The opinion
IN THE COMMONWEALTH COURT OF PENNSYLVANIA
Franjo Vernic DBA SF Rehabitat, :
Objector :
:
v. : No. 4 LIN 2017
: Argued: September 17, 2020
Lincoln General Insurance Company, :
In Liquidation, :
Respondent :
:
(Ancillary matter to In Re: Lincoln :
General Insurance Company In :
Liquidation No. 1 LIN 2015) :
BEFORE: HONORABLE RENÉE COHN JUBELIRER, Judge
HONORABLE MICHAEL H. WOJCIK, Judge
HONORABLE CHRISTINE FIZZANO CANNON, Judge
OPINION BY
JUDGE COHN JUBELIRER FILED: December 3, 2020
Presently before the Court is the question of what priority level should be
assigned to the claim of Franjo Vernic, d/b/a SF Rehabitat or San Francisco
Rehabitat (Vernic), arising out of proceedings surrounding the Notice of
Determination (NOD) issued by the Insurance Commissioner in her capacity as
Liquidator of Lincoln General Insurance Company (Lincoln). The Court granted
reargument at the Liquidator’s request on this specific issue following a single-
judge opinion sustaining Vernic’s exceptions to the Referee’s Report and
Recommendation (Report) on Vernic’s objections to the NOD.1 Vernic v. Lincoln
Gen. Ins. Co. (Pa. Cmwlth., No. 4 LIN 2017, filed Dec. 5, 2019) (Vernic I).
1
The Liquidator had sought reargument on other issues, which the Court denied.
Therein, the Court sustained Vernic’s exceptions on the basis that he did not
irrevocably assign his claim against Lincoln and his claim should be valued at the
total amount of the judgment against Vernic and the attorney’s fees he incurred as
a result of Lincoln’s breach of its duty to defend in California. The Court had also
affirmed the Referee’s decision assigning the claim to class (b) under the order of
distribution provision found in Section 544 of The Insurance Department Act of
19212 (Act), as the Liquidator had initially found. The Liquidator subsequently
asked to assign Vernic’s claim to class (e) as a general creditor claim. Under
California law, the Liquidator asserts that recovery of a judgment resulting from a
wrongful failure to defend is the equivalent to recovery resulting from a bad faith
tort claim, and bad faith tort claims are entitled to no more than class (e) priority.
Vernic first argues the Liquidator waived the ability to challenge the priority level
by failing to file exceptions like he did to the Report. Assuming the issue was
preserved, Vernic argues that the claim should be assigned to class (b) as a
“claim[] under policies for losses wherever incurred,” 40 P.S. § 221.44(b), as the
Liquidator originally found, and the Referee held.
I. FACTUAL BACKGROUND
A. The Policy and Underlying California Litigation
The relevant facts were previously set forth by this Court in Vernic I, as
follows:
Lincoln issued a commercial general liability policy to Vernic, a
general contractor in California, effective from February 15, 2008[,]
to February 15, 2009 (Policy). The Policy stated in pertinent part:
2
Act of May 17, 1921, P.L. 789, as amended, 40 P.S. § 221.44. Section 544 was added
by Section 2 of the Act of December 14, 1977, P.L. 280.
2
We will pay those sums that the insured becomes legally
obligated to pay as damages because of “bodily injury”
or “property damage” to which this insurance applies.
We will have the right and duty to defend the insured
against any “suit” seeking those damages.
(Policy at 1.) The Policy also contained a subcontractor exclusion,
which permitted Lincoln to disclaim coverage for damages caused by
a subcontractor [that] failed to satisfy four specific conditions as set
forth in the Policy.
During the Policy’s coverage period, Vernic entered into a contract
with Edwin A. Hardy (Hardy) to complete remodeling work,
including architectural services, at Hardy’s single-family residence
(Property). Vernic then entered into a contract with Gerald J.
Veverka, d/b/a Veverka Architects[] (Veverka), wherein Veverka
agreed to provide architectural services at the Property. The contract
between Vernic and Veverka included an indemnification provision
requiring Vernic to indemnify Veverka for any and all claims arising
out of Veverka’s architectural services. While Vernic was performing
work at the Property and while the Policy was in effect, the Property
sustained significant damage due to water infiltration. On November
2, 2011, Hardy filed a civil complaint against Vernic in the San
Francisco County Superior Court (trial court), docketed at Edwin A.
Hardy v. Franjo Vernic dba San Francisco Rehabitat, No. CGC-11-
515611, asserting several causes of action arising from Vernic’s
allegedly defective work and the resulting damages to Hardy’s
residence.
It is undisputed that both before and after the complaint was filed,
Vernic and Hardy each notified Lincoln of the claims of damage
allegedly caused by Vernic. On June 14, 2011, Lincoln commenced
an investigation into the claims through an independent adjusting
company, Sams & Associates (Sams). While Sams authored three
reports, the last of which was dated September 29, 2011, its adjuster
admitted to being unable to reach a conclusion regarding whether
Drummond Masonry, a subcontractor whose defective stone work was
believed to be the cause of all or some of the damage to the Property,
was hired by Vernic or Hardy. The last report indicated that Sams
was unable to complete its claim analysis at that time and would
follow up with Vernic to review requested documents from his sub-
contractors.
3
Despite these facts and the questionable applicability of the Policy’s
subcontractor exclusion, Lincoln formally denied coverage in letters
to Vernic dated October 21, 2011[,] and December 14, 2011. . . .
Because Lincoln denied Vernic representation and Vernic could not
afford to hire a private attorney at that time, Vernic filed a pro se
response to Hardy’s complaint.
