A few months ago, I received a call from a woman, who we’ll refer to as Ms. Smith, regarding a weather-related homeowners insurance claim of around $30,000. As it turned out, her insurer had acknowledged coverage and made a small payment, but in dispute was whether most of the damage she claimed was caused by the storm.

Fortunately, MCL 500.2833 provides a mechanism for resolving these amount-of-loss disputes known as appraisal — essentially limited arbitration — which has been referred to as “a simple and inexpensive method for the prompt adjustment and settlement of claims” that is a “substitute for judicial determination of a dispute concerning the amount of loss.”¹ Furthermore, while Ms. Smith and her insurer disagreed about which damage was caused by the storm, at least a dozen legal authorities indicate that such disputes are part of the amount of loss assessment for the appraisers.² Unfortunately, the adjuster in this instance asserted that the disagreement regarding causation of some of damage was a non-appraisable coverage dispute and refused to proceed, leaving the insured with a check for a couple thousand dollars, a $30,000 loss, and no option but to start calling attorneys.

From a liability standpoint, this was an easy win because the insurer’s position was legally indefensible. Unfortunately, one third of $30,000 is generally not enough to support a document-intensive lawsuit on a contingent basis, even if the insurer’s position is at odds with decades of Michigan law. Accordingly, without something more, Ms. Smith was out of luck. We declined the case — just as we had done with hundreds of insureds with rock-solid but smallish claims.

In many jurisdictions, the “something more” that facilitates contingency fee-based lawsuits for smaller claims is the potential for attorney fees, which are often awarded in connection with bad-faith insurance denials. However, no Michigan statute provides for attorney fees in this context. Furthermore, in 1995 the Michigan Court of Appeals decided in Burnside v. State Farm Fire and Cas. Co.³ that the “American rule” precluded aggrieved insureds from seeking attorney fees, even if a denial was in bad faith.

As we’ll discuss, Burnside is at odds with the U.S. Supreme Court cases that gave rise to the American rule and the Michigan Supreme Court’s statements, both of which recognize an exception providing that attorney fees are recoverable when a party has acted in bad faith. Nonetheless, subsequent cases have treated Burnside as sacrosanct, allowing insurers denying claims in bad faith to avoid attorney fees and capitalize on the economic realities of litigation to escape their contractual obligations entirely.

The author submits that three decades of blind deference to this incorrect, destructive decision is enough. It is time for the Michigan Supreme Court to recognize the applicability of the American rule exception for bad faith and overrule Burnside.

LEGAL BACKDROP FOR BURNSIDE

Burnside was not decided in a vacuum. Rather, the court’s analysis involved the interplay between two much older rules.

The first rule governs consequential damages and was initially set forth in 1854 in an English case, Hadley v. Baxendale.⁴ The Hadley court held that when a party breaches a contract,

the damages which the other party ought to receive in respect of such breach of contract should be such as may fairly and reasonably be considered either arising naturally, i.e., according to the usual course of things, from such breach of contract itself, or such as may reasonably be supposed to have been in the contemplation of both parties, at the time they made the contract, as the probable result of the breach of it.⁵

In Kewin v. Massachusetts Mut. Life Ins. Co., a 1980 case involving a claim for mental distress resulting from the insurer’s breach, the Michigan Supreme Court addressed the Hadley rule in the context of disability insurance. The Court stated:

Under the rule of Hadley ... the damages recoverable for breach of contract are those that arise naturally from the breach or those that were in the contemplation of the parties at the time the contract was made. 5 Corbin, Contracts, § 1007.⁶

In its decision, the Court observed that “a disability income protection insurance policy contract is a commercial contract, the mere breach of which does not give rise to a right to recover damages for mental distress.” Because no proof had been offered establishing that such damages “arose naturally from the breach” or were in the “contemplation of the parties,” the court ruled for the insurer.⁷

Further, in a footnote, the Court stated that “[w]e do not address a question not raised: Whether compensation for attorney’s fees or other items of pecuniary loss caused by a breach of the insurer’s contractual obligation to process claims in good faith might be recoverable if properly pleaded,” at least implying such damages might be recoverable.⁸

