Bad Faith and the Tripartite Relationship: Can We All Get Along When the Heat Is On?

Bad Faith and the Tripartite Relationship: Can We All Get Along When the Heat Is On?

By Steven N. Joseph

(Please note that the views expressed in this article are written as my own views to provide guidance for defense counsel, and do not in any way, reflect those views of Western World Insurance Company, Validus Specialty, or AIG.)

This is a republication of a chapter I wrote for the Practicing Law Institute Accountants Liability textbook in July 1995. The strategies discussed in this article are as relevant today as it was then. There are some revisions to the article since, back then, mediation was not a given as it is today. Believe it or not, back then, if you went to a judge, and requested an order to send the case to mediation, the judge would be reluctant to issue an order if it was against one of the parties’ wishes. In one case, I even showed up with counsel in New York and offered to pay for the mediation just so the other side could not object to the cost.  So, times have changed.

As stated in the original chapter, the statements made are not made on behalf of any present or former employer. They are presented as strategies put forward by the author to consider based on collaborations with some outstanding lawyers with who I worked with in the past.)

Consider this situation: You are the managing partner of an accounting firm, its personal counsel, or counsel for the firm retained by the insurer to defend a pending accountant liability lawsuit. A thorough investigation reveals that negligence is certain, damages have also been established and are well in excess of the firm’s available policy limits. Plaintiff’s counsel recognizes that the legal fees for the defense of the case would be substantial and, under the firm’s policy would significantly reduce the available policy limits. Therefore, plaintiff’s counsel makes a demand to resolve the claim for the remaining limits of the accounting firm’s policy.

These facts will almost always result in a settlement. Wearing any of the above three hats, you will likely pick up the phone, call the insurer, and then send a follow up letter requesting that the demand made by the plaintiff’s counsel be accepted. The insurer, recognizing its duty “to act in good faith” toward its insured, will likely accept this request and agree to settle the claim.

However, such “black and white” coverage situations in the real world are rare, and with various type of professional liability claims, are exceedingly more complex. A far more common example might be as follows:

You are counsel retained by the insurer to defend an accounting firm in an accountant liability lawsuit. The actual lawsuit was filed and reported to the insurer two years earlier. At the time it was reported, the letter sent to the insurer enclosing the complaint included a denial of any wrongdoing on the part of the accounting firm and a request that the lawsuit be vigorously defended. This position was echoed to the insurer's underwriters at the firm's annual renewal review.

It is now two years after the lawsuit was filed. A vigorous discovery schedule is in place with a trial date looming on the horizon. Plaintiff’s counsel writes a letter to both you and the firm’s personal counsel indicating that the plaintiff will accept the remaining limits of the accounting firm’s policy.

The letter does not indicate any deadline for the acceptance of this demand, but does suggest that it may be withdrawn after the parties recommence the discovery process. Plaintiff’s counsel also volunteers the opinion in the letter that if the demand is not accepted, the insurer would be acting in bad faith, and plaintiff would proceed accordingly against both the accounting firm and its insurer to collect any judgment that exceeds policy limits.

(A more common scenario, discussed later in this article, is a situation in which the demand is in excess of policy limits, but plaintiff’s counsel has agreed to proceed at mediation. The mediation progresses to a point at which the plaintiff’s attorney makes a demand for policy limits. The mediator indicates that this is the last move that will be made by that side.)

As defense counsel, you had previously determined that though a motion for summary judgment may be filed resolving some issues in the accounting firm’s favor, it would not completely eliminate the lawsuit, and a jury trial is inevitable. Overall, you have determined that the lawsuit is defensible, but not without some risks. Your opinion is that though you strongly believe that you can win the case, a jury still may not understand the accounting issues and may enter a verdict against the accounting firm. Ultimately, you assess the chances of winning at 60-40.

You also opine that if there will be a verdict against the accounting firm, a likely award given by a jury would be well within the accounting firm’s policy limits. You believe that such an award would be reflective of a significant reduction from the actual damages being sought by the plaintiff due to “lack of causation” and contributory negligence defenses. However, you cannot completely rule out a “worse case” scenario in which a jury awards a judgment in excess of the available policy limits.

Because of all the factors considered, defense counsel opines that the settlement value of the case is well below policy limits.

While the managing partner of the firm still believes the firm did not do anything wrong, she is becoming more and more involved in the case. In fact, it is becoming a major distraction from the day to day obligations she may otherwise have. Also, she finds that her fellow partners now recognize this distraction. Some of these partners, having seen the plaintiff’s counsel’s demand, are worried about the potential of an excess verdict with the plaintiff going after their personal assets, and are now asking the managing partner, “What did we buy insurance for?” 

