The Hammer Clause: Not the Solid Coverage Defense You Thought

Most professional liability policies contain the following or a similar provision addressing settlement by an insurer and an insured’s consent to the settlement.

[Insurer] shall…not settle any CLAIM without the written consent of the NAMED INSURED which consent shall not be unreasonably withheld. If however, the NAMED INSURED refuses to consent to a settlement recommended by [Insurer] and elects to contest the CLAIM or continue legal proceedings in connection with such CLAIM, [Insurer’s] liability for the CLAIM shall not exceed the amount for which the CLAIM could have been settled, including CLAIMS EXPENSES up to the date of such refusal, or the applicable limits of liability, whichever is less. Freedman v. United Nat’l Ins. Co., 2011 U.S. Dist. LEXIS 25490, *2; 2011 WL 781919 (C.D. Cal. Mar. 1, 2011) (emphasis added).

Under the first sentence, an insurer can negotiate settlement directly with a claimant. However, any resulting settlement is subject to the consent of the insured. If the insured refuses to consent, that refusal must not be unreasonable. The second sentence also gives the appearance that an insurer can negotiate with a claimant to achieve a settlement. Under this scenario, if the insured does not consent and the litigation continues against the insured, the insurer is not prejudiced because its exposure for loss ceases on the date of the insured’s refusal to consent. This provision often is referred to as the “hammer clause” because of the power it gives an insurer to enforce a settlement. Essentially, insurers believe they have some control over a recalcitrant insured.

That belief is misplaced. A further review of these two sentences elicits a suspicion that there is some ambiguity between the two. The first sentence expressly provides that the insured’s written consent is necessary to any settlement. The first sentence also clearly sets forth that the insured’s consent cannot be unreasonably withheld. In contrast, the second sentence does not address whether the insured’s consent must be reasonable.

The harmonious interpretation of these two sentences was at issue in Freedman v. United Nat’l Ins. Co., cited above. In Freedman, an attorney tendered a legal malpractice action to his professional liability carrier. The claimant offered to settle within the policy limits, but the defendant attorney refused because he believed the action lacked merit. After the insurer invoked the hammer clause, the attorney still declined to settle and filed an action against the insurer claiming the carrier acted in bad faith by settling the underlying suit, which had no merit, over his objection and without his consent. The insured attorney advanced the following interpretation of the above provision: (1) an insurer cannot settle without the insured’s consent, but the insured cannot unreasonably refuse to consent to settle; and (2) if the insured unreasonably refuses to consent to settle, then the insurer’s liability is limited to the amount for which the insurer would have settled plus the cost of the defense up to the date of the insured’s refusal. Essentially, the insured argued that the insurer could rely on the hammer clause only if the insured’s refusal to consent was unreasonable. Conversely, the insurer in Freedman argued that the two sentences actually are separate clauses. The parties’ disagreement arose over whether the second sentence, standing alone, allows an insurer to limits its liability when an insured refuses to consent to a settlement, regardless if that refusal is reasonable. The court sided with the insured and held the policy was not ambiguous and the hammer clause may be invoked only if the insured unreasonably refuses to consent to a settlement.

The Freedman court based its ruling on a decision from the Court of Appeals for the First Circuit in Clauson v. New England Ins. Co., 254 F.3d 331, 337-38 (1st Cir. 2001). In Clauson, the insured attorney refused multiple offers to settle a malpractice action filed against him. The underlying action involved the attorney’s failure to attend a hearing in which a martial asset his client used for business was sold. After the client filed a malpractice suit against the insured, the client made several offers to settle during the pendency of the action which the insured rejected. The insurer twice informed the attorney that his refusal to settle was unreasonable and invoked a clause similar to that in Freedman which limited the insurer’s exposure to the amount of the rejected settlement. After judgment was entered against the insured in excess of the offers, the client filed a declaratory action against the insurer to recover the amount of the judgment in excess of the settlement offer the insurer previously had agreed to pay. The trial court held that the insured was reasonable when he refused to consent to settle, and thus, the provision limiting the insurer’s exposure did not apply. The Court of Appeals affirmed the trial court’s ruling that the hammer clause did not apply, and thus, the insurer was liable for the total judgment against its insured.

Pragmatically, the hammer clause is a provision which is intended to limit an insurer’s liability when an insured refuses to consent to a settlement. However, recent case law has eroded that veneer and revealed that the coverage defense actually rests on the conduct of the insured; specifically, whether the insured’s refusal to settle is unreasonable. Based upon the case law, the merits of the case and a legitimate settlement value alone may not determine if an insured acts unreasonably in refusing consent.

Alaska Supreme Court Rules that Insurer Have No Right to Reimbursement of Defense Fees and Costs

For many years, the prevailing view of Alaska law was that an insurer could obtain reimbursement of defense costs from an insured if it specifically reserved the right to seek reimbursement and subsequently obtained a determination of no coverage. This understanding was based on Unionamerica Inc. Co., Ltd. v. General Star Indem. Co., 2005 WL 757386 (D. Alaska 2005), in which the Alaska federal district court predicted that the Alaska Supreme Court would allow insurers to recover defense costs. It turns out, however, that the district court’s prediction was incorrect.

