Eviscerating the consent-to-settle and cooperation provisions typically found in liability policies, the Pennsylvania Supreme Court, in a 3-2 decision, ruled that an insured being defended under a reservation of rights may breach its insurance contract with impunity by settling within the policy limits absent the insurer’s consent, and then recover the amount from its insurer, so long as coverage exists and the settlement was fair, reasonable and non-collusive. Babcock & Wilcox Co. v. American Nuclear Insurers, 2 WAP 2014 (Pa. July 21, 2015). In so doing, the Court effectively transformed the standard of proof from focusing on an insurer’s alleged bad faith conduct in refusing to consent to settle into merely establishing that a settlement within limits was “fair and reasonable” under the circumstances. While Babcock now controls insurance claims interpreted under Pennsylvania law, we have begun working with our insurer clients to minimize the impact of this landmark decision, as discussed below.
In Babcock, the insurer agreed to defend the insured nuclear facility owners, subject to a reservation of rights, in an underlying class action lawsuit alleging injury and property damage caused by emissions from nuclear facilities. Id. at 2-3. Specifically, the insurer reserved its right to decline indemnity coverage to the extent that the damages were not caused by nuclear energy hazard, were in excess of the policy limits, constituted punitive damages, or were injunctive in nature, and later, based on the insured’s alleged breach of its duty to cooperate by pressuring the insurer to settle. Id. at 3, 4. A jury trial of eight test cases resulted in an initial verdict of $36 million, or $4.5 million per plaintiff. Id. at 2. During the 15 year course of the underlying litigation, the insurer refused consent to any settlement offers, due to its belief that there was a strong likelihood of a defense verdict. Id. at 4.
In 2008 and 2009, the insureds settled with the class action plaintiffs within limits for a total of $80 million, then sought reimbursement from the insurer. Id. The insurer refused, contending that the insured had breached the consent to settlement clause that vested complete control of the decision to settle with the insurer. Id. at 4-5.
The trial court held that an insurer defending its insured under a reservation of rights is “required to reimburse an insured for a settlement reached in violation of the consent to settle clause where coverage is found to exist and the settlement is ‘fair and reasonable’ and made in ‘good faith and without collusion,’” noting that the insured had paid the settlement using its own money, and therefore “had a strong interest to hold out for the best possible deal.” Id. at 6 & n.6. The Superior Court vacated the verdict finding the settlement fair and reasonable, holding that an insured, offered a defense subject to reservation of rights, could either (1) accept the defense, binding it to the consent to settlement provision and vesting full control with the insurer subject only to the Cowden bad faith standard, or (2) reject the defense, thereby entitling it to control its own defense and settlement, and if coverage is found, the insurer is liable for its defense and indemnity costs to the extent deemed “fair, reasonable and non-collusive.” Id. at 8-9. The Supreme Court flatly rejected the Superior Court’s procedure, as unworkable under Pennsylvania law. Id. at 10, 31.
Instead, it held that in a reservation of rights case in which the insured settles after its insurer refuses to consent to a settlement, the insured must establish that the settlement was “fair and reasonable from the perspective of a reasonably prudent person in the same position of [Insureds] and in light of the totality of the circumstances.” Id. at 29, 30. Recognizing the new standard’s inherent conflict with the longstanding Cowden bad faith standard, the Court found that this “lower standard of proof of a reasonable settlement” should be used where the insured’s settlement falls within the contracted-for policy limits. Id. at 30 n.18. By contrast, Justice Eakins, in his separate opinion, states that he would retain the Cowden bad faith standard, finding that the “majority’s rationale allows an insured to alter the nature of the bargain it struck with its insurer.” Babcock, 2 WAP 2014 (Eakins J., concurring & dissenting) at 8.
While this decision will clearly embolden insureds to agree to a “reasonable” settlement within policy limits, absent its defending insurer’s consent, the existence of coverage in the first place must still be established by the insured. Moreover, the decision does provide some potentially valuable dicta. Notably, the Court expressly left for another day the question of whether a “particular reservation of rights” would justify “diverging from the contract’s cooperation clause,” potentially leaving the door open for differing results based on the content and tenor of the reservation of rights letter itself. See Id. at 24 n.15.
Specifically, the Court stated that “not all reservations of rights are equal,” referring to the distinction between so-called “soft” reservations of rights that are unlikely to alter the interests of the parties (e.g., a reservation of rights in a water damage case noting that claims for mold damage would be subject to a mold exclusion, even though the “bulk of the claims would be fully covered and no mold claims would likely be advanced by the plaintiff”) and a “hard” reservation of rights in which the insurer “views the claims as possibly covered, requiring a defense, but ultimately unlikely to be covered by the policy” (e.g., “when intentional acts are also pled in negligence”). Id. at 24 n.15 & 17 n.13. Referring to these distinctions among reservations of rights, the Court recognized that “[t]he mere fact that an insurer restates that it will not cover what the insurance policy does not cover, where it arguably might be part of the damages sought does not automatically result in allowing the insured to settle the entire suit.” Id. at 24 n.15 (emphasis added). Thus, although the playing field has just been rejiggered, the Court nonetheless envisioned that:
Parties and courts may need to consider whether a particular reservation of rights justifies diverging from the contract’s cooperation clause, a question which is not squarely before this Court.
Id. at 24 n.15. As a result, we have developed some targeted ways in which our insurer clients issuing reservations of rights letters for Pennsylvania claims may potentially limit Babcock’s applicability, to level the playing field yet again. Please feel free to contact the author, Nancy Portney, at 484-344-5323 or nportney@StewartSmithLaw.com to discuss the ways in which we can help limit exposure for future Pennsylvania claims.