There are two basic problems involved. One relates to the nature and extent of the duty owed by an insurance company to its insured when excess liability may be involved, and whether that duty was here violated. The second question revolves around the legal effect of the covenant not to execute, and whether the securing of that covenant fulfilled the company's obligation to its insured.
It is obvious that in case where excess liability may be involved the insurance company is in an anomalous position. The attorney for the insurance company then owes allegiance to two clients whose interests may be conflicting. He owes a high duty of care to both clients. Under the terms of the policy the insurance company retains control of the litigation. This conflict of interest and its effect have been discussed in many cases. It usually arises in connection with offers of settlement, but, however it may arise, the problem is the same. All of the cases agree that the insurance company owes a duty to its insured, and if it violates that duty it may be liable to the insured for damages suffered by the insured in excess of its policy limits. There is some conflict as to whether liability in such cases is predicated on negligence or upon bad faith. California has recently aligned itself with the jurisdictions that apply the bad faith test. In that well-reasoned opinion, prepared by Acting Presiding Justice Turney Fox of the Second Appellate District, Division Two, the court collects and discusses most of the pertinent authorities on the subject, rejects the negligence test, and applies the bad faith test. Under that test, when the interests of the insurance company and of the insured conflict, the insurance company must act in good faith to protect the insured, and must take into account and give fair and objective consideration to the insured's interests. The insurance company has the legal right to try and protect its own financial interests, but when those interests conflict with those of the insured, the company must in good faith, give consideration to the interests of its insured. It has no right to sacrifice the interests of the insured in order to protect its own interests. This duty to act in good faith, while not expressly set forth in the policy, is necessarily implied as a correlative duty growing out of certain rights and privileges which the insurance contract gives to the insurer. By the terms of the insurance policy the control of the defense of the action is turned over to the insurer, and the insured is precluded from interfering in any settlement procedure. But when liability in excess of the policy limits in involved the insured's interests become directly involved. It is then the duty to act in good faith becomes important. In order to avoid liability under the bad faith rule the insurance company must give at least as much consideration to the financial well being of the insured as it does to its own interests. These principles are all discussed at length in the Brown case, supra, and the cases announcing them collected and commented on at some length. What was there said need not be repeated in this opinion. All of the cases agree that in order to act in good faith the company, as a minimum, must make a diligent effort to ascertain the facts upon which a good faith judgment may be predicated, where possible excess liability is involved, must communicate the result of such investigation to the insured, and must inform him of any settlement offers that may affect him, so that the insured may take proper steps to protect his own interests.
In the present case the insurance company, through its attorney Cohn, clearly violated the duty it owed to Ivy. The insurance company assumed complete control of the defense of the Smith-Sawatzke action. Without investigation of the facts, and without informing Ivy, it stipulated that Sawatzke was the agent of Ivy, personally, that one of the corporate defendants was the alter ego of Ivy, and then stipulated to a judgment in excess of the policy limits. It even had the findings amended so as to stipulate that Pestgo and East Bay Refinol Company were solely owned enterprises of Ivy and were operated by him under the name of 'Ivy Enterprises.' This was all done in an obvious attempt to save itself money by trying to saddle most of the liability on the Guarantee Insurance Company. The record in this case indicates that the possible liability of Guarantee was questionable. All of this was done without informing Ivy or without even communicating with him. The findings that this was done 'in good faith,' and that 'the evidence available for introduction at the trial of the Smith action justified and supported the finding that Sawatzke was the agent, of this plaintiff at the time of said accident' are simply not only not sustained by the evidence but are contrary to the evidence. It may be assumed that Cohn honestly believed that Sawatzke was negligent and that there was no contributory negligence. It may also be assumed that Cohn honestly believed that Sawatzke was the agent of Pestgo Manufacturing Company at the time of the accident. But Cohn, according to his own admissions, had no facts justifying the admission that Sawatzke was the agent of Ivy, personally, or that Ivy was the alter ego of Pestgo, or that Ivy Enterprises was even then in existence. These stipulations were entered into in the attempt to fasten liability on Guarantee Insurance Company. That company had insured Ivy under the name of Earl Ivy dba as 'Ivy Enterprises.' The only possible way that Guarantee could be held liable would be if Ivy were held personally responsible for the acts of Sawatzke, and then by trying to establish that at the time of the accident Pestgo was in fact nothing more than Ivy dba as 'Ivy Enterprises.' Thus, the only possible way to hold Guarantee was to stipulate that Sawatzke was the agent, personally, of Ivy. Cohn had no information at all upon which to base this stipulation. This was clearly a breach of the duty the insurance company owed to its insured, and was bad faith closely akin to a fraud on Ivy.
For further case law see Persons Affected by Law Do Not Know When It Applies; Court Addressed Scope of General Laws of the State; and Statute of Frauds.
