Independent counsel often take great interest in exactly how much and how often a policyholder’s liability insurer must pay for independent counsel to defend. Standard liability policies have no language regarding this question and therefore provide no guidance. The statutory measure of how much an insurer must pay is “the costs of defense . . . incurred in good faith, and in the exercise of a reasonable discretion.” The common law measure requires an insurer that fails to defend to pay all costs of defense incurred by the policyholder.
However, Civil Code §2860 provides that as soon as an irrevocable determination is made that [A] a liability insurer has a duty to defend, and [B] a disqualifying conflict of interest exists, then [C] the insurer must provide independent counsel to defend the policyholder, whereupon the insurer may pay a reduced hourly rate.
The Insurer’s Options to Control the Costs of Defense
A Liability insurer has numerous decisions to make that impact the options available to it to control the costs of defense.
An Unconflicted, Performing Insurer May Control Costs By Contract
An unconflicted, performing insurer may control the cost of defense through dependent counsel pursuant to the terms of a contract and its freedom to hire and fire dependent counsel at will. Such control rarely leads to discord or litigation.
A Conflicted, Performing Insurer May Control Costs By Qualifying For Civil Code §2860 Protection
A conflicted, performing insurer may opt to qualify for the protection afforded by Civil Code §2860, which specifies minimum competency requirements for independent counsel, mandatory arbitration of all fee disputes, and an hourly rate limitation. Thus, the statute supplies what common law does not – specific controls over the cost of defense even though the insurer may not control the conduct of the defense. The statute does not limit the policyholder’s right to a vigorous defense nor the insurer’s obligation to pay immediately and entirely.
A Conflicted, Performing, Non-Qualifying Insurer Elects Not To Control Costs
A conflicted, performing insurer that fails to satisfy the first two prerequisites of §2860(a) or waives the protection of the statute, effectively opts out of controlling the costs of defense by contract or by statute. Absent such protection, the insurer must pay all of “the costs of defense . . . incurred in good faith, and in the exercise of a reasonable discretion.”
A Non-Performing Insurer May Not Control Costs
An insurer that wrongfully fails to defend has no right to complain about the costs of defense. Having defaulted on its obligation to provide a defense, it may not enforce contractual provisions that protect a performing insurer. The insurer must pay all of “the costs of defense . . . incurred in good faith, and in the exercise of a reasonable discretion.”
Standard Contract Language
The Insurance Services Office (ISO) drafts standard language for a variety of liability insurance policies that are used widely by the insurance industry. Civil Code §2860(c) “does not invalidate other different or additional policy provisions pertaining to attorney’s fees.” However, most, if not all forms have no language addressing the question of how much the insurer must pay any lawyer who represents a policyholder. Given this void, a statutory standard applies.
The Statutory Measure of Costs of Defense
Civil Code § 2778 provides that “unless a contrary intention appears,” a series of “rules are to be applied” “[i]n the interpretation of a contract of indemnity.” Subsection 3 provides: “An indemnity against . . . liability . . . embraces the costs of defense against . . . incurred in good faith, and in the exercise of a reasonable discretion.” This language is significant in that it does not require the policyholder to pay independent counsel to recover from the insurer. All that is required is that the policyholder “incur” defense costs. Thus, the terms of a retainer agreement between the policyholder and independent counsel are generally binding on the insurer. However, there is a limit in that independent counsel may not charge or collect an “unconscionable” fee. The insurer may not control the fee arrangement between the policyholder and independent counsel. Civil Code §2778(4) provides that “[t]he [insurer] is bound, on request of the [policyholder], to defend actions or proceedings brought against [the policyholder] in respect to the matters embraced by the indemnity, but [the policyholder] has the right to conduct such defenses, if he chooses to do so.” Also, independent counsel may not establish a direct financial relationship with the insurer without the policyholder’s informed written consent. Moreover, trial counsel must make all litigation decisions.8]
The Common Law Standards of the Costs of Defense
Ironically, an insurer’s promise to defend establishes a commitment that it cannot discharge by itself. Because an insurer is not licensed to practice law, the only way that an insurer can lawfully discharge its promise to defend is to pay for a lawyer to conduct the defense. In order for a liability insurer to faithfully perform its promise to defend, the insurer must “adequately fund” the defense immediately and entirely. “Imposition of an immediate duty to defend is necessary to afford the insured what it is entitled to: the full protection of a defense on its behalf.” “To defend meaningfully, the insurer must defend immediately. To defend immediately, it must defend entirely.”