Intuitively, it seems obvious that the breach of an insurance contract necessitates litigation — and attorney fees. In short, such damages “arise naturally from the breach” or, at a minimum, are in the “contemplation of the parties at the time the contract was made.” Consequently, it was not surprising that three years later in Murphy v. Cincinnati Ins. Co., the U.S. District Court for the Eastern District of Michigan relied on Kewin to hold that an insurer’s bad-faith “failure to investigate the claim ‘fairly and reasonably’ caused the plaintiffs to incur the expense of this litigation”; those damages (i.e. attorney fees) arose naturally from the breach; and actual attorney fees were recoverable.⁹ The Sixth Circuit agreed, stating:

A contract to insure against fire loss is a commercial contract, and damages for its breach are generally limited to the monetary value of the contract ... However, Michigan law follows the rule of Hadley ... that “the damages recoverable for breach of contract are those that arise naturally from the breach or those that were in the contemplation of the parties at the time the contract was made.”¹⁰

Thus, the district court was correct in deciding that “the expenditure of attorney fees arose naturally from the breach.”¹¹

Finally, in the 1987 case of Wendt v. Auto Owners Ins. Co., the Michigan Court of Appeals relied on Hadley, Kewin, and Murphy to conclude that “the breadth of an insurer’s obligation to process a claim in good faith renders an insurer liable for pecuniary losses which are not otherwise compensated for by statute.”¹² In Wendt, damages included lost profits, loss of use of the insured vehicle, and costs arising from default on the note it secured, all of which were the natural consequence of the insurer’s failure to pay the claim.

THE AMERICAN RULE

Burnside purportedly also relied on the American rule. In that regard, “[a]s early as 1278, the courts of England were authorized to award counsel fees to successful plaintiffs in litigation” and beginning in 1607, such fees could be awarded to defendants as well.¹³ This practice, known as the “English rule,” has been rejected in the United States. Rather, beginning in 1796 with Arcambel v. Wiseman, federal courts generally hold that attorney fees are not to be awarded.¹⁴

Arcambel is short, but later U.S. Supreme Court decisions fleshed out the details of what would become known as the American rule (to distinguish it from the English rule). In particular, several SCOTUS cases decided in the 1970s summarized previous American rule jurisprudence. In Hall v. Cole, the Court stated:

Although the traditional American rule ordinarily disfavors the allowance of attorneys’ fees in the absence of statutory or contractual authorization, federal courts, in the exercise of their equitable powers, may award attorneys’ fees when the interests of justice so require. Indeed, the power to award such fees “is part of the original authority of the chancellor to do equity in a particular situation,” and federal courts do not hesitate to exercise this inherent equitable power whenever “overriding considerations indicate the need for such a recovery.”

Thus, it is unquestioned that a federal court may award counsel fees to a successful party when his opponent has acted “in bad faith[.]” In this class of cases, the underlying rationale of “fee shifting” is, of course, punitive, and the essential element in triggering the award of fees is therefore the existence of “bad faith” on the part of the unsuccessful litigant.¹⁵

The Hall Court later stated that “[i]t is clear ... that ‘bad faith’ may be found, not only in the actions that led to the lawsuit, but also in the conduct of the litigation.”¹⁶ Other SCOTUS cases have awarded fees based on prelitigation conduct and/or favorably cited the above passage.¹⁷

A year later, the U.S. Supreme Court decided F.D. Rich. Co. v. United States ex rel. Indus. Lumber Co. in which it stated that “[t]he so-called ‘American rule’ governing the award of attorneys’ fees in litigation in the federal courts is that attorneys’ fees ‘are not ordinarily recoverable in the absence of a statute or enforceable contract providing therefore.’”¹⁸ However, the Court added that “[t]he federal judiciary has recognized several exceptions to the general principle that each party should bear the costs of its own legal representation. We have long recognized that attorneys’ fees may be awarded to a successful party when his opponent has acted in bad faith ... or where a successful litigant has conferred a substantial benefit on a class of persons[.]”¹⁹

Most important with respect to this article (for reasons discussed later) is the 1975 SCOTUS decision in Alyeska Pipeline Service Co. v. The Wilderness Society,²⁰ in which environmental groups challenged an oil pipeline permit. After dissecting both the English and American rules, the Court declined to award attorney fees, indicating it was hesitant to do so unless authorized by statute. However, it also recognized three judicially created exceptions to the American rule which were “unquestionably assertions of inherent power in the courts to allow attorneys’ fees — the common fund exception; “willful disobedience of a court order”; and “when the losing party has ‘acted in bad faith, vexatiously, wantonly, or for oppressive reasons[.]”²¹

THE MICHIGAN SUPREME COURT AND THE AMERICAN RULE

At the risk of stating the obvious, the American rule is an American rule; it is contrary to the English rule and evolved in the U.S. Supreme Court and lower federal courts. Consequently, state courts interpreting it generally look to federal decisions, and Michigan is no exception.

