ERECTING AN ETHICAL WALL BETWEEN COVERAGE AND DEFENSE BY SPLITTING CLAIM FILES

Transcription

1 ERECTING AN ETHICAL WALL BETWEEN COVERAGE AND DEFENSE BY SPLITTING CLAIM FILES Jay M. Levin Reed Smith LLP Philadelphia, PA Lauren Angelucci Reed Smith LLP Philadelphia, PA US_ACTIVE

2 ERECTING AN ETHICAL WALL BETWEEN COVERAGE AND DEFENSE BY SPLITTING CLAIM FILES By: Jay M. Levin and Lauren A. Angelucci 1 I. Introduction Insurers have a contractual duty to defend insureds potentially covered claims, but usually have no duty to indemnify claims that are not covered. 2 When an insurer must fulfill its obligation to defend the insured s covered or potentially covered claims but seeks to protect its right to dispute coverage, an insurer will often provide a defense under a reservation of rights. 3 The insurer may then bring a declaratory judgment action against the insured seeking a declaration that the claim is not covered under the policy. 4 1 Jay M. Levin is a member of reed Smith LLP s Insurance Recovery Group. Lauren A. Angelucci is an Associate in the Insurance Recovery Group. They are both resident in the firm s Philadelphia office. 2 Douglas R. Richmond & Darren S. Black, Expanding Liability Coverage: Insured Contract and Additional Insureds, 44 Drake L. Rev. 781, 792 (1996); 14 Couch on Ins. 200:1 ( Generally, liability insurance policies allow the insurer exclusive control over litigation against the insured. This right is accompanied by the insurer's responsibility to defend the insured from all actions brought against the insured based on alleged facts or circumstances falling within the purview of coverage under the policy, regardless of the suit's validity or invalidity. ); 3-17 Appleman on Insurance ( The duty to defend imposes a broad obligation on the insurer to defend any suit brought against its insured that presents the possibility that the insured could incur covered legal liability, regardless of the likelihood that the insured ultimately will be held liable for covered damages based on adjudicated facts. ). 3 Gregory P. Deschenes & Kurt M. Mullen, 1-11 New Appleman Insurance Law Practice Guide 11.11[2] (2011). Insurers often agree to provide a defense while still investigating whether a claim is covered. In this situation, an insurer will issue a reservation of rights letter to notify the insured that coverage may not apply. This allows the insurer to defend its insured and simultaneously investigate the claim, without waiving its right to deny coverage if it later determines that the claim is not covered Couch on Ins. 202:3 ( In case of doubt or dispute as to whether there is a duty to defend, based on dispute over whether an insurance policy affords coverage for the conduct alleged in the complaint against the insured, a declaratory judgment action or motion may be brought to make the determination. On the insurer s part, this frequently occurs while the insurer is defending the insured under a reservation of rights. While an insured may obtain an early summary adjudication of the defense obligation, the insurer is entitled to seek a contrary ruling at any time it acquires the requisite evidence to conclusively eliminate any potential for coverage. ) US_ACTIVE

