Conflicts of Interest

Among Liability Insurers, Policyholders, and Dependent Counsel

Introduction

Conflicts of interest among a liability insurer that agrees to defend its policyholder in a third party liability dispute through a common lawyer may ethically disqualify dependent counsel from accepting employment and may require the insurer to pay for independent counsel to control and conduct the policyholder's defense who is selected and directed by the policyholder alone. Two broad fields of conflicts of interest may emerge among a liability insurer that agrees to defend its policyholder in a third party liability dispute through a common lawyer, dependent counsel: 1) insurer-policyholder conflicts; and 2) attorney-client conflicts. Each field of conflicts of interest is governed by different bodies of law, may be resolved at different times, and should be analyzed separately. However ultimately, these two separate analyses may be reconciled that dependent counsel should take the initiative and assume the burden of analyzing potential conflicts of interest, making written disclosure to the insurer and the policyholder, and if appropriate, obtain their informed written consent.

First, insurer-policyholder conflicts of interest may arise whenever they disagree over how much the insurer must pay. Insurer-policyholder conflicts may be created by or they may arise independently of any reservation of rights. Resolution of insurer-policyholder conflicts of interest is: 1) governed by contract law; 2) frequently delayed until after a third party liability dispute is concluded; and 3) suffer a split of authority whether a conflict of interest that requires an insurer to provide independent counsel must be merely potential or must be actual and significant.

Second, attorney-client conflicts of interest emerge whenever the lawyer has a personal interest in the matter or seeks to represent two or more clients with potentially conflicting interests. Resolution of attorney ethical conflicts of interest is: 1) governed by Rules of Professional Conduct, Rule 3-310; 2) must be resolved before the lawyer may ethically start work; and 3) is clearly triggered by merely "potential" conflicts of interest between multiple clients. Dependent counsel's ethical conflicts of interest may arise in one or more of three ways: 1) an insurer/client reserves its rights to deny coverage to a policyholder/client; 2) conflicts between an insurer and its policyholder emerge independently of any reservation of rights; or 3) the lawyer has an interest in the subject matter of the representation. The only way a lawyer may ethically overcome this mandatory prohibition against representation of conflicting interests is for the lawyer to fulfill a non-delegable duty to each client to: 1) analyzes the relevant circumstances and of the actual and reasonably foreseeable adverse consequences to the clients; 2) makes written disclosure to the clients; and 3) obtains the clients' informed written consent.

Despite the differences between these two fields of conflicts of interest, a policyholder may promptly enforce an insurer's duty to pay for independent counsel by making a record of admissible evidence that dependent counsel has some disqualifying conflict of interest. "[T]he Cumis rule is not based on insurance law but on the ethical duty of an attorney to avoid representing conflicting interests."1 Thus in the end, the correct standard to assess conflicts of interest is enunciated in Rule 3-310 - which standard should apply equally to both lawyers and liability insurers.

Definition of Conflict of Interest

The root of California law of conflicts of interest is Biblical. "No one can serve two masters. Either you will hate the one and love the other, or you will be devoted to the one and despise the other."2 In the context of liability insurance "[t]he mandatory rule of disqualification in cases of dual representations involving unrelated matters - analogous to the biblical injunction against 'serving two masters' (Matthew 6:24) - is such a self-evident one that there are few published appellate decisions elaborating on it."3

Generally, a "conflict of interest" has been defined as "a conflict between the private interests and the official responsibilities of a person in a position of trust."4 "Conflict of interest occurs when a person charged with looking after the interest of A and B is faced with an option whereby if he makes one choice it will of necessity hurt A and help B, and if he makes the other choice he will of necessity help A and hurt B."5 Specifically, a lawyer has a conflict of interest if "the lawyer's representation of the client would be materially and adversely affected by the lawyer's own interests or by the lawyer's duties to another current client, a former client, or a third person."6 "A conflict of interest exists when a lawyer's duty on behalf of one client obligates the lawyer to take action prejudicial to the interests of another client; i.e., 'when, in behalf of one client, it is his duty to contend for that which duty to another client requires him to oppose."7

