Settlement Negotiations in Legal Malpractice Cases: Walking the Fine Line of a Conflict

By John D. Dalton & Matthew R. Yost, Baugh Dalton LLC

When a defense is being provided to an insured under the terms of an errors and omissions policy, a number of conflicts can arise in the tripartite relationship among the insured, the insurer and the defense counsel. For defense attorneys, one of the most difficult to navigate is the conflict that arises when the plaintiff makes a settlement offer. Such a demand triggers separate rights and distinct duties to the policyholder/client, which pull against the sense of loyalty many defense attorneys feel to the insurer that hired them and, in many cases, supplies a great deal of their business.

While the focus of this article will be the conflicts that defense lawyers feel between the needs of their clients and the demands of the insurers who pay them, understanding those conflicts requires an understanding of the conflicts the insurers face when determining whether to settle a claim.

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:

[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 (2^nd 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 will seek 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 damages 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); see Marginian v. Allstate Ins. Co., 18 Ohio St. 3d 345, 481 N.E.2d 600, 602 (1985) (where the insurer and the insured “expressly and unambiguously contracted to allow [the insurer] the option of settling any claims,” insurer’s decision to settle within policy limits will not give rise to bad faith claim, even where insured specifically instructed insurer not to settle); see also American Home Assurance Co., Inc. v. Hermann’s Warehouse Corp., 117 N.J. 1, 563 A.2d 444, 448 (1989) (“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”).

Thus, while the general discretion to settle is evident, in many jurisdictions 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. See Herman’s Warehoouse, 563 A.2d 444 at 448 (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)); PPG Indus., Inc. v. Transamerica Ins. Co., 20 Cal. 4^th 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).

Nevertheless, 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 standard some courts around the country use is stricter than mere negligence. As the Michigan Supreme Court made clear:

[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 contract 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); see 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”).

The diverging interests between the insurer and the policyholder, as well as the divergence between 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 (2^nd Cir. 2000). But, it does not appear that giving “equal consideration to the insured’s interests” necessarily requires the insurer to inform the insured of all settlement demands.

Indeed, courts may consider an insurer’s failure to so inform its insured, among other things as evidence 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 Division 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, 82 N.Y.2d at 445(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.

The Consent Provision in Lawyers’ E&O Policies

There are other policies, however, in which the insurer may settle only with the consent of the defendant/attorney. Suffice it to say that black letter law fails to clarify the validity of such 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 (3^rd 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 a position to determine (or challenge) 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.

Insurers May ‘Bring Down the Hammer’ in Response to Consent Provisions

When an insurance policy provides that an insurer can only settle with the consent of the insured, insurers frequently couple that with a so-called “hammer clause.” See Jonathan L. Schwartz, Esq., & Seth L. Laver, Esq., Goldberg Segalla LLP, The Case of the Missing Insured: A Tricky Variation on the Consent to Settle, 25 No. 17 WESTLAW J. Ins. Coverage 1, at *2 (Jan. 30, 2015). A hammer clause is a mechanism for placing a cap on the insurer’s liability when an insured refuses to consent to a settlement that is acceptable to the insurer. See Scottsdale Ins. Co. v. Alabama Mun. Ins. Corp., No. 2:11-cv-668-MEF, 2013 WL 5231928, *3 (M.D. Ala. Sept. 16, 2013); Mutual Ins. Co., Ltd. V. Murphy, 630 F. Supp. 2d 158, 166 n.2 (D. Mass. 2009). A typical hammer provision reads:

“The [insurer] shall … not settle any claim without the written consent of the named insured … however, if the named insured shall refuse to consent to any settlement recommended by the [insurer] … then the [insurer’s] liability for that claim shall not exceed the amount for which the claim would have been settled[.]” Security Ins. Co of Hartford v. Schipporeit, Inc., 69 F.3d 1377, 1383 (7th Cir. 1995).

Under such a hammer clause, the insurer’s liability is limited to the amount set forth to in the proposed settlement and the risk of loss over and above the proposed settlement passes to the insured. Id. But, in some cases the insurer’s ability to invoke the hammer clause may not be absolute, particularly when the hammer clause sought to be invoked provides that the insurer’s rejection of the proposed settlement must be unreasonable. See Freedman v. United Nat. Ins. Co., 2011 WL 781919, *5 (C.D. Cal. Mar. 1, 2011); Clauson v. New England Ins. Co., 254 F.3d 331, 337 (1st Cir. 2001).

Of course, the effect of a hammer clause will vary with each policy; but as with consent clauses generally, determining the validity or scope of a hammer clause is not within the purview of defense counsel appointed by an insurer. Instead, defense counsel must keep in mind that the insured retains the right to reject the settlement, and defense counsel’s chief task is to provide the insured enough information that the insured can make an informed decision regarding the proposed settlement. If the differences between insurer and insured are irreconcilable, defense counsel may have little choice but to withdraw from representation of either the insurer or insured or both. See Alex Hartzler, Steven H. Weisman, & Andrew D. Desutsch, Insurance 101: Don’t Forget the Policy Conditions, American Bar Association, Section of Litigation, Insurance Coverage Litigation (Aug. 15, 2014), http://apps.americanbar.org/litigation/committees/insurance/articles/mayjune2014-dont-forget-policy-conditions.html (last visited Dec. 13, 2016).

Defense Counsel’s Duties

When an insurance company retains counsel to defend its insured, a tripartite relationship is created in many states, 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 fiduciary 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., N.Y. Rules of Professional Conduct (NY RPC), 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); NY RPC 1.2(a) (client must decide on whether to settle case). 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 (3^rd 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 imminent 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”); see also, Hartford Accident & Indem. Co. v. Foster, 528 So.2d 255, 268 (Miss. 1998) ( an attorney’s retention by the insurer “in no way impairs or diminishes the duty of the lawyer to the insured client.”).

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., NY RPC 1.4; Hartford Accident & Indem. Co, 528 So.2d at 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 (1^st 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. 5^th 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 (1^st 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).

Best Practices to Protect the Insurer and Insurer’s Counsel

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 may have a contractual right to 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, 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 may help protect both the insurer and appointed defense counsel from allegations of bad faith or malpractice in the context of settlement.

John Dalton is a member and Matt Yost is an associate at Baugh Dalton LLC where they concentrate their practice in professional liability defense and insurance coverage. John can be contacted directly at 312-863-3678 and jdalton@baughdaltonlaw.com. Matt can be contacted directly at 312-863-3671 and myost@baughdaltonlaw.com.

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DISCLAIMER: This article provides general coverage of its subject area and is presented to the reader for informational purposes only with the understanding that the laws governing legal ethics and professional responsibility are always changing. The information in this article is not a substitute for legal advice and may not be suitable in a particular situation. Consult your attorney for legal advice. New York Legal Ethics Reporter provides this article with the understanding that neither New York Legal Ethics Reporter LLC, nor Frankfurt Kurnit Klein & Selz, nor Hofstra University, nor their representatives, nor any of the authors are engaged herein in rendering legal advice. New York Legal Ethics Reporter LLC, Frankfurt Kurnit Klein & Selz, Hofstra University, their representatives, and the authors shall not be liable for any damages resulting from any error, inaccuracy, or omission.

E&O Policy Insurance Coverage John D. Dalton Malpractice Matthew R. Yost Tripartite Relationship