DUTY TO DEFEND AN ANALYSIS OF THE EIGHT CORNERS RULE

Authored and Presented by:

Lee H. Shidlofsky Cook, Roach & Lawless, L.L.P. 327 Congress Avenue Suite 490 Austin, TX 78701 (512) 472-3067 (512) 472-3068 FAX [email protected]

9TH ANNUAL ULTIMATE INSURANCE SEMINAR

STATE BAR OF TEXAS

March 30-31, 2000 Dallas, Texas

R Duty to Defend R - i

TABLE OF CONTENTS

I. INTRODUCTION ...... 1

II. OVERVIEW OF THE DUTY TO DEFEND ...... 1

III. CONTRACTUAL BASIS FOR THE DUTY TO DEFEND ...... 1

IV. THE “EIGHT CORNERS RULE” ...... 2

A. General Contours ...... 2

B. The Role of Extrinsic Evidence ...... 3

C. The Role of Drafting History ...... 4

V. APPLICATION OF THE DUTY TO DEFEND ...... 6

A. The Duty to Defend Applies to Insureds ...... 6

B. The Duty to Defend Begins at Tender ...... 6

C. Excess and Umbrella Insurers ...... 6

D. The Duty to Defend Does Not Apply To Affirmative Claims ...... 6

E. Burden of Proof ...... 7

VI. TERMINATION OF THE DUTY TO DEFEND ...... 7

VII. COMPARISON WITH OTHER POTENTIAL DUTIES ...... 7

A. The Duty to Indemnify ...... 7

B. The Duty to Investigate ...... 7

C. The Duty to Appeal ...... 8

VIII. AN INSURER’S OPTIONS WHEN FACED WITH A TENDER ...... 8

A. Outright Denial ...... 9

B. Defend Under Reservation of Rights or Non-Waiver Agreement ...... 9

C. Provide an Unqualified Defense ...... 10

IX. USING DECLARATORY JUDGMENTS TO DETERMINE THE DUTY TO DEFEND ...... 10

X. RECOUPMENT OF DEFENSE COSTS ...... 11

XI. ALLOCATION OF DEFENSE COSTS ...... 12

A. Covered vs. Non-covered Claims ...... 12 R - ii 9th Annual Ultimate Insurance Seminar

B. Consecutive Policies ...... 12

XII. LIABILITY FLOWING FROM A BREACH OF THE DUTY TO DEFEND ...... 12

XIII. ETHICAL CONSIDERATIONS OF DEFENSE COUNSEL ...... 13

A. The Tripartite Relationship ...... 13

B. The Use of Captive Firms ...... 14

XIV. CONCLUSION ...... 14 Duty to Defend R - iii

TABLE OF AUTHORITIES

CASES

Acceptance Ins. Co. v. Hood, 895 F. Supp. 131 (E.D. Tex. 1995)...... 3

Alliance Gen. Ins. Co. v. Club Hospitality, Inc., No. 3:97-CV-2448-H, 1999 WL 500229 (N.D. Tex. July 14 1999) ...... 11

American Alliance Ins. Co. v. Frito-Lay, Inc., 788 S.W.2d 152 (Tex. App.—Dallas 1990, writ denied)...... 2

American Eagle Ins. Co. v. Nettleton, 932 S.W.2d 169 (Tex. App.—El Paso 1996, writ denied) ...... 10

American States Ins. Co. v. Arnold, 930 S.W.2d 196 (Tex. App.—Dallas 1996, writ denied) ...... 7

American States Ins. Co. v. Bailey, 133 F.3d 363 (5th Cir. 1998) ...... 7, 11

Balandran v. Safeco Ins. Co. of Am., 972 S.W.2d 738 (Tex. 1998)...... 5

Buss v. Superior Court, 939 P.2d 755 (Cal. 1997)...... 11

Canutillo Indep. Sch. Dist. v. National Union Fire Ins. Co., 99 F.3d 695 (5th Cir. 1996)...... 7

Certain Underwriters at Lloyds v. Oryx Energy Co., 142 F.3d 255 (5th Cir. 1998) ...... 10

Consolidated Underwriters v. Loyd W. Richardson C. Corp., 444 S.W.2d 781 (Tex. Civ. App.—Beaumont 1969, writ ref’d n.r.e.) ...... 7

Cook v. Ohio Cas. Ins. Co., 418 S.W.2d 712 (Tex. App.—Texarkana 1967, no writ) ...... 4

Dairlyland County Mut. Ins. Co. v. Childress, 650 S.W.2d 770 (Tex. 1983) ...... 11

E & L Chipping Co. v. Hanover Ins. Co., 962 S.W.2d 272 (Tex. App.—Beaumont 1998, no writ) ...... 6, 7

Employers Cas. Co. v. Mireles, 520 S.W.2d 516 (Tex. Civ. App.—San Antonio 1975, writ ref’d n.r.e.) ...... 14

Employers Ins. Cas. Co. v. Tilley, 496 S.W.2d 552 (Tex. 1973)...... 14

Enserch Corp. v. Shand Morahan & Co., R - iv 9th Annual Ultimate Insurance Seminar

952 F.2d 1485 (5th Cir. 1992) ...... 9

Farmers Tex. County Mut. Ins. Co. v. Griffin, 955 S.W.2d 81 (Tex. 1997)...... 1, 4, 7, 11

Farmers Tex. County Mut. Ins. Co. v. Wilkinson, 601 S.W.2d 520 (Tex. Civ. App.—Austin 1980, writ ref’d n.r.e.)...... 9

Federated Mut. Ins. Co. v. Grapevine Excavation Inc., 197 F.3d 720 (5th Cir. 1999) ...... 2, 7

Firemen’s Ins. Co. v. Burch, 442 S.W.2d 331 (Tex. 1968)...... 10

First Gen. Realty Corp. v. Maryland Cas. Co., 981 S.W.2d 495 (Tex. App.—Austin 1998, no pet.) ...... 10

Foust v. Ranger Ins. Co., 975 S.W.2d 329 (Tex. App.—San Antonio 1998, writ denied)...... 11

Gonzalez v. American States Ins. Co., 628 S.W.2d (Tex. App.—Corpus Christi 1982, no writ)...... 4

Guaranty Nat’l Ins. Co. v. Vic Mfg. Co., 143 F.3d 192 (5th Cir. 1998) ...... 3, 7

Gulf Chem. & Metallurgical Corp. v. Associated Metals & Minerals Corp., 1 F.3d 365 (5th Cir. 1993) ...... 4, 12

Gulf Metals Indus. v. Chicago Ins. Co., 993 S.W.2d 800 (Tex. App.—Austin 1999, pet. requested)...... 5, 6

Harville v. Twin City Fire Ins. Co., 885 F.2d 276 (5th Cir. 1989) ...... 6, 9

Heyden Newport Chem. Corp. v. Southern Gen. Ins. Co., 387 S.W.2d 22 (Tex. 1965) ...... 2

Hill & Wilkinson, Inc. v. American Motorists Ins. Co., No. 3:98-CV-1411, 1999 WL 151668 (N.D. Tex. March 15, 1999) ...... 6

Houston Petroleum v. Highlands Ins. Co., 830 S.W.2d 153, 155 (Tex. App.—Houston [1st Dist.] 1990, writ denied)...... 1

Katerndahl v. State Farm Fire & Cas. Co., 961 S.W.2d 518 (Tex. App.—San Antonio 1997, no writ)...... 8-10

LaFarge Corp. v. Hartford Cas. Ins. Co., 61 F.3d 389 (5th Cir. 1995) ...... 12

Laster v. American Nat’l Fire Ins. Co., 775 F.Supp. 985 (N.D. Tex. 1991) ...... 6 Duty to Defend R - v

