It wasn’t very long ago that the American Law Institute’s “Principles of the Law of Liability Insurance” were either unknown to many in coverage circles or, for those familiar with them, dismissed as academic irrelevance. I know. I was in the room at the 2012 DRI Insurance Coverage Symposium in New York City when the question was asked, to many hundreds, if they were familiar with the ALI Principles. Only a smattering of hands went up. While I was familiar with the Principles project, put me down as one who, for a long time, dismissed them as the stuff of law professors, academic mumbo jumbo, and nothing that I – as a practicing lawyer – needed to know about. Nothing to see here. Move along folks.
           
But much has changed in the past couple of years. Far from being some secret Skull and Bones-like project, the ALI Principles of Liability Insurance are presently the most talked-about subject amongst liability insurance professionals. As for their possible significance or impact on liability coverage issues, that gets back to the first point -- there wouldn’t be all this talk if there were nothing to see.

The ALI’s Principles Project brings together a host of stakeholders in liability insurance to produce a text that sets forth the law on several liability insurance coverage issues. To be more specific concerning what is a Principles Project, first consider an ALI Restatement (think of the ALI Restatement of Contracts or Torts). In simple terms, a Restatement sets forth what the law is concerning a certain issue. A Principles Project, however, sets forth what is purported to be the best law or what the law should be. So to the extent that a Principle sets forth what is already the existing law, there is no practical difference between a Restatement and Principles Project. However, a Principles Project also purports to set forth more direct statements of what courts actually do and make adjustments to the law that are superior.

I’m not personally involved in the ALI’s Principles Project. The closest I get to the official process is that the American Law Institute is located in Philadelphia and I could walk to its offices if I were so inclined. But you don’t need to know the secret handshake to see why insurers have not given a warm welcome to this latest entrant to the library of all things insurance coverage. As I said, the ALI Principles are now the most talked-about subject amongst liability insurance professionals. But the chat is not all pleasant. To be sure, simply because there are insurer-side representatives involved in the project does not mean that they agree with all of the Principles adopted.

For example, there has been much insurer consternation over the ALI’s proposed Principle that an insurer that breaches the duty to defend loses the right to defend or associate in the defense of the claim, the right to assert any control over the settlement of the claim AND the right to contest coverage for the claim. Waiver of coverage defenses is a very strong – punitive, you might say -- consequence for a breach of the duty to defend. The issue was recently before the New York Court in Appeals in the highly publicized K2-II case, which helped to focus attention on this proposed waiver Principle.

But waiver of coverage defenses, for a breach of the duty to defend, is not the law in the vast majority of states. Rather, there are different consequences imposed on insurers for breaching the duty to defend. Since case law already exists, addressing the consequences for an insurer for beaching the duty to defend, this Principle should not be as concerning for insurers as some others. In other words, I believe that the ALI Principles are less likely to be relevant in situations where a court is addressing an issue for which law already exists on its books.

This is not to say that insurers have been wrong to be concerned about the Principles’s support for the waiver rule. Far from it. For example, ALI’s draft waiver Principle was being urged on the New York Court of Appeals in K2-II. While the New York high court ultimately declined to adopt the waiver rule, concluding that existing New York law mandated otherwise, insurers were right to be concerned. This was uncharted territory. Nobody knew what the New York Court of Appeals would do and how it would respond to an ALI draft Principle being thrust upon it.

Where insurer consternation should be greatest is for those Principles, with which they disagree, that address issues for which there is no or little existing law -- either in a particular state or nationally. For example, courts that are called upon to resolve a coverage issue for the first time in their state will often examine the case law nationally that makes up different schools of thought and decide which camp to join. When weighing this decision, and seeing some merit to all camps, it would not be surprising for the court to choose the rule set out in the Principles as the “tie-breaker.” Likewise, if case law on an issue is sparse nationally, the rule set out in the Principles may be an attractive option for the court. The court gets an answer and can cite to a source for it. This is where I believe that the Principles are likely to have their greatest impact – cases where a court is confronting an issue that has never come before it.

To put all of this another way, on the continuum of concern that insurers should have for each ALI Principle, more is warranted for those issues where case law is sparse than where case law is developed.

All of this being so, consider the following proposed ALI Principle (as set out in Tentative Draft No. 2; March 28, 2014) addressing an issue that is on the table for a vote at the ALI’s annual membership meeting at the end of May. As it is an issue where the law is sparse, it is one that is in the category of having a better chance of being affected in the future by the adoption of a Principle. Depending upon the speed at which the meeting’s proceedings move, smoke seems poised to rise from the chimney of the Ritz-Carlton in Washington announcing the approval of the following ALI Principle of the Law of Liability Insurance.

