The duty to provide an adequate defense

Insurer’s potential bad-faith liability for the breach of the duty to provide competent counsel, fund the defense and provide independent counsel as required

2015 August

There is a well-developed body of law governing the duty to defend in third-party insurance cases when coverage is in doubt. But once the insurer accepts the duty to defend its insured, what exactly is that duty? The duties to provide competent counsel, to adequately fund the defense, and to pay for independent counsel when a conflict of interest arises between insurer and insured, are all sub-parts to the duty to defend. This article will examine an insurer’s potential bad-faith liability for the breach of these duties.

Some of the larger U.S. insurers have formed in-house law firms for the purpose of defending their insureds in third-party cases. This article will also analyze the potential for bad faith when an insurer overrules its captive defense firm on the funding of the insured’s defense, and the attorneys’ ethical responsibilities in that circumstance.

Merritt v. Reserve Insurance Company

A liability insurer has a duty “to employ competent counsel and to represent the assured and to provide counsel with adequate funds to conduct suit,” and may be liable for whatever damages result from its failure to do so. (Glad & DiMugno, Cal. Ins. Law Handbook, § 46:31, 2015 ed. (citing Merritt v. Reserve Ins. Co. (1973) 34 Cal.App.3d 858, 882).) In 1973, Merritt considered whether an insurer can be held liable for the negligence of the attorneys it appoints to defend its insured.

Merritt was a truck driver in an underlying auto-accident case. The defendants, a truck driver and his employer, J.A. Stafford Company, were insured by Reserve Insurance Company. At trial, Stafford was held liable for $434,000 in damages, affirmed on appeal. Reserve paid Merrit its policy limits of $100,000. Merritt then accepted an assignment of Stafford’s rights to sue its insurer, Reserve, in exchange for a covenant not to execute against Merritt’s unsatisfied judgment of $334,000. (Merritt, supra, 34 Cal.App.3d at pp. 861-62.)

Merritt, now in Stafford’s shoes, sued Reserve for bad faith and negligence in Reserve’s handling of the defense of the case of Merritt v. Stafford Co. In his complaint, Merritt alleged that Reserve took complete control of the litigation; that the defense counsel it hired acted as Reserve’s agent; that Reserve failed to properly investigate and prepare for litigation and to engage in settlement discussions; that Reserve misled its insureds into a false sense of security; and that Reserve failed to properly represent its insureds through trial and appeal. (Merritt, supra, 34 Cal.App.3d at pp. 862-63.)

Merritt also charged Reserve with “negligent handling of the defense in the case of Merritt v. Stafford in two respects: (a) negligent failure to initiate settlement discussions; (b) negligent conduct of the litigation (investigation, preparation, trial, appeal, and satisfaction).” (Merritt, supra, 34 Cal.App.3d at p. 880 (italics added).)

In the bad-faith case, the trial court granted judgment on the pleadings as to Merritt’s negligence claim, holding that Merritt failed to state a cause of action. The trial court denied judgment as to the bad-faith claim. The jury awarded Merritt $499,000 in compensatory damages. Merritt and Reserve appealed the respective judgments against them. (Merritt, supra, 34 Cal.App.3d at p. 862.)

The Court of Appeal held that because no offer of settlement had been made in the underlying case, Reserve was not liable for bad-faith refusal to settle. (Merritt, supra, 34 Cal.App.3d at pp. 877-79.) It further held that “failure to initiate settlement discussions” was actionable only as bad faith, and not as negligence. (Merritt, supra, 34 Cal.App.3d at p. 880.)

The Court of Appeal also held that “independent counsel retained to conduct litigation in the courts act in the capacity of independent contractors, responsible for the results of their conduct and not subject to the control and direction of their employer over the details and manner of their performance.” “Absent compelling reasons of public policy [citations] an employer is not liable for the negligence of an independent contractor. [Citations.]” (Merritt, supra, 34 Cal.App.3d at pp. 880-81 (italics added).)

