For decades, the rule in New York has been that the tort of bad faith is not available to insureds except for in limited circumstances, such as failure to settle within policy limits or for misconduct directed at the public. In this vein, New York courts have long recognized that the implied covenant of good faith and fair dealing is implicit in every contract, including insurance policies, and as such, an insured’s remedy for a wrongful denial of coverage traditionally has been limited to breach of contract damages.

The reflexive application of this rule was called into question following the 2008 decision by the New York Court of Appeals – New York’s highest court – in Bi-Economy Market, Inc. v. Harleysville Ins. Co. of New York, 856 N.Y.S.2d 505 (N.Y. 2008) and its companion decision in Panasia Estates, Inc. v. Hudson Ins. Co., 856 N.Y.S.2d 513 (N.Y. 2008). In these cases, both of which involved first-party policies, the Court of Appeals held that an insured is entitled to recovery of consequential damages, without regard to policy limits, as a result of an insurer’s wrongful denial of coverage. The court reasoned that limiting the insured’s recovery to policy limits, in some circumstances, does not place the insured in the position that it would have been in had its insurer acted properly. Thus, for example, in Bi-Economy, the court held that the insured was entitled to recovery of the full amount of its business interruption claim, regardless of policy limits, because such claim was a consequence of its insurer’s initial denial of policy benefits for a fire loss. In the wake of these decisions, commentators and practioners have wrestled with the issue of whether the holding in Bi-Economy allows for extra-contractual bad faith damages for wrongful denials under liability policies.

The recent decision by the United States District Court for the Northern District of New York in Schlather, Stumbar, Parks & Salk, LLP v. One Beacon Ins. Co., 2011 U.S.Dist. LEXIS 5779 (N.D.N.Y. Jan. 21, 2011) addresses this very issue. The policy involved was an attorney malpractice liability policy issued to the Schlather law firm. Shortly after the policy’s inception, a malpractice claim was made against the insured. One Beacon agreed to provide a defense under a reservation of rights, but later disclaimed coverage upon learning that prior to the policy’s inception date, the insured was aware of circumstances that could give rise to the claim, thus triggering one of the policy’s exclusions. The insured later filed suit against One Beacon, alleging causes of action for failure to perform, breach of contract, and breach of covenant of good faith and fair dealing. The Schlather decision concerns One Beacon’s motion to dismiss this third cause of action.

One Beacon argued, among other things, that Schlather’s cause of action for breach of covenant of good faith and fair dealing was duplicative of its cause of action for breach of contract. In response, Schlather contended that its cause of action was a claim for consequential damages as permitted by the New York Court of Appeals in Bi-Economy. Relying on decades of established jurisprudence, the court reiterated that New York does not recognize a cause of action for breach of covenant of good faith and fair dealing independent of a breach of contract claim. The court rejected Schlather’s argument that it could state an independent cause of action for consequential damages. Such damages, the court explained, were duplicative of the relief sought in Schlather’s cause of action for breach of contract. In so holding, the court implicitly held that any recovery of consequential damages would be limited by the policy’s limits of liability, and that the extracontractual damages awarded in Bi-Economy would not be available in a standard breach of contract claim.