In its recent opinion in Telamon Corporation v. Charter Oak Fire Ins. Co., 2017 U.S. App. LEXIS 4207 (7th Cir. 2017), the Seventh Circuit made a pretty serious error in the opinion of the authors of this blog. Indiana’s Supreme Court has unequivocally recognized the fact that a claim for bad faith claim handling may exist even if the ultimate claim decision was correct, yet the Seventh Circuit stated just the opposite in this opinion. What follows is our analysis and reasoning supporting our opinion that on this narrow issue at least, Telamon was wrongly decided.
Insurance companies owe a duty to their insureds to act in good faith, including “the obligation to refrain from (1) making an unfounded refusal to pay policy proceeds; (2) causing an unfounded delay in making payment; (3) deceiving the insured; and (4) exercising any unfair advantage to pressure an insured into a settlement of his claim.” Erie Ins. Co. v. Hickman, 622 N.E.2d 515, 519 (Ind. 1993). A strong public policy interest exists in allowing bad faith claims to proceed because bad faith verdicts with punitive damage awards discourage insurers from underpaying claims under the theory they would only be liable for contract damages. Patel v. United Fire & Cas. Co., 80 F.Supp.2d 948, 959 (N.D. Ind. 2000).
While Indiana “has long recognized that there is a legal duty implied in all insurance contracts that the insurer deal in good faith with its insured”, Erie was the first case in which Indiana established a tort remedy for an insurer’s breach of its duty to act in good faith. Erie, 622 N.E.2d at 518. The Indiana Supreme Court found it appropriate to recognize a cause of action for an insurer’s tortious breach of its duty to act in good faith based upon a public policy rationale and because punitive damages are not awardable for a breach of contract. Id. at 518-19. While the Court recognized four contractual obligations an insurer owes to its insured, the Court specifically noted that these were “general observations” and it “need not determine the precise extent of that duty today.” Id. at 519. The Court also noted that a “good faith dispute about the amount of a valid claim” is not enough to sustain a bad faith claim. Id. at 520.
An insurer’s duty to act in good faith was also addressed where an insurer disclaimed coverage under a pollution exclusion and refused to defend or indemnify the insured. Freidline v. Shelby Ins. Co., 774 N.E.2d 37, 39 (Ind. 2002). The Court stated that “to prove bad faith, the plaintiff must establish, with clear and convincing evidence, that the insurer had knowledge that there was no legitimate basis for denying liability.” Id. at 40. Here, the insurer denied the claim based upon their interpretation of the law, which the Court found to be “a rational, principled basis for denying liability.” Id. at 42. As the insurer’s position was supported by a good faith legal argument, the insured did not meet the burden of proof for their bad faith claim. Id.
The Indiana Court of Appeals has discussed the relevance of an insurer’s bad faith conduct after a suit has been filed. In Gooch v. State Farm, an insured filed suit after she was unable to reach an agreed settlement with State Farm on her uninsured motorist claim and later amended her complaint to include a claim of bad faith. 712 N.E.2d 38, 39 (Ind. Ct. App. 1999). During discovery, the insured learned State Farm may have had a policy to litigate low-damage claims so it would be financially unfeasible for the insured to recover. Id. at 39-40. State Farm contended the duty of good faith and fair dealing does not extend to litigation conduct, so only pre-litigation bad faith conduct should be considered in the bad faith claim. Id. at 42. The Court of Appeals considered a number of cases from various jurisdictions and concluded that post-filing conduct “has little relevance to proving that the insurer’s prefiling actions resulted in the wrongful denial of policy benefits” since litigation usually commences after the tort of bad faith occurs. Id. The court also noted “the tort itself occurs when the contract is breached unreasonably.” Id. In this case, State Farm’s alleged bad faith conduct occurred before the insured filed the bad faith claim, so the conduct was relevant to the litigation. Id. at 42-43.