Maryland Ins. Co. v. Head Indus. Coatings & Services, Inc., 938 S.W.2d 27 (Tex. 1996) ...... 13

Matagorda County v. Texas Ass’n of Counties County Gov’t Risk Management Pool, 975 S.W.2d 782 (Tex. App.—Corpus Christi 1998, pet. granted) ...... 11, 12

Members Ins. Co. v. Branscum, 803 S.W.2d 462 (Tex. App.—Dallas 1991, no writ) ...... 6

Montrose Chem. Corp. v. Superior Court, 861 P.2d 1153 (Cal. 1993)...... 3

National Sav. Ins. Co. v. Gaskins, 572 S.W.2d 573 (Tex. Civ. App.—Fort Worth 1978, no writ)...... 11

National Union Fire Ins. Co v. Merchants Fast Motor Lines, 939 S.W.2d 139 (Tex. 1997)...... 2, 4

National Union v. CBI Indus., 907 S.W.2d 517 (Tex. 1995)...... 5

Ohio Cas. Ins. Co. v. Cooper Mach. Corp., 817 F. Supp. 45 (N.D. Tex. 1993)...... 11

Pennsylvania Nat’l Mut. Cas. Ins. Co. v. Kitty Hawk Airways, 964 F.2d 478 (5th Cir. 1992) ...... 9

Rhodes v. Chicago Ins. Co., 719 F.2d 116 (5th Cir. 1983)...... 10, 14

Safeway Managing Gen. Agency for State & County Mut. Fire Ins. Co. v. Cooper, 952 S.W.2d 861 (Tex. App.—Amarillo 1997, no writ)...... 11

Snug Harbor, Ltd. v. Zurich Ins., 968 F.2d 538 (5th Cir. 1992) ...... 13

Spruiell v. Lincoln Ins. Co., No. 07-97-0336-CV, 1998 WL 174722 (Tex. App.—Amarillo Apr. 13, 1998) (unpublished)...... 11

St. Paul Ins. Co. v. Rahn, 641 S.W.2d 276 (Tex. App.—Corpus Christi 1982, no writ) ...... 13

Standard Fire Ins. v. Sassin, 894 F. Supp. 1023 (N.D. Tex. 1995) ...... 11

State Farm Fire & Cas. Co. v. Gandy, 925 S.W.2d 696 (Tex. 1996) ...... 9, 11

State Farm Fire & Cas. Co. v. Wade, 827 S.W.2d 448 (Tex. App.—Corpus Christi 1992, writ denied)...... 3, 4

State Farm Gen. Ins. Co. v. White, R - vi 9th Annual Ultimate Insurance Seminar

955 S.W.2d 474 (Tex. App.—Austin 1997, no writ)...... 2

State Farm Lloyds, Inc. v. Williams, 791 S.W.2d 542 (Tex. App.—Dallas 1990, writ denied)...... 10

State Farm Lloyds, Inc. v. Williams, 960 S.W.2d 781 (Tex. App.—Dallas 1997, no writ) ...... 9

State Farm Mut. Auto. Ins. Co. v. Traver, 980 S.W.2d 625 (Tex. 1998) ...... 14

Taylor Serv. Co. v. Texas Property & Cas. Ins. Guarantee Ass’n, 918 S.W.2d 89 (Tex. App.—Austin 1996, no writ)...... 6

Taylor v. Travelers Ins. Co., 40 F.3d 79 (5th Cir. 1994) ...... 3

Texas Employers Ins. Ass’n v. Underwriting Members of Lloyd’s, 836 F. Supp. 398 (S.D. Tex. 1993)...... 6

Texas Med. Liab. Trust v. Zurich Ins. Co., 945 S.W.2d 839 (Tex. App.—Austin 1997, writ denied)...... 6

Texas Property & Cas. Ins. Guaranty Ass’n v. Southwest Aggregate, Inc., 982 S.W.2d 600 (Tex. App.—Austin 1998, no pet.) ...... 12

Texas United Ins. Co. v. Burt Ford Enters., 703 S.W.2d 828 (Tex. App.—Tyler 1986, no writ)...... 9, 13

Travelers Ins. Co. v. Newsom, 352 S.W.2d 888 (Tex. Civ. App.—Amarillo 1961, writ ref’d n.r.e.)...... 3, 8

Travelers Ins. Co. v. Volentine, 578 S.W.2d 501, 505 (Tex. Civ. App.—Texarkana 1979, no writ) ...... 7

Trinity Universal Ins Co. v. Cowan, 945 S.W.2d 819 (Tex. 1997)...... 7, 8

Trinity Universal Ins. Co. v. Bethancourt, 331 S.W.2d 943 (Tex. Civ. App.—Amarillo 1959, no writ) ...... 7, 8

Triton Dev. Corp. v. Commerce & Indus. Ins. Co., No. CIV.A.3:98-CV-1263-B, 1999 WL 293877 (N.D. Tex. May 4, 1999) ...... 7

Tri-Coastal Contractors, Inc. v. Hartford Underwriters Ins. Co., 981 S.W.2d 861 (Tex. App.—Houston [1st Dist.] 1998, pet. denied) ...... 3, 4

United Servs. Auto. Ass’n v. Pennington, 810 S.W.2d 777 (Tex. App.—San Antonio 1991, writ denied)...... 13

Utica Lloyd’s of Tex. v. Mitchell, 138 F.3d 208 (5th Cir. 1998)...... 11 Duty to Defend R - vii

Warren v. American Nat’l Fire Ins. Co., 826 S.W.2d 185 (Tex. App.—Fort Worth 1992, writ denied)...... 6

Western Heritage Ins. Co. v. River Entertainment, 998 F.2d 311 (5th Cir. 1993) ...... 3

Whatley v. City of Dallas, 758 S.W.2d 301 (Tex. App.—Dallas 1988, writ denied)...... 9, 12

Willcox v. American Home Assur. Co., 900 F. Supp. 850 (S.D. Tex. 1995) ...... 9, 13

MISCELLANEOUS

ALLAN D. WINDT, INSURANCE CLAIMS & DISPUTES, § 4.17 (3d ed. 1995) ...... 8

BARRY S. OSTRAGER & THOMAS R. NEWMAN, HANDBOOK ON INSURANCE COVERAGE DISPUTES, §5.02[d], at 208-09 (9th ed. 1998) ...... 8

Charles Silver & Michael Quinn, Wrong Turns on the Three-Way Street: Dispelling Nonsense about Insurance Defense Lawyers, COVERAGE, Nov.–Dec. 1995, at 1. ... 13

Charles Silver, The Professional Responsibilities of Insurance Defense Lawyers, 45 DUKE L.J. 255 (1995) ...... 13

Christopher W. Martin, Reservation of Rights In Texas: Why, Why Not, When, and How, in UNIV. HOUS., ADVANCED INSURANCE SEMINAR D (1996) ...... 10

Dennis J. Wall, Insured’s Reimbursement of Insurer’s Defense Expenses: When to Ask, When to Say “No,” COVERAGE, May–June 1999, at 1...... 12

Ellen S. Pryor, Mapping the Changing Boundaries of the Duty to Defend in Texas, ___ TEX. TECH L. REV. ____ (forthcoming 2000) ...... 4, 7, 13

Ellen S. Pryor, The Stories We Tell: Intentional Harm and the Quest for Insurance Funding, 75 TEXAS L. REV. 1721 (1997)...... 1

Michael Huddleston, Buss Arrives in Texas via Matagorda — The Right of Reimbursement, COVERAGE, Sept.–Oct. 1998, at 1...... 12

