Continuing Bad Faith: Theory of Liability or Rule of Evidence?

By: Douglas L. Christian and Nathan D. Meyer

I. Introduction

Not often does a concept’s name obfuscate its meaning. “Continuing bad faith,” however, is much more than its name implies. An insurer’s duty of good faith is pervasive and its application to claim handling has matured into a formidable body of law. The duty is not intractable and is generally shaped by the circumstances of the claim. One circumstance that may alter an insurer’s duty of good faith is a bad faith lawsuit converting the quasi-fiduciary relationship with the policyholder into an adversarial one. How does a policyholder lawsuit affect the insurer’s duty of good faith? Correspondingly, how does the insurer’s duty of good faith affect the lawsuit?

Policyholders argue that if a lawsuit obviates the insurer’s duty it will encourage insurers to engage in conduct that will precipitate a lawsuit. Insurers respond by arguing that if the fiduciary duty continues unabated, it will encourage premature lawsuits by policyholders, deprive insurers of their ability to adjust losses, and eviscerate their rights as litigants.

Who is right? As is true with most scholarly debates, the answer lies somewhere in between. Although a lawsuit does not fundamentally change the policyholder-insurer relationship, it does change the dynamics of that relationship. The goal should be to protect this special relationship while providing an insurer with a fair resolution of the underlying contract dispute.

Decisional authority reflects the confusion over both the theoretical and practical significance of continuing bad faith. In theory, continuing bad faith may be regarded either as a separate, cognizable claim or as an extension of an existing bad faith claim. Its practical significance, however, lies in its impact upon the scope of admissible evidence. Whether insurer post-filing conduct is considered at trial as actionable or merely probative, it is likely to have the same impact upon the jury verdict.

This article discusses the development of the continuing duty of good faith, whether insurer litigation and post-filing conduct is admissible under current rules of evidence, and whether continuing bad faith is actionable as a separate theory of liability.

II. The Problem

The conundrum presented by the continuing duty of good faith is illustrated by the following hypothetical. An insurer is investigating and evaluating a policyholder’s claim for fire damage. The processing of the claim is in its tenth month because the investigation suggests the policyholder’s complicity. The policyholder sues for breach of contract and bad faith before the insurer completes its investigation.[1] The complaint asserts that the insurer is unreasonably delaying settlement and continuing to breach the covenant of good faith by failing to provide policy benefits. The policyholder asserts that the insurer’s subsequent filing of a counterclaim and its litigation tactics are additional evidence of bad faith. Defense counsel contacts a consulting expert. The expert informs her that the fire was not incendiary and she communicates this to her client in a letter.

Defense counsel files a motion for summary judgment on breach of contract and bad faith, as well as a motion in limine seeking to preclude admission of the insurer’s post-filing conduct as evidence of bad faith. The policyholder supplements its disclosure and reveals its intent to introduce the insurer’s litigation and post-filing conduct; that is, the filing of a counterclaim, assertion of affirmative defenses, and the insurer’s adjustment of the loss after suit was filed. The policyholder also lists defense counsel as a trial witness.

Is defense counsel’s file discoverable? Is it admissible at trial? Do the attorney-client, work product, and litigation privileges obtain? Which lawyers will become witnesses rather than advocates? Is the insurer’s post-filing claim handling actionable? If not actionable, is it relevant to the policyholder’s antecedent claim of bad faith? When does a cause of action accrue for post-filing bad faith? Should the claim of continuing bad faith be bifurcated for trial? How may the insurer and its counsel ethically establish lines of communication and claim handling procedures to provide the policyholder with prompt and fair claim handling while still protecting the legitimate litigation interests of the insurer?

III. The Evolution of the Continuing Duty of Good Faith

Most states now recognize a covenant of good faith implied in an insurer’s relationship with its policyholder. What began as an implied covenant of the insurance contract has emerged as a more ephemeral component of the “special relationship” that exists between an insurer and its policyholder. A breach of the implied covenant of good faith is actionable, sometimes even in the absence of a breach of an express obligation contained within the insurance policy.[2] A breach is generally actionable as a tort, and recoverable damages extend beyond contract payments.

A prima facie continuing bad faith claim requires the insured to establish: (1) the insurer’s duty of good faith continues beyond the filing of the bad faith lawsuit; (2) the standard of care by which the insurer’s post-filing and litigation conduct will be judged; (3) the conduct in question breached the continuing duty of good faith; and (4) cognizable damages. This article defines “post-filing conduct” as insurer claim-related actions occurring after an insured files suit. “Litigation conduct,” as its name suggests, is the activity of an insurer and its lawyers during a lawsuit between the policyholder and insurer.

Courts and commentators generally agree that an insurer’s duty of good faith continues even after an insured files suit.[3] However, substantial uncertainty surrounds the nature of that duty and the admissibility at trial of an insurer’s litigation and post-filing conduct as evidence of, or as a separate basis for, bad faith liability:

“An insurer’s unreasonable defense may evidence bad faith . . .”.[4]

“Concluding that the duty of good faith does not end with the filing of a complaint does not, however, require courts either to alter the normal rules of litigation or to admit evidence of an insurer’s postfiling conduct.”[5]

“How to handle the carrier’s post-filing conduct is far from settled.”[6]

“An insurance carrier’s duty to promptly pay a legitimate claim does not end because a lawsuit has been filed against it for nonpayment. Put more bluntly, if you owe a debt the duty to pay does not end who you are sued for nonpayment of it.”[7]

When an insured chooses to resolve an insurance claim in court, both the insured and the insurer are faced with a series of inter-dependent choices that may lead to tactical gamesmanship. In the absence of clear decisional precedent, the insured must bring all claims against the insurer in a single action or risk losing them to an arsenal of defenses including statute of limitations, issue preclusion, and contractual suit limitation provisions. An insurer is faced with the equally daunting task of litigating its contractual duties under the insurance policy while simultaneously justifying the manner in which it arrived at, is arriving at, or will arrive at its claim decision.[8] Whether courts should recognize a continuing duty of good faith is a question deserving of thoughtful deliberation; however, competing interests collide not in its recognition, but in its enforcement. When and how should our courts enforce the continuing duty of good faith?

