Disqualifying Conflicts of Interest

Preamble

"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."1

Introduction

A liability insurer's reservation of rights2 always3 creates some conflict of interest4 with its policyholder. By definition, a reservation of rights is a declaration by the insurer that it does not want to pay and instead it wants its policyholder to pay. Creating uncertainty as to who must pay always results in tension between the insurer and the policyholder. "An insurer's reservation of rights may create a disqualifying conflict of interest requiring the insurer to pay the cost of Cumis counsel to represent the insured in the underlying action."5

Conflicts of interest between the policyholder and the insurer creates closely related attorney-client conflicts of interest for dependent counsel, who represents both the insurer and the policyholder. However, these two sets of conflicts are governed by separate, but symbiotic bodies of law.6

While a reservation of rights always creates some conflict of interest,7 "not every reservation of rights entitles an insured to select Cumis counsel."8 Instead, a disqualifying conflict of interest that compels the insurer to pay for independent counsel arises whenever a disputed issue of fact or law being litigated in the plaintiff's lawsuit is related to any coverage issue.

Insurers Cannot Lawfully Discharge the Promise to Defend

Liability insurance policies usually include an express promise to defend, but even absent such an express promise, an "indemnity against . . . liability . . . embraces the costs of defense against such . . . liability."9 However, ironically the insurer cannot itself lawfully discharge its duty to defend because the insurer is not licensed to practice law.10 Thus, the insurer cannot directly defend the policyholder in a lawsuit. Instead, it must delegate its promise to defend to a attorney who is licensed to appear in court on behalf of the policyholder-client. As a result, conflicts of interest between the insurer and the policyholder become inextricably intertwined with conflicts of interest between dependent counsel and the policyholder/client. Since an attorney cannot represent dual clients whose interests potentially conflict, an insurer must provide independent counsel if dependent counsel has unresolved ethically conflicts representing both the insurer and the policyholder.11

The Cumis Rule Links Attorney Conflict to Insurer Conflicts

Insurer-policyholder conflicts of interest are rooted in the policy contract while attorney-
client conflicts are derived from the Rules of Professional Conduct. A leading case eloquently enunciates its two part, if-then, holding. If dependent counsel has any ethical conflict of interest, then the insurer must provide independent counsel.

"We conclude the 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 (citations). Disregarding the common interests of both insured and insurer in finding total nonliability in the third party action, the remaining interests of the two diverge to such an extent as to create an actual, ethical, conflict of interest warranting payment for the insureds' independent counsel."12

Rule 3-310

The Cumis rule is based on attorney ethics13 governing an attorney's joint representation of clients with potential conflicts of interest. The applicable ethical standard is stated in Rule 3-310 which requires an attorney to analyze potential conflicts14, make written disclosure to and obtain the informed written consent of both the insurer and the policyholder before the lawyer may accept or continue representation of dual clients with potentially conflicting interests.

In order to make the written disclosure required by Rule 3-31015, dependent counsel has a "a duty . . . to disclose potential conflicts of interest between" to the insurer and the policyholder.16 "[L]awyers hired by the insurer [have] 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."17

The "Nothing To Do With" Test

"[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, and no duty to appoint independent counsel."18

The conflict issue can be posed in the following terms: Is the insurance defense counsel in a position where he or she can shepherd the case in a way that favors the interests of the insurer over those of the policyholder? If the answer is "yes", then the insurance defense counsel has a conflict of interest that obligates him or her to obtain the informed written consent of each affected client before accepting or continuing the representation.19

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 a disqualifying conflict of interest exists unless factual or legal disputes are unrelated to,20 have nothing to do with,21 are irrelevant to,22 extrinsic to, independent of,23 or do not overlap24 issues in the third party litigation. A rationale for this rule is that a coverage dispute cannot be allowed to prejudice the policyholder's defense.25

Attorney Conflict Analysis

Nothing in California law renders dependent counsel exempt from compliance with Rule 3-
310.26 "A disqualifying conflict exists if '[I]nsurance counsel had . . . incentive to attach liability to [the insured].'"27 "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."28 "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."29

"The potential for conflict requires a careful analysis of the parties' respective interests."30 "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.'"31

The Civil Code § 2860 Test

Civil Code § 2860 states: "[W]hen an insurer reserves its rights on a given issue and the outcome of that coverage issue can be controlled by counsel first retained by the insurer for the defense of the claim, a conflict of interest may exist."32 The statute does not diminish dependent counsel's ethical duties to a client.33 Instead, the statute expressly affirms that dependent counsel must comply with ethical obligations.34 Civil Code § 2860 codified the Cumis decision.35 The statute enunciates a compatible legal standard, again with different verbiage: "when an insurer reserves its rights on a given issue and the outcome of that coverage issue can be controlled by counsel first retained by the insurer for the defense of the claim, a conflict of interest may exist." However, the statute "does not clearly state when the right to an independent counsel vests."36 Additionally, the code does not apply absent a conclusive determination that the insurer has a duty to defend and that a disqualifying conflict of interest exists.37

Procedures to Determine Conflicts

There are at least ten procedural options by which a policyholder may resolve a dispute whether an insurer's reservation of rights creates a disqualifying conflict of interest: 1) Acquiesce to the insurer; 2) Negotiate while developing evidence of conflicts; 3) Withhold consent and authorization for dependent counsel to represent the policyholder; 4) Resist dependent counsel's motion to withdraw; 5) file a motion in the liability action to disqualify dependent counsel; 6) Sue the insurer for declaratory relief; 7) File a motion to stay a declaratory relief action; 8) File a motion for summary adjudication in a declaratory relief action; 9) Sue the insurer for damages; and 10) Sue dependent counsel for breach of fiduciary duty.38

One reported opinion outlined the following questions to inform a proper conflict of interest analysis: "(1) what is the exact nature of the claims asserted in the underlying action, (2) what defenses to coverage are asserted by the insurers, and to what extent, if at all, are they logically related to the liability issues raised in the underlying action, (3) what factual questions have to be resolved in order to sustain or defeat such defenses, (4) what is the likely nature of the available evidence. . . ."39