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May 22, 2007

On Suits and Prophylactics: Recurring Environmental Coverage Issues

Commercial general liability policies provide coverage for the insured’s liability for “damages” on account of bodily injury and property damage and require the insurer to provide a defense to “suits” seeking such damages. Since the beginning of the environmental liability coverage wars some twenty-five years ago, insurers have disputed whether their insureds’ environmental liabilities seek to impose “damages”, are on account of “property damage,” and are adjudicated in the context of “suit[s].” Recent cases have continued to address these recurring issues.

In Cinergy Corp. v. Associated Electric & Gas Insurance Services, Ltd. (Ind. May 1, 2007), the Indiana Supreme Court considered whether the insured’s liability in that case was in the nature of “damages.” The Indiana court granted the insured a somewhat pyrrhic victory in finding that the insurers in theory had obligations to defend, but holding that the liability for which the insured ostensibly was liable was not of the nature of a monetary obligations to which liability insurance applies. The court gave the insured some sympathy in dealing with the policy language: “Synthesizing the policies’ insuring agreements with their respective definitions of capitalized words and phrases is a daunting task, replete with often confusing, redundant, and sometimes circular concepts.” Slip op. at 7.

But the court held that the liability in the civil action in which the insured was involved was not of the nature and kind covered by liability policies. “There is essential agreement among the parties . . . that the primary thrust of the federal lawsuit is to require the [insured] to incur the costs of installing government-mandated equipment intended to reduce future emissions of pollutants and prevent future environmental harm.” Slip op. at 11. In assessing whether there was coverage, the court adopted the now-familiar distinction between (covered) “remedial” and (uncovered) “prophylactic” measures. The court ruled that the government’s action against the insured was “directed at preventing future public harm, not at obtaining control, mitigation, or compensation for past or existing environmentally hazardous emissions.” Slip op. at 14. Consequently, the court found that the liability of the insured was not as a result of “the happening of an accident, event, or exposure to conditions but rather [was directed at] the prevention of such an occurrence.” Slip op. at 15.

In effect, the court found that the liability involved was not as a result of any past or existing property damage, but rather was based only on complying with legal requirements to conduct its operations safely. (Alternatively, the court could be said to have found that there was no property damage yet for which the insured was being held liable.) Accordingly, “the costs of installing government mandated equipment intended to reduce future emissions of pollutants and to prevent resulting future environmental harm” does not constitute covered sums for which the insured is liable because of property damage. Slip op. at 16.

The “remedial” versus “prophylactic” distinction in the environmental context is often elusive (and for that reason alone courts should be chary of denying coverage for bona fide liability). While it is true that insurance policies are not funding mechanisms for the costs of operating in compliance with the law, where property damage has occurred and an element of the damages on account thereof include measures to prevent the recurrence of damage, then the costs of those future-oriented remedies should be (and generally are) covered. When one is dealing with water contamination or air contamination, for example, it may be that the remedy includes measures to reduce the concentrations of the deleterious substance released by the insured; by limiting additional releases of that substance, the water system, for example, is able to dilute the contaminants through ordinary recharges of the system and reduce the concentration below the level of “damage.” In this way, stopping the on-going contribution of the deleterious substance can be thought of as a remedy for past damage (because this type of preventive remedy allows the damage to be mitigated). Were one to freeze-frame the issue, however, and look only at the remedy (and not the reason for the remedy), it might be argued that the measure is “prophylactic,’ that is, is meant to prevent the future release of contaminants.

For purposes of analyzing the availability of insurance-coverage, however, the question is why is the insured responsible for containing future releases. Where there has already been damage for existing releases of contaminants, “stop[ping] that ongoing release is not mere prophylaxis.” Watts Industries, Inc. v. Zurich American Ins. Co., 121 Cal. App. 4th 1029 (2004)
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In legal proceedings where the insured faces liability for “damages,” primary CGL insurers will have a duty to defend. Where there is no possibility, however, that the action against the insured can eventuate in a judgment covered by the insurer’s duty to indemnify, then the insurer will not have an obligation to defend. Because in Cinergy the Indiana Supreme Court held that the costs at issue were purely prophylactic and not “damages because of property damage,” the court ruled that the insurers had no duty to defend (though rejecting the rationale of the court below that there was a duty to pay defense costs only as an incident to the obligation to indemnify and thus only after the underlying action was concluded). Cinergy, slip op. at 16.

Even if the insured faces bona fide damages, the duty to defend applies to “suits,” and naturally insurers and insureds have joined issue on whether various types of proceedings constitute “suits” to which the duty to defend extends. Most courts have recognized that enforcement proceedings that can eventuate in a “damages” award are in the nature of a “suit” against the insured, but some courts have equated the term “suit” with “lawsuit” and held that only actions in a court of law – as opposed to an administrative proceeding – can constitute a “suit.” That said, even these jurisdictions may allow a claim for the cost of defense of a non-traditional or non-court proceeding where “suit” is defined more broadly to encompass other forms of liability-seeking actions or where the insurer’s obligation to pay includes obligations to reimburse “expenses” incurred in the defense, without those expenses being tethered only to court-proceedings. The recent decision of the California Court of Appeal in Ameron Int’l v. Insurance Co. of State of PA (Cal. App. May 15, 2007) analyzes a number of different formulations of insuring obligations, cast against the backdrop of decisions holding that the undefined term “suit” is limited only to actions in a court of law. Ameron is a useful reminder to policyholder and insurer lawyers that we need to parse the language of the contract carefully in determining the obligations to provide coverage vel non.

Posted by Marc Mayerson at 12:31 AM | Comments (1) | TrackBack

February 18, 2007

Does a Court's (Reversed) Disparagement of the Policyholder's Coverage Claim Alone Eviscerate Its Bad-Faith Claim?

A common enough scenario in a liability-insurance case: the parties file cross-motions for summary judgment, with the insurer arguing it has no duty to defend. In Acme United Corp. v. St. Paul Fire & Marine Ins. Co. (7th Cir. Jan. 9, 2007), the question presented was whether an advertising injury liability insurance policy provided coverage for a suit against the insured for product disparagement. In Acme, the district court accepted the argument of the insurer, thus cutting off the ability of the policyholder to obtain recovery of the defense costs it had run up. Where, as here, the appellate court reverses and finds coverage, does the district court's now-reversed ruling effectively impale the policyholder's bad-faith claim?

Acme manufacturers scissors and paper trimming products and advertised that its products were better because they contained titanium. The question naturally arises -- “better”? "better" than what? Fiskars, another scissors manufacturer, believed that Acme was dissing its products, and Fiskars sued on the ground that there really wasn’t titanium in Acme’s products or that it was negligible or not on the blade or didn’t keep Acme’s scissors extra sharp when tested against Fiskars' products that used only stainless steel. Acme turned to St. Paul and asked for a defense, which St. Paul denied.

St. Paul's policy provided coverage for “advertising injury offense” which was defined in part to be “[m]aking known . . . . material that disparages the . . . products of others.” The district court agreed with Acme that its promotional materials constituted advertising and were disparaging of stainless-steel blades, but granted summary judgment to St. Paul on the ground that the disparagement was not of Fiskars’ products specifically.

The Seventh Circuit agreed that the advertising by Acme was disparaging, finding that disparagement results when a “false comparison” is made or when advertising “bring[s] reproach . . . by comparing with something inferior.’” Slip op. at 6 (citing dictionaries). In looking at Fiskars’ complaint against Acme, the appeals court reasoned that “[w]hile Fiskars did not allege that Acme actually named Fiskars’ products in the text of its advertisement, Fiskars’ underlying complaint specifically alleged that Acme’s advertisements were directed at Fiskars’ products and that Fiskars lost sales to Acme as a result.” Slip op. at 7. Accordingly, “Acme disparaged Fiskars products through a false comparison between its products and [implicitly] Fiskars’ products.” Id. As a result, even assuming that the policy requires a specific “other” in the disparaging of “products of others,” the complaint alleged sufficient facts to indicate the disparagement was of Fiskars even without Fiskars being named. As a result, the Seventh Circuit reversed the grant of summary judgment in favor of St. Paul and directed that summary judgment on the duty to defend be instead granted to Acme. (Any further argument that the Acme's ads were not sufficiently focused on Fiskars instead of the broad class of paper-cutting devices presumably should be advanced in the underlying case that should be being defended by the insurer.)

When St. Paul won at the trial court on its motion for summary judgment, we can assume that the district judge endevored to construe the facts in the light most favorable to the nonmoving party, Acme, construed any uncertain or ambiguous policy language in favor of the insured, Acme, but concluded that St. Paul was entitled to judgment as a matter of law. The Seventh Circuit disagreed and not only found that summary judgment should not be granted in favor of St. Paul (such that the matter should be remanded for trial), but in reversing the district court ruling it directed that summary judgment should be entered in favor of Acme.

Yet, the question arises whether St. Paul is inoculated against a bad-faith claim on the ground that even though its coverage determination was wrong it was at least a reasonable one – given that the district court judge agreed with it and entered summary judgment in its favor. Putting the question more broadly, if an insurer wins a summary judgment ruling on coverage does it simultaneously show that there are no circumstances that would support the policyholder's bad-faith claim (with respect to the coverage decision itself).

In general, insurers face first-party bad-faith liability only if they deny a claim unreasonably and without proper cause. Here, St. Paul may argue that the district court’s decision in its favor perforce shows that its decision was reasonable. Accordingly, so the argument would go, it cannot be held liable for bad faith.

The California Court of Appeal has addressed the question whether a trial-court victory by an insurer insulates its from bad-faith liability on the ground that the decision alone demonstrates that there was a genuine issue as to coverage (and thus the insurer’s denial of coverage even if erroneously was reasonable). In Filippo Industries, Inc. v. Sun Ins. Co., 74 Cal.App.4th 1429 (Cal. App. 1999), the insurer argued that the trial-court ruling in its favor – though reversed on appeal – established that its interpretation had a sufficient basis as to evidence a genuine-issue as to whether coverage applied. In effect, the carrier argued that a trial court ruling in its favor alone precludes bad faith as a matter of law.

The California appellate court rejected this proposition, reasoning:

“We certainly have great faith in the sagacity and reasonableness of trial judges but we decline to impute infallibility to any court, trial or appellate. . . . . Mistakes happen, but . . . that mistake should [not] automatically result in depriving an insured of [its bad-faith claim].”

Insurers are required to construe uncertain policy language or unclear facts in favor of coverage; consequently, they may not rely on ambiguous policy language to argue there is a legitimate dispute and thus no bad faith. Employees Benefit Ass’n v. Grissett, 732 So.2d 968, 976 (Ala. 1998) (“[I]n a ‘normal’ case, the insurer cannot use ambiguity in the contracts as a basis for claiming a debatable reason not to pay the claim.”); Mixson, Inc. v. Am. Loyalty Ins. Co., 562 S.E.2d 659 (S.C. App. 2002) (Although no legal precedent on point, common meaning of disputed term indicated that insurer’s contrary construction was unreasonable.); Lucas v. State Farm Fire & Cas. Co., 963 P.2d 357 (Idaho 1998) (uncertain or disputed factual record insufficient to preclude bad faith claim).

A trial court’s erroneous ruling on the question of coverage is not sufficient to show that the insurer’s original coverage denial was reasonable at the time it was made. See generally Sobley v. S. Natural Gas Co., 210 F.3d 561 (5th Cir. 2000). Indeed, at trial of the bad-faith claim, the court should preclude the insurer even from offering into evidence the erroneous trial court ruling for a number of reasons, including: (i) because the court’s decision post-dates the coverage determination the decision itself is irrelevant as a matter of law; (ii) an erroneous ruling by a trial court does not establish the reasonableness of the carrier’s initial erroneous coverage determination; and (iii) it would be prejudicial to admit the ruling into evidence because it threatens to displace the role of the jury or risks the jurors overweighting the overruled decision.

Posted by Marc Mayerson at 11:02 PM | Comments (2) | TrackBack

February 10, 2007

Insurers' Duty to Defend their Insureds Against Intentional Torts

The duty to defend undertaken by an insurance company is an essential component of the “peace of mind” coverage provided by liability insurance protection. Given the breadth with which the duty to defend is ordinarily construed by the courts, the defense-cost coverage of a policy is also referred to as “litigation insurance,” that is, insurance against the risk and burden of suits brought against the insured. Disputes have raged over whether that litigation insurance applies, however, to suits against the insured alleging an – or only – intentional tort.

In most states, the test for whether an insurer will have a duty to defend is whether the suit against the insured might eventuate in a judgment covered by the duty to indemnify, that is, the insurance company’s obligation to pay for the damages owed by the insured on account of bodily injury, property damage, or wrongful acts. If the claim against the insured permits proof of a covered indemnity claim, the insurer has a duty to defend. Thus, if a “lesser included offense” would be covered by the duty to indemnify, the insurer has the obligation to mount a defense. E.g., Abrams v. General Star Indem. Co., 67 P.3d 931 (Ore. 2003) (conversion claim).

Naturally, if an insurer has a duty to defend where the claim or suit against the insured (only) might result in a covered judgment, the insurer’s obligation to defend may apply even though the judgment ends up being uncovered. E.g., Tanner v. State Farm Fire & Cas. Co., 874 So.2d 1058 (Ala. 2003); Automobile Ins. Co. v. Cook (N.Y. July 26, 2006). (Note that public policy does not prevent the insurer from having a duty to defend even if that public policy would bar the insurer from indemnifying the insured for its deliberate misconduct. E.g., Horace Mann Ins. Co. v. Barbara B., 4 Cal. 4th 1076 (Cal. 1993).) In this way, the duty to defend is broader than is the duty to indemnify: a claim might need to be defended even if it need not be paid -- or it is uncertain whether initially the claim will need to be paid by the insurance company. E.g., Fresno Econ. Import Used Cars, Inc. v. United States F&G Co., 142 Cal. Rptr. 681, 685 (Cal. App. 1977). (Note if that certainty that there is no duty to indemnify comes into focus from the undisputed facts developed in the underlying case, the insurer may be able to terminate its defense, prospectively. See Firco Inc. v. Fireman's Fund Ins. Co., 343 P.2d 311 (Cal. App. 1959); Mayerson, Insurance Recovery of Litigation Costs, at 1000 & n. 16; see also Sterlite Corp. v. Continental Cas. Co., 458 N.E.2d 338, 344 (Mass. Ct. App. 1983) (holding that an insurer "can, by certain steps, get clear of the duty [to defend] from and after the time when it demonstrates with conclusive effect on the third party that as a matter of fact -- as distinguished from the appearances of the complaint and policy -- the third party cannot establish a claim within the insurance," but that "[w]hat is not permitted is that an insurer shall escape its duty to defend the insured against a liability arising on the face of the complaint and the policy by dint of its own assertion that there is no coverage in fact.") .

