Bankruptcy Estate of Lake Geneva Sugar Shack, Inc. v. General Star Indemnity Co.

In the
United States Court of Appeals
For the Seventh Circuit

No. 99-1321

BANKRUPTCY ESTATE OF LAKE GENEVA SUGAR
SHACK, INCORPORATED, a Wisconsin corporation,
and BANKRUPTCY ESTATE OF DANA MONTANA,

Plaintiffs-Appellants,

v.

GENERAL STAR INDEMNITY COMPANY,

Defendant-Appellee.

Appeal from the United States District Court
for the Eastern District of Wisconsin.
No. 91 C 163--Lynn Adelman, Judge.

Argued November 4, 1999--Decided January 11, 2000

Before MANION, KANNE, and EVANS, Circuit Judges.

EVANS, Circuit Judge. This is a diversity case
based on the Wisconsin tort of bad faith in
denying insurance coverage. The district court
granted the motion of the General Star Indemnity
Company (GenStar) for summary judgment and
dismissed the case on the basis of claim
preclusion. Bankruptcy Estate of Lake Geneva
Sugar Shack, Inc. v. General Star Indemnity Co.,
32 F. Supp. 2d 1059 (E.D. Wis. 1999). The issue
before us is whether this action is barred by a
judgment in a case brought by the insurer in
Walworth County, Wisconsin, a case in which
counterclaims were filed, including one for
breach of the contract.

The Lake Geneva Sugar Shack, Inc. is a
Wisconsin corporation that operated the Sugar
Shack nightclub in Lake Geneva, Wisconsin. Dana
Montana was the sole shareholder and principal
officer of the corporation. The Sugar Shack
purchased insurance from General Star in July
1989. In February 1990 a fire substantially
damaged the building, and within 24 hours GenStar
announced that it intended to deny coverage
because it concluded that Montana was somehow
involved in starting the fire. GenStar suspected
that Montana had a financial motive to burn the
building and it ordered a financial background
check, which confirmed that the building was
mortgaged and that the mortgage was cross-
collateralized with other properties, including
Montana’s home. As a result of GenStar’s advising
the mortgage company that Montana set the fire,
Montana lost a refinancing of her properties
which had been approved. The building was
demolished and the mortgagee foreclosed on her
other properties, which were worth $3.327
million.

But GenStar did not formally deny coverage
until after 11 months of investigation. During
that time, which Montana contends was dragged out
in an attempt to deplete her financial resources,
GenStar refused to reinstate coverage and refused
to refund her premiums.

GenStar brought a declaratory judgment action
against the Sugar Shack and Montana in the
Walworth County circuit court, seeking to
dissolve the insurance agreement. GenStar accused
Montana of fraud, breach of the policy agreement,
and other dastardly deeds. Sugar Shack and
Montana then filed the present action in federal
court, alleging claims of breach of contract and
bad faith. The late Judge Robert W. Warren, to
whom the case was assigned, stayed the federal
action pending resolution of the state court
case. In granting the stay request, Judge Warren
said:

If the court stays the action, it will be able
to rely on the state court’s findings of fact
instead of eliciting the facts contemporaneously
alongside the state court in two separate
proceedings. Any state court finding will reduce
the amount of litigation in a parallel federal
matter. If Montana prevails, she will not only be
able to have her day in court, but she will be
leveraged into a better bargaining position if
she chooses to settle out of court. If General
Star prevails, Montana’s claim will be mooted
without both parties having to go through another
expensive, time-consuming procedure.

After the stay was entered, Montana (from here
on, we will often refer to the plaintiffs simply
as Montana) attempted to obtain a stipulation to
consolidate all of her claims in the federal
action with the Walworth County action. GenStar
refused to consolidate the bad faith claim but
agreed to consolidate the vicarious liability and
breach of contract claims. The stipulation as to
the latter claims was entered.

In January 1994 Judge Warren inquired into the
status of the federal action. GenStar responded,
in writing, as follows:
As all matters that were initially embraced in
the federal court action have been embraced in
the state court action, I see no reason why the
federal court action can not simply be dismissed.

Montana did not agree, and she wrote this letter
to Judge Warren:

In no event, should this matter be dismissed as
the Walworth County action does not contain the
same causes of action as this case. . . . A
dismissal of this action would seriously
prejudice the plaintiffs’ rights because it would
create statute of limitations problems for the
causes of action pled in this case that were not
contained in the Walworth County case.
Specifically, the plaintiffs’ Complaint contains
a cause of action for bad faith which has never
been alleged in the Walworth County case.

