Procedural Bad Faith

Given the appealing nature of this tort to insureds who are otherwise unable to prove breach of contract or violations of unfair claims handling statutes, insurers face the possibility that similar claims will emerge in states currently silent on the issue or will gain increasing popularity in those states that recognize the tort. Insurers should always be mindful of the tort of procedural bad faith and, regardless of the merits of the underlying claim and the confidence with which the insurer denies coverage, should recognize that each and every claim, covered or not, can cost you.

Julia Karen Ulrich is an associate and Dennis O. Brown is a partner in the Hartford, CT office of Edwards Angell Palmer & Dodge LLP. Brown is a member of this newsletter's Board of Editors.

It may sound like risk without reward, but an insurer with a policy that does not provide coverage may still be vulnerable for paying out on a bad faith claim. There is a long-held assumption in the insurance industry that a valid claim for bad faith against an insurer must be predicated on a covered claim that was wrongfully denied or mishandled. This misperception is not unfounded ' it stems from a long line of well-reasoned opinions and, quite frankly, a common-sense understanding of the contractual relationship between an insurer and its insured. However, it is critical for insurance companies to be aware of the somewhat arcane yet increasingly popular common law tort often referred to as “procedural” (as opposed to “substantive”) “bad faith.” Unlike substantive bad faith, which is, in basic terms, the failure by an insurer to pay a meritorious claim, procedural bad faith is a vehicle for an insured to seek damages based on an insurer's alleged bad faith handling of any claim, meritorious or otherwise. See United Technologies Corp. v. Am. Home Assurance Co. , 118 F.Supp.2d 181, 188-89 (D.Conn. 2000), mod. after recon. on other grounds , 237 F.Supp.2d 168 (D.Conn. 2001). Simply stated: An insurer can be required to pay bad faith damages related to a non-covered claim for which the insurer has no coverage obligations under an insurance policy if the insurer handled the investigation or denial of the non-covered claim in a purportedly unfair manner.

The Onvia Case

By way of example, just late last year, the viability of the tort of procedural bad faith was reviewed, and upheld, by the Washington Supreme Court in St. Paul Fire and Marine Ins. Co. v. Onvia, Inc. , 196 P.3d 664 (Wash. 2008) (en banc). The plaintiff/insured involved in the Onvia case was served with a lawsuit that it tendered to its liability insurer. The insured reportedly resubmitted its tender letter six months later and, shortly thereafter, submitted to its insurer an amended version of the complaint. Approximately nine months after the original tender, the insurer responded for the first time, denying coverage and a defense. Subsequently, in a bad faith and breach of contract lawsuit against the insurer, the presiding district court found that the insurer's coverage determination that there was no duty under the policy to defend or indemnify the insured was correct. See St. Paul Fire & Marine Ins. Co. v. Onvia, Inc., 2007 WL 2005536, *2 (W.D.Wash. 2007). Regardless, however, of the propriety of the insurer's coverage determination, the Washington Supreme Court, reviewing the issue on certification from the district court, held that, in the third-party context, an insured has available to it a cause of action for bad faith claims handling that is not dependent on the duty to indemnify, settle, or defend. The U.S. District Court for the Western District of Washington certified the following question to the Washington Supreme Court: “Under Washington law, does an insured have a cause of action against its liability insurer for common law procedural bad faith[,] for violation of the Washington Administrative Code and/or for violation of the Washington Consumer Protection Act, even though a court has held that the insurer had no contractual duty to defend, settle, or indemnify the insured?” St. Paul Fire & Marine Ins. Co. v. Onvia, Inc., 2007 WL 2005536, 1 (W.D.Wash. 2007). The court reasoned that, under Washington law, insurers have not only a general duty of good faith, but also a specific duty to act with reasonable promptness in investigating and communicating with their insureds following notice of a claim and tender of a defense. The court further reasoned that the duty of good faith is broad and all-encompassing, and is not limited to an insurer's duty to pay, settle, or defend. The court concluded, however, that no rebuttable presumption of harm can arise in this context, and declined to recognize coverage by estoppel. The court held that an insured must prove actual harm, and its damages are limited to the amounts its has incurred as a result of the bad faith as well as general tort damages. Previously, the Washington Supreme Court had adopted the tort of procedural bad faith in the first-party context in Coventry Associates v. American States Ins. Co. , 136 Wash.2d 269, 961 P.2d 933 (1998), in which case the court “agree[d] with one commentator who states: 'The implied covenant of good faith and fair dealing in the policy should necessarily require the insurer to conduct any necessary investigation in a timely fashion and to conduct a reasonable investigation before denying coverage. In the event the insurer fails in either regard, it will have breached the covenant and, therefore, the policy.'” Id., citing 1 Allan D. Windt, Insurance Claims & Disputes: Representation of Insurance Companies and Insureds
' 2.05, at 38 (3d ed. 1995).

