Courts around the country have held that when an insurer breaches its duty to defend, it can face significant consequences, including limitations on the insurer’s ability to apply hindsight analysis when belatedly reviewing the insured’s defense invoices for reimbursement.
In a case of first impression in North Carolina, the North Carolina Business Court recently adopted this common-sense rationale and held that when an insurer breaches the duty to defend, the insured’s defense costs should be deemed presumptively reasonable, shifting the burden to the insurer to rebut that presumption at a trial on damages.
In Murphy-Brown, LLC v. Ace American Insurance Company, the owners of hog farms in eastern North Carolina sought indemnity and defense costs from their insurers after adverse judgments in several nuisance cases brought by homeowners adjacent to the farms. Case No. 19 CVS 02793 ¶¶ 2-13. The court ruled in 2020 that multiple insurers breached the duty to defend and, before trial, the parties asked the court to clarify which side bore the burden of proving the reasonableness (or unreasonableness) of the farm owners’ defense costs. Id. ¶¶ 12, 14-17.
Drawing upon caselaw nationwide, Judge Mark Davis held that it was “eminently logical” to shift the burden of proving unreasonableness to the insurers, since the court had already decided that the insurers breached their duty to defend. Id. ¶ 23. According to the Business Court, presuming that defense costs are reasonable is “equitable” and “serves as a deterrent to insurers [against] wrongfully breaching their defense obligations.” Id.
This rebuttable presumption in insureds’ favor is consistent with other jurisdictions’ stance that breaching the duty to defend carries significant consequences for insurers. In fact, many jurisdictions hold that insurers who breach the duty to defend waive the right to contest the reasonableness of defense costs entirely. See, e.g., USA Gymnastics v. Liberty Ins. Underwriters, Inc., 46 F.4th 571, 581 (7th Cir. 2022) (“[I]f the policyholder does pay a significant percentage of its fees . . . that is strong evidence of market incentives to economize, rendering the presumption [in favor of reasonableness] applicable.”); Taco Bell Corp. v. Cont’l Cas. Co., 388 F.3d 1069, 1075 (7th Cir. 2004) (presuming defense costs reasonable after insurer refused to defend because insured was incentivized to minimize legal costs) (collecting authority). Others hold that when an insurer breaches the duty to defend, the insurer may forfeit substantive coverage defenses. See, e.g., Truck Ins. Exch. v. Vanport Homes, Inc., 147 Wash. 2d 751, 759, 58 P.3d 276, 281 (2002) (holding that when an insurer wrongfully refuses to defend in bad faith, “the insurer is bound by the decision of the trier of fact” regarding the underlying action); Gray v. Zurich Ins. Co., 65 Cal. 2d 263, 279 (1966) (same); State Farm Fire & Cas. Co. v. Martin, 186 Ill. 2d 367, 371 (Ill. 1999) (holding that if an insurer fails to raise a defense in a coverage letter or declaratory judgment action, “it will be estopped from later raising policy defenses to coverage”).
While other states have not gone so far as to hold that breaching the duty to defend can result in a waiver of substantive coverage defenses, courts in those states have held that an insurer can waive certain coverage conditions, such as late notice, by omitting them from reservation of rights letters. See, e.g., N.Y. Ins. Law § 3420(d)(2) (providing for waiver of certain coverage defenses to bodily injury claims where insurer fails to give timely written explanation of grounds for coverage denial); U.S. Fid. & Guar. Co. v. Budget Rent-A-Car Sys., Inc., 842 P.2d 208, 210 n.3 (Colo. 1992) (“An insurer should raise (or at least reserve) all defenses within a reasonable time after learning of such defenses, or those defenses may be deemed waived or the insurer may be estopped from raising them.”); Thompson v. Floyd Jude Living Tr., No. 337368, 2018 WL 1733440, at *4 (Mich. Ct. App. Apr. 10, 2018) (” Generally, when an insurer denies coverage to its insured and states its defenses, it then has waived or is estopped from asserting new defenses.”); Hoover v. Maxum Indem. Co., 730 S.E.2d 413 (Ga. 2012) (holding insurer waives policy defense like late notice if not referenced in denial and/or reservation of rights letter); State Auto Prop. & Cas. Ins. Co. v. Gorsuch, 323 F. Supp. 2d 746, 757 (W.D. Va. 2004) (holding that insurer waived the defense of late notice by failing to timely raise it).
In Murphy-Brown, the Business Court did not find a waiver of coverage defenses, and did preserve at least one method through which insurers can rebut the reasonableness presumption. Over the farm owners’ objections, Judge Davis permitted the insurers to conduct a “line-by-line” challenge to the farm owners’ attorneys’ bills. Case No. 19 CVS 02793 ¶¶ 32. Even though the bills comprised over 5,000 pages of time entries, the Business Court held that a line-by-line challenge was consistent with Rule 1.5 of the North Carolina Rules of Professional Conduct. Id. Thus, Murphy-Brown suggests that an insurer can attempt to rebut the reasonableness presumption using the following factors:
- the time and labor required, the novelty and difficulty of the questions involved, and the skill requisite to perform the legal service properly;
- the likelihood, if apparent to the client, that the acceptance of the particular employment will preclude other employment by the lawyer;
- the fee customarily charged in the locality for similar legal services;
- the amount involved and the results obtained;
- the time limitations imposed by the client or by the circumstances;
- the nature and length of the professional relationship with the client;
- the experience, reputation, and ability of the lawyer or lawyers performing the services; and
- whether the fee is fixed or contingent.
N.C. R. Prof’l Conduct 1.5(a).
Even then, the Business Court rejected Ace’s attempt to shield from the jury the fact that Ace had breached its duty to defend before it evaluated the reasonableness factors. Murphy-Brown, Case No. 19 CVS 02793 ¶¶ 41. The Court explained that the “value of allowing the jury to be made aware of this information is so that the jurors will understand that they are not being asked to decide the threshold issue of whether ACE actually owed Plaintiffs a defense in the Underlying Lawsuits and are instead only being tasked with deciding the extent to which the Defense Costs incurred by Plaintiffs were reasonable.” Id. ¶ 38.
In light of the Business Court’s decision, once policyholders in North Carolina demonstrate that their insurers have breached the duty to defend, their defense costs are presumed reasonable. Accordingly, if an insurer wrongfully refuses to defend and then argues that the insured’s defense costs were unreasonable, North Carolina policyholders should push back hard and resist efforts on the part of the insurer to shift the reasonableness burden back to the policyholder.
Finally, even when an insurer accepts its duty to defend, policyholders should work with their broker and coverage counsel to resist attempts by liability insurers to impose artificial, unbargained-for hourly rate caps on defense counsel that do not account for real-world considerations, such as the skill required to defend complex litigation and the impact of inflation on the market for legal services.