In holding that the defense counsel Merritt retained was an independent contractor, the court noted that the defense law firm was engaged in the “general practice of law” and “maintained separate offices.” Once the insurer appoints competent defense counsel, Merritt held, the insurer will not be held liable for defense counsel’s legal malpractice. Instead, the insured’s remedy is to sue defense counsel; there is no vicarious liability. (Merritt, supra, 34 Cal.App.3d at pp. 881-82 (italics added).) (Note that the Merritt court used the term “counsel’s employer” in an outmoded sense: The court is emphatically stating that Reserve “employed” – i.e., retained – defense counsel as an independent contractor – and not as an “employee,” with the legal ramifications the latter term carries. If Reserve had actually employed the defense counsel in Merritt – that is, the employee-attorneys reported directly to officials of Reserve – could such attorneys still be considered “independent contractors”?)

The court drew a bright line between an insurer’s duties and those of the defense attorneys it retains:

Reserve, of course, remains liable for the negligent performance of its own duties. Under the policy Reserve assumed three principal duties in relation to the assured: (1) to make immediate inquiry into the facts of any serious accident as soon as practicable after its occurrence; (2) 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; (3) to keep abreast of the progress and status of the litigation in order that it may act intelligently and in good faith on settlement offers. 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, and this is true both on plaintiff’s side and on defendant’s side of the case.

(Merritt, supra, 34 Cal.App.3d at p. 882 (italics added).)

In reality, the lines between the duties of an insurer and those of the attorneys it selects to defend the insured are somewhat blurred. If the insurer has a duty to retain competent defense counsel, it must have some duty to monitor defense counsel’s work to remain assured of its competence. If the insurer has a duty to provide defense counsel with adequate funds for the defense, who decides what level of funding is adequate? Is it the insurer’s duty to fund all costs that defense counsel demands? As the Merritt court observed, “it appears that the insurer is not vicariously liable for the negligence of trial counsel appointed to represent the insured (provided, of course, the attorney is not controlled by the insurer).” (Merritt v. Reserve Ins. Co., supra, 34 Cal.App.3d at pp. 880-81 (italics added).)

Travelers Insurance Company v. Lesher

“An insurer that fails to provide its insured with an adequate defense is liable for all damages proximately caused by its failure to do so, including settlement costs in excess of policy limits. This is so even though the policy does not obligate the insurer to indemnify.” (Glad & DiMugno, Cal. Ins. Law Handbook, § 46:31 (2015 ed.) (citing Travelers Ins. Co. v. Lesher (1986) 187 Cal.App.3d 169 (disapproved on other grounds in Buss v. Superior Court (Transamerica Ins. Co.) (1997) 16 Cal.4th 35, 65))

Lesher’s facts

Dean S. Lesher, a newspaper publisher, was sued in 1978 by two competing newspapers for alleged antitrust violations. Travelers Insurance accepted the defense under a reservation of rights. (Lesher, supra, 187 Cal.App.3d at p. 180.) Travelers appointed a personal injury defense firm to represent Lesher. When that firm failed to make an initial court appearance, Lesher’s personal attorney filed for an extension of time to answer and, from that point forward, “shadowed” the defense attorneys Travelers appointed. (Id. at p. 182.) After Travelers replaced the first defense attorneys, Lesher asked Travelers to authorize the second firm to attempt to negotiate a settlement with the anti-trust plaintiffs. Travelers never did so authorize, and never participated in settlement negotiations.

The second defense firm inadvertently served a document related to a coverage dispute between Travelers and Lesher on one of the anti-trust plaintiffs. When Lesher claimed this disclosure prejudiced him, the second defense firm withdrew. With only five and one-half months until trial, Travelers finally appointed a third defense firm to represent Lesher in the anti-trust case. (Lesher, supra, 187 Cal.App.3d at p. 183.) The judge refused to continue trial in the anti-trust case, and Lesher, claiming that his new defense counsel did not have enough time to prepare for trial, agreed to settlements totaling $1.5 million. (Id. at pp. 183-84.)

