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When Can an Insurer Pursue a Malpractice Claim Against Defense Counsel Retained for an Insured? (Part Two)

January 29, 2024 Articles
American Bar Association Insurance Coverage Litigation Committee (ICLC)

By Jalen M. Brown, Kristin Davis, Shanti Eagle, Peter J. Georgiton, and J. Mark Hart

Part 1 of our two-part article addressed the circumstances in which an insurer can directly pursue malpractice claims against defense counsel. We observed in Part 1 that the majority of courts have allowed insurers to bring claims against defense counsel, and we discussed the three primary legal vehicles through which insurers can bring such claims.

As we previewed in Part 1, a related issue is how insurers can seek reimbursement of defense costs from the insured if it is later found that the insurer did not owe its insured a duty to defend. As in the cases discussed in Part 1, there is a split of authority, with many jurisdictions still uncertain.

In Part 2, we discuss this split of authority and the requirements for an insurer to preserve a right to recoup defense costs, as well as practical considerations for insurers pursuing, and policyholders looking to fend off, a demand for recoupment.

The Insurer's Duty to Defend Is Extremely Broad

Under the standard commercial general liability (CGL) policy, the duty to defend is triggered regardless of the veracity or merits of the underlying claimant's allegations. Often, through a vigorous defense, a policyholder can dispatch a case without any judgment or settlement. Of course, such a result comes at a cost, and a defense against frivolous allegations can be just as expensive, if not more expensive, than the ultimate resolution of a case. Thus, for many policyholders, the most valuable aspect of a liability insurance policy is the insurer's duty to defend rather than the duty to indemnify—i.e., the defense cost coverage.

The insurer's duty to defend is triggered even if the claim includes allegations or causes of action that would never be covered under the policy. Standard CGL policies do not allocate defense coverage between covered and non-covered claims. Instead, the duty to defend applies to costs for defending against all allegations (until it is established that there is no set of facts that could trigger coverage). An insurer providing a defense to a policyholder thus risked paying years of defense costs litigating a case that might ultimately not fall within the bounds of the policy's coverage. The insurer was left without recourse in this situation.

However, over the past 30 years, the tide has slowly shifted to provide insurers with alternatives in certain circumstances. In some liability policies (typically not CGL policies), insurers added allocation clauses, permitting them to allocate defense costs between covered and non-covered claims. Insurers also added language permitting them to "claw back" defense costs that ultimately went to non-covered claims. Still other CGL insurers, rather than add this policy language, focused on reserving the right to recoup defense costs in correspondence with their insureds. This latter approach of unilateral reservation of rights to reimbursement has been met with mixed success, depending on the jurisdiction.

Setting the Stage for a Nationwide Split of Authority

The California Supreme Court's decision in Buss v. Superior Court is recognized as the seminal case on the insurer's right to recoupment through unilateral reservation. In Buss, the court held that the insurer had a duty to defend immediately and entirely, if any claim was potentially covered. However, under certain circumstances, the court found that an insurer can provide a defense while reserving its right to recover some, or all, defense fees it paid at the end of the case. In Buss, the complaint filed against the insured asserted 27 causes of action, only one of which fell within Transamerica Insurance Company's coverage. Transamerica accepted the defense of the action but reserved its rights to reimbursement or an allocation between covered and uncovered claims. The court found that the insurer was obligated to defend the entire case prophylactically to make sure the insured received a meaningful defense.

However, the court also found that the insurer had the right to an allocation and reimbursement for defense costs, after the fact, for claims that it could prove were solely allocable to claims that were not potentially covered. The court reasoned that the insured did not pay a premium for defense of claims that were not potentially covered, and the insurer did not bargain to bear these costs. The court explained that shifting these defense costs to the insurer would upset this arrangement, and the court therefore found a right to reimbursement implied in law. The court referred to this right to reimbursement as justifiable under the theory of "unjust enrichment." 

Post-Buss Division over Recouping Defense Costs

Insurers were quick to rely on Buss. Indeed, Buss has been cited in over 1,000 decisions to date. And while Buss did recognize the right to reimbursement when reserved unilaterally by the insurer (not within the terms of the policy), several courts rejected Buss. The result has been a nationwide split. Several states' supreme courts, in addition to California's, have permitted insurers to seek reimbursement for defense costs spent on non-covered claims. Other states have similarly allowed reimbursement when expressly reserved. By contrast, several jurisdictions have not allowed such recovery absent express policy language. Still other courts rejected the concept of an implied consent to reimbursement, some going as far to require a written non-waiver agreement. Finally, several state courts have yet to weigh in, leaving federal courts to predict state law.