The Wyoming Supreme Court

This issue was similarly reviewed, and the tort of procedural bad faith adopted, by the Wyoming Supreme Court. The issue was first considered in the first-party context, when the court was asked to consider whether the investigatory procedures utilized by an insurer can amount to bad faith when the insurer is entitled to debate the underlying merits of the insured's claim. In Hatch v. State Farm Fire and Cas. Co. , 842 P.2d 1089 (Wyo.1992), the court recognized the tort of procedural bad faith under circumstances (later described as “rather egregious”) purportedly involving such conduct as requiring an insured, who sought coverage after a house fire, to file a detailed inventory of items in the house at the time of the subject fire including how many cornflakes were left in the cereal box and how much salt was in the salt shaker. International Surplus Lines Ins. Co. v. University of Wyoming Research Corp. , 850 F. Supp. 1509, 1527 n. 20 (D. Wyoming 1994), aff'd , 52 F.3d 901 (10th Cir. 1995), citing Hatch, supra , 842 P.2d at 1098. The Wyoming Supreme Court later recognized the tort where the claim was not only debatable, but was ultimately determined to be outside the scope of coverage. State Farm Mut. Auto Ins. v. Shrader , 882 P.2d 813 (Wyo. 1994) (“while an insured may state causes of action for breach of contract and breach of the duty of good faith and fair dealing, the insured does not need to prevail on the contract claim to prevail on the claim for breach of the duty of good faith and fair dealing.”). That rationale was adopted from the Arizona Supreme Court, which has also chosen to recognize procedural bad faith in the absence of coverage. Deese v. State Farm Mut. Auto. Ins. Co. , 172 Ariz. 504, 509 (1992) (“breach of an express covenant is not a necessary prerequisite to an action for bad faith ' a plaintiff may simultaneously bring an action both for breach of contract and for bad faith, and need not prevail on the contract claim in order to prevail on the bad faith claim, provided plaintiff proves a breach of the implied covenant of good faith and fair dealing.”).

Leaning Toward Procedural Bad Faith

While other states have not yet taken such a hard-line position, there are several others that may be leaning in that direction. In an opinion that, on its face, appears to reject the tort, the Supreme Court of Texas actually indicates a willingness to adopt it under appropriate circumstances. In Republic Ins. Co. v. Stoker , 903 S.W.2d 338, 38 Tex. Sup. Ct. J. 1011 (1995), the court relied on the “general rule” that “there can be no claim for bad faith when an insurer has promptly denied a claim that is in fact not covered.” Id. at 341 (emphasis added). Notably, the general principle in Texas is qualified with the use of the word “promptly.” The court in Stoker acknowledges this qualifier and, while rejecting a claim for bad faith absent coverage, noted that “[w]e do not exclude ' the possibility that in denying the claim, the insurer may commit some act, so extreme, that would cause injury independent of the policy claim.” Id.

Similarly, even in California, where it has been determined that “a bad faith claim cannot be maintained unless policy benefits are due,” ( See Love v. Fire Ins. Exchange , 221 Cal. App. 3d 1136 (1990); see also Young v. Illinois Union Ins. Co., 2008 WL 5234052, 2 (N.D.Cal. 2008), citing Love, supra, 221 Cal. App. 3d at 1153 (“[i]n the absence of any underlying coverage, there is no conceivable liability that Young could allege against [the insurer] on any theory of 'bad faith'”; see also Brown v. State Farm Mut. Auto. Ins. Co., 2008 WL 5234255, 13 (N.D.Cal. 2008), citing Love, supra (“[a]bsent an entitlement to policy benefits, a plaintiff may not recover on a bad faith claim, as a matter of law.”) courts have acknowledged the validity of such a claim under unusual or “highly extraordinary” circumstances when benefits are not due under the policy. See Avery Dennison Corp. v. Allendale Mutual Ins. Co. , 310 F.3d 1114, 1117 (9th Cir. 2002) (“ [e]xcept perhaps in highly extraordinary circumstances , California does not permit recovery on a bad faith claim unless insurance benefits are due under the policy”) (emphasis added); see also Murray v. State Farm Fire & Cas. Co. , 219 Cal.App.3d 58, 268 Cal.Rptr. 33,
37 (1990) (“[w]hile there may be unusual circumstances in which an insurance company could be liable to its insured for tortious bad faith despite the fact that the insurance contract did not provide for coverage, no such circumstances are presented here.”) (emphasis added).