While the anti-trust suit was pending, Travelers sued Lesher for declaratory relief, claiming there was no coverage. The trial court agreed, granting summary adjudication in Travelers’ favor on the duties to defend and indemnify, and ordering a trial on Travelers’ claim for reimbursement of attorney fees and costs. Lesher then cross-complained against Travelers for breach of contract and bad faith. (Lesher, supra, 187 Cal.App.3d at pp. 180-81.) A separate jury trial was held on Travelers’ claim for fees and costs and on Lesher’s cross-complaint for bad faith. The court granted Lesher’s motion for nonsuit on the fee claim. The jury found that Travelers breached the implied covenant of good faith and fair dealing and wrongfully refused or failed to defend Lesher; it awarded Lesher $1.5 million in compensatory damages and $1.5 million in punitive damages. (Id.at p. 181.)

Thus, even after the court in the coverage case ruled that Travelers owed no duty to indemnify or defend Lesher, Travelers continued to defend him throughout the anti-trust case.

Appeal of the declaratory relief and bad-faith judgments

The Court of Appeal upheld summary adjudication in favor of Travelers on the issue of its duty to defend or indemnify Lesher, based on an unambiguous exclusion in the insurance contract. (Lesher, supra, 187 Cal.App.3d at pp. 184-86.)

Lesher argued on appeal that “[d]espite the coverage dispute, once Travelers undertook [his] defense, it was obligated to conduct that defense with the same duty of care as if there were no coverage dispute. If Travelers breached that duty of care, it was liable for all damage to Lesher proximately caused by its acts or omissions, even though there was no actual coverage under the policy.” Neither side cited any cases in which an insurer had been held liable under such circumstances. Still, Travelers did not argue that Lesher could not bring a bad-faith action under these facts. (Lesher, supra, 187 Cal.App.3d at p. 187.)

The Court of Appeal rejected Travelers’ arguments that the jury received improper instructions. (Lesher, supra, 187 Cal.App.3d at pp. 187-91.) It held that the insurer is not vicariously liable for the negligence of defense counsel, “provided, of course, the attorney is not controlled by the insurer.” (Id. at pp. 880-81.) Citing Merritt, the Lesher court held that the insurer must provide the attorneys with sufficient funds to conduct the defense and monitor the litigation so that the insurer can act “intelligently and in good faith on settlement offers.” (Id. at pp. 191-92.) The Court of Appeal disposed of Travelers’ other arguments in Lesher’s favor. (Id. at pp. 193-94.)

The Court of Appeal found substantial evidence supporting the jury’s verdict against Travelers of $1.5 million in compensatory damages. It concluded that a series of failures on the part of Travelers’ appointed defense counsel left Lesher unprepared for trial, and forced him to settle with the plaintiffs in the underlying case for a total of $1.5 million. (Lesher, supra, 187 Cal.App.3d at pp. 196-97.) However, the Court of Appeal held that Lesher did not establish the malice, fraud, or oppression necessary to sustain a verdict of punitive damages. (Id. at pp. 200-202.) Finally, the Court of Appeal upheld the trial court’s nonsuit against Travelers for its claim for reimbursement of attorney fees and costs. (Id. at pp. 203-04.)

Lesher was much more willing than Merritt to hold the insurer liable for defense counsel’s negligence, shifting more responsibility for a proper defense to the insurer.

Holdings in other cases re: client’s liability for an attorney’s conduct

Merritt and Lesher seem to suggest that it may be possible for an insurer to exert “control” over defense counsel. In the cases that follow, the concept of the client’s control over the attorney often matters in determining whether the client is liable for the attorney’s acts.

A middle ground may be found in a case that held that a client is not liable for the tortious conduct of her attorney unless she ratified such conduct. (Palmer v. Ted Stevens Honda, Inc. (1987) 193 Cal.App.3d 530, 539.) Arguably, an insurer ratifies defense counsel’s conduct when it approves the funding defense counsel requests – for example, funding for expert witnesses. The insurer makes decisions concerning settlement that are communicated through defense counsel; and we know that the insurer, not the defense attorneys, is held responsible for settlement decisions.

In 1982, the California Supreme Court held that, generally, an attorney’s negligence is imputed to the client. The Court held that a party seeking relief under Code of Civil Procedure section 473 on the basis of mistake or inadvertence of counsel must demonstrate that such was excusable: “[T]he negligence of the attorney . . . is imputed to his client and may not be offered by the latter as a basis for relief.” The client’s remedy for inexcusable neglect by counsel is to sue the attorney for malpractice. (Carroll v. Abbott Labs., Inc. (1982) 32 Cal.3d 892, 898.)