Judge Warren responded by closing the case
administratively/1 but saying:

Nothing herein should be considered a dismissal
or disposition of this matter, however, and
either party may reopen the case at any time by
advising the court and opposing counsel in
writing that further proceedings are desired.

On January 11, 1994, Montana’s attorney,
Christopher Hale, appeared in Walworth County
court and said he was considering bringing a
motion to assert a bad faith claim in that court.
GenStar contends that Hale expressly acknowledged
at the January hearing the risk of his bad faith
claim being barred by claim preclusion if he did
not file it in Walworth County. But Montana
contends that Hale was only concerned about the
statute of limitations. Montana has the better of
this dispute, both on the record and because of
the principle that for purposes of summary
judgment, disputes of fact are resolved in favor
of the nonmovant. The transcript shows:

THE COURT: Well, first of all, Bad Faith
wouldn’t be an issue in this case, would it? It
would come after a decision is rendered in the
case it would seem to me. In other words, you’ve
got a new lawsuit. Question arises whether his
objection to the statute or not would survive--
that would--I can’t see how that issue would come
up here until it was a judgment in this case.

MR. HALE: I think the law is, your Honor, and
Mr. Baxter will correct me, that when facts
giving rise to evidence that there was not a
reasonable basis at the time of the denial of
coverage that at that point in time your cause of
action for Bad Faith accrues and you have two
years to bring it and I think the case law has
Bad Faith claims in trials like this where they
are tried together with the arson case itself.

Hale was clearly discussing the statute of
limitations, not claim preclusion.

Sugar Shack and Montana filed for bankruptcy in
September 1994, which automatically stayed the
Walworth County case. GenStar moved to lift the
stay. Montana wanted to consolidate the Walworth
County coverage claim with the federal bad faith
claim under 28 U.S.C. sec. 1452(a), providing for
removal of claims related to bankruptcy cases.
However, instead, the bankruptcy court lifted the
stay; plaintiffs appealed again, arguing for one
forum, the federal forum. On appeal to the
district court, GenStar again opposed the
request, saying:

As set forth in the Decision . . . Judge Warren
realized the state law nature of those claims,
and stayed further proceedings in the Federal
Court Action until conclusion of the Walworth
County Action. At that time, Appellants could
proceed with the Federal Court Action and
adjudicate their bad faith claim.

. . . .

. . . The Walworth County Action is the best
forum for resolution of all claims other than the
bad faith claim and the bad faith claim should be
litigated in the Federal Court Action after
completion of the Walworth County Action.

Judge John W. Reynolds, to whom the bankruptcy
appeal was assigned, said:

If General wins in state court, obviously there
is no bad faith claim. If General loses, issue
preclusion will prevent General from relitigating
most issues in the bad faith claim. The trustees
would have a stronger case if claim preclusion
and a final resolution of the state case would
bar the federal action, thereby denying the
trustees the right to ever raise the bad faith
claim. Because the trustees have not raised this
issue, the court assumes it is not a problem.

After a 2-week trial in Walworth County, a jury
found that GenStar breached the contract and
awarded Montana and Sugar Shack $260,000 in
insurance coverage damages and $3.327 million in
consequential damages. The state trial judge, on
motions after verdict, set aside both awards. The
Wisconsin Court of Appeals affirmed in part and
reversed in part, reinstating the $260,000 coverage
award.

Montana and Sugar Shack then sought to reopen
and restore this case to the court’s active
docket so they could pursue their bad faith
claim. By letter dated March 9, 1998, Judge Lynn
Adelman, to whom the case had now been assigned,
raised the question of claim preclusion on his
own motion and ordered briefing on the issue.
Seizing the moment, GenStar moved for summary
judgment, claiming that the case was in fact
barred. Finding no controlling Wisconsin law on
the issue before him, the judge conducted a
general, Restatement-based, analysis of claim
preclusion law as he predicted the Wisconsin
courts would do in this situation. He then
granted GenStar’s motion for summary judgment and
dismissed the case. Sugar Shack and Montana
appeal.

We disagree with the conclusion that Wisconsin
law offers too little guidance on this issue.
Because existing snippets of Wisconsin law offer
strong hints of how Wisconsin courts would view
these facts, we cannot agree with the district
court. Furthermore, even under a purely legal
analysis of the issue as one of first impression
in Wisconsin (such as the district judge
conducted), the facts lead us to a conclusion
contrary to the one reached in the district
court.

