In a majority of jurisdictions, when an insurer provides a policyholder with defense counsel and there is no conflict of interest triggering the right to independent counsel, a “tripartite relationship” is created among the insurer, the policyholder, and the defense counsel.
In the tripartite relationship, the defense counsel is “generally recognized as having two clients in any given case: the insurer and the insured.” In a minority of jurisdictions, the policyholder is the “primary client.” Outlier states hold that the policyholder is the only client.
As expected, the creation of a tripartite relationship involves the consideration of ethical principles such as the duty of loyalty and confidentiality, particularly if a conflict of interest arises between the insurer and the policyholder. ABA Model Rule 1.6(a) prohibits the disclosure of confidential client information without the client’s informed consent. Rule 5.4(c) further provides “[a] lawyer shall not permit a person who recommends, employs, or pays the lawyer to render legal services for another to direct or regulate the lawyer’s professional judgment in rendering such legal services.”
Finally, Rule 1.7 instructs that “a lawyer shall not represent a client if the representation involves a concurrent conflict of interest,” if, in relevant part, “there is a significant risk that the representation of one or more clients will be materially limited by the lawyer’s responsibilities to another client, a former client or a third person or by a personal interest of the lawyer.” Accordingly, an initial consideration for defense counsel is to determine whether a conflict of interest may arise due to the unique nature of the tripartite relationship. If such a conflict arises, the insurer may be required to appoint independent counsel.
A conflict of interest may arise when the insurer disputes whether its duty to defend has been triggered, which could give rise to the policyholder’s right to independent counsel. One common scenario is where the underlying action involves both covered and non-covered claims. A conflict of interest may also arise where defense counsel gets involved in the coverage analysis. To trigger the right to independent counsel, some courts have required that any such conflict of interest must be actual; a possibility of a conflict is not enough.
Other courts have rejected the assertion that a conflict of interest creates a right for the policyholder to retain independent defense counsel. For example, Washington law applies instead an “enhanced obligation of fairness” standard, which sets out the following criteria:
(1) the company must thoroughly investigate the claim; (2) it must retain competent defense counsel for the policyholder, and both retained defense counsel and the insurer must understand that only the policyholder is the client; (3) the company must inform the policyholder of the reservation of rights defense and all developments relevant to policy coverage and progress of the lawsuit; [and] (4) the company must refrain from any activity that would show a greater concern for its monetary interest than for policyholder’s financial risk.
Accordingly, whether a particular conflict of interest requires an insurer to appoint independent counsel necessitates a case-by-case, and state-by-state, analysis.
When an insurer does agree to pay defense costs of independent counsel, the agreement typically comes with a constraint—based on statute, policy language, or other grounds—that those defense costs be “reasonable and necessary.” Case law has recognized that “costs incurred by the insured are presumed to be reasonable and necessary, and the burden shifts to the insurer to rebut this presumption.”
Courts generally endorse the presumption because the policyholder has an economic interest to keep its costs low when there is no guarantee that it will be reimbursed by insurance. Furthermore, insurers that gamble on the coverage question do not later get to question the fees incurred to the policyholder’s detriment; otherwise, “the duty to defend would be significantly undermined.”
In cases in which the complexity of the claim justifies the use of multiple attorneys or firms, those costs are also considered reasonable. For example, the U.S. District Court for the Southern District of New York has used a lodestar analysis that considers the qualifications and expertise of the defense counsel against the complexity of the case. Courts have also denied coverage for defense costs that were needlessly incurred, such as costs resulting from defense counsel abusing the discovery process, as being unreasonable.
Courts also look at factors such as the number of hours billed and the hourly rate itself, as compared with legal services provided in similar cases in the community. Even so, policyholders are not required to retain “the cheapest lawyer” available or “solicit competitive bids or hire a starving, obscure young practitioner.” Notably, the relevant community of focus is not necessarily where the case is pending. Importantly, a comparison of independent defense counsel’s rates with an insurer’s panel rates for defense counsel may not be dispositive of “reasonableness.” Additional factors can include expert testimony and surveys and studies on billing rates. Thus, the actual “reasonableness” of defense costs are decided on a case-by-case basis under factors developed by applicable case law (and in some states, by statute). As discussed below, deductions may be made where costs are shown to be unreasonable, unnecessary, or inadequately documented.
