When Is An Insured Entitled To Independent Legal Representation At The Insurer’s Expense? Lessons From A US Court.

In Fabyanske, Westra, Hart & Thomson, P.A. v. Western National Mutual Insurance Company, the Minnesota Court of Appeals held that where a liability insurer undertakes the defence of an insured subject to a reservation of rights, and the factual questions to be resolved in the underlying liability proceedings are the same facts upon which the availability of indemnity cover depends, a conflict of interest arises that transforms the insurer’s duty to defend into a duty to reimburse the insured for the reasonable fees of an attorney of its own choosing, independent of the insurer.

Background

The dispute arose from a motorcycle accident in a construction zone, which resulted in the death of one rider and serious bodily injury to another. The injured party brought proceedings against both the general contractor and its subcontractor responsible for the road works, alleging negligence in the maintenance of the roadway during construction.

The subcontractor held a commercial general liability policy issued by Western National Mutual Insurance Company (“Western”). The general contractor was included as an additional insured under that policy. Upon receiving the general contractor’s tender of defence, Western accepted the obligation to defend but simultaneously issued a reservation of rights letter. The reservation stipulated that Western would indemnify the general contractor only for liability caused by the subcontractor’s acts or omissions – that is, where the general contractor was found vicariously liable for the subcontractor’s conduct – and expressly excluded cover for liability arising from the general contractor’s own negligence. Western appointed separate attorneys to defend the general contractor and the subcontractor respectively.

Approximately one year into the litigation, the general contractor raised concerns about the quality of the defence being conducted by the attorney Western had appointed, and asked the law firm Fabyanske, Westra, Hart & Thomson, P.A. (“Fabyanske”) to review its coverage position. Fabyanske wrote to Western objecting to the reservation of rights and asserting that it created a conflict of interest entitling the general contractor to appoint its own attorney, at Western’s expense, independent of Western’s appointed attorney. Western refused to withdraw the reservation and denied that any conflict existed. Given the advanced stage of the litigation, Fabyanske did not replace Western’s appointed attorney outright, but filed a notice of appearance to monitor the defence, and the appointed attorney continued to represent the general contractor through to settlement of the underlying action. Following settlement, the general contractor assigned its right to reimbursement to Fabyanske, which invoiced Western for its fees. Western refused payment, and Fabyanske sued Western to recover the fees. The trial court granted summary judgement in favour of Western, finding no genuine dispute of material fact as to the existence of a conflict of interest. Fabyanske appealed.

The Court’s Analysis

The Court of Appeals began from the established principle that a liability insurer owes a duty to defend its insured whenever any portion of a claim is arguably within the scope of the policy’s coverage. Where the insurer has reason to question whether cover is available, it must inform the insured of that question by issuing a reservation of rights. However, the court emphasised that the very act of reserving rights can itself generate a conflict of interest between insurer and insured. Where such a conflict materialises, the insurer’s duty to defend is converted into a duty to reimburse the insured for the costs of an attorney selected by the insured, independent of the insurer.

Applying these principles to the facts, the court identified a two-part basis for finding that a disqualifying conflict existed. First, Western had agreed to defend the general contractor subject to a reservation that conditioned coverage on the general contractor not being found negligent. Second, the question of the general contractor’s own negligence was precisely the factual issue that would be determined in the underlying personal injury proceedings. The insurer therefore had a direct financial interest in the outcome of the very litigation it was purportedly defending – an outcome favourable to coverage avoidance (a finding of the general contractor’s negligence) was adverse to the insured’s interests in the defence. This divergence of interest, the court held, was sufficient to establish a conflict requiring the appointment of an attorney independent of the insurer.

The court accordingly formulated the governing rule: a conflict of interest entitling an insured to appoint its own attorney at the insurer’s expense, independent of the insurer, arises where (1) the insurer defends under a reservation of rights, and (2) the facts to be adjudicated in the underlying proceedings are the same facts upon which the insurer’s coverage determination depends. Applying that rule, the court found that an actual conflict existed on the facts before it, reversed the trial court’s grant of summary judgemnt in Western’s favour, and remitted the matter for further proceedings.

Takeaway

The decision underscores an important practical risk for insurers: wherever a reservation of rights is conditioned on a factual issue that will simultaneously be determined in the underlying litigation, the insurer’s own interest in that factual determination diverges from the insured’s, and this divergence may compel the insurer to fund the insured’s own, independent legal representation – in addition to any costs already incurred through the attorney it has appointed.

Insurers should therefore consider, at the point of issuing a reservation of rights, whether the ground for reservation turns on a fact that will also be contested in the underlying merits. Where it does, an insurer should be prepared either to fund separate, independent representation for the insured or to reconsider the terms of the reservation, so as to avoid a later dispute over unpaid fees and possible findings of an unlawful denial of a proper defence.