Though she is outraged by the thought of the plaintiff receiving anything out of this lawsuit, she is now resigned to the fact that life should go on, and some money will need to be paid to get rid of the lawsuit. However, she is convinced that the plaintiff certainly does not deserve to receive the firm’s remaining policy limits. She is also very concerned that a large payment to the plaintiff may result in a correspondingly large increase in the firm’s insurance premiums and may encourage future plaintiffs to file their own lawsuits.

Personal counsel for the accounting firm has been retained to evaluate the lawsuit for the firm and to represent its interests to the extent they may diverge from those of the insurer. Personal counsel has been advised by the firm of its resentment of the plaintiff because of the claims made, as well as its resignation about the fact that the case should be settled with some money being paid to the plaintiff.

Personal counsel has received plaintiff’s demand and is very much troubled by it. He knows the firm wants the case settled for as little as possible. But, he is equally concerned that if the demand is not accepted, there may not be any future opportunity to try to resolve the case short of a jury trial – with its concomitant risk of a judgment in excess of policy limits.

Depending on what decisions are made from this point on, there are three usual outcomes: (1) the case ends up settling for the remaining policy limits; (2) the case ends up going to trial resulting in a defense verdict with the likelihood of an appeal, a plaintiff’s verdict within the policy limits, or a plaintiff’s verdict in excess of policy limits which, if affirmed on appeal, will likely result in a bad faith action against the insurer; or (3) the case ends up settling for an amount that is substantially below the remaining policy limits.

What many attorneys (and the professionals they represent) fail to realize is that the ultimate objectives of a professional organization (in this case, an accounting firm) and its insurer actually are very similar. Assuming they are rational and acting without any other motives, they should both want to have the case settled below policy limits. This article discusses the strategies that may be employed by the professional organization, its counsel, and the insurer to reach this favored and mutually beneficial outcome.

WHAT IS “BAD FAITH?”

The problem that lawyers and their clients (both insureds as well as insurers) face is that cases that lead to bad faith claims often arise from complicated factual scenarios and, accordingly, the case law can vary dramatically among states and fact patterns.

In New York, for example, a case of notoriety on the topic of the insurer’s obligation to make a “good faith” effort to settle on behalf of its insured is Pavia v. State Farm Mut. Auto Ins. Co., 82 N.Y.2d 709, 626 N.E.2d 24, 605 N.Y.S. 2d 208 (1993).15 In Pavia, the court distinguished “good faith” from “bad faith” by recognizing the conflict between the insurer and the insured when it is the insurer’s interest to minimize payments and the insured’s interest to avoid liability beyond the policy limits. The court held that, in order to establish a prima facie case of bad faith where an insurer can be held responsible for a verdict in excess of policy limits, the plaintiff must establish that the insurer’s conduct constituted either (a) a “gross disregard” of the insured’s interests, or (b) a reckless failure to place the interests of the insured on equal footing with its own interests when considering a settlement offer. Pavia, 605 N.Y.S. 2d at 211.16

The court in Pavia noted that the mere evidence of the existence of an unaccepted settlement offer is not dispositive of an insurer’s bad faith, since an insurer cannot be compelled to concede liability and settle a questionable claim. Id. at 212.17 Rather, the plaintiff must show that the insured lost an opportunity to settle the claim when all serious doubts about the insured’s liability were removed. Id.18  However, the following “bad faith equation” set forth by the Pavia court shows how complex bad faith litigation can become:

 “The bad-faith equation must include consideration of all of the facts and circumstances relating to whether the insurer’s investigatory efforts prevented it from making an informed evaluation of the risks of refusing settlement. In making this determination, courts must assess the plaintiff’s likelihood of success on the liability issue in the underlying action, the potential magnitude of damages and the financial burden each party may be exposed to as a result of a refusal to settle. 

Additional considerations include the insurer’s failure to properly investigate the claim and any potential defenses thereto, the information available to the insurer at the time the demand for settlement is made, and any other evidence which tends to establish or negate the insurer’s bad faith in refusing to settle. The insured’s fault in delaying or increasing settlement negotiations by misrepresenting the facts also factors into the analysis.”

