SETTLEMENT NEGOTIATIONS IN LEGAL CASES WALKING THE FINE LINE OF A CONFLICT JOHN D. DALTON BAUGH DALTON LLC

When a settlement demand is made against a policyholder/attorney, the insurer and the defense counsel appointed by the insurer have separate rights and distinct duties to the policyholder.

A. The Provision in ’ E&O Policies

Suffice it to say that black letter law fails to clarify the validity of a consent clause in most jurisdictions. Some states seem to uphold the professional insured’s right to consent to settlement. See, e.g., Rogers v. Robson, Masters, Ryan, Brumund and Belom, 74 Ill.App.3d 467 (3rd Dist. 1979). Other states (like Florida) have declared such consent clauses to be against public policy. See Freeman v. Cohen, 2007 WL 4124604 (Fla. App. 4 Dist.), citing, F.S.A. §627. 4147(1)(b)(2007).

Regardless, defense counsel appointed by a defendant/attorney’s malpractice carrier is not in the position to determine the validity of a consent clause. If such a clause is included in the client’s policy, defense counsel can be faced with numerous conflicts. Many of those conflicts arise even without the consent clause, just given the nature of the tripartite relationship between and among the defendant/attorney, assigned defense counsel and the carrier. Thus, much of the case law related to this inherent conflict relates to typical commercial general liability policies that generally grant the carrier the right to settle, apparently without the insured’s consent.

B. The Insurer’s Duties to the Insured/Attorney

The Second Circuit Court of Appeals recently summarized common conflicts an insurer encounters when a settlement demand is made against an insured, whether the policy contains a consent clause or not:

[W]hen a plaintiff makes a settlement offer within the policy limits, “an inherent conflict arises between the insurer’s desire to settle the claim for as little as possible, and the insured’s desire to avoid liability in excess of the policy limits.”

Pinto v. Allstate Ins. Co., 221 F.3d 394, 399 (2nd Cir. 2000) (citing Smith v. General Accident Ins. Co., 91 N.Y.2d 648, 697 N.E.2d 168, 170-171 (1998)). That is, when an insurer receives a demand within the policy limits, it must endeavor to satisfy its own interests by negotiating the lowest settlement possible and at the same time protect its insured from exposure in excess of the policy limits.

The insuring agreement of a typical comprehensive general liability policy states:

[The insurer] will pay those sums that the insured becomes legally obligated to pay as because of “bodily injury” or “property damage” to which this insurance applies. We will have the right and duty to defend any “suit” seeking those damages. We may at our discretion investigate any “occurrence” and settle any “claim” or “suit” that may result.

Based on such language, courts and commenters widely recognize that “[l]iability or indemnity insurance policies ordinarily reserve to the insurer the decision as to whether an offer to compromise a claim against the insured should be accepted.” W. E. Shipley, Annotation, Duty of Liability Insurer to Settle or Compromise, 40 A.L.R.2d 168 (1999).

In Marginian v. Allstate Ins. Co., 18 Ohio St. 3d 345, 481 N.E.2d 600 (1985), the insuring agreement stated that the insurer “may settle any claim or suit if [the insurer] feel[s] this is appropriate.” After the policyholder instructed the insurer not to settle the claims against him, the insurer settled the claims. The policyholder filed a bad faith claim alleging that the insurer’s actions caused substantial increases in the premiums for subsequent policies. The Ohio Supreme Court found that, by virtue of the policy language, the insurer and the insured “expressly and unambiguously contracted to allow [the insurer] the option of settling any claims . . . .” Id. at 602. As such, the Court held that “a alleging a breach of the insurer’s duty of good faith will not lie where the insurer has settled such a claim within the monetary limits of the insured’s policy.” Id. at 603.

In American Home Assurance Co., Inc. v. Hermann’s Warehouse Corp., 117 N.J. 1, 563 A.2d 444 (1989), the insuring agreement gave the insurer “the right to settle any claim, suit or other proceedings as it may deem expedient.” The insurer settled the claim for an amount within the policy limits but in excess of the $20,000 deductible. When the insurer sought reimbursement for the deductible amount, the insured alleged that the insurer acted in bad faith by failing to secure the insured’s consent to the settlement and by settling a claim that could have been won on the merits.

The New Jersey Supreme Court focused on the rights and obligations of the parties as set forth in the language of the policy and held:

“There is nothing before us to suggest that [the insured] was foreclosed from obtaining coverage that would have included no deductible amount or coverage that would have given it the right to approve any settlement. Had it wished for one or both of the forms of protection, it would have had to pay for such additional consideration. But if, as here, the deductible provision is accompanied by another provision giving the carrier the unfettered right to settle as it “deems expedient,” the insured has bargained away whatever rights might otherwise be created by what might be perceived as a conflict between the insurer and insured.”

