United States: The Advice Of Counsel Defense

This article originally appeared at 50 Fed'n. Ins. & Corp. Counsel. Q. 583 (2000). The author would like to thank THE FEDERATION for allowing the firm to publish the article on our web page.

In the career of a claims professional, the receipt of a bad-faith lawsuit following the denial of a claim for defense or indemnity is never a happy event. Such lawsuits are, however, an unfortunate fact of life. When advice has been sought from experienced coverage counsel in advance of any action on the claim, the claims professional and defense counsel in the extra-contractual action can take considerable comfort from coverage counsel's role in the claims process, since acting on the advice of counsel can provide a significant defense in a bad-faith case. This article explores the "advice-of-counsel" defense from the perspective of all three stakeholders: extra-contractual counsel, coverage counsel, and the claims professional.

In most jurisdictions, the law on "advice-of-counsel" defense is not well developed. For example, beyond claims for bad faith, advice of counsel is also a defense to a malicious prosecution claim. However, courts do not treat the defense identically in both contexts. The defense may not be as successful against a basic bad-faith cause of action as it would be against punitive damages, where the plaintiff must show a good deal more than that the insurer merely was unreasonable.

In addition, the advice-of-counsel defense is not without risks, since to assert it requires waiving the attorney-client privilege, at least for the specific coverage question. The issues that can arise when confidential communications become public need to be carefully scrutinized before the defense is raised. Indeed, the process of analyzing those issues should begin with the decision to obtain coverage advice. If the claims handler and the coverage attorney understand the defense and keep it in mind as their work proceeds, they can enhance the likelihood that the defense will prove successful.

In general, the "advice-of-counsel" defense consists of three elements: 1) the insurer's good faith reliance on advice of counsel; 2) the insurer's lack of knowledge that counsel's advice was erroneous, and 3) the insurer's full disclosure of all relevant facts to counsel, or counsel's actions as determined by the facts of his or her own investigation.¹ Thus, if an insurer withholds facts from counsel, obtains advice only after denying the claim, or seeks advice merely to "rubber stamp" the company's position as protection against suit, the defense may fail.² Obtaining correct advice from the attorney is not an element of the defense, but the insurer may not rely on advice that is obviously incorrect.³

The advice-of-counsel defense can arise in a number of circumstances. It may arise in third-party cases when the attorney hired to defend the insured advises the insurer about whether it should accept the third party's policy limits settlement offer. It may also arise in first-party or duty-to-defend cases when the carrier obtains a coverage opinion before denying the claim.

Typically, advice of counsel is asserted as a defense to two different aspects of an insurance bad faith case: (1) the bad faith allegations themselves and (2) the prayer for punitive damages.⁴ While good-faith reliance on advice of counsel tends to prove proper cause for withholding policy benefits, the converse is also true; ignoring counsel's advice may tend to show bad faith.⁵ Depending on the jurisdiction, however, the effect of successfully proving the defense may be different in relation to bad faith as opposed to punitive damages.

The legal effect of advice of counsel in a bad-faith case varies among the jurisdictions, running the gamut from no defense at all to a complete defense. Many states do not treat advice of counsel as a defense which completely exonerates the insurer when successfully proven. Rather, it is a factor the jury may consider in assessing whether the insurer acted in bad faith.⁶ Other jurisdictions appear to treat it as a complete defense when all the elements have been proved.⁷

Whether advice of counsel is treated as a complete defense or merely as a factor to be considered may depend on the standard by which bad faith is measured. In jurisdictions where bad faith requires knowledge that no reasonable basis exists to refuse benefits, or requires an intent to injure, advice of counsel is often treated as a complete defense.⁸ In jurisdictions where bad faith is assessed under a standard more analogous to negligence, courts tend to treat advice of counsel as another factor to be considered on the question of bad faith.⁹ Still other states refuse to recognize the defense at all. Most of these jurisdictions do so on grounds that the lawyer hired by the insurance company should be treated like any other independent contractor for whose actions the insurer is responsible in its adjustment of the insured's claim.¹⁰