Rules of Professional Conduct, Rule 3-310

The Rules of Professional Conduct are adopted by the Board of Governors of the State Bar of California and approved by the Supreme Court of California to regulate professional conduct of lawyers to protect the public and to promote respect and confidence in the legal profession and shall be binding upon all members of the State Bar.8 Rule 3-310 prohibits a lawyer from representing dual clients with potential or actual conflicts of interest or the lawyer has an interest in the matter. While Rule 3-310 does not define nor distinguish "potential" conflicts of interest from "actual" conflicts of interest, it does recognize that a "potential" conflict may mature into an "actual" conflict during a lawyer's representation of dual clients. The Rule bars a lawyer from starting work where dual clients' interests potentially conflict and from starting or continuing work where the clients' interests actually conflict. "A [lawyer] shall not, without the informed written consent of each client: (1) Accept representation of more than one client in a matter in which the interests of the clients potentially conflict; or (2) Accept or continue representation of more than one client in a matter in which the interests of the clients actually conflict."9 The language of Rule 3-310 makes no mention of "hypothetical", "theoretical", or "significant" conflicts of interest.

Rule 3-310 specifies only one way the a lawyer may overcome the otherwise absolute ban on representing conflicting interests. The lawyer may accept the burden of initiating an analysis of potential and actual conflicts of interests, making written disclosure to both clients, and obtaining their informed written consent. While no comparable ethical mandate applies directly to insurers, a liability insurer that reserves its rights to later deny coverage to its policyholder is required by insurance regulations to make disclosure to its policyholder of its obligation to pay for independent counsel. Because a liability insurer's duty to pay for independent counsel is derivative of its dependent counsel's prohibition against representing conflicting interests, the exact same standard should apply to insurers that applies to their lawyers.

The Difference Between "Potential" and "Actual" Conflicts of Interest

"A conflict of interest is potential if there is no present actual conflict of interest, but there is a possibility of an actual conflict arising in the future, resulting from developments that have not yet occurred or facts that have not yet become known."10 While Rule 3-310 recognizes that conflicts of interest may be "potential" or "actual" and implies that an actual conflict of interest may develop after a potential conflict of interest has been recognized, the Rule does not define either modifying word. A proposed revision for Rule 3-310 (new rule 1.7) drops these modifiers altogether. The landmark Cumis case states that "a distinction between 'potential' and 'actual' conflicts of interest is invalid and unworkable."11

A Panoply of Judicial Modifiers of Conflicts of Interest

One might assume that judicial interpretation of Rule 3-310 would follow well established rules of statutory construction. "We begin with the fundamental rule that our primary task is to determine intent. To determine intent, [t]he court turns first to the words themselves for the answer. If the language is clear and unambiguous there is no need for construction, nor is it necessary to resort to indicia of the intent of the Legislature."12

Strangely, some California courts have read modifiers into various interpretations of Rule 3-
310. One court stated in dicta: "A mere possibility of an unspecified conflict does not require independent counsel. The conflict must be significant, not merely theoretical, actual, not merely potential."13 This court offered no logical analysis nor valid precedence for adding "significant, not merely theoretical" qualifiers to a conflict of interest analysis, but this dicta has spawned an entire line of following cases, none of which analyze the wisdom of applying a legal test that fails to adhere the language of Rule 3-310.14 Another recent case adds "a mere hypothetical conflict" to the analytical mix. The court assessed its task to be whether dual clients "had, at a minimum, a potential conflict of interest. In doing so, we recognize that a mere hypothetical conflict is insufficient. Rather, there must be some identifiable potential conflict [which has been interpreted] to mean a reasonable likelihood an actual conflict will arise' [or] to mean "a reasonably foreseeable set of circumstances which could impair the attorney's ability to fulfill his or her professional obligations to each client in the proposed representation."15

The Recognized Need for Careful Conflict of Interest Analysis

Some courts find that conflict of interest analysis is highly subjective, inconsistent, and unpredictable. "[T]he professional obligations of counsel who represents a liability insurer as well as its insured -- needs clarification."16 "The potential for conflict requires a careful analysis of the parties' respective interests."17 "There is no talismanic rule that allows a facile determination of whether a disqualifying conflict of interest exists. Instead, '[t]he potential for conflict requires a careful analysis of the parties' respective interests to determine whether they can be reconciled . . . or whether an actual conflict of interest precludes insurer-appointed defense counsel from presenting a quality defense for the insured.'"18 "Any lawyer who attempts to represent two adverse masters places himself in a precarious, perilous position. [Rules of ethics] are distilled principles of ancient, time-honored, and judicially-enforced conduct on the part of lawyers in representing clients. Without them our system of justice would be doomed. It hardly needs to be added that no insurance policy can validly diminish a lawyer's duty to his insured client. In sum, the ethical dilemma thus imposed upon the carrier-employed defense attorney would tax Socrates."19

