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Chong v. State Farm: Class Action Alleging Insurer’s Violation of California’s Make-Whole Rule Survives Defense Motion To Dismiss Federal District Court Holds

California District Court Rejects Defense Rule 12(b)(6) Motion to Dismiss Class Action and Holds, as Matter of First Impression, that Insured is Entitled to Recover Lawyer Fees and Costs to be Made Whole

Liability insurers may pay a first party claim and then seek reimbursement from the third-party tortfeasor either by (1) joining in and/or financing the insured’s action against the responsible party, or (2) waiting until the insured prevails in a lawsuit against the third party and then demanding reimbursement. Kathleen Chong filed a putative class action against State Farm Mutual Automobile Insurance Company alleging that it violates California’s make-whole rule waiting until the insured prevails in a lawsuit against the third party and then demanding reimbursement in full, regardless of the amount of the insured’s recovery. Defense attorneys filed a motion to dismiss the class action under Rule 12(b)(6), and the motion was denied. Chong v. State Farm Mut. Auto. Ins. Co., 428 F.Supp.2d 1136 (S.D. Cal. 2006),

The facts underlying the class action representative’s claim are as follows. Chong had first party medical insurance limits of $5,000; she was injured in a car accident, and State Farm paid her $5,000. Chong then filed suit against the driver of the other car; State Farm knew about the lawsuit but did not participate in it and did not fund it. Ultimately, Chong spent $28,000 in litigation costs and settled the case for $65,000. State Farm then demanded reimbursement of the $5,000 it paid under the policy. Chong, at 1138. Plaintiff filed a class action against State Farm, alleging that it acted improperly because “her net recovery after taking into account her attorney fees and costs was far below the amount she needed to make her whole.” Id.

The defense motion to dismiss argued that California has not adopted a “blanket make whole rule” and that “no California case . . . has ever held that a policyholder’s payment of attorney fees to secure a damage recovery from a third party means the policyholder has not bee made whole and that the carrier is therefore not entitled to reimbursement.” Chong, at 1139. The District Court disagreed. First, it concisely summarized California law on the make-whole rule:

Under California’s common law make whole rule, a carrier that has knowledge of a policyholder’s tort action and decides not to participate in it may not seek reimbursement from the successful policyholder unless the policyholder’s tort recovery exceeds his actual loss. [Citation.] California courts have held that this means a policyholder must only reimburse the nonparticipating carrier for the surplus, if any, remaining after the policyholder satisfies “his loss in full and his reasonable expenses incurred in the recovery.” [Citation.] “Thus, when an insurer elects not to participate in the insured’s action against a tortfeasor, the insurer is entitled to subrogation only after the insured has recouped his loss and some or all of his litigation expenses incurred in the action against the tortfeasor.” [Citation.] This rule applies regardless of whether the carrier’s asserted subrogation right is equitable or contractual. [Citation.]

Chong, at 1140 (citing Plut v. Fireman’s Fund Ins. Co., 85 Cal.App.4th 98, 104-05 (Cal.App. 2000).

Chong’s argument was simple math: the amount needed to make her whole is $65,000 (the amount of the settlement), but she recovered only $42,000 – $65,000 (settlement proceeds) plus $5,000 (insurance proceeds) less $28,000 (litigation fees and costs). Accordingly, “she was not made whole and . . . there was therefore no surplus from which [State Farm] was entitled to seek reimbursement.” Chong, at 1142. The defense claimed that this approach “would amount to an improper shift of attorney fees and costs to insurance carriers.” Id. (State Farm “concede[d] that it must contribute a pro rata portion” of Chong’s lawyer fees and costs, but the District Court noted that State Farm “never offered” previously to make such a contribution. Id., at 1142 and n.1.)

The District Court found that no California court had yet decided whether a plaintiff was entitled to recovery attorneys’ fees and costs under the make-whole rule. Chong, at 1142. After a detailed analysis, including a review of out-of-state cases, the Court opined at page 1144 that

the California Supreme Court would follow the well-reasoned out-of-state decisions which hold that the policyholder’s litigation expenses must be taken into account when determining whether the policyholder has been made whole.

The Court explained that a contrary rule would encourage insurance carrier to sit back and let the insured litigate and his or her own expense – “a risk free gamble with the policyholder’s money.” Chong, at 1145. It found this situation unacceptable:

If the policyholder loses her tort action, the carrier has lost nothing because the carrier has not yet incurred any attorney fees and costs. If the policyholder wins, the carrier, knowing the outcome, may then offer to pay its pro rata portion of attorney fees and costs in exchange for reimbursement. Plainly, such a rule would not be in keeping with the equitable principles underlying the make whole rule and the subrogation doctrine. Id.

NOTE: The District Court stressed that the parties may contract around the make-whole rule, but to do so “a carrier must draft a ‘contractual provision clearly and specifically giving the insurer a priority out of proceeds from the tortfeasor regardless whether the insured was first made whole.’” Chong, at 1140 (citation omitted).