On or about February 28, 2013, Hardy filed an amended complaint
adding Veverka as a defendant.[] Veverka tendered the defense of the
amended complaint to Vernic and Lincoln, and Lincoln denied the
tender and refused to defend Veverka. Thereafter, Veverka served a
cross-complaint on Vernic for express indemnity. Vernic claims he
was financially unable to file a response to either Hardy’s amended
complaint or Veverka’s cross-complaint. While Vernic did have
private counsel for a period of time during the parties’ subsequent
mediation, he was unable to afford trial counsel, and the case
proceeded to an uncontested bench trial. The trial court subsequently
entered judgment in favor of Hardy and against Vernic in the amount
of $846,779.09 . . . , and entered judgment in favor of Veverka and
against Vernic in the amount of $180,178 . . . , for a total judgment of
$1,026,957.09[,] (California judgment).
Vernic I, slip op. at 2-4 (footnotes omitted).
While the litigation was pending, the parties also entered into various
“agreements.” The first was a “Stipulation re Consent to Judgment and
Uncontested Trial” (Stipulation), which was not signed by any of the parties, but
indicated that Vernic could not afford counsel to defend against the claims and,
therefore, he agreed not to contest the claims and assigned Hardy and Veverka all
rights, claims, interest, and title in relevant insurance policies. Id. at 4-5. The
parties also entered into a Settlement Agreement and Mutual Release (Agreement)
signed by the relevant parties, which provided in relevant part that Vernic would
stipulate to a judgment and covenant not to execute against him or Lincoln and
Vernic would “seek recovery from his liability insurer . . . [with] any recovery
4
from Lincoln . . . apportioned as between [Hardy], [] Veverka, and Mr. Vernic.”
Id. at 6 (alterations in original) (emphasis omitted).
B. Liquidation Proceedings
In 2015, “upon the petition for review in the nature of a complaint for order
of liquidation of Lincoln filed by the Insurance Commissioner, . . . this Court
ordered that Lincoln be liquidated pursuant to Article V of the [Act],” the
Liquidator was appointed, and claims against Lincoln were ordered to be filed. Id.
at 7. “Vernic filed a timely proof of claim on June 13, 2016, demanding
$1,092,250.09 under the Policy . . . .” Id. The Liquidator issued the NOD,
assigning a priority level (b) classification and valuing Vernic’s proof of claim at
zero dollars, explaining that Vernic assigned any and all claims he had against
Lincoln to Hardy and Veverka. (NOD at 1.)
Following issuance of the NOD,
Vernic filed timely objections to the NOD arguing that (1) he did not
effectively assign his claims against Lincoln to other parties,
(2) payment of the judgment against him is not a prerequisite to the
allowance of a claim under the law, and (3) Lincoln improperly
denied him indemnification and a legal defense. The Liquidator filed
a response denying the material allegations in Vernic’s objections, and
asserting that (1) its denial of coverage was justified by the terms of
the Policy, (2) Vernic assigned his rights against Lincoln to Hardy and
Veverka, neither of whom filed a proof of claim, and (3) the
California judgment is unenforceable against Lincoln’s estate because
it was obtained through collusion.
Vernic I, slip op. at 8. At the parties’ request, this Court appointed a Referee, and
the parties agreed to use a summary judgment procedure before the Referee.
Before the Referee, the Liquidator asserted in response to Vernic’s claims that,
5
even if Vernic had not assigned his claim, his claim should be assigned class (e)
priority. Based upon the parties’ submissions, the Referee then issued his Report.
Specifically, the Referee recommended that the NOD be affirmed
with respect to the priority level (b) classification of Vernic’s claim,
but reversed as to the value of the claim. The Referee concluded that
Lincoln had a duty to defend Vernic in the California litigation
because Hardy’s complaint and amended complaint contained
allegations of property damage “actually or potentially within the
coverage of the [P]olicy.” (Report at 9 (emphasis in original).)
However, relying on the Stipulation rather than the Agreement, the
Referee concluded that “Vernic assigned any and all rights to recover
indemnity benefits from Lincoln to Hardy and Veverka[] . . . .” (Id. at
11.) Therefore, Vernic could not recover on the California litigation.
The Referee went on to conclude that Vernic did not and could not
assign his right to a defense, as that right is personal to the insured.
As such, the Referee recommended that Vernic’s claim be valued at
$44,131.69, the uncontested amount he personally paid for private
counsel as a result of Lincoln’s breach [of its duty] to defend. Given
his decision, the Referee also determined that challenges to the
procedure by which Hardy obtained the California judgment, which
would include the Liquidator’s allegation of collusion, were moot.
On February 8, 2019, Vernic filed . . . exceptions to the Report
claiming as follows:
1. The Referee erred in determining that the sole
damages flowing from the breach of the duty to defend
were defense fees and costs, as the judgment entered
against Vernic also flows directly from the failure to
defend; and
2. The Referee erred in determining that Vernic lacks
standing to pursue indemnity claims, because this finding
is based upon an erroneous determination that Vernic
irrevocably assigned his claims against Lincoln, a finding
which is not supported by, and is contravened by, the
great weight of the evidence.
Vernic I, slip op. at 8-9 (alterations in original).
6
Vernic contended that although the Referee was correct that Lincoln
breached its duty to defend Vernic, the Referee incorrectly concluded that the only
damages recoverable were legal fees and costs because California law provides
that an insurance company is liable for the entire judgment entered against the
insured when the insurer breaches the duty to defend or wrongfully denies
coverage. Vernic further asserted that he had standing because the evidence did
not support a determination that he irrevocably assigned his right to recover
damages from Lincoln. (See Vernic’s Memorandum of Law in Support of
Exceptions to the Referee’s Report at 4.) Vernic argued that the Stipulation was
not a final agreement but contemplated an assignment of rights that would be
effective upon the date such an assignment was executed; however, no such
assignment was ever executed. The Liquidator disputed both of these points and,
with respect to the value of the claim, asserted that under California law, refusal to
defend is a breach of the duty of good faith and fair dealing for which the measure
of damages is the insured’s legal fees. (See Memorandum of Law in Support of
Response of Lincoln at 12.) Vernic filed a response, emphasizing that the damages
resulting from Lincoln’s failure to defend include both defense costs and the
amount of the California judgment and maintaining no assignment of Vernic’s
claim. The Liquidator responded in a sur-reply memorandum of law, arguing that
given the Referee’s correct conclusion that Vernic assigned his claim for the
amount of the judgment, only the unassignable legal fees were recoverable.