Michael S. Quinn, Reserving Rights Rightly: The Romance and the Temptations, COVERAGE , July–Aug. 1997, at 23...... 10, 13

Michael S. Quinn, The Duty to Defend: New Texas Developments, 19 INS. LITIG. REP. 193 (1997)...... 13

R. Brent Cooper, Duty to Defend, in STATE BAR OF TEXAS, ULTIMATE INSURANCE SEMINAR 24 (1996) ...... 5 R - viii 9th Annual Ultimate Insurance Seminar

ROBERT H. JERRY, II, UNDERSTANDING INSURANCE LAW § 111[c][2] (2d ed. 1996)...... 3 Duty to Defend R - 1

I. INTRODUCTION case strategy, the jury charge and negotiation and settlement strategies. See Ellen S. Pryor, The This article addresses the duty to defend under Stories We Tell: Intentional Harm and the Quest Texas law. The main focus of the article is the scope for Insurance Funding, 75 TEXAS L. REV. 1721, of the so-called “eight corners” rule for determining 1725-38 (1997). an insurer’s duty to defend and its application in the litigation process. Additionally, this article III. CONTRACTUAL BASIS FOR THE DUTY addresses the relationship of the duty to defend with TO DEFEND other duties potentially imposed by the insurance contact, such as the duty to indemnify and the duty The duty to defend is a contractual obligation. to investigate. Moreover, although this article See Farmers Tex. County Mut. Ins. Co. v. Griffin, cannot possibly touch on every issue that arises in 955 S.W.2d 81 (Tex. 1997); Houston Petroleum v. the duty to defend context, it does include Highlands Ins. Co., 830 S.W.2d 153, 155 (Tex. discussions of some of the more common issues, App.—Houston [1st Dist.] 1990, writ denied). such as the offering of a qualified defense and the Texas does not recognize a common law or statutory consequences for an insurer’s breach of the duty to duty to defend. Thus, absent a provision in the defend. Finally, this paper addresses some ethical policy, an insurer has no obligation to assume the considerations related to the duty to defend (after defense of its insured or to reimburse its insured for all, we do get ethics credit). incurred defense costs. A typical duty to defend provision provides as follows: II. OVERVIEW OF THE DUTY TO DEFEND We will pay those sums that the insured becomes legally obligated to pay as The duty to defend may be the single most damages because of “bodily injury” or important aspect of a liability policy. At the very “property damage” to which this least, it is on equal footing with the duty to insurance applies. We will have the right indemnify. The reasons are simple: We live in a and duty to defend any “suit” seeking litigious society, and lawyers are expensive. In many those damages. cases, defense costs exceed (and sometimes far exceed) the amount of money necessary to pay a * * * judgment or fund a settlement. Many insureds, If a claim is made or a suit is brought whether individuals or small corporations, simply against an “insured” for damages because cannot afford to retain counsel and/or lack the of “bodily injury” or “property damage” sophistication to retain appropriate counsel to staff caused by an “occurrence” to which this a particular lawsuit. coverage applies, we will:

The duty to defend solves these problems by * * * requiring the insurer to fund the defense and play an 2. provide a defense at our expense by active role in the litigation process. Moreover, since counsel of our choice, even if the suit an insurer has a duty to defend even if the is groundless, false or fraudulent . . . . allegations against the insured are “groundless, false, or fraudulent,” the duty to defend helps In contrast to the above, some policies provide prevent an insured from being bankrupted by for the reimbursement of defense costs. In those frivolous lawsuits. Thus, in a sense, the duty to policies, the insurer has no duty to assume the defend is litigation insurance. defense of its insured, but rather has a duty to reimburse the insured for reasonable and necessary The importance of the duty to defend and its defense costs. Such provisions are typical in D&O role in tort litigation cannot be understated. As one policies. Other policy forms provide the insurer an commentator has noted, an insurer’s defense option—but not a duty—to assume its insured’s obligation can have an influence on every step of the defense. These “voluntary defense” provisions are tort litigation process, including pleading and filing, often found in excess and umbrella policy forms. R - 2 9th Annual Ultimate Insurance Seminar

IV. THE “EIGHT CORNERS RULE” The above quote from the Supreme Court of Texas and the case law (both state and federal) that A. General Contours has followed reveal the following important contours of the duty to defend: Texas follows a fairly strict version of the so- called “eight corners” rule or “complaint allegation” • An insurer is required to defend its insured rule. See Federated Mut. Ins. Co. v. Grapevine if the allegations state a potential claim for Excavation Inc., 197 F.3d 720, 723 (5th Cir. 1999); coverage under the policy. National Union Fire Ins. Co v. Merchants Fast Motor Lines, 939 S.W.2d 139, 141 (Tex. 1997). • The truth or veracity of the allegations are Under this rule, courts compare the words within the irrelevant—all factual allegations must be four corners of the insurance policy with the taken as true. allegations within the four corners of the “live” pleading. Stated simply, the duty to defend is • The allegations should be interpreted determined by two documents: (i) the insurance liberally. Nevertheless, insurers are not policy; and (ii) the latest amended pleading. required to read facts into the pleadings and/or imagine factual scenarios that might The duty to defend does not depend on what trigger coverage. the facts actually are, but instead depends on what the facts are alleged to be. See Merchants, 939 • When a petition alleges multiple or S.W.2d at 141. Moreover, the duty to defend alternative causes of action, the insurer analysis is not affected by facts that may be must examine each separate allegation to ascertained before a lawsuit is filed; by facts that determine whether it has a duty to defend. may develop in the process of a lawsuit; or by the If one alternative cause of action or ultimate outcome of a lawsuit. See American allegation is within the terms of the policy, Alliance Ins. Co. v. Frito-Lay, Inc., 788 S.W.2d the insurer has a duty to defend. 152, 154 (Tex. App.—Dallas 1990, writ denied). Accordingly, except in the rarest of situations, the • The proper focus is on the factual duty to defend is a question of law. See State Farm allegations that establish the origin of the Gen. Ins. Co. v. White, 955 S.W.2d 474, 475 (Tex. damages alleged in the petition rather than App.—Austin 1997, no writ). on the legal theories asserted in the petition.

The Supreme Court of Texas has explained the • Any doubts concerning coverage are to be “eight corners” rule in the following way: resolved in favor of the insured.

Where the [petition] does not state facts In short, an insurer has a duty to defend a sufficient to clearly bring the case within lawsuit against its insured unless it can establish or without the coverage, the general rule that a comparison of the policy with the complaint is that the insurer is obligated to defend if or petition shows on its face that there is no there is, potentially, a case under the potential for coverage. Stated in the alternative, an complaint within the coverage of the insurer can refuse to provide a defense only where policy. Stated differently, in case of the facts as alleged fall outside of the coverage grant doubt as to whether or not the allegations or where they fall squarely within policy exclusions. of a complaint against the insured state a The fact that an initial pleading does not trigger a cause of action within the coverage of a duty to defend, however, does not foreclose the liability policy sufficient to compel the possibility that an amended pleading may do so. insurer to defend the action, such doubt will be resolved in the insured’s favor. B. The Role of Extrinsic Evidence

Merchants, 939 S.W.2d at 141 (quoting Heyden The role of extrinsic evidence in the duty to Newport Chem. Corp. v. Southern Gen. Ins. Co., defend determination continues to be an area of 387 S.W.2d 22, 26 (Tex. 1965)). controversy. As a general rule, the use of extrinsic Duty to Defend R - 3 evidence to either create or defeat a duty to defend holdings, to say that extrinsic evidence violates the strict eight corners rule. Most should not be admitted to show that an jurisdictions, however, recognize an exception to the instrumentality was being used for a eight corners rule where the insurer knows or purpose explicitly excluded from reasonably should know facts that would establish coverage particularly, when doing so does coverage. See ROBERT H. JERRY, II, not question the truth or falsity of any UNDERSTANDING INSURANCE LAW § 111[c][2] (2d facts alleged in the underlying petition ed. 1996). filed against the insured.

