THE RIGHT TO INDEPENDENT COUNSEL

California law requires an insurance company to provide “independent counsel” when the attorney assigned to defend a lawsuit has a conflict of interest. This right is often overlooked or misunderstood.

In the landmark case of San Diego Navy Fed. Credit Union v. Cumis Ins. Society, Inc. (1984) 163 Cal. App. 3d 358, the court found that the insurance company’s reservation of rights to deny coverage for intentional torts created a conflict of interest requiring the appointment of independent counsel. When a conflict of interest arises, control of the litigation must be given to the policyholder.

The determination of whether a conflict of interest is governed by considerations which apply when a lawyer represents multiple clients. A conflict of interest between jointly represented clients occurs “whenever their common layer’s representation of one is rendered less effective by reason of representation of the other”. Spindle v. Chubb/Pacific Indem. Group, 89 Cal. App. 3d 706, 713(1979). Thus, a conflict of interest has been found in these circumstances:

• The insurance company has denied coverage for indemnification. Tomerlin v. Canadian Indem. Co., 61 Cal. 3d 638 (1964)( the insurance company has no stake in reducing liability); Three Sons, Inc. v. Phoenix Ins. Co., 357 Mass. 271, 276, 257 N.E. 2d 774 (1970).
• The insurance company insures several policyholders with conflicting claims against each other. O’Morrow v. Borad, 27 Cal. 2d 794, 800 (1946)
• The insurance company seeks to settle the underlying claim for an amount in excess of policy limits, using the policyholder’s money to do so, without the consent of the policyholder. Golden Eagle Ins. Co. v. Foremost Ins. Co., 20 Cal. App.4th 1372, 1396 (1993)
• The insurance company has a direct incentive to have its counsel develop facts that would lower the coverage amount. Scottsdale Ins. Co. v. Housing Group, 1995 U.S. Dist. LEXIS 8791 * 11 & *12 (N.D.Cal. 1995).
• There is a dispute whether the work in question was performed by an employee (covered) or an independent contractor (not covered). Schaefer v. Elder, 217 Cal. App. 4th 1 (2013); Bethlehelm Construction Inc. v. Transportation Ins. Co., 2006 U.S. Dist. LEXIS 70257 (E.D.Wash. 2006).
• There is a reservation of rights for the “sudden and accidental pollution exclusion”. Federal Ins. Co. v. MBL, Inc., 219 Cal. App. 4th 29, 44 (2013)(“this type of exclusion creates a conflict of interest since the appointed counsel would have an interest in developing facts establishing that any discharge of pollutants by MBL was neither sudden nor accidental”).
• There is a reservation of rights on the “no voluntary payments clause” because the appointed counsel would have an incentive to control the outcome of the factual determination on this issue. Extradition Transp. Of Am., LLC v. Houston Cas. Co., 2014 U.S. Dist. LEXIS 188668 (C.D.Cal. 2014)
• There are claims for damages (covered) and penalties (not covered). Appointed counsel could structure a settlement to favor penalties. Extradition Transport, supra.
• The characterization of facts will help one client or hurt the other. Executive Aviation, Inc. v. National Ins. Underwriters, 16 Cal. App. 3d 799, 809 (1971)(whichever position the attorney took on the commercial nature of the flight would help or hurt one client or the other).
• There is coverage for negligent acts but not intentional acts. All-Star Ins. Co. v. Steel Bar, Inc., 324 F. Supp. 160, 165 (N.D.Ind. 1971); Fireman’s Fund Ins. Co. v. Waste Management of Wisconsin, Inc. 777 F.3d 366, 368-369 (7th Cir. 1985)( negligent v. intentional acts of contaminating groundwater)
• The reservation of rights on the “expected or intended” exclusion and definition of “occurrence” impact the allocation of remedial costs in an environmental case. Armstrong Cleaners, Inc.v. Erie Ins. Exchange, 364 F. Supp. 2d 797 (S.D.Ind. 2005).
• Defense provided under “defense within limits” (“burning limits”) policy.

  In “burning limits”policies, defense expenses and fees reduce the indemnity limits available to the insured. Every dollar of defense costs paid by the insurance company reduces the limits available to pay a judgment or settlement. Although there is no specific case that has been found on this point, there is an inherent conflict of interest here and most insurance companies will advise the policyholder of the right to independent counsel. It is in the insurance company’s interest to “burn” the policy limits by running up defense costs, so as to exhaust the limits of the policy and therefore terminate all duties owed by the insurance company; while it is in the interest of the policyholder to minimize and conserve defense costs, in order to preserve the indemnity limits to pay for a settlement or judgment.