IV. Historical Background: White v. Western Title

White v. Western Title Insurance Co.[9] is the seminal case of the “continuing bad faith” genre.[10] In White the trial court permitted the insured to introduce evidence of an insurer’s litigation and post-filing conduct as evidence of bad faith. The focus of the opinion was the admission during the bad faith trial of the insurer’s post-filing, “nuisance value” settlement offers to resolve the insured’s breach of contract and bad faith claims. The policyholder also argued that the insurer’s litigation conduct provided evidence of bad faith, specifically the expense of prosecuting its suit and the insurer’s failed motion for summary judgment.

The insurer argued that once the insured filed suit, the insured and insurer became legal adversaries, thereby obviating the duty of good faith and fair dealing. Although the California Supreme Court acknowledged the issue as one of first impression, it summarily resolved the issue “as a matter of principle” and concluded, “the contractual relationship between insurer and the insured does not terminate with commencement of litigation.”[11] White found a distinction between pre-filing and post-filing conduct to be undesirable because it would encourage insurers to induce early filing of suits.[12]

The insurer raised several arguments against the continuation of the duty of good faith. First, a continuing duty of good faith would make it difficult for the insurer to defend itself.[13] Second, an insurer would be required to reveal all information discovered post-filing that would help an insured’s claim. Third, ethics rules would require attorneys preparing the defense of the bad faith suit to withdraw from the actual trial defense because the preparing attorney may be called as a material witness to the insurer’s good faith litigation conduct. Nonetheless, White cited three reasons why these concerns did not justify a distinction between pre- and post-filing conduct: (1) an insurer should investigate the factual basis of an insured’s claim before litigation; (2) a court may bifurcate the breach of contract and bad faith trials; and (3) liability for bad faith may often require a factual, case-specific inquiry.

The insurer also argued that admission of the post-filing settlement offers violated the rule of evidence precluding “[e]vidence that a person has, in compromise or from humanitarian motives, furnished or offered or promised to furnish money . . . to another who has sustained . . . loss or damage. . . .”[14] The court noted, however, that settlement offers may be offered to prove something other than contractual liability. Thus, White affirmed admission of the settlement offers because the insured sought their introduction as evidence of bad faith rather than breach of contract.

Finally, the insurer argued that the admission of post-filing settlement offers violated California’s statutory litigation privilege and offer of compromise provisions. California’s litigation privilege provided, “[a] privileged publication or broadcast is one made . . . in any judicial proceeding. . . .”[15] Similarly, California’s offer of compromise provided, “‘if such an offer is not accepted . . . it shall be deemed withdrawn, and cannot be given in evidence upon the trial.'”[16] The insurer argued that its settlement offers were made in a privileged judicial proceeding and as inadmissible offers of compromise; thus, the offers could not be presented as evidence of bad faith. White reasoned that although privileged communications and an offer or compromise may not be the sole basis of bad faith liability, they may be evidence of bad faith.[17]

Since the White decision in 1985, other courts and commentators concur: even after litigation commences and the insurer and policyholder become legal adversaries, an insurer’s duty of good faith continues.[18] More controversial, however, is White’s conclusion that the continuing duty of good faith supports the introduction at trial of evidence of an insurer’s post-filing and litigation conduct.

V. The Continuing Duty of Good Faith as a De Facto Rule of Evidence

A. Evidentiary Impact of the Continuing Duty

Bad faith cases are fought on a battleground of concentric circles. At the center of the dispute is the underlying breach of contract claim: did the insurer fulfill its contractual obligation to the policyholder? The bounds of relevance of the contract claim are circumscribed by facts probative only of the contract obligation. Generally speaking, the adjustment of the loss, other claims, and the insurer’s corporate state of mind are irrelevant. The evidence adduced is similar to evidence in other commercial contract cases; thus, the insurer is afforded the conventional protection associated with the attorney-client, work product, and litigation privileges.

Policyholder claims against insurers for breach of the covenant of good faith and fair dealing widen the circle by expanding the bounds of relevance beyond those applicable to the contract claim. To determine whether the insurer treated the insured fairly, courts sometimes admit evidence of an insurer’s claim handling. Evidence of claim practices, training materials, and other similar files may also be relevant to establish an insurer’s intent or to rebut an assertion by the insurer of inadvertence or mistake. Bad faith claims may also implicate, either affirmatively or defensively, the insurer’s corporate state of mind and thus an expanded evidentiary inquiry.

Claims of continuing bad faith widen the circle again. Although the insurer’s conduct after it is sued by the policyholder is seldom relevant to an antecedent claim of bad faith, the claim of continuing bad faith is a mechanism for offering into evidence additional insurer conduct, usually acts of lawyers and claim managers directly involved in the litigation. These policyholder allegations attempt to expand the bounds of relevance to include conduct that had not even occurred when the insured filed the underlying complaint.

Taken to its logical conclusion, the outermost of these concentric circles deprives the insurer of conventional litigation protection afforded other litigants. The infrastructure of the insurer’s defense implodes with the erosion of the work product protection and even the attorney-client privilege. Whether the insurer’s post-filing conduct is regarded as actionable or merely probative is of little practical consequence. The real impact of a continuing bad faith claim is the potential admissibility of litigation and post-filing conduct and the resultant chilling effect on an insurer’s ability to defend itself against claims of bad faith. If taken too far, what the insurer does (or “thinks” in a corporate sense) on Monday may be discoverable on Tuesday and admissible at trial on Wednesday.

B. Rule 404 and Evidence of “Other Acts”

Historically, Federal Rule of Evidence 404 and its state counterparts have shepherded the admissibility at trial of “other acts” of a defendant. Rule 404(a)[19] precludes evidence of a person’s character to prove action in conformity therewith. Other rules of evidence work in tandem with Rule 404, including Rule 406 [20] relating to the admissibility of evidence of routine practices of an organization. Rule 404(b)[21] provides the exception to the general rule of inadmissibility by allowing the introduction of evidence of other acts for other purposes. Among those purposes, and apropos of a discussion of insurer claim handling, is establishing the absence of mistake.