3 Defending under a reservation of rights or defending while simultaneously or subsequently bringing a declaratory judgment action against the insured creates a conflict of interest between the insurer and the insured. 5 When an insurer defends the claim while at the same time disputing coverage, there are three sources for conflicts of interest that may arise. 6 First, the insurer may be motivated to pursue defense theories for which coverage would be precluded. 7 Second, the insurer may not offer as strong a defense since the insurer believes the loss will not be covered and it will not have to pay any recovery. 8 Third, the insurer may gain access to confidential information from the underlying action it is defending that it can use to its advantage in denying coverage. 9 Often this conflict is addressed with the provision of independent counsel to represent the interests of the insured. 10 However, even if the insured is 5 See Edward Ned Currie, Joseph W. Gill, John G. Farnan, & Laura Megan Faust, Handling Liability and Coverage claims: Splitting Files, the duty to Defend, and Ethical Considerations for Lawyers, FDCC Quarterly, 51 (Fall 2011) (citing Karen O. Bowdre, enhanced Obligation of Good Faith: A Mine Field of Unanswered Questions After L & S Roofing Supply Co., 50 Ala. L. Rev. 755, 759 (1999); see also Steven Plitt & Steven J. Gross, Splitting Claim Files: Managing the Concern for Conflicts of Interest Through Use of Insurance Company Conflict Screens, 32 No. 6 Ins. Litig. Rep. 151 (Apr. 26, 2010) ( [A] simmering potential conflict exists when a carrier defends under reservation and/or pursues a declaratory judgment action. ) 6 See Steven Plitt & Steven J. Gross, Splitting Claim Files: Managing the Concern for Conflicts of Interest Through Use of Insurance Company Conflict Screens, 32 No. 6 Ins. Litig. Rep. 151 (Apr. 26, 2010) (citing Armstrong Cleaners, Inc v. Erie Ins. Exch., 364 F. Supp. 2d 797, 814 (S.D. Ind. 2005); Alaska Inc. v. Employers Reinsurance Corp., 844 P.2d 1113, 1116, 1118 (Ala. 1993)) 7 See Steven Plitt & Steven J. Gross, Splitting Claim Files: Managing the Concern for Conflicts of Interest Through Use of Insurance Company Conflict Screens, 32 No. 6 Ins. Litig. Rep. 151 (Apr. 26, 2010). 8 See Steven Plitt & Steven J. Gross, Splitting Claim Files: Managing the Concern for Conflicts of Interest Through Use of Insurance Company Conflict Screens, 32 No. 6 Ins. Litig. Rep. 151 (Apr. 26, 2010). 9 See Steven Plitt & Steven J. Gross, Splitting Claim Files: Managing the Concern for Conflicts of Interest Through Use of Insurance Company Conflict Screens, 32 No. 6 Ins. Litig. Rep. 151 (Apr. 26, 2010).; see also Edward Ned Currie, Joseph W. Gill, John G. Farnan, & Laura Megan Faust, Handling Liability and Coverage Claims: Splitting Files, the Duty to Defend, and Ethical Considerations for Lawyers, FDCC Quarterly, 52 (Fall 2011) (citing Bowdre at ) ( Further, when defending covered and potentially non-covered claims, the insurance company through defense counsel representing the insured may learn confidential information from the insured that could affect the coverage questions. ) 10 In many states, an insurer must inform the insured of his right to independent counsel at the insurer s expense. See, e.g., Liberty Mutual Ins. Co. v. Tedford, 658 F. Supp. 2d 786, 795 (N.D. Miss. 2009). This independent counsel is often referred to as Cumis counsel, derived from the case San Diego Navy Fed. Credit Union v. Cumis Ins US_ACTIVE

4 represented by independent counsel, including counsel of the insured s own choosing, a conflict still exists. 11 Based on the insured s duty to cooperate with the defense of the case, independent counsel must report significant events and provide copies of requested discovery to the insurer. Even if independent counsel is careful to maintain and protect the attorney-client privilege and work product, these requests can provide information which aids the insurer s coverage defenses. One way an insurer can protect against this potential conflict of interest is to split the claim file and effectively erect a conflict screen between the coverage issues and the defense issues. 12 This article will address whether the insurer has an obligation to split the claim file and what happens if it does not. It will then discuss why best practices demand that the insurer split the claim file and why the insurer should be penalized if it does not. II. File Splitting Best Practices When an insurer is faced with both defense issues and coverage issues, and a conflict of interest arises, such as when an insurer defends under a reservation of rights, the best practice is for the insurer to split the claim file. 13 Splitting the file not only helps to avoid potential conflicts of interest, but also helps to avoid the appearance of impropriety on the part of the Society, Inc. 208 Cal. Rptr. 494 (Cal. Ct. App. 1984). It may also be call Moeller counsel derived from the case Moeller v. Am. Guar & Liab. Ins. Co., 707 So.2d 1062, 1069 (Miss. 1996). 12 Steven Plitt & Steven J. Gross, Splitting Claim Files: Managing the Concern for Conflicts of Interest Through Use of Insurance Company Conflict Screens, 32 No. 6 Ins. Litig. Rep. 151 (Apr. 26, 2010) 13 See Brent W. Huber and Angela P. Krahulick, Bad Faith Coverage Litigation: The Insurer s Covenant of Good Faith and Fair Dealing, 42 Tort Trial & Ins. Prac. L. J. 29, 47 (Fall 2006) ( Because of the insurer s distinct conflict of interest when providing a defense to its insured while simultaneously investigating coverage defenses, many insurers recognize that they must set up a conflict screen, creating one file for liability and defense and one file for coverage purposes. ) US_ACTIVE