  If the insurance company appoints defense counsel, that counsel has a conflict of interest every time there is a decision to spend a single dollar on defense costs. This situation is commonly found in malpractice policies that insure lawyers, engineers, architects, and other professionals. It has not been unheard of for defense counsel to “burn” the limits of the policy in defending the case, leaving very small limits left to settle the case. That counsel is potentially exposed to a malpractice claim by the policyholder who may be left in the lurch, especially if the policyholder lacks personal finances to add necessary funds to settle the case.

  Suppose, for example, the policy limits are $1 million and defense counsel, appointed by the insurance company, incurs $600,000 in defense costs. The limits available for settlement are now reduced to $400,000. The claimant makes a reasonable settlement demand to settle for $600,000. The policyholder must fund the difference of $200,000 to settle; or else, face continued litigation and the prospect of a verdict for $600,000. Continued litigation to verdict, let us assume, will be an additional $100,000, which will reduce the limits available to pay that judgment to $300,000.

  Thus, the insurance company (and its appointed counsel) have placed the policyholder in the situation of having to come out of pocket to settle the case or pay a judgment. That defeats the purpose of insurance and presents a conflict of interest. The insurance company has invited a lawsuit for bad faith and the appointed attorney has invited a lawsuit for malpractice.

  In this situation, the policyholder must be afforded independent counsel. Then the policyholder makes the decision what defense costs to incur and when to incur them. The inevitable conclusion is that the prudent policyholder will ordinarily want to preserve the limits for settlement, rather than defense. The incentive is to settle at the earliest moment, before the limits are used up in defense.

Caifornia Civil Code Section 2860 and Conflicts of Interest.
California enacted Civil Code section 2860 in response to the Cumis decision. The statute reaffirms the right to independent counsel when there is a conflict of interest between an insurance company and its policyholder and sets for the certain provisions that govern the relationship between the policyholder, the insurance company, the appointed counsel and the independent counsel. Section 2860 (b) reaffirms Cumis by providing that there is a conflict of interest when the counsel appointed by the insurance company can affect the outcome of the underlying case. The statute does not go beyond that and list all of the circumstances in which conflicts of interest.

Thus, the statute does not control the determination of what is a conflict of interest. See Golden Eagle Ins. Co. v. Foremost Ins. Co., supra.

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3.09 RESERVATION OF RIGHTS TO SEEK REIMBURSEMENT OF DEFENSE COSTS AND CONFLICTS OF INTEREST THAT RESULT
There is a split in the case authority as to whether an insurance company may sue the policyholder to recover defense costs. Compare Buss v. Superior Court, 16 Cal. 4th 35 (1997) with Great American Assurance Co.v. PCR Venture of Phoenix, LLC, 161 F. Supp. 3d 778 (D. Ariz. 2015)(Arizona law, unlike California law, does not permit reimbursement; collecting authorities)

In Buss v. Superior Court, the California Supreme Court held that in a “mixed’ action, in which some claim are potentially covered and some are not potentially covered, the insurance company must defend the action in its entirety, including those claims for which there is no potential for coverage under the policy. The Court also ruled that the insurance company has an “implied-in-law” right to be reimbursed for those defense costs which are allocable solely to claims that are not even potentially covered. In seeking such reimbursement, the insurance company bears the burden of proving by a preponderance of evidence that the defense costs pertain solely to claims that are not even potentially covered.

Buss did not decide whether the reservation of rights to seek reimbursement itself creates a conflict of interest that requires the appointment of independent counsel. Arguably, such a reservation does require appointment of independent counsel — pursuant to the landmark case of San Diego Federal Credit Union v. Cumis Ins. Society, 162 Cal. App. 3d 358 (1984). That decision confirmed existing law that an insurance company has a duty to provide independent counsel when the insurance company’s reservation of rights to deny coverage creates a conflict of interest. But existing case law, notably James 3 Corp. v. Truck Ins. Co., 91 Cal. App. 4th 1093 ( 2001), has held that Cumis does not require the appointment of independent counsel in this situation. There is a persuasive argument that James 3 was wrongly decided and that a “Buss reservation” requires the appointment of independent counsel because it breaks the bonds of trust beyond attorney and client, beyond repair.