Moreover, the Liquidator asserted that the Referee never addressed the issue of
whether the value of the California judgment would carry a different priority level
because it flowed from a bad faith refusal to defend. Therefore, if the Referee was
reversed with regard to the question of the assignment of the claim, the Liquidator
7
requested that this Court remand for the Referee to decide the priority issue, which
was fully briefed but not addressed by the Referee. (See Sur-Reply Memorandum
of Law in Support of Lincoln at 4-5.)
C. Vernic I and the Application for Reargument
After argument, the Court sustained Vernic’s exceptions. With regard to the
question of standing, the Court disagreed with the Referee that the documentary
evidence and conduct of the parties demonstrated that Vernic intended to assign his
claims. To be effective, an assignment must manifest the intention “to transfer the
right, without further action. . . .” Vernic I, slip op. at 11 (emphasis omitted). The
Court found that the Stipulation did not meet that requirement, and referred to
another document, “the related assignment,” which was never executed. Id. at 12.
In contrast, the Agreement, which did not contain an assignment, “show[ed]
marked indicia of finality.” Id. The Court also found that the conduct of the
parties did not support the finding of an assignment. Noting that during the
extensive history of litigation in federal and state courts, the parties had “vacillated
on the issue of whether an assignment was made,” the Court concluded that “one
thing remains clear – Vernic is the only party who filed a proof of claim during
Lincoln’s liquidation,” even though Veverka and Hardy were notified of the claim
period as well. Id. at 13. In summary, given that “the entire transaction, the
language of the documents, and the conduct of the parties [did] not clearly show
that their intent was to assign Vernic’s right to recover from Lincoln,” the Court
sustained Vernic’s exception to the Referee’s conclusion that he irrevocably
assigned his claims against Lincoln and so lacked standing. Id.
With regard to damages, the Court reiterated that the Referee determined
Lincoln had a duty to defend Vernic, which it breached, and the Liquidator did not
8
dispute that determination or file an exception to the Report, but instead argued
that the Court should adopt the Referee’s conclusion that Vernic’s award did not
include the amount of the California judgment. Because the Court agreed with the
Referee that Hardy’s claims against Vernic included allegations of property
damage that may be within the Policy’s coverage, the Court reviewed what
damages Vernic could recover. The Referee’s determination that the only
recoverable damages were litigation costs or attorney’s fees was premised upon the
determination that Vernic assigned his right to recover under the Policy, with
which the Court disagreed; therefore, the Court reviewed California law governing
an insurer’s denial of coverage or refusal to defend, which the parties do not
dispute controls here. The Court explained that “when ‘a liability insurer
wrongfully denie[s] coverage or refuses to provide a defense, then the insured is
free to negotiate the best possible settlement consistent with his or her interests,
including a stipulated judgment accompanied by a covenant not to execute.’” Id. at
14 (quoting Pruyn v. Agric. Ins. Co., 42 Cal. Rptr. 2d 295, 299 (Cal. Ct. App.
1995)). This was what had occurred in the present case, the Court concluded, as
Vernic was unable to afford an attorney and, thus, had to appear pro se to
participate in mediation and negotiate a settlement to the best of his abilities.
Lincoln did not take the steps to seek declaratory judgment as to coverage under
the Policy or defend under a reservation of rights, and because it did not, the Court
determined, “[u]nder these circumstances, the verdict is a proximate result of
Lincoln’s breach of its duty to defend.” Vernic I, slip op. at 15 (citing Amato v.
Mercury Cas. Co., 61 Cal. Rptr. 2d 909, 913, 915 (Cal. Ct. App. 1997)
(Amato II)3).
3
Amato II was issued after the California Court of Appeals remanded the case for the
(Footnote continued on next page…)
9
An insurance company that fails to provide a defense “is bound by the
judgment against its insured as to all issues which were litigated in the action
against the insured,” regardless of whether it derives from a good faith settlement,
a default judgment, or a judgment without opposition, the Court explained. Vernic
I, slip op. at 15 (quoting Amato II, 61 Cal. Rptr. 2d at 917). Here, because Lincoln
was aware of facts bringing the claims within possible coverage of the Policy and
it still refused to defend, the Court concluded Lincoln could not “now challenge
the judgment by claiming it was the product of collusion or by demanding a trial
within a trial.” Id. Further, the Court found there was sufficient judicial oversight
of the trial court to mitigate the risk of a collusive or fraudulent settlement and no
remand was necessary to consider the Liquidator’s allegation of collusion. Id.
Accordingly, the Court sustained Vernic’s exceptions to the Report, valued
Vernic’s claim as the total amount of the California judgment, plus the attorney’s
fees he personally incurred as a result of Lincoln’s breach of its duty to defend, and
directed the Liquidator to amend the NOD accordingly. Id. at 15-16.
The Liquidator timely filed an Application for Reargument, asserting
various bases why the Court should exercise its discretion for reargument,
including that the Court should address Lincoln’s argument as to which priority
level applies to Vernic’s claim. Because the Court determined the judgment was
the proximate result of Lincoln’s breach of the duty to defend, the Liquidator
_____________________________
(continued…)
trial court to conduct further proceedings in Amato v. Mercury Casualty Company, 23 Cal. Rptr.
2d 73 (Cal. Ct. App. 1993) (Amato I). On appeal after remand, the California Court of Appeals
issued its decision in Amato v. Mercury Casualty Company, 58 Cal. Rptr. 2d 784 (Cal. Ct. App.
1996). The California Court of Appeals then granted reargument and issued Amato II, which
reiterated the conclusions of the 1996 opinion and addressed the new arguments raised for
reargument.
10
asserted that Vernic’s claim for the amount of the entire judgment was a tort
remedy for the failure to defend, rather than a contractual breach, which constitutes
a general creditor claim subject to priority (e) classification. The Court granted
reargument “limited solely to the issue of what priority level(s) should be assigned
to [Vernic’s] claim.”4 (January 6, 2020 Order.)