5 insurer. 14 Although the practice of splitting files has become a common practice in the insurance industry, there is little guidance regarding the mechanics and limitations of this practice. 15 In order for a conflict screen to be effective, [t]he separation between the files must actually and sufficiently protect the policyholder s interest and must not be established as a mere formality. 16 Splitting the file requires the insurer to assign two separate claims handlers to deal with one claim. One claim handler is assigned to manage the insured s defense and another claim handler is assigned to manage the coverage issues, including any investigation and determination of coverage. To ensure adequate protection for both the insurer and the insured, the file should be split at the point when the insurer decides it is going to dispute coverage. 17 At that point, the insurer should ensure complete separation between the coverage and defense files. Complete separation requires that the claim handlers assigned to the coverage and defense files refrain from communications with one another regarding the claim through the entirety of the investigation and litigation. 18 Importantly, any confidential information provided to one claims 14 See Brent W. Huber and Angela P. Krahulick, Bad Faith Coverage Litigation: The Insurer s Covenant of Good Faith and Fair Dealing, 42 Tort Trial & Ins. Prac. L. J. 29, 47 (Fall 2006). 15 See Steven Plitt & Steven J. Gross, Splitting Claim Files: Managing the Concern for Conflicts of Interest Through Use of Insurance Company Conflict Screens, 32 No. 6 Ins. Litig. Rep. 151 (Apr. 26, 2010). 16 See Edward Ned Currie, Joseph W. Gill, John G. Farnan, & Laura Megan Faust, Handling Liability and Coverage Claims: Splitting Files, the Duty to Defend, and Ethical Considerations for Lawyers, FDCC Quarterly, 62 (Fall 2011) (citing Brent W. Huber & Angela P. Krahulik, Bad Faith Coverage Litigation: The Insurer s Covenant of Good Faith and Fair Dealing, 42 Tort Trial & Ins. Practice L.J. 29, 48 (Fall 2006); Armstrong Cleaners, Inc. v. Erie Ins. Exch., 364 F. Supp. 2d 797, 817 (S.D. Ind. 2005)). 17 See Edward Ned Currie, Joseph W. Gill, John G. Farnan, & Laura Megan Faust, Handling Liability and Coverage Claims: Splitting Files, the Duty to Defend, and Ethical Considerations for Lawyers, FDCC Quarterly, 61 (Fall 2011) 18 See Edward Ned Currie, Joseph W. Gill, John G. Farnan, & Laura Megan Faust, Handling Liability and Coverage Claims: Splitting Files, the Duty to Defend, and Ethical Considerations for Lawyers, FDCC Quarterly, 61 (Fall 2011) US_ACTIVE

6 handler should not be shared with the other. 19 Further, the defense handler must not engage in any coverage determination and the coverage handler must not participate in the defense of the underlying claim. 20 Although not yet required by law, insurers should implement such procedures to protect themselves and their insureds from potential conflicts and to avoid any assertions of improper or bad faith claim handling. III. The Current Law The case law discussing the ethical dilemma faced by insurers when defending under a reservation of rights is sparse. There are very few cases that discuss the practice of file splitting, and those cases that do, have not provided any easily applicable rules for insurers to follow. While courts have recognized the propriety of splitting claim files in the face of conflict, 21 and some courts even recognize that failure to split claim files can be evidence of improper claims handling, 22 no court has explicitly held that insurers must split the files. 19 See Edward Ned Currie, Joseph W. Gill, John G. Farnan, & Laura Megan Faust, Handling Liability and Coverage Claims: Splitting Files, the Duty to Defend, and Ethical Considerations for Lawyers, FDCC Quarterly, 61 (Fall 2011) 20 See Edward Ned Currie, Joseph W. Gill, John G. Farnan, & Laura Megan Faust, Handling Liability and Coverage Claims: Splitting Files, the Duty to Defend, and Ethical Considerations for Lawyers, FDCC Quarterly, 61 (Fall 2011) 21 See, e.g., Harleysville Lake States Ins. Co. v. Granite Ridge Builders, Inc., 2008 WL , *11 (N.D. Ind. Nov. 17, 2008) (noting that the original adjuster had split the file with another adjuster because he felt it was improper for him to handle both the defense and the coverage issues, knowing that [the insurer] needed a full reservation of rights and intended to file a declaratory judgment action ); World Harvest Church, Inc. v. Guideone Mutual Ins. Co., 2008 WL , *1 (N.D. Ga. Dec. 2, 2008) (noting that insurer recognized there may be coverage issues under the Policy, so the file was split, with one claim handler assigned to address the liability issues and one claim handler assigned to the coverage issues ); Flynn s Lick Comm. Center & Volunteer Fire Dept. v. Burlington Ins. Co., 2003 WL , *2 n.2 (Tenn. Ct. App. July 31, 2003) (noting that splitting a claim file between one adjuster to handle the defense of the underlying claim and one adjuster to handle the coverage issues is common in the insurance industry ). 22 See, e.g. Twin city Fire Ins. Co v. City of Madison, Mississippi, 309 F.3d 901 (5th Cir. 2002) (finding that improper claim handling including failure to separate coverage and defense could constitute evidence of bad faith); Armstrong Cleaners, Inc v. Erie Ins. Exch., 364 F. Supp. 2d 797 (S.D. Ind. 2005) (finding sufficient conflict to require independent counsel when file was split but separation did not extend above front-line adjusters); Specialty Surplus Ins. Co. v. Second chance, Inc., 2006 WL (W.D. Wash. Aug. 22, 2006) (finding evidence that US_ACTIVE