The policyholder is surely placed in peril when the insurance company appoints defense counsel for the policyholder, but reserves its right to sue the policyholder to recover any defense bills incurred by that attorney. The scope and extent of the peril may not even be known to the policyholder when the reservation of rights is sent, typically by letter at the outset of the underlying lawsuit. The policyholder has to be concerned – and rightly so — that every dollar of defense costs billed by the insurance company’s choice of appointed counsel will become the subject of a later lawsuit by the insurance company to recover those very same dollars. However, the ordinary person is helpless to control the situation. The ordinary policyholder has no control over how the appointed defense attorney decides to defend the case, how the attorney incurs expenses, how the attorney bills the insurance company, and how the attorney keeps time records. Yet, allocation of defense costs to covered or non-covered claims will be at the heart of a future lawsuit which the insurance company reserves its right to bring. The appointed defense counsel will likely, if not inevitably, become a witness for the insurance company and against the policyholder when the insurance company seeks reimbursement. How can the ordinary policyholder place trust in the appointed lawyer who may later provide the ammunition for a reimbursement claim brought by the insurance company? The policyholder would of course be much better served to control the situation with the defense provided by independent counsel who represents solely the interests of the insured. Such an attorney would minimize or eliminate the problem of allocating defense resources to non-covered claims and thus would, in turn, undercut the basis for a later lawsuit by the insurance company.

Despite these considerations, James 3 Corp. v. Truck Insurance Company, 91 Cal. App. 4th 1093 ( 2001) held that there is no automatic right to independent counsel in this situation and rejected these very arguments. In the underlying lawsuit, Coca- Cola Company brought suit against James 3 Corporation for selling beverage syrup for use in making drinks known as “slurpees”. Coca-Cola asserted a total of eight causes of action for trademark infringement under the Lanham act, contributory infringement, false designation of origin, California trademark infringement, California statutory unfair competition, common law unfair competition, accounting, and fraud. Truck Insurance Company accepted the defense and appointed counsel to defend the lawsuit. Truck reserved its right to seek reimbursement of attorneys fees and costs paid to defend non-covered claims; informed the policyholder that there was no conflict of interest; and refused to pay for independent defense counsel.

After the policyholder insisted upon appointment of independent counsel, Truck replied that there was no coverage for the fraud claim, for the request for attorneys fees under the Lanham Act, or for claims for restitution and disgorgement. Truck did, however, agree to defend the trademark infringement and related claims without any reservation of rights.

The policyholder argued that a “Buss reservation” always triggers an obligation to appoint independent counsel. The gist of the argument was that the appointed defense counsel decides how to defend the claims, decides how to bill for services, and decides how to allocate charges between covered and non-covered claims – all of which are beyond the control of the insured. In other words, the appointed counsel can determine the outcome of the coverage dispute in this fashion.

The Court of Appeal rejected these arguments and agreed with the trial court that the reservation of rights to seek reimbursement of defense costs allocated to non-covered claims, standing alone, does not constitute a coverage issue, because the allocation of covered and non -covered claims is not an issue that will be litigated in the underlying Coca- Cola action. Furthermore, the court held that there was nothing in the record to suggest that appointed counsel would violate his ethical duties to the insured. Id. at 1108-1109. Thus, the policyholder failed to rebut Truck’s showing that that there was no “actual conflict” of interest which required the appointment of insurer-paid independent counsel.

This decision is deeply flawed. The policyholder was entitled to independent counsel because Truck reserved its rights to deny coverage for an intentional tort –i.e, the claim of fraud. That is the paradigm situation, recognized in the Cumis decision, which requires the appointment of independent counsel where the claimant has alleged an intentional tort. Yet this point – the insurance company’s reservation of rights to deny coverage for fraud — is nowhere recognized, addressed, or analyzed in the James 3 decision. This critical fact is merely noted in passing, but never given any consideration.

The essence of Cumis is that a reservation of rights to deny coverage for an intentional tort creates a conflict of interest between the insurance company and the policyholder. In this situation, the insurer-appointed attorney is faced with irreconcilable and competing interests. A finding that the policyholder is liable for an intentional tort benefits the insurance company because it can then deny coverage on that basis. In contrast, a finding that the policyholder is not liable for intentional misconduct benefits the policyholder because non-intentional acts are covered: “Opposing poles of interest are represented on the one hand in the insurer’s desire to establish in the third party suit the insured’s liability rested on intentional conduct, and thus no coverage under the policy, and on the other hand in the insured’s desire to obtain a ruling…such liability emanated from nonintentional conduct within his insurance coverage.” Cumis, 162 Cal. App. 3d at 364 (internal quotations omitted). Cumis thus found that the insurer- appointed attorney, however ethical and well-intentioned, can control the outcome of the coverage dispute by the manner in which the defense is conducted. The court found that the attorney may well be tempted to favor one client (the insurance company ) – because it is the source of business — over the other client (the policyholder) , who is not going to be a repeat customer. Id. at 365. The mere possibility of this preference – without proof that the attorney act did in fact actually favor the insurance company – is at the heart of the conflict of interest. The attorney was placed in the situation where a conflict of interest necessarily arose by virtue of the reservation of rights.

