In those jurisdictions where “independent counsel” is required once an “actual conflict of interest” exists, the insurer’s refusal to provide same as well as its selection of defense counsel cannot discharge its legal duty to the insured. Where a matter is pending and lead counsel requires local counsel in jurisdictions where the underlying suit is pending (as often happens in intellectual property litigation), allowing the insurer to select local defense counsel can be problematic.
Where a compulsory counterclaim must be asserted, an insurer may not select appointed counsel to function both as local counsel (typically in responding to declaratory relief claims for invalidity and non-infringement) and pursue a compulsory counterclaim rather than pay for independent counsel. In Polymer Industrial Products Co. v. Bridgestone/Firestone, Inc. [347 F.3d 935 (Fed. Cir. 2003)], the court found that the patent infringement claim was a compulsory counterclaim to the alleged infringer’s declaratory judgment claim of noninfringement. Yet an offensive claim, such as a compulsory counterclaim, may be defensive, and the fees incurred therein “conducted against liability,” and thus the insurer’s obligation.
The same point was made by the court in Adobe Systems, Inc. v. St. Paul Fire and Marine Ins. Co. [2007 WL 3256492, at *9 (N.D. Cal. Nov. 5, 2007)]: “The Court finds persuasive the reasoning in IBP, Inc. v. National Union Fire Ins. Co. of Pittsburgh, PA, which held that even though an insured initiates a lawsuit, that fact does not automatically preclude coverage for defense-type legal fees and expenses where the insured is resisting a contention of liability for damages.” And in KLA-Tencor Corp. v. Travelers Indem. Co. [2004 WL 1737297, at *4 (N.D. Cal. Aug. 4, 2004)], the court observed, “[T]he best defense to the disparagement counterclaims was showing that the `055 patent was valid . . . . [T]his was not an unreasonable strategy.” Finally, applying California and New York law, the court in Ultra Coachbuilders, Inc. v. General Security Ins. Co. [229 F. Supp. 2d 284, 289 (S.D.N.Y. 2002)] found that “the counterclaims . . . were thus ‘inextricably intertwined with the defense . . . of the litigation as a strategic matter.’ ”
Absent an agreement with the insurer on this issue, an insured must be allowed to retain its own local counsel, paid by the insurer, and permit at most the appointed counsel to serve as “associate counsel.”
Conflict Posed by Claims of Intentionally Caused Conduct is Classic Actual Conflict Recognized by a Majority of Forums as Requiring Independent Counsel
In most jurisdictions, an “actual conflict of interest” must appear before an insured is allowed to select “independent counsel.” Various courts, such as Alaska, California, Illinois, Minnesota, New York and Texas, have found that dual claims for negligent and intentional conduct will usually create an actual conflict sufficient to allow the insured to select independent counsel.
Applying Maryland law, the court in Britamco Underwriters, Inc. v. Nishi, Papagjika & Associates, Inc. [20 F. Supp. 2d 73, 76 (D.D.C. 1998)] found that an actual conflict does not exist when the complaint alleges only a negligent act but later attempts, unsuccessfully, to add an intentional cause of action.
In New Jersey, there is a right to independent counsel where an actual conflict exists, although the insured is required to pay the costs of the independent counsel up front and the court will later determine whether they are to be reimbursed. Burd v. Sussex Mut. Ins. Co. [267 A.2d 7, 10-11 (N.J. 1970)]; Schmidt v. Smith [684 A.2d 66, 76-77 (N.J. Super. Ct. 1996)].
The Insurer’s Reservation of Its Rights to Deny Indemnity Under the “Knowledge-Based” Exclusions in the Policy Creates a Conflict of Interest Entitling its Insured to Independent Counsel
A conflict of interest requiring reimbursement of fees incurred by “independent counsel” may also arise where an insurer has reserved its rights under the “knowledge of falsity” and “knowing violation of the rights of another” exclusions as part of its reservation of “all of its rights under the policy.”
Pursuit to policy exclusions in the 1998/2001 CLG Insurance Services office policy forms “This insurance does not apply to ‘personal and advertising injury’ [1] arising out of oral or written publication of material, if done by or at the direction of the insured with knowledge of its falsity [or] [2] caused by or at the direction of the insured with the knowledge that the act would violate the rights of another and would inflict ‘personal and advertising injury.’ ”
The court in Utica Mut. Ins. Co. v. David Agency Ins., Inc. [327 F. Supp. 2d 922, 929 (N.D. Ill. 2004)] held: “It was in David’s interest to argue that it did not know of the falsity of the alleged statements; if David succeeded, its liability for defamation and any resulting damage award would be covered under the insurance policy. By contrast, Utica had no interest in trying to show David’s lack of knowledge. Were the fact finder to hold David [liable] for intentional defamation, Utica would escape liability for any compensatory damage award.”