Insurers are motivated to oversee and manage defense spend when they do accept coverage. To that end, insurers may provide guidelines as a tool to establish boundaries for incurring defense costs, including protocols for project planning and budgeting. A budgeting plan recognizes that litigation can be unpredictable and protects an insurer from overenthusiastic litigants. Indeed, it is important for both the policyholder and the insurer to realize that flexibility from both parties is required in mapping out a defense strategy.
Litigation management guidelines can also set parameters on the day-to-day tasks required to defend a lawsuit. Insurers may try to restrict the number of professionals permitted to engage in an activity, the extent of intrafirm communications, time spent on legal research and drafting projects, etc. These restrictions present a ripe ground for disputes between the insurer and the policyholder. For instance, if the case is particularly complex, independent defense counsel may need to staff multiple members of the firm on the matter in order to fulfill its professional responsibilities to the policyholder.
Enforcement of litigation management guidelines varies. In Illinois and Texas, courts strongly disfavor the use of litigation management guidelines and decline to enforce guidelines if they were not incorporated into or otherwise made a part of the insurance policy itself. In states where litigation management guidelines are not barred, courts consider the reasonableness of the guidelines and any deductions made pursuant to them in deciding whether to enforce the guidelines. “If the attorney’s representation is to be limited in any way that unreasonably interferes with the defense, it is the insured, not the insurer, who should make that decision.”
That is not to say that guidelines are never reasonable. If the insurer can show that it has removed itself from the process of questioning defense costs and focused its guidelines on minimizing needless defense work, then its guidelines are more likely to be enforced. In other words, insurers should impartially evaluate defense cost submissions—while questioning the necessity of defense costs is permitted, insurers should also be fair in providing reimbursement where the policyholder provides support for the necessity of those costs.
If independent defense counsel must comply with litigation management guidelines to any extent, defense counsel must also keep in mind their ethical duties to their client, the insured policyholder. In addition to the duties of confidentiality and loyalty, defense counsel also must consider their duties of professional independence and competence to their client if litigation management guidelines are involved. ABA Model Rule of Professional Conduct 5.4(c), Professional Independence of a Lawyer, states: “A lawyer shall not permit a person who recommends, employs, or pays the lawyer to render legal services for another to direct or regulate the lawyer’s professional judgment in rendering such legal services.” The ABA has clarified in a formal opinion that “lawyers representing insured clients must not permit the client’s insurance company to require compliance with litigation management guidelines the lawyer reasonably believes will compromise materially the lawyer’s professional judgment or result in his inability to provide competent representation to the insured.”
In conjunction with using litigation management guidelines as well as budgeting and project planning methods to manage the forward-looking defense costs, the insurer may also assign claims professionals and third-party auditors to look backward, review and evaluate defense invoices to ensure that the fees charged by the independent defense counsel comply with litigation management guidelines, and deduct incurred defense costs that appear to be excessive. The audit process can be formulaic, without much consideration given to the overall litigation strategy, as the outside auditor generally makes deductions based on litigation management guidelines.
Common deductions include the format of billing entries, the number of attorneys and legal professionals on a matter or task, the amount of time spent on a task, and intrafirm communications that may be prohibited by the insurer’s litigation management guidelines. Insurers often contest (and may succeed in contesting) defense costs where independent counsel engages in block-billing, the “practice of aggregating multiple tasks into one billing entry.” Courts have observed that, “[a]lthough not prohibited, block-billing makes it ‘exceedingly difficult’ for courts to assess the reasonableness of the hours billed.”
Reasonable deductions may also be made where billing entry descriptions are too vague to allow assessment of the work performed in conjunction with billing guidelines, but time spent in intrafirm conferences is generally allowed. Finally, courts vary in whether they will allow or reduce billing entries from multiple participants in an intrafirm conference.