Pavia, 605 N.Y.S.2d at 21219

Even in those states that are considered more favorable to the insured than New York, the exact state of the law is often uncertain. In New Jersey, for example, the case of Rova Farms Resort, Inc. v. Investors Ins. Co. of America, 65 N.J. 474, 323 A.2d 495 (1974) is frequently viewed as the standard defining an insured’s duty to settle. There, the court held that an insurer has a positive fiduciary duty to take the initiative and attempt to negotiate a settlement within policy limits. Rova Farms, 65 N.J. at 49621. Under Rova Farms, an insurer may be held liable for an excess judgment unless the insurer demonstrates not only that there was no realistic possibility of settlement within policy limits, but also that the insured would not have contributed to whatever settlement figure above that sum might have been available. Id.22

However, this duty was recently defined more favorably toward the insurer in Pickett v. Lloyd’s, 131 N.J. 457, 465-6, 621 A.2d 445 (1993)23:

“[T]he relationship of the Company to its insured is one of inherent fiduciary obligation. A necessary corollary of that fiduciary duty to act on behalf of the insured is that a decision not to settle within the policy limits must be an honest one. It must result from a weighing of probabilities in a fair manner. To be a good faith decision, it must be an honest and intelligent one in light of the company’s expertise in the field. Where reasonable and probable cause appears for rejecting a settlement offer and for defending the damage action, the good faith of the insurer will be vindicated.”

Other jurisdictions follow variations of the standards adopted in New York and New Jersey. In Texas, for example, the insurer’s duty is defined in G.A. Stowers Furniture Co. v. Am. Indemnity Co., 15 S.W. 2d 544 (Tex. App. 1929)24. Under this case, the insurer must be held to that degree of care and diligence that an ordinarily prudent person would exercise in the management of his own business when settling a claim against the insured. If an ordinarily prudent person, in the exercise of ordinary care (as viewed from the standpoint of the insured) would have settled the case and failed to do so, then the insurer should be liable to the insured.

However, in the case of Transportation Ins. Co. v. Monel, 879 S.W. 2d 10 (1994)25, this duty appears to have been relaxed. In Monel, the court noted that when a policyholder alleges bad faith, it must prove that the insurer has no reasonable basis for denying payment of the claim and that the insurer knew or should have known that.

As this case law suggests, bad faith litigation is somewhat of a moving target and is very fact specific. Such cases often pose their own substantial risks for both the insured and the insurer. An insured may face the possibility of having to pay an excess verdict and potentially incur a substantial amount of additional legal fees in order to bring a bad faith action against its insurer, which may ultimately be unsuccessful. 

Similarly, an insurer may face the possibility of having to pay an excess verdict and additionally incur a substantial amount of legal fees to defend a bad faith action, which may ultimately be successful. In some jurisdictions, if the insurer loses, it may also face liability for punitive damages and legal fees incurred by the insured in the bad faith action.

Because bad faith litigation poses enormous risks for both the insured and the insurer, it is in both sides’ interests to avoid this outcome. These risks increase if the relationship between the insured and the insurer is viewed as in the Pavia case – i.e., one of necessary conflict where it is the insurer’s interest to avoid making payment and the insured’s interest to avoid liability in excess of its policy coverage. The key to reducing this risk is a cooperative relationship between the insured and the insurer in recognition of the fact that the interests of both the insured and the insurer are ultimately aligned.

GET MORE BY SETTLING FOR LESS

In the factual scenario discussed above, the managing partner has no particular affinity for the plaintiff. Other than protecting the firm from excess exposure and the partners from personal liability, and otherwise getting on with business as usual, she has no interest in seeing that the plaintiff gets any money.

Although most settlements involving professional organizations may be kept confidential, she is also justifiably concerned about the effect such a settlement may have on putative plaintiffs or disgruntled clients that learn of it. Moreover, she may be concerned that a large payment by the insurance company for a settlement can result in a large increase in the firm’s premiums or, even worse, loss of coverage. Therefore, it is in the firm’s best interest to settle for the lowest possible amount.

It can be a mistake if, upon receipt of plaintiff’s demand, the firm’s personal counsel merely fires off a letter to the insurer requesting that the case be settled within the policy limits. Such a demand is not necessarily reflective of the firm’s best interests. While there may ultimately be a “worst case” scenario in which there would be a judgment above the firm’s policy limits, the insurer, having experience in handling similar claims, may honestly evaluate the settlement value of such a claim well below the firm’s policy limits. Yet such a letter, by itself, can create the mutually detrimental conflict described in the Pavia case.    

It can be an even bigger mistake when personal counsel takes it upon himself to begin “sympathy” discussions with plaintiff’s counsel. In extreme cases, such discussions may constitute a violation of the “cooperation clause” of the firm’s policy. Such a clause may read as follows:

“The insured shall cooperate with the Company and upon the Company’s request, assist in making settlements, in the conduct of suits and in enforcing any right of contribution or indemnity against any person or organization who may be liable to the insured because of acts, errors or omissions with respect to which insurance is afforded under this policy; and the insured shall attend hearings and trials and assist in securing and giving evidence and obtaining the attendance of witnesses. The insured shall not, except at his own cost, admit liability, voluntarily make any payment, assume any obligation or incur any expense without the consent of the Company.”