But what about the situation where the allegations of the complaint, if true, show there is no duty to indemnify and there is no covered lesser-included offense? Insurers typically argue, often with success, that there is no duty to defend such a complaint. E.g., Farmland Mut. Ins. Co. v. Scruggs, 886 So. 2d 714 (Miss. 2004). The paradigm case involves allegations of an intentional tort against the insured the essential elements of which negate coverage.

The intentional consequences of an intentional act may still be the basis for coverage, where the legal consequences are not anticipated by the insured. The Illinois Court of Appeal addressed a recurring fact pattern recently, where a contractor cut down trees on the wrong property. Finding it “immaterial that the underlying complaint alleges intentional torts,” the Illinois court found that the insured did not expect liability for the physical injury of cutting down the trees. Pekin Ins. Co. v. Miller, 854 N.E.2d 693, 696 (Ill. App. 2006).

Recently, the Eighth Circuit was called upon to get involved with a domestic love triangle, in which the insured had an affair with someone’s wife, and the cuckold filed suit for alienation of affections. The policy provided coverage for “loss,” defined as an “accident . . . which results in bodily injury.” The insurer conceded that the injury at issue was bodily injury (though without any physical harm being alleged, cf. Lavanant v. General Accident Ins. Co., 595 N.E.2d 819 (N.Y. 1992). The insurer denied coverage, however, on the ground that affairs of the heart (or body) are not accidents or, in this case, that the cuckold’s injury was “expected or intended” by the insured.

The Eighth Circuit in Pins v. State Farm Fire and Cas. Co. (8th Cir. Feb. 8, 2007) analyzed the elements of proof for the tort claim of alienation of affections under the applicable law (South Dakota). The court found that “intent to injure the marital relationship” was the sine qua non of the tort. As the court explained, “ ‘the acts must have been done for the very purpose of accomplishing this result.’” Slip op. at 4 (citation omitted). The policyholder argued that the record was not sufficient to find conclusively that he expected/intended injury; but distinguishing prior authority, the Eighth Circuit found there were no circumstances where an “accidental loss was even arguably possible.” Slip op. at 5. The court concluded that proof of the underlying tort ipso facto and ipso jure meant the injury was expected or intended, holding:

[T]he comfort and consortium injuries alleged by [the husband] were sufficient to state a claim for alienation of affections, and under South Dakota law, [the husband] could not recover on this claim unless he proved that Pins intended to cause those specific injuries. In these circumstances, any ‘loss’ to [the husband] was ‘expected or intended’ by Pins and could not be deemed an ‘accident.’ Therefore, State Farm had no contractual duty to defend.

Slip op. at 5. Put differently, the court found that State Farm issued a homeowner’s policy, not a home-wrecker’s policy.

The Eighth Circuit’s conclusion that there was no duty to defend where the elements of proof by definition negated coverage is consistent with a Tenth Circuit opinion decided two months before, Notwen Crop. v. American Economy Ins. Co. (10th Cir. Dec. 1, 2006). The gravamen of the underlying tort in Notwen was that trade secrets were misappropriated and the tortfeasor-insured allegedly used corporate and bankruptcy maneuvers to try to shield its misconduct. While recognizing that unintended consequences of an intentional act still may qualify as covered conduct, the court found that the complaint against Notwen admitted of no such possibility. Compare Cincinnati Ins. Co. v. Eastern Atl. Ins. Co., 260 F.3d 742 (7th Cir. 2001). As in Pins, the policyholder sought to argue that there was a dispute of fact whether it was culpable and that those facts should be aired out in the underlying action – which the insurer should be defending. The Tenth Circuit rejected this argument in part reasoning:

[T]he argument is patently circular, rendering the exclusion of intentional torts from the liability policy meaningless, at least under the circumstances presented here: it asserts, in effect, that a duty to defend against intentional-tort claims excluded under the policy is nevertheless triggered whenever the insured seeks to defend itself (with the insurer’s assistance) in a lawsuit alleging intentional-tort claims.

Cf. Evett v. Corbin, 305 S.E.2d 469, 472 (Mo. 1957). While courts are reluctant to confer on insureds the power to compel their insurers to defend solely by their incanting a denial of the allegations, policyholders reasonably do expect their insurers will protect them when they are wrongly accused of torts.

Many insurance-coverage lawyers are familiar with the California Supreme Court’s landmark decision in Gray v. Zurich Ins. Co., 419 P.2d 168 (Cal. 1966), but there is a lesser-known companion case to Gray decided concurrently that addresses the important issue of insurers’ duty to defend against intentional torts. Lowell v. Maryland Cas. Co., 65 Cal.2d 298 (1966). Standard liability policies provide that the insurer will defend an insured “even if such suit is groundless, false or fraudulent.” The California Supreme Court in Lowell found this "groundless, false or fraudulent" language to be key in giving rise to a reasonable expectation that the insurer will defend a suit that if the allegations were true would not be covered but where the insured also could obtain a defense verdict of non-liability. (This is different from an insured not being liable for intentional injury but being held liable of the lesser-included offense of negligently caused injury.) So long as there was a substantial basis for the insured’s contention of non-liability, the insurer is required to defend:

The insured could reasonably expect that the insurer would furnish him a defense against the “groundless” charge that the insured had committed an assault and battery against the third party. The insured would not expect that the insurer could avoid the obligation of defense on the ground that such obligation covered only ‘accidents” which were indemnifiable under the policy and that an assault and battery was not such an indemnifiable “accident.” The policy promised a defense “even if [the third party] suit is groundless.”

65 Cal. 2d at 301. Lowell was in some regards an easy case because the insured obtained a defense verdict in the tort case and the policy expressly afforded defense to "groundless, false or fraudulent" claims; the exclusion for assault and battery did not apply (since the insured was found “not guilty”). See Travelers Ins. Co. v. North Seattle Christian and Missionary Alliance, 650 P.2d 250, 254 (Wash. 1982). Thus, given that Lowell was -- if defense were not granted -- an insured who would be left with a gap in coverage for defense costs that inurred to the insurer's benefit (by avoiding a potentially larger loss or a change in the course of the mounting of the successful defense, cf. Arenson v. National Auto. & Cas. Ins. Co. , 48 Cal.2d 528 (1957) ), the court reached out to find an obligation to reimburse the cost of the successful defense. Nevertheless, forty years after Lowell insurers and insureds continue to tangle over the applicability of the duty to defend to cases of intentional torts.

Posted by Marc Mayerson at 11:52 PM | Comments (3) | TrackBack

January 21, 2007

Cone of Silence or Echo Chamber: A Policyholder’s Privileged Communications and its Insurers

An insurance company that receives a claim from one of its policyholders inevitably wears both a white hat and a black one. The insurer is there to help its insured deal with the claim – it may dispatch claims handlers or service providers to help the policyholder in its time of need; the insurer, however, also is the insured’s adversary in the sense that it must determine whether it has any obligation to pay the insured. To the latter extent, the insured and the insurer have directly adverse interests. (The law of first-party insurance bad faith is predicated on the recognition in part of this fundamental adversity of interests between the insurer and its insured, especially at the precise moment when the insured is calling upon the insurer for performance.)

The insurer’s wearing two hats poses the opportunity for mischief when those roles get confused or blurred. Take the example of a defense lawyer hired by an insurance company to defend the insured: the defense attorney plainly has an attorney-client relationship with the insured, the touchstone of which is confidentiality. Assume that the defense lawyer is told a fact by the insured that supports the insurer’s denying coverage: the insured confesses to being drunk while driving, the insured acknowledges that it knew of a latent problem before it purchased the policy, or the insured knew of the potential claim against it for a long time but had simply hoped it would go away and so did not notify the insurer sooner. The insurance company might wish to learn of this fact because it might permit it to terminate its defense obligation and avoid paying anything on the claim. In these circumstances, may the defense counsel tell the insurance company about this admission from the insured?

Ratting out the insured in this fashion would be found to be a breach of the lawyer’s duties to his or her client (the policyholder). What happens if the insurance company acts on this information to deny coverage? Has the insurer breached any duty?

Different courts have approached this question somewhat differently, but no court (to my knowledge) is comfortable with the insurer acting on this information. The Arizona Supreme Court has held that the insurer has committed an act of bad faith if it denies coverage based on defense counsel’s breach of the policyholder’s confidence. In Parsons v. Continental National American Group, 660 P.2d 94 (Ariz. 1976), the court held:

When an attorney who is an insurance company’s agent uses the confidential relationship between an attorney and a client to gather information so as to deny the insured coverage . . . . we hold that such conduct constitutes waiver of any policy defense, and is so contrary to public policy that the insurance company is estopped as a matter of law from disclaiming liability.

550 P.2d at 99. Other courts have adopted an exclusionary-rule approach, barring the insurer from using the information or any fruit from the poisonous tree in service of a denial of coverage Employers Cas. Co. v. Tilley, 496 S.W.2d 552, 560-61 (Tex. 1973); Snodgrass v. Baize, 405 N.E.2d 48, 54 (Ind. App. 1980). These cases recognize that mixing the insurer’s two roles – mixing up its white and black hats – is at a minimum inappropriate and potentially abusive. This double betrayal – of confidence and using the confidence as a weapon against the insured – calls for some remedy.

But let’s vary the situation somewhat, from an insurer that has provided defense counsel to an insurer that has not provided counsel when the insured believes it should have done so. In those circumstances, the insured will defend the liability case against it and separately pursue coverage against the insurer in a coverage case. Routinely, we see insurers seeking discovery of underlying defense counsel’s files. Often, this is seemingly an effort to obtain evidence that will embarrass the insured and sway the jury – for example, a memo from defense counsel to the insured evaluating the liability case and stating something like “the [insured] company’s conduct flagrantly disregarded standards for appropriate conduct and safety and this led directly to the injury.” In a coverage case, the insurer would like to proffer this kind of document against the insured to argue that the insured expected/intended the injury and thus coverage should not be provided. (Moreover, carrier counsel wants to argue at closing that “even the insured’s defense counsel agrees that the insured flagrantly disregarded safety standards, etc. etc.”) Discovery of this kind of document also makes carrier counsel’s job easier because the defense lawyer has investigated and synthesized the facts leading to the liability claim.

Insurers have argued that they are entitled to the discovery of this information in the coverage case on the ground that it fits within the scope of discovery and that, although the documents constitute privileged communications, no privilege is properly assertable as against them. The rationale insurers offer is that they share a common interest with the insured in these privileged communications.

A tiny number of jurisdictions have accepted this argument, and the vast majority of cases have rejected it. In Illinois for example, where the argument has been accepted, insurance companies have an unfettered right of access to defense counsel’s files. Waste Management Inc. v. International Surplus Lines Ins. Co., 579 N.E.2d 332 (Ill. 1991). The Illinois Supreme Court reasoned that, even though the insurer was alleged to have breached its contract with the policyholder, the insurers nonetheless shared a “common interest” with the insured in defeating the underlying plaintiff’s claim against it. Because the insurers “shared” in the privilege, relevant materials could not be withheld on this ground. (In other words, like Big Brother, in Illinois one’s insurers are always looking over defense counsel’s shoulder, even where the insurer has breached its contract to perform.)

Thus, even though there is direct adversity of interests between the insurers and the policyholder at the time that the insurers are seeking discovery of defense counsel-s files, the Illinois courts hold that at the time of document creation (as opposed to disclosure) the insurer’s are privy to the thoughts of defense counsel.

Policyholders find this argument preposterous; the insurer may be in breach of contract and unquestionably is seeking bullets to fire at the insured. Ruling that insurers are on the same side as the policyholder and therefore get access to defense counsel’s files confuses the two different roles of insurers – in service of a coverage denial insurers plainly have adverse interests with the insured, and when the insurer has failed to perform they have failed to come to the insured’s aid and rescue (the role that forms the premise for the Illinois courts’ ruling that insurers have a common interest with the insured). As the Fifth Circuit observed in a related context:

We know of no case in which the insured’s duty of assistance and cooperation has been used to force a putative insured to divulge to the insurer every jot and tittle of information which may aid the insurer in defeating his claim for coverage but which in no way hinders the insurer’s ability to provide the insured with a proper defense.

Martin v. Travelers Indemnity Co., 450 F.2d 542, 553 (5th Cir. 1971).

Most courts have rejected the Illinois approach, on a variety of rationales. See Remington Arms. Co. v. Liberty Mut. Ins. Co., 142 F.R.D. 408, 418 (D. Del. 1992). One is that, properly understood, the common interest “privilege” is no privilege at all but rather is a shorthand way of considering whether the disclosure of otherwise privileged communications effects a waiver of the privilege. See United States v. McPartlin, 485 F.2d 1321, 3336 (7th Cir. 1979). As a result, whether there is a common interest depends on the circumstances at the time of disclosure. In these circumstances, while the coverage war is en flagrante there will typically not be a common interest. Put differently, the insured’s privilege still exists and may properly be interposed as a basis for refusing to produce otherwise relevant documents and materials. In Re Envtl. Ins. Declaratory Judgment Actions, 612 A.2d 1338, 1341-43 (N.J. Super. App. Div. 1992). An insurer cannot force a waiver by the fact that a coverage suit is pending. (Relatedly, courts uniformly hold that the mere fact that the insured has been required to file a suit against its insurer does not waive privilege or put all privileged communications “at issue” (which is simply another variant of waiver principles). See FDIC v. US, 527 F. Supp. 942, 950-51 (S.D.W.Va. 1981) (advice-of-counsel defense places communications at issue and subject to discovery); Long Island Lighting Co. v. Allianz Underwriters Ins. Co., 749 N.Y.S.2d 488, 496 (App. Div. 2002); Home Ins. Co. v. Advance Mach. Co., 443 So. 2d 165, 168 (Fla. 1st Dist. App. 1983); Rockwell Int’l Corp. v. Superior Court, 26 Cal. App. 4th 1255, 1268 (1994).)

