By Joshua Broudy and James Killelea
A Pennsylvania intermediate appellate court recently prescribed new rules relative to the defense of insureds under a reservation of rights. In Babcock & Wilcox Company, et al. v. American Nuclear Insurers, et al., 2013 PA Super. 174, 2013 PA Super. LEXIS 1630 [enhanced version available to lexis.com subscribers], a majority panel of the Superior Court of Pennsylvania held that when an insurer tenders a defense subject to a reservation, the insured now has the option of rejecting the insurer's tender, funding its own defense, and settling the case without the insurer's consent. Should coverage later be found, the insured may recover from the insurer the costs of defense and settlement to the extent those costs are deemed fair, reasonable and non-collusive. As set forth in the concurring and dissenting opinion, the majority's decision may contravene controlling Pennsylvania Supreme Court precedent regarding the insurer's right to control the settlement when it tenders a defense. The Supreme Court may be weighing in on this decision in the near future.Underlying CaseThe instant decision arises out of a federal class action lawsuit initially filed in 1994 against Babcock & Wilcox Company ("B&W") by five individuals and three purported class representatives who worked in, or lived near, nuclear fuel processing facilities currently owned and operated by B&W. The employee plaintiffs alleged they had sustained bodily injury and property damage caused by radiation emanating from these facilities. Thereafter, amended complaints were filed adding approximately 300 plaintiffs. B&W's insurers, American Nuclear Insurers and Mutual Atomic Energy Liability Underwriters (collectively, "ANI") agreed to defend B&W in the case under a reservation of rights.In 1998, the federal district court tried a number of "test cases" which resulted in verdicts totaling approximately $36 million. Due to evidentiary errors, these verdicts were overturned and the federal trial court granted a new trial. Counsel retained by the insureds subsequently settled the underlying claims without ANI's consent for $80 million, an amount less than ANI's policy limits. B&W funded the settlement and then sought reimbursement from ANI for the full amount of the settlement, plus pre-judgment interest. ANI disagreed with the settlement decision and refused to reimburse B&W for the settlement or defense costs, arguing that it had no obligation to make any payment because B&W had violated the insurance policy's "consent to settle" clause.A declaratory judgment action was subsequently filed in Pennsylvania state court. In that action, B&W argued that it had a right to settle the underlying claims without the insurer's consent provided its settlement was reasonable. ANI countered that under existing Pennsylvania law, an insurer who honors its defense obligation (namely, by tendering a defense under a reservation of rights) maintains control over any settlement. The trial court determined that B&W was entitled to indemnity from ANI, notwithstanding the violation of the consent to settle clause in the policy, provided that the settlement was "fair and reasonable." The trial court further held that no distinction existed between the instant case, where the insurer was defending subject to a reservation of rights, and a case where the insurer denied coverage. A jury then found that the settlement entered into by B&W was fair and reasonable, and the court entered a judgment in favor of B&W.Decision Of Superior CourtOn appeal, the sole issue before the Pennsylvania Superior Court was whether B&W was obligated to honor the consent to settle provision in its insurance policy given that ANI had provided a defense to B&W subject to a reservation of rights. The majority suggested that this issue was one of first impression in Pennsylvania, and therefore considered three competing lines of cases from other state and federal courts.The court first considered United Services Auto Ass'n v. Morris, 741 P.2d 246 (1987) [enhanced version available to lexis.com subscribers], a case in which the Arizona Supreme Court held that when an insurer tenders a defense subject to a reservation of rights, the insured is permitted to reject the defense, thereby forcing the insurer to provide coverage and defend, or to refuse to defend at all. The consent to settle clause would thus prevent an insured from settling claims only in those instances where the insurer unconditionally assumes liability under the policy. The B&W court disapproved of the reasoning of Morris, noting that the decision relieved the insured of its contractual obligation to honor the consent to settle provision, despite the absence of a material breach on the insurer's part. Under Arizona as well as Pennsylvania law, the Pennsylvania Superior Court opined, an insurer's defense under a reservation of rights does not breach the policy.In the second case to be considered, Vincent Soybean & Grain Co, Inc. v. Lloyd's Underwriters of London, 246 F. 3d 1129 (8th Cir. 2001) [enhanced version available to lexis.com subscribers], the Eighth Circuit held that an insurer defending under a reservation of rights retains full authority to control the settlement under a consent to settle provision. The insured's rights are protected to the extent that it can sue the insurer for bad faith in the event that the insurer fails to settle, and a verdict in excess of policy limits results. According to the Eighth Circuit, the insured can then recover the excess judgment if it is determined that the insurer's failure to settle within policy limits was unreasonable. The Pennsylvania Superior Court criticized the ruling in Vincent Soybean as "too cavalier" regarding the risk imposed on the insured where an insurer rejects an opportunity to accept a reasonable settlement offer. Although the insured could sue the insurer for an excess verdict, the B&W court observed that an insured could still be harmed by an insurer's failure to accept a reasonable settlement even where a verdict was ultimately within policy limits.The Superior Court ultimately adopted a third approach espoused by a Florida appellate court in Taylor v. Safeco Ins. Co., 361 So.2d 743 (Fla. Ct. App. 1978)[enhanced version available to lexis.com subscribers]. The B&W court majority contended that the Taylor approach "best balances the interests of an insurer and