 Additionally, such discussions play right into plaintiff’s hands. Plaintiff, having learned of the firm’s eagerness to settle, will be less willing to move off of his or her policy limits demand. Even worse, plaintiff may now believe that he or she can recover an excess verdict against the insured, and raise or withdraw the demand. The insurer, having the honest belief that the settlement value is well below the policy limits and that it is acting in good faith, may determine that it no longer has any incentive to negotiate when plaintiff is showing no willingness to be reasonable. The alternative result is that the insurer relents and pays the remaining policy limits.

By overprotecting against the “worst case” scenario, personal counsel can ensure that his client gets two of the options that the accounting firm hoped to avoid: a jury trial, an excess judgment, and the expense of a potentially unsuccessful bad faith lawsuit, or the insurer surrendering the remaining policy limits.

In contrast, it can also be a mistake if you as defense counsel stand idly by as if your only role is to defend the litigation. Having been retained by the insurer as well as having established a relationship with the firm, you can now become the bridge of communication between the firm, personal counsel, and the insurer. Whether the case ultimately settles or goes to trial, you have a primary role and should be at the forefront to ensure that a coordinated response is given to an inappropriate policy limits demand.

The insurer’s claims representative should also have taken the effort to create a positive working relationship with the insurer every step of the way. The insurer representative is the hand holder and listens to the insured’s concerns, and a level of mutual trust and good will between the parties needs to be created.

We now have the pieces together when everyone is on the same team. If they have not yet already done so, this will be an opportune time for the insured, its counsel, and the insurer to evaluate the case collectively and map out a strategy for settlement. The evaluation should consist of much more than simply a discussion of “will we win or will we lose?” There should be an examination of whether the timing of the demand makes sense. For example, where are the parties in the discovery process? Does the plaintiff have weaknesses in the case that can be exploited by further discovery? 

On the flip side, are there weaknesses in the defense that may be exposed by further discovery? Has an expert been retained to evaluate damages alleged by the plaintiff? Has anything recently taken place that has prompted the plaintiff’s policy limits demand? If much can be done in investigation, discovery, or motion practice to expose weaknesses in the plaintiff’s claim, the risk of withdrawal of any early policy limits demand may be worth taking.

MEDIATION

When I originally wrote this article, mediation was not necessarily a given as it is today. Because the Court will either order the case to mediation or the parties go willingly, the more common scenario is to have a demand in excess of policy limits, and the plaintiff’s counsel will negotiate and stop at the policy limits demand number.   

The first strategy for defense counsel is to try to get a demand within policy limits. Plaintiff’s counsel may go willingly, understanding the weaknesses of the case, or may simply decline to go there without something being offered. If an offer needs to be made, it can be made in the form of a bracket. The defendants are willing to make an offer of X dollars if the plaintiff moves to a number within the policy. If accepted, we have a negotiation within policy limits.

Once the parties get into mediation, brackets can be re-employed again with the accounting firm willing to make an offer at X, if the plaintiff’s demand is within policy limits. Plaintiff’s counsel may propose a counter-bracket, and if the midpoint is at the policy limit, a continued negotiation would likely bring the parties negotiating in a range under that amount.

Also, when you have this kind of case, think of retaining a mediator who will control the process and help the case get settled within the policy. This is not the time to experiment with a mediator who you do not have a high level of confidence in.

“There are times when I am in the position representing the insurer, and we see the case differently than the insured. It is these times that I will want to sit down with the insured and give them my one rule: “In private, you are free to beat me up, throw me out the window, yell at me, and put gum in my hair. In public, we are a united front.” I have never had an insured break that rule.

Steven Joseph

Once we are in the mediation, it is important that there is a high level of trust between the insured, insurer, and defense counsel. When the mediator is in the room, the presentation is always one of a united front. There is also a level of good faith. The purpose of a mediation is to have an open mind and if presented with new facts for the insured and the insurer to consider, that has to be taken in consideration, and both the insured and insurer agree to act prudently based on the new information. If the prudent course of action is to pay the policy limits, that should be considered.

However, sometimes, it is the opposite. The case seems to be better. Or the case simply stays the same with the same evaluation. Arguments brought in from the other room fall flat, but there is no correlation to the continuing unreasonable demands. Nobody has yet to be impressed.

One thing that is overlooked in this situation is the “consent clause” of an insurance policy. Insurers use it only when they want to get consent or if they do not get consent. However, in the context of a mediation, if all the parties go willingly, the insurer does not need full consent to settle up to the available policy limit, but limited consent at each step of the way. 