Id. at 448. But, the Court emphasized that the policy language reserving the insurer’s exclusive right to settle did not exonerate the insurer from exercising good faith in the settlement of the claim, characterized as the duty “to observe ordinary diligence in performing that power when in the exercise of it.” Id. (citing Mitchum v. Hudgens, 533 So.2d 194, 198 (Ala. 1988)).

Hermann’s Warehouse typifies the legal landscape with respect to an insurer’s right to settle. Many courts have similarly enforced an insurer’s right to settle under the “deems expedient” language. Shuster v. South Broward Hosp. Dist. Physicians’ Prof’l Liab. Ins. Trust, 591 So.2d 174, 176-177 (Fla. 1992); Feliberty v. Damon, 72 N.Y.2d 112, 527 N.E.2d 261, 262 (1988); Western Polymer Tech., Inc. v. Reliance Ins. Co., 38 Cal. Rptr. 2d 78 (Cal. Ct. App.), review denied, 1995 Cal. LEXIS 2612 (1995) (finding an insurer cannot be held liable for damage to an insured’s reputation as a result of a settlement); Casualty Ins. Co. v. Town & Country Pre-School Nursery, Inc., 147 Ill.App.3d 567, 498 N.E.2d 1177, 1178-1179 (1st Dist. 1986). Other courts have held that an insurer generally has discretion to settle a claim within the policy limits even if the insured pays a retrospective premium. See, e.g., National Surety Corp. v. Fast Motor Serv., Inc., 213 Ill.App.3d 500, 572 N.E.2d 1083, 1087 (1st Dist. 1991).

Hermann’s Warehouse also typifies the standard for measuring bad faith. See also Kransco v. International Ins. Co., 23 Cal. 4th 390, 2 P.3d 1, 9 (2000) (finding that an insurer “breaches the implied duty of good faith and fair dealing by unreasonably refusing to accept a settlement offer within policy limits”); Cramer v. Insurance Exch. Agency, 174 Ill.2d 513, 675 N.E.2d 897, 900- 903 (1996) (holding that §155 of the Illinois Insurance Code pre-empts the of bad faith and requires a showing of the insurer’s “unreasonable and vexatious” refusal to pay a claim); Pavia v. State Farm Mut. Auto. Ins. Co., 82 N.Y.2d 445, 626 N.E.2d 24, 27 (1993) (holding that a bad faith claimant must establish the insurer acted with “gross disregard” by the “deliberate or reckless failure to place on equal footing the interests of its insured with its own interests when considering a settlement offer”).

In Maroney v. Allstate Ins. Co., 12 Wis. 2d 197, 107 N.W.2d 261, 263 (1961), the Wisconsin Supreme Court rejected a mere standard:

[I]t is not bad faith if counsel for a liability insurer refuses to settle the claim of an injured person under the bona fide belief that the insurer might defeat the action or keep the verdict within the policy limits. Considering all the [facts], it may be that the insurer acted negligently, exercising poor judgment, but it is not enough to show that it acted negligently in deciding to litigate rather than settle the case.

The Michigan Supreme Court reached a similar result:

[T]he insurer does not act in bad faith if it refuses settlement in the honest belief that it has a fair chance of victory, or of keeping the verdict within the policy limit, or . . . the compromise amount is excessive, or if it has legal defenses. . . . On the other hand, arbitrary refusal to settle for a reasonable amount, where it is apparent that suit would result in a judgment in excess of the policy limit, indifference to the effect of refusal on the insured, failure to fairly consider a compromise and facts presented and pass honest judgment thereon, or refusal upon grounds which depart from the and for the purpose of the grant of power, would tend to show bad faith.

Commercial Union Ins. Co. v. Liberty Mut. Ins. Co., 426 Mich. 127, 393 N.W.2d 161, 163-164 (1986) (quoting City of Wakefield v. Globe Indem. Co., 246 Mich. 645, 225 N.W.2d 643 (1929).