California, for example, permits both the Wade, 827 S.W.2d at 452. Thus, under the Wade insured and the insurer to use extrinsic evidence in exception to the eight corners rule, extrinsic determining the duty to defend. See Montrose evidence may be admitted in a declaratory judgment Chem. Corp. v. Superior Court, 861 P.2d 1153 proceeding where the petition does not set out facts (Cal. 1993). Texas courts, on the other hand, have sufficient to allow a determination of whether those not allowed extrinsic evidence to be admitted to facts—even if true—would state a covered claim. create a duty to defend. See Taylor v. Travelers Ins. Stated differently, under Wade, extrinsic evidence Co., 40 F.3d 79, 81 n.2 (5th Cir. 1994); Travelers can be admitted where there is a “gap” in the Ins. Co. v. Newsom, 352 S.W.2d 888, 890-94 (Tex. pleadings. Civ. App.—Amarillo 1961, writ ref’d n.r.e.). In contrast, Texas courts have recognized narrow Wade has been cited favorably by several exceptions whereby an insurer may use extrinsic federal courts. See Guaranty Nat’l Ins. Co., 143 evidence to defeat the duty to defend. See Guaranty F.3d at 194-95 (acknowledging a “narrow Nat’l Ins. Co. v. Vic Mfg. Co., 143 F.3d 192, 194 exception” to the eight corners rule where a petition (5th Cir. 1998); State Farm Fire & Cas. Co. v. does not contain sufficient facts to enable a court to Wade, 827 S.W.2d 448, 452-53 (Tex. determine if the duty to defend exists); Western App.—Corpus Christi 1992, writ denied). Heritage Ins. Co. v. River Entertainment, 998 F.2d 311, 313 (5th Cir. 1993) (same); Acceptance Ins. Wade is the most widely cited case supporting Co. v. Hood, 895 F. Supp. 131, 134 n.1 (E.D. Tex. the use of extrinsic evidence under Texas law. The 1995) (same). In contrast, Texas state courts have facts of Wade are as follows. Williamson owned a generally rejected the Wade approach to extrinsic boat that was insured by State Farm. Williamson evidence. In Tri-Coastal Contractors, Inc. v. and a passenger set off from Port O’Connor, Texas Hartford Underwriters Ins. Co., 981 S.W.2d 861 in Williamson’s boat, but were subsequently found (Tex. App.—Houston [1st Dist.] 1998, pet. denied), drowned in the Gulf of Mexico. The passenger’s for example, the court noted that “we are unable to estate brought suit against Williamson. State Farm find other Texas appellate courts that have followed tendered a defense under reservation of rights and the Wade rationale.” Id. at 863-64. filed a declaratory judgment action to determine its rights. The applicable policy contained a “business Although rejecting Wade, the Tri-Coastal pursuits” exclusion. The problem, according to the court did recognize certain instances where extrinsic court, was that the petition did not contain sufficient evidence may be permissible: factual allegations to determine whether State Farm owed a defense: In Texas, extrinsic evidence is permitted to show no duty to defend only in very Texas courts allow extrinsic evidence to limited circumstances, for example where be admitted to show a lack of a duty to the evidence is used to disprove the defend. We conclude that the underly-ing fundamentals of insurance coverage, such petition, read broadly does not address as whether the person sued is excluded the issue of how the boat was used, which from the policy, whether a policy contract is an essential fact for determining exists, or whether the property in question coverage under this private boat owner’s is insured under the policy. policy, and whether State Farm has a duty to defend the wrongful death suit. It Id. at 863 n.1. makes no sense to us, in light of these R - 4 9th Annual Ultimate Insurance Seminar

At least impliedly, the Tri-Coastal court Moreover, even assuming such extrinsic evidence is recognized that the extrinsic evidence issue may turn admissible, Texas law is unclear as to whether it can on the type of extrinsic evidence being considered. be considered at the outset or whether the insurer Generally speaking, there are three types of extrinsic must first file a declaratory judgment action. evidence: (i) evidence that relates only to liability; (ii) evidence that relates only to coverage; and (iii) Finally, it should be noted that the Supreme mixed evidence that relates to both liability and Court of Texas has in recent years reaffirmed that coverage. See Ellen S. Pryor, Mapping the Texas is a strict eight corners state. See Farmers Changing Boundaries of the Duty to Defend in Tex. County Mut. Ins. Co. v. Griffin, 955 S.W.2d Texas, ___ TEX. TECH L. REV. ____ (forthcoming 81 (Tex. 1997); National Union Fire Ins. Co. v. 2000) [hereinafter Pryor, Mapping Changing Merchants Fast Motor Lines, 939 S.W.2d 139 Boundaries]. (Tex. 1997). Although the court never mentioned Wade, its holdings in Griffin and Merchants cast Texas courts, including federal courts doubt on the future viability (and necessity) of using construing Texas law, have correctly recognized that extrinsic evidence to deny a defense. The court did extrinsic evidence should never be considered so by noting that the plaintiff’s pleadings—although where it relates strictly to liability. See Gulf Chem. liberally construed—must be specifically pleaded & Metallurgical Corp. v. Associated Metals & from a factual point of view in order to trigger the Minerals Corp., 1 F.3d 365, 371 (5th Cir. 1993); duty to defend. See Merchants, 939 S.W.2d at 141. Gonzalez v. American States Ins. Co., 628 S.W.2d Thus, after Merchants and Griffin, insurers can 184, 187 (Tex. App.—Corpus Christi 1982, no arguably deny a defense where the petition or writ). The more difficult issue is where the extrinsic complaint is too gap-filled to raise even “that degree evidence relates only to coverage or even more so of doubt which requires resolution for the insured.” where the evidence relates to both coverage and See Merchants, 939 S.W.2d at 142. Of course, the liability. issue of what is necessary to raise “that degree of doubt” will no doubt be the subject of many duty to As noted above, there is limited support for defend battles. admitting extrinsic evidence in “coverage only” situations. Although such a rule technically violates C. The Role of Drafting History a strict eight corners rule, the reality is that considering “coverage only” evidence does not Although drafting history could have been violate the underpinnings of the duty to defend. included under the extrinsic evidence discussion, Insurers will still have to defend “groundless, false, some courts and commentators have drawn a or fraudulent” claims that otherwise state a potential distinction between drafting history and extrinsic for coverage. Thus, under the “coverage only” evidence. Regardless of whether such a distinction exception, insurers will only be able to avoid the has merit, the role of drafting history has been the duty to defend in situations where the insured has subject of several recent judicial opinions and is not paid for a defense (e.g., where the defendant is thus worthy of separate discussion. not an insured). It should be noted that drafting history has To date, Texas courts have not drawn a clear most often been raised in the duty to indemnify distinction between “coverage only” evidence and context. Nevertheless, drafting history can also be “mixed” evidence. See Pryor, Mapping Changing relevant in the duty to defend analysis. In particular, Boundaries, supra. To the extent a generalization drafting history is a good example of “coverage can be made, however, Texas courts appear more only” evidence. Thus, to the extent extrinsic likely to permit extrinsic evidence where the evidence is admissible, drafting history could be evidence falls into the “coverage only” category. See used in determining the duty to defend where the Cook v. Ohio Cas. Ins. Co., 418 S.W.2d 712, 715- scope of a particular policy provision is at issue. 16 (Tex. App.—Texarkana 1967, no writ) (noting “a distinction between cases in which the merit of Before addressing the recent case law, it is the claim is the issue and those where the coverage important to provide a bit of historical perspective. of the insurance policy is in question . . . .”). In 1995, the Supreme Court of Texas held that Duty to Defend R - 5 parol evidence in the form of drafting history is not exclude evidence of drafting history. The court admissible for the purpose of creating an ambiguity. sided with the insurer. Citing CBI, the majority See National Union v. CBI Indus., 907 S.W.2d 517 noted that the fundamental rule of construction (Tex. 1995). In CBI, the insured had attempted to permits introduction of extrinsic evidence only after introduce evidence of industry-wide testimony an ambiguity has been established. See id. at 808. concerning the breadth of the absolute pollution Moreover, the majority held that the only relevant exclusion to demonstrate that the insurers “surrounding circumstances” were those “understood that the pollution exclusions would not circumstances surrounding the creating of the exclude coverage in construction accident specific contract in question rather than those situations.” See id. at 520-21. The Supreme Court, circumstances involving a regulatory body and its however, held that such extrinsic evidence could not regulations of a type of policy. See id. be used for purposes of creating a latent ambiguity. See id. at 521. After CBI, it was assumed that items Justice Bea Smith, relying on Balandran, such as regulatory history, drafting history, and authored a strong dissent: testimony from the State Board of Insurance would likewise be inadmissable to create an ambiguity Balandran specifically holds that where there was a lack of facial ambiguity. See R. surrounding circumstance evidence Brent Cooper, Duty to Defend, in STATE BAR OF regarding promulgation of the policy TEXAS, ULTIMATE INSURANCE SEMINAR 24 (1996). form is not “extrinsic evidence” and may be considered in determining whether a This assumption, however, may be party’s interpretation of the policy is questionable in light of recent case law. In 1998, reasonable. the Supreme Court of Texas revisited CBI and held that the circumstances surrounding the drafting of a * * * policy could in fact be considered. See Balandran v. Safeco Ins. Co. of Am., 972 S.W.2d 738, 741 Can Gulf Metals rely on representations (Tex. 1998). Balandran involved the interpretation allegedly made by the insurance industry of the “settling, cracking, bulging” exclusion [i.e., to the Department that the language Exclusion 1(h)] and whether it excluded foundation “sudden and accidental” in the revised losses caused by plumbing leaks. The insurers form would not restrict existing coverage argued that the policy language on its face was of unintentional pollution? I think unambiguous and thus no extrinsic evidence could Balandran holds that it may. be considered. The court disagreed: “While parol evidence of the parties’ intent is not admissible to * * * create an ambiguity, the contract may be read in In this regard I think the majority got it light of the surrounding circumstances to determine backwards when it held that the “the whether an ambiguity exists.” Id. at 741. The court surrounding circumstances” that may be then proceeded to consider evidence from the Board considered in determining ambiguity are of Insurance. The dissent, relying on CBI, those surrounding the making of the challenged the majority for “resort[ing] to contract, not those present when a inadmissible extrinsic evidence to find support for regulatory body promulgates the form of its construction of the policy.” Id. at 745. the contract.