In Connecticut, where the tort has not yet been adopted at the state court level, the federal district court has predicted that it will. In United Technologies Corp. v. Am. Home Assurance Co. , 118 F.Supp.2d 181, 188-89 (D.Conn. 2000), mod. after recon. on other grounds, 237 F.Supp.2d 168 (D.Conn. 2001), the district court was asked to determine whether the Connecticut Supreme Court would likely recognize a common law action for procedural bad faith not involving wrongful withholding of payment due under an insurance policy. Although the defendant insurer argued that a claim for bad faith is not actionable without a showing of a failure to pay a meritorious claim (substantive bad faith), the court concluded, after carefully analyzing existing state court precedent, that the Connecticut Supreme Court would not limit the tort of bad faith to claims of unreasonable or wrongful denial of claims. The federal court reasoned that an insurer's duty of good faith is triggered not only when coverage is unquestioned, but rather is a duty that can be violated even when there is no coverage. The United Technologies holding has been acknowledged numerous times in Connecticut since that decision, including at the state trial court level. See Joseph Fortin et al. v. Hartford Underwriters Ins. Co. et al., 2006 WL 3524562, 42 Conn. L. Rptr. 353 (Conn. Super. 2006) (insurer claimed that tort was only available when insurer breached its contract; court noted that such expansive reading of case law does not withstand scrutiny in light of United Technologies' careful review of Connecticut case law and conclusion that Connecticut courts have recognized an independent common law tort for such conduct.)

Not All Courts Impose Liability

Fortunately for insurers, not all courts have been willing to impose bad faith liability on insurers that have no coverage obligations to their insureds. In California, despite the potential willingness expressed by the courts to allow a procedural bad faith claim absent coverage in unusual or “highly extraordinary” circumstances, to date the general rule remains that no award for bad faith can be made without first establishing that coverage exists. See Avery Dennison Corp. v. Allendale Mutual Ins. Co. , 310 F.3d 1114 (9th Cir. 2002) and Murray v. State Farm Fire & Cas. Co. , 219 Cal.App.3d 58, 268 Cal.Rptr. 33, 37 (1990), discussed above. See also Love v. Fire Ins. Exchange, 221 Cal. App. 3d 1136 (1990), citing California State Auto Assn. Inter-Ins. Bureau v. Superior Court, 184 Cal.App.3d 1428 (1986). When faced with a claimant's argument that delay in denying a claim constitutes bad faith even if no coverage exists, the court in Love maintained the status quo in that state, opining that its conclusion “that a bad faith claim cannot be maintained unless policy benefits are due is in accord with the policy in which the duty of good faith is rooted. The covenant of good faith and fair dealing is implied in law to assure that a contracting party refrain[s] from doing anything to injure the right of the other to receive the benefits of the agreement. ' In essence, the covenant is implied as a supplement to the express contractual covenants, to prevent a contracting party from engaging in conduct which ' frustrates the other party's rights to the benefits of the contract.” The court further explained that, “when benefits are due an insured, delayed payment based on inadequate or tardy investigations, oppressive conduct by claims adjusters seeking to reduce the amounts legitimately payable and numerous other tactics may breach the implied covenant because it frustrates the insured's primary right to receive the benefits of his contract ' i.e., prompt compensation for losses. Absent that primary right, however, the auxiliary implied covenant has nothing upon which to act as a supplement, and should not be endowed with an existence independent of its contractual underpinnings.” Love, supra, at 1153 (emphasis in original).