Thus, while the general discretion to settle is evident, it is equally well established that an insurer also has a duty arising out of the implied covenant of good faith and fair dealing to act in good faith and settle claims within the policy limits. PPG Indus., Inc. v. Transamerica Ins. Co., 20 Cal. 4th 310, 975 P.2d 652, 655 (1999); Cramer v. Insurance Exch. Agency, 174 Ill.2d 513, 675 N.E.2d 897, 903 (1996); Pavia v. State Farm Mut. Auto. Ins. Co., 82 N.Y.2d 445, 626 N.E.2d 24, 27 (1993). When the insurer breaches this duty and unreasonably refuses to settle in good faith within the policy limits, the insurer can be held liable for the entire judgment against the insured, including the amount in excess of the policy limits. Id. at 26; Cramer v. Insurance Exch. Agency, 174 Ill.2d 513, 675 N.E.2d 897, 903 (1996); Commercial Union Assurance Cos. v. Safeway Stores, Inc., 26 Cal. 3d 912, 610 P.2d 1038, 1040-1041 (1980).

The diverging interests between the insurer and the policyholder and the authority with respect to an insurer’s discretion to settle and its duty to settle can be reconciled when the insurer acts in good faith and “gives equal consideration to its insured’s interests in avoiding liability in excess of the policy limit as it does its own interests when considering plaintiff’s demand to settle a lawsuit.” Pinto v. Allstate Ins. Co., 221 F.3d 394, 398 (2nd Cir. 2000). But, it does not appear that giving “equal consideration to the insured’s interests” requires the insurer to inform the insured of all settlement demands.

Courts may also consider an insurer’s failure to so inform its insured, among other things, as of bad faith in a failure to settle action. Smith v. General Accident Ins. Co., 91 N.Y.2d 648, 697 N.E.2d 168, 172 (1998). In Smith, the plaintiff, a pedestrian, sustained serious and permanent injuries after being struck by an automobile. Plaintiff’s view of the automobile was obstructed by the insured’s parked delivery truck which had coverage limits of $500,000. After the jury returned verdicts finding the insured 50% at fault and damages in the amount of $1.1 million, the insured assigned his bad faith failure to settle cause of action to the plaintiff.

The plaintiff offered evidence that the insurer did not inform the insured of the settlement negotiations and that it was the industry practice to keep policyholders abreast of settlement discussions. The plaintiff also established that the insurer’s claim manual instructed claims personnel to keep policyholders apprised of settlement negotiations in claims where the liability may exceed the coverage limits. The trial court instructed the jury in the bad faith action that it could consider the following factors in determining whether the insurer acted in bad faith:

1. The probability that the jury in the underlying action would find for the plaintiff; 2. The probability that the underlying verdict would exceed the insured’s policy limits; 3. Whether the insurer properly investigated the claim; 4. The extent of the insurer’s efforts to settle the claim; 5. Settlement recommendations from the insurer’s attorney; 6. The “relative financial risk” of the insurer; and 7. Whether the insurer informed the insured of the plaintiff’s demand and the course of negotiations with the plaintiff.

The Appellate Court reversed the judgment entered on the jury verdict in favor of the plaintiff, finding that the instruction regarding the insurer’s failure to inform the insured of the status of settlement negotiations was improper.

The Court of Appeals reversed and reinstated the trial court’s judgment in favor of the plaintiff. The Court found that “[t]he majority of jurisdictions hold that evidence of an insurance company not informing its insured of settlement negotiations is a factor which the jury is entitled to consider in a bad faith claim.” Id. at 171. The Court conceded that under Knobloch v. Royal Globe Ins. Co., 38 N.Y.2d 471, 344 N.E.2d 364 (1976), an insurer has no specific obligation to consult with its insured with respect to settlement. Smith, 697 N.E.2d at 171-172. But, the Court noted that under Pavia v. State Farm Mut. Auto. Ins. Co., 82 N.Y.2d 445, 626 N.E.2d 24 (1993), courts may consider any evidence that “tends to establish or negate the insured’s bad faith in refusing to settle.” Smith, 697 N.E.2d at 171.

In Hermann’s Warehouse, the court, with respect to whether an insurer is obligated to keep the insured abreast of settlement discussions, stated:

Finally, we would add that good business judgment, to say nothing of simple civility, might suggest that a carrier . . . take some step to notify its insured of its intention to settle. That recommendation, however, does not translate into a requirement that the insurer secure the insured’s consent to the settlement on pain of losing its right to reimbursement of the deductible.

American Home Assurance Co., Inc. v. Hermann’s Warehouse Corp., 117 N.J. 1, 563 A.2d 444, 448 (1989). Thus, the fact that an insurer does not inform its insured of either specific settlement demands or the general status of settlement discussions that are within the limits of liability does not in and of itself constitute bad faith. However, prudence and good claim handling practices suggest that an insurer endeavor to keep the insured abreast of settlement negotiations.