Nor is the insured’s duty of cooperation with its insurers construed as a waiver of privilege. Metropolitan Life Ins. Co. v. Aetna Cas. & Sur. Co., 730 A.2d 51, 63-64 (Ct. 1999); Martin, 450 F.2d at 553. See also Gulf Ins. Co. v. Transatlantic Reinsurance Co., 788 N.Y.S.2d 44 (1st Dep’t 2004).

So, insurers cannot compel insureds to provide them with privileged (or work product) information. This is true both informally and in the context of coverage litigation. Nevertheless, insureds and their insurers may wish to exchange defense counsel’s evaluation of a case, for example. Can an insured provide its carrier with privileged communications without fear that it has effected a broad waiver with respect to the tort claimants? Does a policyholder need fear that its carrier will use that communication against it to deny coverage?

Policyholders may wish to share defense-counsel’s analysis with its insurers to facilitate the insurers decision to pay to settle a case. I have found it reasonably common in the directors’ and officers’ liability insurance, fiduciary-liability insurance, and errors and omissions insurance contexts that policyholders and their insurers do share privileged communications, reflecting the reality that in many cases the insurers will pay for settlement of the underlying claim against the insured. On the other hand, in the product-liability and mass-tort context, such sharing of information is seemingly more rare.

If an insured elects to share privileged information, is there a risk of finding of waiver? While I am reluctant to provide a definitive conclusion one way or the other, no doubt there is a risk that a court may find waiver.

The starting point for any analysis of this problem is that, in most jurisdictions, there is no insured-insurer privilege. Linde v. Resolution Trust Corp., 5 F.3d 1508, 1514-15 (D.C. Cir. 1993) (“we now firmly reject any sweeping general notion that there is an attorney-client privileged in insured-carrier communications”). As the Linde court ruled:

An insured may communicate with its carrier for a variety of reasons, many of which have little to do with the pursuit of legal representation or the procurement of legal advice. Certainly, where the insured communicates with the carrier for the express purpose of seeking legal advice with respect to a concrete claim, or for the purpose of aiding an insurer-provided attorney in preparing a specific legal case, the law would exalt form over substance if it were to deny application of the attorney-client privilege. However, a statement betraying neither interest in, nor pursuit of, legal counsel bears only the most attenuated nexus to the attorney-client relationship and thus does not come within the ambit of the privilege. . . . . [I]f what is sought is not legal advice, but insurance, no privilege can or should exist.

Linde, 5 F.3d at 1515. See also Aiena v. Olsen, 194 F.R.D. 134, 136 (S.D.N.Y. 2000). As the Alaska Supreme Court explained, “communications between insured and insurer are not in the same class as communications between client and attorney, because the insurer may use its information for purposes inimical to the interests of the insured.” Langdon v. Champion, 752 P.2d 999, 1002-03 (Alaska 1988). Thus, some courts have found that otherwise privileged communications lose their protection from sharing them with an insurer. See Go Medical Indus. Pty., Ltd. V. C.R. Bard, Inc., 1998 WL 1632525 (D. Conn. Aug. 18, 1998); Hartford Fire Ins. Co. v. Guide Corp., 206 F.R.D. 249, 250-51 (S.D. Ind. 2001).

Even if both the carrier and its policyholder would benefit from a defense victory over a tort plaintiff, that may not be sufficient to establish a “common interest” to maintain privilege. See Shamis v. Ambassador Factors Corp., 34 F. Supp. 2d 879, 893 (S.D.N.Y. 1999) (holding that the fact that two entities would benefit from a judgment in favor of the plaintiff, that is not sufficient to find that they share an identical legal interest). What constitutes a common interest has been defined in the following manner:

A community of interests exists among different persons or separate corporations where they have an identical legal interest . . . . The key consideration is that the nature of the interest be identical, not similar, and be legal, not solely commercial. The fact that there may be an overlap of a commercial and legal interest for a third party does not negate the effect of the legal interest in establishing a community of interest.

North River Ins. Co. v. Columbia Cas. Co., 1995 WL 5792, at *3 (S.D.N.Y. Jan. 5, 1995) (citation omitted). The court continued, “What is important is not whether the parties theoretically share similar interests but rather whether they demonstrate actual cooperation toward a common goal.” Id. at *4. Stated further, the same court held in International Insurance Co. v. Newport Mining Corp., 800 F. Supp. 1195 (S.D.N.Y. 1992):

The “common interest,” logically viewed, and New York law supports, which makes the privilege inapplicable, is where an attorney actually represents both the insured and the carrier – joint representation – and accordingly both clients are working together with a single attorney toward a common goal.

Id. at 1196 The International Insurance court found that, while the insurance carrier and its insured shared the same desire for a successful defense of a legal claim against the insured, this was insufficient to find a common legal interest. Id. The International Insurance case involved a defendant-insured seeking to withhold from a plaintiff-carrier materials that were privileged. When the plaintiff-insurer argued that the common-interest exception should apply and the privileged materials (which were otherwise relevant) therefore should be produced, the court disagreed. The court stated:

I conclude that while the insurer had the same ‘desire’ as its insured to have a successful defense of [the actions that necessitated the case at bar], for if coverage was later determined to exist, it would be responsible for any obligation of its insured remaining, this in my view is an insufficient ‘common interest’ to warrant invasion of the attorney-client relationship with the privilege . . .

By extension, and this is the key point, if the insured provided these types of materials to its insurers, then it is providing the communications to an entity that does not share a common interest; therefore, privilege (or immunity) may not be preserved vis a vis (other) third parties. Kansas City Fire & Marine Insurance Corp., 351 N.Y.S.2d 767, 768 (App. Div. 1974).

In Go Medical Industries Pty, Ltd. v. C.R. Bard, Inc., 1998 WL 1632525, a patent-infringement action, the defendant sought production of the plaintiff’s communications with its insurance carrier, which included certain opinions of its lawyer that had been provided to the carrier. The plaintiff alleged the common-interest extension of the attorney-client privilege shielded these documents from discovery. The court in Go Medical disagreed, finding that the plaintiff and its insurance carrier did not share common legal interests:

Go Medical’s [the plaintiff] purpose in providing these documents to CIC [its insurance carrier] was to try to obtain coverage from CIC for expenses Go Medical would incur in litigation to stop the alleged infringement of its patent. However, whereas Go Medical’s interest is in protecting its patent, CIC has no interest in the [] patent. CIC’s interest in Go Medical’s infringement claim is limited to CIC’s coverage of Go Medical’s litigation expenses. An insurer’s contractual obligation to pay its insured’s litigation expenses does not, by itself, create a common interest between the insurer and the insured that is sufficient to warrant application of the common interest rule of the attorney client privilege.

Id. at *3.

So, can communications with an insurer be conducted in a manner that does not result in a waiver? Certainly, if the insurer acknowledges coverage and takes over control of the defense, unquestionably in that circumstance the insurer is functioning as the insured’s lawyer and is entitled to no less protection. When the insurer has not yet provided full-throated acknowledgement of coverage, the insured and the insurer need to lay a foundation to show that, in the particular circumstance, the exchange of privileged information should not be deemed to be a waiver. To accomplish this, the parties are advised to make clear that there is a purpose related to the settlement or defense of the underlying case that justifies sharing the information – that is, the justifies extending the cone of silence over lawyer-client communications of the policyholder to include the carrier. (The carrier’s merely sharing the hope that the policyholder may win the liability case is not likely to be sufficient basis for proving sufficient commonality of interest. E.g., Shamis, 34 F. Supp. 2d at 893.)

So the issue for all counsel involved – policyholder, carrier, tort plaintiffs, government investigators – is whether a foundation has been established that satisfies a showing that in the particular circumstance disclosure of privileged/work product material is consistent with preserving the confidentiality protections we otherwise protect them with. See Cutchin v. State of Maryland, 143 Md. App. 81 (2002); Metroflight Inc. v. Argonaut Ins. Co., 403 F. Supp. 1195 (N.D. Tex. 1975); Reavis v. Metro Property & Liability Ins. Co., 117 F.R.D. 160 (S.D. Cal. 1987); Bellman v. District Court, 531 P.2d 632 (Colo. 1975); Grand Union Co. v. Patrick, 246 So.2d 474 (Fla. Dist. Ct. App. 1971); People v. Ryan, 197 N.E.2d 15 (Ill. 1964). Some courts have ruled that statements to an insurance adjuster are protected by the work-product doctrine, and thus the plaintiff who later sues the insured making the statement cannot obtain its discovery. In re Fontenot, 13 S.W.3d 111 (Tex. App. 2000); Heidebrink v. Moriwaki, 706 P.2d 213 (Wash. 1985). Some courts have employed seemingly more stringent proof requirements to show that privilege should be preserved. In Re Bevill, Bresler & Schulman Asset Mgmt Corp., 805 F.2d 120, 126 (3d Cir. 1986); Government of Virgin Islands v. Joseph, 685 F.2d 857, 862 (3d Cir. 1982); Sheet Metal Workers Int’l Ass’n v. Sweeney, 29 F.3d 120 (4th Cir. 1994); Ft. Howard Paper Co. v. Affiliated FM Ins. Co., 64 F.R.D. 694 (E.D. Wisc. 1974); Travelers Ins. Cos. v. Superior Court, 143 Cal. App. 3d 436 (1983).

The key lesson is that, if one desires to preserve the privilege (or immunity) that would otherwise attach to a statement shared with an insurance company, the circumstances surrounding sharing the statement should indicate that it is being provided to assist the insurer in the defense or in evaluating the settlement of the claim. E.g., Exxon Corp. v. St. Paul Fire & Marine Ins., 903 F. Supp. 1007, 1010 (E.D. La. 1995). In other words, to the extent that one can show that the insurer’s role is in protecting the interest of the insured, then the communication is more likely to remain protected. If the role of the insurance company is more ambiguous – that is, if it is unclear which hat the insurer is wearing and whether the statement might be used against the insured in service of a denial of coverage – then the risk of a court finding waiver is increased. See Hedebrink, 706 Pl.2d at 220 (Goodloe, J., dissenting) (“The use of the statement for a purpose adverse to the interest of the insured is certainly inconsistent with the claim of privilege upon his behalf.”); see also Vermont Gas Systems, Inc. v. United States Fid. & Guar. Co., 151 F.R.D. 268, 277 (D. Vt. 1993); cf. Great American Surplus Lincs, Inc. v. Ace Oil Co., 120 F.R.D. 533 (E.D. Cal. 1988) (preserving insurer’s privilege re information shared with reinsurer). Ideally, the policyholder and the insurer will enter into an agreement that pledges the insurer will maintain the communication in confidence, is receiving the communication for the purpose of evaluating the defense of the claim or settlement of the claim, and will not use the communication as a basis to deny coverage to the insured (subject to the insurer’s being able to use the documents in defense of a failure-to-settle bad-faith claim and allowing the insurer to seek the identical discovery in a coverage case against the insured, though without being able to argue that sharing the information effected a waiver). Such an approach differentiates the insurer's white hat and black hat and allows the policyholder's privileged information to be kept under the insurer's hat.

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December 23, 2006

Caveat Advocat: Defense Lawyers as Coverage Lawyers

While insurance-coverage law has developed over the last 20 years into a rarefied specialty practice, lawyers who handle the defense of liability cases cannot punt on considering coverage issues – or they risk malpractice claims by their disgruntled clients. The New York Appellate Division recently confirmed that defense counsel may be exposed for failing to investigate the possibility of coverage – even where defense counsel has been retained by another insurance company for the benefit of the insured defendant.

In Pacific v. Wilson, Elser, Moskowitz, Edelman & Dicker, LLP (N.Y. App.Div. Dec. 19, 2006), the plaintiff – who was the defendant in a liability case – sued defense counsel for malpractice – not for dissatisfaction in how the defense case was handled but rather for failing to help in securing coverage in the event the defense mounted was unsuccessful. As the New York court framed the question:

The principal issue presented on this appeal concerns whether a law firm, retained by a primary carrier to defend its insured in a pending action, has any obligation to investigate whether the insured has excess coverage available and, if so, to file a timely notice of excess claim on the insured’s behalf.

In Pacific, the insured was covered under a policy from certain underwriters at Lloyd’s for $1 million. The underlying plaintiff sought damages in excess of $50 million, so in addition to appointing defense counsel to defend the insured against the suit, Lloyd’s advised that the insured might wish to investigate whether additional excess coverage might be available.

The Wilson, Elser firm defended the suit against the insured, but lost a summary-judgment motion establishing the insured’s liability. Two months later, before trial of the damages claim was set to commence, the firm, on behalf of the insured, tendered the defense to AIG, which denied coverage in part on the ground that it had not received prompt notice.

Several months later, the underlying plaintiff obtained a verdict against the insured for roughly $6 million, well in excess of Lloyd’s primary insurance policy limits. “In its [malpractice] complaint, the [insured] claimed that the [law firm] had been negligent in failing to advise [AIG] of the underlying action or, alternatively, that its failure to do so constituted a breach of contract.”

The appellate court (ruling on a motion to dismiss) first examined whether the retention arrangement between the law firm and the insured made clear that the firm would not have any responsibility for investigating or pursuing coverage. The court in effect presumed that when a lawyer is retained to defend a case her responsibility includes investigating the possibility of insurance coverage. Cf. Jordache Enterprises v. Brobeck, Phleger & Harrison (Cal. July 30, 1998). As the court rules:

Thus, a legal malpractice plaintiff need not, in order to assert a viable cause of action, specifically plead that the alleged malpractice fell within the agreed scope of the defendant’s representation. Rather, a legal malpractice defendant seeking dismissal . . . must ender document evidence conclusively establishing that the scope of its representation did not include matters relating to the alleged malpractice.

. . .

We turn, then, to the central question presented on this appeal: Whether a law firm retained by a carrier has any duty to ascertain whether the insured it was hired to represent has available excess coverage, or to file a timely notice of excess claim on the insured’s behalf. The issue is best addressed by examining two questions. The first is whether, under ordinary circumstances, an attorney retained directly by a defendant in a personal injury action has any obligation to investigate the availability of insurance for his or her client and to see that timely notices of claim are served; the second is whether, if such an obligation exists, it also binds an attorney who is retained to defendant a personal injury action, not by the defendant directly, but by the defendant’s carrier.