7 A. Failure to Split the File or Prevent Crossover May be Evidence of Improper Claims Handling or Bad Faith Because file splitting is still emerging as a standard practice in the insurance industry, it is no surprise that a few cases have found that failure to split files or failure to prevent crossover between files may constitute evidence of improper or bad faith claim handling on the part of the insurer. In Twin City Fire Ins. Co. v. City of Madison, Mississippi, 309 F.3d 901 (5th Cir. 2002), the court found that the insurer could be estopped from denying coverage because of its actions during the claim handling process and that such actions could be evidence of bad faith. There, several developers sued the City of Madison. 23 The City s insurer, Twin City, defended the claims and paid a settlement to the developers, both under a reservation of rights. 24 Twin City then filed a declaratory judgment action against the City, seeking a declaration that coverage was excluded under the policy. 25 The district court granted Twin City s motion for summary judgment finding that a policy exclusion applied and the claims were not covered. 26 On appeal, the Fifth Circuit agreed that coverage was excluded under the policy. 27 However, the court considered the City s argument that Twin City should be estopped from denying liability under the policy because of various claims handling violations and breach of the duty to defend. 28 In support of its estoppel argument, the City asserted that there was a conflict of interest between comingling of files of employee insured and employer insured and sharing notes between the two was improper because insurer used such information to promote the insurer s best interest). 23 Twin City, 309 F.3d at Twin City, 309 F.3d at Twin City, 309 F.3d at Twin City, 309 F.3d at Twin City, 309 F.3d at Twin City, 309 F.3d at US_ACTIVE

8 itself and Twin City because counsel appointed by Twin City wanted coverage for his client the City, and Twin City seeks to avoid coverage. 29 Moreover, the defense counsel reported to both the City and Twin City s claims adjusters. 30 The City, therefore, contended that Twin City improperly utilized privileged information from [the defense counsel s] claim file to develop Twin City s position of non-coverage. 31 The court found that the City s conflict of interest claim may give rise to estoppel or liability for breach because it concerns the duty to defend. 32 It concluded that there was a genuine issue of fact regarding prejudice resulting in coverage by estoppel because the ruling obtained by the defense counsel was used by Twin City against the City in the coverage dispute. 33 The court also found that summary judgment was inappropriate for the bad faith claim because there were genuine issues of fact surrounding the claims handling, including whether the adjuster was involved in both claim analysis and coverage analysis, prejudicing the insured with a conflict of interest [and] whether [the insurer] adequately separated claim-handling responsibility from coverage analysis. 34 Even if the claim file is split between two claims handlers at the outset, failure to extend the separation beyond the front-line may be evidence of improper claim handling and bad faith. 29 Twin City, 309 F.3d at Twin City, 309 F.3d at Twin City, 309 F.3d at Twin City 309 F.3d at Twin City, 309 F.3d at 908. The court found that the City of Madison was unaware that it did not truly have independent counsel Id. It noted that if the City had known earlier of its right to independent counsel, it could have hired counsel who would have forgone the argument in the underlying action that was relied on by Twin City in the coverage action. Id. 34 Twin City, 309 F.3d at US_ACTIVE