The debate over the discoverability and admissibility in bad faith cases of insurers’ “other acts” has fanned the flames of extra-contractual liability and punitive damages for decades. In some instances, evidence of other improper claims handling must be received to establish a prima facie bad faith case, particularly in jurisdictions that recognize statutory bad faith only where there is a demonstrable “pattern and practice” of inappropriate claim handling.[22] Rulings regarding the discoverability and admissibility of insurer “other acts,” and the application of Rule 404(b), may vary dramatically, even within a jurisdiction. The lynchpin of admissibility, however, is similarity. To be received at trial, evidence of other claim handling or insurer conduct must be sufficiently similar to the claim at issue.[23] Consequently, “other acts,” if too dissimilar or remote in time, may not be admissible under Rule 404(b).

The advent of the duty of continuing good faith presented policyholders a way to proffer evidence of insurer conduct dissimilar and often remote from the insurer’s antecedent acts. The duty supports introducing at trial evidence of insurer conduct that had not even occurred when the insured filed the underlying bad faith lawsuit.

The admissibility of post-filing conduct presents an evidentiary issue analogous to the admissibility of past claims practices. In Hawkins v. Allstate Insurance Co.[24] the Arizona Supreme Court considered the admissibility of evidence of an insurer’s past claims practices. Hawkins held that such evidence may be admissible, but grounded its holding on a similarity requirement. Hawkins spoke in terms of “[e]vidence of previous, similar acts,” a “pattern of similar unfair practices” and “sufficient similarity” as standards for admitting “other bad acts” evidence.[25]

In State Farm Mutual Automobile Insurance Co. v. Stephens[26] the West Virginia Court of Appeals considered an insured’s interrogatory to an insurer. It requested information on every claim filed against it for the last twelve years involving allegations of bad faith, unfair trade practices, excess verdict liability, or inquiries from insurance industry regulators questioning the insurer’s claim handling. Stephens found the discovery request to be cumulative and oppressive. Stephens narrowed “the scope of the interrogatories to other similar claims filed against [the insurer] in West Virginia.”[27]

Evidence of an insurer’s post-filing conduct, particularly its litigation conduct, will not often survive scrutiny under Rule 404(b). Nonetheless, if the post-filing conduct is also a wrongful act at issue in the litigation, then it will circumvent Rule 404. While a Rule 404 analysis is imperfect, it provides a threshold mechanism for evaluating whether the insurer’s post-filing conduct is too remote in time or bears too little resemblance to the wrongful conduct alleged in the policyholder’s complaint.

Rules of Evidence 403 and 404 may hold the key to balanced enforcement of the continuing duty of good faith. These Rules establish the admissibility of evidence at trial based upon the relationship of the evidence to the issues framed by the pleadings. In continuing bad faith cases, the converse may also be true. The Rules, or at least their analytic predicate, may help establish actionable continuing bad faith issues based upon their relationship to trial evidence otherwise admissible on the insurer’s antecedent conduct.

In some cases, it may be appropriate to “complete the story” of loss adjustment by admitting evidence of post-filing insurer conduct. Under those circumstances, it is likely that the evidence adduced to “complete the story” would meet the requirements of Rules 403 and 404. However, not all post-filing conduct is sufficiently similar to the alleged, antecedent acts of bad faith to be admitted simply to complete the story of loss adjustment. If the post-filing conduct is dissimilar or remote in time, then it is should not be received as evidence.

The Rule 403[28] probative versus prejudicial balancing test may also help courts weigh the admissibility of insurer litigation or post-filing conduct. This balancing test is particularly appropriate if the trial court is considering the admission of insurer litigation conduct as evidence at trial. The prejudice to the insurer from the erosion of its litigation privileges should weigh heavily when balanced against the probative value of admitting the insurer’s litigation conduct at the same trial.[29] Although promulgated to shape evidence to the trial issues, Rules 403 and 404 may actually help courts shape trial issues around probative, non-prejudicial evidence.

VI. The Continuing Duty of Good Faith as a Theory of Liability

A. Post-Filing Conduct as Bad Faith

1. Standard of Care

Although an insurer’s duty of good faith may continue after an insured files suit, the standard of care changes.[30] Indeed, “what constitutes good faith and fair dealing depends on the circumstances of each case, including the . . . posture of the parties.”[31] Jurors know that insureds and insurers in a lawsuit are adversaries, and if instructed to do so, jurors “will evaluate the insurer’s conduct in relation to that setting.”[32] Furthermore, “[w]hile the general good faith obligation [does] remain intact for the term of the insurance contract, [by] necessity the parties’ duties and relationship alter when a given claim is made by the insured, disputed by the insurer, and suit thereon is commenced.”[33] “Properly understood, [the continuing] duty of good faith requires only that insurers satisfy a policyholder’s claim if changed circumstances eliminate the insurer’s fairly debatable reason for denying the claim.”[34] The continuing duty of good faith may require an insurer to disclose information supporting an insured’s claim when the post-filing adjustment of the loss eliminates the reasonable basis previously relied upon to deny coverage.[35]

This concept is discussed in Nies v. National Automobile & Casualty Insurance Co.[36] In Nies an insurer filed a declaratory judgment action to determine if its insured was entitled to uninsured motorist benefits after being hit by an unregistered dune buggy.[37] The insured responded by filing suit for breach of contract and bad faith.[38] Within ten days after the insured filed suit, the insurer’s attorney began researching the coverage issue and discovered case law suggesting the insured was, in fact, entitled to uninsured motorist benefits.[39] The attorney immediately advised the insurer to pay the claim, and the insurer paid the insured the uninsured motorist policy limit.[40]

2. Accrual of Continuing Bad Faith Claims

When does a cause of action for continuing bad faith accrue?[41] May an insured bring a claim for continuing bad faith before an insurer is found liable for pre-filing bad faith?[42] The answer to this question depends upon whether a claim of continuing bad faith is a separate cause of action.