Although Gooch in 1999 noted the tort of bad faith occurs when the contract is breached unreasonably, Indiana courts now recognize that a bad faith claim between an insured and his insurer may proceed even where there has not been a breach of contract. Monroe Guar. Ins. Co. v. Magwerks Corp., 829 N.E.2d 968 (Ind. 2005). A company reported a clam to its insurer when the roof of their business collapsed after heavy rain and snow, causing water and moisture damage to some of the company’s equipment. Id. at 971. One part of the insurance policy excluded loss for collapse but another section provided coverage for collapse. Id. After the insurer denied the claim, the company sued for breach of contract, bad faith, including the manner in which the insurer handled the claim, and punitive damages. Id. at 971, 976. The trial court granted summary judgment to the company as to the breach of contract claim and at trial the company ultimately received a $5.1 million jury verdict including an award for punitive damages. Id at 971. The Court of Appeals found it inappropriate to grant the company summary judgment as to the breach of contract claim because there was an issue of fact as to the definition of “collapse”. Id. at 972. The Court of Appeals also found that the insurer could not have acted in bad faith because the case involved a good-faith coverage dispute and punitive damages could not be awarded to the company. Id.
Our Supreme Court agreed there was an issue of fact as to whether the insurer breached the insurance contract, but disagreed regarding the company’s ability to pursue a bad faith claim. Id. at 976. The Court noted that
[A]n insurer’s duty to deal in good faith with its insured encompasses more than a bad faith coverage claim. And Freidline should not be read to suggest otherwise. In that case the only dispute at issue concerned a good faith difference of opinion over whether a claim was or was not covered. As a result we said “to prove bad faith” etc. the plaintiff must establish “that the insurer had knowledge that there was no legitimate basis for denying liability.” This was not meant however to suggest that this is the only way to demonstrate bad faith.
Magwerks, 829 N.E.2d at 976 (internal citation omitted, emphasis added). In this bad faith case, “the question is whether Monroe Guaranty’s conduct leading up to and including the issuance of the denial letter rose to the level of bad faith.” Id. at 977. The bad faith and punitive damages claims were allowed to proceed as they were a question for the jury and the jury had already reached a verdict. Id. at The Court’s holding was crystal clear—“[w]e hold that a good faith dispute concerning insurance coverage does not automatically preclude a punitive damages claim for bad faith when coverage is denied.” Id. at 978. Additionally, the Court noted that Magwerks asserted part of an insurer’s good faith duty includes the “manner of handling the claim” but did not address the matter further since neither party provided the Court “much guidance on the issue.” Id. at 976.
The cases which predated Magwerks did not have the occasion to address the situation presented in Magwerks—whether bad faith claims are precluded if there is no breach of contract. The insured in Freidline asserted the insurer’s bad faith conduct was the coverage denial and the Court found the insurer had a good faith legal basis for their coverage denial. The Court in Erie made general observations about what an insurer’s duty of good faith entails, but did not determine the extent of an insurer’s duty to act in good faith. As such, Magwerks was a case of first impression, and the Court could not have stated its holding more plainly—“we hold that a good faith dispute concerning insurance coverage does not automatically preclude a punitive damages claim for bad faith when coverage is denied.” Magwerks, 829 N.E.2d at 978. The Magwerks decision must be followed unless it is overturned by the Indiana Supreme Court or the General Assembly enacts a statute.
The Court of Appeals correctly applied the Magwerks opinion in a class action case to determine whether the Class could pursue a bad faith claim against an insurer regardless of the insurer’s coverage determination. Klepper v. ACE Am. Ins. Co., 999 N.E.2d 86, 98-99 (Ind. Ct. App. 2013). The Court found the Magwerks holding consistent with Erie’s conclusion that “an insured who believes that an insurance claim has been wrongly denied may have two distinct legal theories, one in contract and one in tort”. Id. at 98. Because the Class had two distinct theories of recovery, the court could not “conclude . . . that the resolution of the contract dispute necessarily disposes of the tort-based bad faith claim” and found entering “a final judgment on the Class’s bad faith claim would be premature”. Id. at 98-99.
