California Supreme Court: notice-prejudice rule in first-party insurance contract is a fundamental public policy that can trump a choice-of-law provision

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In a significant decision last week, the Supreme Court of California broadened the reach of the notice-prejudice rule and applied it, as a matter of fundamental public policy, to override a choice-of-law provision in a first-party pollution insurance policy. In Pitzer College v. Indian Harbor Ins. Co., Case No. S239510, 2019 WL 4065521 (Cal. Aug. 29, 2019), Pitzer College (Pitzer), as part of The Claremont University Consortium, was covered under a pollution insurance policy issued by Indian Harbor.

The Indian Harbor policy “covered Pitzer for legal and remediation expenses resulting from pollution conditions discovered during the policy period of July 23, 2010 to July 23, 2011.” Id. It contained provisions requiring Pitzer to (1) provide written notice of any pollution condition as soon as practicable and (2) “obtain Indian Harbor’s written consent before incurring expenses, making payments, assuming obligations, and/or commencing remediation due to a pollution condition.” Id. However, the policy also allowed for an emergency exception to the consent provision if Pitzer incurred costs “on an emergency basis where any delay ... would cause injury to persons or damage to property or increase significantly the cost of responding to any [pollution condition].” Where the emergency exception applies, Pitzer is still required to notify Indian Harbor “immediately thereafter.”Id. Finally, the policy contained a choice-of-law provision in favor of New York.

Pitzer sought coverage from Indian Harbor for costs and expenses incurred in remediating contaminated soil it discovered on January 10, 2011, during the construction of a new on-campus dormitory. That day, Pitzer determined that remediation would be required given the need to complete the dormitory for the start of the 2012-2013 school year. Pitzer conferred with environmental consultants, who concluded that the least expensive and best option was to remove the soil onsite through a transportable treatment unit. Id. at *2. Remediation work began on March 9, 2011, and was completed a month later for nearly $2 million. Pitzer did not obtain Indian Harbor’s consent before commencing remediation and incurring remediation costs. Id. In fact, “Pitzer did not inform Indian Harbor of the remediation until July 11, 2011, approximately three months after it completed remediation and six months after it discovered the darkened soils.” Id.

On March 16, 2012, Indian Harbor denied coverage due to Pitzer’s breach of the notice conditions and failure to obtain Indian Harbor’s consent before commencing remediation and incurring remediation costs. Pitzer then sued Indian Harbor in California state court, the case was removed to federal court, and Indian Harbor moved for summary judgment. The district court ruled in favor of Indian Harbor, holding that New York law applied based on the choice-of-law provision and that “although a state’s fundamental policy can override a choice-of-law provision, Pitzer had ‘failed to establish’ that California’s notice-prejudice rule is such a policy.” Id. Applying New York law, the district court granted Indian Harbor summary judgment based on Pitzer’s late notice, although it noted in passing that Indian Harbor would not have prevailed if it had to show prejudice. Id. The district court also ruled that Pitzer breached the consent provisions and that, even if the emergency exception applied, Pitzer still failed to provide the required notice “immediately thereafter.” Id. at *3.

Pitzer appealed to the Ninth Circuit Court of Appeals, which certified to the Supreme Court of California the question of whether the notice-prejudice rule is a fundamental public policy, and if so, then “the appeal then turns on whether, in a first party policy like Pitzer’s, a consent provision operates as a notice requirement subject to the notice-prejudice rule.” Id>. In answering the certified question, the California Supreme Court first considered whether the choice-of-law provision in the Indian Harbor insurance contract was enforceable. It stated that such a provision is generally enforceable unless “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.”Id. The court explained that “[i]f there is no such conflict, the court shall enforce the parties’ choice of law. If, however, there is a fundamental conflict with California law, the court must then determine whether California has a ‘materially greater interest than the chosen state in the determination of the particular issue. ...’” Id. It found that the choice-of-law provision was enforceable because “the parties agree with the district court’s finding that there is at least a “reasonable basis” for the selection of New York law.” Id.

Next, the court considered the issue of whether the notice-prejudice rule is a fundamental public policy. It explained the notice-prejudice rule as follows:

California’s notice-prejudice rule requires an insurer to prove that the insured’s late notice of a claim has substantially prejudiced its ability to investigate and negotiate payment for the insured’s claim. A finding of substantial prejudice will generally excuse the insurer from its contractual obligations under the insurance policy, unless the insurer had actual or constructive knowledge of the claim. Id. at *3.

The court noted that the notice-prejudice rule has not been referred to a “fundamental rule of public policy,” but has been referred to as “the public policy of this state, favoring compensation of insureds over technical forfeiture.” Id. at *4. It also stated that “when our goal is to protect those with inferior bargaining power in the insurance context … the notice-prejudice rule may be considered fundamental because it is connected to concerns of fundamental fairness in the negotiation process.” Id. It then explained the various reasons for construing the notice-prejudice rule as a fundamental public policy.

First, the court stated that the notice-prejudice rule “cannot be contractually waived and, thus, restricts freedom of contract.” Id. As such, it “overrides the parties’ express intentions for a defined notice term” and prevents a technical forfeiture of coverage unless the insurer can show prejudice. Id. Second, the court found that “the notice-prejudice rule protects insureds against inequitable results that are generated by insurers’ superior bargaining power.” Id. at *5. Citing to the Restatement of Contracts, the court stated that “policies ‘designed to protect a person against the oppressive use of superior bargaining power’ may be considered fundamental and unwaivable.” Id Third, the court found that the “notice-prejudice rule promotes objectives that are in the general public’s interest because it protects the public from bearing the costs of harm that an insurance policy purports to cover.” Id.

Rejecting the argument that the notice-prejudice rule is not a fundamental policy, the court stated that the fundamental public policy is meant to prevent “a windfall redounding to the benefit of the insurer, the party with superior bargaining power” and noted that “courts already decline to enforce contractual provisions that they consider to be contrary to state public interests.” Id. It expressly found that the “notice-prejudice rule, by contrast, overrides a contractual term, and is expressly “designed to restrict freedom of contract.” Id. at *6. Thus, it concluded that “California’s notice-prejudice rule is a fundamental public policy of California,” “is based on the rationale that the essential part of the contract is insurance coverage, not the procedure for determining liability, and “ the notice requirement serves to protect insurers from prejudice, ... not ... to shield them from their contractual obligations’ through ‘a technical escape-hatch.’” Id.

Next, the court considered “whether the notice-prejudice rule should be extended to a consent provision in the context of first party coverage.” Id. at *8. It found that because “there is no claim of liability for the insurer to defend and hence no logical need for it to retain unimpaired control over the claims handling,” the “failure to obtain consent in the first party context is not inherently prejudicial, and the usual logic of the notice-prejudice rule should control, in the absence of a coverage requirement for a third party claim or potential claim.” Id. It held that “California’s notice-prejudice rule is applicable to a consent provision in a first party policy where coverage does not depend on the existence of a third party claim or potential claim.” That said, because Pitzer and Indian Harbor disagreed as to whether the policy provided a first or third-party coverage, the court left the specific question of whether the notice-prejudice rule applies to the consent provision in the policy to the Ninth Circuit. Id.

We highlight the Pitzer College v. Indian Harbor Ins. Co., decision because it holds, in the first-party pollution coverage context, that the notice-prejudice rule is a fundamental public policy in California that can override a choice-of-law forum in a pollution insurance contract in certain circumstances.

See the decision here.

Learn more by contacting either of the authors.