A representative definition of bad faith is that an insurer knowingly performed an unreasonable investigation, evaluation, and processing of an insured’s claim.[43] Fair treatment of the insured is the touchstone of the duty of good faith. When an insured files suit for breach of contract and bad faith before an insurer makes a claim decision, the insured is essentially asserting that the insurer has already knowingly treated the insured unfairly, not that it may do so in the future. Post-filing conduct is not, therefore, the graveman of the claim. An insurer’s conduct must be assessed based upon facts that are known or knowable at the time of the alleged breach.[44] Thus, some may consider a claim of continuing bad faith a separate and distinct action from a claim for bad-faith that occurred before suit was filed.[45]

In Sosebee v. State Farm Mutual Automobile Insurance Co.[46] an insured attempted to bring a subsequent bad faith action based on an insurer’s alleged bad faith post-filing conduct during a previous breach of contract and bad faith action. Sosebee held an insured must consolidate a claim of continuing bad faith for an insurer’s post-filing conduct with the underlying breach of contract and bad faith claims, or, in the alternative, appeal a court’s refusal to allow such consolidation. Additionally, if an insured fails to appeal consolidation, a second action for bad faith is barred by the doctrine of res judicata.

The Sosebee insured was injured in an automobile accident. Her insurer began paying her medical bills under the medical payments provision of the policy. Eventually a dispute arose over the cause of a shoulder injury and benefits were stopped. The insured underwent surgery and sued her insurer for breach of contract and bad faith.

The trial court granted summary judgment for the insurer on the bad faith claim. However, in a deposition an adjuster testified that the insurer retained a biomechanical engineer to determine if it was possible for the insured to sustain the injuries she alleged during the accident. The adjuster testified that a report was sought from the biomechanical engineer as part of the ongoing adjustment of the claim before the trial court granted summary judgment on the bad faith claim. The insured did not subpoena or make a formal discovery request for the report but did make unsuccessful, informal attempts to acquire it.

In light of this information, days before the breach of contract trial the insured moved to vacate the trial date, reopen discovery, and compel production of the report. At the hearing, the insured argued that the report could confirm her injury had possibly resulted from the accident and supported a “new cause of action” for the insurer’s violation of the continuing duty of good faith. The insurer stated the biomechanical engineer had been contacted at counsel’s request, had never formally been retained by the insurer, had not prepared a report, and was not a trial witness. The trial court denied the motion because the biomechanical engineer was a protected witness, noted the irrelevance of the evidence to the breach of contract claim, and concluded the motion was untimely. The insured then attempted to amend her complaint to add a claim of continuing bad faith, but the district court denied that motion as well. The breach of contract claim proceeded to trial and the insured prevailed. At the conclusion of the trial the insured moved for, but the district court denied, reconsideration of the bad faith claim. The insured chose not to appeal the district court’s rulings; instead, she filed a second, separate action for “post-filing bad faith.”

On appeal, Sosebee first noted “[u]nder Nevada law, the duty of good faith on the part of an insurer does appear to continue after an initial denial of coverage and requires the insurer to consider new evidence brought to its attention after the initial denial.”[47] The insured argued that Nevada precedent allowed her to establish breach of contract and liability in a first action, and then, after discovery of bad faith evidence, bring a second, separate action for bad faith. The Sosebee court, however, distinguished cited precedent by noting it involved an uninsured motorist claim subject to “special rules” and by observing that separate actions were allowed only where breach of contract and liability must be established in a previous proceeding.

More important, the Sosbee court found “no authority to suggest that the Nevada courts would allow a separate bad faith action based on the insurer’s refusal to consider new evidence that was uncovered during discovery in [a previous action].”[48] Sosebee held that Nevada law allows litigation of claims discovered after a first trial has already determined breach of contract. However, it does not allow “piecemeal litigation of claims that were known or, in the exercise of reasonable discovery during litigation, should have been known while there was time to try all claims in one trial.”[49] TheSosebee court noted that if the district court erred in preventing the insured from consolidating her claims, then the insured’s proper remedy was appeal.

The court expressed “no opinion on the presence or absence of bad faith.”[50] It simply held that an insured who knows, or should have known through competent discovery, all facts that could justify a bad faith claim, yet refuses to appeal a ruling disallowing the bad faith claim in the first action must “confront the problem of res judicata as it relates to claims actually litigated and claims that could have been litigated in the first case.”[51] Accordingly, the court held that the insured second’s bad faith action was “correctly barred by the doctrine of res judicata.”[52]

In Gooch v. State Farm Mutual Automobile Insurance Co.[53] the Indiana Court of Appeals held that a claim of continuing bad faith for post-filing conduct accrues and is actionable in the same suit in which it occurred. Gooch involved an insurer’s bad faith conduct after the insured filed suit for breach of contract, but before the insured amended her complaint to allege bad faith. The insurer refused to further investigate the insured’s claim because the insurer knew that a more extensive investigation could weaken its factual predicate for a motion to dismiss the bad faith claim. The insurer characterized its post-filing conduct as litigation conduct and argued against the admission of such conduct. The Goochcourt acknowledged the insurer’s concerns; however, it also noted that the focus of the insured’s complaint was not really the litigation process. Gooch observed that an insurer’s intentional refusal to investigate in order to give its counsel a factual predicate for a motion to dismiss could not escape judicial scrutiny simply because it was cast as a “litigation position.” The court of appeals reversed the trial court’s grant of summary judgment in favor of the insurer and implicitly considered the claim based on post-filing conduct to accrue immediately.

B. Litigation Conduct as Bad Faith

“Litigation conduct” is the conduct of an insurer and its lawyers in litigation with a policyholder. Policyholders argue that the admission into evidence of an insurer’s litigation conduct is a logical extension of the doctrine of continuing bad faith. If evidence of other post-filing conduct is admissible at the bad faith trial, is an insurer’s treatment of the insured in the litigation also admissible? In addition to all of the issues discussed previously, this question requires us to consider time-honored protections afforded to litigants including the attorney-client, work product, and litigation privileges. Since the insurer is adjusting the claim while it is also litigating the claim, do the insurer’s interests as a litigant trump the insured’s interest in the fair resolution of its claim?