It can hardly be disputed that everyone assumed
all along that the bad faith claim could proceed
in federal court after the trial was completed on
the other issues pending in state court. There
was no issue of judicial economy and no way to
avoid two trials. Even had the bad faith claim
been filed in Walworth County, the state court
judge stated that he would have tried that claim
separately from the rest of the case. That suited
GenStar, which quite naturally wanted bad faith
issues kept out of the first trial. More than
likely, GenStar was not very concerned all along
with the stayed federal case because it thought
it would win in Walworth County and the bad faith
case would go away. Although GenStar tried to get
rid of the bad faith suit when it incorrectly
told Judge Warren that there was nothing left of
the federal case, it did not object when he
declined to dismiss the case. Plus, on more than
one occasion, GenStar specifically acknowledged
that the federal case could proceed after the
state case was over.

At least two Wisconsin cases strongly suggest
that in this situation, Wisconsin courts would
not be offended by the existence of an action
based on the tort of bad faith and a separate
action regarding coverage issues. That is what
happened in Heyden v. Safeco Title Insurance
Company, 175 Wis. 2d 508, 498 N.W.2d 905 (Wis.
App. 1993), overruled on other grounds, Weiss v.
United Fire, 197 Wis. 2d 365, 541 N.W.2d 753
(1995). Prior to the 1993 decision in Heyden, the
court of appeals had issued (in 1989) an
unpublished order which concerned precisely the
issue before us. Even though the unpublished
order is not controlling precedent (see sec.
809.23(3) Wisconsin Statutes) there is no
impediment to noting what the court of appeals
said in the published decision about its holding
in the unpublished order:

[O]ur November 20, 1989, order, which is the law
of this case, made it clear that I.W.S.’s "bad
faith" action against Safeco is not barred by the
earlier breach-of-contract action.

At 520. Further, in a footnote, the court said:

On November 20, 1989, this court summarily
reversed the judgment of dismissal, holding that
the breach-of-contract claim and the bad-faith
claim "each arose from a separate transaction"
for res judicata purposes.

N.2, at 515. What we learn from Heyden, then, is
that in at least one instance a bad faith claim
was not barred by a prior breach of contract
action. When we are predicting the course of
Wisconsin law, clues like these indicate to us
that Wisconsin courts might very well be willing
to allow Montana’s bad faith claim to proceed.

The second case is Davis v. American Family
Mutual Insurance Company, 212 Wis. 2d 382, 569
N.W.2d 64 (Wis. App. 1997), in which the insured
was injured in a one-vehicle accident in Hennepin
County, Minnesota, in a vehicle driven by an
underinsured motorist. Davis settled with the
driver (for less than the inadequate policy
limits) and then claimed underinsured motorist
benefits from his insurance company, American
Family. American Family denied the claim and
Davis sued in Minnesota, which allows an insured
to sue for underinsured motorist benefits after
the acceptance of a settlement for less than the
policy limits of the underinsured motorist. Davis
won. He then filed a bad faith action against
American Family in Wisconsin. American Family
moved to transfer the case to Minnesota; the
Wisconsin judge granted the motion and said that
to the extent claim is unavailable in Minnesota,
he presumably would allow the parties to proceed.
The Hennepin County court dismissed the case
because Minnesota does not recognize a tort of
bad faith. Back in Wisconsin, American Family
moved for summary judgment on res judicata
principles. The court granted the motion and
Davis appealed. The court of appeals rejected the
argument. Davis, even though he seemed clearly to
be forum shopping, was allowed to proceed with
his bad faith claim. In finding that the suit was
not barred, the court relied heavily on what the
trial judge said he would do:

Davis argues that claim preclusion is
inapplicable to this case. We agree. As a matter
of law, claim preclusion does not apply when the
plaintiff accepts the trial court’s invitation to
file his claim elsewhere. Schneider v. Mistele,
39 Wis.2d 137, 158 N.W.2d 383 (1968). "[A] prior
judgment is not res adjudicata or an estoppel bar
as to any matter which the court in the earlier
case expressly refused to submit to the jury and
expressly directed should be litigated in another
forum, or in another action." Id. at 141, 158
N.W.2d at 385 (footnote omitted). Here, the trial
court granted a stay so that Davis’ bad faith
claim could be tried in Minnesota, and ordered
that "[t]o the extent that the claim and
prosecution are unavailable in Minnesota, this
court would retain jurisdiction and allow the
parties to pursue action in this Court for
ultimate determination." We conclude that the
trial court’s order granting the stay but
permitting Davis to return with his bad faith
claim to Wisconsin prevents the application of
claim preclusion to bar Davis’ bad faith claim.

The situation bears a strong similarity to what
happened in the present case.