Here, too, there is a split between the courts-federal courts in Arizona, Hawaii, Kentucky, Michigan, New York, and Tennessee predicted their state counterparts would allow reimbursement, whereas federal courts in Idaho, Iowa, Louisiana, Maryland, Massachusetts, Missouri, Ohio, and Virginia predicted state law would not permit such reimbursement. Still other federal courts have issued conflicting predictions. Of course, the courts do not always get it right-for instance, in 1999, a federal court in Nevada suggested that a right to reimbursement would be permitted only if there was a "clear understanding between the parties that [the insurer] reserved the right to reimbursement," suggesting that a unilateral reservation would not suffice and that reimbursement would not be permitted under the ordinary terms of a policy. 

Recent Developments in Recouping Defense Costs

The majority view in Nautilus. On March 11, 2021, the Nevada Supreme Court addressed a certified question from the Ninth Circuit concerning an insurer's right to reimbursement in Nautilus Insurance Co. v. Access Medical, LLC. The Ninth Circuit presented the following certified question to the Nevada Supreme Court: 

Is an insurer entitled to reimbursement of costs already expended in defense of its insureds where a determination has been made that the insurer owed no duty to defend and the insurer expressly reserved its right to seek reimbursement in writing after defense has been tendered but where the insurance policy contains no reservation of rights?

The Nevada Supreme Court ruled 4-3 that yes, an insurer can recoup restitution when a party to a contract performs an obligation in dispute and under protest and a court later determines that the insurer did not have an obligation to perform under the contract. Nautilus cited Buss and is consistent with that reasoning.

The respondent in Nautilus, Access Medical, LLC, was facing 31 claims by a former business partner, Ted Switzer, including a claim for "interference with prospective economic advantage." The respondent tendered defense to its insurer, Nautilus Insurance Co. The insurer was required under the policy to defend the respondent against "any 'suit' seeking ... damages" because of a "personal and advertising injury," "arising out of ... [o]ral or written publication, in any manner, of material that slanders or libels a person or organization." The insurer initially declined to defend the suit but then defended the suit while expressly reserving its rights to withdraw from coverage and recoup defense costs if a court determined that the insurer had no duty to defend. The insurer's declaratory judgment action eventually was heard by the Ninth Circuit on appeal, and the Ninth Circuit affirmed that the insurer did not have a duty to defend.

The Nevada Supreme Court accepted the Ninth Circuit's holding that the insurer did not have a duty to defend and analyzed only the consequences of this determination. The court concluded that because the Ninth Circuit ruled that the insurer does not have a duty to defend, the insurance contract between the insurer and respondent is inapplicable. The Nevada Supreme Court analyzed whether the insurer's claim for unjust enrichment had any merit. A claim for unjust enrichment has three elements: "the plaintiff confers a benefit on the defendant, the defendant appreciates such benefit, and there is acceptance and retention by the defendant of such benefit under such circumstances that it would be inequitable for him to retain the benefit without payment of the value thereof." The first two elements of an unjust enrichment claim applied, and the court analyzed whether equity required the policyholder to pay back the insurer. Using the Nevada Restatement (Third) of Restitution and Unjust Enrichment as support, the Supreme Court found that "[w]hen time is precious, it makes sense for the parties to decide quickly what to do, and to litigate later who must pay."  Moreover, the court found that an insurer risks unbounded liability for refusing to defend a suit and losing the coverage determination that it is reasonable to initially pay to defend while determining coverage later. The Nevada Supreme Court concluded that an insurer can recover restitution when it clearly reserves its rights in writing and a court determines that the insurer has no contractual duty to defend. 

The minority view in Nautilus. Three justices on the Nevada Supreme Court dissented in Nautilus, reasoning that the insurance policy did not have a provision that allowed the insurer to seek reimbursement. The dissent points to Nevada's precedent, which does not allow a party to recover under unjust enrichment when there is an express written contract. In Nautilus, there was an express written contract between the insurer and the respondent, and the written contract did not provide a remedy for reimbursement. The fact that the insurance contract did not provide the particular remedy that the insurer seeks does not nullify the fact that the insurance contract governs. Last, in addressing the majority's equity argument for unjust enrichment, the dissent stated, "[C]oncerns of equity and fairness weigh against reimbursement, because an insurer benefits unfairly if it can hedge on its defense obligations by reserving its right to reimbursement while potentially controlling the defense and avoiding a bad faith claim." 