In 1998, three years after Burnside, the Michigan Supreme Court decided Nemeth v. Abonmarche, which concerned violations of a state environmental law.²² In an attempt to establish a recognized exception to the American rule, the plaintiffs advanced what they described as the “‘well-established’ private attorney general exception” to the basic rule. However, after carefully analyzing several SCOTUS decisions, including Hall and Alyeska, the Court rejected the plaintiff’s position as a “not-so-well established common-law doctrine.”²³ The Court also stated that in Alyeska:

[T]he Supreme Court acknowledged the existence of two common-law exceptions to the American rule — the bad-faith exception and the common-benefit exception — but reversed the federal court of appeals holding that litigants who vindicate important statutory rights of all citizens were entitled to attorney fees.²⁴

Lastly, in a footnote, the Michigan Supreme Court observed that lower federal courts “also recognized the same two exceptions acknowledged by the Supreme Court in Alyeska.”²⁵ In short, the state Supreme Court (looking to SCOTUS) recognizes that there are perhaps two established exceptions to the American rule, one of which is the bad-faith exception.

BURNSIDE v. STATE FARM

Burnside v. State Farm Fire and Casualty Company was a Michigan Court of Appeals case decided in 1995 that concerned the insurer’s refusal to compensate its insureds for a fire six years earlier, purportedly based on arson and misrepresentation.²⁶ Following the jury’s determination that State Farm breached the contract in bad faith, the Burnsides made a request for attorney fees which the trial court refused as “not authorized by court rule, statute, or controlling case law.”²⁷

When the Burnsides appealed, Kewin had already hinted that attorney fees might be recoverable for a bad-faith denial, the federal Murphy opinions had held they were, and both Wendt and Salamey had ruled that economic injuries were generally recoverable as consequential damages. Accordingly, there was every reason to expect the court to rule attorney fees were recoverable as consequential damages and no reason to talk about the American rule. Consistent with this, the Burnsides’ 39-page brief cited the “consequential damages” cases but did not use the phrase “American rule.”²⁸

While State Farm also focused primarily on consequential damages, it did devote a half-page to the American rule, or at least a version of it. Specifically, it cited two Michigan cases, neither of which addressed the bad-faith exception, for the principle that “Michigan adheres to the ‘American rule’ that attorney fees are not awarded either as an element of the costs of the suit or as an item of damages, unless allowance of the fees is expressly authorized by statute, court rule, or recognized exception.”²⁹ It then stated that “[a]n insurer’s failure to ‘act fairly and reasonably in investigating and refusing to pay an insured’s claim’ is not a recognized exception to the American rule.”³⁰ This was remarkable, since by this point Hall, F.D. Rich, Alyeska, and various lower court cases had established the bad-faith exception, which is not limited to any particular type of case (e.g. insurance) as one of the two or three recognized exceptions.

Nearly two years later, State Farm filed a long supplemental brief in which it again argued consequential damages with copious references to Hadley and Kewin, and the Burnsides filed a response.³¹ Neither addressed the American rule; by the time the filings were completed, that topic comprised just one half-page of the 102 pages submitted. Accordingly, one would have expected the court’s opinion to be limited to consequential damages. However, the first paragraph of the Burnside opinion states:

We affirm. In doing so, we hold that the application of the American rule precludes the recovery of attorney fees incurred as the result of an insurer’s bad-faith refusal to pay a claim.³²

In explaining its ruling, the Court of Appeals stated:

In Michigan, it is well-settled that the recovery of attorney fees is governed by the “American rule.” Under the American rule, attorney fees are generally not allowed, as either costs or damages, unless recovery is expressly authorized by statute, court rule, or a recognized exception. ...