Elements of a Proper Analysis of Conflicts of Interest

The opinion in Montrose II offers the following analysis of how trial courts should approach resolving coverage contests that often spawn conflicts of interest: "[T]he trial court must determine: (2) Of those that are still pending, what issues remain to be decided and when will that happen? (3) Which defenses to coverage (whether pleaded as affirmative defenses or raised by general denials) do each of the carriers intend to pursue as to each of the underlying actions? (4) What facts have to be determined to reach the merits of the carriers' defenses? (5) What other facts, if any, are relevant to the determination of prejudice [to the policyholder's defense by resolving coverage issues]? (6) Who has the burden of proof? [T]he trial court needs declarations from the attorneys representing [the policyholder] in the [liability] cases, copies of dispositive orders, judgments and trial schedules, and a statement from each of the carriers listing the defenses to be pursued and the issues to be litigated as part of those defenses. Then and only then can the court determine whether the issues overlap and make the type of detailed findings needed for meaningful appellate review."20

Broad reservations of rights almost always create disqualifying conflicts if coverage may be denied based on issues of substance in the third party liability suit. "Of course, the insurer may have more than one defense to coverage. In that event, the trial court will need to consider each defense separately to decide whether it can be determined without prejudice to the insured and whether it is amenable to resolution by summary judgment or summary adjudication."21

Judicially Recognized Conflicts of Interest

A liability insurer's assertion of a reservation of rights is merely one of the many ways in which conflicts of interest may emerge among a liability insurer, its policyholder, and their common dependent counsel. California courts have emphasized that two primary fiduciary duties are invoked by potential conflicts of interest. "A court may disqualify an attorney upon a showing that disqualification is required under professional standards governing avoidance of conflicts of interest or potential adverse use of confidential information. An attorney bears two distinct ethical duties to a client: (1) a duty of loyalty, whereby an attorney devotes his or her entire energies to his client's interests, and (2) a duty of confidentiality, which fosters full and open communication between client and counsel."22

Several California courts have sought to chronicle the many ways in which conflicts have arisen. "Conflicts [of interest] come in all shapes and sizes. The following list, by no means exhaustive, illustrates circumstances giving rise to a conflict: (1) counsel has divided loyalty between current client and former clients; (2) counsel has acquired a pecuniary interest which is adverse to the interests of the client; (3) unpaid fees to counsel may result in the sacrifice of important client rights; (4) there exists a romantic relationship between counsel and client; (5) there is a conflict between the interest of the insurer and the insured which in turn creates a conflict for counsel hired by the insurer to represent the insured; (6) client tells counsel that he intends to give perjured testimony at trial; (7) there has been an irreparable breakdown of the working relationship between counsel and client; (8) counsel plans to take on the role as a witness; (9) there have been settlement negotiations in which attorney's fees are recoverable apart from the amount sought for damages."23

"Some of the circumstances that may create a conflict of interest requiring the insurer to provide independent counsel include: (1) where the insurer reserves its rights on a given issue and the outcome of that coverage issue can be controlled by the insurer's retained counsel; (2) where the insurer insures both the plaintiff and the defendant; (3) where the insurer has filed suit against the insured, whether or not the suit is related to the lawsuit the insurer is obligated to defend; (4) where the insurer pursues settlement in excess of policy limits without the insured's consent and leaving the insured exposed to claims by third parties; and (5) any other situation where an attorney who represents the interests of both the insurer and the insured finds that his or her representation of the one is rendered less effective by reason of his [or her] representation of the other.'"24

The Cumis Rule25 focuses upon only one of these identified bases of conflict. "[W]hen coverage is disputed, the interests of the insured and the insurer are always divergent. The attorney should not be placed in the position of divided loyalties. Such an arrangement would be adverse to the best interests of the insured, the insurer, the attorney, and the profession. [O]nce the insurer decides to assert a coverage defense, the same attorney may not represent both the insured and the insurer."26

Synergism of Attorney-Client and Insurer-Policyholder Conflicts of Interest

The landmark Cumis case makes a two part - cause and effect holding, if-then - holding that merges the relationship between insurer-policyholder conflicts of interest and attorney-client conflicts of interest. If attorneys cannot ethically represent dual clients with potentially conflicting interests, then a reserving insurer must discharge its promise to defend the policyholder by paying for independent counsel (selected and directed by the policyholder alone) to conduct 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, counsel must cease to represent both. Moreover, divergent interests brought about by the insurer's reservation of rights [require that] 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."27

