel arbitration under a provision in the policy that stated the parties agreed to waive the right to a jury trial and to submit to binding arbitration.[20]  The trial court and the appellate court refused to enforce the arbitration provision and the California Supreme Court granted review.

In determining whether the arbitration provision was enforceable, the court construed the policy language "based on the same state law standards that apply to contracts generally."[21]  After finding the arbitration provision unambiguous, the court determined whether the insured's breach of contract and bad faith claims were protected by public policy and concluded they were not.[22]

Specifically, after explaining that fundamental public policies are unwaivable rights "tethered" to statutes or constitutional provisions, the court found the insured's "claims for nonpayment of benefits and breach of the covenant of good faith and fair dealing cannot properly be so described."[23]  A failure to pay benefits under the policy "is a claim for breach of contract, pure and simple" and a claim such failure was in bad faith "may properly be described either as a tort claim … or as a special type of contract claim for which we allow tort damages …."[24]  In reaching its conclusion to enforce the arbitration provision, the Boghos court explicitly rejected the insured's argument that a bad faith claim reflects a fundamental public policy of California:

While insurance bad faith claim were for a time thought to have a statutory basis in the Unfair Practices Act (Ins. Code, §790 et seq.), we definitively rejected that position in Moradi-Shalal v. Fireman's Fund Ins. Cos. (1988) 46 Cal.3d 287, 304 … and expressly overruled prior contrary authority … For the same reason, insurance bad faith claims also cannot properly be described as tethered to a statute, in the sense that Tameny claims subject to arbitration under Little are necessarily "'based on policies "carefully tethered to fundamental policies …delineated in constitutional or statutory provisions"'" … While the business of insurance is sufficiently affected with a public interest to justify its regulation by the state … the fact of regulation does not suffice to demonstrate that any given insurance-related claim entails an unwaivable statutory right, or that any given claim seeks to enforce a public policy articulated in a statute.[25] 

Because enforcing an arbitration provision would deprive a policyholder of its ability to recover tort remedies in a court proceeding, the Boghos court necessarily considered and rejected the notion that a policyholder has a fundamental public policy right to pursue such damages against an insurer.

And while Foley, 47 Cal.3d 654, 683-700, Egan v. Mutual of Omaha Ins. Co. 26 Cal.3d 809, 820 (1979) and other decisions certainly recognize the special nature of insurance contracts and the rationale for permitting tort remedies for an insurer's bad faith, such cases do not hold that the ability to recover tort damages against an insurer is a fundamental policy in California.

In California, "[p]ublic policy is defined as a policy covering health, safety or welfare and established by constitutional provision, statute, or administrative rule."[26]  Boghos confirmed that the right to sue an insurer in tort is not established by statute.[27]  Nor are such causes of action established by constitutional provision or administrative rule.  It is the lack of these attributes, which should have precluded the Tri-Union court from concluding an insured has a fundamental policy right to seek tort remedies for bad faith.

California has long recognized and protected the freedom to contract.  It has eschewed rewriting contracts by failing to give effect to plain and unambiguous wording.  California recognizes the special nature of insurance policies and has in that regard regulated such contracts and even allowed for tort recovery where an insurer breaches a policy in bad faith.  But California has not elevated the right to redress such grievances with tort remedies as a fundamental public policy that overrides enforcement of a valid choice-of-law provision where it satisfies Nedlloyd.  Insurers, like any other business entity, should be entitled to rely upon such provisions.