Ask a first-year law student what the consequence of a breach of contract should be, and you will get the classic answer, “It depends.” An “A” student will then begin to explain the nuances of contract law. Unless the breach destroys the essence of the agreement, though, breaches typically are addressed via monetary damages. Damages allow scaling the burden on the breaching party to the actual harm caused. Compensatory damages take into consideration the value of the breaching party’s performance, less the benefits already received, and costs saved by the non-breaching party plus consequential damages. Any other result is unfair and inefficient, misallocates resources, overtaxes the breaching party and provides a windfall to the other party beyond actual injury.
Yet courts sometimes miss this point when deciding whether a policyholder can recover costs incurred prior to “tender” of a claim to its insurer. Most of courts recognize that application of a “prejudice” test — requiring an insurer to show it has been damaged by the delay — limits an insurer to damage it has actually sustained.
The pre-tender-costs defense is rooted in two clauses found in a commercial general liability (CGL) policy’s “conditions.” CGL policies require prompt notice of a “suit.” The voluntary-payments clause requires policyholders to make no payment without the insurer’s consent.
When courts first addressed what should happen if a policyholder breached these “preconditions” to coverage, they generally found that unreasonably delayed notice barred coverage. See, e.g., Members Mut. Ins. Co. v. Cutaia, 476 S.W.2d 278, 280–81 (Tex. 1972). But over time, almost all jurisdictions, recognizing the undue harshness of forfeiture, evolved to prejudice-based analysis. Today, the clear majority — at least 38 — apply a prejudice analysis to late notice. See PAJ, Inc. v. Hanover Ins. Co., 243 S.W.3d 630, 631, 634 n.3 (Tex. 2006) (citing Prince George’s County v. Local Gov’t Ins. Trust, 879 A.2d 81, 94 n.9 (Md. 2005)). A much smaller group creates a presumption of prejudice, rebuttable by evidence that no prejudice has occurred. See, e.g., Miller v. Dilts, 463 N.E.2d 257, 265–66 (Ind. 1984). Only six states impose a complete bar. See PAJ, Inc., 243 S.W.3d at 634 n.3.
In Miller, the Indiana Supreme Court described the duty to notify as a condition precedent to the insurance company’s liability to its insured. 463 N.E.2d at 263. The court did not follow a no-prejudice rule. Instead, the court determined that “[p]rejudice to the insurance company’s ability to prepare an adequate defense can … be presumed by an unreasonable delay in notifying the company about the accident or about the filing of the lawsuit.” 463 N.E.2d at 265. But once prejudice is presumed, an insured can “establish some evidence that prejudice did not occur[.]” Id.
Nowadays, insurers frequently argue that Indiana has completely barred all pre-tender costs, eschewing prejudice analysis. As authority, the insurers ultimately cite to Dreaded, Inc. v. St. Paul Guardian Ins. Co., 904 N.E.2d 1267 (Ind. 2009) (J. Dickson writing for the court) and Travelers Ins. Co. v. Maplehurst Farms, Inc., 953 N.E.2d 1153 (Ind. Ct. App. 2011). Dreaded involved a long-tail environmental cleanup. Dreaded did not make a claim until three years after it received a demand letter from the Indiana Department of Environmental Management (“IDEM”). Dreaded requested its insurer, St. Paul, to pay for all defense costs incurred to that point and all defense costs going forward. Id. St. Paul agreed to defend Dreaded from that point forward but refused to reimburse Dreaded for defense costs incurred prior to notice.
Noting St. Paul’s acceptance of responsibility for post-notice costs, the Indiana Supreme Court held that, “as to claims seeking recoupment of an insured’s pre-notice defense costs predicated on an alleged breach of an insurer’s duty to defend, the insurer’s duty to defend did not arise and prejudice is an irrelevant consideration.” Id. at 1268. The court found the insurer entitled to summary judgment on the issue of pre-tender defense costs because there was no viable breach claim — the “duty to defend did not arise until Dreaded complied with the policy’s notice requirement.” Id. at 1273.
In Maplehurst, decided 2-1 in the Court of Appeals followed by a 3-2 denial of transfer, the Court of Appeals denied coverage for indemnity and defense costs when a settlement was made prior to notice or tender. The court relied on Dreaded as to defense costs. As to indemnity, it based its denial on the voluntary payments prohibition — that a policyholder not make any commitment or spend any money “without our consent.” The court found that no prejudice analysis was required for either defense or indemnity costs.
Maplehurst unfortunately went well beyond Dreaded, imposing a forfeiture of all benefits even when the insurer had suffered no actual prejudice. In both cases, the majority did not address the Restatement (Second) of Contracts or the disproportionate nature of the loss of all benefits. In the Restatement of Contracts, lawyers, judges, and scholars assess and guide the common law. Restatement (Second) § 229 (1981) is on point in pre-tender cost cases: “To the extent that the non-occurrence of a condition would cause a disproportionate forfeiture, a court may excuse the non-occurrence of that condition unless its occurrence was a material part of the agreed exchange.”
Excusing a condition if enforcement causes “disproportionate forfeiture” is not new. It evolved from the Restatement of Contracts § 302 (1932): “A condition may be excused without other reason if its requirement (a) will involve extreme forfeiture or penalty, and (b) the existence or occurrence forms no essential part of the exchange for the promisor’s performance.” Moving from an “extreme forfeiture” to only a “disproportionate forfeiture” is a critical change. Proportionality allows courts to align consequences with actual damage and not impose extreme remedies.
Consider this typical long-tail environmental claim. A policyholder is required to defend injury that took place many years ago. Its insurance agent and insurer have told it no coverage exists. It may not be able to locate policies. The policyholder’s broker or risk manager may no longer be available. It may spend many dollars defending exactly as its insurer would have defended if it had received notice. Usually the insurer would have declined coverage on other grounds even if notice had been immediate. Contract law ordinarily would require a court to consider whether all the benefits should not be forfeited.
Prejudice analysis like that required in late notice cases would allow an insurer to reduce its obligation to the extent it has been damaged, but not receive a windfall where it has not been harmed. Complete forfeiture is what used to happen in most states when notice was late. The law has evolved, as the cases in most of states and the Restatement reflect. The same evolution should occur in Indiana. As in late notice cases, demonstrating an absence of prejudice should be allowed to avoid a loss of benefits disproportionate to any harm in the delay of notice.•
• George M. Plews and Sean M. Hirschten are partners and Andrea K. Townsend is an associate at Plews Shadley Racher & Braun. The opinions expressed are those of the authors.