The law firm argued that because it was appointed by an insurance company to represent the insured in the liability litigation it was plain that the scope of its representation was confined by the scope of the carrier’s duty to defend (which is not ordinarily thought to include insurance-recovery issues) and that there was an implicit conflict of interest when defense counsel in a tripartite relationship is asked to opine on coverage issues. The New York Appellate Decision rejected these arguments, finding that there was no legal rule that prevented a lawyer from being sued for breach of professional duty when he fails to pursue coverage in connection with a matter he is defending.

One judge dissented strongly, writing:

The insured’s contractual responsibility to notify its alleged excess insurance carrier cannot be avoided or diminished through the subterfuge of attempting to foist such obligation on an unsuspecting law firm selected by the primary carrier particularly where, as here, the law firm may have been assigned the case after the time to notify the excess carrier had expired.

Note that Wilson, Elser has not been found to have breached any duty to its former client. The issue on appeal is only whether a duty to investigate insurance coverage did not exist as a matter of law. As a matter of fact, the firm can seek to show that the scope of its representation was confined or that it was reasonable in not pursuing the excess coverage here or that the plaintiff cannot establish causation or damages.

The lessons of the Pacific case for defense lawyers include (i) do not shirk investigating whether there is coverage for the case being defended or (ii) make clear in the retention letter that defense counsel’s representation is limited to the defense of the case and expressly does not include advising on or investigating insurance coverage.

I think that the ordinary policyholder will not react negatively to a retention letter that states that the scope of counsel’s representation is limited by the paying insurer’s duty to defend and does not include advising the insured on the availability of coverage as against the defending insurer or against any other insurance company. But in the absence of an agreement making clear that defense counsel will not be advising about insurance, the lawyer may be exposed to a potential claim of breach of professional duty from the failure to pursue offsetting insurance for the client-defendant-insured. (And the law firm should look to its own E&O or professional-liability insurance for protection in the event a former client makes such a claim.)

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October 18, 2006

The Duty to Defend Class-Action Claims (Before a Class with Covered Claimants Is Certified)

A liability insurer’s promise to defend its insured is at the core of the protection purchased by policyholders and, in most states, the insurer will be required to defend any suit alleging facts that possibly could result in a judgment against the insured that would be covered by the policy’s duty to indemnify. A duty to defend will be found where the undisputed facts surrounding a claim – typically the language of the policy and the allegations of the complaint – permit proof of a claim potentially covered by the duty to indemnify. The complaint-allegations test, or what some jurisdictions term the eight-corners rule, results in the duty to defend being found by courts easily, commensurate with the broad contract language and the policy’s intention to afford the insured “litigation insurance” protecting against the risk and burden of litigation.

In any given liability case, the insured defendant might win, in which event no indemnity would be required, or the insured defendant might lose the case on a ground that is outside the scope of coverage; nothwithstanding the possibility of results where the insurer will not have a duty to indemnify the policyholder, the insurer still has a duty to assume the defense, which matures at the outset of the liability case. Because the duty to defend arises based on the possibility of the duty to indemnify a complaint, rather than based on a prediction of the likely outcome or indeed the actual outcome, we typically say that the duty to defend is broader than is the duty to indemnify.

Although an insurer's duty to defend will be triggered if the allegations raise the possibility of a duty to indemnify, sometimes
the complaint is unclear whether nestled within the allegations is a potentially covered claim. An interesting take on the issue arose in a recent Eleventh Circuit decision, Hartford Acc. & Indem. Co. v. Beaver (11 Cir. Oct. 16, 2006).

In Beaver, the question presented was whether an insurer has a duty to defend a putative class action where the claim of the named plaintiff would not be covered but the class was defined in a fashion so as to include covered claims by other class members – if the class were certified.

The Hartford argued that the complaint could not be deemed to include covered claims at least until the class in fact was certified. The Eleventh Circuit rejected this argument, based on both class-action law principles and insurance-law rules. As a matter of civil procedure, the court relied on the Florida rule that putative class members’ claims can be aggregated to satisfy various jurisdictional requirements. Id. at 11, citing Johnson v. Plantation Gen’l Hosp., Ltd., 641 So.2d 58, 60 (Fla. 1994).

As a matter of insurance law, the court relied on the allegations setting forth claims that were potentially covered, even though the claimants were yet to be formally joined, finding analogous authority in LensCrafters, Inc. v. Liberty Mut. Fire Ins. Co., 2005 WL 146896 (N.D. Cal. 2005). As the court analogized, if “the duty to defend arises in spite of the uncertainty and impracticality of defending wholly meritless individual claims, we think it equally clear that the duty to defend is not defeated by some uncertainty as to the merits of a class certification.” Slip op. at 15.

The Beaver court observed that “Hartford would have ignore this basic truth about class action litigation: the fight over class certification is often the whole ball game.” Id. at 12. Given the purpose of the litigation insurance provided pursuant to the promise to defend, “[t]he overwhelming importance of class certification to the ultimate resolution of the case militates strongly against leaving the insured without a defense until after a decision on class certification.” Id. at 14.

The Eleventh Circuit furthermore sought to apply a principle of enlightened self-interest to protect the insurer from the tactical arguments of its lawyers. “Thus, the rule Hartford advocates would not only deny an insured the defense it contracted for, but also would lock insurers out of the litigation until after the critically important issue of class certification had been decided.” Id. While an insurer’s right to defend is not unfettered, the absolutist position of The Hartford of denying a defense until covered claimants are added to the case via certification “would poorly serve insurers and insureds alike.” Id. at 15.

Note: A version of this entry can be found also at 6 Insurance Coverage Litigation Bulletin 9 (March 2007).

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July 10, 2006

Additional Insured?: Defense Assured

Companies that work with each other share insurance through adding the other company as an “additional insured” in connection with their work together. Sometimes it is not clear that the claim falls within the scope of additional-insured coverage. The New York Appellate Division recently confronted whether an insurer had a duty to defend in those circumstances, answering the question that it does. BP A.C. Corp. v. One Beacon Ins. Group, 2006 NY Slip Op. 05297 (N.Y. App. Div., 1st Dept. July 6, 2006).

What happens if we don’t know if the entity is “truly” an additional insured until the underlying liability case is resolved? In the New York case, an HVAC contractor was an additional insured “only with respect to liability arising out of your ongoing operations performed” and “ends when your operations for that insured are completed.”

The New York court found that the purpose of being an additional insured, with the concomitant right of defense, would be defeated if the insurer did not provide a defense until the underlying action was over. The majority reviewed prior cases, which basically cleave between those policies that require proof of a fact establishing additional-insured status as a condition precedent and those where no such pre-condition is made clear. The court found that, so long as the allegations of the complaint reasonably can be construed as indicating the facts establishing additional-insured status, the insurer has a duty to defend.

The dissent is right that, if the accident at issue took place after the operations are completed, then there is no coverage (and from the perspective of heaven there never was coverage). But that fact will be determined during the trial of the liability case. The dissent reasons that this dispute of fact precludes summary judgment, and thus that the parties need to await the outcome of the liability case before determining additional-insured status. The dissent does not flesh out the analysis whether the insurer would be collaterally estopped by the finding in the liability case (and under traditional collateral-estoppel principles it’s not clear that it would be bound), but it obviously would make no sense to allow the insurer to relitigate the question and obtain a different result. And the dissent does not address how the question should be resolved if the liability case is settled rather than tried.

The majority, in contrast, finds a presumptive, ongoing duty to defend, but recognizes that indemnity coverage might not apply depending on the way the facts are developed in the underlying case. Given (i) the vigilance of courts in construing defense coverage, (ii) that awaiting the trial of the underlying case before determining whether there was a duty to defend defeats the purpose of the duty to defend, and (iii) the impracticality of not knowing whether coverage is potentially involved (which will impede settlement, among other things), the majority opinion on balance is better taken.

The dissent is also right that an essential element of the insured’s prima facie case for coverage is that it is a covered entity, but it does seem sufficient, in the absence of other undisputed evidence, to allow the insured to rest on the allegations on this point. One way to harmonize the result with existing case law is to apply the ordinary principle that contract provisions are presumed not to be contractual conditions precedent. As a result, in the absence of clear and unambiguous language mandating that proof of a particular fact is a prerequisite to coverage, allegations permitting proof of that fact combined with a dispute of fact proves additional insured status (for purposes of the duty to defend).

The insurer will have the right to terminate its defense prospectively and not to pay for the judgment depending on the facts as found against the insured (which if adverse to the insured would be subject to offensive non-mutual collateral estoppel), but the duty to defend will not terminate retroactively. In other words, the insurer will not have a right to recover from the putative additional insured the defense costs it incurred even though in truth the conduct was not covered by the particular policy.

This is no different from any other circumstance where the duty to indemnify does not apply to the judgment eventually awarded. If a policy applies only to injury during the policy period and injury in that period is disproved at trial of the liability case, the insurer then will not have a duty to indemnify, but the defense obligation is not lost retroactively. While one can come up with some distinctions between named-insured status and other coverage facts, ultimately it does not seem that there is any real distinction of substance. Accordingly, unless the contract makes clear that insured status is a condition precedent or provides an express right of reimbursement for defense costs incurred on behalf of putative insureds, the majority holding seems right: the insurer has an obligation to defend.

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June 13, 2006

Running Out of Time: Statute of Limitations for Liability Insurance Policies

Liability-insurance policies were introduced in 1881, yet there is no great certainty in most states as to when the statute of limitations commences for bringing suit on an insurance policy for performance. Somewhat complicating matters – and simplifying it too – is the availability of declaratory relief, a remedy designed in part to pull insurance disputes into court. So to understand the application of statute of limitations in this context, one must draw distinctions among several concepts: (i) anticipatory repudiation of contract, which is considered a present breach of contract; (ii) anticipatory relief of seeking a declaration of rights before breach of contract; (iii) continuing breach of the duty to defend by an insurer; and (iv) breach of the duty to indemnify. The Alaska Supreme Court recently confronted these issues and elected to follow the California Supreme Court's approach to the questions presented.

Declaratory judgments are meant as a vehicle for obtaining a ruling from a court, typically in advance of a breach of contract. E.g., Cal. Civ. § 1060 (“The declaration may be had before there has been any breach of the obligation in respect to which said declaration is sought.”). They are not meant ony for policyholders: an insurance company may seek a negative declaration from a court that there is no obligation to defend or indemnify; in the absence of a declaratory-relief remedy a carrier could not sue at common law for non-breach of contract. Declaratory relief – a form of equitable remedy (and not a separate cause of action) – does not require a breach of contract at the time of bringing suit; it is properly directed in futuro, that is, before the time for contractual performance is due. The power of a court to entertain a declaratory judgment is constrained by the advisory-opinion doctrine; in other words, one can bring a declaratory judgment so long as the dispute is sufficiently mature that a court ruling would be helpful, concrete and not advisory. See Marc Mayerson, Executability of Article III Judgments and the Limits of Congressional Discretion, 35 DePaul L. Rev. 51, 58-61, 63-64 n.71 (1985). If a case is nonjusticiable, then it is axiomatic that a statute of limitations cannot have started.

Just because a case is justiciable is not sufficient, however, to initiate the statute of limitation, which protects interests of repose and guards against staleness of evidence (among other things). There is some confusion, however, as to whether if one can bring a suit whether one must bring a suit.

If a breach-of-contract claim exists, the right way to plead the matter is one for damages or other relief appropriate to the contract claim. In other words, it is not necessary or really proper to plead an declaratory count for a declaration of duty (on an existing set of facts) and then a count for damages; such a claim is more properly styled as a breach-of-contract claim based on an existing set of facts; if the set of facts that would ripen a contractual duty has not yet occurred, then a declaratory-relief action would be proper.

Declaratory relief may lie regarding any issue of contractual interpretation, though a court maintains a residuum of discretion not to hear an action that otherwise is proper. Wilton v. Seven Falls Co.., __ U.S. __ (1995). In fact, declaratory relief actions were largely designed to facilitate the resolution of insurance disputes. Edwin Borchard, Declaratory Judgments and Insurance Litigation, 34 Ill. L. Rev. 245-270 (1939); Edwin M. Borchard, Declaratory Judgments (2d ed. 1941).

In the context of liability insurance, when a claim has been made against an insured, an insurer will then have a present obligation to respond. If the insurer does not assume the defense, for example, the duty to defend may have been breached. If it is anticipated that the claim will continue to be prosecuted against the insured, then the insurer will have future obligations to the insured, i.e., a declaratory relief action as to the insurer’s obligations in the future will be proper.

An insurer, like any other contractual party, can renounce its obligations even before the time for performance has occurred. This is an anticipatory repudiation, which is considered a present breach of contract at the time of repudiation. Hall v. Allstate Ins. Co., 880 F.2d 394, 397 (11th Cir. 1989); Snow v. Western Savings & Loan Ass'n, 730 P.2d 204 (Ariz. 1986). The nonbreaching party is as of that moment vested with the option to bring its breach of contract claim and obtain whatever damages it can show, subject to the rules for mitigation and proof of damages. (In the meantime, the insured may be freed of its obligations to provide further notice, provide proofs of loss, and the like.) However, through a repudiation, the breaching party cannot accelerate the running of the statute of limitations; the law allows the nonbreaching party the option to bring an immediate action for breach of contract or to await the time for contractual performance and bring an action at that time. See Lane v. Nationwide Mut. Ins. Co., 582 A.2d 501, 505 (Md. 1990). The nonbreaching party is vested with that option to allow the repudiator the opportunity to have a change of heart and to perform its obligations. Cf. Mobley v. New York Life Ins. Co., 295 U.S. 632 (1935).

This in part is the context for a recent decision of the Alaska Supreme Court, which addressed the question when the statute of limitations commences. Brannon v. Continental Cas. Co. (Alaska June 9, 2006). The court first ruled that “[a] cause of action for denial of coverage under an insurance policy accrues when coverage is disclaimed and the insured is notified.” Id. at 7 (footnotes omitted). While a breach-of-contract action may lie at that moment, the question is whether the insured necessarily must commence a lawsuit or risk forfeiting its claim for coverage. Usually, courts find that an insured is not required to bring an action for breach of the duty to defend until the claim against it is over. See Moffat v. Metropolitan Cas. Ins. Co., 238 F. Supp. 165, 175 (M.D. Pa. 1964). This avoids insureds being doubly burdened from the carrier’s nonperformance – fighting the defense case on its own and being required to sue its insurer simultaneously.