C. Defense Counsel’s Duties

When an insurance company retains counsel to defend its insured, a tripartite relationship is created in many states, in which the attorney represents the interests of both the insurer and the insured. Mitchum v. Hudgens, 533 So.2d 194, 199 (Ala. 1988). However, within this tripartite relationship, the attorney-client relationship exists between the attorney and the insured:

It must be emphasized that the relationship between the insured and the attorney is that of attorney and client. That relationship is the same as if the attorney were hired and paid directly by the insured and therefore it imposes upon the attorney the same professional responsibilities that would exist had the attorney been personally retained by the insured. These responsibilities include ethical and obligations as well as maintaining the appropriate standard of care in defending the action against the insured. Id.

The attorney-client relationship imposes upon the attorney the duty to advise the client of the status of the litigation. See, e.g., Illinois Rules of Professional Conduct, Rule 1.4. This duty includes the attorney’s duty to inform the client of settlement offers. Hartford Accident & Indem. Co. v. Foster, 528 So.2d 255, 270 (Miss. 1998); Model Rules of Professional Conduct R. 1.2(a). As such, while an insurance policy may not contractually obligate the insurer to communicate settlement demands and offers to the insured, the attorney has an ethical obligation to do so.

In Rodgers v. Robson, Masters, Ryan, Brumund & Belom, 74 Ill.App.3d 467, 392 N.E.2d 1365 (3rd Dist. 1979), affirmed, 81 Ill.2d 201, 407 N.E.2d 47 (1980), an underlying medical malpractice action was filed against the plaintiff. The plaintiff expressly informed the defendants, his attorneys, that he did not want the claim to be settled. Nevertheless, the defendants settled the underlying claim and the plaintiff sued the defendants for settling against his wishes.

The court found that although the insurer retained defense counsel, the professional obligations imposed on the attorneys were the same as those that would exist if the attorneys had been personally retained by the insured. Id. at 1370. In light of the plaintiff’s request that the claim not be settled, the court held:

Apart from any considerations arising from the insurance policy, we believe that when [the defendant attorneys] became aware that a settlement was eminent because of the preferences of the insurance company, and that their client, the plaintiff, did not want the case settled, a conflict arose and defendant could not continue to represent both without a full and frank disclosure of the circumstances to its clients.

Id. at 1372. The court reiterated that the provisions of an insurance policy may govern the relationship between the insurer and the policyholder, such provisions “ought not and do not negate the duties an attorney owes his client.” Id. at 1373.

Other courts have reached substantially similar results. Tank v. State Farm Fire & Cas. Co., 105 Wash.2d 381, 715 P.2d 1133, 1137-1138 (1986) (finding that defense counsel appointed by the insurer “owes a duty of full ongoing disclosure to the insured” and that “all offers of settlement must be disclosed to the insured as those offers are presented”); Miller v. Byrne, 916 P.2d 566, 574 (Colo. Ct. App. 1995), reh’g denied, cert. denied (finding that the “duty to communicate all settlement offers exists even when an insurance company retains the attorney to defend the action against its insured, because the insured is, nevertheless, a client”).

In Hartford Accident & Indem. Co. v. Foster, 528 So.2d 255 (Miss. 1998), the Mississippi Supreme Court considered the duality of the attorney’s obligations. The court recognized that in a tripartite relationship the insurer has the exclusive right to retain defense counsel and defend the claim. Id. at 267. Nevertheless, the court found that an attorney’s retention by the insurer “in no way impairs or diminishes the duty of the to the insured client.” Id. at 268. Indeed, the court stated that a contract by which the attorney-client relationship was diluted would be in violation of public policy. Id.

Still, other courts have found that the policy language does affect the attorney-client relationship. In Mitchum v. Hudgens, 533 So.2d 194 (Ala. 1988), the policy did not require that the insurer notify the insured of settlement demands. After examining the attorney-client relationship in the context of counsel retained by the insurer, the court held:

Although we agree with the general principles enunciated by the court in Rodgers, we do not share that court’s conclusion that a conflict arose when the insured informed his defense counsel that he did not want the case settled. Contrary to that court’s holding, we believe that the insurance contract does affect the attorney- client relationship with respect to settlement of an action brought against an insured. If the insured has contracted away the right to require his consent prior to a settlement of a claim against him, no real conflict of interest exists between the insured and the insurer, at least where the claim or settlement is within policy limits and there has been no reservation of rights by the insurer.

Id. at 201.

