Ethical Dilemmas by Use of Captive Law Firms

Introduction

A number of bar associations and state regulatory agencies recently have been addressing ethical issues raised by the insurance industry’s use of “captive law firms.” Insurance companies many times are required to provide a legal defense for their policyholders. Increasingly, insurance companies have been using lawyers who are employees of the insurance companies, but who practice law in a private law firm setting using a typical law firm name. The lawyers in these captive law firms are full-time, salaried employees of the insurance company, many of whom receive performance bonuses. The insurance company pays the office rental and all business expenses for the law firm. The lawyers only work on defense or subrogation cases involving their employer’s policyholders, and these firms do not advertise, solicit or accept business from the general public.

The Disciplinary Board of the Hawaii Supreme Court recently issued Formal Opinion No. 42 (Captive Law Firms) which addressed one of the ethical problems raised by these business arrangements. Below is a discussion of the ethical issues raised by the use of captive law firms, and how Hawaii and other states have addressed these issues.

Ethical Issues Raised By Use Of Captive Law Firms

In 1892 in New York City, Travelers Insurance Company began a staff counsel program to defend policyholders. A century later, more than 300 lawyers work in-house for Travelers. A number of other insurance companies have followed Traveler’s lead by employing lawyers to work in the insurance companies’ captive law firms to defend their policyholders against covered claims. Insurance companies have increasingly been using captive law firms as a means to reduce the large expense of defending its policyholders. Insurance companies cite many benefits to captive law firms. Captive law firms offer less risk, and have no client development, law firm management or compensation issues. Insurance companies perceive that outside law firms pass on the cost of client development, inefficient office management, and partner profits to the insurance companies through higher hourly rates. Insurance companies can avoid these costs by managing their own law firms staffed with employee attorneys who have only one client - their employer - and who have no expectation of profit sharing. Indeed, in 1993, an American Insurance Association study reported that having staff counsel represent policyholders saved carriers an average of $32 million annually, and that outside counsel costs almost three times as much, or $4,984 more per case.

However, the insurance industry’s use of captive law firms to reduce legal expenses creates a number of ethical issues. First, many argue that there is an inherent conflict of interest when lawyers represent policyholders but get a paycheck from the insurance company. It is argued that this arrangement creates a dual loyalty on the lawyer. On the one hand, the lawyer owes a fiduciary of loyalty to the client. On the other hand, the lawyer also owes the duty of loyalty to his employer - the insurance company. These conflicting loyalties may cause tension, particularly in cases where the interests of the lawyer’s client differ from those of the lawyer’s employer. The most common example is where an expensive investigation and defense of the policyholder may create in a better result, but the insurance company believes the same result can be achieved with much less expense. The lawyer has a duty to represent the client in the best means possible, including using the employer’s funds for a vigorous defense, but may also feel compelled to act on the lawyer’s duty to his or her employer to save money. Lawyers employed by captive law firms may risk losing their jobs and employment benefits, and damage their careers if they take actions on behalf of their policyholder clients that cause additional expense to their employer, the insurance company. See Finley v. Home Ins. Co., 90 Haw. 25, 34, 975 P.2d 1145, 1154 (1998) (approving the proposition that "while the insurer may have a contractual right to select defense counsel, the insurer's desire to limit expense must yield to the attorney's professional judgment and his or her responsibility to provide competent, ethical representation to the insured,"as governed by the Hawaii Rules of Professional Conduct).

Second, some advocate that the use of captive law firms constitutes the unauthorized practice of law because corporations cannot practice law. It is argued that the insurance company is practicing law by defending its policyholders through the use of the corporation’s employee lawyers and that the lawyers are not independently representing the policyholders.

Third, many advocate that the use of captive law firms will lessen the quality of the defense received by a policyholder. It is argued that insurance companies will hire lesser qualified attorneys who will accept a lower salary than offered at private law firms and that both the lawyer and the insurance company have an incentive to reduce defense costs which will result in a less effective and thorough defense of the policyholder. One critic of captive law firms, former Indiana Supreme Court Justice Jon Krahulik, likened captive law firms to HMOs, where large corporation control, and its cost-consciousness, diminishes quality.

Finally, and most significantly, it is advocated that captive law firms deceive policyholders and the public. Captive law firms appear to policyholders and the public that they are private, independent, for profit law firms when in fact they are paid for and managed by the insurance company. Absent adequate disclosure, a policyholder will presume the law firm “retained” to defend him or her is independent of the insurance company. Most bar associations and regulators have focused on this implied deception created by the use of captive law firms.

