One step beyond Meadowbrook: can an insurer direct defense counsel to dismiss covered claims? An examination of insurance defense attorneys' roles and ethical duties.

• Author: Baldwin, Shaun McParland

A COMPLAINT may contain some allegations, which are covered under the terms of the defendant's insurance policy and others that are not. In most jurisdictions, the insurer will have the duty to defend its insured against all the claims, not just those portions that are potentially covered by the policy. Typically an insurer will advise the insured of those claims for which it believes it has no duty to indemnify. This is commonly accomplished through a reservation of rights letter or a coverage position letter.

It is a well-settled proposition that an insurer can withdraw from the defense if the potentially covered clams are dropped from the suit. (1) The next question that arises is whether an insurer, who is providing a defense to its insured under a reservation of rights, can extinguish the duty to defend by settling the covered claims directly with the plaintiff. Can the insurer withdraw from the insured's defense once it has settled out the covered counts?

In Meadowbrook, Inc. v. Tower Insurance Co. Inc., the Minnesota Supreme Court held that an insurer can settle out the covered claims and extinguish its duty to defend. (2) Meadowbrook involved a suit brought by four employees for charges including, but not limited to, discrimination, wrongful discharge, and defamation. Tower Insurance Company agreed to defend Meadowbrook pursuant to a reservation of rights. Tower concluded that the policy only covered the defamation claim. When the trial court eventually dismissed the defamation claim, Tower withdrew its defense.

Meadowbrook then commenced a declaratory judgment action against Tower, arguing that Tower had a continuing duty to defend. Thereafter, Tower settled the defamation claim directly with the plaintiffs and filed a motion for summary judgment. The trial court denied the motion, but the court of appeals held that Tower was entitled to summary judgment in its favor. The Supreme Court of Minnesota also found for Tower, stating that, "an insurer who undertakes an insured's defense under a reservation of rights can withdraw its defense once all arguably covered claims have been dismissed with finality." (3) It held that the term "finality" included the option of engaging in direct settlement negotiations with the plaintiff. The court reasoned that,

To require an insurer who undertakes a defense on the basis of arguably covered claims to remain in the litigation even after those claims have been resolved, is to force the insurer to defend claims not arguably covered by the policy. Such a policy would encourage insurers to avoid defending lawsuits that actually include arguably covered claims. The result would be an increase in declaratory judgment actions brought by insureds to force insurers to perform their contractually mandated duties. Consequently, we hold that an insurer who undertakes an insured's defense under a reservation of rights can withdraw its defense once all arguably covered claims have been dismissed with finality. (4) The Seventh Circuit Court of Appeals cited and tacitly approved of the Meadowbrook ruling in its 2001 decision, Lockwood Int'l. B. V. v. Volta Bag Co., Inc., when it stated, "if in the course of litigation the covered claims fall out of the case through settlement or otherwise, the insurer's duty to defend his insured ceases." (5) The facts of the Lockwood case, however, are distinguishable from Meadowbrook. In Lockwood, the insurer and the defense attorney unilaterally (without consulting or obtaining the insured's informed consent) negotiated to pay the plaintiff to re-draft the complaint with the effect of converting all the covered claims to uncovered claims. Notably, the insurer actually paid sums in excess of its policy limits to the plaintiff in exchange for re-drafting the complaint. The Seventh Circuit disapproved of such tactics. It cautioned that while Meadowbrook allowed an insurer to settle covered claims, the duty to defend is extinguished only if the settlement is made in good faith. (6) The court found that the arrangement in the Lockwood case was not made in good faith.

Other courts have also commented on the duty of insurers to engage in settlements in the best interests of the insured so as to avoid having the settlement rejected by the courts as being made in bad faith. (7) Those courts, however, do not answer the question of whether settling out the covered claims, in and of itself, constitutes bad faith--even though the effect of that action might extinguish the insurer's duty to defend.

The notion that an insurer's duty to defend ends once the covered claims are dismissed is prevalent among most jurisdictions across the country. However, whether an insurer can extinguish the duty to defend by settling out covered claims is less settled. A significant issue also arises regarding the defense attorney's role in the settlement negotiations that result in the dismissal of the covered counts. The focus of this article is whether the defense attorney retained by the insurance company to represent the insured (and in some jurisdictions also the insurer) can participate in such settlement negotiations and the ethical duties that govern defense counsel in such situations.

1. The Tripartite Relationship between the Attorney, the Insurer, and the Insured

   The tripartite relationship describes the relationship between the defense counsel, the insurer, and the insured and the duties that flow between them. Typically the insurance policy gives the insurer the right and duty to defend the insured. Where the carder retains a defense attorney to represent the insured, in some jurisdictions that defense attorney will be deemed to have two clients: the insured and the insurer. In other jurisdictions, the defense attorney will be viewed as having only one client: the insured. To determine the ethical obligations of the defense attorney with regard to settlement negotiations, it is first important to determine who the attorney represents.

   (1) The attorney represents both the insured and the insurer

   In most jurisdictions, a defense attorney retained by an insurer to represent the insurer has two clients: the insured and the insurer. For example, the Illinois Supreme Court has held that "when insurer retains attorney to defend insured, attorney represents both insured and insurer in furthering the interests of each." (8) The Alabama Supreme Court echoed this sentiment in Mitchum v. Hudgens by indicating that when an insurance company retains an attorney to defend an action against the insured, the attorney represents the insured as well as the insurer in furthering the interests of each other. (9) The Arizona Supreme Court stated that it was possible, absent a conflict of interest, for defense counsel to represent both insurer and insured, "but in the unique situation in which the lawyer actually represents two clients, he must give primary allegiance to one (the insured) to whom the other (the insurer) owes a duty of providing not only protection, but of doing so fairly and in good faith." (10) Many other courts agree that an attorney may represent both the insurer and the insured. (11)

   In order to ethically represent two clients, the client's interests must be aligned. If there is any conflict of interest between the two clients, the attorney must provide the clients with a full disclosure of the conflict and seek each client's written consent to his or her continued representation of both clients, in light of the disclosed conflict. (12) This basic notion falls within the purview of...