Bad Faith and the Duty to Defend
I’m reading a wonderful book right now called “Young Men and Fire,” by Norman Maclean. The book is about a horrific forest fire that took place in Montana in 1949. Amazing how small sparks can result in a conflagration beyond all belief. Those of us involved in the litigation game are familiar with that problem. How about an $11 million claim by a client against a law firm resulting from a discovery violation, spawning several lawsuits and a major insurance battle? That was the situation recently faced by the Third Circuit in Post v. St. Paul Travelers, which has been approved for publication. The case has some interesting things to say about how far the duty to defend extends, and about the essential elements of a bad faith claim.
The facts: Post and another attorney at the firm of Post & Schell, P.C. got themselves into hot water for improperly redacting information from documents produced by their client Mercy Hospital in a medical malpractice suit. Unfortunately for Post, the misconduct came up during testimony at trial. Mercy immediately fired Post, but became extremely concerned that the jury believed there had been a “cover-up,” which could lead to uninsured punitive exposure. So, Mercy settled with the plaintiffs for $11 million – its full liability limit.
Mercy then retained counsel to bring a malpractice suit against Post. The malpractice lawyer asked Post to advise his carrier (Travelers) of the claim, but did not immediately file suit.
The plaintiffs in the underlying case commenced a sanctions proceeding against Post and his firm for the redactions. Here’s where this gets interesting, from an insurance perspective. Post filed a claim for coverage for the sanctions proceeding under his E&O policy on the ground that, although styled as a sanctions proceeding, the complaint was basically a claim for legal malpractice, and facts developed in the sanctions proceeding could be used against him in a malpractice suit. (Note: The underlying plaintiff, not Post’s client, filed the sanctions petition.)
Travelers denied coverage based upon an exclusion for “civil or criminal fines, forfeitures, penalties or sanctions.” Travelers also denied coverage on the ground that a covered “claim” is defined in the policy as a “demand that seeks damages,” and sanctions are not “damages.”
Then, the plot thickened. Mercy (or perhaps its carrier, perhaps sensing a potentially quick way to recover some insurance money) intervened in the sanctions proceeding, arguing that it had an “important interest” in the proceeding because the misconduct of its former counsel was at issue. Mercy requested whatever relief was “just and equitable” from Post, including “costs, attorneys’ fees and expenses.” Mercy’s Chief Executive Officer confirmed at deposition that Mercy sought money damages in the sanctions proceeding, including the amount of the settlement and compensation for negative publicity.
At this point, Travelers “saw the light” and offered to contribute to Post’s defense costs in the sanctions proceeding, subject to various qualifications. Post agreed to Travelers’ terms, and submitted legal invoices for over $400,000, which included $250,000 in fees incurred in the sanctions proceeding before Mercy had intervened. Travelers, bless its heart, generously offered to pay $36,000 of the $400,000. Post was not happy. Later, Mercy offered to mediate its malpractice claim with Post, and Travelers again generously agreed to contribute $3000 toward the mediation. Post was even unhappier.
Meanwhile, Post sued the underlying plaintiffs’ lawyer (Quinn) for defamation and tortious interference, thinking that, faced with such a suit, Quinn might withdraw the sanctions petition, preventing Mercy from getting “free discovery” to be used in the yet-to-filed malpractice suit. The “best-defense-is-a-good-offense” tactic worked, and the underlying plaintiffs withdrew their claim. Mercy then sued Post for malpractice, and Post filed a separate suit against Mercy (not a counterclaim), presumably for fees. Ultimately, Mercy and Post dismissed their claims against each other, with no money exchanging hands.
In the inevitable coverage litigation between Post and Travelers over defense costs incurred in the various litigations, here were the main issues and how they were resolved:
1. Did Travelers have to pay defense costs associated with the sanctions proceeding (in addition to the malpractice suit)? Answer: Yes, but only after Mercy (Post’s client) joined the proceeding and sought damages from Post. The Court wrote: “No amount of participation by Mercy in the sanctions proceedings would be sufficient prior to the filing of a ‘suit’ – which means under the Policy ‘a civil proceeding that seeks damages’ – a prerequisite to Travelers’ liability…that prerequisite was satisfied [when] Mercy filed its answer to the sanctions petition and sought damages against Post.” Once that condition was met, however, the sanctions proceeding and the malpractice claim were inextricably intertwined, so the defense of one necessitated the defense of the other.
2. Did Travelers have to pay the costs of Post’s separate suit against Mercy, which was interposed as part of his overall defense strategy? Answer: No, although had Post asserted a counterclaim instead of a separate suit, Travelers would have been compelled to cover the costs of prosecuting the counterclaim, because “the pursuit of the counterclaims [would have been] inextricably intertwined with the defense.” The Court wrote: “However, Post did not simply assert counterclaims in the same proceeding; rather, he filed a separate civil action in a different venue…to hold that Post’s separate action was covered by the Policy simply because it related to Mercy’s suit would condone, and perhaps even encourage, the multiplicity of litigation.”
3. Did Travelers commit bad faith by denying coverage based upon the “sanctions exclusion” when it knew that actual damages were sought? Answer: No, because according to the Court, there was no “dishonest purpose.” Specifically, the Court wrote: “Travelers did not frivolously decline to provide a defense to Post; rather, after an investigation and retention of outside counsel, Travelers reasonably concluded that the sanctions exclusion in the Policy applied to Post’s claim and denied coverage. Even if Travelers’ claims-handling was not ideal, there is no evidence in the record…to indicate that Travelers’ purported handling of Post’s claim was motivated by dishonest purpose or ill will.” (Emphasis added.)
One observation on the bad faith issue. “Dishonest purpose or ill will” is a pretty murky standard. Exactly how would a policyholder go about proving that? Not every case involves a statement from a claims person saying: “Even though we should, we’re not paying, and, by the way, I hate you.” Maybe judges should avoid formulating standards that are difficult if not impossible to apply in the real world. If the insurance company takes a coverage position that is not legitimately debatable and is not reasonably supported by documents in the claim file, that’s bad faith…which most people in the insurance industry understand.
You can read the full decision by clicking here.