insured." In Taylor, the insurer rejected the tender offered by its insurer, consented to a substantial judgment, and assigned its right to seek reimbursement from its insurer to the plaintiff in exchange for a release from all personal liability. The trial court granted summary judgment to the insurer in the ensuing coverage litigation between the assignee and the insurer. The Florida Court of Appeals reversed, holding that because the insured rejected the insurer's defense, if coverage were established, the insurer would be obligated to indemnify the insured for the amount of the settlement up to the policy limits if the settlement was reasonable and not entered into in bad faith. The Pennsylvania Superior Court also noted that numerous jurisdictions have adopted variations of the Taylor approach.1The majority ultimately found that the decision in Taylor best corresponded with Pennsylvania law, which recognizes the correlation between the insurer's provision of the defense and the right of the insurer to control the same. The B&W court held that when an insurer offers a defense subject to a reservation of rights, the insured may choose either of two options: (1) it may accept the defense, thereby remaining bound to the terms of the consent to settlement provision of the underlying policy, and granting full control of the litigation to the insurer; or (2) it may decline the insurer's tender of a defense and furnish its own defense, including the option of settling the underlying claim under terms it believes best. Under the latter option, should subsequent litigation establish coverage, the insured may recover its defense and settlement costs if they are "fair, reasonable and non-collusive." The Superior Court remanded the case to the trial court to determine if B&W expressly rejected ANI's defense and, if not, whether ANI's refusal to consent to the $80 million settlement constituted bad faith.In an opinion concurring in the result, but dissenting in the reasoning, Judge Judith Olson agreed that the trial court's $80 million judgment should be vacated, but did not agree that the case should be remanded for further proceedings consistent with Taylor. Rather, Judge Olson noted that controlling Pennsylvania law required that since ANI tendered a defense subject to a reservation of its rights to contest coverage, B&W would need to comply with its obligations under the consent-to-settlement clause in the parties' insurance contract unless B&W could establish bad faith on the part of ANI. See, e.g., Cowden v. Aetna Casualty and Surety Co., 134 A.2d 223 (Pa. 1957) [enhanced version available to lexis.com subscribers]. Notably, review of the majority's decision may be forthcoming, as a petition for allowance of appeal was recently filed with the Pennsylvania Supreme Court.ConclusionThe B&W ruling likely will reassure liability insurers defending underlying litigation subject to a reservation of rights that they maintain full control of the defense and settlement of that litigation, provided that the insured has accepted their tender of the defense. However, the insured's new option to reject the insurer's conditional defense, settle on its own, and recover its defense costs and settlement raises a number of questions. For example, the B&W opinion does not provide guidance as to whether an insured continues to have a right to independent defense counsel where the facts in the underlying matter could determine coverage, or whether that right is eliminated because the insured has the option of defending itself. It is unclear whether the insurer would be permitted to argue in a later proceeding that coverage does not exist, such as where the underlying settlement extinguishes both covered and non-covered claims. It is also unclear whether the insurer is required to advise the insured in a reservation of rights letter issued in Pennsylvania that it has the option to reject the insurer's defense offer and proceed to strike out on its own in accordance with B&W.In sum, the B&W ruling may have an impact on the decision-making process of both insurers and policyholders in the context of a reservation of rights letter. As reflected in the cases above, courts across the nation have adopted very different rules for this situation, so insurers should be mindful of the governing law. In Pennsylvania and other jurisdictions with similar rules, an individual or smaller commercial insured is likely to continue to accept an insurer's defense subject to a reservation of rights. However, there may be circumstances where a larger, deep-pocketed commercial insured which has the resources to provide for its own defense and pursue coverage litigation may decline an insurer's defense tender. Such a possibility may cause an insurer to more carefully consider defending under a reservation of rights if it does not believe its coverage defenses will ultimately prevail. In any event, the long-term impact of this decision remains to be seen, as further review may take place by the Pennsylvania Supreme Court.Endnotes1. See Continental Insurance Co. v. Bayless and Roberts, Inc., 608 P.2d 281 (Alaska 1980) [enhanced version available to lexis.com subscribers]; Norton v. Farmers Automobile Inter-Insurance Exchange, 40 Cal.App.2d 556, 105 P.2d 136 (1940) [enhanced version available to lexis.com subscribers]; Boise Motor Car Co. v. St. Paul-Mercury Indemnity Co., 62 Idaho 438, 112 P.2d 1011 (1941) (insurance company must decide its position) [enhanced version available to lexis.com subscribers]; Three Sons, Inc. v. Phoenix Insurance Co., 357 Mass. 271, 257 N.E.2d 774 (1970) [enhanced version available to lexis.com subscribers]; Butters v. City of Independence, 513 S.W.2d 418, 425 (Mo. 1974) [enhanced version available to lexis.com subscribers] (in view of its attempt to reserve the coverage question, the insurer had no right to insist upon controlling the defense).Joshua Broudy and James Killelea are attorneys with the law firm of Edwards Wildman Palmer LLP. Mr. Broudy is counsel in the Insurance & Reinsurance Department, and is based at the firm's office in Hartford, Connecticut. Mr. Killelea is an associate in the same department, and is based at the firm's office in New York, New York. Any commentary or opinions do not reflect the opinions of Edwards Wildman Palmer LLP or Mealey's Publications. Copyright (c) 2013 by Joshua Broudy and James Killelea. Responses are welcome.