Armstrong Cleaners, Inc. v. Erie Insurance Exchange
2005 U.S. Dist. LEXIS 5836, 364 F. Supp. 2d 797, 2005 WL 774629 (2005)
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Rule of Law:
Under Indiana Rule of Professional Conduct 1.7(a)(2), an insurer's defense of an insured under a reservation of rights creates a conflict of interest requiring the insurer to pay for the insured's independent counsel if there is a 'significant risk' that the insurer-appointed attorney's representation of the insured would be materially limited by the attorney's responsibilities to the insurer, especially when underlying litigation issues are relevant to the insurer's coverage defenses.
Facts:
- Forest and Betty Armstrong (the "Armstrongs") operated a dry cleaning business, Armstrong Cleaners, in Muncie, Indiana, from 1989 to 1996, at locations including one on Tillotson Avenue.
- During this period, the Armstrongs were insured under a liability insurance policy issued by Erie Insurance Exchange ("Erie") for the Tillotson Avenue location.
- In 2002, the Indiana Department of Environmental Management identified the Tillotson Avenue location as a potential source of soil and groundwater contamination.
- Another insurance carrier, State Farm, filed a third-party complaint against the Armstrongs, alleging they were responsible for environmental investigation and cleanup costs under Indiana law.
- The Armstrongs notified Erie of the third-party complaint and requested that Erie defend them in the State Farm lawsuit.
- Erie agreed to defend the Armstrongs but issued a reservation of rights, indicating potential denial of coverage based on the policy's definition of "occurrence" and the "expected or intended acts" and "pollution" exclusions.
- Erie then appointed attorney John Trimble of Lewis & Wagner to defend the Armstrongs in the State Farm litigation without consulting them.
- The Armstrongs subsequently asserted their right to select their own independent counsel, Michael Nelson, to be paid by Erie.
- Erie declined to pay for the Armstrongs' chosen counsel, maintaining its right to appoint defense counsel, and stating that any additional counsel would be at the Armstrongs' own expense.
Procedural Posture:
- On September 4, 2002, Mary Ivey, the property owner, filed a complaint against her insurance carrier, State Farm Insurance, in the Southern District of Indiana, regarding the alleged contamination.
- On May 22, 2003, State Farm filed a third-party complaint for declaratory judgment and damages against Muncie Dry Cleaners, Ronald and Carol Ray, the Armstrongs, and their insurers.
- On October 10, 2003, the Armstrongs filed this action in state court against Erie Insurance Exchange, seeking a declaratory judgment and damages for alleged bad faith.
- On November 20, 2003, Erie removed the action to the U.S. District Court for the Southern District of Indiana.
- Erie moved for summary judgment on both the selection of counsel and bad faith issues.
- The Armstrongs moved for summary judgment on the issue of selection of counsel.
- The parties began briefing the pending motions for summary judgment in May 2004.
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Issue:
Does an insurer's defense of its policyholders under a reservation of rights create a "significant risk" of "material limitation" on defense counsel, thereby entitling the policyholders to select their own counsel paid for by the insurer, even when the underlying lawsuit does not explicitly allege both covered and non-covered conduct but the allocation of damages would raise issues relevant to coverage?
Opinions:
Majority - Hamilton, District Judge
Yes, an insurer's defense of policyholders under a reservation of rights creates a "significant risk" that the representation by insurer-chosen attorneys would be materially limited, entitling the policyholders to select their own counsel. The court found that the core problem arises when an insurer defends under a reservation of rights because the handling of the underlying litigation may affect whether the claim is covered. The Indiana Rules of Professional Conduct 1.7(a)(2) govern, stating a conflict exists if there is "a significant risk that the representation of one or more clients will be materially limited by the lawyer’s responsibilities to another client... or a third person" (the insurer). The court clarified that not every reservation of rights creates a conflict; only those where the coverage dispute turns on issues that are not independent of the issues in the underlying lawsuit. Here, Erie reserved rights based on the "expected or intended acts" exclusion and the definition of "occurrence," both turning on whether the Armstrongs expected or intended the contamination. While the underlying environmental liability statute (Ind. Code § 13-30-9-2) requires only causation for liability, the allocation of cleanup costs (Ind. Code § 13-30-9-3) makes the Armstrongs' state of mind and degree of care directly relevant through factors like "degree of care exercised" and violations of statutes (which could include criminal statutes requiring intentional or knowing acts). Thus, the coverage issues are not independent of the underlying litigation, especially concerning cost allocation. An attorney selected by Erie would face a "significant risk" of material limitation because information gathered during the defense on remedial issues (knowledge, intent, care) could harm the Armstrongs in the coverage dispute. The court rejected Erie's narrow interpretation of a conflict (only for explicit alternative claims of intentional vs. negligent conduct) and found Erie's "Chinese Wall" procedures insufficient as they did not extend to supervisors or final decision-makers. However, the court granted summary judgment to Erie on the bad faith claim, finding that Erie had a reasonable, though ultimately incorrect, legal basis for its position, and did not act with "dishonest purpose, moral obliquity, furtive design, or ill will."
Analysis:
This case significantly broadens the circumstances under which an insured is entitled to independent counsel, moving beyond a narrow interpretation focused solely on alternative claims of covered and non-covered conduct. It establishes that a conflict of interest exists when facts relevant to an insurer's coverage defenses, such as the insured's intent or degree of care, will also be directly at issue in determining the allocation of damages in the underlying litigation. The ruling ensures that defense counsel's loyalty remains solely with the insured, particularly in complex environmental cases where initial strict liability may later give way to fault-based considerations for cost apportionment, thereby protecting insureds from compromised defenses.