The drafting history issue, including both CBI Gulf Metals, 993 S.W.2d at 812 (Smith, J., and Balandran, were recently addressed by the dissenting). Austin Court of Appeals in Gulf Metals Indus. v. Chicago Ins. Co., 993 S.W.2d 800 (Tex. The Supreme Court of Texas has asked for full App.—Austin 1999, pet. requested). Gulf Metals briefing in Gulf Metals. Accordingly, should the involved an interpretation of the “sudden and Court decide to entertain the issue, Gulf Metals will accidental” discharge exception to the traditional provide an opportunity for the Court to clarify when, CGL pollution exclusion. The insured, relying on if ever, drafting history and other extrinsic evidence Balandran, attempted to admit evidence of drafting can be considered. history. The insurer, relying on CBI, attempted to R - 6 9th Annual Ultimate Insurance Seminar

V. APPLICATION OF THE DUTY TO Other excess and umbrella policy forms, DEFEND however, require the insurer to assume the duty to defend. Typically, in such policy forms, the excess A. The Duty to Defend Applies to Insureds or umbrella insurer’s duty to defend will not be triggered until the limits of the primary insurance An insurer’s duty to defend extends to all have been exhausted. See Texas Employers Ins. insureds and additional insureds, including those Ass’n v. Underwriting Members of Lloyd’s, 836 F. named specifically by endorsement and omnibus Supp. 398, 404 (S.D. Tex. 1993). insureds. In some cases, an insurer may have a duty Under Texas law, insolvency does not equate to defend both its insured and an additional insured. with exhaustion. Thus, an excess or umbrella insurer See Hill & Wilkinson, Inc. v. American Motorists has no duty to “drop down” and defend its insured Ins. Co., No. 3:98-CV-1411, 1999 WL 151668 where the primary insurer is declared insolvent, (N.D. Tex. Mar. 15, 1999); Texas Med. Liab. Trust unless of course a “drop down” provision in v. Zurich Ins. Co., 945 S.W.2d 839, 843 (Tex. included within the duty to defend provision. See App.—Austin 1997, writ denied). Harville v. Twin City Fire Ins. Co., 885 F.2d 276, 278-79 (5th Cir. 1989); Taylor Serv. Co. v. Texas B. The Duty to Defend Begins at Tender Property & Cas. Ins. Guarantee Ass’n, 918 S.W.2d 89, 91 (Tex. App.—Austin 1996, no writ). Under Texas law, an insurer does not have a duty to defend until the lawsuit is “tendered” to the Another issue that may arise in the insurer for a defense. See E & L Chipping Co. v. excess/umbrella context is whether the duty to Hanover Ins. Co., 962 S.W.2d 272, 278 (Tex. defend is triggered where the primary insurer does App.—Beaumont 1998, no writ); Members Ins. Co. not have a duty to defend. Again, the resolution of v. Branscum, 803 S.W.2d 462, 466-67 (Tex. this issue depends on the terms of the insurance App.—Dallas 1991, no writ). What is necessary to policy and, in particular, the terms of the duty to constitute “tender” depends on the terms of the defend provision. If, for example, the policy. At the very least, however, an insured must excess/umbrella policy is a “following form” policy, provide the insurer with a copy of the latest then the excess/umbrella policy will most likely not amended pleading. See Branscum, 803 S.W.2d at have a duty to defend in situations where the 467. primary policy has not been triggered. If, however, the excess/umbrella policy covers a claim that is not C. Excess and Umbrella Insurers otherwise covered by the primary policy, the excess/umbrella policy may—depending on whether Whether an excess insurer has a duty to defend the duty to defend is an option or an depends upon the terms of the excess or umbrella obligation—have a duty to defend. policy. Stated simply, the duty to defend is contractual in nature regardless of the layer. D. The Duty to Defend Does Not Apply To Affirmative Claims Some excess or umbrella policies provide the insurer with the option to assume the defense and/or An issue that may arise in the course of to participate in the defense of its insured. The defending insureds is whether the duty to defend purpose of such language is to permit excess extends to the cost of prosecuting affirmative insurers to participate in the defense of the insured claims, such as cross-claims or counterclaims. in situations where the insured’s liability exposure Although there is no Texas caselaw on point, the likely exceeds the primary layer. When an excess answer to this question—at least under typical insurer is provided the option to provide a defense, insuring agreements—is “no.” This follows directly it may decline to do so without breaching its duties from the language of typical insuring agreements, under the insurance contract. See Laster v. which provides for a defense obligation only for American Nat’l Fire Ins. Co., 775 F. Supp. 985, claims brought “against” the insured. As a practical 994 (N.D. Tex. 1991); Warren v. American Nat’l matter, however, it may be wise for the insurer to Fire Ins. Co., 826 S.W.2d 185, 187 (Tex. finance the insured’s affirmative claims in App.—Fort Worth 1992, writ denied). Duty to Defend R - 7 circumstances where they can reduce the insured’s VII. COMPARISON WITH OTHER liability. POTENTIAL DUTIES

