Introduction

Every liability insurer that agrees to defend its policyholder under a reservation of rights to later deny coverage and the insurer’s dependent counsel have an affirmative duty to take the initiative to advise the policyholder of the right to independent counsel. Each must accurately analyze the reservation of rights to determine whether it creates a disqualifying conflict of interest and report the analysis to the policyholder. Dependent counsel must also obtain the policyholder’s informed written consent to representation before starting work.

“[I]n the insurer-insured context, the attorney owes the ‘highest duty’ to [the policyholder] to make a full disclosure to enable the [policyholder] to make a fully informed decision including potential conflict.”[1] “Every insurer shall disclose to a [policyholder] all benefits that might reasonably be payable and cooperate with and assist the insured in determining the extent of the insurer’s additional liability.”[2] Both dependent counsel and a reserving insurer have a duty to advise a policyholder of the right to independent counsel.

Reservation of Rights

A reservation of rights is a conditional denial of the plaintiff’s claim for damages and the policyholder’s claim for a indemnification and a conditional acceptance of the policyholder’s claim for a defense of the liability dispute. Typically, a reservation of rights letter states that the insurer will defend the policyholder but does not concede indemnity coverage and does not waive any ground upon which the insurer may later learn that it is entitled to deny all coverage. A reservation of rights always creates potential conflicts of interest and it creates maddening uncertainty. “[W]hen coverage is disputed, the interests of the insured and the insurer are always divergent.”[3]

Insurers tend to reserve their rights to later deny coverage “in a ‘mixed’ action, in which some of the claims are at least potentially covered and the others are not. To defend meaningfully, the insurer must defend immediately. To defend immediately, it must defend entirely. The ‘plasticity of modern pleading’ allows the transformation of claims that are at least potentially covered into claims that are not, and vice versa.”[4] Insurers often reserve their rights to later deny coverage in business litigation, construction defect, employment, and malpractice cases, as well as cases in which exclusions or other limitations on coverage may or may not apply.

Insurance regulations require liability insurers to make a coverage decisions “immediately”. “Upon receiving proof of claim, every insurer shall immediately, but in no event more than forty (40) calendar days later, accept or deny the claim, in whole or in part. Where an insurer denies a claim, in whole or in part, it shall do so in writing and shall provide to the [policyholder] a statement listing all bases for such denial and the factual and legal bases for each reason given for such denial which is then within the insurer’s knowledge. Where an insurer’s denial is based on a specific policy provision, the written denial shall include reference thereto and provide an explanation of the application of the provision to the claim.”[5]

A Reservation of Rights Creates Uncertainty

A reservation of rights always produces uncertainty in that it defers coverage decisions until after the liability dispute is resolved. Yet, all the while the liability dispute is being litigated, things are happening that could hurt the policyholder’s coverage, with virtually no reciprocal harm to the insurer’s coverage challenges. Through the conduct of the policyholder’s defense, the policyholder bid to perfect coverage may be undermined by sworn testimony, other admissible evidence, collateral estoppel, res judicata, law of the case, and judicial admissions in the liability suit, all of which may adversely impact the policyholder’s coverage. All this time, the insurer is not giving sworn testimony, is not developing evidence, and may not be bound by res judicata or collateral estoppel because many courts interpret the concept of privity is softly.[6] Insurers often argue persuasively that the whole purpose of a reservation of rights is that it will not be bound by adverse developments in the liability dispute, but that it may use against the policyholder developments that undermine coverage. Courts sometimes allow insurers to reserve their rights at almost any time, fostering uncertainty.[7]

Disqualifying Conflict of Interest

“Conflict of interest between jointly represented clients occurs whenever their common lawyer’s representation of the one is rendered less effective by reason of his representation of the other.”[8] “A disqualifying conflict exists if [i]nsurance counsel had incentive to attach liability to [the insured].”[9] The distinction between reservations of rights which do and do not create disqualifying conflicts of interest is whether any ground upon which the insurer reserves the right to disclaim coverage is related to any disputed issue of fact or law in the third party litigation. While judicial expressions of the concept of a disqualifying conflict of interest are consistent, the nomenclature used is not. Thus, the courts have stated that unless the coverage issues raised by an insurer’s reservation of rights are limited by waiver, factual and legal disputes which are unrelated to,[10] irrelevant to,[11] extrinsic to, independent of,[12] or have nothing to do with[13] or do not overlap[14] the third party litigation, the insurer’s coverage dispute cannot be allowed to prejudice the policyholder’s defense.[15]

