The Georgia Court of Appeals summarized the common-law duty of good faith in dicta more than 60 years ago, noting that a liability insurer may be held liable for damages to its insured for failing to adjust or compromise a claim covered by its policy of insurance, where the insurer is guilty of negligence or of fraud or bad faith in failing to adjust or compromise the claim to the injury of the insured. While this statement of the law endures today, it was the former Fifth Circuit Court of Appeals, applying Georgia law, that gave firm shape to the concept. From 1962 to 1967, the Fifth Circuit issued three decisions in the matter of which describes the duties of the liability insurer to investigate, adjust, and, in the proper case, settle claims against the insured. A detailed examination of the trilogy is a highly instructive primer to the law of common-law bad faith.
The Smoot Cases
The Smoot cases arose from a 1955 automobile accident. Sergeant Smoot was insured by State Farm on an automobile liability policy with limits of $10,000 per person and $20,000 per accident. In November 1955, Smoot was driving, not paying attention and rear-ended Katie Mae Donaldson. The accident involved five cars and was severe enough to knock one of Donaldson’s passengers to the floor of the car. Smoot notified State Farm of the accident and State Farm took a statement from him. Three months after the accident he was assigned to military duty in Guam.
In March 1956, Donaldson’s attorney provided State Farm with a medical report showing that Donaldson had received a severe whiplash injury that was generally improving. Her attorney made an oral offer to settle for $2,500. Her attorney later made a written settlement demand for $4,000. State Farm rejected both offers. In July 1956, Donaldson’s attorney communicated to State Farm that Donaldson’s symptoms were reoccurring. State Farm had Donaldson examined by a doctor, and the examination revealed continuing symptoms. Donaldson’s attorney demanded $5,000 to settle but State Farm rejected it. None of these settlement offers and refusals was communicated to Smoot.
Finally, Mrs. Donaldson and her husband filed separate suits against Smoot, claiming $33,980 and $2,922.83 in damages, respectively. Mrs. Donaldson demanded $5,000 to settle the case and her husband demanded his full amount of damages. State Farm sent Smoot a letter indicating that it had hired attorneys to represent him in the suits. The letter contained the following language:
Because of the fact that the amount claimed against you in these suits is in excess of the protection afforded by this policy, there may be a personal liability upon your part. In view of the possible personal liability, it will be agreeable with this company and its representatives for you, if you so elect, to procure attorneys of your own choosing, at your own expense, to represent you personally and appear in this matter, in addition to the attorneys we have selected and will compensate.
State Farm also secured a stay of the suits pending Smoot’s return from Guam. Smoot returned to Georgia in early 1958. In March 1958, the court ruled against Smoot and State Farm on the issue of whether service upon Smoot had been valid. State Farm’s attorneys failed to have a transcript or a certificate made and therefore were unable to appeal the ruling.
Shortly before the trial, State Farm offered to settle both of the Donaldsons’ cases for $5,000, but the Donaldsons refused. Mrs. Donaldson’s doctors re-examined her, but State Farm failed to obtain the results of the examinations. At trial, two doctors testifying for the defense confirmed the nature and extent of Mrs. Donaldson’s injuries. State Farm knew the doctors would testify unfavorably but did nothing to counteract it. During jury deliberations, one of the attorneys hired by State Farm discussed the possibility of an excess verdict with the Donaldsons’ attorney. He even mentioned the letter that State Farm wrote to Smoot claiming that the letter of the issue. After judgment was entered on the jury verdict of $26,902.83 (an amount in excess of policy limits), State Farm’s attorneys filed a motion for new trial but failed to file the supporting brief of evidence. The motion automatically failed and the case concluded.
Smoot then filed suit against State Farm for damages, seeking the amount that the judgments against him exceeded policy limits. State Farm removed to Federal court and filed a motion to dismiss for failure to state a claim, which was granted by the district court. The Fifth Circuit reversed. State Farm then added the Donaldsons as indispensible parties and pled accord and satisfaction. The jury found in favor of State Farm and Smoot appealed. The Fifth Circuit again reversed and remanded and directed a trial solely between Smoot and State Farm.
