Insurance Law Client Alert: Contractor’s Conditions Endorsement Can Give Rise to Conflict Requiring Independent Counsel

In Schaefer v. Elder (No. C068229, filed 5/16/13; pub. order 6/12/13), a California Court of Appeal held that the question of whether a subcontractor was an independent contractor or an employee can create a conflict giving rise to a right to independent “Cumis” counsel under Civil Code section 2860 where the policy conditioned coverage on obtaining certificates of insurance and indemnity agreements from any independent contractors performing work for the insured.

In Schaefer, the insured had contracted to build a residence, and was sued by the homeowner for negligence and other claims. The insured tendered the action to his insurer, which retained counsel and reserved its rights based in part on a provision stating that the policy would not cover work performed by independent contractors unless the insured first obtained from those independent contractors indemnity agreements and certificates of insurance. The contractor’s condition attached to the policy stated:

“As a condition precedent to coverage for any ‘suit’ based, in whole or in part, upon work performed by independent contractors, the insured must have prior to the date of the ‘occurrence’ giving rise to the ‘suit:’ (1) received a written indemnity agreement from the independent contractor holding the insured harmless for all liabilities, including costs of defense, arising from the work of the independent contractor; and (2) obtained certificates of insurance from the independent contractor indicating that the insured is named as an additional insured and that coverage is maintained with minimum limits of $1,000,000 per occurrence.”

The insurer refused the insured’s demand for appointment of independent counsel but the court disagreed, finding the question whether a subcontractor working for the insured was an employee or an independent contractor created a conflict for defense counsel, requiring the appointment of independent counsel.

The insurer relied on Blanchard v. State Farm Fire & Casualty Co. (1991) 2 Cal.App.4th 345, where the court held that a conflict of interest does not arise unless the outcome of the coverage issue can be controlled by counsel retained by the insurer for the defense of the underlying claim. In Blanchard, the court found no conflict based on the insurer’s reservation of the right to deny coverage for mere faulty workmanship by the insured, not involving damage to the property of others.

But the Schaefer court found that the question of employee or independent contactor status created a conflict under the contractor’s conditions endorsement, because coverage could be barred for work performed by independent contractors if the insured did not comply with the conditions for hold harmless agreements and certificates of insurance:

“This question of proof causes the conflict of interest between Elder and CastlePoint, as it was identified by the trial court. It is in Elder’s interest to argue that the work was done by employees because the insurance policy would apply even if Elder did not comply with the contractor’s special condition. On the other hand, it is in CastlePoint’s interest to argue that the work was done by independent contractors so that, in the declaratory relief action, CastlePoint could argue that Elder is not covered because he failed to comply with the contractor’s special condition. Therefore, there was a conflict of interest for the Koeller law firm.”

Thus, the court found that the insured was entitled to independent counsel and his chosen law firm was not disqualified but that counsel appointed by the insurer was disqualified from continued representation of either Elder or CastlePoint in the litigation.

The outcome in this case appears to hinge on the fact that the contractor’s condition endorsement was limited to “independent contractors” and thus may be limited as precedent. The court’s conclusion that it was in the insured’s interest for defense counsel to establish employee status for subcontractors to avoid operation of the exclusion also seems to ignore that doing so would expose the insured to vicarious liability, workers’ compensation and tax consequences, and foreclose the opportunity for any risk transfer to the subcontractors.

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June 17, 2013