The Alaska court, following the California Supreme Court, held that, while the cause of action for breach of contract accrues upon the carrier’s refusal to perform, the limitations period is tolled while the underlying action is pending. Id. at 10. The Alaska court recognized that its holding was consistent with the majority result, which sometimes finds that due to the continuing nature of the breach by the insurer the insured’s damages are not finalized until the underlying action is concluded, and thus the statute of limitations does not commence. Under either approach, equitable tolling or simply ruling that the insured’s damages must be complete before the statute of limitations commences, the court found that “any prejudice [from awaiting until the underlying action was completed] should not be held against the insured” because “the insurance company has the ability and motivation to gather evidence.” Id. at 11. The court further recognized the unfairness of “requir[ing] the insured to file a lawsuit against the insurance company while simultaneously defending himself in the underlying lawsuit.” Id. at 12 (fn. omitted).

Regardless of the particular rationale, most courts that have carefully analyzed the question hold as the Alaska Supreme Court did that the insured must be permitted to await the conclusion of the underlying action before being at risk of losing its rights to insurance recovery. Yet to ensure that the value of the insurer's timely help is not lost, the insured has the option to bring an action seeking a declaration of the insurer’s obligation to defend on an ongoing basis and potentially for specific performance of the duty to defend. See Marc Mayerson, Insurance Recovery of Litigation Costs, 30 Tort & Ins. L. J. 997 (1995).

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March 29, 2006

Blast Fax -- Policyholders Continue to Obtain Defense Coverage

The ongoing fights over coverage for junk faxes continue, with the trend favoring policyholders, most recently in the form of a US Court of Appeals for the Tenth Circuit decision, Park University Enterprises, Inc. v. American Cas. Co. (10th Cir. March 27, 2006).

A year ago at this time, policyholders began to feel more confident following an Eighth Circuit opinion that refused to follow negative decisions from the Seventh and Fourth Circuits; since then, the trend has continued to swing toward policyholders, at least insofar as they seek defense coverage to class actions alleging violations of the Telephone Consumer Protection Act (TCPA), 47 U.S.C. 227.

Most recently, the Tenth Circuit found that there was coverage under both the property-damage and the advertising-injury coverage. With respect to property damage, the court focused in part on what I term "prong 2" property damage, that is, loss of use of tangible property that has not been physically injured. Here, the court considered the loss of use of the fax machine during transmission to be the loss-of-use property damage. The court implicitly considered the waste of paper and ink to be "prong 1" property damage, that is, physical injury to tangible property. See Park University, slip op. at 8.

The Park University court rejected the argument that the property damage was expected or intended from the standpoint of the insured or was so unfortuitous as not to be covered. Instead, the court focused on the denial of liability of the insured in the TCPA action wherein it alleged (subject to Fed. R. Civ. P. 11) that it believed it had permission to send the offending fax. Id. at 14 n.3. "Hence, from its standpoint, any resulting use of [the recipient's] fax machine, paper, and toner could not have resulted in injury because Park University thought the fax was welcome." Id. at 11.

As to advertising-injury coverage, the Tenth Circuit rejected the argument that coverage was limited only to injury to "seclusion," the theory espoused by the Seventh Circuit (per Judge Easterbrook), concluding that the policy, "defined by a reasonable person in the position of the insured, provides coverage for TCPA violations." Slip op. at 17. Ultimately, the Park University court found that accepting the advertising-injury coverage arguments of the insurer would be to "construe the language of the contract from the vantage of an insurer or an attorney, rather than the insured." Slip op. at 20.

Accordingly, "[t]he transmission of an allegedly unsolicited fax can constitute a [covered] publishing act, while receiving the same can result in a[ covered] invasion of privacy." Slip op. at 22. Furthermore, the nature of insurers' responses to these claims likely will vest in the policyholder the right to select the counsel it wishes to defend it against the TCPA liaiblities.

Note that the increased success of policyholders in obtaining defense and indemnity coverage for these cases pressures insurers not to offer this type of coverage at all, a development I have previously described.

Posted by Marc Mayerson at 11:57 AM | Comments (0) | TrackBack

February 4, 2006

Fettering the Insurer’s Privilege to Control the Defense It Is Duty Bound to Provide

For more than fifty years, policyholders and their insurers have been struggling over the insurer’s promise to defend and the insurer’s control the defense. Policyholders properly have been concerned that an insurance company that controls the defense of an action potentially covered by the carrier’s duty to indemnify will use that control to avoid that very same indemnity obligation. While in egregious cases where a lawyer hired by the carrier has abused his or her relationship with the insured, the client, so as to favor the lawyer’s source of income – the insurance company – the courts have responded to protect the insured’s interests. But most courts have ruled that such after-the-fact remedies are insufficient: they do not adequately compensate for the injury; meritorious claims are not pursued (in part because insureds may not discover the abuse); and the potential for this abuse alone undermines the dominant purpose of the insurance relationship to afford protection and peace of mind for the insured.

As a result, most jurisdictions have fashioned a number of rules affording remedies in cases of actual abuse – by allowing bad-faith actions to proceed against insurers, by barring insurers from using the fruits of the poisonous tree, by allowing malpractice claims against the lawyer, and other measures. But most furthermore have held that where there is a situation of potential abuse a prophylactic approach is appropriate; thus the insured is permitted to select the lawyer to defend it and the carrier continues to have the obligation to pay for that defense. This is usually referred to as the "independent counsel" rule (or in California, the Cumis or 2860 rule).

Rarely do I see as a policyholder lawyer a insurance provision that expressly addresses this problem – something that is incomprehensible given that for more than two generations this struggle has been waged. Since at least the 1950s, the courts have made clear to insurers that, because their policies do not set out how these circumstances should be handled, the courts themselves will fashion rules designed to balance the interests of policyholders and their insurers. In general, the courts have looked to the dominant promise of the insurance contract to defend (and to indemnify) the insured and held that the correlative responsibility of the insurer to defend can yield to safeguarding that dominant purpose of the insurance contract. In part this stems from the contract drafting in which two words – “right and” -- in the insurance policy are what carriers rely on: they have the “right and duty to defend” (plus the insured’s duty to cooperate set out in the boilerplate portion of the policy).

Because insurers are well aware of the rule that uncertainties in the contract will be construed against them and the rule in the overwhelming majority of jurisdictions that their right to defend and its entailed privilege of selection and control of counsel has to yield to protect the benefit of the bargain the insured struck to obtain both defense and indemnity, the courts generally have held that insurers forfeit their privilege of control.

The paradigmatic circumstance where the insurer’s privilege of control yields to its duty to defend, to protecting the insured’s expectations of coverage, and to subordination to the insured’s interest is where a complaint alleges more than one claim arising out of a single event and the case can be lost on either a covered basis or an uncovered one. Take as an example where an during a pickup basketball game an elbow is thrown: if that occurred because of gross negligence, there will be coverage, but if it occurred because the player sought to intentionally injure the recipient, there won’t be. Trial of the case involves the same facts and testimony either way, and ultimately it’s up to the jury to weigh the testimony and the facts. The insurer if it is to lose the case would prefer to lose it on intentional-injury grounds, for then it won’t have to pay the judgment.

Another example: assume there is a technical defense available to the covered claim; should the lawyer file a motion for summary judgment on the covered claim, which will effectively pretermit the carrier’s ongoing obligation to defend (since the case no longer can eventuate in a judgment covered by the duty to indemnify)? Does the lawyer have an obligation to leave the weak claim hanging around just to preserve the defense or does the lawyer – whose bills are being paid by the insurer – have the obligation to clean out the dross and thus allow the carrier off the hook?

Insurers have pooh-poohed such concerns by contending that lawyers act ethically so the courts’ concerns are unfounded. And the United States Court of Appeals for the Fourth Circuit – a court that has a penchant for mispredicting state insurance law by siding with insurance companies – recently agreed with the insurers in what should become carrier-side lawyers’ favorite case to cite on these issues. In a well-written, well-analyzed, but erroneous ruling, Twin City Fire Ins. Co. v. Ben Arnold-Sunbelt Beverage Co. (4th Cir. Dec. 27, 2005), the Fourth Circuit rejected the argument that an insurer’s reservation of the right to deny coverage called for prophylactic protection of the interest of the insured by allowing it to select counsel of it choice to defend at the insurer’s expense.

Of course, Ben Arnold involves reasonably favorable set of facts for carriers and overbroad argument by the policyholder, but the court’s ruling is not so confined. The court sets up the question presented as follows:

When a party with insurance coverage is sued, the insured notifies the insurance company of the suit. The insurance company, in turn,typically chooses, retains, and pays private counsel to represent the insured as to all claims. If the suit involves some claims that are covered under the insurance policy and some claims that are not covered, the insurance company typically will send a reservation of rights letter to the insured stating what claims the insurance company believes are covered and what claims it believes are not covered. In this case, we examine whether, under South Carolina law, such a reservation of rights letter automatically triggers a conflict of interest entitling the insured to reject counsel tendered by the insurance company and instead to choose and retain its own counsel and to have the insurance company pay for that counsel.

Slip op. at 1. The proposition offered by the insured was that any time an insurer issues a reservation-of-rights letter it is still required to provide a defense but the policyholder gets to select counsel to defend it and control the course of the defense.

The Fourth Circuit rejected the policyholder’s argument, noting correctly that courts tend to require that the insured show there to be a conflict of interest between it and the insurance company before wresting the defense from the carrier. This is sensible, of course, given that in the insurance policy the policyholder delegated to the insurance company the right to defend the case. Insurance companies issue reservation-of-rights letters in response to case law in the 1950s and 1960s that a carrier that defends a suit cannot turn around at the end of the case and tell the insured that it won’t pay for the judgment – at least without alerting the insured of this possibility earlier; as a result, insurance companies issue reservations of rights to prevent the insured from having detrimental reliance (or claiming waiver). National Mut. Ins. Co. v. McMahon & Sons, 356 S.E. 2d 488, 493 (W. Va. 1987); Safeco Ins. Co. v. Elllingshouse, 725 P.2d 217, 221 (Mont. 1986); Richmond v. Georgia Farm Bureau Mut. Ins. Co., 231 S.E.2d 245 (Ga. 1976); Royal Ins. Co. v. Process Design Associates, 582 N.E.2d 1234, 1239 (1st Dist. 1991).

But it is not the insurance company’s fault that a suit may involve both covered and uncovered amounts, and coverage is not to be expanded beyond the terms of the policy through application of principles of waiver. As a result, it is entirely appropriate for an insurance company that is contractually obligated to provide a defense to a policyholder to alert it to the possibility that the judgment in the case might not be covered. D.E.M. v. Allickson (North Star Mut. Ins. Co.), 555 N.W.2d 596 (N.D. 1996). In this way, the policyholder can act to protect its own interest, including in some states choosing to settle the lawsuit against it in a fashion that camouflages whether the payment is also on account of uncovered amounts or claims. See generally Miller v. Shugart, 316 N.W.2d 729 (Minn. 1982).

So, unless some other interest or question is involved, the mere fact that an insurer sends a reservation-of-rights letter should not alter the parties’ preexisting rights and powers (since all the insurer is trying to do is to avoid waiver/estoppel from its assuming the defense).

Against this background, the Fourth Circuit rejected the notion that a reservation-of-rights letter per se creates some sort of conflict between the interests of the insured and its insurer such that the insurer is divested of its contractually bargained-for right to defend. But the court went on to recognize that there are circumstances where the interest of the insured and the insurer in the development of the defense can diverge, which has led most courts to express concern about insurer-appointed and insurer-directed counsel.

The Ben Arnold court reviews the law in a number of jurisdictions (having found that South Carolina law applies and was without governing precedent) and concludes that some courts allow the insured to select counsel paid contemporaneously by the insurer whereas other courts permit the insurer to select “independent” counsel who in turn may have heightened professional duties to safeguard the insured’s interest. Because a strong undercurrent in those cases vesting the choice of counsel in the hands of the insured questions the ethical integrity of the insurance-defense bar, e.g., Howard v. Russell Stover Candies, Inc., 649 F.2d 620, 625 (8th Cir. 1981) (requiring independent counsel for fear that counsel for insurer “would be inclined, albeit acting in good faith, to bend his efforts, however unconsciously” in insurer’s favor), the Fourth Circuit was highly reluctant to impugn with such a broad brush the integrity of an entire swath of the bar. Slip op. at 11 (“We are equally unable to conclude that the Supreme Court of South Carolina would profess so little confidence in the integrity of the members of the South Carolina Bar. Rigorous ethical standards govern South Carolina attorneys.”).

The Fourth Circuit concluded that the ethical rules and discipline, “coupled with the threat of bad faith actions or malpractice actions if a lawyer violates these rules, provide strong external incentives for attorneys to comply with their ethical obligations.” Slip op. at 12. Accordingly, the Ben Arnold court refused to find that, where there was a conflict of interest between the insured and the insurer in the development of the facts at issue in the liability case, the insured had a right to counsel of its choice, paid for contemporaneously by the insurer.

The court furthermore adopted a strict forfeiture rule in this regard, finding that if an insured rejected counsel tendered by an insurance company it forfeits the right to defense coverage. In other words, the policyholder is precluded from seeking coverage even if the insurance company cannot show that it was in any way was harmed by the policyholder’s selection of counsel (e.g., competent counsel at the same rate, for example, who obtains an outstanding result). The court rejected the policyholder’s contention that the insurers must show substantial injury or prejudice or at least some detriment in order to be excused from providing the policyholder any of the benefit of the bargain. Slip op. at 13-15.

Ben Arnold is sure to be relied on by insurance companies as a cogent statement of their position in favor of rejecting the policyholder’s selection of counsel of its choice. Nevertheless, the court need not have reached out to proclaim its own, pro-insurer prophylactic rule because the facts of the case and the conduct of the insurers at issue merit no such prolegomenon.

In Ben Arnold, the insurers retained qualified counsel to defend the covered counts and in addition offered to pay for separate counsel to represent the insured’s interests with respect to uncovered counts. Moreover, with respect to a different insured in the case where there was a conflict of interest in the development of the facts, both the trial court and the Fourth Circuit found that independent counsel was required to be appointed at the carriers’ expense. And even with respect to the principal insured for which there was no conflict at issue in the development of the underlying facts, the trial court recognized that at the time of settlement independent counsel might be required due to the conflict that then would be manifest. 2004 WL 2165971 (D.S.C. July 26, 2004), at n. 14.