Regulation Of Captive Law Firms

A number of states have addressed the ethical issues raised by the use of captive law firms in a variety of ways. In Hawaii, the Disciplinary Board recently issued Formal Opinion No. 42 (Captive Law Firms) to address and resolve the ethical issue of deception created by captive law firms. Formal Opinion No. 42 first addresses the issue of deception to the client caused by a captive law firm which appears to be an independent business entity. Applying Hawaii Rules of Professional Conduct, Rule 7.1, the opinion states that an attorney who is the employee of an insurance company and represents policyholders of the insurance company must not state or imply that he or she practices as an independent law firm because Rule 7.1 provides that a lawyer shall not make a false or misleading communication about the lawyer or the lawyer’s services. Formal Opinion No. 42 also notes that H.R.P.C. Rule 7.5 specifies that a lawyer shall not use a firm name, letterhead, or other professional designation that violates HRPC 7.1. Thus, Formal Opinion No. 42 states that a lawyer shall not state or imply that he or she practices in a separate law firm, use a firm name, letterhead, business card, or other professional designations that state or imply that he or she practices in a separate independent law firm, or state or imply that he or she practices in a partnership or other organization. Significantly, Form Opinion No. 42 states that compliance with the above rules can be achieved if the attorney’s letterhead, business card, and other professional designations communicated to clients and the general public clearly and accurately describe the attorney’s relationship to the insurance company employer and specify that all personnel associated with the attorney are employees of the insurance company.

Other states have addressed the ethical dilemmas created by the use of captive law firms. The West Virginia State Bar issued its Legal Ethics Inquiry 99-01 to address this issue. Like Hawaii, the West Virginia State Bar recognized that the use of captive law firms does not constitute a conflict of interest per se, but the potential for conflict is significant enough that the Bar set forth guidelines that those who are employed by insurance companies should follow. These common sense guidelines included the recognition that the insured is the sole client of the attorney, the insured is entitled to attorney-client confidentiality to the exclusion of the insurance company employer, and that the attorney maintain professional independence from his or her insurance company employer.

The Kentucky Bar Association issued an ethics opinion, U-36, which found, like the Hawaii Disciplinary Board’s Formal Opinion No. 42, that a captive law firm may mislead the general public and its client by the implied representation that it is an independent law firm. The Kentucky Bar Association went even further by holding that the captive law firms were misleading the general public even though the firm sends a disclosure letter to the insured at the beginning of the representation. The Kentucky Bar Association stated that the purpose of having in-house counsel practice under a firm name in a separate office may be to facially demonstrate the attorney’s independence from their employer. The Kentucky Bar Association stated this was in effect concealing the nature of the lawyer’s relationship with the insurance company. The Kentucky Bar Association advised captive law firms to disclose their affiliation with the insurance company on their letterhead, business cards, telephone identification, office entrances, and pleadings.

A number of courts have also addressed the issue of whether using a captive law firm to represent a policyholder creates a per se conflict of interest. Most of the courts have held that a per se conflict of interest is not created when there are no coverage disputes between the insurer and policyholder. However, most of these decisions have recognized that a potential conflict exists and captive counsel must obey their ethical responsibilities to maintain their duty of loyalty to their client and protect their client’s confidences to the exclusion of their employer. See, In re: Allstate Insurance Company, 722 S.E.2d 947 (Mo. 1987) (en banc); In re Youngblood, 895 S.W.2d 322 (Tenn. 1995).

Conclusion

The use of captive law firms has been used increasingly by insurance companies to control the costs of defending its policyholders. However, this business arrangement can create ethical dilemmas for the lawyers employed by captive law firms. Lawyers must still abide by and conform their conduct to the Hawaii Rules of Professional Conduct, such as maintaining their duties of loyalty and confidentiality to their client-the policyholder. Consistent with Formal Opinion No. 42, captive law firms should also institute procedures to insure that the policyholder and public are appropriately advised of the relationship between the insurance company, the captive law firm, and the lawyer assigned to defend the policyholder.

__________________________________________________________


Jeffrey P. Miller is a Honolulu lawyer whose practice includes business litigation, insurance coverage, legal malpractice and collections in Honolulu and California.