Denial of Coverage For Ponzi Claim Not Bad Faith
A recent opinion of the U.S. Court of Appeals for the Third Circuit has emphasized the general rule that an insurer’s failure to follow its own internal procedures does not necessarily equate to bad faith.
In Smith v. Continental Cas. Co., No. 08-4140 (3rd Cir. October 8, 2009), Continental Casualty’s insureds were sued for marketing various securities in what later proved to be a Ponzi scheme. The insured tendered its claim to its professional liability insurer, Continental Casualty, which denied coverage. The insured thereafter entered into a settlement with the plaintiffs for $150,000 and an assignment of their rights against their insurer. The plaintiffs thereafter sued Continental Casualty for breach of contract and bad faith.
The Third Circuit affirmed the Pennsylvania District Court’s conclusion that the claims in question were subject to an exclusion in the Professional Liability policy for unapproved financial products, as was the case here.
Turning to the issue of the plaintiffs’ bad faith claims, the Third Circuit took note of the two-part test for recovery under 42 Pa. Const. Stat. § 8371. Thus, in order to recover, a bad faith claimant must establish by “clear and convincing” evidence that (1) the insurer lacked a reasonable basis for denying benefits and (2) that the insurer knew or recklessly disregarded its lack of reasonable basis. In this case, the court found that the plaintiff had evidence of neither prong. In light of the fact that Continental Casualty had prevailed on the contractual issue, it clearly had had a “reasonable basis” for denying coverage. Furthermore, there was no evidence that it had known or disregarded the lack of a reasonable basis for denial. Finally, although Continental Casualty’s internal best practice procedures apparently suggest that the insurer should communicate with the policyholder before denying coverage, the court observed that, “While perhaps Continental should have spoken with Sprecker before it made a final coverage decision, a failure to follow best practices does not give rise to a bad faith claim.”
The Third Circuit opinion also contains an interesting footnote with respect to the scope of the reasonable expectations doctrine in Pennsylvania. In this case, the court ruled that reasonable expectations doctrine “applies only to unsophisticated, non-commercial insureds, and only to protect such insureds from ‘policy terms not readily apparent and from insurer deception.’” In this case, the court found not only that the insureds were sophisticated but that in light of the clear application of this exclusion, any suggestion that they were entitled to coverage was not a reasonable one to hold.