Insurance is a regulated industry charged with implementing standards for the prompt, fair and equitable payment of claims. Each invoice submitted by independent counsel to a client’s liability insurer constitutes a first party claim for policy benefits. Insurance regulations require “every insurer . . . shall immediately, but in no event more than thirty (30) calendar days later, tender payment.”
An insurer that fails to meet this standard of performance risks breaching the duty to defend. Paying too little “would force the insured to finance his own investigation and the defense of the lawsuit, and then to seek reimbursement in a second lawsuit against the insurance company. This, in turn, could not only impose an undue financial burden on persons who have purchased insurance protection, but it could deprive them of the expertise and resources available to insurance carriers in making prompt and competent investigations as to the merits of lawsuits filed against their insureds.”
Civil Code § 2860 Permits Qualified Insurers to Pay Reduced Hourly Rates
A liability insurer that qualifies may pay independent counsel only the hourly rate that it pays to dependent counsel. “The insurer’s obligation to pay fees to the independent counsel selected by the insured is limited to the rates which are actually paid by the insurer to attorneys retained by it in the ordinary course of business in the defense of similar actions in the community where the claim arose or is being defended.”
In order to qualify for the rate limitation provision, the insurer must satisfy an A + B = C formula specified by the statute. The statute does not apply unless there is a conclusive determination that [A] the liability insurer has a duty to defend, and [B] a disqualifying conflict of interest exists, whereupon [C] the insurer must provide independent counsel to defend the policyholder. This language simply recites the Cumis rule. The A and B elements of this formula may be established by a final court order, a binding stipulation or an irrevocable agreement of the insurer and the policyholder.
If for example, the insurer agrees to provide independent counsel, but reserves its rights to establish either that it has no ultimate duty to defend or that there is not ultimate disqualifying conflict, the insurer does not satisfy the language of the statute. The statute requires a definitive conclusion to each qualifier. “[I]n the absence of a stipulation or unconditional agreement between the insurer and insured, unless and until there has been a judicial determination of an insurer’s duty to defend and the existence of a conflict of interest, the provisions of Civil Code section 2860 are inapplicable.”
As a practical matter, securing an irrevocable agreement that 2860 applies is completely in the insurer’s control. The policyholder will almost always assert that [A] the liability insurer has a duty to defend. If the policyholder contended that the insurer had no duty to defend, the insurer would have no obligation to pay independent counsel! Similarly, the policyholder will almost always assert that [B] a disqualifying conflict of interest exists. Again, if the policyholder contended that no disqualifying conflict of interest existed, the insurer would have no obligation to pay independent counsel! Therefore, if the insurer irrevocably agrees that it has a duty to defend and that a disqualifying conflict exists satisfying the A and B elements of the A + B = C formula. Having done so, then the insurer must provide independent counsel and may pay a reduced hourly rate.
“Any dispute concerning attorney’s fees not resolved by these methods shall be resolved by final and binding arbitration by a single neutral arbitrator selected by the parties to the dispute.” “[T]he California Legislature has spoken. It has decided that within the California courts these Cumis fee issues are to be decided in an arbitration forum, not the state’s judicial forum.” This remedy may not easily be waived.
Civil Code §2860(c) “does not invalidate other different or additional policy provisions . . . providing for methods of settlement of disputes concerning those fees.” “We conclude section 2860 does not require the arbitration of disputes regarding defense costs. . . .”
One reported opinion concludes that 2860 arbitration is appropriate before determining whether the insurer has a duty to defend or a disqualifying conflict exists. The policyholder and insurer agreed to 2860 arbitration, following which an interlocutory judgment was entered. The policyholder then brought a motion for summary adjudication that insurer was barred by res judicata from denying that it had a duty to defend or that a disqualifying conflict of interest existed. The trial court granted the motion, but the court of appeal reversed stating: “Therefore, where the carrier is providing a defense under a reservation of rights and has agreed to utilize independent counsel, we conclude that section 2860 arbitration is appropriate to resolve attorneys fee disputes prior to a legal determination of the coverage issues.”