By contrast, when advice of counsel is asserted as a defense to a claim for punitive damages, courts generally give the defense more conclusive application. If successfully proven, the defense precludes an award of punitive damages.¹¹

Obviously, the decision to assert the defense and waive the attorney-client privilege with respect to coverage counsel should not be taken lightly. However, coverage counsel may well be a powerful witness at trial. For example, coverage counsel can provide a "buffer" on technical coverage issues for the claims witnesses who sought and relied on counsel's advice. Indeed, coverage counsel can, and sometimes does, literally argue the case from the witness stand. Such a substantial asset to the defense should not be discarded without serious thought. However, there may be weaknesses lurking in coverage counsel's file or the relationship between the client and its coverage counsel which require a cost/benefit analysis before the veil of privilege is cast aside in hopes of a victory on extra-contractual issues or punitive damages.

Trial counsel should begin with a careful analysis of the coverage attorney's whole file, including his or her bills. That analysis also should contemplate the following issues:

• How accurate is the advice and the coverage analysis?

• What is the experience, demeanor and appearance of the attorney responsible for the coverage work?

• Who actually did the work – a minimally experienced junior lawyer or a seasoned partner?

• What are the factual assumptions made by the coverage attorney and what support exists in the file for those assumptions?

• What is the overall "tone" of communications between coverage counsel and the carrier – are they professional and polished, or chatty and jocular?

When the attorney-client privilege is waived, the broader relationship between coverage counsel's firm and the client may be open to scrutiny as well. The advice-of-counsel defense will be vulnerable if coverage counsel appears to be "on the payroll" of the carrier. A very extensive relationship may lend credence to the typical policyholder's argument that the carrier hires coverage counsel merely to speak "what it wants to hear," and coverage counsel makes the statements only to stay employed. On the other hand, a divisive relationship, or one that was terminated because of a lack of confidence in coverage counsel, presents a major problem. It is difficult to argue credibly that the carrier placed great faith in the advice of a firm no longer used because of reservations about work quality.

While a waiver of the attorney-client privilege will not necessarily subject these issues to examination, there is no guarantee that a court will not view the door as having been opened. If there is any hint of disharmony, these issues should be discussed with key claims people involved in the case. Signs of dissatisfaction may appear in the claim file as well. Comments like, "as usual, they won't really give us advice" or other signs of skepticism toward the advice rendered, when found in the claim file, can savage the defense. Similarly, if there is no previous relationship at all with the law firm, extra-contractual counsel must understand why the company selected this particular coverage attorney for this assignment. Was this an "audition" for a new firm (which poses its own set of issues), or was this an attorney chosen for particular expertise in a specific area?

When extra-contractual counsel concludes that the coverage attorney will make a less-than-powerful witness, or when the substance of privileged communications makes lifting a veil of privilege too risky, counsel must weigh the odds. Often, coverage counsel is at the center of many information-gathering activities, and the claims people involved in decision-making may learn many facts about a loss through communications from coverage counsel. Without disclosing the contents of privileged communications to the jury, or using such communications to refresh the recollections of claims witnesses, extracting thoughtful testimony from those witnesses or keeping them resilient under cross-examination may be difficult. When coverage counsel has assessed the credibility of an insured while taking a statement, interviewed eyewitnesses, and examined and analyzed evidence germane to the coverage analysis, finally communicating her evaluation to the carrier, the hole left in the "story" by the absence of privileged communications can be devastating to the jury case. Thus, under these circumstances, only significant flaws in the relationship with coverage counsel should justify asserting the attorney-client privilege.

However, if a decision must be made to assert the privilege, the best alternative is a combination of powerful experts to explain the legal technicalities involved in the coverage decision and judicious use of coverage counsel as a fact witness to describe the investigation that he or she conducted. This path is fraught with evidentiary and substantive problems. The admissibility of expert attorney testimony in bad-faith cases is always subject to attack. Furthermore, trial courts may not distinguish between an attorney expert discoursing on the law of bad faith (disallowed in California Shoppers v. Royal Globe¹²) and use of an attorney expert to discuss the reasonableness of a coverage decision in light of either the technical nuances of the law or the uncertainty in the law when the decision was made. In addition, when coverage counsel acts as a fact witness, much of the testimony concerning her investigation – which would have been admissible for a non-hearsay purpose when the issue is her advice to the client and the client's reasonable reliance on it – may become hearsay or even irrelevant.