1. The Litigation Privilege

Assessing the importance of an insurer’s litigation privileges complicates an already difficult analysis. Insurer interaction with its insured during litigation is often inextricably entwined with the adjustment of the loss. The breach of contract component of the lawsuit becomes the mechanism by which the insurance claim is resolved. Simply because the insured has chosen to merge its insurance claim with tort claims for emotional distress, economic loss, and punitive damages, there is no logical reason to deprive the insurer of its litigation privilege as it walks through the courthouse door. Although the interests of the insurer and policyholder must be balanced, their interests are not always mutually exclusive. Admitting evidence of insurer litigation conduct does not require wholesale abandonment of insurer litigation privileges. Correspondingly, upholding the litigation privilege does not provide the insurer with a license for misconduct.

The insurer may commit acts as a litigant that breach the continuing duty of good faith. For instance, the insurer may use litigation tactics to unreasonably delay the resolution of the insurance claim. The insurer’s conduct in doing so should not be excused simply because it is in litigation with the policyholder, and the insurer should be held accountable. However, balancing the interests of the insurer and the policyholder becomes more difficult when the insurer’s putative wrongful act is performed only in its role as defendant, and other sanctions are available to deter that conduct. An insurer’s discovery and motion practices may, for example, be detrimental to the insured in its recovery of extra-contractual damages. However, those practices do not invade an interest protected under the insurance policy. If the tactics are inappropriate, the remedy lies in the inherent power of the court.

In White the California Supreme Court first discussed the interaction of the litigation privilege and allegations of post-filing and litigation misconduct.[54] The insured argued that, after commencement of litigation, its alleged nuisance value settlement offers were protected by the litigation privilege. The court, however, found it obvious that “even if liability cannot be founded upon a judicial communication, it can be proved by such a communication . . . .”[55] Accordingly, the White court drew “a careful distinction between a cause of action based squarely on a privileged communication, such as an action for defamation, and one based upon an underlying course of conduct evidenced by the communication.”[56] The court ruled that the post-filing settlement offers were admissible, notwithstanding the litigation privilege, because they were proffered to show that the insurer did not evaluate and seek to resolve the insured’s claim in good faith.

In Tucson Airport Authority v. Certain Underwriters at Lloyds, London[57] the Arizona Court of Appeals recognized the same distinction. The trial court granted an insurer’s motion to dismiss an insured’s bad faith claim because it reasoned the insurer’s conduct during the course of litigation was absolutely privileged. The appellate court reversed the trial court because the putative wrongful act was not a privileged communication made during litigation; rather, the insurer’s course of wrongful and tortious conduct occurred during the lawsuit. The insurer’s statements during litigation, arguably inadmissible because of the litigation privilege, merely provided evidence of (not the sole basis for) the bad faith claim. Applying the White distinction, the court in Tucson Airport Authority held that the litigation privilege protected the insurer from a continuing bad faith claim based solely on privileged statements but not the admission of those statements as other evidence of bad faith.[58]

2. Opposing Admission of Litigation Conduct as Evidence of Bad Faith

Critics of White and opponents of the admission of litigation conduct as evidence of bad faith raise four arguments.

(1) (1) Sufficient Existing Protections: The trial judge, rules of civil procedure, and ethics rules protect insureds from improper insurer litigation conduct.

(2) (2) Relevance: The litigation conduct of an insurer’s lawyer is only marginally probative of the insurer’s claim handling; furthermore, the prejudice resulting from placing litigation tactics before a jury substantially outweighs the probative value of such evidence.

(3) (3) Chilling Effect: The possibility that an insurer’s litigation conduct may be admitted as evidence of bad faith has a “chilling effect” on an insurer’s defense.

(4) (4) Attorney Compromise: Attorneys for insurers will be unreasonably constrained in their advocacy and will be required continually to evaluate whether they will be advocates or witnesses at trial.

a. Sufficient Existing Protections

Opponents of the admission of litigation conduct as evidence of bad faith argue that the trial judge, rules of civil procedure, and ethics rules provide sufficient deterrence to improper insurer litigation conduct. In Palmer v. Farmers Insurance Exchange,[59] the Montana Supreme Court found that sufficient safeguards exist to protect insureds from improper litigation conduct. The insurer filed a motion in limine to prevent the insured’s introduction at the bad faith trial of the insurer’s litigation conduct during the bifurcated uninsured motorist trial. The court stated:

The Rules of Civil Procedure control the litigation process and, in most instances, provide adequate remedies for improper conduct during the litigation process. Once the parties have assumed adversarial roles, it is generally for the judge in the underlying case and not a jury to determine whether a party should be penalized for bad faith tactics.

An attorney in litigation is ethically bound to represent the client zealously within the framework provided by statutes and the Rules of Civil Procedure. These procedural rules define clear boundaries of litigation conduct. If a defense attorney exceeds the boundaries, the judge can strike the answer and enter judgment for the plaintiff, enter summary judgment for the plaintiff, or impose sanctions on the attorney. There is no need to penalize insurers when their attorneys represent them zealously within the bounds of litigation conduct. To allow a jury to find that an insurer acted in bad faith by zealously defending itself is to impose such a penalty.[60]

Other courts and commentators agree.[61]

b. Relevance

Palmer also analyzed the relevance of litigation conduct to bad faith. It concluded, “[i]n general, an insurer’s litigation tactics and strategy in defending a claim are not relevant to the insurer’s decision to deny coverage.”[62] The Palmer court noted that at least one court held that the commencement of litigation rendered the defensive actions taken by an insurer completely non-probative of whether the insurer committed bad faith.[63] It explained:

After the onset of litigation, an insurer begins to concentrate on supporting the decisions that led it to deny the claim. The insurer relies heavily on its attorneys using common litigation strategies and tactics to defend against a debatable claim. Consequently, actions taken after an insured filed suit are at best marginally probative of the insurer’s decision to deny coverage.[64]

The Palmer court recognized, that, “[i]n some instances, however, evidence of the insurer’s [litigation] conduct may bear on the reasonableness of the insurer’s decision and its state of mind when it evaluated and denied the underlying claim.”[65]