Similarly, the Supreme Court of Kentucky reviewed the issue in Davidson v. American Freightways, Inc. , 25 S.W.3d 94 (Ky. 2000), and concluded that, absent a contractual obligation, there can be no bad faith. The court first reviewed the three elements of a cause of action for bad faith, including the first element which requires that “[t]he insurer must be obligated to pay the claim under the terms of the policy.” It concluded that “ an insurance company is required to deal in good faith with a claimant, whether an insured or a third-party, with respect to a claim which the insurance company is contractually obligated to pay. Absent a contractual obligation, there simply is no bad faith cause of action, either at common law or by statute.” Id. at 100 (emphasis in original). Similarly, in New York, it has been held that “a claim of bad faith must be predicated on the existence of coverage of the loss in question.” Zurich Ins. Co. v. Texasgulf, Inc. , 649 N.Y.S.2d 153 (1996).

Conclusion

Despite those opinions rejecting the tort, and despite the fact that procedural bad faith in the absence of coverage has only been recognized by a handful of states, insurers across the board are cautioned to be mindful of its existence and extremely careful to avoid falling prey to such a claim for numerous reasons. First and foremost, a bad faith action can be filed in, or litigated under, the laws of any number of different jurisdictions regardless of the venue of the underlying claim for which coverage is sought or the location of the insured to whom the policy was issued. What may start out as an ordinary insurance claim in an insurer-friendly state could eventually result in a bad faith lawsuit in a state recognizing the tort.

Moreover, insurers should be cognizant that the common law tort of procedural bad faith opens the door to the possibility of much greater liability to the insurer than seemingly similar statutory protections. Although several states offer statutory protections against unfair claims handling, (See, e.g., the Connecticut Unfair Insurance Practices Act, which includes a section specifically regarding “unfair claim settlement practices.” Conn. Gen. Stat. ' 38a-816(6)), certain states do not allow individual insureds to bring a claim for a violation of the statute. The Supreme Court of California, for example, has held that ' 790.03 of the California Insurance Code, addressing unfair claim settlement practices, was not intended to create a private civil cause of action against an insurer that commits one of the various acts listed in that section. Moradi-Shalal v. Fireman ' s Fund Ins. Cos. , 46 Cal.3d 287, 304, 758 P.2d 58, 250 Cal.Rptr. 116 (1988) (en banc). Some states do not allow the statutory protections to be invoked for a single violation. For example, in Connecticut, unfair claim settlement practices must be committed or performed “with such frequency as to indicate a general business practice.” Conn. Gen. Stat.
' 38a-816(6). In those states recognizing the tort of procedural bad faith, however, insurers can be liable to individual insureds for isolated instances of unfair claims handling.

Additionally, insurers should be mindful of seemingly innocent setbacks in the handling of claims. Although an insured will often have to prove “extraordinary” or “egregious” conduct to obtain such damages, (See, i.e., Avery Dennison Corp. v. Allendale Mutual Ins. Co., supra, 310 F.3d 1117; International Surplus Lines Ins. Co. v. University of Wyoming Research Corp., supra, 850 F. Supp. at 1527 n. 20), procedural bad faith can also be found as a result of something as seemingly innocuous as a delayed notification of a proper denial of coverage, as demonstrated by St. Paul v. Onvia. Even non-meritorious procedural bad faith claims based on nothing more than sloppy claims handling can result in lengthy and expensive litigation until a conclusion regarding the insurer's good faith can be reached. And, along those lines, insurers may have a much harder time obtaining summary judgment in lawsuits involving seemingly obvious non-covered claims when the deciding court is faced with a theoretical possibility that accompanying bad faith claims could live on even in the face of a clear finding of non-coverage.

Given the appealing nature of this tort to insureds who are otherwise unable to prove breach of contract or violations of unfair claims handling statutes, insurers face the possibility that similar claims will emerge in states currently silent on the issue or will gain increasing popularity in those states that recognize the tort. Insurers should always be mindful of the tort of procedural bad faith and, regardless of the merits of the underlying claim and the confidence with which the insurer denies coverage, should recognize that each and every claim, covered or not, can cost you.

Julia Karen Ulrich is an associate and Dennis O. Brown is a partner in the Hartford, CT office of Edwards Angell Palmer & Dodge LLP. Brown is a member of this newsletter's Board of Editors.