In summary, the decision to assert or discard this defense should never be made lightly. A full assessment of facts, witnesses and documents must precede any recommendation or decision on the advice-of-counsel issue.

In analyzing and researching a coverage issue, or in performing the legal tasks associated with claim investigation, the central mission of coverage counsel is, of course, to provide the client with sound recommendations based on the facts, the policy terms and the law. However, in jurisdictions that permit extra-contractual lawsuits, the reality is that any recommendation resulting in rescission of a policy after a significant claim or the denial of a substantial claim is highly likely to draw suit for insurance bad faith. That unpleasant reality means that the coverage attorney best serves his or her clients, especially when a policyholder challenges the coverage decision in court, by following the course of conduct prescribed below.

First, examine the fact investigation presented with a detached and critical eye. The aspect of claims-handling subject to greatest attack in a bad-faith case is the thoroughness of the claims investigation. Factual conclusions contained within the file should be scrutinized to disclose the substantiating information. In particular, examine the file for "holes" in the investigation regarding untapped potential sources of information that could prove significant, recommending that those avenues be pursued.

Second, pursue the facts relating to coverage, and the evidence to substantiate those facts, with the same rigor. As noted above, coverage attorneys sometimes make crucial factual assumptions (such as whether a claim was made, in the context of a claims-made policy) on the basis of casual conversations which are not confirmed in writing or otherwise documented in coverage counsel's file. Experienced lawyers should recognize these as the very type of statements likely to be recanted, or at least hedged, when significant controversy develops. Facile assumptions about the facts can be deadly. An attorney familiar with the law of evidence and the trial process is far more likely to recognize these assumptions than a claims person.

Third, be acutely sensitive to the level of professionalism displayed by the file. Letters to the client are not a private dialogue; they are a likely display for the jury. Counsel's tongue-in-cheek descriptions of policyholders (e.g., "bleached blonde trailer trash") may provide "humor" to the claims representative, but they are guaranteed to offend some future juror. If the comments of coverage counsel cross the line about what is politically correct, counsel has rendered herself useless as a witness. In all probability, extra-contractual counsel will report to the client that coverage counsel's antediluvian remarks deprived it of a substantial defense in the case, leaving the client less than pleased.

Finally, be mindful of the role of coverage counsel. Develop, analyze and evaluate the facts and the law on insurance coverage issues and make recommendations based on those evaluations. There is great mischief in advising clients that they probably will be sued for bad faith and may wish to "make a business decision" to pay a claim you have advised them they do not owe. If coverage counsel has substantial experience with extra-contractual litigation and feels that the client genuinely carries grave exposure in that regard, it may well be counsel's responsibility to point that out. However, what is much more common in coverage counsel's letters are casual remarks about the probability of a bad-faith lawsuit and how that ought to influence a business decision to pay a non-covered claim to avoid the expense and distraction of a bad-faith case.

When placed before a lay jury, such advice often sounds as though the coverage attorney thinks that the company has acted in bad faith, or is ambivalent about the coverage issue. Letters like this are often accompanied as well by bitter comments from claims professionals to the effect that counsel is "as usual, refusing to give us advice," or remarks that mistakenly assume coverage counsel thinks there is genuine extra-contractual exposure. In short, coverage counsel should be slow to move beyond her key technical role as advisor on coverage to advisor on "business decisions" or tort liability. Conflating the coverage issue limits the effectiveness of the advice-of-counsel defense; it also limits coverage counsel's ability to assist the client in the event that such legal advice precipitates a lawsuit.