II. DISCUSSION
A. Waiver
1. Parties’ Arguments
Before reaching the merits of the priority argument, the Court first considers
a threshold issue raised by Vernic: whether the Liquidator waived the ability to
challenge the priority level. Specifically, Vernic argues that the Liquidator failed
to file exceptions to the Referee’s Report within 30 days, as required by
Pennsylvania Rule of Appellate Procedure 3781(f), Pa.R.A.P. 3781(f). As a result,
Vernic argues the Liquidator is now foreclosed from challenging the class (b)
priority level assigned by the Referee. Vernic also points out that the class (b)
priority level assigned by the Referee is the same priority that the Liquidator
initially assigned the claim.
The Liquidator responds that the Liquidator did not waive the priority issue;
rather, Vernic did by trying to “refashion” his claim.5,6 (Liquidator’s Brief (Br.) at
4
The Court first granted reargument by Order dated January 3, 2020, and denied the
Application for Reargument to the extent that it requested a remand to the Referee. By Order
dated January 6, 2020, this Court clarified its prior order granting reargument by limiting the
issue to solely that of the priority level.
5
The Liquidator’s arguments concerning waiver have been reordered for ease of
discussion.
6
The Liquidator contends Vernic violated the Court’s order granting reargument by
raising an issue for which reargument was not granted and asks the Court, if necessary, to strike
(Footnote continued on next page…)
11
16.) According to the Liquidator, Vernic requested extra-contractual relief in his
proof of claim and, in his objections to the NOD, he asserted that his claim
sounded in tort, but before this Court, Vernic asserts his claim is contractually
based upon the Policy. It was at this time that the Liquidator asserted, at the first
opportunity, that Vernic’s claim warranted class (e) priority, a position the
Liquidator has continually argued since. The Liquidator further argues that
because the Referee found Vernic assigned his claim, the Referee did not decide
the priority issue and, as a result, the Liquidator could not have filed an exception
to the Report challenging priority because the Liquidator was not aggrieved and,
therefore, lacked standing. Moreover, the Liquidator argues waiver, generally, is
“incompatible” with liquidation proceedings and the Liquidator’s statutory duty to
protect the interests of Lincoln’s insureds by seeking “‘equitable apportionment of
any unavoidable loss’ caused by [] [Lincoln’s] failure.” (Id. at 11 (quoting Section
501(c)(iv) of the Act, 40 P.S. § 221.1(c)(iv)).) Further, the Liquidator argues
nothing in the Act precludes the Liquidator from changing the initial priority
assignment “as the facts develop,” (id. at 12), and the Court has the “ultimate
power to decide the correct priority assignment for every claim,” (id. at 13 (citing
40 P.S. § 221.44)).
2. Analysis
Although the Liquidator did not file a formal exception to the Referee’s
Report challenging the priority level, the Liquidator has consistently raised the
_____________________________
(continued…)
the portion of Vernic’s brief related thereto. However, because Vernic argued the Liquidator
waived the priority issue in his answer to the request for reargument, we will consider it.
12
issue, at a minimum, as an alternative argument throughout the proceedings.
Specifically, before the Referee, the Liquidator contended that even if Vernic had
not assigned his claim and had a claim for failure to defend, that claim would
warrant no more than (e) priority level. (See Liquidator’s Response to Vernic’s
Motion for Summary Judgment at 8-12.) Before this Court, addressing Vernic’s
exceptions to the Referee’s Report, the Liquidator contended that, should the Court
determine that Vernic did not assign his claims, this matter should be remanded
because “if the entire judgment were recoverable at all by anyone, it would carry a
class [(e)] priority rather than a class [(b)] priority because it flowed from a bad
faith cause of action.” (Sur-Reply Memorandum of Law at 5.)
Before the Referee, the Liquidator prevailed on its argument that Vernic
assigned his claim. As a result, the Liquidator was not aggrieved by the Report.
Rule 3781(f) of the Pennsylvania Rules of Appellate Procedure, Pa.R.A.P. 3781(f),
governs the filing of exceptions to a referee’s recommended decision.7 It provides
in pertinent part:
(1) Time for filing. Any party may file with the Court exceptions to
the Referee’s recommended decision no later than thirty (30) days
after the filing date of the recommended decision. The exception shall
be served on any other party and the referee.
....
(6) Final order. Upon completion of its review of exceptions, the
Court will enter a final order sustaining or overruling exceptions in
whole or in part. . . .
7
The Liquidator cites Rule 501 of the Pennsylvania Rules of Appellate Procedure,
Pa.R.A.P. 501, which provides that “any party who is aggrieved by an appealable order . . . may
appeal therefrom,” in support of its argument, but Rule 3781 governs the entire claim procedure
in liquidation proceedings from the filing of a claim through to issuance of a final order.
13
(7) When no exceptions filed. Any party may apply to the Court for,
or the Court on its own initiative may issue, an order either adopting
the recommended decision or stating that in the absence of exceptions,
the referee’s proposed order is entered as the order of the Court.
....
(9) Waiver. Unless otherwise ordered by the Court, failure to file
timely exceptions to a referee’s recommended decision shall be
deemed a waiver of further appeal if the Court approves the
recommended decision without modification.
Pa.R.A.P. 3781(f)(1), (6), (7), (9).
Because this Court did not adopt the Referee’s Report “without
modification” but instead sustained Vernic’s exceptions, the waiver in Rule
3781(f)(9) resulting from “failure to file timely exceptions to a referee’s
recommended decision” would not be implicated. Pa.R.A.P. 3781(f)(9). The
Liquidator’s argument regarding priority level was not implicated until the Court
sustained Vernic’s exceptions in Vernic I. In summary, because the Liquidator
raised priority throughout the proceedings, the Referee found in the Liquidator’s
favor on the assignment issue and did not specifically address the arguments
regarding the priority level, and this Court did not adopt the Referee’s Report
without modification, the Liquidator did not waive the issue of which priority level
applies.8 Accordingly, we turn to what priority level is appropriate for Vernic’s
claim.
