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By Patrick A. Calhoon

Damages for Insurance Bad Faith actions are peculiar in how they are calculated. The amounts for each item of damages (contract damages, attorney fees, emotional distress, and punitive damages) are all tied to one another in one way or another. Of course, the starting point and lynchpin for analyzing damages is the amount of wrongfully withheld insurance benefits, i.e. the contract damages. Attorney fees are available for breach of the implied covenant of good faith and fair dealing, but they are directly tied to the contract damages. Brandt v. Superior Court (1985) 37 Cal.3d 813 (only fees attributed to the recovery of insurance benefits may be awarded). Next, provided the insured is a person and not an artificial entity, emotional distress damages are generally recoverable. However, the amount of emotional distress damages must bear a “reasonable relationship” to the economic loss caused by the denial of policy benefits, including the amount attorney fees expended to recover the policy benefits. Major v. W. Home Ins. Co. (2009) 169 Cal. App. 4th 1197, *1216 (in looking at the amount of the economic damages award, the court considers not only the policy benefits recovered, but also the attorney’s fees awarded by the jury; two-to-one ratio appropriate).  Finally, the amount of punitive damages is directly tied to the compensatory award, which includes both attorney fees and emotional distress. Nickerson v. Stonebridge Life Ins. Co. (2016) 63 Cal. 4th 363 (attorney fees spent to recover insurance benefits included in calculating the ratio of punitive to compensatory damages to determine whether the punitive damages exceed due process limits).  

Of course, the net effect of this relationship is that the recovery of a larger sum of policy benefits results in an increased attorney fee award, a greater fee award results in a larger emotional distress damages award, a larger attorney fee and emotional distress award results in a greater amount of punitive damages that may be awarded. Obviously, it is no surprise that attorneys will always look for ways to enhance the damages in effort to increase the total award. However, as will be examined below, courts are on guard that attorney fee calculations are particularly vulnerable to improper manipulation. Case law such as Cassim v. Allstate Insurance Company (2004) 33 Cal.4th 780, *813 has long warned against manipulating the attorney fee calculation in an effort to increase the total award. Now, the recent case of Pulte Home Corporation v. American Safety Indemnity (2017)14 Cal.App.5th 1086 (review denied (Nov. 15, 2017) drives the point home. There, the Court of Appeal perceived a late-in-the-game modification of a fee agreement from a contingency fee to an hourly agreement as an improper attempt to manipulate the attorney fees and punitive damages award to the benefit of the policyholder.

Background on Attorney Fees in Insurance Bad Faith Cases

In Brandt v. Superior Court (1985) 37 Cal.3d 813, the California Supreme Court permitted policyholders to recover their attorney fees for obtaining policy benefits as bad faith damages. The Brandt court asked, “[w]hen an insurer tortuously withholds benefits, are attorney’s fees, reasonably incurred to compel payment of the policy benefits, recoverable as an element of the damages resulting from such tortuous conduct?” Id. at *815. The court held that if the insured had to incur attorney’s fees to compel the payment of policy benefits and the insured proves the insurance company unreasonable withheld the policy benefits, then attorney’s fees are recoverable.

However, as mentioned above, Brandt fees are directly tied to the amount of policy benefits recovered. Specifically, Brandt states that only those fees “reasonably incurred to compel payment of the policy benefits” may be awarded. The insured cannot recover attorney’s fees incurred in proving the tort of bad faith itself. Id. at *817.

Next, in Cassim v. Allstate Insurance Company (2004) 33 Cal.4th 780, the Court explained how Brandt fees are calculated in contingency cases.  The Cassim Court held that a proper calculation of Brandt fees requires the trier of fact to determine the percentage of all fees attributable to obtaining the contract recovery.  This formula is based on the percentage of the attorney’s overall efforts devoted to the contractual recovery portion of the case.  The Court directed that hours spent on the case should be divided into categories: contract claim only; bad faith claim only, and both claims combined.  The Court then established a formula so the fee award would equal the ratio of the hours devoted to recovery of the policy benefits plus the hours allocable to both contract and bad faith claims divided by the hours devoted to the prosecution of the entire case. Id. at *812.

An example of this calculation, using easy numbers, demonstrates how this is done. Suppose the compensatory damages are $1,000,000. Assume that the representation is based on a 40 percent contingent fee agreement. The total legal fee for the compensatory award is thus 40 percent of $1,000,000, or $400,000.  The insured’s attorney spent 1,500 hours on the case, and can prove how it breaks down: 200 hours on issues related solely to recovery of the contract benefits, 500 hours on issues relevant to both the contract benefits and bad faith, and 800 hours on issues related solely to bad faith. The trial court could reasonably conclude that half the hours spent on the joint contract/bad faith issues are fairly attributable to the contract (i.e., half of 500 hours, or 250 hours), and thus 30 percent of the hours worked (200 hours plus 250 hours, divided by 1,500 total hours) is attributable to the contract recovery. Thirty percent of the total legal fee (30 percent times $400,000) is $120,000. According to Cassim, this is the amount a trial court should award as Brandt fees in this hypothetical situation. Id. at *812.

Based on the fee calculation prescribed under Cassim, it is clear there are circumstances where an hourly fee agreement will result in a much higher fee award. For example, take the situation where the ultimate contract recovery is very small, but the number of hours expended in that endeavor is large. Cassim contemplates this possibility, stating a “client paying his or her lawyer an hourly fee may choose to pay more than 40 percent (or even more than 100 percent) of an anticipated contract recovery in order to obtain that recovery.” Id. at *809. “Indeed, in either an hourly or a contingent fee case, the amount “attributable to the attorney’s efforts” to obtain the contract benefits could conceivably exceed those benefits entirely.” Id. Foreseeing possibility for manipulation, the court stated that trial courts retain discretion to disregard fee agreements that appear designed to manipulate the calculation of Brandt fees to the plaintiff’s benefit. Id. at *813.