“The question of the existence of a conflict is a question of law unless there is a dispute over an underlying fact.”[16] “In the absence of dispute over some underlying fact, the existence of a conflict is a question of law for the trial judge to decide, not a jury question.”[17] Civil Code § 2860 does not preclude judicial determination of actual presence or absence of conflict.[18]

Cumis Rule

When a liability insurer issues a reservation of rights that creates a disqualifying conflict of interest, dependent counsel must comply with Rule 3-310, and failing such compliance, the insurer must pay for independent counsel selected and directed by the policyholder to control the defense. “Canons of Ethics impose upon lawyers hired by the insurer an obligation to explain to the insured and the insurer the full implications of joint representation in situations where the insurer has reserved its rights to deny coverage. If the insured does not give an informed consent to continued representation, counsel must cease to represent both. Moreover, in the absence of such consent, where there are divergent interests of the insured and the insurer brought about by the insurer’s reservation of rights based on possible noncoverage under the insurance policy, the insurer must pay the reasonable cost for hiring independent counsel by the insured. The insurer may not compel the insured to surrender control of the litigation.”[19]

Regulatory Duty to Advise of Additional Benefits

A benefit of a liability policy is the right to have independent counsel control the policyholder’s defense at the insurer’s expense. Liability insurers are required by regulation to disclose to a policyholder the right to have independent counsel within 15 days. “Every insurer shall disclose to a [policyholder] all benefits that may apply to [a first party claim for defense]. When additional benefits might reasonably be payable under an insured’s policy, the insurer shall immediately communicate this fact to the insured and cooperate with and assist the insured in determining the extent of the insurer’s additional liability.”[20] “Upon receiving notice of [a first party claim for defense], every insurer shall immediately, but in no event more than fifteen (15) calendar days later provide to the [policyholder] instructions, and reasonable assistance.”[21]

Statutory Duty to Disclose Material Facts

Insurance Code § 332 provides: “Each party to a contract of insurance shall communicate to the other, in good faith, all facts within his knowledge which are or which he believes to be material to the contract and as to which he makes no warranty, and which the other has not the means of ascertaining.”[21a] Arguably, an insurer has a statutory duty to disclose to a policyholder the existence of policy benefits that may be payable, such as fees of independent counsel, because the policyholder has no means of ascertaining this right without hiring an attorney.

Policy Provisions Granting Control of the Defense to an Insurer Does Not Govern Dependent Counsel

While the relationship between a liability insurer and its policyholder is governed by contract law, the relationship between dependent counsel and a policyholder/client is not. Instead, the later relationship is governed by Canons of Ethics. “It hardly needs to be added that no insurance policy can validly diminish a lawyer’s duty to his insured client.”[22] “[A]ny policy, arrangement or device which effectively limits, by design or operation, the attorney’s professional judgment on behalf of or loyalty to the client is prohibited by the Code, and, undoubtedly, would not be consistent with public policy.”[23]

Dependent Counsel’s Duty of Disclosure

In addition to the Cumis Rule, stated above, that dependent counsel must “explain to the insured and the insurer the full implications of joint representation in situations where the insurer has reserved its rights to deny coverage”, Rule 3-310(B)(4) requires that a lawyer “shall not accept or continue representation of a client without providing written disclosure to the client where: The [lawyer] has or had a financial interest in the subject matter of the representation.” Since disclosure to the policyholder of the right to independent counsel often results in dependent counsel losing work, this ethical obligation may be invoked.