9 Armstrong Cleaners, Inc. v. Erie Ins. Exchange, 364 F. Supp. 2d 797 (S.D. Ind. 2005). In Armstrong Cleaners, the Armstrongs operated a dry cleaning business insured by Erie Insurance Exchange. 35 The Armstrongs became defendants in lawsuits claiming environmental contamination at the sites of their dry cleaning facilities and tendered the defense of the suits to Erie. 36 Erie agreed to defend under a reservation of rights regarding coverage and the duty to defend. 37 Erie insisted on using counsel of its choice for the defense instead of allowing the Armstrongs to choose independent counsel. 38 The Armstrongs believed that representation by counsel of Erie s choosing would result in a conflict of interest and filed suit to force Erie to pay for the counsel of the Armstrongs choice. 39 The court noted that, when an insured files a claim with the insurer and the insurer has doubts regarding whether the claim is covered, it may defend the insured under a reservation of rights. 40 When the insurer does so, a conflict of interest often arises for which independent counsel may be necessary. 41 Among other arguments, Erie contended that there [was] no significant conflict of interest because of the Chinese Wall procedures it [had] implemented by dividing its file between one claims adjuster to work on the defense of the [underlying] action and another claims adjuster to work on the coverage issue. 42 The court rejected this argument, 35 Armstrong, 364 F. Supp. 2d at Armstrong, 364 F. Supp. 2d at Armstrong, 364 F. Supp. 2d at Armstrong, 364 F. Supp. 2d at Armstrong, 364 F. Supp. 2d at Armstrong, 364 F. Supp. 2d at Armstrong, 364 F. Supp. 2d at Armstrong, 364 F. Supp. 2d at US_ACTIVE

10 finding that the procedures were limited to front-line adjusters and did not go far enough up to avoid conflict. 43 The court noted that there [was] no indication that [the file splitting procedures] appl[ied] to more senior supervisors of both adjustors, including those who would have to approve payment of the attorneys fees and any settlement. 44 The court further noted that the adjuster handling the defense issues [had] a copy of the reservation of rights letter and must be presumed to understand the coverage issues, thus indicating that the files were not adequately split. 45 B. Failure to Split or Prevent Crossover Not Per Se Improper Of the remaining courts that have addressed the issue, none have explicitly required file splitting, but instead have held that failure to split the file and failure to prevent crossover between split files is not per se improper. 46 In State Farm Fire & Cas. Co. v. Superior Court [hereinafter Durant ], 216 Cal. App. 3d 1222 (Cal. Ct. App. 1989), the court held that as long as independent counsel was provided to the insured, a single claims adjuster could handle both the defense of the underlying action and the coverage action. 47 In Durant, State Farm had issued 43 Armstrong, 364 F. Supp. 2d at Armstrong, 364 F. Supp. 2d at Armstrong, 364 F. Supp. 2d at See State Farm Fire & Case. Co v. Superior Court, 216 Cal. App. 3d 1222, (Cal. Ct. App. 1989) (finding that file splitting is unnecessary because independent counsel for insured adequately protects insured against conflict); Employers Ins. of Wausau v. Albert D. Seeno Construction Co., 945 F.2d 284 (9th Cir. 1991) (finding no legal authority to support request for injunctive relief requiring insurer to split file); Flynn s Lick Comm. Center & Volunteer Fire Dept. v. Burlington Ins. Co., 2003 WL (Tenn. Ct. App. 2003) (finding that failure to prevent crossover between split files was not per se bad faith); American Capital Homes v. Greenwich Ins. Co., 2010 WL , *5 (W.D. Wash. Aug. 30, 2010) (finding no support for the assertion that comingling coverage and defense functions constitutes bad faith and that insurer did not act in bad faith when it assigned a single adjuster to defense and coverage functions). 47 Durant, 216 Cal. App. 3d US_ACTIVE

11 a homeowners liability policy. 48 The Durants were sued by the purchasers of their home who sought damages for alleged foundation defects. 49 The Durants filed a claim with State Farm which agreed to defend the suit under a reservation of rights. 50 Because the defense under a reservation of rights created a conflict, State Farm was required to, and did, provide independent Cumis counsel to the Durants to defend the liability action. 51 State Farm then retained other counsel to pursue its declaratory relief action against the Durants. 52 State Farm assigned one adjuster to the case. 53 The single adjuster dealt with the Durants independent counsel and State Farm s coverage counsel. 54 The adjuster therefore served in a dual capacity, assisting and communicating with counsel defending [the] Durants in the liability case, and at the same time communicating with and assisting the State Farm counsel asserting lack of coverage in the declaratory relief case. 55 The adjuster also maintained only one file for both the defense and coverage cases. 56 The Durants sought discovery of all the documents in the adjuster s file, including communications between the adjuster and State Farm s coverage counsel which would otherwise be privileged. 57 The Durants argued that because the adjuster was aiding in their defense, and was thus their agent, any communications made to the adjuster waived the 48 Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at US_ACTIVE

