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Discovery in Bad Faith Litigation - Avoiding Irreparable Prejudice to an Insurer?

September 1, 2009

New Jersey - Bad Faith

In the area of bad faith litigation, courts across the country have repeatedly been faced with the question of whether to sever an underlying breach of contract claim from its companion bad faith assertion, as well as stay discovery on the bad faith action until the underlying claim is concluded. The large majority of jurisdictions have held that severance of the claims is necessary, but refuse to stay discovery on the bad faith claims during the pendancy of the breach of contract action. A small minority of courts, however, have determined that both severance of the claims, as well as staying discovery on the bad faith action, is necessary to avoid irreparable prejudice on the part of the insurer.

Those courts that have determined that a stay of discovery is necessary have focused on the stark differences in permissible discovery in bad faith actions as opposed to breach of contract claims. In bad faith actions, a plaintiff is entitled to discovery of the majority of an insurer's claim file, including their internal discussions and valuations regarding the merit of the claim. These materials are protected by the attorney-client privilege and work product privilege in general breach of contract actions. Therefore, these courts have concluded that the insurer is entitled to the same discovery protections in the breach of contract claim as any defendant would have in similar circumstances.

For example, in Dahmen v. American Family Mutual Insurance Company, 247 Wis. 2d 541, 551 (Wisc. App. 2001), the court granted a stay of discovery on the plaintiff's bad faith action, noting "the risk of prejudice to the insurance carrier when discovery proceeds on a bad faith claim while an underlying claim against the same defendant remains unresolved." In Bartlett v. John Hancock Mutual Life Insurance Company, 538 A.2d 997, 1000-1002 (R.I. 1988), the court held that a plaintiff's need of the information discoverable in a bad faith action was outweighed by the insurer's right to defend itself against the breach of contract claim. See also Maryland American General Insurance Company v. Blackmon, 639 S.W.2d 455, 457-458 (Tex. 1982) ("regardless of the other reasons which might justify the use of [the insurer's investigative files], it would be impossible to limit the prejudicial effect of disclosure on the insurer's right to defend a contract cause of action."); In re: Bergeson, 112 F.R.D. 692, 697 (D. Mont. 1986) ("[f]or the claims file to be discoverable, the underlying claim must first be resolved, either by settlement or litigation. Otherwise, privileged material may be disclosed which would jeopardize the insurance company's defense.")

New Jersey has yet to expressly address whether both severance of the claims and staying discovery is necessary in bad faith litigation. In 2008, the Appellate Division of New Jersey decided Taddai v. State Farm Indemnity Company, 401 N.J. Super. 449 (App. Div. 2008), where the court concluded that the trial judge did not err in declining to rule upon the plaintiff's late bad faith assertion. While the court did not make any express holdings regarding severance and staying discovery, it did, in dicta, recognize the importance of doing so. The court stated:

To respect the rights of all parties, the [breach of contract claim] could be severed from the bad faith claim, with the latter being held in abeyance until the conclusion of the former. The severed bad faith claim would then be activated, triggering the possibility for the right to discovery, motions, and, if necessary, a separate trial. Bartlett v. John Hancock Mutual Life Insurance Company, 538 A.2d 997, 1000-02 [(R.I. 1988)]. In this way, the plaintiff's ability to pursue a potential bad faith claim would be preserved, but the insurer would not be required to produce its claim file prematurely, "[o]therwise, privileged material may be disclosed which would jeopardize the insurance company's defense." Id. at 1001.

In reasoning that a stay of discovery may be necessary, the Taddai court expressly relied upon the Supreme Court of Rhode Island's decision in Bartlett. The reasoning in Bartlett is similar to that discussed in the Wisconsin decision of Dahmen, which also determined that the substantial risk of prejudice to an insurer justifies a stay of discovery. The Appellate Division's reliance on the reasoning outlined by the Rhode Island and Wisconsin courts is consistent with the longstanding development of bad faith law in New Jersey. New Jersey adopted their bad faith standard, known as the "fairly debatable" standard, from Rhode Island and Wisconsin jurisprudence. Staying discovery until the underlying contractual claims are completed, as suggested in Taddai, continues with New Jersey's favorable view of the bad faith law of Rhode Island and Wisconsin.

The Taddai decision creates a strong basis in New Jersey for an insurer to argue that a stay of discovery is necessary to protect an insurer's interests in bad faith litigation. While the court's discussion of staying discovery has no precedential value, it does give insight to the Law Division of New Jersey as to how the Appellate Division may address the dilemma. The case can be used as a building block for insurers to argue that staying discovery is essential to avoid the prejudicial effect caused by producing their claim file.

As a tactical matter, obtaining such a stay would be highly beneficial to insurers facing breach of contract claims coupled with bad faith allegations. First, it would keep the plaintiff's attorneys from obtaining an insurer's internal evaluations of a plaintiff's claim. This is especially critical in instances where the insurer has assigned specific monetary values. Second, it could help insurers obtain lower settlements with the plaintiffs. Given that plaintiff's attorneys oftentimes use the bad faith action as a "hammer," putting off such a claim can allow the parties to reach equitable settlements on the issues actually presented in the breach of contract claim. Third, staying discovery can keep the plaintiff's attorney from "muddying the waters" with bad faith allegations during litigation of the breach of contract action. Finally, obtaining a stay of discovery could severely impact the amount an insurer pays in litigation costs. As a matter of logic, an insurer cannot be held to have committed a bad faith breach of contract if it is determined that they have not breached the underlying contract. As such, if the insurer is successful in defending their breach of contract claim, the parties would not have to engage in extensive discovery and posturing regarding the documentation discoverable in the bad faith litigation.

*George is an associate in our Cherry Hill, New Jersey, office. He can be reached at (856) 414-6074 or gcdeeney@mdwcg.com.

Defense Digest, Vol. 15, No. 3, September 2009

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