5/9/2014

Declaration of Independence

When does a reservation of rights entitle an insured to independent counsel and control of its defense?

By Jonathan M. Stern

The scenario plays out time and time again. An insurer agrees to undertake the defense of its insured, but for one or more reasons, it reserves the right not to indemnify the insured. The ramifications of the insurer’s decision to reserve rights can be very significant, but knowing what those ramifications are is often difficult.

There are three general approaches to the issue. The “reject the defense” approach holds that an insured faced with defense by an insurer that reserves the right to decline indemnity can reject the insurer’s defense. At the opposite end of the spectrum are a few jurisdictions that do not take away the insurer’s contractual right to select counsel and control the defense even in conflict of interest situations. The majority approach, which lies between these two other approaches, is the “conflict of interest” rule. In conflict of interest jurisdictions, the courts assess whether a particular reservation of rights creates a conflict of interest between the insurer and its insured. If a conflict is created by the reservation, the insurer loses its right to select counsel and control the defense.

Lest the task be too easy, if the type of approach that is applied changes over time, it may require a conflict-of-laws analysis. Thus, the best one can do is to find the most recent authority in the interested jurisdictions, conduct a choice-of-law analysis, and assume that the law will hold true for at least one more case.

There are other complicating factors. One is that, in conflict of interest jurisdictions, a “set it and forget it” approach does not work. It is not always possible to foresee all possible conflicts of interest when a case is filed. Changing circumstances can require a reevaluation and may lead to a midcourse loss of control of the defense and right to select counsel.

A second complicating factor is that some jurisdictions simply have not addressed what an insurer must do in a conflict of interest situation.

A third complicating factor is that some jurisdictions employ more than one of the three approaches. For example, giving the insured the right to reject a conditional defense but not requiring insurers to pay independent counsel even in conflict of interest situations if the defense is rejected.

Three Approaches to Independent Counsel

Much has been written about the tripartite relationship in an insurance defense context. The relationship involves the plaintiff, the defendant-insured, and the insurer. There are some principles of this relationship that become important to any discussion of the consequences of a reservation of rights.

First, when an unconditional defense is provided by the insurer (no reservation of rights is issued), the insurer’s and insured’s interests are aligned. Both wish to defeat the liability claim or, if they cannot, to minimize the damages awarded. This is because, generally, in the absence of any reservation of rights, the insurer is bound by the result of the suit brought against its insured. Therefore, in the absence of a reservation of rights, the insurer generally will be responsible to pay any resultant judgment.

Second, a majority of (but not all) jurisdictions deem both the insured and the insurer to be a client of the defense counsel appointed by the insurer. As a result, if there is a conflict between the insured and the insurer with respect to the defense of the third-party claims, a lawyer will not, absent informed consent, be able to undertake the joint representation.

Third, the grounds of a reservation of rights can either be that the policy does not or may not cover particular liabilities (hereinafter a “coverage defense”) or that the insured has failed to comply with the conditions of the coverage. For example, that might include not cooperating with the insurer or not giving proper notice (hereinafter a “policy defense”).

Reject the Defense Approach

The reject-the-defense approach is straightforward: an insured has the right to reject a conditional defense from its insurer. If rejected, the insurer loses its right to select counsel and control the defense. Depending on the jurisdiction, the insured is entitled to payment of reasonable defense costs on an ongoing basis after establishing its right to coverage, or not at all.

The possibilities that an insurer may not have an obligation to indemnify its insured, or that the counsel the insurer selects might provide only a token defense, might obtain confidential or privileged information that it will use to avoid coverage, or might not pursue reasonable settlement opportunities are given as the reasons for this approach. Some courts and commentators have asserted that appointed defense counsel may view the hiring insurer as the true client and, therefore, seek to benefit the insurer to the detriment of the insured, most often a one-time client.

The reject-the-defense approach has the advantage of simplicity in application but the disadvantage of potential unfairness to the insurer. It deprives the insurer, arguably without good reason, of a contractual right. The insurer has the contractual obligation to provide a competent defense and, if coverage exists, to settle when in the insured’s interest. The insured can enforce those rights in a breach of contract or bad faith action without laws that routinely require the insurer to cede control of the defense.

Why should the insurer lose its contractual right to control the defense when, for example, a suit that unquestionably is covered by the policy includes a demand for relief that includes uncovered punitive damages or an amount in excess of the limitation of liability in the policy? These situations would not lead an insurer to provide only a token defense or avoid settlement opportunities. Yet, if the reject-the-defense approach is strictly applied, a reservation on these grounds would trigger the insured’s right to select counsel and control the defense. Some reject-the-defense jurisdictions do not apply the approach dogmatically and recognize exceptions.