12 privilege. 58 The court agreed that, generally, when the insured makes statements to the insurance adjuster for the purpose of defending against the liability claim, those statements are protected from third-party discovery. 59 However, this does not create an agency relationship between the insured and the adjuster for all purposes. 60 Instead, the court found that the adjuster is primarily the agent of the insurer and can, under particular circumstances, also become the agent of the insured. 61 Consequently, when there are coverage issues, the adjuster s loyalties are divided between the insurer and the insured, and the insured and his independent counsel cannot reasonably expect that the adjuster represents the interests of the insured. 62 The court reasoned that the provision of Cumis counsel is the proper and sufficient remedy for such a conflict. 63 The Durants requested, with the support of amici curiae, that the court require a layer of separation in addition to separation of counsel. 64 They argued that, not only must the counsel involved in the defense and liability cases be separate, but the adjusters assigned to each case must be separate as well. 65 They urged the requirement of a veritable wall between the insurance company s administration of the two cases. 66 The court disagreed, holding instead that the existence of independent Cumis counsel adequately protects the interests of the 58 Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at US_ACTIVE

13 insured. 67 It noted [i]n these days of ever-increasing costs in the processing of insurance settlements, we conclude it would be unwise to impose yet another layer of administration. 68 The court reasoned that requiring such a separation would be unreasonable and impractical. 69 The court found that, because the adjuster occupied a role of divided loyalty, the Durants and their independent counsel could not have reasonably believed that he was acting, at all times, as their agent. 70 Therefore, the court found that the communications between coverage counsel and the adjuster remained privileged and were not discoverable by the Durants. 71 The Ninth Circuit affirmed this reasoning in Employers Ins. of Wausau v. Albert D. Seeno Construction Co., 945 F.2d 284 (9th Cir. 1991) [ Seeno ]. Seeno, a real estate developer and general contractor, built several thousand homes in an area of California. 72 Several hundred homeowners brought claims against Seeno for construction defects and soil movement. 73 Seeno had comprehensive general liability insurance coverage with Employers Insurance of Wausau for bodily injury and property damage. 74 Seeno submitted the homeowners claims to Wausau, which reserved its right to deny coverage. 75 At the time Seeno tendered the claims to Wausau, some of the claims had reached litigation ( litigated claims ) and others had not ( unlitigated 67 Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Durant, 216 Cal. App. 3d at Seeno, 945 F.2d at Seeno, 945 F.2d at Seeno, 945 F.2d at Seeno, 945 F.2d at US_ACTIVE

14 claims ). 76 Seeno exercised the right to independent Cumis counsel for the litigated claims, but declined to do so for the unlitigated claims, instead requesting that Wausau handle them. 77 Wausau hired counsel to represent its interests in all litigation stemming from the homeowners claims. 78 This counsel and Wausau s internal investigators handled both the unlitigated claims that Seeno requested be handled by Wausau and the coverage dispute against Seeno. 79 Seeno contested this practice, arguing that Wausau was using the investigation and settlement of the unlitigated claims to gain information for the coverage dispute. 80 Wausau filed a declaratory judgment action against Seeno for declaratory relief seeking a declaration that there was no coverage for the homeowners claims. 81 Seeno counterclaimed and sought injunctive relief requiring Wausau to segregate its liability claims handling from its coverage investigation. 82 The trial judge found that there was no legal authority to support Seeno s request and denied the motion for injunctive relief. 83 Seeno appealed the order arguing that California law and insurance industry practice require insurance carriers to segregate their coverage investigations from their liability claims handling. 84 Seeno argued that such a duty arises from a fiduciary duty between and insurer and insured whereby the insurer must 76 Seeno, 945 F.2d at Seeno, 945 F.2d at Seeno, 945 F.2d at Seeno, 945 F.2d at Seeno, 945 F.2d at Seeno, 945 F.2d at Seeno 945 F.2d at Seeno, 945 F.2d at Seeno, 945 F.2d at US_ACTIVE