* * *

Implicit in the holding in Kewin, and reaffirmed in Valentine v. General American Credit, Inc, 420 Mich. 256, 362 N.W.2d 628 (1984), however, was the willingness of our Supreme Court to apply less than scrupulously the foreseeability test stated in Hadley v. Baxendale in the face of another controlling point of law. In Valentine, the Supreme Court held that although mental distress damages are foreseeable within the rule of Hadley v. Baxendale for virtually all breach of contract actions, the general rule in most jurisdictions is to deny recovery. As a rationale for its decision to deny recovery, the Court explained that the rule barring the recovery of mental distress damages is “a gloss on the generality of the rule stated in Hadley v. Baxendale [and] is fully applicable to an action for breach of an employment contract ...”

* * *

After applying these principles in the present case, we reject the Sixth Circuit’s decision in Murphy and hold that the recovery of attorney fees incurred as a result of an insurer’s bad-faith refusal to pay an insured’s claim is governed by the American rule. Like the Court in Valentine, we conclude that the American rule is a “gloss on the generality” of the foreseeability test stated in Hadley v. Baxendale.

We find unavailing plaintiffs’ argument that the American rule is inapplicable when an insurer acts in bad faith. In general, breach of contract damages are not awarded to punish a wrongdoer. We see no reason to carve out an exception in this instance when none exists. [A]n insured’s right to recover attorney fees as an element of damages is not triggered by the foreseeability of loss. Instead, attorney fees are recoverable only when expressly authorized by statute, court rule, or a recognized exception[.]³³

To quickly recap:

(1) The court acknowledged that scrupulous application of the Hadley/Kewin rule warranted both attorney fees and mental anguish damages; but

(2) the rule would be applied “less than scrupulously” (i.e. those damages were not recoverable) if some other rule, referred to as a “gloss on the generality,” barred their recovery;

(3) the American rule, which dictated that “attorney fees are generally not allowed, as either costs or damages,

unless recovery is expressly authorized by statute, court rule, or a recognized exception” was such a “gloss;” and

(4) the court would not “carve out an exception in this instance when none exists.”

The problem, of course, is that even in 1995, three years before Nemeth, the bad-faith exception had become well-established as one of a few recognized exceptions. Thus, if the American rule (including its bad-faith exception) provided any sort of gloss on the consequential damages rule, it affirmed that attorney fees are recoverable for a bad-faith breach.

To further support its ruling, the Burnside court noted that MCL 500.2006 provided for the payment of interest on claims that were not “reasonably in dispute” which “intended to provide a penalty to be assessed against recalcitrant insurers who procrastinate in paying or are dilatory in paying meritorious claims in bad faith.”³⁴ In short, it claimed the Michigan Legislature had already created a statutory remedy for bad-faith conduct, which did not include attorney fees. The problem was that the statute did not provide a special remedy for bad-faith denials, at least in the context of first-party insurance claims. Rather, penalty interest was owed if payment was late regardless of whether the claim was “reasonably in dispute” or denied in bad faith (i.e. the interest obligation has nothing to do with the insurer’s good or bad faith), as an en banc panel of the Court of Appeals would later confirm.³⁵

In short, the entire rationale for the Burnside ruling was demonstrably wrong.

THE BURNSIDE LEGACY

Burnside was decided before Nemeth, which affirmed the existence of the bad-faith exception. One would think that after Nemeth, courts would have acknowledged it was decided incorrectly, ignored it, or declared a conflict panel. However, that has not happened. Instead, most opinions have uncritically accepted the Burnside ruling without mentioning Nemeth, the U.S. Supreme Court cases it cited, or the bad-faith exception.³⁶ Consequently, insureds able to obtain counsel and sue have had to bear the cost of dealing with their insurer’s bad-faith conduct, resulting in net payments of around two-thirds of the insurance proceeds to which they are legally entitled. What’s worse is that due to the economics governing contingency-based litigation, attorneys have turned away thousands of insureds with rock-solid claims for roughly three decades solely because they are not large enough to support a lawsuit.

It is time to straighten out the 29-year train wreck that began with Burnside. While it could be fixed legislatively, if that does not occur, the Michigan Supreme Court should step in and overrule this incorrect and destructive decision.