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September 2010

Village Northridge Homeowners Association v. State Farm Fire and Casualty Company ? Settling Insured May not Keep Settlement Proceeds and Sue Insurer for Fraud

Statutory Scheme Requires Insured Claiming Settlement was Fraudulently Induced to Rescind Contract and Return Settlement Proceeds Before Suing Insurer

(August 30, 2010) ___Cal.4th__; 10 C.D.O.S. 11321

The Supreme Court of California reversed the Court of Appeal, ruling an insured who executes a full and complete release of a claim against its insurer and later claims the release was induced by fraud, may not elect to affirm the contract, keep the settlement proceeds, and sue instead for fraud damages.  The insured must follow the statutory rules governing rescission including restoration of settlement proceeds.

Plaintiff Village Northridge Homeowners Association (Northridge) owned property damaged in the 1994 Northridge earthquake.  Northridge filed a property damage claim with its insurer, State Farm and Casualty Company (State Farm).  State Farm paid Northridge about $2,068,000 on policy limits totaling $4,979,900, including a 10 percent deductible.  Northridge later sought additional benefits based on a recalculation of the deductible.  State Farm paid Northridge some small additional amounts but the parties continued to dispute policy limits and the amount of money owed.

In November 1999, Northridge and State Farm negotiated a settlement under which State Farm paid an additional $1.5 million.  Northridge released State Farm from all known or unknown claims related in any way to Northridge's earthquake claim and waived its rights under Civil Code section 1542.

In December 2001, Northridge sued State Farm for breach of contract and bad faith.  Northridge alleged State Farm had undervalued Northridge's earthquake loss, Northridge had been compelled to sign the release, and that the amounts paid to Northridge did not provide full compensation for Northridge's earthquake losses.  Northridge did not seek to rescind the settlement agreement but rather wanted to affirm the release and seek additional damages.

The trial court granted State Farm's motion for judgment on the pleadings with leave for Northridge to amend to allege fraud in the inducement or rescission.  Northridge did so alleging State Farm committed fraud in the inducement by misrepresenting policy limits.  State Farm demurred, asserting Northridge "could not affirm the settlement agreement and simultaneously assert claims that were expressly released in it."  The trial court sustained the demurrer.

The Court of Appeal reversed.  Analyzing leading cases on the issue, Garcia v. California Truck Co. (1920) 183 Cal. 767 and Taylor v. Hopper (1929) 207 Cal. 102 (holding that if a party seeks to avoid a settlement on the ground of fraud, it must return the settlement amounts), the Court of Appeal limited their application to personal injury actions.  The Court of Appeal based its determination largely on policy considerations articulated in cases from other jurisdictions, which apply common law principles in the absence of statutory authority, to conclude that other general principals applicable to fraud actions allowed Northridge to keep the settlement proceeds and sue for fraud by affirming the agreement.

The California Supreme Court reversed.  The Supreme Court cited the general principle that "where the promisor knows what he is signing but his consent is induced by fraud" the contract is voidable, and the party seeking to void the contract must rescind.  Ford v. Shearson Lehman American Express, Inc. (1986) 180 Cal.App.3d 1011, 1028.  Rescission requires "prompt notice" by the aggrieved party, and its restoring of anything of value received under the contract.  Cal. Civ. Code § 1691.

The Supreme Court disagreed with the Court of Appeal and applied the analysis of Garcia and Taylor distinguishing the cases on which the Court of Appeal relied.  Among other things, these cases did not involve a settlement and release of all disputed claims in which the plaintiff was attempting to "buy peace" from the threat of future litigation (Denevi v. LGCC, LCC (2004) 121 Cal.App.4th 1211), or a release that did not include an unknown claims waiver and for which no monetary consideration was paid (Sime v. Malouf (1949) 95 Cal.App.2d 82).

In addition, the Supreme Court found that, unlike Sime and other cases on which Northridge relied, Northridge did not have a right to retain the settlement proceeds that arose independent of the settlement agreement itself. The release was not included in a contract that had another purpose but rather was the sole purpose of the settlement.  The Supreme Court found that Garcia controls whenever a release is "the sole object of the contract for which consideration was paid."

The Supreme Court rejected the policy considerations cited by the Court of Appeal. The Supreme Court noted the California Legislature declined to overrule Garcia and Taylor when it amended Section 1691.  Citing the legislative history of this amendment, the Supreme Court found the Legislature had specifically rejected the "affirm and sue" principle as applied in the instant case and instead required plaintiffs to comply with the rescission statutes.

Finally, the Supreme Court rejected Northridge's arguments State Farm had a quasi-fiduciary obligation to Northridge and that an adverse decision would undermine the general policy favoring settlement. It noted victims of fraud would still have a remedy by rescinding the contract and suing for damages.  The Supreme Court found the established rule of Garcia and Taylor is more likely to favor settlements.

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This opinion is not final.  It may be withdrawn from publication, modified on rehearing, or review may be granted by the California Supreme Court.  These events would render the opinion unavailable for use as legal authority.

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