15 preserve and promote the insured s interests above its own and avoid even the appearance of impropriety. 85 Seeno further argued that, because of this duty, whenever an insurer defends under a reservation of rights, it must use different people on the liability side and the coverage side, without exchange of information between them. 86 The court found that, although the cases cited by Seeno mentioned the practice of file splitting, no California case required the separation of files. 87 The court further found that the fact that most other insurance carriers choose to segregate their liability and coverage activities does not establish a duty to do so. 88 Therefore, the court held that California law does not require an insurance carrier to segregate its liability claims handling from its coverage investigation in a reservation of rights situation. 89 Similarly, Courts have held that where the insurer does erect an ethical wall by splitting the file, failure to prevent crossover is not improper. 90 In Flynn s Lick, three lawsuits were filed against Flynn s Lick, which was insured by Burlington. 91 Flynn s Lick notified Burlington of the lawsuits and sought coverage under its liability insurance policy. 92 Burlington s adjuster notified Flynn s Lick by letter that that lawsuit gave rise to some potential coverage questions under the insurance policy, and that Burlington would provide a defense under a reservation 85 Seeno, 945 F.2d at Seeno, 945 F.2d at Seeno, 945 F.2d at Seeno, 945 F.2d at Seeno, 945 F.2d at Flynn s Lick Comm. Center & Volunteer Fire Dept. v. Burlington Ins. Co., 2003 WL (Tenn. Ct. App. 2003). 91 Flynn s Lick, 2003 WL at *1. 92 Flynn s Lick, 2003 WL at * US_ACTIVE

16 of rights. 93 Once the coverage investigation began, Burlington retained Flynn s Lick s defense counsel and assigned two separate adjusters to handle the claim, one to handle the defense of Flynn s Lick and the other to handle the coverage issues. 94 Burlington also retained a separate attorney to investigate the coverage issue. 95 After an investigation, the coverage attorney advised Burlington that he believed that the claimed losses were excluded from coverage under the policy. 96 The defense adjuster notified Flynn s Lick by letter that Burlington was of the opinion that its losses were not covered and that Burlington planned to file a declaratory judgment action regarding coverage. 97 Burlington then filed a declaratory judgment action seeking a declaration that Burlington owed no duty to defend or indemnify Flynn s Lick for the claims. 98 The action was dismissed and Flynn s Lick filed an action against Burlington alleging that Burlington s actions violated the Tennessee Consumer Protection Act. 99 In the action against Burlington, Flynn s Lick alleged that Burlington acted in bad faith. 100 Flynn s Lick s counsel for the declaratory judgment action testified regarding the allegedly improper actions of the defense adjuster. 101 Moreover, during the declaratory judgment action, Burlington had submitted an affidavit of the defense adjuster in 93 Flynn s Lick, 2003 WL at *2. 94 Flynn s Lick, 2003 WL at *2. 95 Flynn s Lick, 2003 WL at *2. 96 Flynn s Lick, 2003 WL at *2. 97 Flynn s Lick, 2003 WL at *2. 98 Flynn s Lick, 2003 WL at *2. 99 Flynn s Lick, 2003 WL at *3 (citing Tennessee Code Ann et. seq.). 100 Flynn s Lick, 2003 WL at * Flynn s Lick, 2003 WL at * US_ACTIVE

17 which she stated the reasons for her belief that there was no coverage for Flynn s Lick s claim. 102 Flynn s Lick s counsel opined that the defense adjuster s position was contrary to Burlington s own company policy of splitting files between the defense and coverage aspects of the case, and that Flynn s Lick was treated unfairly because there was crossover between the defense and coverage files. 103 Burlington s coverage counsel also testified regarding the file splitting procedure. 104 He opined that insurance companies frequently split files between the defense and coverage aspects of a case, because the adjuster handling the defense aspect has different duties than the adjuster handling coverage issues. 105 He agreed that [t]he two [adjusters] should not have contact with one another so that the insured is protected from the danger of having the coverage counsel control the actions of the liability adjuster. 106 However, he also testified that the actions taken by the adjusters, even if the actions resulted in a crossover, were not inappropriate, 107 and opined that Burlington did nothing unfair or deceptive in resolving [the] dispute. 108 The jury returned a special verdict for Burlington, determining that Burlington did not act in an unfair or 102 Flynn s Lick, 2003 WL at * Flynn s Lick, 2003 WL at * Flynn s Lick, 2003 WL at * Flynn s Lick, 2003 WL at * Flynn s Lick, 2003 WL at * Flynn s Lick, 2003 WL at *5-6. First, the coverage counsel stated that he never talked to the defense adjuster and only worked with the coverage adjuster. Id. at *5. Next, he asserted that there was no conflict when the coverage adjuster made the decision to settle the underlying claim because he was essentially waiving the coverage defense by agreeing to pay Flynn s Lick s claim and thus was justified in breaching the wall. Id. He also opined that it was not inappropriate for the defense adjuster to send the reservation of rights letter because such letters are typically sent from the liability adjuster to the insured. Id. 108 Flynn s Lick, 2003 WL at * US_ACTIVE