Palmer found that the proper balance between protecting insureds from improper litigation conduct and guaranteeing insurers’ rights to a vigorous defense may be obtained by applying the Rule 403 balancing test. If a trial court deems an insurer’s litigation conduct relevant, then it must weigh the probative value of litigation conduct evidence against the inherently prejudicial effect of such evidence and the insurer’s right to an undiluted defense.[66] Other courts and commentators agree with the Palmeranalysis.[67]

c. “Chilling Effect” on Insurer’s Defense

The Tenth Circuit Court of Appeals in Timberlake Construction Co. v. United States Fidelity & Guaranty Co.,[68] emphasized the chilling effect of allowing litigation conduct to serve as evidence of bad faith. In Timberlake the insurer challenged the trial court’s admission of three items of evidence as bad faith: (1) a letter from the insurer’s counsel to one of its adjusters; (2) the insurer’s filing of a counterclaim against the insured; and (3) the insurer’s filing of a motion to join a necessary party. The court noted the disturbing policy implications of admitting litigation conduct as evidence of bad faith:

Allowing litigation conduct to serve as evidence of bad faith would undermine an insurer’s right to contest questionable claims and to defend itself against such claims . . . . [P]ermitting allegations of litigation misconduct would have a “chilling effect on insurers, which could unfairly penalize them by inhibiting their attorneys from zealously and effectively representing their clients within the bounds permitted by law.”[69]

It held that evidence of an insurer’s litigation conduct is generally inadmissible.[70]

In White, dissenting justices of the California Supreme Court noted that the “fundamental problem with the [admission of litigation conduct] is its complete failure meaningfully to consider or accord any weight to the right of a defendant to defend itself.”[71] The dissent drew an analogy in considering whether an appeal is frivolous and warrants the imposition of sanctions, noting that “a balance must be struck between avoiding improper [litigation] conduct and assuring that attorneys are free actively to assert their clients’ interests.”[72] The dissent noted that an insurer’s free access to the courts is one of the most important aspects of our civil justice system. Moreover, an insurer must be allowed to challenge a debatable claim without fear of reprisal.[73] The dissent concluded that exposure to bad faith liability and the attendant possibility of punitive damages for common litigation tactics amounted to an unreasonable penalty.

In Palmer the Montana Supreme Court also analyzed what it considered to be the most serious policy consideration against admitting evidence of an insurer’s litigation conduct as evidence of bad faith-punishment of insurers for pursuing legitimate defenses and obstructing insurers’ rights to litigate fairly debatable claims. The court noted that its facts presented an example of the problems inherent in presenting litigation conduct as evidence of bad faith. The trial court admitted evidence of the insurer’s litigation conduct, but the insured offered no testimony or argument that the litigation tactics themselves were improper. Rather, the insured allowed the jury to infer that the insurer’s litigation conduct amounted to bad faith.[74] The Palmer court concluded that courts must use caution in admitting evidence of litigation conduct, even after a determination of relevance. Other courts and commentators have echoed concern over this “chilling effect” on an insurer’s right to a zealous and vigorous defense.[75]

d. Attorney Compromise

Attorneys for insurers may be compromised by the advocate-witness rule if their litigation conduct is argued at trial. Arguments of adverse attorney impact were first raised in White. Specifically, “the attorney who prepares the case for trial could not conduct the trial because he would be a critical witness to the insurer’s good faith during the pretrial period.”[76] The California Supreme Court did not find these arguments sufficient to draw a distinction between an insurer’s pre-filing and post-litigation conduct.[77]

The North Dakota Supreme Court admitted the prejudice resulting from calling an attorney as a witness to defend against allegations of bad faith in Ingalls v. Paul Revere Life Insurance Group.[78]Ingalls considered an insurer’s argument that the trial court erred in admitting testimony that the insured’s litigation conduct, specifically its pleadings and strategy, evidenced bad faith. The insurer argued that admission of the litigation conduct forced it to take the prejudicial step of calling its counsel as a witness to defend its litigation conduct. Although Ingalls acknowledged “[c]ounsel’s testimony may well have compounded [the insurer’s] litigation problems,”[79] it held that “[a]n insurer’s unreasonable defense may evidence bad faith.”[80] Other courts have also noted the precarious position in which attorneys for insurers may be placed if litigation conduct is received as evidence of bad faith.[81]

3. Supporting Litigation Conduct as Evidence of Bad Faith.

White offers support for admitting an insurer’s litigation conduct as evidence of, or the basis for, bad faith. This conduct includes: (1) settlement offers,[82] (2) unreasonable defenses,[83] (3) filing in a particular forum,[84] (4) the filing of responsive pleadings,[85] (6) filing a meritless appeal,[86] (7) conducting discovery,[87] and (8) cross examination of a witness.[88] Many courts, however, have narrowed the application of White.[89]

Nonetheless, other courts have also admitted an unreasonable defense[90] or an insurer’s counterclaim for fraud[91] as evidence of bad faith. One court admitted an insurer’s pleadings not as evidence of bad faith, but for impeachment.[92]

Of particular note, however, is the Montana Supreme Court’s analysis in Federated Mutual Insurance Co. v. Anderson.[93] In Anderson an insured appealed the trial court’s refusal to allow the insured to amend its complaint and add the insurer’s litigation conduct, specifically the filing of a meritless appeal, as a basis for bad faith.[94] Anderson began its analysis by noting, “[t]he commencement of a lawsuit by the insured does not end an insurers [sic] duties to the insured. Therefore, the continuing duty of good faith can be breached by an insurer’s post-filing conduct.”[95] Anderson then discussedPalmer,[96] reiterating the arguments regarding evidence of litigation conduct under “normal circumstances.”[97]

Anderson distinguished Palmer, however, because it involved litigation conduct previously sanctioned by the court under the pre-existing protections that Palmer discussed.[98] Anderson declared that “[m]eritless appeals are not legitimate litigation conduct”[99] and an insurer’s “fundamental right to defend itself extends only to legitimate litigation conduct.”[100] Furthermore, Anderson found that because a judge rather than a jury had already considered the propriety of this litigation conduct, thePalmer concerns regarding relevance and prejudice did not apply. Accordingly, Anderson held that the insured was entitled to present evidence of the insurer’s prosecution of a frivolous appeal to prove “a continuing course of conduct designed to avoid a prompt, fair, and equitable settlement of a claim in which liability had become reasonably clear.”[101]

VII. The Impact of the Continuing Duty of Good Faith on Counsel

Allegations of continuing bad faith may place counsel for both the insurer and insured in a precarious position. Three points deserve consideration: the advocate/witness rule, the attorney-client privilege, and the permissible scope of discovery.