Such a reservation can trigger a right to independent counsel. An insurer’s specification in its denial letter that its reservation is not exhaustive of the rights the insurer is reserving is inconsistent with a claim that no conflict arises as statements that the insurer makes a “complete reservation of all of its rights” and, further, is not waiving “any of its rights.” Absent a clarification in writing from the insurer, however, that it intends to waive all rights it may have under these exclusions in connection with the underlying suit, this form of reservation allows insurers in many, but not all, states to assert new grounds for denial of coverage.
In Melton v. Industrial Indem. Co. [103 Cal. Rptr. 2d 222 (Cal. Ct. App. 2001)], the court found equitable estoppel based on a showing of detrimental reliance by the insured that barred the insurer from asserting grounds to contest coverage not raised in its reservation of rights letter. And in Utica Mut. Ins. Co. [327 F. Supp. 2d at 930], the court, referencing the holding in Royal Ins. Co. v. Process Design Assocs., Inc. [582 N.E.2d 1234, 1239 (Ill. App. Ct. 1991)], stated, “Royal's letter reserving its right was inadequate because, in using the words ‘may’ and ‘possibly,’ it did not advise [the insured] ‘unequivocally and clearly’ of its intention to reserve a particular defense.”
However, in Waller v. Truck Ins. Exch. [44 Cal. Rptr. 2d 370, 387 (Cal. 1995)], the court observed that waiver is the intentional relinquishment of a known right, and it will not be implied where the insurer reserved its right to assert additional grounds for denial of a defense other than those articulated in its initial denial letter.
Where an insurer reserved its rights under the policy’s “knowledge-based” exclusions, the same allegations in an underlying suit create a conflict of interest entitling the insured to independent counsel. The reserved coverage questions relate to the insured’s conduct that will be litigated in the underlying suit. To prove no coverage the insurer must establish that the insured made the disparaging statements with knowledge of their falsity (for the first exclusion) or knowing that the statements would inflict injury and violate the plaintiff’s rights (for the second exclusion). This is the very conduct of the insured that will be litigated in the underlying suit.
It is in the insurer’s interest in the underlying suit to establish knowingly false disparaging statements, rather than reckless or negligent conduct, and also an intent to injure. The insurer would then avoid paying for any judgment under the exclusions. But it is in the insured’s interest to establish the converse to avoid enhanced damages, secure coverage, and to advance their jury appeal. The parties thus have directly conflicting interests in the defense of the underlying suit. Any defense counsel appointed by the insurer will be in a position to control the outcome of the reserved coverage issue in the insurer’s favor by the manner in which they defend. The two-part test is thus met and the insured is entitled to independent counsel.
In one California case, Foremost Ins. Co. v. Wilks [253 Cal. Rptr. 596, 600 and n.7 (Cal. Ct. App. 1988)], the court reasoned that where an insurer reserves it rights under the “knowledge of falsity” exclusion in a defamation suit, a conflict warranting independent counsel exists because the outcome of the reserved coverage issue would depend upon conduct of the insured also being litigated in the underlying action. The court stated, “We note that the policy contained an exclusion for libel or slander made by the insured ‘with knowledge of the falsity thereof.’ Foremost in its April 26 letter did not reserve the future right to deny coverage under this exclusion and thereby waived its right to assert the exclusion as a defense to coverage. . . . If Foremost had reserved its rights under this exclusion, a conflict would have been presented.”
Indeed, several cases offer persuasive evidence that the insurer should provide independent counsel since the underlying suit alleges knowing disparaging misconduct and the insurer has reserved its rights under knowledge-based exclusions.
In Citi Apartments Inc. v. Markel Ins. Co. [2007 WL 1689013, at *4, *5 (N.D. Cal. June 11, 2007)], where the underlying suit involved intentional misconduct (but not defamation), the court recognized a right to independent counsel based on an exclusion for personal and advertising injury “caused by . . . the insured with the knowledge that the act would violate the rights of another . . . .” But since the insurer did not reserve its rights under the “knowledge exclusion,” there was no actual conflict. And in Zeevi v. Michigan Millers Mut. Ins. Co. [1998 WL 123122, at *1 n.1 (9th Cir. (Cal.) 1998)], the parties agreed that independent counsel was warranted under Cal. Civ. Code § 2860 in the underlying defamation lawsuit. The court noted in dicta that “Michigan Millers was defending itself against Zeevi’s action for wrongfully failing to defend and indemnify her in the defamation action. Arguably, it would have been improper for Michigan Millers to select counsel to defend Zeevi in that defamation action.”