A recent decision from the Superior Court of Pennsylvania adopts the reject-the-defense approach. In Babcock & Wilcox Co. v. Am. Nuclear Insurers & Mut. Atomic Energy Liab. Underwriters, the two-judge majority held that an insured confronted with a reservation of rights could reject the conditional defense, fund its own defense, and recover reasonable indemnity and defense costs if it subsequently established coverage. It also recognized the insured’s right to settle without the insurer’s consent when the insurer’s offer of a conditional defense was rejected. The court, citing mostly older cases, asserted that the reject-the-defense approach is the majority rule. The concurring and dissenting judge in the Babcock & Wilcox case observed that “the majority alters the parties’ insurance contract, bestowing upon the insured a new option, never before recognized under Pennsylvania law, to reject a defense offered pursuant to a valid reservation of rights clause in an insurance agreement.”

Reject-the-defense jurisdictions differ with respect to whether consent of the insured may be implied, as for example by the absence of any objection, and whether the insurer must affirmatively advise the insured of its right to reject the defense.

Good Faith Approach

Several jurisdictions that have addressed the issue have held that an insurer does not lose the right to select counsel and control the defense because of a conflict of interest. In Alabama, Hawaii, and Washington state, insurers do not lose the right to select counsel and control the insured’s defense when they issue reservations of rights that create conflicts of interest. They must, however, abide by an “enhanced obligation of good faith,” as established in Ki Sin Kim v. Allstate Ins. Co. 

This “enhanced obligation” to defend requires the insurance company to (1) thoroughly investigate the cause of the insured’s accident and the nature and severity of the plaintiff’s injuries; (2) retain competent defense counsel, recognizing that only the insured is the client; and (3) fully inform the insured not only of the reservation of rights defense itself, but of all developments relevant to his or her policy coverage and the progress of the lawsuit.

Hawaiian law allows the insured to reject the conditional defense tendered by the insurer in a conflict situation, but the insured then must fund the defense and cannot recover defense costs even if coverage is later established. 

Conflict-of-Interest Approach

In most jurisdictions, defense counsel appointed by the insurer to defend the suit against the insured is deemed to have two clients, the insurer and the insured. Whether the insurer may select counsel and control the defense in those jurisdictions usually will depend on whether appointed defense counsel, if fully apprised of the facts, would have a conflict in undertaking joint representation of both insured and insurer.

The conflict-of-interest approach is not limited, however, to so-called “dual-client” jurisdictions. Michigan, for example, appears to be a single-client jurisdiction. Nonetheless, Michigan applies the conflict-of-interest approach to determine whether counsel appointed by the insurer to represent the insured must be “independent.”

The jurisdiction with the most developed body of law on the conflict-of-interest approach is California. California has a statutory scheme that has been interpreted by literally hundreds of cases. The California statute requires that insurers pay for independent counsel selected by the insured when there is a conflict of interest, as illustrated in Cal. Civil Code § 2860(b):

[A] conflict of interest does not exist as to allegations or facts in the litigation for which the insurer denies coverage; however, when an insurer reserves its rights on a given issue and the outcome of that coverage issue can be controlled by counsel first retained by the insurer for the defense of the claim, a conflict of interest may exist. No conflict of interest shall be deemed to exist as to allegations of punitive damages or be deemed to exist solely because an insured is sued for an amount in excess of the insurance policy limits.

Under California’s rules and as noted in Dynamic Concepts Inc. v. Truck Ins. Exch., “[T]he potential for conflict requires a careful analysis of the parties’ respective interests to determine whether they can be reconciled (such as by a defense based on total nonliability) or whether an actual conflict of interest precludes insurer-appointed defense counsel from presenting a quality defense for the insured.”

The prototypical scenario that creates a conflict between insurer and insured and requires, in conflict-of-interest jurisdictions, provision of independent counsel is when negligence and noncovered intentional acts are pled in the alternative in the complaint. In that scenario, the insurer could avoid any indemnity obligation if the bodily injury or property damage that is the subject of a lawsuit were found to be caused by the insured’s intentional acts. It is the type of coverage issue that can be controlled by counsel first retained by the insurer for the defense of the claim. Even then, if the defense to the case will be one of mistaken identity, indicating total nonliability, there may be no conflict.

Even under the well-developed law of California, determining which issues’ outcomes can be controlled by counsel first retained by the insurer for the defense of the claim is far from black and white. The challenge is greater when controlled by jurisdictions with less-developed law.

Knowing the ramifications to the issue of independent counsel of an insurer’s reservation of rights can be difficult. It is critical, however, to determine—to the extent reasonably possible—what these ramifications are, or, in the case of an insurer, what they will be. Only then can one determine whether independence can safely be declared.  



Jonathan M. Stern is a managing attorney with CLM Member Firm Schnader Harrison Segal & Lewis LLP. He can be reached at (202) 419-4202, jstern@schnader.com, www.schnader.com.

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