By Rebecca Aherne
On March 23, 2010, the Second Appellate District filed its opinion in Amerigraphics, Inc. v. Mercury Casualty Company, 182 Cal. App. 4th 1538, holding the insurer erroneously, and in bad faith, denied coverage to its insured for continuing operating expenses pursuant to business-interruption coverage provided by a “Special Multi-Peril Policy.” The court further held the insured was entitled to punitive damages, but it reduced the amount of punitive damages from $1.7 million to $500,000.
Factual and Procedural Background
Amerigraphics is a printing and graphics design company established in 1997 by Mark Volper and Boris and Marina Smordinsky. The company leased space in Sherman Oaks, CA and made tenant improvements over the next several years in the approximate amount of $70,000. The company was very successful until 2001 when it experienced a substantial drop in business. In April 2003, its premises were flooded by a broken water heater in a second floor restroom. The water damaged all of the company’s electrical equipment including a $12,000 printer and a $5,000 scanner. Volper contacted the seller of the equipment, RM Consulting, which determined it was irreparably damaged.
The policy issued to the company by Mercury included business-interruption coverage which provided the company will pay for the actual loss of business income sustained due to necessary suspension of operations during the period of restoration. Business income was defined as net income that would have been earned if no loss had occurred and continuing normal operating expenses incurred.
Volper promptly reported the loss to Mercury and the claim was assigned to adjuster Ken Brown. Although Brown subsequently called Volper, he failed to discuss the available coverages with Volper as required by company guidelines. In May, Volper provided Mercury with a preliminary loss evaluation listing items of business personal property worth approximately $43,000. Mercury paid $10,000 toward the business property loss.
It was not until more than a month after the flood that Mercury arranged for an inspection of the printer and scanner. The tests were performed in June, but the results were not given to Volper until September. Mercury’s position was that the equipment had been restored to pre-loss condition, but Volper asserted the tests were inaccurate and inconclusive. When Mercury finally reexamined the equipment in June 2004, it was found to be inoperable.
When Volper inquired about normal operating expenses, Brown denied such coverage existed until Volper provided him with a copy of the relevant policy language. Pursuant to Brown’s request, Volper sent him a list of $59,467 in expenses as of September 12, 2003 with the indication that the funds were needed ASAP in order for his business to survive. A year later, Mercury denied the claim on the ground Amerigraphics did not incur a loss in business because its expenses exceeded its income, resulting in an operating loss.
When Volper submitted a claim for tenant improvement loss in June of 2004, Mercury denied such coverage existed. Again, Volper sent Mercury a copy of the portion of the policy providing such coverage as well as a letter identifying the $73,000 in tenant improvements. Mercury denied the claim on the ground there was no damage to the tenant improvements as a result of the flooding, but subsequently directed an investigation to determine whether such damage had occurred. Six months later, Volper wrote several letters to Mercury inquiring as to the status of the claim, including several letters to the president of the company which were routed to the vice-president of claims and the claims supervisor, but never answered. It was not until February 2005, that Mercury sent Amerigraphics a check for $23,000 as “payment in full” for the tenant-improvement claim.
Amerigraphics sued Mercury for breach of contract and bad faith. The trial judge held the insured was entitled to recover both net income and continuing normal operating expenses without having to offset one against the other. The jury determined that Mercury breached the insurance contract, and that Amerigraphics sustained damages as a result thereof in the amount of $130,000. The jury also found that Mercury breached the implied covenant of good faith and fair dealing, and in addition, that it acted with fraud, malice and oppression. The jury awarded Amerigraphics $3 million in punitive damages and $40,000 in prejudgment interest. The judge reduced the award of punitive damages to $1.7 million – ten times the amount of the compensatory damages and interest.
Judicial Holding and Analysis
The appellate court affirmed the judgment except for the amount of punitive damages which it reduced to $500,000. As respects the application of the business income provision, Amerigraphics argued it required Mercury to pay for (i) lost income and (ii) continuing normal business expenses during the period of business suspension. To the extent there was no lost income (i.e., there was only a net loss), there would be no amount paid under subpart (i), but the insured would still be paid under subpart (ii) for its operating expenses. Mercury, relying on several non-California cases, argued that if the insured’s net income during the period before the loss was a net loss that was greater than its operating expenses, the insured would not recover any proceeds under this provision. Stating that it was not bound by out-of-state authorities, the court adopted the insured’s interpretation. In its opinion, the plain meaning of the policy language would lead an ordinary insured to conclude that in the event of a covered loss that forced the suspension of its business operations, the policy would provide coverage for any lost profits, and even if there were no lost profits, for ongoing expenses incurred during the period of suspension. There is nothing in the policy language to suggest to an insured that if a business is not earning a profit it should not expect coverage for its continuing expenses during the period it cannot operate.
