Why it matters: An insurer breached its duty to defend by failing to provide substitute counsel for a securities broker where the insurer had agreed to defend with a reservation of rights but original counsel had withdrawn, the Tenth Circuit Court of Appeals recently determined. Two investors filed a Financial Industry Regulatory Authority (FINRA) arbitration action against a securities broker and the brokerage firm he worked with for allegedly failing to disclose the risks involved in a series of investments. The firm and the broker sought coverage for the arbitration from their insurer, which agreed to defend subject to a reservation of rights. Appointed defense counsel later withdrew and the parties never agreed on new counsel. However, the insurer provided limited approval to the brokerage firm's attorney to settle the matter. The parties reached a deal but the investors limited their agreement to the securities firm and not the broker. Unaware that he lacked counsel, the broker failed to attend the arbitration and a $500,000 award was entered against him. In a subsequent breach of the duty to defend suit against the insurer, a federal court judge divided the dispute into three time periods where a duty to defend was potentially implicated and ruled in favor of the carrier. A panel of the Tenth Circuit reversed with respect to one period of time: the lead-up to and during the FINRA arbitration. The court was not persuaded by the insurer's argument that it thought the settlement included the broker and that it believed the brokerage firm's counsel was defending the broker, finding that the insurer breached its duty to defend the broker by failing to appoint counsel.

Detailed discussion: A licensed securities broker, Forrest Templeton, sold high-risk investments over a three-year period to a Robert and Lisa Cordaro. He sold one of the investments while he was a registered representative for CapWest Securities, Inc. When the investments failed, the Cordaros filed claims against Templeton and CapWest with FINRA.

Catlin Specialty Insurance Co. insured CapWest and Templeton under an errors and omissions policy, which provided coverage for claims regarding the sales of securities while Templeton was a registered representative at the brokerage firm. The insurer agreed to defend both the firm and Templeton against the Cordaros' claim subject to a reservation of rights.

Although Catlin retained counsel, the law firm withdrew after a disagreement with CapWest. The brokerage firm and the insurer disagreed about replacement counsel, with Catlin objecting to Fields, Fehn & Sherwin (FF&S), the law firm preferred by CapWest. The insurer did not acquiesce to the firm's representation but did provide it with limited authority to attempt a settlement with the Cordaros.

Just prior to the FINRA arbitration hearing, FF&S negotiated a deal with the Cordaros. The couple then dismissed CapWest from the action but not Templeton. Believing that the settlement resolved the claims against him, Templeton did not attend the FINRA hearing, and a $500,000 award (plus interest and costs) was entered against him.

Templeton paid the Cordaros $550,000 to settle the arbitration award. He then filed suit against Catlin (and others), alleging the insurer breached its duty to defend. A Colorado federal court granted summary judgment in favor of all the defendants.

The broker appealed to the Tenth Circuit. Although the three-judge panel affirmed the majority of the district court's findings, it reversed on the issue of Catlin's breach of the duty to defend.

Three phases existed during the length of the dispute potentially implicating the insurer's duty to defend: "the lead-up to and during the FINRA arbitration, the time when an appeal could have been taken, and during settlement negotiations with the Cordaros," the court explained. "We conclude Catlin breached its duty to defend during the first phase, but did not breach its duty to defend during the second and third phases."

Catlin argued that it justifiably believed FF&S was handling the Cordaro matter on behalf of both CapWest and Templeton and that the firm settled the matter before the FINRA hearing date. Templeton countered that the insurer violated its duty because it never retained replacement counsel after the initial law firm withdrew and even if the insurer had retained FF&S, that firm could not represent him because of a conflict of interest.

The panel agreed. Catlin never yielded and "adamantly objected" to the appointment of FF&S, the court said. Although the insurer authorized via e-mail authority to settle the Cordaro matter for $15,000, "that e-mail does not show that Catlin acceded to CapWest's selection of FF&S as defense counsel," the panel wrote, particularly as the insurer's message included a statement that Catlin and CapWest "still need to find an 'agreed-to defense counsel.'"

At most, the communications between CapWest and Catlin "can be read to show Catlin agree to retain FF&S to represent the insureds only for settlement negotiations with the Cordaros," the court said. "Nothing indicates Catlin agreed to FF&S assuming the defense of CapWest and Mr. Templeton for the entire arbitration proceeding."

The insurer could not rely on the settlement agreement, the panel added, because the timing cut a little too close. Even if Catlin reasonably believed that FF&S had settled the Cordaro matter, "it still had not retained defense counsel for the arbitration proceeding scheduled to start the next day and therefore did not fulfill its duty to defend Mr. Templeton. No evidence shows that Catlin had counsel in place for CapWest or Mr. Templeton had the arbitration actually proceeded, which it did for Mr. Templeton. If Catlin had fulfilled its obligation to hire counsel to represent Mr. Templeton, Mr. Templeton's counsel would have been aware that the matter had not settled against him, and Mr. Templeton would have been represented in the arbitration."

Even if the court found that Catlin permitted CapWest to select FF&S, the insurer "still failed to appoint nonconflicted counsel for Mr. Templeton, who was separately insured under the Policy," the court wrote. When the insurer originally appointed counsel, that firm required Templeton and CapWest to sign a waiver for their joint representation. "Catlin never received a waiver from any of the parties for FF&S' possible joint representation of them," the court said. "Without such a waiver, Catlin could not satisfy its duty to defend Mr. Templeton."

However, the panel did not find Catlin breached its duty to defend for the latter two phases of the dispute, either the post-arbitration period or a post-judgment duty to negotiate a settlement with the Cordaros.

"Mr. Templeton does not point to any reasonable basis to appeal the arbitration award," the court noted, and the duty to prosecute an appeal exists only if there are reasonable grounds to do so. "[T]he duty to defend does not include bringing a groundless appeal." As for the duty to negotiate a settlement, Templeton failed to appeal this aspect of the case and the panel declined to consider it.

The court reversed summary judgment in favor of Catlin on the duty to defend claim as it related to the lead-up to and during the FINRA arbitration proceedings and remanded to the district court.

To read the order in Templeton v. Catlin Specialty Insurance Co., click here.