In another case, a client who had previously assigned a 40 percent interest in a cause of action to a third party was liable to the third party on an “implied authority” or “ratification” theory for funds improperly retained by its attorney, in derogation of a third party’s rights. (In re Banks (Bankr. C.D. Cal. 1998) 225 B.R. 738, 748 (aff’d, 246 B.R. 452 (B.A.P. 9th Cir. 1999; aff’d sub nom. Banks v. Gill Distribution Centers, Inc. (9th Cir. 2001) 263 F.3d 862.)

Considine Co. v. Shadle, Hunt & Hagar (1986) 187 Cal.App.3d 760, 768 held that while a client is not vicariously liable for the acts of his attorneys, a client who is sued by a third party may cross-complain against his attorneys for implied indemnification where the attorneys’ negligence contributed to the client’s liability.

And under the Fair Debt Collection Practices Act (15 U.S.C.A. § 1692), debt collectors can be vicariously liable for the acts of their attorneys. (Fox v. Citicorp Credit Servs., Inc. (9th Cir. 1994) 15 F.3d 1507. But the Ninth Circuit has distinguished the vicarious liability that was baked into the FDCPA from the general context of the attorney-client relationship: “Although we have recognized vicarious liability under the FDCPA [citation], there is no legal authority for the proposition that an attorney is generally liable for the actions of his client . . . . Under general principles of agency – which form the basis of vicarious liability under the FDCPA, . . . to be liable for the actions of another, the ‘principal’ must exercise control over the conduct or activities of the ‘agent.’” (Clark v. Capital Credit & Collection Servs., Inc. (9th Cir. 2006) 460 F.3d 1162, 1173 (italics added).)

Conflicts of interest and the right to independent counsel

The complexity of the tripartite, insurer/insured/defense counsel relationship can lead to conflicts of interest that entitle the insured to independent counsel. Code of Civil Procedure section 2860 (Section 2860) codified the Cumis independent-counsel rule: It requires, among other things, that if an insurance policy requires an insurer to defend an insured and a conflict of interest arises that creates a duty on the part of the insurer to provide independent counsel to the insured, the insurer must provide the insured with independent counsel unless the insured expressly waives this right. (Section 2860, subd. (a).)

In Golden Eagle Insurance Company v. Foremost Insurance Company (1993) 20 Cal.App.4th 1372, 1394 (Golden Eagle), the insureds contended that their insurers “created a conflict of interest by pursuing a settlement without their consent, in excess of the insurers’ alleged policy limits and which would leave them exposed to subsequent claims by [others] who were not plaintiffs in the underlying action.” The trial court held that the insurers’ conduct did not trigger the duty to provide the insureds with independent counsel. (Id. at p. 1394.) The Court of Appeal observed that “the Cumis rule is not based on insurance law but on the ethical duty of an attorney to avoid representing conflicting interests.” (Ibid. (italics added).) Here, the court found a clear conflict of interest entitling the insureds to independent counsel. (Id. at p. 1396.)

The classic example of the independent-counsel rule is the case in which the way the insurer-appointed defense counsel defends the action will affect an underlying coverage dispute between the insurer and the insured. (Golden Eagle, supra, 20 Cal.App.4th at p. 1395.) But it is the role of the courts to determine, consistent with Section 2860, whether a conflict of interest gives rise to the duty to provide independent counsel. (Ibid.) Thus, the conflicts of interest identified in case law to date are not the “universe” of all such conflicts or potential conflicts.

Potential conflicts of interest between insurer and its in-house counsel

In 1987, the California State Bar considered the ethics of the practice of law in a law firm owned by an insurer. The State Bar assumed the following facts:

The insurer (hereinafter “Insurance Company”) proposes to establish a Law Division. The attorneys in the Law Division will hold themselves out as a law firm practicing under the name of one or more of the attorneys in the firm. Insurance Company will decide the “firm name” to be used. All attorneys comprising the Law Division will be salaried employees of the Insurance Company. All personnel matters of each Law Division (hiring, firing, compensation, etc.) will be handled by Insurance Company’s personnel department.