What is lamentable about the Fourth Circuit’s opinion is that the court could easily and more properly have held that, given the absence of a conflict of interest between the insured and insurer in the development of the underlying facts, independent counsel was not required and in any event the insurers satisfied their obligations by offering to pay for two sets of counsel. This is the rule in “independent counsel” states where most courts recognize that merely sending a reservation-of-rights letter – without more – is insufficient to oust the insurer of the control of the defense. National Union Fire Ins. Co. v. Hilton Hotels Corp., 1991 WL 405182 (N.D. Cal. 1991). In fact, wresting control whenever a reservation of rights is sent ironically defeats the purpose for why such reservations were sent in the first place.

But Ben Arnold should not be rejected just because it is overly broad, for even were the facts to match the very broad rule adopted that rule still would be ill advised and erroneous under principles both of insurance law and of contract law. Perhaps because the issue has been in dispute for so long (half-a-century), the footings of the independent-counsel rule seem to have become beclouded.

Let’s look first at the consequences of the Ben Arnold court position. The court makes clear that, while there might a perception of discomfort by the policyholder in the carrier’s selected lawyer being in charge (and thus having the ability to steer the defense toward uncovered grounds), the insured’s interest is adequately protected because of legal-ethics rules, attorney-malpractice liability, and insurance bad-faith principles. This rejoinder to the policyholder position really does not withstand scrutiny.

The Fourth Circuit’s remedies render nugatory the peace of mind and security the insured is supposed to receive by paying a premium to the insurance company for the broad protection afforded by insurance policies. See Rawlings v. Apodaca, 151 Ariz. 149, 154-55 (1986) (“Although the insured is not without remedies if he disagrees with the insurer, the very invocation of those remedies detracts significantly from the protection or security which was the objection of the transaction.”). The court envisions requiring policyholders to endure bad faith or ethical breaches, and then seeking recovery only at the end of the underlying litigation by suing for legal malpractice or bad faith. Ben Arnold thus replaces the security that insurance is supposed to provide with a chose in action against the insurer-appointed lawyer, requiring the policyholder to (a) sue for legal malpractice, requiring a showing both of breach of the standard of care and a showing that the outcome would have been different (the “trial within the trial” of such malpractice actions), (b) undertake that action at its own expense (since the insurer is not paying, and there’s no attorneys’ fees recovery in malpractice cases), (c) in the meantime front the money for the adverse judgment in excess of policy limits or even the entire judgment if it is based on an uncovered claim (and subsequently, if successful, refund to the carrier in subrogation any amounts recovered after the policyholder was made whole), and (d) expose itself to an uncollectible judgment because the lawyer may not have assets sufficient to cover the judgment that resulted from his malpractice.

The Ben Arnold solution to the conundrum of insurer-appointed counsel further would do substantial injury to the attorney-client relationship; not only would the insured find it difficult to confide in counsel assigned to it, but counsel’s effectiveness would be undermined by its knowledge that the carrier has set it up for an impending malpractice action. And the same problems apply regarding suing the carrier for bad faith for some misconduct of the insurer-appointed lawyer or suing for negligent performance of the duty to defend by providing inadequate counsel.

The proposed remedy that the Ben Arnold court contemplates is a feeble substitution for the security and protection that the policyholder thought it was paying for. And if one looks at the cases decided forty or fifty years ago, these courts found it salient that the insurers’ policies did not spell out how this conflict situation would be handled. Standard insurance policies then (as now) were not written to state plainly and unambiguously that (i) interference with the right to defend forfeits coverage or (ii) the right to defend constitutes a material part of the consideration of the overall insurance transaction (which would be an overreach anyway given the aleatory nature of insurance contracts, that is, that the policyholder has fully performed its principal obligation of paying the premium).

Thus, the courts have applied the ordinary rules that where the policy language was uncertain and the insurer was in a position to clarify by drafting a provision clearly, the policy is construed in favor of coverage to achieve its purpose of indemnifying the insured, especially bearing in mind the reasonable expectations of insureds and avoiding the appearance of unseemliness from insurer-appointed counsel’s being in the position to steer the case to favor his or her source of future business. E.g., Employers' Fire Ins. Co. v. Beals, 240 A.2d 397, 402 (R.I. 1968); Magoun v. Liberty Mut. Ins. Co., 195 N.E.2d 514 (Mass. 1964); Prashker v. United States Guarantee Co., 136 N.E.2d 871 (N.Y. 1956); see also CHI of Alaska, Inc. v. Employers Reinsurance Corp., 844 P.2d 1113, 1116 (Alaska 1993). As a result, most courts ruled that the carriers’ right to control the defense – an ancillary part of the insurance contract – must yield to the predominate purpose of the contract to provide the policyholder a defense and to safeguard the policyholder’s peace of mind. See Jacobs & Youngs, Inc., 129 N.E. 889, 891 (N.Y. 1921) (Cardozo, J.) (“There will be no assumption of a purpose to visit venial faults with oppressive retribution.”). That carriers have not fixed their policy language after 50 years of litigation and instead require that the law be developed in each state and locality smacks of ineptitude or bad faith or some synergistic combination of the two.

Nevertheless, one dissembling rejoinder to this would be to contemplate a situation where the policyholder does erroneously reject the carrier’s offered defense (which approximates the actual facts in Ben Arnold). In that circumstance, so the argument goes, if the carrier remains responsible for funding the defense, the carrier that offers to perform properly is no better off than is the carrier that breaches its contract by refusing to provide a defense at all. In other words, a carrier that breaches its duty to defend by erroneously denying coverage is liable to pay the reasonable costs of defense; and according to this argument a carrier that offers counsel that is rejected by the policyholder is still obligated to pay the reasonable costs of defense.

This is a false counter, because it misstates the damages that are to be paid by a breaching carrier (that is, the contract-law damages it owes for breach of the duty to defend). It is not precise to say that a breaching insurer owes the reasonable costs of defense; rather, under Hadley v. Baxendale, the insurer owes all foreseeable damages. In the circumstances, the policyholder proffers in its prima facie case all defense costs it incurred (that were caused in fact by the carrier’s failure to perform), and the carrier may argue by way of affirmative defense (and for which it has the burden of proof) that the costs were so unreasonable as to constitute unforeseeable damages ( which when framed correctly is a difficult standard for the carrier to meet, especially in the light of the fact that the insured had every economic incentive to incur only reasonable costs since, at the time, it was paying them out of its own pocket with no certainty of recovery from the carrier). Moreover, a breaching carrier is not just liable for defense costs, it is liable for all damages incurred by the insured from the breach. Beck v. Farmers Insurance Exchange, 701 P.2d 795, 801 (Utah 1985).

Contrast this situation to that of the carrier that does offer a defense but which is rejected by the policyholder on the ground that independent counsel is required – though in this illustration the policyholder is wrong to do that. In that circumstance, the concepts of material versus immaterial breach are key (as are dependent versus independent covenants). Here, the carrier has not breached, but the policyholder has. But the policyholder’s breach – by interfering with the carrier’s right of control – exposes the policyholder to the carrier’s set-off claim because it is an immaterial breach of the overall contract. In other words, the carrier is still required to perform its contract – for the policyholder’s breach is not a material breach of the contract excusing the carrier’s obligation (especially when the policyholder has probably already paid the full premium). See generally Steakhouse, Inc. v. Barnett, 65 So.2d 736, 738 (Fla.1953)(defining dependent covenants). But because the policyholder did breach the contract, the carrier is entitled to show its damages from the policyholder’s breach. In this context, what that means is the additional cost of the defense that would not have been incurred had the policyholder not breached (i.e., not been in charged). So, if the defense counsel the insurer would have appointed charged only $300 an hour (because of say a bulk deal with the carrier) and the policyholder’s selected lawyer charges $400 an hour, the carrier is not obligated to pay the $100 an hour difference. (Unlike Ben Arnold where the carriers' to their mirth owe nothing.) Importantly, this is in contrast to the breaching carrier which is unlikely to be able to show that the $100 an hour delta is such an unreasonable cost differential as to constitute unforeseeable damages under Hadley v. Baxendale. Moreover, the carrier that properly offered counsel is not exposed to paying the insured’s full damages (sometimes pejoratively characterized as “consequential damages” (Machan v. Unum Provident Ins. Co., 2005 UT 37 (Utah June 17, 2005)), because it did not breach.

Thus, a carrier that properly tenders performance that is incorrectly rejected is not in the same (disadvantaged) position as is a carrier that breaches its contract. Accordingly, under this analysis, everyone is put in the position they would be in had the contract been properly performed – the benefit of the bargain is preserved.

Until such time, therefore, that insurers revise their contracts to specify that even in a conflict of interest situation the insurer still gets to appoint counsel (or whatever method it would propose, such as allowing the insured to pick from a list of five counsel suggested by the insurer), the uncertainty of the contract, and the disproportionality of the proposed remedy contemplated by the Ben Arnold court, confirms the rightness of the independent-counsel rule. See generally Restatement (2d) Contracts Sections 197, 229 (2004). If insurers do revise their contacts, then (i) insurance regulators would be in the position to weigh in, (ii) policyholders would know expressly what the process is for dealing with a conflict situation if it purchases the particular insurance policy, and (iii) policyholders could choose to purchase policies from other insurers that offer more generous terms. But it is folly to believe that policyholders contemplate the remedial scheme adopted by the Ben Arnold court. See Restatement (2d) Contracts Section 211(3).

Note: A version of this commentary was published in 5 Insurance Coverage Law Bulletin (May 2006) at 1

Posted by Marc Mayerson at 11:39 PM | Comments (0) | TrackBack

January 4, 2006

Defense Coverage Under Excess Insurance Policy Forms

Defense-cost expense in major litigation – either one-shot cases or related, serial cases – can accumulate to rather substantial amounts, so naturally policyholders look to their liability-insurance policies for coverage. While most defense-cost coverage disputes concern primary-layer policies, excess insurers, too, may have obligations to perform. As discussed below, a recent Indiana appellate decision addressed coverage for defense costs under a primary-layer policy written on an excess policy form and held that the coverage was restricted to after-the-fact payment as an incident to covered indemnity amounts.

Defense costs will be sought under excess-type policies when the primary coverage is exhausted or where the insured maintains a self-insured retention with an “excess” policy sitting above the retention. (Calling a policy above an SIR an “excess” policy is a bit of a misnomer, since it is excess to no-insurance but such policies are written commonly on excess-type forms with the obligation to perform characterized in terms of “ultimate net loss,” the common wording in excess policies. Cf. Nabisco, Inc. v. Transport Indemnity Co., 143 Cal.App.3d 831 (1983)).

The typical issues for defense coverage under excess policies are:

1. Is there an obligation to pay defense costs at all (once the underlying is exhausted)? See Aetna Cas. & Sur. Corp. v. Certain Underwriters at Lloyd’s, 129 Cal. Rptr. 47 (Cal. App. 1976); State Farm Mut. Auto Ins. Co. v. Foundation Reserve Ins. Co., 431 P.2d 737 (N.M. 1967); Maryland Cas. Co. v. Marquette Cas. Co., 143 So. 2d 249, (La. App. 1962).

2. Is the obligation to pay defense costs only an incident to paying covered indemnity claims (such that there is no coverage if the insured wins the liability case or to the extent that defense costs relate to potentially covered claims rather than to actually covered ones)?

3. Relatedly, does the obligation to pay defense costs arise at the outset of the liability case or only after the insured has lost the liability case (meaning both that the insured fronts the costs of the defense and that the defense costs are covered not based on the allegations of the complaint but only based on the facts as proved at trial)?

4. Where the insurer does not have an obligation to defend but has a right to associate in the defense or to consent to the incurrence of defense costs, does the insurer have the unfettered power to refuse to contribute to defense costs for a covered claim?

5. Where an insurer does not have an obligation to assume control of the defense, may it still have an obligation to reimburse the costs of defense as they are incurred? Gon v. First State Ins. Co., 871 F.2d 863 (9th Cir. 1989).

6. Where an excess policy does not expressly set forth a defense obligation but “follows form” to an underlying policy with a defense obligation, does the following-form carrier presumptively have an obligation to contribute to the defense costs? Monsanto Co. v. American Centennial Ins. Co., 1991 WL 35714 (Del. Super. Ct. Feb. 20, 1991); Ford Motor Co. v. Northbrook Ins. Co., 838 F.2d 828 (9th Cir. 1988).

7. Are defense costs paid by the excess carrier in addition to policy limits or within its policy limits (sometimes referred to as “defense inclusive” policies)? Alternatively, if policy limits are expressed in terms of “ultimate net loss” and defense costs are carved out of ultimate net loss, does that mean that costs are not payable at all or are they still payable but outside of policy limits? Affiliated FM Ins. Co. v. Owens-Corning Fiberglas Corp., 16 F.3d 684 (6th Cir. 1994); North River Ins. Co. v. Cigna Re Co., 52 F.3d 1194 (3d Cir. 1995); Home Ins. Co. v. American Home Prods. Corp., 902 F.2d 1111 (2d Cir. 1990); Continental Cas. Co. v. Pittsburgh Corning Corp., 917 F.2d 297 (7th Cir. 1990); Planet Ins. Co. v. Mead Reinsurance Corp., 789 F.2d 668 (9th Cir. 1986).

[The above-cited cases touch on some of these issues both pro and con (depending on one’s perspective). Lawyers for both policyholders and insurers should be mindful that some cited cases are inter-insurer disputes where the policyholder perspective – and supporting facts – were not presented, e.g., Crown Center Redevelopment Corp. v. Occidental Fire, 716 S.W.2d 348 (Mo. App. 1986) (and compare this holding to my note, An Insurance Company’s Duty to Consent , or are reinsurance disputes where the factual record may not have been developed or where there is a deferential standard of review of an arbitration decision, e.g., North River, 52 F.3d at 1208-1217.]

The Indiana Court of Appeals recently addressed some of these matters, Cinergy Corp. v. St. Paul Surplus Lines Ins. Co.., (Ind. App. Dec. 13, 2005). The court described the question presented as “Whether a policyholder of a first-layer liability insurance policy is entitled to payment of defense costs as they are incurred when the insurance policy does not contain a duty to defend clause or express language authorizing a delay in payment of those costs until determination of whether the underlying claims are covered.” The policy at issue provided that the insurer was obligated “to indemnify” sums the insured becomes liable to pay “as Ultimate Net Loss by reason of the liability imposed upon the Insured by law or liability assumed by the Insured under Contract.” The case did not go off on the language that the insurer was to “indemnify . . . by reason of the liability imposed” but instead turned on the ultimate-net-loss provision.