E. Burden of Proof A. The Duty to Indemnify

The burden of proof for the duty to defend is The duty to indemnify obligates an insurer to the same as for the duty to indemnify. The burden pay either a judgment or a settlement that is taken is on the insured to show that a claim against it is against its insured. Like the duty to defend, the duty potentially within the scope of coverage under the to indemnify is a contractual obligation. policy. See Federated Mut. Ins. Co. v. Grapevine Excavation Inc., 197 F.3d 720, 723 (5th Cir. 1999). The duty to defend and the duty to indemnify If, however, the insurer relies on policy exclusions are distinct and separate duties. See Farmers Tex. to defeat the duty to defend, the burden shifts to the County Mut. Ins. Co. v. Griffin, 955 S.W.2d 81, 82 insurer to prove than one or more of the exclusions (Tex. 1997); Trinity Universal Ins Co. v. Cowan, defeat the duty to defend. See Guaranty Nat’l Ins. 945 S.W.2d 819, 821-22 (Tex. 1997). In contrast Co. v. Vic. Mfg. Co., 143 F.3d 192, 193 (5th Cir. to the duty to defend, the duty to indemnify is not 1998). Once the insurer proves that an exclusion based on the third party’s allegations, but rather applies, the burden then shifts back to the insured to upon the actual facts that comprise the third party’s show that the claim falls within an exception to the claim. See Canutillo Indep. Sch. Dist. v. National exclusion. See id. Union Fire Ins. Co., 99 F.3d 695, 701 (5th Cir. 1996). VI. TERMINATION OF THE DUTY TO DEFEND It has been uniformly accepted that the duty to defend is broader than the duty to indemnify. See The duty to defend terminates in one of three Triton Dev. Corp. v. Commerce & Indus. Ins. Co., ways: (i) the pleadings are amended in such a way as No. CIV.A.3:98-CV-1263-B, 1999 WL 293877 to defeat the duty, see Consolidated Underwriters (N.D. Tex. May 4, 1999); E&L Chipping Co. v. v. Loyd W. Richardson C. Corp., 444 S.W.2d 781, Hanover Ins. Co., 962 S.W.2d 272, 274 (Tex. 784-85 (Tex. Civ. App.—Beaumont 1969, writ App.—Beaumont 1998, no writ). Accordingly, in ref’d n.r.e.); (ii) the covered portion of a petition or some cases, the negation of the duty to defend will complaint is dismissed, see Travelers Ins. Co. v. also negate the duty to indemnify. See Griffin, 955 Volentine, 578 S.W.2d 501, 505 (Tex. Civ. S.W.2d at 84 (Tex. 1997). App.—Texarkana 1979, no writ); or (iii) depending on policy language, when the policy limits are The negation of the duty to defend does not, exhausted by payment of a judgment or settlement, however, automatically negate any possibility of a see American States Ins. Co. v. Arnold, 930 S.W.2d duty to indemnify. But see American States Ins. Co. 196, 201 (Tex. App.—Dallas 1996, writ denied) v. Bailey, 133 F.3d 363 (5th Cir. 1998) (holding that (construing Texas Personal Automobile Policy). there can logically be no duty to indemnify in the absence of a duty to defend). If, for example, a plaintiff brings a lawsuit against the insured alleging only intentional conduct but is granted a trial amendment alleging non-intentional conduct and obtains a judgment on the alternative grounds, the duty to indemnify should be triggered. See Pryor, Mapping Changing Boundaries, supra.

B. The Duty to Investigate

Some jurisdictions require an insurer to investigate potential liability prior to denying the duty to defend. In Trinity Universal Ins. Co. v. Bethancourt, 331 S.W.2d 943 (Tex. Civ. App.—Amarillo 1959, no writ), the Amarillo Court R - 8 9th Annual Ultimate Insurance Seminar of Appeals held that an insurer had an affirmative According to Windt, an insurer should be required duty to investigate prior to denying a defense. Id. at to finance an appeal either: “(a) if there are 945-946. The case involved an insured who was reasonable grounds to believe that a judgment in sued for assault and battery. The insurer denied the excess of the policy limits might be reversed or claim on the grounds that the pleadings alleged materially reduced; or (b) if there are reasonable intentional conduct. The insured argued, however, grounds to believe that a judgment entered in a the he was owed a defense because an investigation noncovered area might be reversed.” See ALLAN D. of the “true facts” would have proven that his WINDT, INSURANCE CLAIMS & DISPUTES § 4.17, at actions were not intentional. The Amarillo Court of 213-14 (3d ed. 1995). Likewise, Ostrager & Appeals agreed. Newman note that “[m]ost courts hold that an unparticularized ‘right and duty to defend’ clause in The holding in Bethancourt, however, was a liability insurance policy obligates the insurer to short lived. In fact, the very court that decided appeal a judgment against the insured in an Bethancourt quickly retreated from its holding. See underlying action where there are reasonable Traveler’s Ins. Co. v. Newsom, 352 S.W.2d 888, grounds for appeal.” See BARRY S. OSTRAGER & 894 (Tex. Civ. App.—Amarillo 1961, writ ref’d THOMAS R. NEWMAN, HANDBOOK ON INSURANCE n.r.e.). More recently, the Supreme Court of Texas COVERAGE DISPUTES §5.02[d], at 208-09 (9th ed. has put any controversy to rest: 1998) (citations omitted).

Finally, Cowan argues that, because The duty to appeal is a logical extension of the Trinity did not investigate whether there duty to defend. See Cooper, supra, at 43. was a reasonable basis for denying Accordingly, once the duty to defend is triggered, coverage after Gage sought coverage, it the insurer should be obligated to see the case cannot complain about subsequent through to the end. Any other result would overlook developments in the Cowan v. Gage suit. the fact that the trial court is only the first step in the To the contrary, under the “complaint litigation ladder. Of course, the insurer need only allegation rule” an insurer is entitled to appeal when the insured’s interests are at stake. rely solely on the factual allegations Thus, if the entire judgment falls within coverage, contained in the petition in conjunction an insurer can forgo any duty to appeal by simply with the terms of the policy to determine satisfying its duty to indemnify. whether there is a duty to defend. The duty to defend is not affected by facts As with all aspects of the duty to defend, the ascertained before suit, developed in the language of the particular policy is of paramount process of litigation, or by the ultimate importance in the duty to appeal determination. outcome of the suit. Thus, there was no Accordingly, one should always begin the duty to duty to investigate coverage under these appeal analysis by looking at the terms of the facts. particular policy.

