Vail’s Resurgence: Is Independent Damage Still Required for Bad Faith’

In the arena of liability coverage, a number of significant, yet unresolved, issues are being considered by the Texas Supreme Court: The insurability of punitive damages is under review; selection of defense counsel is in flux; and the use of extrinsic evidence may soon be clarified. There are also more subtle shifts reflected in the opinions of lower courts. One of these is the requirement of independent damage to establish bad faith or statutory violations.

It appeared to be established in Texas jurisprudence that a claim for violation of Article 21.21 of the Texas Insurance Code must involve independent damage: damage separate and apart from that caused by the breach of the insurance contract.

In an early case addressing DTPA claims, the Texas Supreme Court indicated that the breach of contract damages were sufficient, and also constituted damage under the DTPA for wrongful denial of a claim, allowing recovery of three times the policy limits. See Vail v. Texas Farm Bureau Mut. Ins. Co., 754 S.W.2d 129 (Tex. 1988). In Transportation Ins. Co. v. Moriel, 879 S.W.2d 10 (Tex. 1994), the court recognized that bad faith required a different level of conduct than mere breach of contract, concluding that “The threshold of bad faith is reached when a breach of contract is accompanied by an independent tort.” Id. at 17. The supreme court clarified that both an independent tort, and independent damage, were required in Provident American Ins. Co. v. Castaneda, 988 S.W.2d 189 (Tex. 1998). In Castaneda, the court held that breach of contract damages will not support an Article 21.21 claim. Instead, Article 21.21 provides an independent cause of action, and must involve new and different damages, apart from that caused by the breach of contract. (1)

A new interpretation
After Castaneda, several courts of appeal fell into line, adopting and implementing the independent damage rule. A recent opinion, however, reflects a trend away from the independent damage rule, or towards a new and superficial interpretation of it. See Kirby Co. v. Hartford Cas. Ins. Co., 2004 WL 2165367 (N.D. Tex., Sept. 23, 2004).

In Kirby, the Kirby Company sought coverage as an additional insured on a policy issued to Robertson Sales & Service, a distributor of Kirby vacuum cleaners. After an automobile accident, suit was filed against the distributor, the driver and Kirby. Kirby sought coverage from Hartford, the distributor’s insurer. Hartford initially denied coverage. Kirby then filed a declaratory judgment action, seeking a declaration of defense and indemnity, and also asserted breach of contract, violations of Article 21.21, and breach of the duty of good faith and fair dealing. During the course of the declaratory judgment suit, Hartford agreed to defend Kirby, subject to a reservation of rights, under a joint counsel arrangement with the distributor. Kirby objected to the joint representation, and continued to control its own defense. Before the suit was concluded, Hartford conceded that it would pay Kirby’s defense costs, subject to determination of reasonableness and necessity.

The district court’s opinion basically affirmed the findings of the magistrate judge. The magistrate recommended summary judgment to Kirby, not only on its breach of contract claims, but also its Article 21.21 claims. The magistrate recommended, and the district court concluded, that Article 21.21 would allow Kirby to recover post-tender defense costs in the underlying lawsuit–the same defense costs that Hartford had already agreed to pay. Hartford objected to the magistrate’s findings and recommendations. The magistrate also recommended an award of $50,000 for a knowing violation.

The court found, in part, that Hartford had unreasonably delayed in issuing a reservation of rights. According to the court, Hartford’s coverage position did not change substantially, and no additional investigation was conducted for approximately a year before the reservation of rights letter was ultimately issued. The court found this delay was unreasonable. The court also found that Hartford did not adequately tender defense, when it offered to pay “its share” of defense costs, based upon a belief that another carrier arguably owed defense costs as well.

The most baffling discussion, however, is in response to Hartford’s objection that there were no damages for breach of contract, as it already had paid, or was in the process of paying, the defense costs incurred in the underlying lawsuit. The court reasoned “[t]hat Hartford has paid or is in the process of paying the defense costs incurred by Kirby in the underlying lawsuit is of no moment. There is no question that but for Hartford’s breach of its duty to defend, Kirby would not have incurred such costs. ‘Texas courts have held that attorney’s fees incurred involving litigation with a third party are recoverable as actual damages.'” Id., at *4 (citing American Home Ins. Co. v. United Space Alliance, LLC, 378 F.3d 482, 490 (5th Cir. 2004)). Hartford also objected on the basis that a breach of contract did not constitute a violation of Article 21.21, and that Kirby had suffered no independent damages. The court concluded that a breach of the duty to defend was actionable under Article 21.21, relying on Travelers Indem. Co. v. Presbyterian Healthcare Resources, 313 F.Supp.2d 648, 652 (N.D. Tex. 2004). In regard to the damages, the court again concluded that “there is no doubt that Kirby would not have incurred defense costs in the underlying lawsuit had Hartford not breached its duty to defend.” Id. The court did not find adequate evidence for a knowing violation, and therefore sustained Hartford’s objection to that finding.

Thus, despite the independent damage rule pronounced by the Texas Supreme Court, and despite the fact that Hartford had already conceded that it owed reasonable and necessary defense costs, the court found that the defense costs formed the basis for both a breach of contract claim and a claim for violation of Article 21.21. (2)

Although third-party bad faith claims appeared to be largely eliminated by the supreme court’s pronouncements in Maryland Ins. Co. v. Head Indus. Coatings & Services Inc., 938 S.W.2d 27 (Tex. 1997) that bad faith in the third-party context was typically limited to Stowers violations, Article 21.21 claims were given new life by the supreme court’s opinion in Rocor Internat’l, Inc. v. National Union Fire Ins. Co., 77 S.W.3d 253 (Tex. 2002), in which the court allowed an Article 21.21 claim for a failure to settle. The Kirby opinion does not discuss any of the cases involving independent damage. Yet, it is impossible to see how this case can be harmonized with the supreme court’s ruling in Castaneda. Instead, it appears to also signal a new opportunity for Article 21.21 claims in the third-party context.

With recent changes in the Texas Supreme Court, it is difficult to predict future trends. The Kirby case, however, portends an unwarranted abandonment of any distinction between breach of contract and extracontractual liability.

(1) While both breach of contract and violation of Article 21.21 support recovery of attorney’s fees, Article 21.21 is still an attractive remedy because of the potential for treble damages, as well as the arguably broader range of damages, which are recoverable.

(2) This is a different issue from whether a failure to pay defense costs gives rise to a claim for penalties under Tex. Ins. Code art. 21.55, which is also unresolved and hotly contested.

Bradley is a partner in the Dallas office of Thompson, Coe, Cousins & Irons, L.L.P. She is a member of the Insurance Litigation and Coverage Section and leads the firm’s coverage practice. She has represented agents in disputes with policyholders and insurers and routinely represents insurers in evaluating and litigating coverage issues under general and pro
fessional liability policies, commercial auto and trucking policies, commercial property policies and homeowners policies.