“Ultimate Net Loss” was defined as “the total of the following sums . . . to which this Policy applies: (1) all sums which the Insured shall become legally obligated to pay as damages . . . and (2) all expenses incurred by the Insured in the . . . defenses of any claim or suit seeking such damages.”

The court ultimately seized on the use of the term “total” in the ultimate-net-loss provision, reasoning that one cannot know the “total” ultimate net loss until both the defense costs and the damages were determined. Slip op. at 11 (“The pivotal requirement in the payment of the defense costs lies in the definition of ultimate net loss as a total of incurred defense costs and damages which h the insured becomes legally obligated to pay.”) From this, the court found it plain and unambiguous that there was no obligation to pay defense costs until covered damages were awarded. The court further stated that until the policyholder was found liable, one cannot know that a covered occurrence or wrongful act took place, and thus (?) ultimate net loss does not “even exist,” slip op. at 10. Because the carrier’s obligation is to indemnify ultimate net loss, there was no duty to pay for defense costs before the insured was found liable for a covered act.

Probably the court’s strongest rationale is that, unless one waits until the underlying liability case is over, it is possible that the carrier will pay defense costs for a matter found ultimately to be outside of coverage (even if that prejudice might be mitigated by the insurer’s obtaining reimbursement of the amounts expended. See In re Kenai Corp., 136 B.R. 59 (S.D.N.Y. 1992)). (And the split of authority regarding whether insurers may recover defense costs from their own insureds – or trend away from permitting such claims – serves to strengthen the equities favoring insurers.) Note that directors’ and officers’ insurance policies may disclaim an obligation to defend but provide for the advancement of defense costs subject to reimbursement, which often makes those cases of little use in this context.

The Cinergy court’s holding principally is predicated on the use of the term “total” in the ultimate net loss definition and the language “to which this policy applies” (in that definition). While this language may support the court’s conclusion, other language does not: in the ultimate-net-loss provision, the coverage for defense costs is defined as expenses incurred in the defense of “any claim or suit seeking such damages.” In this context, the word “seeking” is key. A suit “seeking” such damages is judged ex ante – that is, is judged by what the complaint alleges. If the carrier intended for defense to be reimbursed only where a covered indemnity claim was adjudged, the defense language should say something like “all expenses incurred by the Insured in the defense of any claim or suit where such damages are awarded” or “have been awarded”. These formulations, especially the latter, would make clear that a truly retrospective approach was intended.

At a minimum, the policy language should be found to be unclear on this point, and while the carrier’s argument that it might have to pay for potentially uncovered claims has some force, the overwhelming practice for “first layer” insurers is to pay for defense costs on a allegations basis. Further, the court’s construction creates a gap in coverage for cases where the insured wins the liability case (since no “wrongful act” or “occurrence” took place), a gap in coverage that surely would be unexpected by any reasonable policyholder. In this light, the insurer should have utilized language making it clear that defense costs are reimbursed only as an incident to covered indemnity claim. Indeed, I think that the insurer should make express its negative intention not to pay defense costs unless and only if the policyholder loses a suit for a covered wrongful act.

Part of the difficulty in this entire area is the dearth of case law and the superficiality of much of the analysis in the cases. The keys to successfully litigating these issues for policyholder counsel are: (i) focus on the policy language; (ii) think about what happens if the policyholder wins the liability case; (iii) considering the overwhelmingly common practice of carriers’ funding the defense, argue that the burden of dispelling the expectation of coverage is on the carrier to negate defense coverage; and (iv) recognize that while the incurrence of defense costs can be a catastrophic exposure to the policyholder it can also be so for the carrier, meaning that the policyholder must sensitively respond to the equitable force of the insurer’s arguments and not simply rely on “punish the drafter” arguments or what the Nabisco court characterized as “‘mom and pop’ grocery store argument[s]” (unless one has to). Of course, sometimes the excess policy really will have no or quite limited obligations to pay defense costs, which the client needs to recognize is a consequence of the coverage it purchased (and possibly the insufficient advice provided by its broker – opening a different vista for recovering the unpaid defense costs).

Posted by Marc Mayerson at 3:05 PM | Comments (3) | TrackBack

October 11, 2005

Kentucky Rules on Environmental Coverage

Many of us who have been practicing for quite some while in the insurance-coverage area at times marvel at the return or continuation of the coverage "wars" of the 1980s. We still confront the same issues in cases that were the focus twenty years ago, though sometimes courts confront new twists in otherwise well-trodden paths.

The Kentucky Supreme Court recently had the opportunity to address a number of the key environmental coverage issues in an insurance dispute commenced in 1987. In an opinion challenged by a lengthy dissent, the Kentucky high court addressed (among others): (i) whether response costs represent covered “damages” on account of property damage indemnifiable by CGL policies; (ii) whether administrative enforcement proceedings were “suits” to which the duty to defend applied; and (iii) how the (equivalent of an) owned-property exclusion applies. It also addressed whether the insured knew of the risk of injury such that coverage should be denied. And the court addressed whether the insurers’ payment of damages for breach of the duty to defend was subject to policy limits, which would have been the case had the insurers performed initially. This last issue, especially as resolved by the Kentucky high court, is not typical fodder in environmental-coverage cases.

In Aenta Cas. & Sur. Co. v. Commonwealth, (Ky. Sept. 22, 2005), the Kentucky Supreme Court held that coverage applies to “any claim asserted against the insured arising out of property damage, which requires the expenditure of money, regardless of whether the claim can be characterized as legal or equitable in nature.” Slip op. at 13. The ordinary meaning of “damages” to which CGL-type policies apply includes response or cleanup costs “as long as the purpose is to rectify, correct, control, lessen or stop ongoing injury of the premises.” Id. The court further ruled that measures undertaken onsite (that is, at the insured’s own property) were covered “when the primary intent is to prevent additional harm to the property of others or to public waters.” Id. at 16.

The court likewise rejected the insurers’ argument that the word “suit” can refer only to actions in court. Instead, the court found that “the term ‘suit’ is susceptible of more than one interpretation.” Id. at 10. In finding a duty to defend, the Kentucky court recognized that the power of the environmental authorities to pursue matters in court or in an administrative proceeding should not result in coverage being afforded in one instance and not the other, ruling that the insurers were “clinging to an archaic definition of ‘suit.’” Id. at 11.

Turning to whether the insureds had acted with so much knowledge of the risk of loss that coverage should be denied, the Court reversed the jury verdict denying coverage on this point, finding fatal error in the instructions. More specifically, the court held that the insureds were “entitled to insurance coverage unless they specifically and subjectively intended to cause the migration of radioactive contamination.” Id. at 9.

All of the foregoing is essentially consistent with the majority law of the land. The court addressed another matter that caused the author of the dissenting opinion to charge that the majority’s ruling constituted “the exercise of arbitrary power” in violation of Section 2 of the Kentucky Constitution. Dissenting Opinion of Justice Cooper, slip op. at 32. The factual context is that defense costs paid under the policy applied against policy limits. As the policy states: “Each payment made by the companies in discharge of their obligations under this policies . . . shall reduce by the amount of such payment the limit of the companies’ liability under this policy.” Slip op. at 17.

The majority reasoned that this limitation on coverage – that is, counting defense costs within limits – applied only to “voluntary payments by the companies in furtherance of the contractual obligations under the policy . . . . .[It does not] include payment of damages under compulsion.” Id. at 18. In other words, the court found that a condition of the carriers’ ability to count the defense costs toward policy limits was their voluntarily making payment; as a result of their breach, the protection of the provision was not available to them.

The dissent took a different tack on this point, by arguing that the purpose of breach-of-contract damages was simply to place the insured in the same position it would have been in had the carrier performed as contractually required. Framing the issue this way, the dissent found that allowing recovery to the insured without offset against the policy limits was a windfall.

The dissent reflects the general instinct that contract damages should place the insured in the same position it would have other been in had performance been rendered. But that principle is misunderstood often to mean that damages are in effect substitute performance, i.e., if a contract to pay $100 is breached, the damages are $100. That conclusion, however, is too facile. At a minimum, the $100 = $100 does not account for the timing of performance – that is, that I was supposed to have received my $100 when the other side’s obligation to perform was mature. The point of contract damages is to compensate me for not receiving my $100 when it was owed, which at a minimum requires that the time value of money be accounted for (that is, interest on the principal amount should be paid). (In insurance, the policyholder also has lost the benefit of peace-of-mind protection, assistance in the time of need.) But my damages from not having the $100 at the time I should have received it could be more – maybe, I lost my house because I couldn’t make mortgage payments. That type of claim sometimes is derided as “consequential” damages, but that’s not the right way to look at it (because that largely assumes the conclusion). The questions for calculating contract damages are: (i) were those damages factually caused; (ii) are those damages not foreseeable within the meaning of Hadley v. Baxendale; and (iii) are they capable of being reasonably estimated. One of the more thoughtful cases on insurance contract damages is the Utah Supreme Court’s decision, Beck v. Framers Ins. Exch., 701 P.2d 795 (Utah 1985).

Moreover, the damages owed for breach of contract are not capped by the policy limits – where the contract-performance owed and the factually caused foreseeable damages exceed the policy limits. The policy limit is relevant to the insured’s expectation damages. But it does not resolve the question of the amount of damages that are proper to be awarded. One cannot turn around in the face of factually caused foreseeable damages that exceed policy limits and assert an affirmative defense that the additional amounts are not owed due to policy limits. The policy-limits cap is available where a carrier performs, not where it breaches.

The majority is surely right to consider the impact of the policy provision that as the court reads it counts defense costs toward policy limits only where the carrier voluntarily performs. Just as waivers of consequential damages clauses will be enforced (if clear, voluntarily entered, etc.), so too the provision here limiting the insurer’s obligations to pay should be treated similarly to other exculpatory clauses. Here, the carriers sought to limit their obligation to pay defense costs when they assumed the defense voluntarily.

That the provision does not apply to breaches creates a bit of a conundrum because, as the dissent points out, the expectation was not that defense would be paid in addition to policy limits. But in the absence of a policy provision that applied by its terms and given that the carriers were the breaching party seeking to cabin their damages obligation, the carriers lacked a valid basis to limit the damages to be awarded. Once the court interpreted the provision by its terms to apply only where the insurers voluntarily assumed the defense, then no other result really seems possible.

Posted by Marc Mayerson at 2:24 PM | Comments (0) | TrackBack

September 15, 2005

Defending Defense Costs: Parrying the Attack of the Legal-Fee Auditors

A common play by insurers that have failed to perform their duty to defend is to challenge the defense costs their policyholders incur on the grounds that they were unreasonable. The suggestion is that had the carrier defended the costs would have been less because the carrier would have hired cheaper defense counsel, or it would have ridden tighter herd on the costs incurred, or it would have required that only a limited number of lawyers be involved, or any of several other grounds for second-guessing the costs incurred by the policyholder. In addition to advancing these arguments, insurers have fabricated a specialized mouthpiece for making these points: "legal fee auditors." But both the legal premise and the "expert" testimony offered in support increasingly are being looked upon with the skepticism properly applied to the excuses of a breaching party that is seeking to reduce its obligation to pay damages - especially when that breaching party is an insurance company that was supposed to defend its insured in the first place.

The legal premise of a carrier's argument is that it needs to reimburse the insured only for "reasonable" defense costs, even if the policyholder already has spent the money. But this misconceives the legal context and the nature of the carrier's obligation. In these after-the-fact circumstances, the carrier's obligation is measured by ordinary principles of contract damages - and the hoary rule of Hadley v. Baxendale. E.g., Hajoca Corp. v. Security Trust Co., 25 A.2d 378, 381 (Del. 1942). The key to properly understanding the issues is to hold fast to first principles: when a party breaches a contract, the non-breaching party proves its recoverable damages by showing what was factually caused by the breach. In the context of the duty to defend, the natural and probable consequences of a breach of a duty to defend is that the policyholder will hire lawyers and experts to defend the suit against it. These costs, therefore, are the presumptive amount of damages for breach of the duty to defend.

Because the policyholder had no certainty that it would obtain recovery from someone else (i.e., the insurer), the amounts it incurred are presumed in the first instance to have been "reasonable" and "foreseeable." E.g., Aerojet-General Corp. v. Transport Indem. Co., 948 P.2d 990, 924-25 (Cal. 1997); Lanier v. Lovett, 213 P.2d 391, 394 (Ariz. 1923) ("The price agreed upon for labor or materials . . . is, prima facie, the reasonable value"); Smith v. Champaign Urbana City Lines, Inc., 252 N.E.2d 381, 382 (Ill. App. 1969) (paid invoice prima facie evidence). Once the policyholder establishes the amounts it paid (which therefore would be sufficient to support a jury verdict in its favor on damages), the burden shifts to the carrier to prove by competent evidence that some or all of the insured's incurred costs are so unreasonable as to constitute "unforeseeable" damages. See Marc Mayerson, Insurance Recovery of Litigation Costs, 30 Tort & Ins. L. J. 997 (1995). The presumption that costs incurred are reasonable or recoverable, though not conclusive, is a strong one: as the Seventh Circuit held:

When [the insured] hired its lawyers, and indeed at all times since, [the insurer] was vigorously denying that it had any duty to defend - any duty, therefore, to reimburse [the insured]. Because of the resulting uncertainty about reimbursement, [the insured] had an incentive to minimize its legal expenses (for it might not be able to shift them); and where there are market incentives to economize, there is no occasion for a painstaking judicial review.

Taco Bell Corp. v. Continental Cas. Co. (7th Cir. Nov. 5, 2004). Cf. National American Ins. Co. v. Certain Underwriters at Lloyd's, London, 93 F.3d 529, 539-40 (9th Cir. 1996); Laffey v. Northwest Airlines Inc., 746 F.2d 4, 17 & n.88, 24-25 (D.C. Cir. 1984). (It is also worth mentioning that lawyers have an independent professional obligation only to charge a reasonable fee. DR 1.5; Florida Bar v Herzog, 521 So.2d 1118 (Fla. 1988).)