After the second remand, the jury returned a special verdict finding (1) State Farm was negligent in the manner in which it carried out its obligation to the insured under the auto policy; (2) the negligence resulted in damage to Smoot; (3) State Farm was guilty of bad faith in the manner in which it carried out its obligations as insurer; (4) State Farm’s bad faith damaged Smoot; (5) Smoot was entitled to special damages of $23,858.40; (6) Smoot was entitled to general damages of $10,000; (7) Smoot was entitled to punitive damages of $10,000; and (8) Smoot was entitled to recover attorneys’ fees of $21,929.20. A general verdict of $65,787.60 was entered. State Farm appealed again, and the Fifth Circuit affirmed.
Smoot makes sense when viewed in context of the development of liability insurance. Under the earliest liability policies, the insurer agreed only to indemnify the insured if the insured was subject to a judgment and the insured actually paid the judgment. Later, some insurers expanded coverage, agreeing to pay the judgment on behalf of the insured as soon as it was rendered, removing the requirement that the insured pay the judgment first. To make their product more attractive (and to protect themselves from the risk of high judgments), some insurers also agreed to provide a defense to the insured. Thus, under older policies, an insurer might not become involved in a lawsuit against the insured until and unless a judgment was actually entered against the insured. In the newer policies, the insurer charged a premium for promising to get involved and protect the insured as soon as the insured faced potential legal liability.
Today, the typical liability insurance contract expressly states that the insurer will indemnify and may settle. By use of the word “may,” and similar constructions, the insurer reserves for itself discretion as to whether the case is worth settling. Thus, the insurer totally controls the decision to settle and, therefore, whether and under what terms to protect the insured against a financially injurious judgment. The Fifth Circuit in Smoot I expressly recognized that the insurer had taken a premium not just to pay a sum certain if the insured was adjudged liable for damages. The insurer was accepting advance payment to use its skill, experience and resources in protecting the insured (and itself) from the risk of potential legal liability. This distinction is not borne from any public policy or championship of individuals over big companies, but from the words the insurer used in drafting its policy. The liability insurer’s decision to keep exclusive control over the decision to settle claims imports to the insurer the corresponding duty to make such decisions non-negligently and in good faith.
Within this context, the court ruled that [t]he allegations were quite sufficient to charge want of good faith in rejecting settlement offers within the policy limits and generally in the handling of the defense.The complaint could not be dismissed at its early stages, according to the panel, because of the intensely factual nature of an analysis under the good faith doctrine. Foreshadowing the development of Georgia law in this area, the former Fifth Circuit explained that [b]y its very nature that question [the insurer’s good faith] encompasses the more specific ones concerning the reasonable valuation of the case, whether, at each stage, proposed settlements were rejected consciously in terms of deliberative judgment evaluation or because of other or no reasons. For this reason, discovery in bad-faith lawsuits often focuses on whether the insurer promptly and thoroughly investigated the liability case against the insured and the damages alleged to have been caused by the insured so as to be able to reasonably evaluate such proposed settlements.
The insurance company’s deliberative judgment could be at issue, because the whole thing was being directed by adjusters or other functionaries who must have sufficient judgment and ability to direct or choose a prudent course of action.Thus, while performing duties it undertook under the insurance contract, the insurer must determine in intelligent good faith just what the case was worth in terms of the probabilities of success or failure. If the insurer failed in its promise to use its litigation expertise, investigative resources and prudent discretion to protect its insured, and if the insured was damaged thereby, the insured had the basis of an action in tort. The Fifth Circuit in Smoot I understood that the contractual duty the insurance company had undertaken in agreeing to defend, while retaining for itself the discretionary power to settle, created duties in tort as well.