Insurer’s right to recoup defense costs. Courts are split on whether an insurer may recoup defense costs. The majority approach is to permit recoupment under a reservation of rights. The minority approach holds that there is no right to recoupment unless the policy (or other express agreement between the insurer and the policyholder) reserves that right. In a review of cases throughout the country following the majority approach, the U.S. Court of Appeals for the Sixth Circuit observed that courts upheld the insurer’s right to recoup defense costs
when the insurer did not have a duty to defend any of the asserted claims where the insurer: 1) timely and explicitly reserves its right to recoup the costs; and 2) provides specific and adequate notice of the possibility of reimbursement. The general rule thus appears to be that, if these conditions are met, a reservation of rights is enforceable even absent an express agreement by the insured.
Further, the reservation of the right to recoup should be express, made in writing, and timely.
The minority approach limits the insurer’s right to recoupment and does not recognize the right to recoup defense costs that is preserved only in the reservation of rights and not the policy. The Illinois Supreme Court has stated that it is “a matter of public policy” that “an arrangement where an insurer can unilaterally modify its contract, through a reservation of rights, to allow for reimbursement of defense costs in the event a court later finds that the insurer owes no duty to defend” cannot be condoned. The Illinois Supreme Court counseled insurers that, if they wish to preserve their right to recoup defense costs, they are “free to include such a term in [the] insurance contract. Absent such a provision in the policy, however, an insurer cannot later attempt to amend the policy by including the right to reimbursement in its reservation of rights letter.”
Interestingly, New York and Georgia courts are seemingly shifting away from the majority approach toward the minority approach. The New York appellate court recently recognized and followed the trend in disallowing recoupment, noting that the insurer may not recoup based on a unilateral reservation of right to do so “absent an express provision to that effect in the policy.” The U.S. District Court for the Northern District of Georgia similarly observed: “Simply put, ‘the insurer should not be able to unilaterally alter the terms of an insurance policy.’ This follows straightforwardly from the concept of a reservation of rights: the right must be preexisting to be reserved; otherwise an entirely new right is created.”
California has created a more nuanced path: It follows the majority approach for uncovered claims and the minority approach for covered claims. In a “mixed-action” case involving both covered and uncovered claims, an insurer cannot recoup defense costs paid on covered claims unless that right was expressly stated in the policy or a separate contract, but the insurer may recoup defense costs for claims that are not potentially covered by the policy. The California Supreme Court recognized that the right to reimbursement for defense costs on uncovered claims is one that is implied in law to prevent unjust enrichment.
Nonetheless, many of the cases reviewed here would indicate that an insurer would be well situated if it preserves its right to recoup defense costs as an express term in its policy, as well as clearly expressing and reserving that right in writing at the time a claim is made.
Policyholders can take both proactive and reactive steps to maximize the reimbursement of their defense costs. For instance, if an insurer indicates that it will expect independent defense counsel to follow litigation management guidelines, then the policyholder should respond promptly to receipt of the insurer’s guidelines and object to any potentially improper limitations. Policyholders should provide copies of those guidelines to their independent defense counsel. Policyholders also should consider providing regular updates and submit defense costs on a regular basis to avoid any disputes over their duty to cooperate with the insurer in the claim. Policyholders should further play an active role in their defense strategy and managing independent counsel, such as ensuring that independent defense counsel provide detailed billing descriptions to avoid deductions based on vagueness and to better show the value of the time worked. And if the insurer disputes defense costs, the policyholder should appeal any deductions—and provide further support in response to reasonable requests—promptly.
Insurers also can better protect their interests by being more proactive in engaging policyholders to provide regular updates and invoicing. Upon receipt of invoices, the insurer should promptly review and raise concerns about billing entries. Finally, to preserve and protect their own interests in the event that non-coverage of defense costs is found, then insurers may want to consider including a provision regarding the right to recoupment in their insurance policies to adequately preserve that right and properly reserve the right to recoup defense costs under appropriate circumstances.
As a final practical matter, the insurer and its policyholder can always negotiate their own compromises on what constitutes reimbursable or non-reimbursable defense costs. Such compromises could involve the hourly rates that the insurer will agree to reimburse (with the policyholder paying the difference), the number of attorneys permitted at events such as court hearings and depositions, and even an allocation (commonly by percentage) that the insurer must reimburse when the loss includes both covered and uncovered claims. This avenue is usually advisable, before the insurer incurs costs in retaining an auditor and the policyholder risks non-reimbursement of a substantial amount of fees, and certainly before both parties expend yet more money in litigating disputes over defense cost reimbursements.