18 deceptive manner. 109 On appeal, Flynn s Lick argued, among other things, that the jury s verdict was contrary to the weight of the evidence. 110 It argued that the failure to prevent the adjusters from crossing over the wall between defense and coverage aspects established that Burlington acted unfairly. 111 The court concluded that Burlington introduced into evidence testimony which provided the jury a cogent explanation for its actions and decisions, and therefore affirmed the trial court s decision allowing the verdict in favor of Burlington regarding the cross over. 112 IV. Best Practices Require an Insurer to Split The File The cases which allow an insurer to have one person both defend the underlying action and address coverage concerns do not recognize the practical problems that presents. When there is a sufficient conflict of interest such that the way the case is defended can have a significant effect on whether a judgment is covered, the claim file should be split. The person holding the purse strings for the defense, and deciding what attorney time is well-spent and reasonable and what is not, should not be the person who will decide whether the claim is covered. If the same person is doing both, the cost of defending the covered claims and the work necessary to properly defend them might be given short shrift by the claims handler. Although this would likely lead to a bad faith finding in subsequent litigation, that will be small solace for the insured who will be liable for a large uninsured judgment and then faced with a whole new lawsuit to prosecute against the insurer. 109 Flynn s Lick, 2003 WL at * Flynn s Lick, 2003 WL at * Flynn s Lick, 2003 WL at * Flynn s Lick, 2003 WL at * US_ACTIVE

19 The fairest way for the insurer to defend an insured when reserving rights on serious issues is to split the file and erect a wall between defense and coverage. The defense claims handler should be able to give unbiased views on liability for all causes of action without having to worry which are covered and which are not. The coverage claims handler can focus on the insurer s duty to indemnify. The insured can be more open with the defense claims handler and still cooperate with the coverage side of the house. As a practical matter, however, defense and coverage will have to come together at some point to address the case. That time is when settlement is appropriate. Optimally, the insured and the insured s coverage counsel should be present for that discussion. The insured and the insurer should reach agreement on the potential for an adverse verdict on each of the claims, covered and not, and the coverage claims handler will then address with the insured how much the insurer will pay to settle and how much the insurer thinks the insured should pay for the uncovered claims. This tri-partite discussion should always be held with everyone in the room for the evaluation of the case, and only the insured, the coverage claims handler, and coverage counsel should be present for the discussion about how to create the settlement pot. If the claim file is not split, the possibility that the claims handler will focus on the uncovered claims and evaluate them at a higher number than the covered claims becomes much greater. In addition, the claims handler can use information obtained from defense counsel to bolster coverage defenses. For example, if the file is not split and the plaintiff makes a policy limits demand, the sole claims handler is entitled to request and receive a detailed evaluation of the case from defense counsel. That evaluation can be forwarded to the insurer s coverage counsel who can use it to support coverage defenses without the insured knowing until the US_ACTIVE

20 declaratory judgment action is filed. While this might not be enough to prove bad faith in some jurisdictions, it is at least unfair and misleading. Where the file is not split, the insurer should at least tell the insured and defense counsel that the report will be shared with the insurer s coverage counsel. That gives the insured notice and the ability to better defend itself in both the underlying action and the coverage dispute. V. Conclusion While best practices require the claims file to be split between defense and coverage when the insurer is defending under a reservation of rights which creates a conflict of interest, not all states recognize that the failure to do so is bad faith. Policyholders should, therefore, be on the alert for conflict situations and ask whether the file is being split. If it is not, even after the insured makes that request, the insured should ask for independent counsel of its choice (if it does not already have such counsel) and, even if the insured is being defended by panel counsel, the insured should make sure that defense counsel s reports are limited to information which does not impair coverage and should monitor the defense very carefully to make sure that the case is being properly and aggressively defended as to all claims, whether covered or not. Of course, the insured is well-served to have its own coverage counsel monitoring both the defense and coverage implications, so when the time comes to settle the underlying action, the insured has a complete team in place to make sure that the exposure is eliminated with the minimum possible contribution from the insured US_ACTIVE