Trinity Univ. Ins. Co. v. Cowan, 942 S.W.2d 819, VIII. AN INSURER’S OPTIONS WHEN 829 (Tex. 1997) (citations omitted) (emphasis FACED WITH A TENDER added). In short, Texas does not recognize a duty to investigate. Thus, if the complaint—in and of When an insurer is faced with the dilemma of itself—does not create a potential for coverage, the whether to defend or refuse to defend a proffered insurer has no duty to look outside of the pleadings claim, it has four options: (i) completely decline to before declining a defense. Such a rule is consistent assume the insured’s defense; (ii) seek a declaratory with the principles of the eight corners analysis. judgment as to its obligations and rights; (iii) defend under a reservation of rights or a non-waiver C. The Duty to Appeal agreement; or (iv) assume the insured’s unqualified defense. See Katerndahl v. State Farm Fire & Cas. The duty to appeal is an issue that has yet to be Co., 961 S.W.2d 518, 521 (Tex. App.—San addressed by a Texas court. It has, however, been Antonio 1997, no writ). Options (i), (iii), and (iv) addressed by some of the leading commentators. Duty to Defend R - 9 will be discussed in this section. Declaratory arrangements, the court’s broad language arguably judgments will be addressed in the next section. prevents an insured from binding an insurer that wrongfully refused to defend to a pre-trial A. Outright Denial settlement. Whether or not the court would apply its holding in such a situation, however, remains up in An insurer can simply respond to a tender with the air. an outright denial. An insurer who properly refuses to assume the duty to defend can still insist on B. Defend Under Reservation of Rights or compliance by the insured with all policy conditions. Non-Waiver Agreement See Harville, v. Twin City Fire Ins. Co., 885 F.2d 276, 279 (5th Cir. 1989). Outright denials, of When faced with a lawsuit that raises good course, should be reserved for those situations faith coverage questions, a prudent insurer will offer where the insurer is certain of its “no coverage” a defense subject to a reservation of rights or non- position. waiver agreement (i.e., a qualified defense). The purpose of a reservation of rights and/or a non- Wrongfully refusing to provide a defense, waiver agreement is to permit the insurer to comply whether qualified or unqualified, comes with with its contractual obligation to defend while consequences: (i) the insurer loses the right to preserving its right to later contest coverage. See control the defense; (ii) the insurer loses any right to Katerndahl v. State Farm Fire & Cas. Co., 961 insist that the insured comply with policy conditions S.W.2d 518, 521 (Tex. App.—San Antonio 1997, (e.g., no action clause); (iii) the insurer will be no writ). bound by those findings of facts that were actually litigated in a fully adversarial trial and essential to A reservation of rights is a unilateral action the underlying judgment; and (iv) the insurer will be whereby the insurer informs the insured in writing of liable for foreseeable damages flowing from the the specific coverage issues. A non-waiver insurer’s breach of the duty to defend. See Willcox agreement differs from a reservation of rights in that v. American Home Assur. Co., 900 F. Supp. 850, the policyholder contractually stipulates that the 855 (S.D. Tex. 1995); Whatley v. City of Dallas, insurer’s conduct following its receipt of notice will 758 S.W.2d 301 (Tex. App.—Dallas 1988, writ not waive policy defenses. Because a reservation of denied). rights letter is unilateral, it is more commonly used than a non-waiver agreement. Despite the multitude of consequences for breaching the duty to defend, it is important to note Although the general rule is that the doctrines that an insurer which breaches its duty to defend of waiver and estoppel cannot be used to create does not lose the right to contest coverage. See coverage, an exception exists when an insurer, with Enserch Corp. v. Shand Morahan & Co., 952 F.2d knowledge of facts indicating noncoverage, assumes 1485, 1493 (5th Cir. 1992); Texas United Ins. Co. the insured’s defense without properly reserving its v. Burt Ford Enters., 703 S.W.2d 828, 833 (Tex. rights to later contest coverage. See Pennsylvania App.—Tyler 1986, no writ). Accordingly, while an Nat.’l Mut. Cas. Ins. Co. v. Kitty Hawk Airways, insurer may be bound by liability facts that were 964 F.2d 478, 481-82 (5th Cir. 1992); State Farm actually litigated, the insurer remains free to contest Lloyds, Inc. v. Williams, 960 S.W.2d 781, 785-86 coverage for such liability. See id. Moreover, in the (Tex. App.—Dallas 1997, no writ). This is known past few years, the Supreme Court of Texas has as the “Wilkinson exception” and is intended to (perhaps unknowingly) softened the blow to insurers protect the insured from any conflict of interest that who breach their duty to defend. In State Farm Fire might arise between the insurer and the insured. See & Cas. Co. v. Gandy, 925 S.W.2d 696 (Tex. 1996), Farmers Tex. County Mut. Ins. Co. v. Wilkinson, the court held that a judgment rendered for the 601 S.W.2d 520 (Tex. Civ. App.—Austin 1980, plaintiff against the insured without a fully writ ref’d n.r.e.). adversarial trial is not binding on the insurer or admissible as evidence of damages in an action Even though the threat of waiver and estoppel against the insurer by the plaintiff as the insured’s can be daunting to an insurer, the doctrines are not assignee. Id. at 714. Although the Gandy court was automatically applied when an insurer fails to trying to mitigate the effects of collusive sweetheart properly reserve its rights. Both Texas and federal R - 10 9th Annual Ultimate Insurance Seminar

courts construing Texas law have required the in UNIV. HOUS., ADVANCED INSURANCE SEMINAR insured to show prejudice (a/k/a “clear and D (1996) unmistakable harm”) before invoking waiver and/or estoppel. See Certain Underwriters at Lloyds v. C. Provide an Unqualified Defense Oryx Energy Co., 142 F.3d 255, 257 n.2 (5th Cir. 1998); State Farm Lloyds, Inc. v. Williams, 791 An insurer always has the option of offering an S.W.2d 542, 553 (Tex. App.—Dallas 1990, writ unqualified defense. By doing so, the insurer can denied). demand compliance with all policy conditions and may also assert the right of exclusive control of the Offering a qualified defense is a proper course defense. This is so because the insurer, by offering of action only when the insurer has a good faith an unqualified defense, has waived any potential belief that the petition alleges conduct that may not coverage defenses. Stated differently, there is no be covered by the policy. See American Eagle Ins. conflict of interest precluding the insurer’s control Co. v. Nettleton, 932 S.W.2d 169, 174 (Tex. over the defense. See Katerndahl v. State Farm App.—El Paso 1996, writ denied); see also Rhodes Fire & Cas. Co., 961 S.W.2d 518, 523 (Tex. v. Chicago Ins. Co., 719 F.2d 116, 120 (5th Cir. App.—San Antonio 1997, no writ). 1983). Absent a good faith belief, an offer of a qualified defense arguably constitutes a breach of IX. USING DECLARATORY JUDGMENTS the duty to defend. Where, however, an insurer has TO DETERMINE THE DUTY TO a good faith belief that the allegations raise coverage DEFEND issues, it will not breach its duty to defend by offering a qualified defense. Nettleton, 932 S.W.2d A declaratory judgment is a judicial at 174. Moreover, if the insurer properly offers a determination of the rights of respective parties, as qualified defense, it can insist on compliance by the opposed to coercive relief or damages. The purpose insured of all policy conditions. See id.; State Farm of declaratory judgments is to settle and afford relief Lloyds Ins. Co. v. Maldonado, 963 S.W.2d 38, 40- from uncertainty and insecurity with respect to 41 (Tex. 1998); First Gen. Realty Corp. v. rights, status, and other legal relations. Declaratory Maryland Cas. Co., 981 S.W.2d 495 (Tex. judgments can be brought in federal court pursuant App.—Austin 1998, no pet.). Additionally, as some to 28 U.S.C. § 2201 or in state court under Chapter courts have recognized, there is no downside to the 37 of the Civil Practice and Remedies Code. insurer in offering a qualified defense as it may withdraw its defense if it becomes clear that there is Declaratory judgments play a big role in no coverage under the applicable policy. See determining the duty to defend in that insurers Katerndahl, 961 S.W.2d at 522; Nettleton, 932 frequently initiate declaratory judgments to resolve S.W.2d at 174. But see Liberty Mut. Ins. Co. v. duty to defend disputes. Because the duty to defend Mustang Tractor & Equip. Co., 812 S.W.2d 663, is a question of law, declaratory judgments are 666 (Tex. App.—Houston [14th Dist.] 1991, no typically disposed of by summary judgment. writ) (affirming a temporary injunction preventing the insurer from withdrawing its defense where the Although Texas courts have had no problem insured can show irreparable injury). Of course, entertaining a declaratory judgment on the duty to absent some exception to the eight corners rule, the defend issue, the traditional rule—until insurer should be able to withdraw only in recently—was that the duty to indemnify issue had circumstances where the petition, in and of itself, to await resolution of the underlying lawsuit. See does not raise the potential for coverage. Firemen’s Ins. Co. v. Burch, 442 S.W.2d 331 (Tex. 1968). In 1997, however, the Supreme Court of For a more in depth analysis of reservation of Texas held that “the duty to indemnify is justiciable rights and non-waiver agreements, see Michael S. before the insured’s liability is determined in the Quinn, Reserving Rights Rightly: The Romance liability lawsuit when the insurer has no duty to and the Temptations, COVERAGE, July–Aug. 1997, defend and the same reasons that negate the duty to at 23; Christopher W. Martin, Reservation of defend likewise negate any possibility the insurer Rights In Texas: Why, Why Not, When, and How, will ever have a duty to indemnify.” See Farmers Tex. County Mut. Ins. Co. v. Griffin, 955 S.W.2d Duty to Defend R - 11