It is proposed that the Insurance Company will retain the Law Division to provide a defense to certain of its insureds. Insurance Company will have the right to assign individual cases either to the Law Division or to outside counsel. Insurance Company intends to assign a percentage of cases to the Law Division, with more complex cases being assigned to outside firms. The motivation is economic. It is believed that the cost of the Law Division providing a defense will be substantially less than the cost of retaining outside counsel to provide such a defense.

Attorneys and other timekeepers in each Law Division will bill their time to particular files in the same manner as an outside law firm. Statements will be rendered by the Law Division to the Insurance Company and income will be credited to the Law Division with a corresponding expense charged to the Insurance Company on its books. In theory, the Law Division seeks to operate as an independent law firm. All correspondence and pleadings emanating from the Law Division will be on the “firm’s” letterhead. However, individual clients, i.e., insureds, will not be informed that the attorneys comprising the Law Division are employees of Insurance Company.

(Cal. State Bar Formal Opn. No. 1987-91 (Opinion 1987-91).)

By appointing in-house attorneys to represent its insureds, is Insurance Company engaging in the unauthorized practice of law? Business and Professions Code section 6125 states that “no person shall practice law in this state unless he is an active member of the State Bar.” California Rules of Professional Conduct, Rule 1-300(A) provides that “[a] member of the State Bar shall not aid any person, association, or corporation in the unauthorized practice of law.” (Opinion 1987-91.)

The State Bar concluded that “the mere fact that the lawyers are employees of Insurance Company does not necessarily compromise the attorney’s independent professional judgment” and that, absent a conflict of interest between Insured and Insurance Company,

…it cannot be presumed that simply because the attorneys handling defense cases are salaried employees of Insurance Company that they will act unethically or will otherwise sacrifice their professional obligations to the insureds in favor of Insurance Company. The determinative factor is whether the Insurance Company’s in-house counsel can maintain professional independence comparable to that of an outside law firm. Under the facts of this opinion, with one reservation, we believe they can”: “attorneys working within the Law Division should be sensitive to the possibility that the Insurance Company may directly or indirectly seek to interfere with or control the performance of the member’s duty to his or her client. However, the Committee recognizes that, in absence of a conflict of interest between the insurer and the insured, Insurance Company is entitled to control the defense of litigation and may in many circumstances dictate defense and settlement strategy.

(Merritt v. Superior Court (1973) 34 Cal.App.3d 858.)

(Opinion 1987-91 (italics added).]

To illustrate how another flavor of conflict-of-interest may arise, assume the following facts in addition to those of the State Bar, above:

• Insurance Company’s Insured is sued for damages resulting from an auto accident;
• Insurance Company appoints Law Division to represent Insured;
• Plaintiff refuses to accept Insurer’s offer of Insurance Company’s policy limits of $50,000 in settlement;
• Plaintiff designates five experts, in the following fields: accident reconstruction, biomechanics, orthopedics, vocational rehabilitation, and economics.
• Insurance Company decides that a verdict against Insured is likely;
• Expecting to pay its $50,000 following a verdict for plaintiff, Insurance Company decides to save on litigation costs, and instructs Law Division not to retain any experts for trial, against Law Division’s recommendation;
• Insurance Company informs Insured of his right to independent counsel, but does not offer to pay for it;
• Law Division does not inform Insured of the existence of any conflict of interest;
• Plaintiff obtains a $2 million judgment against Insured at trial;
• Insurance Company pays its $50,000; and
• Insured files for bankruptcy.

Insurance Company’s decision not to provide funds for experts at trial conflicts with its Law Division’s recommendation, which is to retain experts to counter those of plaintiff. Under Merritt, isn’t Insurance Company entitled to control “defense strategy”? At the same time, according to the State Bar, the Law Division must perform its duty to Insured free of interference or control from Insurance Company.

