Insurers Beware: Choice of Law Provisions May be Overridden by Public Policy Provisions

In answering two questions posed to it by the Ninth Circuit Court of Appeals, the California Supreme Court on August 29, 2019, addressed two significant issues: 1) whether California’s common law notice-prejudice rule is a fundamental public policy for the purpose of choice of law analysis; and 2) if so, whether the notice-prejudice rule applies to the consent provision of the insurance policy in the case before the court. Pitzer College v. Indian Harbor Insurance Company, 2:13-cv-05863-GW-E (Cal. 2019). The “notice-prejudice rule” requires that if an insurer seeks to deny coverage on the ground that an insured failed to comply with a policy’s notice provision, the insurer must establish that it was prejudiced by the insured’s failure to provide timely notice.

The California Supreme Court answered the first question in the affirmative, holding that the “notice-prejudice rule” was a “fundamental public policy of our state in the insurance context” and that “the rule generally applies to consent provisions in the context of first-party liability coverage and not to consent provisions in the third-party liability policies.”  The court limited its decision to addressing the public policy of California, thus leaving to the Ninth Circuit the issue of whether in the particular case before it California has a materially greater interest in determining coverage such that the New York choice of law provision would be unenforceable on the notice issues as contrary to California “fundamental public policy.”

The Underlying Action and Lower Court Decision:

The underlying action involved an insurance policy that provided coverage for “legal and remediation expenses resulting from pollution conditions discovered during the policy period of July 23, 2009 to July 23, 2011.” The insured, a California college, had discovered an environmental condition, determined that remediation was necessary, and incurred nearly $2 million in costs.  It did not obtain the insurer’s consent prior to incurring the remediation costs, instead waiting until three months after the remediation was complete to even provide notice to the insurer.  The policy contained a choice of law provision stating that New York law governed all matters arising under the Policy.

The insurer denied coverage on the basis that the insured had violated the notice and consent clauses of the Policy.  After removal to federal court, the Central District of California granted the insurer’s motion for summary judgment based on the insured’s failure to give notice as soon as practicable and its failure to obtain the insurer’s consent before commencing the remediation process. The district court found that there was at least a “reasonable basis” for the selection of New York law, and applied New York’s “no prejudice” common law.  While the district court granted the insurer summary judgment, it did note that it “… would not have prevailed at summary judgment on this ground if it had been required to show prejudice.”

Additionally, the district court held that the insurer was also entitled to summary judgment because the insured did not comply with the policy’s consent provisions.  The court rejected the insured’s argument that the remediation costs had been incurred on an emergency basis and thus fell within an exception to the consent requirement.  

The insured appealed to the Ninth Circuit, which sought the California Supreme Court’s certification of the above two questions of California law.

The California Supreme Court’s Decision:

A. Choice of Law Provision

The California Supreme Court considered the issue of enforceability of a contractual choice of law provision under the principles set forth in the Restatement Second of Conflict of Laws (section 187), noting that under those principles the parties’ choice of law generally governs unless (1) it conflicts with a state’s “fundamental public policy” and (2) that state has a materially greater interest in the determination of the issue than the contractually chosen state.  Thus, it examined whether the notice-prejudice rule was a “fundamental” public policy of California, and found it was. In reaching that conclusion, it noted that the public policy of California was “compensation of insureds over technical forfeiture.” Ultimately, the California Supreme Court honed in on the argument that the notice-prejudice rule protects against the “insurers’ superior bargaining power.” The court also noted that the notice-prejudice rule serves the fundamental public policy of protecting “the public from bearing the costs of harm that an insurance policy purports to cover.”

According to the court, when a fundamental policy of the state applies, it prevents enforcement of a contractual term contrary to that fundamental policy and overrides the parties’ express intentions for a defined notice term, thus preventing a technical forfeiture of insurance benefits unless the insurer can show it was prejudiced by the insured’s late notice. The court also noted that under California’s notice-prejudice rule, the insurer must establish “actual and substantial” prejudice from delayed or late notice. The example it gave was that, in the third party coverage context, the insurer “must show that timely notice would have enabled it to achieve a better result in the underlying third party action.”

After answering the limited question as to whether the notice-prejudice rule was a fundamental public policy of the state of California, the California Supreme Court returned the case to the Ninth Circuit for a determination as to which state had a materially greater interest in determining coverage in that particular case. While a decision from the Ninth Circuit on that issue has not yet been issued, it is notable that the case involves a California insured and the alleged environmental damage occurred in California, which are likely factors to be considered in weighing the interests of California versus New York.

B. The Policy’s Consent Provision

Applying the same rationale used with respect to the notice-prejudice question, the California Supreme Court also held that a prejudice requirement applies where an insurer seeks to deny coverage for an insured’s failure to comply with a policy’s consent provisions.  The court did, however, make a distinction between consent provisions in first party coverages, and those in third party coverages, and held that a prejudice requirement should be imposed only in the first party coverage context.

The court reasoned that requiring first party insurers to show prejudice is consistent with the purpose of consent requirements of avoiding potential unilateral increase in remediation costs or waiver of subrogation rights; if that happened, then prejudice would exist and the requirement would be satisfied. 

This was unlike consent provisions in the context of third party liability coverages, in which “the insurer is invested with the complete control and direction of the defense.” Thus, in the third party context the direction to pay remediation costs is “a judgment call left solely to the insurer” and its right to control that is “paramount.” The Court held such consent provisions to be sufficiently dissimilar to notice of claim provisions as to require a departure from the notice-prejudice rule.

Because the question of whether the particular claim at issue arose in the first party or third party context was “vigorously disputed” between the parties, the California Supreme Court left that issue to be decided in further federal court proceedings.

Take Away:

A policy’s choice of law provision is important in that it generally serves to provide the parties with certainty as to which state’s laws will govern the interpretation and application of policy provisions should an issue arise, and can serve to minimize the costs and risks faced by both insurers and insureds of predicting which law a court hearing a coverage dispute will apply. The Pitzer decision introduces an element of uncertainty at least as to the enforcement of notice and prior consent provisions when a party or risk is based in California and the choice of law is of a jurisdiction in which prejudice would ordinarily not be required in order for an insurer to enforce such a provision. Further, even apart from notice-prejudice rules, this case serves as a message to insurers that even though a policy may contain a choice of law provision, there is precedent for an insured to argue that a court may override the choice of law provision based on California’s (or indeed any state’s) “fundamental” public policy concerns. While an insurer may have taken very considered, calculated steps in determining which state’s body of law should control a particular dispute, Pitzer is a reminder that there is a possibility that a choice of law provision will be overridden by the public policy of the state that is found to have the most material interest in the outcome of the party’s dispute.