The Third Circuit affirmed the dismissal of a bad faith claim against a professional liability insurer, finding that because the insurer had a reasonable basis for denying coverage, the claim failed as a matter of law. In addition, the court held that the insurer’s duty to defend did not encompass the obligation to fund a lawsuit initiated by the policyholder, regardless of whether that lawsuit was related to the original underlying action against the policyholder. Post v. St. Paul Travelers Ins. Co., 2012 WL 3095352 (3d Cir. July 31, 2012).

An attorney brought suit against his legal malpractice insurer, Travelers, alleging breach of contract and bad faith. The insured attorney had been named as a defendant in a malpractice action and was also the subject of a sanctions petition in connection with alleged discovery misconduct. In turn, the attorney filed a defamation and tortious interference suit against the petitioners in the sanctions proceeding. In the ensuing coverage litigation, the district court ruled that Travelers’ policy covered both the legal malpractice claim and the sanctions petition. The court also held that because the attorney’s countersuit against the sanctions petitioners was inextricably intertwined with the covered claims, Travelers was required to cover the prosecution of that lawsuit. However, the court found in favor of Travelers on the bad faith claim, finding that Travelers had a reasonable basis to deny coverage. The Third Circuit reversed in part and affirmed in part.

First, the Third Circuit held that Travelers had no obligation to cover the costs of the attorney’s countersuit. The court explained that although a policyholder’s counterclaims are generally covered defense costs, a separate civil action in a different venue is beyond the scope of coverage, regardless of whether the claims are related to the original underlying action against the policyholder. In rejecting an analysis based on “relatedness,” the court stated that “[s]uch a holding would place insurers in the difficult and unenviable situation of having to determine whether related cases are related enough—i.e., ‘inextricably intertwined’— to trigger coverage for the insured’s counterclaims.” Instead, the court adopted the following bright line rule: “[A]n insurer has a duty to cover an insured’s expenses for prosecuting counterclaims in the initial proceeding, but that the insurer has no duty to cover the expenses incurred by an insured in prosecuting an entirely new and separate action (even if that action is related to the underlying case).”

Second, the Third Circuit held that the bad faith claim against Travelers was properly dismissed on summary judgment. Under Pennsylvania law, bad faith must be proven by clear and convincing evidence and may be defeated where an insurer establishes that it had a reasonable basis for denying coverage.

Finally, the Third Circuit affirmed Travelers’ duty to defend the malpractice and sanctions actions, but limited the scope of that duty, finding that Travelers’ defense obligation in the sanctions proceeding did not begin until a formal demand for damages was made against the attorney—an event that did not occur until several months after the sanctions proceeding began.