Where Law Division attorneys inform Insurance Company that Insured requires experts for trial, and Insurance Company denies funding for such experts, have Law Division’s attorneys maintained professional independence comparable to that of an outside law firm? The question requires us to imagine what Outside Law Firm would have done, had Insurance Company appointed it to defend Insured rather than Law Division. If Outside Law Firm determined that performing its duty to Insured required retaining experts for Insured at trial, and Insurance Company refused to fund experts, Outside Law Firm could (1) report a conflict of interest to Insurance Company and Insured, (2) move to withdraw, or both.

Those choices are not as readily available to Law Division, which is subject to at least the administrative control of its master, Insurance Company. If Outside Law Firm knuckled under to Insurance Company – as Law Division did in our hypothetical – then Insured may later be able to prove that the defense was not adequately funded, as the law requires. “[I]f there is a risk of an excess judgment, the insurer’s failure to fund the defense properly may be actionable either as a breach of its contractual duty to defend, or as a breach of its implied covenant of good faith and fair dealing with the insured. In either case, the insured’s liability for the uncovered claim or the excess judgment may be regarded as a consequential damage (“expectable result”) of the insurer’s breach.” (Cal. Practice Guide: Ins. Litigation, Ch. 13-A (The Rutter Group 2015).)

By the same principle, the insurer could be liable for bad faith if it appoints in-house counsel to defend its insured, and that in-house counsel is found not to be competent in its representation. (Aerojet-General Corp. v. Transport Indemnity Co. (1997) 17 Cal.4th 38, 57-58.)

No California decision has yet considered the liability of insurer or defense counsel where the insurer’s decision not to fund part of an insured’s defense – such as retention of expert witnesses – conflicts with the professional judgment of defense counsel.

All Law Division attorneys – partners and associates – are employees of Insurance Company. In some ideal universe, they would be immune to the background pressure of Insurance Company’s profit motive. But in reality, those employees know that their jobs, salaries, bonuses, promotions and case assignments are ultimately under the control of Insurance Company. The Law Division attorneys quite naturally wish to please their employers and to fulfill their duties as lawyers – all at the same time.

Most of the time, the interests of Insurance Company and Insurer coincide. The Law Division attorneys know to watch for cases where Insurance Company has reserved its rights: Where coverage is in doubt and the attorneys have the power to conduct the defense in a way that tends to negate coverage, the attorneys must notify Insured and Insurance Company of a conflict of interest.

But the attorneys are naturally sensitive to Insurance Company’s goal to minimize litigation costs. After all, lower costs are behind the decision of Insurance Company to found its Law Division in the first place. Thus, the Law Division attorneys are aware that their employers will be pleased if litigation costs are lower rather than higher. And the attorneys know that Insurance Company would prefer to avoid paying independent counsel in third-party cases. Thus, there is a built-in disincentive to report a conflict of interest that results in appointment of independent counsel: The attorney may know it is his duty to report such conflicts to both clients – Insured and Insurance Company. But here, Insurance Company is, ultimately, her boss. Whether a conflict of interest exists is a judgment call. It seems all too easy – because it is all too human – for the employee-attorney to shade her professional judgment toward the absence of a conflict.

Now, picture the Law Division attorneys whom Insurance Company has appointed to defend Insured, when those attorneys learn that Insurance Company has decided not to pay for experts, against the attorneys’ recommendations. The partner on the case delivers the news to the associate preparing the case for trial. The associate reflects that to properly perform his duty to Insured, he must retain experts to oppose those of plaintiffs. Do you think the associate will write a letter to the partner, stating his opinion that a conflict of interest has arisen between Insurance Company and Insured? Will blowing the whistle in this instance cause Insurer to reevaluate his next raise, his bonus, or even his employment? It seems an invidious choice.

Conclusion

No cases have yet decided whether an insurer should be liable for the malpractice of its in-house counsel. When such a case finally comes before the Court of Appeal, the court will surely carefully examine the control the insurer exerted over the defense of the insured, and any disparity between the recommendations of in-house counsel about the conduct of the defense and the insurer’s decision. When that case finally is considered, the artificially bright line that Merritt drew between the duties of the insurer and those of in-house counsel will likely blur.