This ruling is sound insofar as it concludes that an insurer that reserves its rights does not waive its reservation by voluntarily submitting to arbitration of attorney fee disputes. However, this ruling should not be misinterpreted to mean that the protections of 2860 apply absent a conclusively determination that the insurer has a duty to defend and that a disqualifying conflict of interest exists. After all, the results of the 2860 arbitration to which the parties agreed would be come a nullity if a later declaratory relief judgment ruled that the insurer either had to duty to defend or that no disqualifying conflict existed.
Defaulting Insurers Must Pay All Costs of Defense
An insurer that fails to faithfully provide a defense, must pay “all” defense costs incurred by the policyholder through independent counsel. A defaulting insurer “is liable for all costs and attorneys’ fees expended by” the policyholder. “‘An insurer contracts to pay the entire cost of defending . . . claim[s]’ that are at least potentially covered.’” “[T]he insurer having breached its contract to defend should be charged with a heavy burden of proof of even partial freedom from liability for harm to the insured which ostensibly flowed from the breach.” Where “the insurer has breached its duty to defend [defense costs] are then presumed to be reasonable and necessary.” An insurer which breaches its duty to defend is “presumptively liable” for the costs of defense. “[W]here the insured is thus compelled to conduct his own defense, it is uniformly held that he may recover the expenses of litigation, including costs and attorneys’ fees, from the insurer. . . .” “[T]he courts have held that, by its refusal to participate, the recalcitrant [insurer] waives the right to challenge the reasonableness of defense costs.” “If, after request, the [insurer] neglects to defend the [policyholder], a recovery against the [policyholder] suffered by him in good faith, is conclusive in his favor against the [insurer]. “[The insurer]’s payment of defense fees at the end of the litigation [was] the equivalent of a defense denial. [Any other rule] would encourage insurers to reject their Cumis obligations for as long as they chose.”
An insurer that breaches its duty to defend risks losing any of the benefits of the Civil Code. “Breach of duty to defend also results in the insurer’s forfeiture of the right to control defense of the action or settlement, including the ability to take advantage of the protections and limitations set forth in section 2860.
Contingent Fee Is Permissible
“By breaching its duty to defend, [the insurer] became liable for reasonable attorney’s fees incurred for the defense. [Otherwise], the premiums paid by the insured would purchase nothing more than a lawsuit. Entering a contingency fee agreement when an insurer improperly refuses to defend may be appropriate. If the insurer’s refusal to defend was wrongful, attorneys may be willing to defend the insured in the underlying action and then sue the insurer for damages on a contingency fee basis.”
The no-voluntary-payment provision of most standard policies may excuse an insurer’s obligation to pay costs of defense incurred by the policyholder prior to giving notice of a plaintiff’s lawsuit. However, if the insurer denies a duty to defend, it may be required to pay “all” costs of defense. (See fn. 22.)
Burden of Proof
“In the general case, it is the insured that must carry the burden of proof on the existence, amount, and reasonableness and necessity of defense costs, and it must do so by the preponderance of the evidence. Evidence Code section 500 provides that, generally, a party desiring relief must carry the burden of proof thereon. Evidence Code section 115 provides that the burden of proof that is generally applicable is proof by a preponderance of the evidence. ¶ By contrast, in the exceptional case, wherein the insurer has breached its duty to defend, it is the insured that must carry the burden of proof on the existence and amount of the [defense] expenses, which are then presumed to be reasonable and necessary as defense costs, and it is the insurer that must carry the burden of proof that they are in fact unreasonable or unnecessary.” “The [policyholder] met its burden when it demonstrated the hours worked and provided testimony that the work was all related to the defense.”
Pursuant to the Cumis rule, a liability insurer that has a duty to defend and whose reservation of rights creates a disqualifying conflict of interest must pay independent counsel to provide a defense to its policyholder. The amount that it must pay may be established by the retainer agreement between the policyholder and independent counsel that are “incurred in good faith, and in the exercise of a reasonable discretion.” The policyholder, independent counsel, and the insurer may agree to other terms and other methods of resolving fee and cost disputes. The insurer may qualify to pay to independent counsel only what it pays to dependent counsel pursuant to Civil Code §2860. However, first there must be a final determination that the insurer has (A) a duty to defend; (B) a disqualifying conflict of interest exists; and (C) the insurer must then faithfully provide independent counsel to represent the insured.