8
Because the Court finds the Liquidator did not waive its argument related to priority, it
is unnecessary to address the Liquidator’s policy arguments.
14
B. Priority Level
1. Parties’ Arguments
The Liquidator’s argument that Vernic’s claim belongs in a class (e) priority
rather than class (b) priority is twofold: (1) the judgment for defective construction
work was not covered under the Policy; and (2) even if Lincoln wrongly denied
Vernic a defense under the Policy, that claim is tort-based, which falls in class (e).
First, with regard to whether the judgment was covered under the Policy, the
Liquidator argues as follows. To be entitled to class (b) priority, Vernic must be
seeking to recover a benefit to which he was entitled under the Policy. Lincoln
issued Vernic the Policy, which covered bodily injury or property damage due to
Vernic’s accidental conduct, but the Policy did not cover damage to, or defects in,
Vernic’s own work. Hardy alleged in his complaint that he experienced water
damage in the new home Vernic built as a result of Vernic’s defective
construction. Therefore, this damage did not fall within the coverage of the Policy.
California law supports this conclusion; the District Court for the Northern District
of California (Northern District Court) recently concluded that “a policy virtually
identical to Lincoln’s did not apply to defective construction claims against a
general contractor and specialty contractor on a hotel project” because defective
workmanship is not property damage and, even if it was, there was no coverage
given the policy’s exclusions. (Liquidator’s Br. at 18-19 (citing Webcor Constr.,
LP v. Zurich Am. Ins. Co., 372 F. Supp. 3d 1061 (N.D. Cal. 2019), aff’d, 801 F.
App’x 577 (9th Cir. 2020)).) The Policy in the present case “did not cover
Vernic’s contractual assumption of liability for [] Veverka,” nor did Veverka
allege property damage under the Policy, thereby “eliminating any coverage for
Veverka’s cross-claim.” (Id. at 20.) The Referee “did not apply either the
15
[P]olicy’s language or the California coverage principles . . .” but nonetheless
concluded there was an obligation to defend without addressing “whether Hardy’s
claimed damages even qualified as ‘property damage’” or whether other exclusions
apply. (Id. at 21.)
Second, regardless of whether the claim which Vernic seeks to recover is
covered under the Policy, the Liquidator argues the claim warrants only class (e)
priority “because it sounds in tort.” (Id.) In support thereof, the Liquidator argues
that the California Court of Appeals held in Amato II that “[b]reach of an insurer’s
duty to defend violates a contractual obligation and, where unreasonable, also
violates the covenant of good faith and fair dealing, for which tort remedies are
appropriate.” (Id. at 22 (alteration in original) (quoting Amato II, 61 Cal. Rptr. 2d
at 912).) “Vernic based his claim in the Lincoln estate on Amato [II],” arguing that
when he objected to the NOD, the insurer can be liable for the judgments resulting
from third-party litigation where the insurer tortiously does not tender a defense.
(Id. at 23.) Vernic now claims to be seeking only contractual recovery, but as set
forth in Amato II, typical contract damages are the costs of defense while tort
damages include reimbursement for the judgment, even if it is not covered by an
insurance policy. Therefore, even if this Court agrees that Vernic’s claim is purely
contractual and entitled to priority (b) assignment, Vernic can only recover the
amount of his contract damages, the costs of defense, which is $44,131.69 in
counsel fees. Although Vernic contends that insureds, such as he, have always
been able to recover extra-contractual judgments, the California Court of Appeals
would not have had “to resort to tort law” in Amato II to award the amount of the
judgment if that was the case. (Id. at 25.) Additionally, the cases upon which
Vernic rely preceded Amato II, were mostly “decided in materially different
16
circumstances,” and only reiterate the principle that an insurer’s breach of its duty
to defend may allow the insured to recover the amount of a settlement or judgment.
(Id.) These cases do not address under what theory, tort or contract, the insured
may recover. Finally, this Court is required to treat similar claims consistently,
and this Court has already assigned claims like Vernic’s to class (e) priority, such
as in Cohen v. Reliance Insurance Company (Pa. Cmwlth., No. 2 REL 2006, filed
January 7, 2013), and Ario v. Reliance Insurance Company (Pa. Cmwlth., No. 269
M.D. 2001, filed July 2, 2009). Accordingly, the Liquidator asks this Court to
assign Vernic’s claim a priority level (e).
Vernic asserts that the class (b) priority is the correct classification, arguing
as follows. His claim is “for recovery of losses payable under [the P]olicy,” as he
seeks to recover amounts awarded against him within the $1,000,000 Policy limit
and the defense costs allowed under the Policy. (Vernic’s Br. at 20.) This claim
for “amounts payable under [the Policy]” falls within priority (b) as do “all claims
under policies for losses wherever incurred.” (Id. at 21 (quoting 40 P.S. § 221.44)
(emphasis omitted).) Moreover, the Liquidator’s argument otherwise is contrary to
California law. Even if the facts surrounding Lincoln’s denial of benefits may
support a bad faith claim if asserted in a California court, there has been no claim
for insurance bad faith in the present case. Vernic seeks only the amounts payable
under the Policy. While California law may permit an award of tort damages, in
addition to benefits under the Policy where there is a finding of bad faith, Vernic’s
claim is only for amounts owed under the Policy. If this Court accepted the
Liquidator’s argument, “losses to the insured flowing from Lincoln’s breach of its
duty to defend would be assigned an unfavorable priority position simply because
the insurer’s conduct not only breached the contract but was in ‘bad faith.’” (Id.)
17
It would be “patently unfair” to follow such logic as it would reward insurers for
“engaging in bad faith conduct by potentially having policy-based claims
extinguished along with ‘bad faith’ claims assigned a lower priority.” (Id. at 21-
22.)
