August 31, 2018 Feature

Does Counterclaim Litigation Exhaust a SIR? The Visionaid Effect

By Eric Hermanson

An insured—say, an excavation contractor—arranges an excess policy with a cost-erosive self-insured retention (SIR) of, say, $1M per occurrence. Problems develop on a job. The owner says the contractor’s poor work has damaged a neighbor’s property. The owner sues the contractor. It also holds back payment under its contract, to offset the cost of resolving the neighbor’s claim and redoing other poor work it says the contractor performed.

The contractor denies liability. It notifies its insurer and hires counsel to defend the suit. It also files a counterclaim to recover the money the owner is withholding. Sometime later, the contractor finds it has paid its lawyers just over $1 million. Because the SIR is cost-erosive—i.e., it is reduced dollar-for-dollar by costs incurred in “defending” in the underlying proceeding—the contractor asks the carrier to take over its representation.

The carrier declines. It points out that the $1 million in claimed “defense” expenditures also includes amounts spent litigating the counterclaim—in other words, amounts spent to recover amounts due under the contract. It says these costs don’t qualify as costs of “defending” covered claims. It invites the contractor to break down the invoices—i.e., to allocate between the defense of the owner’s claim and the costs of litigating the counterclaim. But the contractor’s counsel says there’s no practical way to do so. The two claims are intertwined. They involve the same operative facts, and many of the same litigation activities.

Is the SIR exhausted? In the past, some courts have suggested it could be. These courts acknowledge—as they must—that satisfaction of a SIR is a condition precedent to the insurer’s defense obligation. They acknowledge it is the insured’s burden to show the SIR has been exhausted through “defense” payments. But these courts find the term “defense” to be ambiguous. In addition to the costs of defending the owner’s claims, they say, “defense” can encompass prosecution of compulsory counterclaims, or “affirmative claims which, if successful, have the effect of reducing or eliminating the insured’s liability.” Great West Cas. Co. v. Marathon Oil Co., 315 F. Supp. 2d 879 (N.D. Ill. 2003).

Other courts have agreed but on different grounds. They point to the insurer’s duty to defend both covered and noncovered claims, sometimes called the “in-for-one, in-for-all” rule. Where a counterclaim is “inextricably intertwined” with a plaintiff’s claim against the insured, Safeguard Scientifics, Inc. v. Liberty Mutual Ins. Co., 766 F. Supp. 324 (E.D. Pa. 1991), such that “defense costs [cannot] be separated by distinct legal theories,” see In re Feature Realty Litig., 634 F. Supp. 2d 1163 (E.D. Wash. 2007), these courts find it “only logical” that “where a dollar of loss is incurred as a result of both a covered claim and a non-covered claim, the dollar is covered —regardless of the dollar’s tangential benefit of settling, or defending against, the non-covered claim.” Id.

Last year, in Mount Vernon Fire Ins. Co. v. Visionaid, Inc., 477 Mass. 343 (2017), Massachusetts’ highest court suggested an alternative position: one that may support the insurer’s position on SIR exhaustion. Although Mt. Vernon was not a SIR case, it held that an insurer with a contractual duty to defend an insured was not required—under either the contractual language or the “in for one, in for all” rule—to pay the costs of pursuing an affirmative counterclaim on the insured’s behalf.

As to the meaning of the term “defense,” the court held:

In common usage, to “defend” means to “deny or oppose the right of a plaintiff in . . . a suit or wrong charged.” . . . Accordingly, . . . the essence of what it means to defend is to work to defeat a claim that could create liability against the individual being defended . . . . [T]he duty to “defend” requires an insurer to work to defeat a claim brought against the insured, but not to prosecute an affirmative claim against the plaintiff in the underlying suit, no matter how advantageous that claim would be to the insured.

Id. at 348–49.

As to the “in-for-one, in-for-all” rule, the court held:

Expanding the “in for one, in for all” rule . . . misaligns the interests of the party who stands to benefit from the counterclaim (the insured) and the party who bears the cost of prosecuting the counterclaim (the insurer). As a result, allowance of such a rule would increase the total number of counterclaims brought by insured parties . . .. If insurers were obligated to prosecute affirmative counterclaims on behalf of insured parties, “an insured would have every incentive—and little disincentive—to file suit, knowing that it could reap the benefits of success—however unlikely—while transferring the costs of an otherwise predictably unsuccessful suit onto its insurer.”

Id. at 352.

How will this apply in practice? The dissent in Visionaid offers one grim prediction. It says the insured may need two counsel— “one attorney appointed by the insurer [to] defend against some [claims] and an attorney retained by the insured [to] defend against others.” Id. at 356–57. It points to the possibility of conflict, inefficiency and waste.

But conflict is not inevitable. In some cases, the two attorneys may be able to amicably coordinate their activities. In other cases—where a claim is likely to be covered, and an insurer thinks a counterclaim would strengthen the insured’s negotiating position—the insurer may agree to prosecute the insured’s counterclaims (on a voluntary basis) despite the absence of any contractual obligation to do so. In still other cases, the insurer and the insured may agree to hire a single counsel, dividing the costs to reflect the benefits to each.

What Visionaid will require is timely cooperation between the insured and the insured: specifically, an up-front discussion of case strategy, and what legal activities are (or are not) related to the “defense” of the claim, followed by good-faith negotiations as to how these activities are to be handled and paid for.

The same suggestion can be made for cost-erosive SIRs. If an insured wants to litigate affirmative counterclaims at the same time (and in the same proceeding) where its insurer is defending the claims of a third party, the insured should advise the insurer promptly of that fact. It should offer to discuss the need for the counterclaims, and the strategic benefit of pursuing them. At that point, the parties can decide whether separate counsel make sense, or whether to reach some other solution: perhaps a negotiated agreement that allocates part of the counsel’s fees to “defense,” and part to counterclaims, for purposes of SIR exhaustion.

The result need not be conflict and inefficiency. Quite the contrary: it may be clearer, more timely communication, a collaborative focus on litigation strategy—and an honest recognition of the parties’ divergent interests, with appropriate arms-length negotiation to reconcile and align those interests, to the benefit of all involved.

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By Eric Hermanson

Eric Hermanson is a partner at White and Williams LLP in Boston, Massachusetts, and is chair of the TIPS Self-Insurers and Risk Managers Committee (SIRM) for the 2018–2019 bar year. He represents insurers in negotiating, litigating, and resolving complex coverage disputes and can be reached at hermansone@whiteandwilliams.com.