So, an insurer bears a heavy burden in showing that costs are so unreasonable as to constitute unrecoverable contract damages (recognizing the costs actually were already incurred). The means for the insurers to make these arguments in recent years has been via "legal fee auditors." These chaps - typically former lawyers for insurance companies and almost certainly not "auditors" - really are disguised advocates who lack professional training and opine with no professional standards guiding their work. The audit profession is a real one, of course, and audits require compliance with written standards, such as Generally Accepted Auditing Standards promulgated by the AICPA. See generally Cumis Ins. Society Inc. v. Tooke, 293 A.D. 2d 794, 797-98 (N.Y. App. Div. 2002). The "legal audit" firms are not part of such disinterested, professional organizations - instead, they are mouthpieces with a mission to flyspeck legal fees on an after-the-fact basis. Several courts have not welcomed the testimony offered by these auditors/advocates:

[The insurance company] submitted an affidavit by a firm that hires itself out to review lawyers' bills and that opined that [the insured] had overpaid the lawyers who represented it [in the underlying] litigation. We are unimpressed, as was the district court. . . The affidavit of the firm that picked through [the insured's] legal bills is excruciatingly detailed. The amount of time and money that went into its preparation and would be incurred in adjudicating its accuracy probably would exceed the potential excesses that it identifies.

Taco Bell, slip op. at 9. The District of Massachusetts recognized that the testimony of a legal auditor is not likely to pass muster under Fed. R. Evid. 702 and the Daubert rule. E.g., Liberty Mut. Ins. Co. v. Black & Decker Corp., 2004 WL 1941351 (D. Mass. Aug. 25, 2004), at *8 & n.8. In Black & Decker, the court indicated that a fee auditor from one of the national fee-auditing outfits lacked the “specialized knowledge” and methodology as to testify properly as an expert witness. Id. While the court sought to be generous in saying that the effort was still helpful to the court, helpfulness alone is not a sufficient basis for its admission into evidence.

But there is an insurance spin that is worth returning to in evaluating the admissibility of the testimony of legal auditors and consideration of their project: As the Seventh Circuit concluded, "the duty to defend would be significantly undermined if an insurance company could, by the facile expedient of hiring an audit firm to pick apart law firm's billings, obtain an evidentiary hearing on how much of the insured's defense costs it had to reimburse." Taco Bell, slip op. at 10-11. To similar effect was the thinking of the District of Massachusetts:

Having declined to involve itself in the insured’s conduct of the litigation once notified, [the insurer] is in no position ex post to complain that the insured’s billing and litigation management policies do not meet its private criteria. The insurer that declines defense after notice cannot claim prejudice in the form of billing format or litigation practices that do not meet its standards, since it could have assumed the defense and imposed those standards.

Black & Decker, 2004 WL 1941351 at *8.

The context of breach of contract is different from the situations where an application for reimbursement of fees is submitted under a federal statute or in a bankruptcy proceeding. Just because the insured’s damages for breach of contract are in the form of attorneys’ fees does not mean that the standard of proof of damages is any different – a distinction insurers often seek to efface. Insurers thus often object to “block billing” or “inadequate descriptions” and argue that they are excused entirely from reimbursing such amounts, but this is simply wrong. The issue is whether a jury is provided with a non-speculative basis to determine the insured’s damages – and in the circumstance of block billing or the like so long as one can be reasonably certain that the business methods of the law firm yields an accurate statement of the time spent on the matter, the insured has established its right to those damages. E.g., Jowdy v. Guerin, 457 P.2d 745, 749 (Ct. App. 1969) (“Under Arizona law there is a distinction between the degree of proof necessary to establish the fact of damages and that necessary to fix the amount. Once the plaintiff has clearly established that he has suffered damages, his burden is relaxed and he need only show the amount with reasonable certainty, free from mere speculation or conjecture.”). Lawyers bill for their time, not for their time descriptions (as the old “for services rendered” billing format confirms).

Similarly, some carriers have objected to including as an element of damages the costs of computerized legal research and other expenses, arguing that these are more properly overhead expenses; while such costs could be wrapped into the hourly rate at particular law firms, there is no impediment to billing for them separately. E.g., ABA Comm. On Ethics and Prof’l Respo., Formal Op. 93-379 (Dec. 6, 1993). These are not per se unforeseeable costs and their being billed separately is not outside market practices.

None of this is to deny that clients should control the costs incurred by their counsel, and sophisticated corporate clients monitor the costs incurred and the manner of their billing – because they are paying for it! There are innumerable ways to structure the fees and expenses of lawyers, including increasing the lawyers’ billing rates so that expenses are no longer broken out (i.e., setting the rate so that the firm absorbs expenses rather than setting rates contemplating that expenses are separately billed); clients may impose standards for how law firms use outside vendors for copying and the like. Some clients want task-based billing and are willing to pay for it; others are satisfied with daily billing or what carriers like to call “block” billing. All of these may be appropriate business deals to work out with defense counsel. The point here, however, is in determining a carrier’s obligation to reimburse defense costs all of these quibbles are too late – in a breach of contract the insured shows what it spent and the breaching party bears a heavy burden of showing that costs that were spent and were caused by its breach should nonetheless not be awarded as an element of damages. Holding fast to these straightforward principles of contract law and damages jurisprudence simplifies coverage cases and streamlines the presentation of damages evidence at trial (to the considerable relief of jurors).

In one of my cases, the legal auditor purported to question 73 percent of all the defense costs incurred for a sophisticated client by a leading employment-liability defense firm, preparing a report of some 748 pages. This should be Exhibit A in showing that this entire project quite properly is a dead-end, as the Seventh Circuit and District of Massachusetts both found.

Posted by Marc Mayerson at 12:14 PM | Comments (15) | TrackBack

June 9, 2005

Recoupment of Defense Costs

The question whether an insurance company that defends its policyholder may recoup the defense-cost payments it made continues to be litigated with divergent results. Most recently, the Illinois Supreme Court and Montana Supreme Court reached opposite conclusions in opinions issued a few weeks apart. See General Agents Insurance Company Of America, Inc. v. Midwest Sporting Goods Company, http://www.state.il.us/court/Opinions/SupremeCourt/2005/ March/Opinions/Html/98814.htm (Ill. March 24, 2005); Travelers Cas. & Sur. Co. v. RIBI Immunochem Research Inc., http://www.lawlibrary.state.mt.us/dscgi/ds.py/Get/File-39479/04-228.pdf (Mont. March 1, 2005).

Primary-layer liability insurance policies typically contain a promise by the insurer to defend the insured against suits alleging injury and damages covered by the duty to indemnify. In most states, where a suit expressly or implicitly alleges a set of facts that, if proven, would eventuate in a judgment covered by the duty to indemnify, the insurer has a duty to defend. The duty to defend applies to potentially covered indemnity claims; it applies at the outset of the case; it arises immediately and continues until such time as the insurer establishes that there no longer is any possibility that a covered indemnity claim may result in the case. See Marc S. Mayerson, Insurance Recovery of Litigation Costs, 30 Tort & Ins. L. J. 997 (1995), available at http://www.spriggs.com/news/pdfs/ACF54A7.pdf.

An insurer that defends should alert its insured of the possibility that the judgment in the case against the insured might not be covered by the policy’s duty to indemnify, whether that is because an exclusion bars coverage completely or in part or because the damages that might be awarded may exceed the limits of the insurance policy. An insurer that fails to apprise the insured of this possibility risks being found to have waived its ability (or to be estopped) to assert bases to refuse to indemnify that reasonably were known to the insurer. This is the origin of reservation-of-rights letters where insurers identify those grounds that may bar coverage. See D.E.M. v. Allickson, 555 N.W.2d 596 (N.D. 1996).

An insurer that defends an insured may terminate the defense where there no longer is any prospect that the case may result in a covered judgment. See Insurance Recovery at 1000. Where the insurer has so “confined the claim,” its duty to defend will terminate prospectively; that is, it may cease performing its defense obligation (subject to its withdrawal not prejudicing the insured, but that is a special case), but its contract will be interpreted to have required it to perform up until that time.

But what happens where there never was a possibility that the duty to indemnify might arise but the insurer defended anyway? The recoupment cases deal with the situation that with respect to the entirety of the action or an allocable portion of it the insurer should never have had to defend in the first place.

This question arises in part because of the “discovery theory” of the common law, that is, that a court discovers the preexisting, if undeclared law; for example, a ruling that a policy provision means that a certain class of cases is not covered means that those cases were never covered, not just that they are not covered once the relevant state’s supreme court says so. If one is considering a type of suit, such as a nontraditional environmental liability claim that a court finds to be barred by the absolute pollution exclusion, the insurer never had any obligation to defend or indemnify.

Even if the carrier thinks the case should not be covered in such circumstances, until there is a court ruling declaring no coverage it risks (i) being held liable for breach of contract and prejudgment interest and (ii) being found to have acted in bad faith (though if its construction were reasonable, even if wrong, it won’t be found to have failed to perform in bad faith, see Marc S. Mayerson, “First Party” Insurance Bad Faith: Mooring Procedure to Substance, 38 Tort Trial & Ins. Prac. J. 861 (2003), available at http://www.spriggs.com/news/pdfs/MSM-31.pdf)). Moreover, where the carrier refuses to defend and that determination was wrong, it may also be found liable for third-party bad faith if it fails to settle a case that is covered and its unreasonable failure to settle proximately causes a verdict in excess of policy limits.

Accordingly, insurers may elect to defend initially and concurrently litigate their defense obligations or wait until the underlying case is over and then try to sort things out in a coverage case. (In some states, like Illinois, the carrier really does not have the luxury of waiting until the underlying case is over because it may be found to have waived its right to deny coverage by not bringing an early declaratory-judgment action.) The insurer will advance a claim that, though it defended, it never had an obligation to do, so it should be able to get its money back from the insured.

Insurance policies do not contain provisions explaining that where an insurer agrees to pay for the defense of a matter that does not potentially implicate indemnity coverage the policyholder will be required to reimburse the carrier. Instead, carriers seek to force such reimbursement, or to recoup their payments, through the help of the courts.

Because the insurance policy itself does not explain what happens when a defense payment is made pendente lite, the insurer must go outside the policy and rely either on (i) a new and separate contract with the policyholder or (ii) principles of equity.

Typically, the separate “contract” insurers cite is the reservation-of-rights letter sent in response to the policyholder’s notice of claim; this letter will identify the grounds that potentially apply to bar coverage, but nevertheless states the insurer will provide the defense, subject to its “right” of reimbursement. This now- boilerplate language is interpreted by some courts as establishing a new agreement whereby following the reservation-of-rights letter the policyholder’s acceptance of the defense is an acceptance of the reimbursement term. Some courts have found such agreement by the policyholder simply from the policyholder’s allowing the carrier to defend, and indeed some courts have found such an agreement even where the policyholder has objected to the insurer’s reservation of a reimbursement right but allowed the insurer to defend. This is what the Montana Supreme Court held, at least where the policyholder did not expressly object at the time to the claim for reimbursement. See RIBI, slip op. at 20 (“Ribi implicitly accepted Traveler’s defense under a reservation of rights when it posed no objections.”).

For a contractual relationship otherwise governed heavily by state regulation, it is surprising indeed that courts find an new contract created by the insurer’s stating in a lengthy letter that it “reserves” its right to reimbursement, especially in the absence of a writing confirming the policyholder’s promise to repay. Of course, where a court finds an “implied” agreement one understands that it is really imposing an agreement – the best evidence of which is the fact that the policyholder is litigating the reimbursement issue. (Obviously, if the policyholder thought it had agreed to reimburse the carrier there would be no litigation on this point.) But the court’s imposing this arrangement on policyholders does not have a sound analytical foundation: the court is seeking to protect carriers and avoid “unjust” enrichment of the policyholder – though carriers could easily protect themselves by writing provisions into their policies allowing for reimbursement rather than relying on courts to impose such an implied reimbursement agreement by a post-policy letter.

The Illinois Supreme Court refused to find such an implied agreement to reimburse: “As a matter of public policy, we cannot condone an arrangement where an insurer can unilaterally modify its contract, through a reservation of rights, to allow for reimbursement of defense costs in the event a court later finds that the insurer owes no duty to defend.”

The absence of a satisfactory contract law basis for a recoupment claim leads to the argument that at equity the carrier should be able to recoup its money on the grounds that it would be inequitable to allow the policyholder to keep the benefit conferred by the carrier that was never owed in the first place. But if the carrier never had an obligation, assuming the carrier was not seeking to waste corporate assets, one can presume that the carrier undertook the defense to protect its own interests – notably, the avoidance of a bad-faith claim cast against the backdrop of legal uncertainty of its coverage obligations or helping to ensure that the underlying claim is defended appropriately. As the Illinois court held: “We agree that when an insurer tenders a defense or pays defense costs pursuant to a reservation of rights, the insurer is protecting itself at least as much as it is protecting its insured. Thus, we cannot say that an insured is unjustly enriched when its insurer tenders a defense in order to protect its own interests, even if it is later determined that the insurer did not owe a defense.”

Once it is clear that the carrier has a dog in the fight – that it is acting to protect its own interests – then the calculus at equity changes considerably, because equity typically will not intervene if one pays money in the teeth of a legal dispute or is seeking to protect one’s own interest (even if the payment is disproportionate). Moreover, that the carrier is facing a potential bad-faith claim if it were to deny coverage incorrectly is not sufficient to render its payment involuntary (since voluntary payments are not recoverable via equity). See Genesis Ins. Co. v. Wausau Ins. Co., 343 F.3d 733 (5th Cir. 2003).

The way to balance the insurer’s interest in not paying for uncovered claims, the policyholder’s interest in obtaining a complete defense, and both side’s interests in having insurance promptly perform is to require insurers to write into their contracts a right to reimbursement. In this way, policyholders can elect to purchase a policy with a reimbursement provision or not and state insurance commissioners can determine whether or not to approve such policies. The question in these cases is whether action at the point of claim can create a reimbursement right. The Illinois Supreme Court, following other courts, such as the Third Circuit and the Wyoming Supreme court said no: “Certainly, if an insurer wishes to retain its right to seek reimbursement of defense costs in the event it later is determined that the underlying claim is not covered by the policy, the insurer is free to include such a term in its insurance contract.” Montana allows an insurer to stand silent at the point of sale but to unilaterally reserve a right to reimbursement at the time the policyholder needs to turn to its coverage or potential coverage. Were the Illinois approach followed, insurance regulators could monitor reimbursement provisions, and policyholders could elect to purchase policies from carriers that do not include such provisions. For now, however, as with so many other issues, the question of reimbursement of defense costs will continue to be fodder for litigation.

Posted by Marc Mayerson at 4:16 PM | Comments (0) | TrackBack