When Fee Audits and Legal Privileges Collide

Few areas of insurance law practice are as sensitive as the audit of a defense counsel’s bills or case file. Insurance companies and defense attorneys alike dread these necessary but often divisive processes.

Two years ago, I wrote a “Legal Beat” column that addressed various ways to make law firm fee audits less painful. (See “Auditing Legal Bills without Bloodshed,” Insurance Journal, May 27, 2002.) The column explored ways to foster cooperation and avoid disputes between the auditor, defense attorney and carrier. But, of course, there are other twists and turns that can complicate the audit process. Some defense counsel have begun to worry that audits by insurance carriers, as opposed to third-party auditing firms, raise the risk of the waiver of attorney-client or attorney work-product privileges. If that is true, some audits may be improper, or must be carefully constructed so as to protect the interests of
policyholders.

Waiver of privilege?
Specifically, the issue raised is whether a carrier’s audit, using its own personnel, of the defense counsel’s case file or billing records creates a potential waiver of the attorney-client or work product privileges? Put the other way around, where the carrier reviews the defense counsel’s files or billing records, can the plaintiff’s attorney, or some other third-party, then claim a right to review the same material based upon a waiver of privilege?

When I first heard this concern raised my knee jerk response was, “Of course not!” But since my opinion is not considered dispositive in most (or, actually, any) courts, I decided to take a look at the law.

Outside auditors
To start with, I took a look at the case law and ethics opinions regarding third-party or outside auditors. That was the hot auditing issue of the late 1990s when there was considerable conflict over whether the use of third-party auditors created a waiver of privileges. The outside auditor issue reached a boiling point following the controversial ruling by the Montana Supreme Court in the case of In the Matter of Rules of Professional Conduct and Insurer Imposed Billing Rules and Procedures, 2 P.3d 806 (Mont. 2000). In that landmark decision, the Montana Supreme Court rejected the argument that an insurer and the insured are dual clients of defense counsel and held that the insured is the sole client (which is contrary to the law of many other states, however). The Montana Court held that the third-party auditors selected by the insurer are not a part of a “privileged community or magic circle within which confidential information may be shared without waiver of attorney-client or work-product privilege.” In other words, third-party auditors are not confidential agents of the insured.

Following the Montana decision, several states, including Texas, had spirited debates as to whether third-party auditors are safe to use or instead raise confidentiality risks. Texas dealt with the issue in the State Bar Professional Ethics Committee Opinion No. 532, issued in September 2000. In Opinion No. 532, the committee addressed the specific issue of whether “without the informed consent of the client, may a lawyer, who is retained by an insurance company to defend the insured, be required by the insurance company to submit fee statements to a third-party auditor describing services rendered by the lawyer on behalf of the client?” The committee decided that since submissions of confidential information to a third-party auditor do not come within any of the authorized disclosures allowed under the Texas Disciplinary Rules, the information could not be disclosed without the informed consent of the client.

Notably, Opinion No. 532 was limited to invoices and fee statements, and did not deal with other defense counsel material. Also, it did not address whether an audit that reviewed pleadings, correspondence and the like, created confidentiality problems. Further, the opinion was limited to third-party auditors and did not consider audits performed by the carrier itself.

The remaining question is, can an insurance carrier audit the defense counsel files and billing records without the fear of a potential waiver of privileges? The answer, at least in Texas, is clearly “Yes.” Carrier audits do not waive privileges.

Carrier audits are privilege safe
The beginning point is the American Bar Association’s Standing Committee on Ethics and Professional Responsibility’s Formal Opinion 01-421, issued on Feb. 16, 2001. Once you get past the long title, you find that the committee reached the common sense conclusion that disclosure of confidential information of the insured to the insurer is appropriate provided that a lawyer does not disclose the confidential information unless the client gives informed consent, the disclosure is impliedly authorized in order to carry out the representation, or the disclosure is otherwise permitted by other Rules of Professional Conduct. Therefore, if the insured has contractually agreed to provide information, such as through provisions in the insurance policy, then disclosure is appropriate. Given that most insurance policies have cooperation or related provisions, this opinion gives considerable support for carrier audits.

Back home here in Texas, the issue turns more precisely on provisions in the Rules of Evidence (primarily Rule 503) and on certain changes made to the Rules of Civil Procedure several years ago. Multi-party communication privileges in the Texas Rules of Civil Procedure were re-organized into the rule defining “work-product.” The redefinition specifically includes a party’s insurers within the definition of the party’s representatives for purposes of defining the work-product doctrine. This change was clearly intended to bring communications between a party, its attorney, and its insurer within the zone of protected communications.

In addition, the case law has protected the privileges where insureds or their attorneys have disclosed information to carriers. For example, in Pittsburgh Corning Corp. v. Caldwell, 861 S.W. 2d 423 (Tex. App. [14th Dist.] 1993, orig. proc.), the Court held that a memorandum prepared by an insured’s claims director for its insurer was a protected communication. Even as recently as last March, the El Paso Court of Appeals applied the attorney-client privilege to protect insurer-insured communications. In re Arden, No. 08-03-00269 (Tex. App. – El Paso, March 24, 2004, orig. proc.). These and other cases offer protection to carriers and insureds during the audit process. Thus, information provided to the carrier via the insured’s defense counsel remains confidential.

The bottom line is that Texas law offers real protection to communications between the insured, insurer and defense counsel. The risk of losing privileges should not stymie the audit process.

It’s nice to know that sometimes my knee jerks in the right direction.

Brian S. Martin is a partner in the Insurance and Coverage Section of the Houston office of Thompson, Coe, Cousins & Irons L.L.P. He has extensive experience in insurance coverage and defense matters, specializing in environmental, toxic tort and products cases. Martin is a frequent author and CLE speaker on insurance
topics, including coverage and bad faith issues.