The Hypothetical Facts
Take the following hypothetical: A California company is sued in the Los Angeles Superior Court for personal injuries suffered by the driver of a vehicle that was injured in a crash involving the company’s car. The company has insurance for bodily injury liability. Its insurance company, however, does not believe there is coverage and denies that it has any duty to indemnify its insured. The insurer agrees, however, that it will defend the insured subject to a reservation of rights.
The insurance company retains a lawyer employed by one of its panel firms. The lawyer has litigated personal injury suits for 15 years and appears, at least outwardly, competent to handle the insured’s case.
It turns out, though, that the retained lawyer does a very poor job of defending the insured, failing to take or follow up on critical discovery and missing various deadlines. The insurance company is aware of the lawyer’s incompetent performance, but does nothing about it. As the case approaches trial, the insured settles the case, using $250,000 of its own money and a small amount begrudgingly offered by the insurer.
The insured preserves its right to sue the insurer and brings two claims against the insurer in the Los Angeles Superior Court: (1) for breach of the duty to defend, and (2) for breach of the implied covenant of good faith and fair dealing. In its complaint, the insured alleges the retained counsel’s inept performance and the insurer’s awareness of that performance.
Responding to the complaint, the insurer demurs, arguing that under California law, retained counsel is considered an independent contractor, and the insurer cannot be held vicariously liable as a matter of law for counsel’s malpractice. The insured’s sole remedy, according to the insurer, is to sue the lawyer for malpractice.
Should the Court sustain or overrule the insurer’s demurrer?
The Correct Outcome
The demurrer should be overruled, and the insured’s case permitted to go to trial.
Cases around the country have conflicting views as to the duty owed by an insurer to its insured when an insurer retains counsel to defend the insured in a suit against the insured and that counsel commits malpractice. Some states hold that the relationship between the insurer and counsel retained by it to defend the insured is one of agency, that the insurer’s responsibility for retained counsel’s performance is non-delegable, and that the insurer may be vicariously liable for the attorney’s malpractice. See e.g. Majorowicz v. Allied Mut. Ins. Co., 569 N.W. 2d 472, 475-477 (Wisc. Ct. App. 1997); Continental Ins. Co. v. Bayless & Roberts, 608 P. 2d 281, 294 (Alaska Sup. Ct. 1980).
California has taken a different position. It views counsel retained by the insurer (other than an in-house employee) to be an independent contractor, finds that the insurer’s duty to defend its insured is delegable to the retained counsel, upon whom the insurer is entitled to rely, and holds that the insurer is not vicariously liable for counsel’s negligence—the insured’s remedy being a suit against the lawyer for malpractice. Merritt v. Reserve Ins. Co., 34 Cal. App. 3d 858, 880-882 (1973).
But should the result be different where the insurer knows that the lawyer it hired is incompetently defending the insured? Although there are no reported California cases deciding that precise issue, the answer should be yes; the insurer should face liability for breach of its duty to defend and bad faith under those circumstances.
Merritt itself recognized that an insurer “remains liable for the negligent performance of its own duties.” Id. at 882. The court referred to three principal duties: “(1) to make immediate inquiry into the facts of any serious accident as soon as practicable after its occurrence; (2) on the filing of suit against its assured to employ competent counsel to represent the assured and to provide counsel with adequate funds to conduct the defense of the suit; (3) to keep abreast of the progress and status of the litigation in order that it may act intelligently and in good faith on settlement offers.” Id.
But Merritt did not involve a situation where the insurer was aware of the attorneys’ misconduct, but did nothing about it. Nor did Merritt describe the universe of duties subsumed in an insurer’s duty to defend.
In fact, subsequent California opinions have expanded on the duties owed by a defending insurer to its policyholder. For example, in Travelers Ins. Co. v. Lesher, 187 Cal. App. 3d 169 (1986), the Court of Appeal, referencing Merritt, found that in addition to the duties articulated in that case, “[o]ther duties and obligations may attach if necessary to assure the provision to [the insured] of a proper defense by the insurer.” 187 Cal. App. 3d at 191. Notably, in coming to this conclusion, the Court in Lesher explicitly rejected the insurer’s contention that an insurer’s obligation to defend its insured is discharged when it retains competent counsel. Id. at 191.
The court in Lesher also acknowledged that the processing of claims in a “competent manner” requires that an insurer conduct the defense of its insured “in good faith and with due care,” even if it turns out that there was no coverage under the insurance policy and no duty to defend. As the court noted, once the insurer undertook the insured’s defense, “the presence of the coverage dispute did not affect the degree of care with which it was obligated to handle that defense.” Id. at 194.
Lesher’s recognition of additional duties encompassed within the duty to defend is consistent with broad and well-known principles of California law. An insurer’s duty to defend its insured is broader than its duty to indemnify that insured. Aerojet-General Corp. v. Transport Indem. Co., 17 Cal. 4th 38, 58 (1997). The duty to defend “entails the rendering of a service, viz., the mounting and funding of a defense . . . in order to avoid or at least minimize liability.” Id. at 58. “As such, it requires the undertaking of reasonable and necessary efforts for that purpose . . . , including investigation.” Id. An insurer that defends its insured, even under a reservation of rights, is obligated to pursue the defense “in a reasonable manner.” Waller v. Truck Ins. Exch., 11 Cal. 4th 1, 36 (1995).
An insurer’s duty to investigate a claim against its insured is an integral part of its duty to defend the insured. As one court has explained, “[a]mong the most critical factors bearing on the insurer’s good faith is the adequacy of its investigation of the claim.” Shade Foods, Inc. v. Innovative Products Sales & Marketing, Inc., 78 Cal. App. 4th 847, 879 (2000). And, “[a]n unreasonable failure to investigate amounting to . . . unfair dealing may be found when an insurer fails to consider, or seek to discover, evidence relevant to the issues of liability and damages.” Id. at 880.
Finally, the implied covenant of good faith and fair dealing in every insurance policy mandates that an insurer will not do anything to injure the right of the insured to receive the benefits of the policy. Johansen v. Cal. State Auto Ass’n Inter-Ins. Bureau, 15 Cal. 3d 9, 14 (1975). Among other situations, a breach of this implied covenant occurs when an insurer engages in unreasonable conduct in carrying out its duty to defend. Shade Foods, 78 Cal. App. 4th at 880-881.
These bedrock principles of California law mandate liability where an insurer knows but disregards its retained counsel’s incompetent defense of its insured. In that situation, the insurer is not being held responsible on an agency/vicarious liability theory for the misconduct of its retained counsel.
Instead, its liability is founded on its own independent breach of its duty to defend. To hold otherwise would eviscerate the insurer’s duty to make reasonable and necessary efforts to avoid or minimize its insured’s liability. Aerojet, 17 Cal. 4th at 58. And, particularly where the insurer contends that it has no duty to indemnify its insured against a resulting settlement or judgment, an insurer would be incentivized to ignore known deficiencies in the performance of its chosen defense counsel if it faced no consequences for that ignorance.