Vernic argues that his claim is payable under the Policy because, under
California law, “[w]rongful failure to provide coverage or defend a claim is a
breach of contract” that implicates liability under the Policy. (Id. at 22 (quoting
Isaacson v. Cal. Ins. Guarantee Ass’n, 750 P.2d 297, 308 (Cal. 1988)). As the
California Supreme Court has held, where an insured makes a reasonable
settlement after an insurer denies coverage in violation of its contractual duty, the
insured may seek to recover the amount of that settlement against the insurer. In
this case, the judgment was entered following a bench trial and constitutes
presumptive evidence of Vernic’s liability and the amount of that liability. This
liability derives from Lincoln’s breach of its contractual duty to defend; therefore,
Vernic did not need to make a showing of tortious breach or bad faith. It is well
settled that where an entity is bound by agreement to protect another from liability
and does not defend that party despite notice and an opportunity to do so, the entity
is bound by the result of the litigation. Lincoln had notice of the action and the
opportunity to defend Vernic, but it repeatedly refused to do so. In this way,
Vernic’s case is like those in California where judgment was entered against the
insured which led to a contractual right of recovery, but where there was no claim
for insurance bad faith.
Vernic contends this Court agreed that his underlying claims in the
California litigation were covered under the Policy because Vernic appeared at the
bench trial pro se and judgment was entered against him for property damage and
18
litigation costs. As this Court noted in Vernic I, the judgment entered against an
insured, such as Vernic, where the insurer fails to defend is “the proximate result
of the refusal to defend.” (Id. at 25.) This longstanding rule established through
case law does not require a finding of bad faith. Therefore, the judgment entered
against Vernic following Lincoln’s failure to defend is recoverable under the
Policy and there is no requirement for an action in bad faith in order to recover
those losses under the Policy.
Vernic argues the Liquidator’s reliance upon Amato v. Mercury Casualty
Company, 23 Cal. Rptr. 2d 73 (Cal. Ct. App. 1993) (Amato I), and Amato II is
misplaced. The longstanding law is that “the wrongful refusal to defend entitles
the insured to recover all damages within the policy resulting from the breach and
binds the insurer to the judgment entered against the insured,” (Vernic’s Br. at 27),
and the decisions in Amato I and Amato II did not change this rule. Rather,
although Amato I and Amato II involved facts supporting a recovery in tort for the
amount of the judgment, the California Court of Appeals “did not hold that this
was the only avenue to recovery of judgments entered as a result of the failure to
defend.” (Vernic’s Br. at 28.) Moreover, these decisions by the California Court
of Appeals cannot alter the controlling rule of the California Supreme Court in
Isaacson that wrongful failure to provide coverage is a breach of contract. The
possibility for recovery under both theories of tort and contract “does not eliminate
the insured’s right to pursue recovery under a purely contractual theory,” and both
“types of recovery are [] not coextensive.” (Id.) Vernic seeks only contractual
damages limited to the claims under the Policy. Finally, although the Liquidator
cites in its Application for Reargument various Pennsylvania case law and asserts
that the priority determination in this case conflicts with that law, Vernic contends
19
that these cases are distinguishable. Vernic’s claim should “be evaluated under
California law, which holds that both defense costs and the resulting judgment
within the policy limit are contractual losses under the policy,” bringing Vernic’s
claim “squarely within the scope of [Section 544(b)].” (Vernic’s Br. at 31.)
Therefore, the classification of this claim as priority (b) should be affirmed.
2. Analysis
“[C]laim priority is important to all claimants in the liquidation,” where it is
anticipated that the insurer “will not have assets sufficient to pay all claims.” Ario
v. Reliance Ins. Co., 980 A.2d 588, 591 (Pa. 2009). “Recognizing the importance
of classifying claims, the General Assembly enacted the Act to ensure that
claimants entitled to more protection have prioritized claims.” Id. at 594. “Claim
priority . . . is governed by Section 544 of the Act, [40 P.S. § 221.44,] which sets
forth the order of distribution of an insolvent insurer’s assets.” Ario, 980 A.2d at
591. Section 544(b), (e) provides, in relevant part, as follows:
The order of distribution of claims from the insurer’s estate shall be in
accordance with the order in which each class of claims is herein set
forth. Every claim in each class shall be paid in full or adequate funds
retained for such payment before the members of the next class
receive any payment. No subclasses shall be established within any
class.
....
(b) All claims under policies for losses wherever incurred,
including third[-]party claims, and all claims against the insurer for
liability for bodily injury or for injury to or destruction of tangible
property which are not under policies, shall have the next priority. . . .
....
20
(e) Claims under nonassessable policies for unearned premium or
other premium refunds and claims of general creditors.
40 P.S. § 221.44(b), (e) (emphasis added). Claims classified under subsection (b)
have a higher priority than those classified under subsection (e), meaning claims
assigned to class (b) priority will be paid before those assigned to (e). See Ario,
980 A.2d at 591.
Here, the Liquidator, in the NOD, initially classified Vernic’s claim as
priority (b), which the Referee recommended affirming although finding that the
only claim Vernic had under the Policy was for his attorney’s fees because he had
assigned all other rights under the Policy. (Referee’s Report at 18-19.) The Court
concluded in Vernic I that Vernic had not assigned his rights under the Policy and,
therefore, was entitled to recover both attorney’s fees and the amount of the
California judgment under the Policy, but did not expressly address arguments
regarding the priority level. Vernic I, slip op. at 12-13, 15-16.
We begin with the Liquidator’s argument that Vernic’s claim is not one that
falls within the Policy’s coverage. This argument seeks to challenge the Referee’s
conclusion that Hardy’s Complaint “contain[ed] allegations of property damage
actually or potentially within the coverage of the [P]olicy,” which triggered
Lincoln’s duty to defend, which it did not do. (Referee’s Report at 9 (emphasis
omitted).) If the Liquidator disagreed with the Referee’s conclusion regarding
Lincoln’s breach of the duty to defend, the Liquidator could have filed exceptions
to the Referee’s Report pursuant to Rule 3781, but it did not. As the Court stated
in Vernic I, “[u]nder these circumstances,” where Lincoln knew of facts potentially
bringing the claim within its coverage and did not provide a defense, “the verdict is
a proximate result of Lincoln’s breach of its duty to defend.” Vernic I, slip op. at
15. Therefore, this Court will not consider the Liquidator’s arguments to the extent
21
the Liquidator now seeks to challenge the previous conclusive determination that
Lincoln was aware of facts potentially bringing Vernic’s claim under the coverage
of the Policy and, therefore, breached its duty to defend. Nor will this Court
evaluate whether the claims set forth in Hardy’s Complaint fall within the coverage
of the Policy.