We think Wisconsin courts would look to the
procedural history of Montana’s case, to what the
judges and the parties said and assumed, and
determine that, at least under these peculiar
facts, the bad faith case is not barred.

Our conclusion is consistent with the long-
standing view of the Wisconsin courts that a
breach of contract claim and a bad faith claim
are separate claims. See Anderson v. Continental
Ins. Co., 85 Wis. 2d 675, 271 N.W.2d 368 (1978).
In fact, in Warmka v. Hartland Cicero Mutual
Insurance Company, 136 Wis. 2d 31, 400 N.W.2d 923
(1987), the court said that the bad faith claim
is not based on the policy (as is the breach of
contract claim, of course) but grows out of a
breach of a duty to properly investigate a claim.
While these cases are not dispositive on the
claim preclusion issue, taken together with
Heyden and Davis they further bolster our belief
that Wisconsin courts--at least in the odd
circumstances of this case--would allow the bad
faith claim to proceed.

We hesitate to say more because the procedural
facts before us make this a poor case in which to
proclaim general principles of law. Particularly,
it is not a good case for the federal courts to
make unnecessary predictions about the future of
Wisconsin law. That said, we will comment only
briefly on the effect of the Restatement (Second)
on Judgments (1982).

In the absence of what it perceived to be a
clear statement of Wisconsin law, the district
court turned to the Restatement (Second) of
Judgments (1982) to analyze whether the bad faith
claim should be allowed to proceed. Determining
that Wisconsin follows a transaction approach,
the district court proceeded to look to the
Wisconsin rule on counterclaims. Although it
recognized that the Wisconsin rule generally
provides for permissive counterclaims,/2 the
court concluded that the permissive counterclaim
rule did not answer the question whether a
defendant may split its counterclaims, as Montana
did here by bringing some in Walworth County and
maintaining the bad faith claim in federal court.
It is at this point that the analysis was guided
by the Restatement, which says in the comment to
sec. 21 that a defendant who interposes a
counterclaim is in effect a plaintiff to whom the
rules of merger apply--which means that a party
who obtains a judgment cannot bring a separate
action on any part of the original claim because
the original claim is merged into the judgment.
sec. 18(1). The district court then concluded
that a defendant who obtains a judgment on a
counterclaim is foreclosed from recovering on
other counterclaims arising out of the same
transaction.

At best, we think the district court’s analysis
stops one step short of the finish line. The
Restatement also sets out exceptions to the general
rule against splitting counterclaims in sec. 26.
The Comment to that section notes that splitting is
not prohibited when the opposing party consents to
or acquiesces in the splitting. We will quote at
length:

(a) Consent to or acquiescence in splitting
(Subsection (1)(a)). A main purpose of the
general rule stated in sec. 24 is to protect the
defendant from being harassed by repetitive
actions based on the same claim. The rule is thus
not applicable where the defendant consents, in
express words or otherwise, to the splitting of
the claim.

The parties to a pending action may agree that
some part of the claim shall be withdrawn from
the action with the understanding that the
plaintiff shall not be precluded from
subsequently maintaining an action based upon it.
The agreement will normally be given effect. Or
there may be an effective agreement, before an
action is commenced, to litigate a part of a
claim in that action but to reserve the rest of
the claim for another action. So also the parties
may enter into an agreement, not directed to a
particular contemplated action, which may have
the effect of preserving a claim that might
otherwise be superseded by a judgment, for
example, a clause included routinely in
separation agreements between husband and wife
providing that the terms of the separation
agreement shall not be invalidated or otherwise
affected by a judgment of divorce and that those
terms shall survive such a judgment.

Where the plaintiff is simultaneously
maintaining separate actions based upon parts of
the same claim, and in neither action does the
defendant make the objection that another action
is pending based on the same claim, judgment in
one of the actions does not preclude the
plaintiff from proceeding and obtaining judgment
in the other action. The failure of the defendant
to object to the splitting of the plaintiff’s
claim is effective as an acquiescence in the
splitting of the claim.

The record shows that GenStar clearly acquiesced
in--and in fact encouraged--the splitting of
Montana’s claim. Even under an analysis based on
the Restatement, Montana must be allowed to
proceed with her bad faith claim.

The judgment of the district court is

REVERSED and REMANDED.

/1 A device which permits a district court to remove
a case like this from its active docket and thus
relieve the court from reporting on its status at
periodic intervals.

/2 For an exception, see A.B.C.G. Enterprises, Inc.
v. First Bank Southeast, 184 Wis. 2d 465, 515
N.W.2d 904 (1994).