Courts in other states, consistent with the dissent in Nautilus, hold that insurers cannot seek reimbursement when the insurance policy does not explicitly include a right to reimbursement. This question was examined by the Illinois Supreme Court in General Agents Insurance Co. of America, Inc. v. Midwest Sporting Goods Co., a case in which the insurer chose both to defend under a reservation of rights to seek reimbursements and to file for a declaratory judgment that there was no coverage. Illinois took the minority view on this issue by not allowing "an insurer to receive reimbursement of its defense costs even though the underlying claim was not covered by the insurance policy and the insurer had specifically reserved its right to reimbursement." The Illinois Supreme Court concluded that it would go against public policy to allow an insurer to unilaterally modify a contract through a reservation of rights letter and allow it to seek reimbursements for defense costs when a court later determines there was no duty to defend. 

Practical Considerations

Increasingly, many types of policies include allocation provisions specifically requiring an attempt to agree on a division of costs and providing for the insurer to attempt to recoup such costs in the event the parties cannot agree. These clauses vary widely, and insurers will likely be more successful pursuing reimbursement under such policies than under policies without allocation clauses. For policyholders, they can mean agreeing to an insurer's proposed allocations early in the case, often without the benefit of coverage counsel and before the merits of the case are truly understood. For example, an allocation of one-third of all fees because one out of three causes of action is not covered may sound reasonable but can be disadvantageous where those claims are in the alternative and substantially overlap and may not hold up as pleadings are amended and discovery develops the merits of the claims.

Even where the insurer has specifically reserved the right to reimbursement of defense costs in its reservation of rights letter, in a jurisdiction where reimbursement is allowed, it is rare that reimbursement from the insured is actually pursued (let alone awarded). The reasons for this include collectability concerns, ongoing relationships with large insureds, as well as the hurdles to proving reimbursement. In mixed actions, such as in Buss, the insurer must bear the burden to prove which (if any) fees are solely allocable to uncovered claims. The Buss court recognized that this burden "if ever feasible, may be extremely difficult" and, hence, will only be pursued in "apparently exceptional cases." As in indemnity situations,  the presumption is that unless the insurer can prove the fees were more than they would otherwise have been in the absence of the covered claim, this burden cannot be met. This is a factual issue that often turns on the defense bills; so the ability of the insurer to seek reimbursement may turn on the specificity (or lack thereof) in defense counsel's time entries. It also poses logistical difficulties: The defense counsel may become a witness. Where defense counsel was independent or no tripartite relationship exists, that creates privilege issues. In a tripartite relationship, counsel's loyalties are divided, adding another level of complexity.

Timing is also an issue. Under Buss, the insurer should wait until the conclusion of the underlying case to seek reimbursement. However, in some jurisdictions, a failure to promptly seek declaratory relief may preclude a recovery of fees: In states where the duty to defend can be terminated only prospectively, it would be inconsistent to allow an insurer to wait until the case is over and then seek to recoup fees. Where the basis for reimbursement is not confined to the initial pleadings but is instead based on developments in the litigation, the question of when the right to reimbursement would date from, and whether it could be retroactive, also remains to be seen.

Another level of complexity is added when there are multiple insureds being defended. Even where multiple insureds received policy benefits to which they were not entitled, subjecting them to liability for reimbursement, "it does not follow that all ... insureds should be jointly liable for reimbursing the entire amount of those costs." As an equitable restitution remedy, it must be for an equitable share. Thus, insurers should also consider the relative benefits to each insured before attempting recoupment where there are multiple insureds.

Conclusion

There is no one-size-fits-all answer for insurers seeking to recover indemnity or defense payments. These determinations are jurisdiction-specific and fact-driven. However, it is clear that most jurisdictions allow insurers to attempt to recover for adverse outcomes from defense counsel under a theory of malpractice, whether or not the insurer had any engagement with the defense counsel. Furthermore, while the majority of states allow insurers to unilaterally reserve rights and recover defense costs in the event the insurer can prove the claims were uncovered, a significant minority refuse to allow the insurer to do so—a minority that may gain further traction in many jurisdictions.

This article is jointly authored through a collaborative process by attorneys representing policyholders and insurance carriers. The opinions expressed herein do not necessarily reflect the opinions of each of the authors, their firms, or their clients.

Related content: When Can an Insurer Pursue a Malpractice Claim Against Defense Counsel Retained for an Insured? (Part One)

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