In Attorneys Liability Protection Society, Inc. v. Ingaldson Fitzgerald, P.C., No. 7095 (March 25, 2016), the Alaska Supreme Court ruled that a policy provision entitling an insurer to reimbursement of fees and costs incurred by the insurer defending under a reservation of rights is unenforceable, even if (1) the insurer explicitly reserves the right to seek reimbursement in its offer to provide a defense by an independent counsel, (2) the insured accepts the defense subject to the reservation of rights, and (3) the claims are subsequently determined to be excluded from coverage under the policy.

Attorneys Liability Protection Society, Inc. (“ALPS”) issued a malpractice insurance policy to Ingaldson & Fitzgerald, P.C. (“IF”) from April 29, 2007 to April 29, 2008. The policy contained a provision that entitled ALPS to seek reimbursement for amounts paid by ALPS in defending non-covered claims.

During the policy period, IF reported to ALPS a lawsuit against it alleging, among other things, restitution, disgorgement, and conversion for recovery of a retainer that had been paid to IF. ALPS accepted IF’s tender but reserved rights because the policy excluded coverage for claims arising from conversion or fee disputes. ALPS retained independent counsel to defend IF and paid all defense costs in full, as required by AS 21.96.100.

In the underlying case, summary judgment was rendered against IF on claims of restitution, disgorgement and conversion, all of which were specifically excluded under the malpractice policy. Thereafter, ALPS commenced a declaratory judgment action against IF and moved for partial summary judgment on the reimbursement of defense costs issue. In denying the motion, the district court declined to follow the Unionamerica case and held that Alaska law prohibits the inclusion of a right to reimbursement in insurance policies under AS 21.89.100(d), which states, in part, that in providing independent counsel, an insurer “shall be responsible only for the fees and costs to defend those allegations for which the insurer either reserves its position as to coverage or accepts coverage.”

ALPS appealed to the Ninth Circuit Court of Appeals. The Ninth Circuit noted that while AS 21.96.100(d) requires the insurer to pay defense costs if it either covers the claims against its insured or defends pursuant to a reservation of rights, the statute is not clear as to whether the insurer can later seek reimbursement of fees assumed under a reservation of rights under these circumstances. Therefore, the Ninth Circuit certified two questions to the Alaska Supreme Court:

  1. Does Alaska law prohibit enforcement of a policy provision entitling an insurer to reimbursement of fees and costs incurred by the insurer defending claims under a reservation of rights, where (1) the insurer explicitly reserved the right to seek such reimbursement in its offer to tender a defense provided by independent counsel, (2) the insured accepted the defense subject to the reservation of rights, and (3) the claims are later determined to be excluded from coverage under the policy?
  2. If the answer to Question 1 is “Yes,” does Alaska law prohibit enforcement of a policy provision entitling an insurer to reimbursement of fees and costs incurred by the insurer defending claims under a reservation of rights, where (1) the insurer explicitly reserved the right to seek such reimbursement in its offer to tender a defense provided by independent counsel, (2) the insured accepted the defense subject to the reservation of rights, and (3) it is later determined that the duty to defend never arose under the policy because there was no possibility of coverage?

In answering both questions with “YES,” the Alaska Supreme Court ruled that AS 21.96.100 renders any defense costs reimbursement provisions in insurance policies unenforceable.

The Alaska Supreme Court first acknowledged that under Alaska case law, an insured has a right to demand an unconditional defense. To meet this right, the insurer has three options: (1) affirm the policy and defend unconditionally; (2) repudiate the policy and withdraw from the defense; or (3) offer its insured the right to retain independent counsel to conduct the defense and agree to pay all the necessary costs of that defense. CHI of Alaska, Inc. v. Employers Reinsurance Corp., 844 P.2d 1113 (1993); Continental Ins. Co. v. Bayless & Roberts, Inc., 608 P.2d 281 (1980). The Court continued that AS 21.96.100 is the codification of such requirements.

In examining the statutory text, the Alaska Supreme Court noted that the subsections (a) through (d) focus on the mandatory requirement that insurers pay for the cost of independent counsel. The Court noted that the statute clearly allocates to the insurer the responsibility to pay the fees and costs when an insurer provides independent counsel to the insured. Therefore, any effort to shift such expenses to an insured would violate the allocation that the statute requires and would be invalid. In short, there is nothing in AS 21.96.100 that permits reimbursement, so the Court concluded that the statutory scheme prohibits reimbursement. The Court held that “reimbursement is prohibited, and because there is no evidence of contrary legislative purpose or intent, we conclude that the statute prohibits reimbursement provisions.”

In ruling that reimbursement provisions are unenforceable, the Alaska Supreme Court declined to follow the California case of Buss v. Superior Court, 939 P.2d 766 (1997). First, the Court noted that the California statute does not contain language similar to that in AS 21.96.100(d). Second, the California statute actually provides a section on reimbursement, which states that “[t]his subdivision does not invalidate other different or additional policy provisions pertaining to attorney’s fees or providing for methods of settlement of disputes concerning those fees.”