Cumis involved a reservation of rights for intentional breach of contract and intentional infliction of emotional distress. The key is the reservation of rights for intentional conduct, which created the conflict of interest over coverage. Thus, the reservation of rights for fraud, asserted by the insurance company in James 3, required the appointment of independent counsel under the logic and reasoning of Cumis. Independent counsel was required, without even reaching the issue of the Buss reservation of rights for reimbursement. The James 3 decision inexplicably ignored and glossed over this essential point. It might be said, therefore, that the remainder of the case is pure dicta, because the court ruled on an issue that it never should have addressed in the first place.

This glaring omission then led to a second flaw, which appears to be the holding of the case: “the allocation of defense costs between covered and non-covered claims is not an issue that will be litigated in the underlying case.” James 3, 91 Cal. App. 3d at 1108-1109. This point is simply a truism that does not address or eliminate the conflict of interest. See Cumis at 364: “Although issues of coverage under the policy are not actually litigated in the third party suit, this does not detract from the force of these opposing interest as they operate on the attorney selected by the insurer who has a dual status.”. The lawsuit by the claimant against the policyholder will never concern the issue of how the appointed defense counsel apportions defense costs between covered and non-covered claims. James 3 nevertheless presupposes that the coverage dispute must be an issue that is litigated in the underlying case. That is not so. There are all sorts of conflicts of interest that are not “litigated” in the underlying case. See, e.g., Golden Eagle Ins. Co. v. Foremost Ins. Co., 20 Cal. App. 4th 1372 (1993)(conflict of interest where insurance company sought to settle the underlying case for amounts in excess of policy limits, thereby using the policyholder’s money to do so without the policyholder’s consent; that issue was not litigated in the underlying tort action, which concerned injuries arising from a mobile home park).

The James 3 decision contains a third flaw in emphasizing that there was no evidence presented that the insurer-appointed attorney had yet done anything unethical. The implication here is that the policyholder must prove that a conflict of interest has already taken place. Such a suggestion is at odds with Cumis, which made the point that the policyholder need not wait until a conflict of interest has already caused harm:

“Cumis makes a distinction between ‘potential’ and ‘actual’ conflicts of interest which is invalid and unworkable. Recognition of a conflict cannot wait until the moment a tactical decision must be made during trial. It would be unfair to the insured and generally unworkable to bring in counsel midstream during the course of trial expecting the new counsel to control the litigation. Contrary to Cumis’ argument, the existence of a conflict of interest should be identified early in the proceedings so it can be treated effectively before prejudice has occurred to either party.” 162 Cal. App. 3d at 370, fn 7. See also Scottsdale Ins. Co. v. Housing Group, 1995 U.S. Dist. LEXIS 8791 at * 10 ( N.D. Cal. 1995)( “an insured such as THG need not wait until counsel retained by the insurer actually takes action detrimental to the insured’s interests before it may move for the appointment of Cumis counsel… Rather Cumis and its progeny require only a specific showing of how the claims conflict could arise”)(emphasis in original).

What should a policyholder do upon receipt of a reservation of rights to seek reimbursement of defense costs? If there is a lesson to be learned from James 3, it must be that the policyholder should create a factual record to support the conflict of interest, even though such a record should be unnecessary. For example, the policyholder should ask the insurer- appointed attorney how, if at all, that attorney is going the diametrically opposed interests on the subject of reimbursement. How does the attorney view the distinction between covered and non-covered claims? Where does the attorney draw the line? Does the attorney recognize a conflict? If so, what is the conflict in the specific facts of the case? What if anything is the attorney going to do about it? Conceivably, the answers to those questions might not only provide grounds for the appointment of independent counsel, but might also be provide grounds for disqualification of the attorney.

Unfortunately, James 3 compels the advisability, if not the outright necessity, of an adversarial relationship between the policyholder and the insurer-appointed attorney.