California law governing conflicts of interest between a liability insurer and its policyholder is distinct from the law governing conflicts of interest between an attorney and client. However, these two bodies of law are symbiotic since an attorney cannot represent dual clients whose interests conflict and an insurer must provide independent counsel if dependent counsel has unresolved ethically conflicts representing both the insurer and the policyholder.28

1.	Conflicts of Interest Between Liability Insurer and Policyholder

An insurer has fiduciary like obligations to its policyholder, which preclude the insurer from interfering with the policyholder's rights.29 The insurer's fiduciary obligations arise from the contract of insurance, statutes, regulations, and decisional law of bad faith.30 "Bad faith liability may attach when an insurer fails to notify its insured of a conflict of interest.31

In California,32 "not every reservation of rights entitles an insured to select Cumis counsel."33 "A disqualifying conflict exists if insurance counsel had [an] incentive to attach liability to [the insured]."34 "It is only when the basis for the reservation of rights is such as to cause assertion of factual or legal theories which undermine or are contrary to the positions to be asserted in the liability case that a conflict of interest sufficient to require independent counsel, to be chosen by the insured, will arise."35

2.	Conflicts of Interest Between Attorney and Client

"The relation between attorney and client is a fiduciary relation of the very highest character, and binds the attorney to most conscientious fidelity."36 "An attorney's duty of loyalty to a client is not one that is capable of being divided."37 "It is an attorney's duty to protect his client in every possible way. By virtue of this rule an attorney is precluded from assuming any relation which would prevent him from devoting his entire energies to his client's interests."38 California attorney-client conflicts of interest are governed by Rules of Professional Conduct, Rule 3-310.39 An attorney cannot represent two clients whose interests potentially or actually conflict.40 An attorney's fiduciary obligations to a client are governed by a body of law separate from the body of law governing insurers, including the State Bar Act, Rules of Professional Conduct, and decisional law.

An attorney cannot represent two clients whose interests conflict without analyzing the conflict,41 making written disclosure, and obtaining the informed written consent of both clients.42 "The paradigm case requiring independent counsel is one in which the way counsel retained by the insurance company defends the action will affect an underlying coverage dispute between the insurer and the insured."43

Dependent counsel always represents the insurer as a client even though the insurer is not technically a party to the policyholder lawsuit44 and is beholden to the insurer.45 The difference between dependent counsel and independent counsel is that the latter represents only the policyholder. The phrase "dependent counsel" describes the counterpart to "independent counsel." This moniker acknowledges that "[a]s a practical matter . . . in reality, the insurer's attorneys may have closer ties with the insurer and a more compelling interest in protecting the insurer's position, whether or not it coincides with what is best for the insured"46, "[i]nsurance companies hire relatively few lawyers and concentrate their business. A lawyer who does not look out for the Carrier's best interest might soon find himself out of work."47 and "defense counsel and the insurer frequently have a longstanding, if not collegial, relationship".48 "In California, an attorney may usually, under minimum standards of professional ethics, represent dual interests as long as full consent and full disclosure occur."49 Some dependent counsel may incorrectly assert that they are exempt from compliance with Rule 3-310.50 A client who is concerned that dependent counsel may have unresolved conflicts of interest may inquire of the lawyer, who must respond.51 Because dependent counsel are usually reliant upon insurers for their livelihood, some will offer a series of excuses why they have no conflicts of interest, many of which are erroneous.52

"A conflict of interest between jointly represented clients exists whenever their common lawyer's representation of the one is rendered less effective by reason of his representation of the other. [T]he existence of a conflict depends upon the grounds on which the insurer is denying coverage. [W]here the reservation of rights is based on coverage disputes which have nothing to do with the issues being litigated in the underlying action, there is no conflict of interest requiring independent counsel."53

Practice Pointer

The fact that some courts apply two separate standards of law to attorney-client conflicts and liability insurer-policyholder conflicts makes no sense. The Cumis case clearly holds that because dependent counsel cannot represent dual clients with potentially conflicting interests, therefore, a reserving insurer must discharge its contractual promise to defend its policyholder by paying for independent counsel to conduct the policyholder's defense. "The obligation of an insurer to provide independent Cumis counsel for an insured is premised on the ethical inability of an attorney to represent conflicting interests."54 "The Cumis opinion was based heavily on the canons of ethics and the possibly conflicting choices confronting an attorney."55 "Cumis is based on ethical standards, not on insurance concepts."56 "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."57

Thus policyholders and their counsel can and perhaps should argue that only one consistent standard of law should apply to both dependent counsel and to reserving insurers - the standard enunciated by Rule 3-310.