To the extent the Liquidator argues such a determination is necessary to
determine whether the claim falls within priority class (b) as a “claim[] under [the
P]olic[y] for losses wherever incurred,” 40 P.S. § 221.44, we disagree. Under
Section 520(d) of Article V of the Act, “[u]pon issuance of the order [to liquidate],
the rights and liabilities of . . . [an] insurer and of its creditors, policyholders,
shareholders, members and all other persons interested in the estate shall become
fixed as of the date of the filing of the petition for liquidation.”9 40 P.S.
§ 221.20(d). Moreover, the “[Li]quidator steps into the shoes of the insurer’s
officers and directors in the conduct of that insurer’s affairs.” Koken v. Legion Ins.
Co., 865 A.2d 945, 958 (Pa. Cmwlth. 2004) (quotation omitted). Therefore, the
Liquidator cannot now assert a lack of coverage when Lincoln, although it asserted
various Policy exclusions, did not pursue an adjudication of that issue. In short,
the Liquidator is essentially stuck with the consequences of Lincoln’s decision not
to defend Vernic and, as discussed more fully below, the resulting verdict against
Vernic. If the Court was to permit the Liquidator to reopen the record to determine
whether policy exclusions applied, we would undermine Section 520(d)’s
requirement that the parties’ rights and obligations are fixed as of the date of the
filing of the petition for liquidation. We decline to do so.
9
Section 540(d) was added by Section 2 of the Act of December 14, 1977, P.L. 280.
22
Thus, we turn to the Liquidator’s contention that Vernic’s claim arises from
Lincoln’s breach of its duty to defend, which sounds in tort, and therefore warrants
an (e) priority as a claim of a general creditor. It is undisputed that California law
applies. As set forth in California law, “where one is bound either by law or
agreement to protect another from liability, he is bound by the result of a litigation
to which such other is a party, provided he had notice of the suit and an
opportunity to control and manage it.” Kershaw v. Md. Cas. Co., 342 P.2d 72, 77
(Cal. Ct. App. 1959). Accordingly, an insurer “bears a duty to defend its insured
whenever it ascertains facts which give rise to the potential of liability under the
policy.” Isaacson, 750 P.2d at 308. Further, when “an insurer erroneously denies
coverage and/or improperly refuses to defend the insured in violation of its
contractual duties, the insured is entitled to make a reasonable settlement of the
claim in good faith and may then maintain an action against the insurer to recover
the amount of the settlement . . . .” Id. (internal quotations omitted).
The Liquidator relies upon the California Court of Appeals’ decisions in the
Amato cases to support its position that Vernic’s claim is one sounding in tort. In
the Amato cases, Mercury Casualty Company (Mercury) issued the insured a
policy for car insurance that provided, as relevant, coverage for bodily injury
sustained by the insured, including resident relatives of the insured. The insured
was driving his car with his mother-in-law as a passenger when he was involved in
an accident in which his mother-in-law sustained injuries. The mother-in-law sued
the insured, the insured requested Mercury to defend him, and Mercury declined
on the basis that the policy did not cover the claim because the insured’s mother-
in-law was not the insured’s resident relative. When the underlying case was
resolved, the insured and his mother-in-law filed suit for “bad faith breach of
23
insurance contract against [Mercury].” Amato I, 23 Cal. Rptr. 2d at 74. The jury
concluded that the insured’s mother-in-law was residing with him at the time of the
accident, and the trial court determined that Mercury breached its duty to defend
and awarded an amount equal to the amount of judgment entered against the
insured in the underlying case, including costs and post-judgment interest. On
appeal, the California Court of Appeals, concluding that Mercury breached its duty
to defend, remanded to the trial court for the purpose of determining damages
because “where the issues upon which coverage depended were not raised in the
underlying action, the insurer [is] not liable for the entire judgment.” Id. at 79
(citing Hogan v. Midland Nat’l Ins. Co., 91 Cal. Rptr. 153 (Cal. 1970)). In Amato
I, the “issues relevant to coverage were not decided in the underlying action” and
therefore the Court of Appeals determined “the proper measure of damages is that
amount which will compensate the insured for the harm or loss caused by the
breach of the duty to defend, i.e., the cost incurred in defense of the underlying
suit.” Id. Because it was not clear from the record before the court whether the
insured “mounted a defense in the underlying action,” or whether the judgment
was entered after default, the California Court of Appeals remanded for the trial
court to “ascertain the amount of damages, if any, properly awardable.” Id.
On remand, the insured stipulated that the matter went by default and
therefore there was no cost of defense, and the trial court concluded, in light of
Amato I, that the insured could only recover damages for the cost of defending the
underlying suit, of which there were none. The insured appealed, and the
California Court of Appeals, “[i]n light of more recent authority and the
clarification of the record that the underlying judgment was by default,” held that
“where an insurer tortiously breaches the duty to defend and the insured suffers a
24
default judgment because the insured is unable to defend, the insurer is liable for
the default judgment, which is a proximate result of its wrongful refusal to
defend.” Amato II, 61 Cal. Rptr. 2d at 911. In reaching this conclusion, the
California Court of Appeals explained that “[b]reach of an insurer’s duty to defend
violates a contractual obligation and, where unreasonable, also violates the
covenant of good faith and fair dealing for which tort remedies are appropriate.”