The Court further noted that the legislative history supports its conclusion that the statute allocates responsibility to pay for independent counsel to the insurer when the insurer defends under a reservation of rights. Finally, the Court acknowledged that even though the Division of Insurance had approved the policies containing the reimbursement provision, the Division’s past practice is not dispositive. More importantly, however, the Division had disavowed its past practice in its amicus brief with a more “considered interpretation” that “under AS 21.96.100, if an insurer has a duty to defend and elects to reserve its rights on an issue, it is obligated to provide and pay for independent counsel.”

So insurers beware – reimbursement of defense costs provisions are prohibited and unenforceable in Alaska.

Delinquent Claims Are Timely Claims: Eighth Circuit Declares Notice Provision Ambiguous

In George K. Baum & Co. v. Twin City Fire Insurance Co., No. 12-3982 (8th Cir. July 16, 2014), the Eighth U.S. Circuit Court of Appeals ruled that the “as soon as practicable” notice language in a claims made professional services policy was ambiguous, rejecting the insurer’s late notice defense.

The insured, a municipal bonds dealer, secured professional services insurance from Twin City for a policy period from 2003 to 2004.  In 2003, the Internal Revenue Service opened an investigation based on the insured’s faulty representation that interest on the municipal bonds was tax exempt.  The insured notified its insurer of actual claims by the IRS and future potential claims by the insured’s municipal clients.  The insurer treated the IRS investigation as a claim under the policy and the insured ultimately settled with the IRS for $7.7 million without admitting misconduct.  In 2008, two years after settling with the IRS, various municipalities filed derivative suits against the insured, which were consolidated into an MDL in Southern District of New York.  The insured did not notify Twin City of the litigation until 2010, another two years later.

The insurer initially denied coverage on the basis that the derivatives claims were not claims made during the 2003-2004 policy period, but it later withdrew its position because the claims related back to the timely-reported IRS investigation.  The insurer also denied coverage based on late notice, arguing that under New York law, it did not have to prove prejudice.

The U.S. District Court for the Western District of Missouri ruled that Missouri law applied and that the insurer could not prove the prejudice required to deny coverage based on late notice.  The Eighth Circuit Court of Appeals affirmed rejection of the late notice defense, but on different grounds.   The court first ruled that New York law applied because the policy was issued to the insured’s office in New York specifically to avoid paying Missouri’s surplus lines tax.  Although the insurer was correct that it was not required to prove prejudice under New York law, the court found that the policy’s notice requirement was ambiguous.

The policy’s insuring agreement required notice “as soon as practicable, but in no event later than sixty (60) days after the POLICY EXPIRATION DATE” in 2004.  The policy also provided that “all claims based upon, or arising out of, the same wrongful act or interrelated wrongful acts shall be considered a single claim for all purposes…which shall be deemed first made at the time the earliest of all such claims was first made.” Thus, the court concluded that the subsequent multi-district litigation “constitute[d] ‘a single claim for all purposes,’ including notice” that was provided in 2003.  The court also found that the “as soon as practicable requirement” was ambiguous when considered in conjunction with the 60-day time limitation and the relation back language.  Finally, the court rejected the insurer’s alternative argument that the insured’s interpretation would allow it “to wait weeks, months or even years” before providing notice. The court was unpersuaded by “the complaints of a poor draftsman” and it warned that it would not “rescue an insurer from its own drafting decisions.”

Baum reminds us that courts continue to construe notice provisions generously in the insured’s favor and encourages a vigilant approach both to drafting and to litigation strategy regarding how that drafting might be later perceived by a court.

No Professional Liability Coverage for Law Firm Victimized by Check Scam

On June 28, the U.S. District Court for the District of New Hampshire issued a ruling denying coverage under a professional liability policy to an insured attorney and his law firm who were victimized by a Nigerian-style check scam. The court held that the claim fell under a policy exclusion for losses from “conversion, misappropriation or improper commingling by any person” of funds held or controlled by an insured.

INS BLOG_checkAttorneys Liability Protection Society, Inc. v. Whittington Law Associates, PLLC, the insureds, Whittington Law Associates and W.E. Whittington, were contacted by an imposter prospective client. The imposter asked the insureds to deposit a check for $195,790 into the insured attorney’s client trust account in Ledyard National Bank and then promptly wire the bulk of the funds to a bank account in Japan. Ledyard later discovered that the check deposited to the insured’s account was invalid, by which time the wire transfer to the Japanese bank account already had been processed and the funds withdrawn from the insured’s account.

Ledyard sued the insureds in New Hampshire state court to recover the funds, prompting the insureds to seek coverage from their professional liability insurer, Attorneys Liability Protection Society, Inc. The insurer responded by filing an action in the federal court seeking a declaration that no coverage was available for the claim. The insureds filed counterclaims for declaratory judgment and breach of contract.

The insurer moved for summary judgment, arguing that there was no coverage because the claim did not fall within the definition of “an act, error or omission in professional services that were or should have been rendered,” and that even if the claim fell within the insuring agreement, it was excluded as “conversion, misappropriation or improper commingling.” In response, the insureds cross-moved for summary judgment.

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