As respects the determination that Mercury breached the implied covenant of good faith and fair dealing, the jury was instructed that it could find Mercury liable for bad faith if it found Mercury unreasonably failed to pay, or unreasonably delayed payment or failed to properly investigate the loss. There was substantial evidence on which the jury could find that Mercury engaged in bad faith. There was also more than substantial evidence to support an award of punitive damages. Pursuant to Civil Code section 3294(a), punitive damages may be awarded if the defendant is guilty of oppression, fraud or malice. The evidence showed Mercury was intentionally dishonest and showed a conscious disregard of Amerigraphic’s rights. Mercury failed to abide by its own guidelines, unreasonably delayed in responding to demands for coverage, failed to promptly and fully investigate Amerigraphics’ claims, denied the existence of coverage provided by the policy, and denied coverage prior to conducting an investigation.
Regarding the amount of punitive damages, the court held that $1.7 million was constitutionally excessive. The due process clause of the Fourteenth Amendment places constraints on punitive damage awards. “Grossly excessive or arbitrary awards” are prohibited. Citing the Sate Farm v. Campbell case, (2003) 538 U.S. 408, the court noted the following factors determine the appropriateness of punitive damage awards: 1) the degree of reprehensibility of the defendant’s misconduct; 2) the disparity between the harm suffered and the damages awarded; and 3) the difference between the punitive award and the civil penalties authorized in similar cases. The most important of these factors is the degree of reprehensibility of the defendant’s conduct. Courts look at a number of factors to determine the degree of reprehensibility. Because only one of the factors applied here-Amerigraphics was financially vulnerable, the court did not discern a high degree of reprehensibility. Regarding the ratio of punitive damages to the compensatory award, the trial court relied on the Simon v. San Paolo case, (2005) 35 Cal. 4th 1159, in reducing the award of punitive damages to a ten-to-one ratio, but on appeal Mercury argued that a one-to-one limit was appropriate in most cases, especially those involving pure economic loss. The appellate court decided that neither the interest in deterrence, nor Mercury’s substantial wealth, justified a punitive damages award of ten times the amount of compensatory damages. On the other hand, the $10,000 statutory penalty for deceptive practices by insurers was not sufficient where, as in this case, the insurer engaged in a course of conduct over a period of years that involved many prohibited acts. The court concluded that the maximum award of punitive damages, consistent with due process, was $500,000, an award based on a 3.8-to-one ratio.
Comments and Implications
The determination of the appropriate amount of punitive damages is not an exact science. As the court stated, “[t]o state a particular level beyond which punitive damages in a given case would be grossly excessive, and hence unconstitutionally arbitrary, is not an enviable task. In the last analysis, an appellate panel, convinced it must reduce an award of punitive damages, must rely on its combined experience and judgment.” The pendulum appears to be swinging back in the direction of defendants. In the Roby v. McKesson case, (2009) 47 Cal. 4th 686, the California Supreme Court, for the first time, reduced the amount of punitive damages awarded by a jury. In this employment discrimination/harassment case, the jury awarded $15 million in punitive damages and $3 million in compensatory damages. Based on its finding the defendant’s conduct represented a relatively low degree of reprehensibility, the Supreme Court reduced the compensatory damages to $1,905,000, and concluded that for punitive damages, a one-to-one ratio was the constitutional limit. However, courts have applied a higher ratio depending on the degree of reprehensibility of the defendant’s conduct. In Txo Productions v. Alliance Res. Corp., 509 U.S. 443, the U.S. Supreme Court upheld a punitive damage award of $10 million even though the actual damages were only $19,000. The court eschewed an approach that focuses entirely on the relationship between actual and punitive damages, and considered the magnitude of the potential harm the defendant’s conduct would have caused to the intended victim as well as the possible harm to other victims.