If an insured’s basis for alleging a bad faith claim is a coverage denial, it is necessary to first determine whether the insurer wrongfully denied coverage before considering whether the insurer breached its duty of good faith and fair dealing. HemoCleanse, Inc. v. Philadelphia Indem. Ins. Co., 831 N.E.2d 259, 264 (Ind. Ct. App. 2005). The Court of Appeals followed Magwerks, noting in a footnote:
In addition, however, the court noted that an insurer may breach the covenant of good faith and fair dealing in ways other than a wrongful denial of coverage; hence, an insurer may exhibit bad faith in, for example, its handling of the claim such that even if it engages in a good faith dispute over coverage it may still breach the covenant of good faith and fair dealing.Magwerks, 829 N.E.2d at 977. We note that HemoCleanse has not alleged that Philadelphia acted in bad faith in any way other than its refusal to defend HemoCleanse.
Id. In this case, the Court of Appeals stayed the insured’s bad faith claim pending the outcome of arbitration on the breach of contract claim because the insured’s ability to pursue the bad faith claim depended on the outcome of the breach of contract claim. Id.
The Southern District of Indiana found that a breach of contract is not necessary for a bad faith claim because the legal theories between breach of contract and the tort of bad faith are distinct. Westfield Ins. Co. v. Sheehan Constr. Co., 580 F.Supp.2d 701, 717 (S.D. Ind. 2008). The court found “an insurance company which is ultimately correct in denying a claim may still be liable for acting in bad faith if they had no ‘rational, principled basis’ for denying coverage” and even if the court determines the insurer was correct in denying coverage to the insured, the court still must examine whether the initial denial was made in bad faith. Id.
Unfortunately, the Seventh Circuit misconstrued the Magwerks holding in a recent case. Telamon Corporation v. Charter Oak Fire Ins. Co., 2017 U.S. App. LEXIS 4207 (7th Cir. 2017). Here, the insured sued its insurer for denying two claims—one under a crime policy and one under a general commercial policy. Id. at 4. Telamon alleged its insurer acted in bad faith in handling the claims, and did not allege bad faith conduct under the four types of established bad faith actions laid out in Erie v. Hickman. Id. at 10-11. The Seventh Circuit declined to certify to the Indiana Supreme Court the issue of whether bad faith claim handling is a basis for a bad faith claim, instead determining that “Magwerks explicitly refused to recognize the claim-handling ground for which Telamon advocates” and the Indiana Supreme Court has not expanded the grounds which would support a claim of bad faith since Erie. Id. at 11-12. In addressing HemoCleanse, the Seventh Circuit found that “Magwerks expressly rejected that argument” (referring to the footnote in which the HemoCleanse court noted an insurer may act in bad faith in handling a claim). Id. at 12. The court also found that the Indiana Court of Appeals did not endorse the claim-handling theory of bad faith in Klepper. Id.
The Seventh Circuit concluded that the answer to Telamon’s legal argument was clear and there was no need to certify the question to the Indiana Supreme Court. However, the court mischaracterized the holding in Magwerks—the Indiana Supreme Court did not “explicitly refuse” to recognize claim-handling as a ground for a bad faith claim. The Indiana Supreme Court noted that Erie “specifically declined to determine the precise extent of an insurer’s duty to deal in good faith” and “decline[d] at this time” to expand the duty because neither party provided much guidance to the Court. Magwerks, 829 N.E.2d at 976. Declining to expand a duty because the parties did not brief the Court on the issue is not the same thing as “explicitly refusing” to acknowledge that the good faith duty encompasses more than the four categories explained in Erie. In Magwerks, the Court upheld the jury verdict on the insured’s bad faith claim although the Court determined there was a good faith coverage dispute. So, although the Court declined to expand the duty of good faith and fair dealing to include claim handling, claim handling was the basis on which the jury verdict was upheld.
Accordingly, in our opinion, Telamon incorrectly interpreted Indiana law and has the unfortunate potential to influence the outcome of bad faith litigation in our federal courts. The Seventh Circuit should have granted Telamon Corporation’s request to certify the issue, in which event we are confident the outcome would have been different.