Pacific-Southern Mortgage Trust Co. v. Insurance Co.

Citations: 166 Cal. App. 3d 703; 212 Cal. Rptr. 754; 1985 Cal. App. LEXIS 1868Docket: Civ. 26454

Court: California Court of Appeal; April 10, 1985; California; State Appellate Court

SummaryOriginalCytator Case TreatmentBackward CitatorAnalysis

EnglishEspañolSimplified EnglishEspañol Fácil

Insurance Company of North America (INA) appeals a judgment that awarded damages to Pacific-Southern Mortgage Trust for INA's bad faith refusal to settle a claim regarding a commercial blanket bond issued to Pacific-Southern. Palomar Financial, a subsidiary of Standard Life Corporation, created two real estate investment trusts (REITs): Palomar Mortgage, a short-term lender, and Pacific-Southern, a long-term lender. Perry Davis, an officer of Palomar Financial, was deeply involved in both REITs, making significant investment decisions and serving on loan and executive committees.

Davis sought Pacific-Southern's subparticipation of $1.5 million in a loan to Joe P. Farina, based on several misrepresentations about the loan's terms and origin. In September 1974, Pacific-Southern attempted to rescind the subparticipation agreement due to these irregularities, but Palomar Mortgage refused. Unbeknownst to Pacific-Southern, the loan had been extended beyond its original terms.

Pacific-Southern filed a lawsuit against Palomar Mortgage in federal court, alleging fraud by Davis. The parties agreed to delay proceedings until the loan was resolved. The loan defaulted in October 1976, and a foreclosure sale followed in April 1977, leading to a settlement in 1978. Pacific-Southern notified INA of a potential claim on the bond for fraudulent acts in December 1976, but INA denied indemnification. This prompted Pacific-Southern to sue INA for failing to provide coverage, while INA counterclaimed against Davis.

Pacific-Southern pursued claims against INA for breach of an insurance contract and breach of the implied covenant of good faith and fair dealing. INA disputed coverage for the loss, asserting that Pacific-Southern's lawsuit was untimely under the bond's two-year limitation period following the discovery of the loss. The case was tried before two juries, with the first trial resulting in a mistrial due to a deadlocked jury on fraud allegations. The second jury addressed factual determinations regarding fraud, leading the trial court to rule in favor of Pacific-Southern, finding that the bond covered the loss and that INA breached its duty of good faith by failing to adequately investigate the claim. Pacific-Southern was awarded $1,710,000. INA appealed, claiming insufficient evidence regarding the timeliness of the suit and bad faith, and raised issues concerning jury instructions, attorney's fees, and the damages awarded. INA argued that the action was barred because Pacific-Southern did not file suit within the required two years after discovering the loss, as mandated by the bond's terms, which are enforceable despite being shorter than the statutory period. California courts have consistently upheld such limitations. The definition of "discovery of the loss" has been a contentious legal issue, with precedents indicating it requires more than mere suspicion; the insured must realize both the loss and the associated dishonesty, though full details of the fraud are not necessary for discovery to occur.

A 'loss' in the context of employee dishonesty insurance typically occurs when the insured loses money due to an employee's fraudulent actions. This loss is recognized at the time the dishonest acts take place, rather than when the insured is obligated to cover the loss or when a final adjudication occurs. While this general rule applies in most cases—such as forgery or embezzlement—situations involving secured loans based on fraudulent misrepresentations complicate this timeline, as losses may not manifest immediately and could depend on the debtor's future creditworthiness or property value appreciation. 

Court rulings on when a loss occurs in cases of employee dishonesty have varied. Some courts suggest that loss occurs at the time of the improper loan, while others assert it is only recognized once the loss is clearly established. California case law on this issue remains inconclusive. For instance, in US LIFE Savings & Loan Assn. v. National Surety Corp., the court indicated that loss is discovered upon gaining knowledge of fraudulent acts but did not clarify when the loss itself happened. Similarly, in Continental Ins. Co. v. Morgan, Olmstead, Kennedy, Gardner, Inc., the court found ambiguity in the term 'discovery of the loss,' ultimately ruling that both bonds provided coverage during the relevant periods. The term 'discovery of the loss' is interpreted as the moment the insured learns of an actual loss, not merely a potential one. If the insurer intended for reporting to begin upon discovering fraud, it could have explicitly stated so in the bond terms.