Given that an attorney-client relationship exists between defense counsel and insured in the context of the tripartite relationship between insurer, insured, and defense counsel, defense counsel must be mindful of the duties imposed by the rules of legal ethics. See, e.g., Illinois Rules of Professional Conduct, Rule 1.4; Hartford Accident & Indem. Co. v. Foster, 528 So.2d 255, 270 (Miss. 1998); Miller v. Byrne, 916 P.2d 566, 574 (Colo. Ct. App. 1995), reh’g denied, cert. denied; Tank v. State Farm Fire & Cas. Co., 105 Wash. 2d 381, 715 P.2d 1133, 1137-1138 (1986). Although generally the ethics codes applied to lawyers do not establish a separate legal duty or cause of action in tort, ethics violations do have at least some impact on legal malpractice actions in the vast majority of states. See Nagy v. Beckley, 218 Ill. App. 3d 875, 879 (1st Dist. 1991); Nicola A. Boothe-Perry, No Laughing Matter: The Intersection of Legal Malpractice and Professionalism, 21 Am. U.J. Gender Soc. Pol’y & L. 1, 29-30 (2012). Depending on jurisdiction, evidence of ethics violations may be conclusive of legal malpractice; create a rebuttable presumption of legal malpractice; or merely serve as evidence of the duty owed by the lawyer, the appropriate standard of care, and breach. Only a small minority of states hold that evidence of ethics violations are completely inadmissible in civil matters. See Kathleen J. McKee, Annotation, Admissibility and Effect of Evidence of Professional Ethics Rules in Legal Malpractice Action, 50 A.L.R. 5th 301 (1997); Douglas L. Christian & Michael Christian, Practice Management: Twice Bitten Violations of Ethics Rules as Evidence of Legal Malpractice, American Bar Association General Practice Solo & Small Firm Division Magazine, Vol. 17, No. 2 (Mar. 2000) (suggesting that only Arkansas and Washington hold evidence of ethics violations completely inadmissible in civil matters).

Accordingly, defense counsel must carefully navigate the inherent conflict in insurance settlement negotiations when representing both insurer and insured, advising both the insurer and insured of the nature of the tripartite relationship and communicating all settlement demands and offers to both insurer and insured. See Nagy v. Beckley, 218 Ill. App. 3d 875, 879 (1st Dist. 1991; Barth v. Reagan, 139 Ill.2d 399, 410, 564 N.E.2d 1196, 1201 (1990) (stating that conflict of interest concerns may be the subject of expert testimony in legal malpractice cases).

D. Best Practices to Protect the Insurer

In light of the foregoing discussion, several conclusions can be drawn. If the policy language reserves for the insurer the right to settle claims against the insured, the insurer can do so without disclosure to the insured, unless of course the policy requires the insured’s consent. The insurer is bound only to act in good faith by giving equal consideration to the insured’s interests and exercising diligence in the settlement process. However, the attorney appointed by the insurer to defend the insured is obligated to fully and frankly communicate all settlement offers to the insured. That obligation is the same whether the insured’s policy has a consent clause or not.

In order to protect itself against allegations of bad faith arising in the context of settlement, the insurer could inform the insured of all settlement demands and offers. However, in addition to being excessively burdensome, such disclosure would tend to undermine the insurer’s right to settle without disclosure to the policyholder. Therefore, rather than requiring the claim adjuster to advise the insured of all settlement demands and offers, we recommend that the claim adjuster directly advise the insured of settlement demands in instances where the full limits of the policy are potentially involved, there is a reservation of rights by the insurer, or the policyholder has expressed an interest in settlement. These are the scenarios discussed in Rodgers and Mitchum, and disclosure by the insurer in such situations will protect against bad faith claims.

More importantly, we recommend that insurers amend their guidelines to outside defense counsel to instruct defense counsel to advise the insured of all settlement demands and offers. In all likelihood, the vast majority of outside counsel apprise policyholders of all settlement demands and offers without instructions from the insurer in order to satisfy their ethical obligations. Nevertheless, we believe that prudence dictates that letters of engagement to outside counsel contain specific instructions requesting that defense counsel inform the insured of all settlement demands and offers. Such instructions will most fully protect both the insurer and appointed defense counsel from allegations of bad faith or malpractice in the context of settlement.

E. On the Horns of a Dilemma – Examples of Defense Counsel Avoiding the Conflict

a. Settlement demand within the limits i. Insured wants to settle/carrier does not ii. Carrier wants to settle/insured does not

b. Settlement demand with consent clause and no consent from insured i. Carrier wants to settle/insured does not

c. Settlement demand where insured does not want to pay deductible i. Carrier wants to settle/insured does not

d. Settlement demand where insured wants carrier to pay more than demand i. With consent clause ii. Without consent clause