A Liability Insurer May Be Held Liable for Wrongful Acts of Dependent Counsel

“[A]n insurer can be held vicariously liable for the acts or omissions of an attorney hired to represent an insured when those acts or omissions were directed, commanded, or knowingly authorized by the insurer. Nevertheless, when the insurer does undertake to exercise actual control over the actions of the insured’s attorney, then it may be held vicariously liable for any harm to a plaintiff proximately caused thereby.” [W]e simply cannot ignore the practical reality that the insurer may seek to exercise actual control over its retained attorneys in this context. While this practical reality raises significant potential for conflicts of interest, it does not become invidious until the attempted control seeks, either directly or indirectly, to affect the attorney’s independent professional judgment, to interfere with the attorney’s unqualified duty of loyalty to the insured, or to present a reasonable possibility of advancing an interest that would differ from that of the insured. To be clear, [we do] not condone this practice. Accordingly, we hold that an insurer can be held vicariously liable for the acts or omissions of an attorney hired to represent an insured when those acts or omissions were directed, commanded, or knowingly authorized by the insurer.”[24]

^[1] Betts v. Allstate Ins. Co. (1984) 154 Cal.App.3d 688, 716 (ellipses omitted).

^[2] Cal. Code. Regs. § 2695.4(a) (ellipses omitted).

^[3] San Diego Navy Fed. Credit Union v. Cumis Ins. Society, Inc. (1984) 162 Cal.App.3d 358, 375 (Cumis).

^[4] Buss v. Superior Court (1997) 16 Cal.4th 35, 47-49 (Buss) (citations and ellipses omitted).

^[5] Cal. Code Regs. § 2695.7(b)(1) (emphasis added, ellipses omitted).

^[6] Res Judicata – Collateral Estoppel – Law of the Case

^[7] There Is No Deadline to Deny Coverage.

^[8] Spindle v. Chubb/Pacific Indemnity Group (1979) 89 Cal.App.3d 706, 713.

^[9] Gulf Ins. Co. v. Berger, Kahn, Shafton, Moss, Figler, Simon & Gladstone (2000) 79 Cal.App.4th 114, 131 (ellipsis omitted).

^[10] “[C]overage hinges on factual issues that are unrelated to the issues in the third party liability action,” (Montrose Chemical Corp. v. Superior Court (1993) 6 Cal.4th 287, 305.)

^[11] “Accordingly, the question before us is whether the coverage questions are logically unrelated (that is, irrelevant) to the issues of consequence in the (third party litigation which might) prejudice [the insured] in the underlying actions”. (Montrose Chemical Corp. v. Superior Court (Canadian Universal Ins. Co.) (1994) 25 Cal.App.4th 902, 909 (Montrose II).)

^[12] No prejudice “where the coverage issue is ‘independent of, or extrinsic to, the issues in the underlying action.’” (Gafcon, Inc. v. Ponsor & Associates (2002) 98 Cal.App.4th 1388, 1422.)

^[13] “[W]hen the reservation of rights is based on coverage disputes that have nothing to do with the issues being litigated in the underlying action . . . there is no conflict of interest.” (Long v. Century Indemnity Co. (2008) 163 Cal.App.4th 1460, 1470.)

^[14] United Enterprises, Inc. v. Superior Court (2010) 183 Cal. App. 4th 1004, 1010, (“[B]ecause factual issues to be resolved in the declaratory relief action overlap factual issues to be resolved in the underlying actions, the court was required to issue the stay.”)

^[15] Montrose II, supra, 25 Cal.App.4th at 909.

^[16] Clarendon Nat’l Ins. Co. v. Insurance Co. of the West, 442 F. Supp. 2d 914, 943 (E.D. Cal. 2006)

^[17] Blanchard v. State Farm Fire & Casualty Co. (1991) 2 Cal.App.4th 345, 350.

^[18] United States Fid. & Guar. Co. v. Superior Court (1988) 204 Cal.App.3d 1513, 1525.

^[19] Cumis, supra, 162 Cal.App.3d at 375.

^[20] Cal. Code. Regs. § 2695.4(a) (ellipses omitted).

^[21] Cal. Code. Regs. § 2695.5(e)(2) (ellipses omitted).

[21a] Ins. Code § 332; see also, Pastoria v. Nationwide Ins. (2003) 112 Cal.App.4th 1490

^[22] Hartford Acc. & Indem. Co. v. Foster 528 So.2d 255, 269 (Miss. 1988).

^[23] Givens v. Mullikin Ex Rel. McElwaney, 75 S.W.3d 383, 394 (Tenn. 2002)

^[24] Id. at 395-96.