Of course, the vast majority of claims which insurance companies refuse to pay are obvious denials, accepted by the insured, and handled without the assistance of coverage counsel. However, when a claim involves issues beyond the scope of the claims professional's knowledge, or if the insured rebutts a denial, the issue must be examined by more experienced eyes. Often, a company's own senior claims people can themselves examine the issues and arrive at a correct decision on coverage. Occasions arise, however, when a decision concerning coverage requires the assistance of counsel.

For the claims professional, following certain basic principles will enhance the likelihood of obtaining sound, reliable advice, and will make it easier to defend any bad-faith claim. In that regard, the initial question should be: Do I need a coverage attorney to evaluate the coverage question?

A positive response should follow in at least four situations. First, does the question involve an unsettled area of coverage law? The policyholder bar is a creative group with aggressively expanding theories of coverage. These are often suggested in response to the efforts of another creative group – the plaintiffs' bar – to develop new theories of liability. As new theories of liability evolve, new theories of coverage emerge apace. One year it may be advertising injury for intellectual property suits; three years later it will be continuous trigger for construction defects. In a volatile area, the ground can shift overnight. A strong coverage attorney can help navigate these minefields.

Second, does the claim involve the potential for claim denial or rescission on the basis of the insured's fraud? By definition, such denials are risky; both require dispassionate review by an evidence expert. Too often, claims professionals "take the bit" in response to a difficult situation, convincing themselves that a denial on the basis of fraud is warranted where the hard evidence simply will not support that denial. Knowing the difference between speculation, innuendo and admissible proof should lie well within the expertise of coverage counsel. If the "evidence" on fraud is tenuous, the time to discern that fact is before the contract is rescinded or the claim denied.

Third, does the claim involve a very large exposure, even if the coverage issues seem common? If the claims professional contemplates denial of a defense in a substantial piece of litigation, a second look by coverage counsel is probably warranted, simply because of the likelihood that a lawsuit will follow.

Fourth, does the matter have "program" implications? In most companies the interpretation of certain policy provisions may have enormous impact on a line or lines of business. These change over time. Some years, the Employment Related Practices Exclusion looms large; other years, coverage for toxic mold infestation dominates. When key exclusions or policy conditions are challenged, particularly with a unique and plausible theory, the implications for the company can be significant. It is crucial to respond with a well-designed and fully defensible position, or at least to know whether such a position can be supported. Haphazard response is usually ill-advised when key policy provisions are in question. If the question is a reoccurring one, where consistency matters, a coordinated approach to coverage questions is prudent.

The second question in deciding whether coverage issues require counsel is likely to be: Which attorney should be retained? The ideal candidate is an attorney who is expert in the legal issues presented by the coverage question and in whom the claims professional has confidence. As a practical matter, if the coverage question is significant enough to require counsel, the ultimate decision will likely be made by a group in many companies. And, the greater the confidence by members of that group, the more likely it is that the resolution will prove satisfactory.

The third question should be: What should coverage counsel be asked to do? Ordinarily, the most cautious course is to seek review of the claim, tender or settlement demand as a whole, including recommendations for any further investigation, and an evaluation of the company's obligations under the policy. Of course, there may be many instances where a more focused, less sweeping assignment is completely appropriate. If there exist specific questions or areas of concern, or a specific investigation is required, that matter should be addressed. However, it should also be clear that the parties intend to limit counsel's analysis. In a bad-faith case, the assignment letter will be scrutinized. Accordingly, if the assignment is limited, supporting reasons should be articulated and placed in the file.

A fourth question to ask concerns the information provided to coverage counsel. Only in rare circumstances should the claims professional supply anything less than "everything we have." Indeed, counsel's file should be supplemented with any new information the company receives or develops post-assignment. There is no cost/benefit analysis that warrants the risk of withholding facts, even the seemingly superfluous ones. Sending something less than the whole file not only risks inaccurate advice, it can eliminate the defense altogether.

The final question is also the most difficult: What if the claims professional believes counsel's advice is wrong? Coverage attorneys sometimes provide advice that is seriously flawed legally, or that requires greater risk than a claims professional is willing to indulge. Though this experience should be rare, it does occur. In that event, there are only three choices: follow the advice anyway, get a second opinion, or ignore the advice. If the advice is to honor a claim or tender, following it may involve comparatively low risk. Ignoring it, without more, is simply reckless. If the advice is to decline a claim or a tender, however, following advice that "goes against the grain" can be very risky.

