Insurer Defending under Reservation of Rights Acted in Bad Faith by Sending Subpoena to Arbitrator for Coverage-Related Information

Mutual of Enumclaw Ins. Co. v. Dan Paulson Construction, Inc. (Wash. S. Ct. 2007)

The Martinellis filed an arbitration claim against Dan Paulson Construction, Inc. (DPCI), alleging construction defects. DPCI’s insurer, Mutual of Enumclaw (MOE), agreed to defend under a reservation of rights. Before arbitration commenced, MOE filed a declaratory judgment action to determine coverage. Suspecting that DPCI would seek a lump sum award in arbitration, depriving MOE of the ability to determine the portions of the damage award, if any, that were for covered claims, MOE sent the arbitrator a subpoena duces tecum and planned to depose him with written questions after the hearing. MOE also sent the arbitrator a cover letter that was not copied to the parties. DPCI, the Martinellis, and the arbitrator demanded that MOE withdraw the subpoena.

During the arbitration hearing, DPCI and the Martinellis settled for a covenant judgment -- a stipulated arbitration award and judgment of $1.3 million, subject to a covenant not to execute. DPCI assigned its coverage and bad faith claims against MOE to the Martinellis, who counterclaimed in MOE’s declaratory judgment action that MOE acted in bad faith by sending the subpoena and ex parte cover letter to the arbitrator. The trial court agreed and entered summary judgment for the Martinellis, ordering MOE to provide coverage by estoppel of the stipulated judgment plus attorney’s fees, costs, and interest.

The court of appeals reversed, holding that MOE’s actions did not amount to bad faith because MOE faced “unreasonable options”: risking a bad faith claim by litigating coverage issues before arbitration or being forced to pay the entire award or settlement regardless of whether it was based on covered claims. On MOE’s discovery requests to the arbitrator, the court held: “This tactic, while somewhat clumsy, did not amount to bad faith.”

The Washington Supreme Court unanimously reversed the court of appeals and held that MOE demonstrated greater concern for its own interests than for its insured’s financial risk. This constitutes bad faith under Tank v. State Farm Fire & Cas. Co., 105 Wn.2d 381, 715 P.2d 1133 (1986). The supreme court disagreed with the notion that MOE faced “unreasonable options.” The court stated: “An insurer defending under a reservation of rights is not automatically liable to pay the entire settlement amount. … Absent a successful bad faith claim and the resulting coverage by estoppel, the insured ‘still has the burden of proving how much of the [settlement] should be allocated to covered claims.’” Slip op. at 16, quoting Thomas V. Harris, Washington Insurance Law § 17.8, at 17-19 (2d ed. 2006).

The remedy of coverage by estoppel is applied in Washington when an insurer (1) provides no defense and the failure to defend is in bad faith or (2) provides a defense but places its own interests above the insured’s interests while doing so. The supreme court reaffirmed that the amount of a covenant judgment is the presumptive measure of an insured’s harm caused by the insurer’s bad faith if the covenant judgment is reasonable. The court rejected the insurer’s argument that intervening to participate in the reasonableness hearing would have been futile because the trial court’s authority to overturn the arbitrator’s finding of reasonableness was limited by the statutory scheme governing arbitration awards.

The supreme court also concluded that MOE failed to rebut the presumption that its actions, including the filing of the declaratory judgment action, harmed DPCI. The court concluded that MOE’s conduct caused uncertainty and increased risk for DPCI’s defense, interfered with its preparation for the arbitration hearing, interjected coverage issues into the arbitration, and might have prejudiced the arbitrator. While acknowledging that rebutting the presumption of harm is “almost impossible,” the court held MOE to this requirement because, “[a]s between the insured and the insurer, it is the insurer that controls whether it acts in good faith or bad. Therefore, it is the insurer that appropriately bears the burden of proof with respect to the consequences of that conduct.” Slip op. at 19. In addition, while the filing of a declaratory judgment action is not in and of itself bad faith, an insurer cannot use a declaratory judgment action to interfere with the defense of the underlying case.