MEMORANDUM OF LAW

CIVIL CODE § 2860 LIMITED APPLICATION

INTRODUCTION

"Civil Code, section 2860 codifies (with clarifications and limitations) the holding in [Cumis1], which concluded that an insurer is responsible to pay the reasonable cost for hiring independent counsel for the insured when the insured and insurer have divergent interests due to the insurer's reservation of its right to deny coverage."2 However, "in 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."3 The existence of a duty to defend and a disqualifying conflict of interest, "if contested, may not be decided in an arbitration ordered pursuant to Civil Code section 2860 but must be resolved by the trial court in the first instance."4 Proper application of the statute can create some practical problems.5

THE CUMIS RULE

Insurance is a "contract whereby one undertakes to indemnify another against . . . liability."6 Liability insurance makes two primary7 promises: 1) to indemnify for liability that is actually covered after considering all of the terms of the policy; and 2) to defend against any claim of liability that is "potentially" covered. "[W]hen coverage is disputed, the interests of the insured and the insurer are always divergent. ¶ 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. . . . 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."8

THREE PREREQUISITES TO THE APPLICATION OF CIVIL CODE § 2860

Civil Code section 2860(a) identifies an A + B = C formula to trigger the application of the statute. "If [A] the provisions of a policy of insurance impose a duty to defend upon an insurer and [B] a conflict of interest arises which creates a duty on the part of the insurer to provide independent counsel to the insured, [then C] the insurer shall provide independent counsel to represent the insured."9 California courts have uniformly concluded that the code "assumes the existence of a duty to defend and a conflict".10 Thus, the statute does not apply unless the insurer and the policyholder reach an irrevocable agreement or a court enters a final judgment that [A] an insurer's duty to defend; [B] a disqualifying conflict of interest exists; and [C] the insurer is faithfully paying for the policyholder's defense.11 "Where insurer and insured unconditionally agree independent counsel is warranted and where independent counsel is actually retained," the statute applies.12 Statutory remedies "would be appropriate '[w]here insurer and insured unconditionally agree independent counsel is warranted and where independent counsel is actually retained . . . .'"13 Still, one court enforced a 2860 arbitration award absent a prior unconditional agreement that a duty to defend and a disqualifying conflict existed. "[W]here 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."14

A.	The Existence of a Duty to Defend?

One of the express prerequisites to the application of Civil Code § 2860 is that "the provisions of a policy of insurance impose a duty to defend upon an insurer." However in practice, the fact that an insurer agrees to defend does not necessarily mean that it concedes that a duty to defend actually exists. Indeed, most reservations of rights letters include a blanket statement that the insurer denies that it has any duty to defend and that the insurer reserves its rights to recover reimbursement of all defense costs from its policyholder.15 This distinction between and agreement to defend and an agreement that a duty to defend actually exists may appear to be small, but it is often important to develop evidence that the insurer concedes that the duty exists.

B.	The Existence of a Disqualifying Conflict of Interest?

A second express prerequisite to the application of Civil Code § 2860 is that "a conflict of interest arises which creates a duty on the part of the insurer to provide independent counsel to the insured." Although "when coverage is disputed, the interests of the insured and the insurer are always divergent"16, "not every conflict of interest triggers an obligation on the part of the insurer to provide the insured with independent counsel at the insurer's expense."17 As a practical matter, insurers that agree to pay for independent counsel do not necessarily concede that a disqualifying conflict of interest actually exists. Typically, insurers reserve the right to recover reimbursement of the costs of defense from the policyholder18 and/or independent counsel.19 Thus, an insurer's agreement to pay independent counsel does not necessarily imply that the insurer concedes irrevocably that the duty actually exists. It is often important to develop evidence that the insurer concedes that a disqualifying conflict does indeed exist.

Civil Code "Section 2860, subdivision (a), provides that when such conflict of interest arises, an insurer with the duty to defend must provide independent counsel to represent the insured. Section 2860, subdivision (b), provides that '... 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.' When an insurer's reservation of rights creates such conflict of interest, section 2860, subdivision (c), imposes a specific limitation on the hourly rate an insurer must pay to independent Cumis counsel selected by the insured. [S]ection 2860 applies only where a 'conflict of interest arises which creates a duty on the part of the insurer to provide independent counsel for the insured....' Since no Cumis conflict existed here, the statute was inapplicable."20

C.	Faithful Performance of the Duty to Defend?

The third prerequisite to the application of Civil Code § 2860 is that "the insurer shall provide independent counsel to represent the insured." "There is an important difference between the liability of an insurer who performs its obligations and that of an insurer who breaches its contract."21 Lip service does not satisfy the duty to defend. The insurer's duty requires it "to provide counsel with adequate funds to conduct the defense of the suit."22 Reservation of rights "letters were only an expression of [the insurer]'s future intent to comply with its duty to defend, and not an actual acceptance or agreement to provide a defense or to appoint plaintiffs' chosen counsel as Cumis counsel. [The insurer]'s payment of defense fees at the end of the litigation [is] the equivalent of a defense denial. [Any other rule] would encourage insurers to reject their Cumis obligations for as long as they chose."23

SUMMARY OF PROTECTION PROVIDED BY CIVIL CODE § 2860

For insurers that qualify, the statute provides significant protection. While Civil Code § 2860 codifies the Cumis decision, it also significantly expands upon the scope of the published opinion. Subsection (b) narrows the scope of conflicts for which the insurer must pay independent counsel: "a conflict of interest does not exist as to allegations or facts in the litigation for which the insurer denies coverage [and no] conflict of interest shall be deemed to exist as to allegations of punitive damages or be deemed to exist solely because an insured is sued for an amount in excess of the insurance policy limits." "[H]owever, a conflict of interest may exist" "when an insurer reserves its rights on a given issue and the outcome of that coverage issue can be controlled by [dependent counsel]."

Subsection (c) specifies minimum qualifications for independent counsel, limits the hourly rates insurers must pay, and requires that attorneys fee disputes "be resolved by final and binding arbitration by a single neutral arbitrator."

Subsection (d) provides that independent counsel and the insured have a duty to consult with and "to disclose to the insurer all information concerning the action except privileged materials relevant to coverage disputes." Claims of privilege are "subject to in camera review" and such disclosure does not waive any privilege.24

Subsection (e) specifies language for a policyholder to waive the right to independent counsel.

Subsection (f) permits dependent counsel "to participate in all aspects of the litigation" and "in the exchange of information" consistent with "ethical and legal obligation to the insured."

RULES OF STATUTORY INTERPRETATION

Rules of statutory interpretation are clear. "We begin with the fundamental rule that our primary task is to determine the lawmakers' 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."25

Civil Code § 2860 does not expressly state that the statute applies only if there is an irrevocable agreement nor a final judicial determination that [A] a duty to defend exists; [B] a disqualifying conflict of interest exists; and [C] the insurer is faithfully paying for independent counsel.26 Still, none of the rights or obligations recognized by the statute would exist at all unless these prerequisites are satisfied.