Insurers Beware: District Court Finds Lack of Specificity in Reservation of Rights Letter Plus Citation of Definition of “Occurrence” Created Conflict of Interest

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In Select Comfort Corp. v. Arrowood Indemnity Co. (D. Minn. No. 12-2975 (JNE/FLN), Aug. 26, 2014), a Minnesota federal district court ruled that there existed a conflict of interest between Arrowood Indemnity and its insured, Select Comfort Retail, requiring Arrowood to reimburse Select Comfort for its reasonable attorney fees incurred in the defense of a class action suit.  The underlying class complaint alleged that certain Select Comfort Retail mattresses “had a propensity to develop and incubate mold.”

Arrowood agreed to defend Select Comfort Retail pursuant to a reservation of rights.  The reservation of rights letter referenced several potential coverage defenses, which Arrowood reiterated over a series of letters to Select Comfort.  The district court was primarily concerned with Arrowood’s first coverage position letter, which cited to the definition of “occurrence” and highlighted factual allegations of knowing and fraudulent wrongs.  Notably, in a subsequent series of letters to Select Comfort, Arrowood denied the existence of a conflict of interest while also maintaining its reservation of rights.

Arrowood argued that there was no conflict of interest here because, as stated in its correspondence with Select Comfort, its coverage position was not dependent on the intentionality of Select Comfort’s conduct. The district court disagreed, finding that the reservation of rights letters created an ambiguity to be construed against Arrowood.  The district court also found persuasive extrinsic evidence, including deposition testimony from Arrowood’s Rule 30(b)(6) designee, indicating that Arrowood had reserved its right to challenge coverage based on the intentionality of Select Comfort’s conduct.  Accordingly, the district court found in favor of Select Comfort and denied Arrowood’s motion to dismiss.

The district court also addressed Arrowood’s concerns that allowing insureds to select their own counsel would lead to counsel charging of rates well in excess of the rates typically paid to the insurer’s panel counsel. The district court responded that a determination of the reasonableness of the attorney fees incurred provided the appropriate means to address this potential for abuse.  The court also suggested that this could be managed through contract, i.e., include as part of the policy the rates the insurer will pay for “independent” counsel.

The importance of this case is two-fold.  First, policyholders will undoubtedly rely on this case when pointing to a reservation of rights letter’s summary of allegations in the underlying complaint to argue that an insurer is reserving its rights on a particular issue that gives rise to the right to independent counsel.  This decision suggests that by not vehemently and expressly disclaiming a reservation of rights on the intentionality of Select Comfort’s conduct, Arrowood may be found to have reserved its rights to disclaim coverage on this issue, and in turn, created a conflict of interest relieving it of its right to select defense counsel.  Second, and by the same token, Arrowood here was intentionally vague in its coverage position letters, of course, to avoid waiving the right to disclaim coverage for otherwise excluded intentional conduct.  The district court recognized as much, as it stated, “Arrowood’s communications show a cautious attempt to preserve the right to challenge coverage based on the intentionality question along with the ability to argue that it was not reserved.”  The district court was not on board with this approach and found that Arrowood’s refusal to take a clear position on the alleged intentional conduct deprived it of the ability to control Select Comfort’s defense.