Id. at 912. Further, “[w]here an insured mounts a defense at the insured’s own
expense following the insurer’s refusal to defend, the usual contract damages are
the costs of the defense.” Id. at 913. The trial court determined in its prior
judgment that “Mercury had no good cause to refuse to defend, and Mercury
therefore tortiously breached the covenant of good faith and fair dealing.” Id. Due
to Mercury’s wrongful refusal to defend and the insured’s financial inability to
mount a defense, the insured suffered a default judgment and it was not discovered
until the subsequent action that there was no coverage under the policy, the
California Court of Appeals stated. Therefore, the Court determined that “Mercury
is liable for the judgment, which is a proximate result of its wrongful refusal to
defend.” Id. The California Court of Appeals also emphasized that “the duty to
defend is of vital importance,” and Mercury was required to defend in lawsuits,
even where “liability under the policy ultimately fails to materialize.” Id.
Vernic has not asserted a separate claim of bad faith refusal to defend, as the
insured did in Amato II, but rather has asserted since he filed the proof of claim
that he was entitled to recover the judgment under the Policy and that Lincoln
breached its duty to defend. Vernic also persuasively argues that even if his claim
arises from Lincoln’s bad faith refusal to defend an action that may have been
25
covered under the Policy, it is counterintuitive to give a lower priority to claims for
judgments resulting from the insurer’s tortious breach of the duty to defend.
The present case is similar to Pruyn, upon which this Court relied in Vernic
I. In Pruyn, the plaintiff filed suit against her homeowners’ association, alleging
that it negligently constructed and maintained the roads and drainage, which
facilitated the water eroding the area around her home, resulting in a landslide and
home damage. The plaintiff served the association’s insurers with the complaint,
but the insurers refused to provide a defense. The association entered into
negotiations with the plaintiff and reached a settlement, assigning the insured’s
right to recover against the insurers in exchange for the plaintiff not executing
judgment on the association. The assignment included a right of action based upon
a breach of duty to defend and a breach of contract. The plaintiff filed to enforce
the judgment. The insurers argued that the judgment could not be enforced against
them as a matter of law, the trial court agreed, and the California Court of Appeals
reversed on appeal.
The California Court of Appeals explained that if the litigation settled
without trial and judgment, “the question whether the liability of the insured was
one which the contract of insurance covered is still open, as is also the question as
to the fact of liability and the extent thereof,” and these questions can be litigated
in a separate action for the purpose of recovering the amount paid in settlement.
Pruyn, 42 Cal. Rptr. 2d at 312. The California Court of Appeals further stated that
“an insured who has been abandoned by . . . [an] insurer and elects to settle rather
than risk an adverse judgment is entitled to an evidentiary presumption in a
subsequent action against the insurer to enforce policy provisions, as to the
insured’s liability on the underlying claim, and the amount of [] liability.” Id. at
26
311-12 (emphasis added) (internal quotations omitted). Because of this, the
California Court of Appeals concluded that the trial court in that case had erred in
sustaining the demurrers to the plaintiff’s complaint on the basis that the plaintiff
could not recover as a matter of law because the allegations, if supported by
evidence, “would be sufficient to raise a presumption that the settlement reflected
the existence and amount of [the insured’s] liability . . . .” Id. at 314.
It does not appear on the record that Vernic has asserted that Lincoln’s
failure to defend was the result of bad faith, but has asserted it was a breach of the
duty to defend, resulting in a judgment against him that is a loss under the Policy.
Although the Liquidator contends that Vernic asserted in the objections to the
NOD that Lincoln’s failure to defend was in bad faith and now asserts that he seeks
only contractual damages, this is not supported by the record, as Vernic asserted in
those objections that Lincoln “fail[ed] to investigate the claim” and “breached its
duty to defend in this matter.” (Objection to NOD ¶ 61.) Vernic’s assertion that
he is entitled to the judgment under the Policy because Lincoln breached its duty to
defend is consistent with California case law, which provides that when “an insurer
erroneously denies coverage and/or improperly refuses to defend the insured in
violation of its contractual duties, the insured is entitled to make a reasonable
settlement of the claim in good faith and may then maintain an action against the
insurer to recover the amount of the settlement . . . .” Isaacson, 750 P.2d at 308
(internal quotations omitted).
Like the insured in Pruyn, it appears Vernic negotiated a settlement to the
best of his abilities after Lincoln refused to defend. Because the California
judgment results from Lincoln’s breach of the duty to defend, which creates a
presumption as to liability, Pruyn, 42 Cal. Rptr. 2d at 311-12, and that liability
27
should have been covered under the Policy, Vernic’s claim is one “under policies
for losses wherever incurred,” 40 P.S. § 221.44(b), and should be assigned
priority (b) under the Act. The Policy expressly provided that Lincoln had “the
right and duty to defend” Vernic. (Supplemental Reproduced Record at 24b.)
Therefore, Vernic is entitled to the amount of the judgment against him, plus the
amount of attorney’s fees he has personally incurred as a result of Lincoln’s breach
of its duty to defend.
III. CONCLUSION
Contrary to Vernic’s assertions, the Liquidator has not waived its ability to
challenge the priority level assigned to Vernic’s claim. However, for the foregoing
reasons, we agree with Vernic’s argument that his claim should be assigned class
(b) priority.
_____________________________________
RENÉE COHN JUBELIRER, Judge
28
IN THE COMMONWEALTH COURT OF PENNSYLVANIA
Franjo Vernic DBA SF Rehabitat, :
Objector :
:
v. : No. 4 LIN 2017
:
Lincoln General Insurance Company, :
In Liquidation, :
Respondent :
:
(Ancillary matter to In Re: Lincoln :
General Insurance Company In :
Liquidation No. 1 LIN 2015) :
ORDER
NOW, December 3, 2020, upon reconsideration of what priority level
should be assigned to Franjo Vernic DBA SF Rehabitat’s (Vernic) claim, the
Notice of Determination shall reflect that Vernic’s claim is assigned to class (b)
priority.
_____________________________________
RENÉE COHN JUBELIRER, Judge