INA's bond provides indemnity against actual losses rather than anticipated or uncertain future losses. The bond's limitation period begins upon the discovery of a real loss, not when a loss is anticipated. The trial court determined that Pacific-Southern discovered a covered loss on October 26, 1976, the date of a loan default, supported by substantial evidence. Although Pacific-Southern was aware of fraud by September 12, 1975, this date represented an anticipated loss, not an actual one. The jury selected both September 12, 1975, and October 26, 1976, as significant dates; however, this does not necessitate a reversal of the verdict due to ambiguity. The jury was instructed that loss occurs when the insured loses money due to an employee's dishonesty, allowing for the interpretation that the discovery of fraud occurred on September 12, 1975, while the actual loss was recognized on October 26, 1976. INA argued against the inclusion of a specific jury interrogatory, but the determination of a loss occurring at the time of loan default renders that argument moot. The court emphasized that Pacific-Southern needed to identify both the loss and its connection to dishonesty before the limitation period began. INA also contended that the jury instructions regarding fraud were erroneous, claiming that negligent representations were incorrectly classified as fraud. When assessing jury instructions, all must be viewed collectively, and a party must request any necessary qualifying instruction to avoid waiving claims of error on appeal.

The trial court provided extensive jury instructions, reiterating that a finding of intent to defraud required more than mere negligent misrepresentation or a simple breach of a trustee's duties. It clarified that intent must be inferred from circumstantial evidence, providing examples to illustrate this point. In one scenario, a wino's incorrect directions were deemed unlikely to indicate intent to defraud, while in another, a cotrustee's reliance on a hazy memory could suggest such intent. INA did not request additional clarifications, and the court concluded that it had adequately instructed the jury regarding the necessity of proving actual intent to defraud, finding no prejudicial instructional error.

Moreover, INA was found to have breached its duty of good faith in settling Pacific-Southern's claim, as the jury determined that by February 11, 1977, liability for the claim had become reasonably clear. The court noted that INA was aware of the relevant facts by that date and had no need for further investigation, yet it denied the claim without justification. Evidence supported the conclusion that INA failed to act fairly in its contractual obligations, potentially giving rise to a tort action for breach of the implied covenant of good faith and fair dealing.

INA failed to attempt a settlement with Palomar Mortgage, Davis, or Farina, and did not seek buyers for the Farina property, thereby not mitigating potential losses. INA contests the court's conclusion that Pacific-Southern incurred consequential damages due to INA’s refusal to settle a claim, which the court deemed liable for damages beyond the bond's penal sum. The trial court awarded Pacific-Southern $1,710,000, comprising $1 million for the bond's penal amount and $710,000 related to breaches of contract and good faith obligations. This included $425,000 in prejudgment interest and $285,000 in attorney's fees. The court's award of prejudgment interest was found to be incorrectly calculated at 10 percent; it should have been at 7 percent, resulting in a reduction of the total judgment to $1,582,500. The award of attorney's fees was upheld as appropriate for efforts related to recovering payments withheld in bad faith. INA's policy indicates that liability for fraudulent acts attaches regardless of when the loss is discovered, and the bond covers losses up to $1 million for dishonest acts by employees during the policy term.

The jury found that Perry Davis committed fraud in representations related to the Farina loan involving PSMT, confirming that he acted within his duties as an employee or committee member of PSMT. PSMT had actual knowledge of its loss due to this fraud on October 26, 1976, which also marked the date when it had sufficient information to alert a reasonably prudent person to the loss. Additionally, an officer, employee, or trustee of PSMT, excluding Davis or colluding individuals, discovered the fraud on September 12, 1975, the same date PSMT recognized the loss. By September 12, 1975, PSMT did not know Davis acted in his official capacity when the loss occurred. The jury also concluded that INA failed to fulfill its legal duty to settle the claim promptly, with liability becoming reasonably clear by January 14, 1977. The document is dated July 14, 1980, and signed by Millard Biggs, Foreman.