The Facts of Pulte Home Corporation v. American Safety Indemnity

The Pulte case concerned the development of two residential housing projects beginning in 2003 and sold in 2005-2006. The subcontractors were required to name Pulte as additional insured on their policies, some of them issued by American Safety. In 2013, several homeowners sued Pulte for defects in the work performed by the subcontractors insured by American Safety. American Safety denied coverage and refused to provide a defense to Pulte because the construction had taken place years earlier. Pulte Home Corp. v. Am. Safety Indem. Co. (2017) 14 Cal. App. 5th 1086, *1096.

When coverage was denied, Pulte was forced to defend itself and then sue for bad faith. Ultimately, the Pulte court concluded that the lawsuits triggered a duty to defend.  The Pulte court then addressed the finding of bad faith, noting that American Safety had continued to deny Pulte coverage even after the trial court had denied an initial summary adjudication motion on one of the policies. In addition, the evidence at trial showed American Safety never appealed the result in order to continue its strategy of applying its own interpretation of the policies at issue. The court also found American Safety’s continued denial unreasonable in light of numerous federal trial court decisions against its position on the interpretation of “ongoing operations,” including a case against American Safety itself. (Citing D.R. Horton Los Angeles Holding Co., Inc. v. American Safety Indem. Co. (S.D.Cal., Jan. 5, 2012, No. 10CV443WQH) Id. at *1119-1123.

The Pulte court also noted evidence taken from testimony of its claims representatives and corporate claims counsel about how hundreds of additional insureds’ claims were routinely denied based on the restrictive policy interpretations offered and “[t]he three adjusters who testified did not recall ever accepting an additional insured tender.” Additionally, the fact that the denials were form letters, “rather than the product of any appropriate case-by-case analysis” also weighed in favor of finding bad faith. Id.

As to to punitive damages, the court found that American Safety had demonstrated a “pattern and practice of using every conceivable argument to deny coverage, whether the arguments are weak or strong, valid or invalid.” “Such conduct showed the company was primarily protecting its own interests in refusing to defend its additional insureds in construction defect cases.” Using a third party administrator to handle claims was no defense either, because an insurer “cannot avoid responsibility by creating a company to handle claims and allowing the company and its managing agent … to deny all AI claims….” The pattern of not accepting additional insured tenders had gone on for years and clearly was known to the officers and managing agents of American Safety. In effect, American Safety had been issuing additional insured endorsements with knowledge “that coverage would never be honored and knowing that the additional insureds intended that they would be receiving a defense if they were sued in construction defect cases.” Accordingly, the court found that a punitive damage award was appropriate. Id. at *1124-1126.

The appellate court then discussed the award of Brandt fees. Id. at *1127. American Safety disputed the amount of the award because Pulte’s representation was originally based on a contingency fee agreement. Under the original contingency fee arrangement, the fee award would have been approximately $371,000.  However, after the trial on bad faith but before the punitive damages award, Pulte modified the agreement to be based on an hourly rate. Id. at *1130. After modification of the fee agreement, Pulte sought to recover fees of approximately $645,000.  While the trial court addressed Cassim v. Allstate Ins. Co., supra 33 Cal. 4th 780, stating that “trial courts retain discretion to disregard fee agreements that appear designed to manipulate the calculation of Brandt fees to the plaintiff’s benefit”, it disagreed with American Safety that the change in the fee agreement was to manipulate the process.  Therefore, after making deductions for fees unrelated to pursuing amounts due under the insurance contract, the trial court awarded $471,313.52 in Brandt fees. Accordingly, based on a one-to-one ratio with the Brandt fees, the trial court awarded $500,000 in punitive damages.

The Court of Appeal reversed stating, “[w]e have serious concerns that this change in Pulte’s fee agreement was apparently ‘designed to manipulate the calculation of Brandt fees to the plaintiff’s benefit.” Id. at *1132. The appellate court also disagreed with the trial court’s decision that case law suggests that parties have the right to modify a prior contingent fee arrangement, such that a subsequent award based on a reasonable hourly rate is allowable. See, Merced Irrigation Dist. v. Woolstenhulme (1971) 4 Cal.3d 478, *505 (where a modified agreement was reached, “the trial court could properly find that the arrangement was no longer a purely contingent one”.) The appellate court also disagreed with the argument that because Pulte had actually incurred and paid the hourly fees, that amount must be considered as the proper amount of Brandt fees. The appellate court concluded that the trial court should have made the attorney fee award based on the agreement in force during the trial.  The Court of Appeal then remanded the case to the trial court to recalculate the proper amount of attorneys’ fees and to adjust the punitive damage award since it was based on the improper attorney fee award. Id. at *1133.

Lessons to be learned

Clearly, courts will not allow modifications in fee agreements that are designed to manipulate the calculation in Brandt fees to increase a punitive damages award. When assessing a possible bad faith case consider from the outset whether a contingency fee agreement or an hourly agreement makes the most sense based on the principles set forth in Pulte Home Corporation v. American Safety Indemnity. Analyze the amount of work involved in recovering the policy benefits based on the facts of the case. If you assess the possibility of punitive damages recovery to be high but the amount of policy benefits to be recovered to be small, perhaps an hourly agreement should be considered. On the other hand, if the amount of policy benefits at issue is substantial, a standard contingency agreement is appropriate.