Because I have not asked for the consent, I do not have that kind of consent. We can then present to the mediator that there is no consent to settle at the certain demand level, but somewhere the later offers being made, thus putting further pressure on plaintiff’s attorney to reduce the demand further.

POLICY LIMITS OR TRIALS?

Let’s assume that now, everything has been tried, and plaintiff’s counsel has refused to reduce the demand below policy limits. Here, the “united front” approach has been presented, the weaknesses in the plaintiff’s claims have been identified, a reasonable offer to settle has been made, and still, whether in mediation or out, plaintiff’s demand for policy limits remains firm. Further, plaintiff’s counsel has indicated that the demand may be withdrawn and indicates that he or she will proceed against both the accounting firm and the insurer to collect any excess judgment.

The united front could now show some stress at its seams. The partners in the accounting firm are unfamiliar with the process, and they are growing impatient and nervous. The managing partner is getting pressured to consider paying the demand. The insurer is getting frustrated by the unreasonableness of plaintiff’s position and is resigned to the fact that the case will have to go to trial. Defense counsel is alerting all involved to the costs and risks of the trial. The question at this point becomes whether any joint strategies between the insured and the insurer can be employed to get the case resolved.

In certain “bad faith” situations, an insured may assign a bad faith action against the insurer to the plaintiff who receives an excess judgment against the insured. See, e.g., Allstate Ins. Co. v. Kelly, 680 S.W. 2d 595 (Tex. App. 1984)

However, this can be done in a creative way by both the firm and its insurer prior to a judgment being entered where the insurer insists on trying the case in the following manner:

1. The insurer and the firm together assign the bad faith claim to the plaintiff in the event of an excess judgment;
2. The offer to assign the bad faith claim is made on insurance company letter head and signed by both an insurer and insured representative;
3. The insurer waives any standing issues so that the plaintiff can proceed directly against the insurer in the event of an excess judgment;
4. The plaintiff agrees not to proceed against the accounting firm or its partners to collect an excess judgment;
5. It is stipulated that the agreement cannot and will not be admitted into evidence in any future bad faith action against the insurer; and
6. All settlement offers are withdrawn. 

First, this kind of offer can only be done when a high level of trust has been created between the insured and insurer representative. This kind of assignment has many benefits. It sends a signal that the plaintiff may not get a very cooperative witness in the accounting firm representatives in a future bad faith action. In other words, the folks at the accounting firm will be giving glowing reviews of the insurer which does not make for a great bad faith action. If necessary, it makes the accounting firm and its partners more cooperative and willing to try the case, since they face no excess judgment. Finally, it gives the insurer a less sympathetic plaintiff than the accounting firm in any resulting bad faith litigation. If plaintiff’s counsel refuses this form of assignment, plaintiff’s counsel still has another daunting factor to consider – the likelihood of success in any future bad faith litigation. 

This is not an offer that is being made with the hope that plaintiff will accept it. It is an offer of “go ahead and try your case, and you will have a questionable bad faith claim, assuming you get to that point.” But if they reject the offer, the offer sends the same message of a questionable bad faith claim because plaintiff’s counsel will still have the same case. The hope here is not to just go forward with the assignment at the end of the day, but rather, continue to show that there is still a united front, and get the other side will continue to negotiate and be reasonable.

Another creative option (which can be combined with the assignment alternative) is if both the accounting firm and its insurer are comfortable with a “high-low” binding arbitration, this method can also be used to present the ultimate “put-up or shut-up” show of good faith to plaintiff’s counsel. Under this process, the “high” can be set at the remaining available limits of the policy and the “low” can be set at a reasonable valuation of the case from the insurer’s perspective.

Plaintiff’s counsel may be very hard pressed to accept such an offer because of the risk of an arbitrator picking the low number. Plaintiff’s counsel will also be hard pressed to say that there is a potential bad faith claim when the plaintiff has been offered an efficient method to show that what he or she says is in fact true – i.e., that the case is worth the firm’s policy limits. This may ultimately be the point where plaintiff’s counsel ends the game playing and starts talking about what constitutes a more reasonable settlement.

WORKING WITH MUTUAL INTERESTS IN MIND

When a professional entity and its insurer understand that they both share the same interests, objectives, and adversary, they can mutually benefit one another. By cooperating, the insurer and the insured can defeat one of the most potent weapons in the plaintiff’s counsel’s arsenal – the technique known as “divide and conquer.” When both the insured and insurer do not divide, the ultimate result is that they will be the conquerors that will benefit each of the parties.