By way of introduction, Chapter 2, Section 18 of the Principles (not yet approved) states that when a defense is provided under a reservation of rights and “there are common facts at issue in the claim and the coverage defense such that the claim could be defended in a manner that would advantage the insurer at the expense of the insured, the insurer must provide an independent defense of the claim.” This is essentially the adoption of California’s “Cumis rule.” In general, many states apply a rule that looks something like Cumis (just not in statute form and without a name). The key issue here is whether the reservation of rights creates a conflict that requires an insurer to pay for the insured’s selection of independent counsel. That’s where the disputes exist. But because Section 18 is not inconsistent with the rules that exists in many states, it is not a Principle that should rank too high on the continuum of insurer concerns.

Section 19 goes on to state that, when independent defense counsel is required, “[t]he insurer is obligated to pay the reasonable fees of the defense counsel and related service providers on an ongoing basis in a timely manner.” This too, as a general principle, is also the rule in many states.

However, the comment to the rule states that an insurer’s panel rate is not per se the reasonable fee to be paid to the insured’s independent counsel (it is, however, under the Cumis statute). The comment states that the panel rate is relevant but not dispositive. However, the comment also acknowledges that a lawyer’s rate may be excessive in relation to the complexity of the claim or the amount at stake. The comment states that when a dispute over what is a reasonable rate for independent counsel arises, and they do regularly, the insured has the option of paying the difference between the panel rate and the independent counsel’s rate. That is the ideal solution. It just doesn’t come out this way too often.

Now here’s the part that insurers should be quite concerned about. The Section 19 comment goes on: “In the event of a dispute during the course of the defense about the reasonableness of fees, the insurer must pay the disputed fees and may bring an action against the independent defense counsel seeking return of the disputed fees after the duty to defend has ended and any coverage defenses have been adjudicated or settled, so as not to invade the attorney—client privilege or work-product immunity. If the fees are later found to be unreasonable, the insurer’s sole recourse is from defense counsel, not the insured.”

While this provides a much-needed rule, on the much-disputed and generally law-lacking issue of “what is a reasonable rate for independent counsel,” it is an approach that exists nowhere in the law and creates a host of problems. It is easy to see what will happen when an insurer believes that a rate in the $200 per hour range is reasonable, and the insured hires counsel that regularly charges $600 (or more), and claims that is a reasonable rate. If the Section 19 comment’s approach is used, the insurer must pay independent counsel $600 per hour and then, at some point down the road – maybe a long way down the road -- engage in litigation with such counsel over the reasonableness of its fees. The comment also states that the insurer can request reasonable security from the independent counsel for the fees in dispute. Yeah, like that’s gonna be a simple and non-contentious process.

If the difference between the insurer’s proposed reasonable rate, and the rate charged by independent counsel, is several hundred dollars per hour, and it will be in many cases, then the amount of disputed fees at stake, even for a case of moderate duration, will be quite significant. In many cases the amount will be too much for insurers to simple walk away from, as well as perhaps make a settlement of the fee dispute difficult to achieve.

Under this approach, underlying cases will end and then Act II will begin – collateral litigation over the reasonableness of defense counsel’s fees. Insurers will have to hire counsel to handle the disputes or saddle their in-house counsel with them. That no court (that I know of) has adopted, or even considered this approach to the reasonable fee issue, speaks volumes about it merit.

The Section 19 comment’s approach may also have some unintended consequences. If insurers are paying several hundred dollars per hour more than they believe is reasonable, it may force them to settle more cases on a cost of defense basis. In other words, turn off the meter for the defense, even if it means settling a non-meritorious case. Nobody wins there -- except plaintiffs with, well, non-meritorious cases.

Policyholders may think that none of this affects them. After all, the insurer is the one paying the defense bills and any subsequent litigation over the reasonableness of the fees is between the insurer and defense counsel. But policyholders may re-think this at renewal time when they see the affect that these higher defense bills have on their experience, and, hence, renewal premium. Maybe the lunch wasn’t so free for the policyholder after all.

In addition, under this approach, will policyholders really get the choice of counsel that it is specifically designed to give them? After all, some lawyers may be unwilling to represent a policyholder under this arrangement. While counsel may get its full rate during the duration of the case, it is also signing on to possible litigation over the reasonableness of its fees. Counsel runs the risk of having to pay some fees back, as well as incurring the expense of the fee dispute litigation.

Simply put, Section 19’s approach to resolving the reasonable fee issue is a recipe for a variety of disputes and litigation between insurers and law firms and may come with a host of unintended consequences. It is hard to believe that ALI believes that a solution to the reasonable fee issue is one that welcomes -- even endorses -- litigation.

Any project like the ALI’s “Principles of the Law of Liability Insurance” is not going to make every stakeholder happy. But Section 19 is one Principle that should rate high for insurer concern. Insurers should make it very clear that, just because they were on the roster of participants in the Principles process, does not mean that they agree with every Principle adopted.