If coverage advice appears seriously awry, time should be taken to analyze reservations and review them with a peer or with someone of greater experience. The law of insurance coverage can be profoundly counter-intuitive. If counsel's advice appears wildly off-base, it may be a function of disjointed case law, which is simply a fact of life in the insurance industry. On the other hand, if the opinion appears sloppy or conclusory, or it contains obvious mistakes, it will not inspire confidence. Thus, consider developing specific questions for counsel, seeking an explanation of specific policy provisions or specific evidence developed during the investigation. Do not hesitate to be demanding; the claims professional is the client, and bad advice places the employer at risk.

Furthermore, the claims professional should be persistent with questions until the analysis is fully understood. The claims professional should be able himself to defend the opinion. If questions persist after exploring the specifics with coverage counsel, a second opinion may be in order. However, most experienced claims professionals agree – when counsel has advised the company to honor a claim, the risk of not paying it is simply too great.

Providing and receiving coverage advice may carry substantial consequences for the claims professional, the coverage lawyer, and the company which follows that advice and is subsequently sued for bad faith. At the very least, the parties must analyze the issues on the front end, remembering that communications between counsel and the claims professional may be scrutinized by the jury if a bad-faith lawsuit ensues.

1 Melorich Builders, Inc. v. Superior Court, 207 Cal. Rptr. 47, 50 (Ct. App. 1984).

2 Beacon Nat'l Inc. v. Reynolds, 799 S.W.2d 390, 397 (Tex. 1990); Bertero v. National Gen. Corp., 529 P.2d 608, 617-18 (Cal. 1974).

3 Giampapa v. American Family Mut. Ins. Co., 919 P.2d 838 (Colo. 1995).

4 Western Line Consol. Sch. Dist. v. Continental Cas. Co., 632 F. Supp. 295 (N.D. Miss. 1986) (bad faith); Beck v. State Farm Mut. Auto. Ins. Co., 126 Cal. Rptr. 602, 607 (Ct. App. 1976) (punitive damages).

5 Merritt v. Reserve Ins. Co., 110 Cal. Rptr. 511, 523 (Ct. App. 1973).

6 Decker v. Amalgamated Mut. Cas. Ins. Co., 324 N.E.2d 552, 553 (N.Y. 1974) (factor to be considered).

7 Berk v. Milwaukee Auto Ins. Co., 15 N.W.2d 834, 838-39 (Wis. 1944) (apparently a complete defense); Davis v. Cotton States Mut. Ins. Co., 604 So. 2d 354, 359-60 (Ala. 1992) (same).

8 Berk, 15 N.W.2d at 839; Davis, 604 So. 2d at 359; Steward v. Truck Ins. Exch., 21 Cal. Rptr. 2d 338 (Ct. App. 1993) (advice of counsel applied to punitive damages claim); Western Line Consol. Sch. Dist., 632 F. Supp. at 304.

9 Bohemia, Inc. v. Home Ins. Co., 725 F.2d 506 (9th Cir. 1984) (applying law of Oregon); Cotton States Mutual Ins. Co. v. Trevethan, 390 So. 2d 724 (Fla. 1980); Crab v. National Ind. Co., 205 N.W.2d 633 (S.D. 1973); Worden v. Tri-State Ins. Co., 347 F.2d 336 (10th Cir. 1965) (applying law of Kansas); Szumigala v. Nationwide Mut. Ins. Co., 853 F.2d 274 (5th Cir. 1988) (applying law of Mississippi).

10 Blakely v. American Employers' Ins. Co., 424 F.2d 728, 734 (5th Cir. 1970) (applying law of Texas).

11 Beck v. State Farm Mut. Auto. Ins. Co., 126 Cal. Rptr. 602, 607 (Ct. App. 1976).

12 221 Cal. Rptr. 2d 171 (Ct. App. 1985).

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