 Civ. Code § 2778(3).
 Civ. Code § 2778(3).
 Civ. Code § 2778(3).
 “A member shall not enter into an agreement for, charge, or collect an illegal or unconscionable fee.” (Rules of Professional Conduct (Rule), Rule 4-200(A).)
 Rule 3-310.
 “The conduct of the actual litigation, including the amount and extent of discovery, the interrogation, evaluation, and selection of witnesses, the employment of experts, and the presentation of the defense in court, remains the responsibility of trial counsel.” (Merritt v. Reserve Ins. Co. (1973) 34 Cal.App.3d 858, 882 (Merritt).)
 “No person shall practice law in California unless the person is an active member of the State Bar.” (Bus.&Prof. Code §6125.)
 The insurer assumed the duty “in relation to the assured: . . . on the filing of suit against its assured to employ competent counsel to represent the assured and to provide counsel with adequate funds to conduct the defense of the suit.” (Merritt, supra, 34 Cal.App.3d at 882.)
 Montrose Chemical Corp. v. Superior Court (1993) 6 Cal.4th 287, 295.
 Buss v. Superior Court (1997) 16 Cal.4th 35, 48 (Buss) (citation omitted).
 Ins. Code § 790.03(h).
 Cal. Code Regs. § 2695.7(h).
 Mullen v. Glens Falls Ins. Co. (1977) 73 Cal.App.3d 163, 173-174.
 Civ. Code § 2860(c).
 “If the provisions of a policy of insurance impose a duty to defend upon an insurer and a conflict of interest arises which creates a duty on the part of the insurer to provide independent counsel to the insured, the insurer shall provide independent counsel to represent the insured.” (Civil Code §2860(a).)
 See, San Diego Navy Fed. Credit Union v. Cumis Ins. Society, Inc. (1984) 162 Cal.App.3d 358.
 Handy v. First Interstate Bank (1993) 13 Cal.App.4th 917, 926.
 Civil Code §2860(c).
 Caiafa Prof. Law Corp. v. State Farm Fire & Cas. Co. (1993) 15 Cal.App.4th 800, 803.
 “[A]rbitration is strongly favored. Courts will closely scrutinize any claims of waiver [citations] and ‘indulge every intendment to give effect to [arbitration] proceedings.’” (Christensen v. Dewor Developments (1983) 33 Cal.3d 778, 782.)
 Gray Cary Ware & Freidenrich v. Vigilant Insurance Company (2004) 114 Cal App 4th 1185, 1188.
 Truck Ins. Exchange v. Superior Court (1996) 51 Cal.App.4th 985, 998.
 Hogan v. Midland National Ins. Co. (1970) 3 Cal.3d 553, 558.
 Aerojet-General Corp. v. Transport Indemnity Co. (1997) 17 Cal.4th 38, 59 (Aerojet).
 Buss, supra, 16 Cal.4th at 55.
 Aerojet, supra, 17 Cal.4th at 64.
 Arenson v. National Auto. & Cas. Ins. Co. (1957) 48 Cal.2d 528, 537.
 Safeco Ins. Co. of America v. Superior Court (2006) 140 Cal. App. 4th 874, 878-79.
 Civ. Code § 2778(5).
 Housing Group v. PMA Capital Ins. Co. (2011) 193 Cal.App.4th 1150, 1156-1157.
 Intergulf Development LLC v. Superior Court (2010)183 Cal.App.4th 16, 20; See also, Fuller-Austin Insulation Co. v. Highlands Ins. Co. (2006) 135 Cal.App.4th 958, 984; Atmel Corp. v. St. Paul Fire & Marine Ins. Co. (N.D.Cal. 2005) 426 F.Supp.2d 1039, 1047.
 State of California v. Pacific Indemnity Co. (1998) 63 Cal. App. 4th 1535, (citations, quotation marks, and ellipses omitted).
 Aerojet, supra, 17 Cal.4th at 64 (citations, quotation marks and ellipses omitted); see also, State of Calif. v. Pacific Indem. Co. (1998) 63 Cal.App.4th 1535, 1548-49 (Pacific Indem).
 Pacific Indem, supra, 63 Cal.App.4th at 1549.