The Seventh Circuit Court of Appeals in Lorenz v. Valley Forge Insurance Co.,[102] provides a road map of the problems an insurer’s attorney may face when presented with a continuing bad faith claim. In Lorenz the insureds argued that the insurer’s post-filing conduct constituted bad faith because it continued to deny the insured’s claim after litigation commenced and it “improperly packaged” post-filing settlement offers to resolve both the insured’s breach of contract and bad faith claims. The insureds asked the court of appeals to affirm the magistrate’s ruling allowing discovery and admission of an otherwise privileged communication from the lawyers to the insurer advising it that it owed the insureds $60,000 in policy benefits and faced bad faith exposure to punitive damages in the six-figure range.

Lorenz precluded the discovery and admission of the privileged communication for two reasons. First, the insurer did not voluntarily waive the attorney-client privilege because it did not introduce evidence of its state of mind (subjective good faith). Instead, the insurer proffered evidence of settlement offers as claim-handing activity. Second, the insurer did not waive the privilege by communicating settlement offers to the insureds, since those communications were intended to be disclosed to a third party and therefore not subject to the privilege.

A. The Advocate-Witness Rule

Lorenz illustrates the compromising ethical position in which attorneys are placed by the interaction of a claim of continuing bad faith and the advocate-witness rule. The first attempt to litigate Lorenz ended with the magistrate’s declaration of a mistrial. The insured’s allegations of continuing bad faith made it necessary for the insurer to call its attorney to testify. The testimony related to the numerous post-filing settlement offers attempting to resolve the insured’s claim and to the insured attorney’s suggestion that they package such settlement offers to resolve both the breach of contract and the bad faith claims.

An insurer’s attorney is often the best historian of the insurer’s post-filing conduct. Occasionally an insured may attempt to call the insurer’s attorney as a witness to the insurer’s post-filing conduct.[103] This presents an ethical dilemma. The American Bar Association Model Rules of Professional Conduct prohibit an attorney from trial advocacy on behalf of a client where the attorney may be called as a witness.[104] An attorney’s testimony regarding an insurer’s post-filing conduct does not fall within the exceptions of the advocate-witness rules; however, the lawyer’s withdrawal may be a “substantial hardship” on the insurer.

B. The Attorney-Client Privilege and the Scope of Discovery

Lorenz also illustrates the impact of a continuing bad faith claim on the interrelated issues of the attorney-client privilege and the scope of discovery. In Lorenz the insured argued that the insurer continued to breach the contract and commit bad faith by continuing to deny policy benefits after litigation commenced.[105] The insurer countered with evidence that it did, in fact, make numerous offers to settle the insured’s claims after litigation commenced.

The insured argued that the settlement offers injected the issue of the insurer’s state of mind into the case. The insureds argued that it was necessary to examine the settlement offers to determine if they were, in fact, made in good faith. Accordingly, the insured sought discovery of privileged memoranda between the insurer and its attorneys evaluating the insured’s claim. The magistrate agreed with the insured and admitted the documents in which the insurer’s attorney advised the insurer that it might be liable for breach of contract, bad faith, and punitive damages.

The Lorenz court disagreed. It found that the insurer did not inject the issue of subjective good faith into the matter, and thereby waive the attorney-client privilege. The insurer proffered settlement offers to counter the insured’s allegations of bad faith. The court reasoned that an insurer must do more than merely deny an insured’s allegations of bad faith to waive the attorney-client privilege and expand the permissible scope of discovery into privileged communications. The insured “did not assert that the offer to settle was made in bad faith-it did not have to.”[106] The settlement offers were evidence of claim activity and part of the insurer’s general denial.[107]

The court also noted that the insurer did not impliedly waive the attorney-client privilege by using a method of proof that partially revealed confidential communications. Rather, the settlement offers were not privileged because the information contained therein was intended to be disclosed to third parties, that is the insureds. Such communications were not subject to the privilege and disclosure did not waive the privilege.

Lorenz also reversed the magistrate’s alternative finding that the former attorney’s trial and deposition testimony, pertaining only to the settlement offers, waived the attorney-client privilege. Such testimony only waived the privilege for the specific subject of settlement offers. Finally, the Lorenz court reversed the magistrate’s alternative ruling that an insurer has a fiduciary obligation to its insured preventing invocation of the attorney-client privilege against the insured.

C. Permissible Scope of Discovery In General

In Graham v. Gallant Insurance Group[108] the District Court for the Western District of Kentucky considered a discovery issue in the context of a “continuing bad faith” claim. The insureds were involved in an automobile accident with an uninsured motorist. The insurer denied coverage. Initially the insureds filed suit for uninsured motorist benefits and property damage only; subsequently however, the insureds amended the complaint to add a bad faith claim. The insureds alleged that the insurer, through counsel, admitted coverage but failed to make a good faith attempt to settle. The district court had already sanctioned the insurer twice for failure to provide requested discovery and failure to comply with court orders. The insureds sought discovery of documents created after the filing of the complaint. The insurer argued that litigation conduct is not discoverable or admissible in a bad faith claim.

In its analysis of the discovery issue the Graham court “recognize[d] it ha[d] the authority under the Federal Rules of Civil Procedure to impose penalties for bad faith litigation tactics, and [it had] exercised that authority twice in this case.”[109] However, the court also stated:

[T]he duty of good faith by an insurance company is a continuing duty, which continues past the filing of a bad faith complaint against the insurer. Because of this continuing duty, there may be evidence ofpost-filing conduct that is relevant to the bad faith claim. While the weight of authority recognizes the need to restrict the introduction of evidence regarding litigation tactics after a suit has been filed, the cases discussed above do not draw an absolute barrier to such evidence. Therefore, this evidence is discoverable even though it may ultimately be found to be inadmissible.[110]

Accordingly, the court allowed discovery of all documents concerning the defense of the underlying underinsured motorist and property damage claims, including the alleged post-filing admission of coverage, but no discovery of documents concerning the bad faith claim. The court stated that “clearly” not all litigation conduct would be admissible, and therefore reserved ruling on the admissibility of the discovered material. The court then concluded with the following observation:

On the whole, defensive pleadings and traditional tactics, absent a “smoking gun,” will not be admissible. The insurer is certainly entitled to defend itself and deny allegations and dispute discovery, just like any other litigant. However this should not completely bar Plaintiff’s right to discover evidence in which “the information sought appears reasonably calculated to lead to the discovery of admissible evidence.”[111]

VIII. Practical Application: Ten Ways to Avoid Continuing Bad Faith

A policyholder versus insurer lawsuit may have a detrimental impact upon an insurer’s continuing adjustment of a loss, not by design, but by default. Even the best-intentioned insurer may not be prepared to deal with the simultaneous adjustment of a policyholder’s loss while defending against the policyholder’s bad faith lawsuit. There may be confusion over the role of inside and outside counsel, the number of claim files required, and how to distinguish between litigation activity and claim handling activity. The following “Top Ten” list is synthesized from decades of experience analyzing and litigating insurer conduct.

1. Don’t forget the claim.

Even though the policyholder has filed suit, establish a procedure for obtaining, maintaining, and evaluating information that may help adjust the claim. Information obtained through discovery that is relevant to the ongoing adjustment of the loss should be provided to the claim personnel monitoring the claim. Correspondingly, information obtained through the adjustment of the loss should be provided to the lawyer defending the bad faith lawsuit.

2. When the claim goes into suit, it doesn’t mean there is one less claim to worry about.

When an insurer is unable to compromise a liability claim against its insured, the natural course of events is for the claimant to file a lawsuit against the insured to resolve the dispute. To a busy adjuster, this “third party” lawsuit may mean that retained counsel will assume primary responsibility for the claim. However, the filing of a “first party” bad faith lawsuit by a policyholder during the adjustment of a loss is quite different. The lawyer representing the insurer may not participate in the adjustment of the loss or, if so, in a more limited role. The claim personnel responsible for adjusting the loss should maintain the same pace of activity and vigilance after suit is filed.

3. Do not transfer claim authority to extra-contractual counsel.

If the policyholder’s loss is still being adjusted and a decision remains regarding payment of benefits, that decision should not be abdicated to either inside or outside extra-contractual counsel. The decision-making process leading up to the payment or denial may be relevant, admissible evidence in the bad-faith lawsuit and the role of extra-contractual counsel is not that of trial witness.

4. Recognize the separate role of each lawyer.

Several lawyers may be retained while defending a bad faith case, each with a distinct job. Coverage counsel and counsel retained to assist with claim handling may be more valuable as witnesses than advocates, particularly if advice of counsel is asserted as a defense. Increasingly, courts are limiting or even abrogating the attorney-client privilege between coverage counsel and the insurer.[112] Relying upon bad faith litigation counsel for advice on how to handle the claim, or as the only conduit for information from the insured, can compromise his or her role as an advocate.

5. Adjust, rather than litigate, as much of the claim as possible.

If the policyholder sues before completion of the loss adjustment, continue to adjust the loss as though the lawsuit had not been filed. Invariably, litigation will slow the resolution of a claim. If information necessary to the adjustment of the loss is obtained only through formal discovery and disclosure, it can delay a decision on payment of the claim. At the inception of litigation, let the insured know what additional information is needed to evaluate the claim. Encourage the insured to provide that information informally, rather than through formal discovery, or to expedite formal discovery and disclosure in order to get the information to claim management who can evaluate and resolve the claim. There are ethical constraints on how much direct contact the insurer can have with the insured or its corporate employees during litigation, so it is important to pursue the non-litigation claim handling with the full knowledge and cooperation of the insured’s lawyer.

6. Assess the impact of the insurer’s post-filing conduct.

Before objecting to either the discovery or admission into evidence of the insurer’s post-filing conduct, think about whether that information will help “complete the story” of the loss adjustment. Too often, a quick decision is made to restrict discovery, and thereby the introduction of evidence, of the activities occurring before the policyholder’s lawsuit was filed. Often, it is helpful to disclose and embrace the insurer’s post-filing good faith efforts to resolve the claim fairly. First ask, can the story of our adjustment of this loss be told without discussing post-filing claim handling?

7. Bifurcate the contract and bad faith claims.

Litigating bad faith and breach of contract claims simultaneously can create an evidentiary and procedural quagmire. It is difficult to obtain a focused and impartial resolution of the underlying contract dispute while the parties, court, and jury are distracted by ancillary issues of insurer claim handling and litigation conduct. Claims of continuing bad faith compound the problem because the conduct at issue may involve the same individuals present on behalf of the insurer in the courtroom defending the breach of contract claim. Yesterday’s bench conference becomes today’s evidence. Although not always appropriate, consider a motion to bifurcate the breach of contract claim from the bad faith claim and a concomitant motion to stay all proceedings related to the bad faith claim until the contract dispute is resolved. It will at least allow the parties and court first to focus their attention on whether the insurer breached a duty under the insurance policy.

8. Determine which state’s law applies.

Insurance policies may cover a policyholder’s activities in a number of different states, and claims may be “adjusted” in several states. An insurance policy may be issued from an insurer’s home state to the home state of the policyholder, covering activities in yet another state. Which state’s law will apply to the resolution of the contract claim? The bad faith claim? Each of those states may have developed different choice of law rules and different laws relating to breach of contract and bad faith. It is important to determine early which state’s law will apply to each aspect of the case.

9. Address case management early.

Even within a particular jurisdiction, trial courts vary dramatically in how they process claims of continuing bad faith. Request an early case management conference and address with the trial judge the scope of discovery and disclosure and the manner or sequence in which claims of continuing bad faith will be considered. Insurers who understand how the rules of discovery and rules of evidence will be applied may avoid expensive and contentious discovery battles and take the initiative toward a prompt and fair result.

10. Keep your eye on the ball.

In lawsuits for breach of contract, bad faith, continuing bad faith, and punitive damages, the fundamental concept is fairness. Before you get caught up in protracted litigation, step back and take a very simple look at the claim. Explain the claim in declarative sentences and simple words to people who have no experience as adjusters or lawyers. What do they think? Eventually, the same commonsense logic will decide your case.

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