81, 84 (Tex. 1997). Thus, if and only if the court judgment actions involving the duty to defend. See declares that there is no duty to defend, the court State Farm Fire & Cas. Co. v. Gandy, 925 S.W.2d may also rule (prior to resolution of the underlying 696, 714 (Tex. 1996); Spruiell v. Lincoln Ins. Co., litigation) that there is also no duty to indemnify. No. 07-97-0336-CV, 1998 WL 174722 (Tex. See Foust v. Ranger Ins. Co., 975 S.W.2d 329, 332 App.—Amarillo Apr. 13, 1998) (unpublished). n.1 (Tex. App.—San Antonio 1998, writ denied) Accordingly, if squarely presented with the issue, (noting that the duty to indemnify is not justiciable the Supreme Court may reassess its prior holding in prior to resolution of the underlying litigation where Dairyland. the insurer’s duty to defend is triggered). Accordingly, in declaratory judgment actions X. RECOUPMENT OF DEFENSE COSTS involving duties under the insurance contract, the court’s analysis must always begin with the duty to One of the “hottest” issues in insurance law is defend. the attempted recoupment of defense costs by liability insurers. The California Supreme Court Both Texas and federal courts have held that a lead the way with Buss v. Superior Court, 939 P.2d lawsuit filed against an insured creates a justiciable 755 (Cal. 1997). In Buss, the court held that where controversy so as to afford jurisdiction. See Griffin, a liability insurer provides a defense to the entire 955 S.W.2d at 82; American States Ins. Co. v. underlying lawsuit, it may seek reimbursement of Bailey, 133 F.3d 363, 368 (5th Cir. 1998). Some defense costs for claims that are clearly not covered. differences between the Federal Declaratory See id. at 776-77 Judgment Act and the Texas Declaratory Judgment Act exist, however, that are worthy of discussion. The Buss arrived in Texas in August 1998. In First, whereas attorneys’ fees are awardable to the Matagorda County v. Texas Ass’n of Counties prevailing party under the Texas statute, the federal County Gov’t Risk Management Pool, 975 S.W.2d statute does not provide for such an award. See 782 (Tex. App.—Corpus Christi 1998, pet. Utica Lloyd’s of Tex. v. Mitchell, 138 F.3d 208, granted), the Corpus Christi Court of Appeals cited 210 (5th Cir. 1998). Second, in federal court, tort Buss with approval and held that an insurer may claimants in pending litigation may be joined in the have a right to reimbursement for defense costs declaratory judgment action. See Ohio Cas. Ins. incurred in defending clearly noncovered claims. In Co. v. Cooper Mach. Corp., 817 F. Supp. 45 (N.D. so holding, however, the court explicitly noted that Tex. 1993). But see, Standard Fire Ins. v. Sassin, reimbursement of defense costs is available only 894 F. Supp. 1023 (N.D. Tex. 1995) (dismissing when the insurer specifically notifies the insured that the injured third party). In state courts, on the other reimbursement of defense costs will later be sought. hand, a tort claimant is not a proper party until final Id. at 784. The Corpus Christi Court of Appeals resolution of the liability issues. See Safeway held that the reservation of rights letter in the case Managing Gen. Agency for State & County Mut. before it was inadequate because it merely stated Fire Ins. Co. v. Cooper, 952 S.W.2d 861, 868-69 that the insurer was reserving its right to contest (Tex. App.—Amarillo 1997, no writ). coverage without any mention that the insurer may seek reimbursement of defense costs. See id. This The fact that tort claimants cannot be added to “specific reservation” requirement has been strictly declaratory judgment proceedings in state court has followed. See Alliance Gen. Ins. Co. v. Club the potential for creating duplicative litigation. Hospitality, Inc., No. 3:97-CV-2448-H, 1999 WL Technically, the non-party tort claimant cannot be 500229 (N.D. Tex. July 14, 1999) (rejecting a claim bound by any issues resolved in the declaratory for reimbursement where the insurer failed to judgment proceeding and is thus free to relitigate the include specific reimbursement language in its insurance issues. See Dairlyland County Mut. Ins. reservation of rights letter). Co. v. Childress, 650 S.W.2d 770, 773-74 (Tex. 1983); National Sav. Ins. Co. v. Gaskins, 572 The exact contours of a reimbursement action S.W.2d 573 (Tex. Civ. App.—Fort Worth 1978, no will hopefully be settled by the Supreme Court of writ). Thus, for now, federal courts may provide for Texas, which has already granted a petition for more finality. Nevertheless, the Supreme Court of review and heard oral arguments in Matagorda. For Texas has (at least impliedly) suggested that tort now, however, an insurer may seek reimbursement claimants may be proper parties in declaratory of defense costs only where: (i) it specifically R - 12 9th Annual Ultimate Insurance Seminar reserves its right to seek reimbursement; (ii) it damages caused by exposure to silica over a period obtains a judicial declaration of noncoverage; and of many years. (iii) the defense costs are allocable to the noncovered claims. Alliance, Southwest Aggregate’s liability insurer, argued that it was entitled to a pro rata For a more detailed discussion of this topic, see allocation of defense costs for the portion of the also Dennis J. Wall, Insured’s Reimbursement of claim occurring outside of its policy period. More Insurer’s Defense Expenses: When to Ask, When to precisely, under Alliance’s theory, when coverage Say “No,” COVERAGE, May–June 1999, at 1; under consecutive, non-overlapping policies issued Michael Huddleston, Buss Arrives in Texas via by different insurance companies is triggered by a Matagorda—The Right of Reimbursement, claim of injury occurring across all the policy COVERAGE, Sept.–Oct. 1998, at 1. periods, each insurer’s duty to defend is determined by a ratio of that insurer’s “time on the risk” over XI. ALLOCATION OF DEFENSE COSTS the total time period for which damage is claimed to have occurred. The Guaranty Association, on the A. Covered vs. Non-covered Claims other hand, responded by arguing that the duty to defend is absolute and that nothing in the policy One of the core concepts of the eight corners provides for a partial defense as to the insured. rule is that only one claim must potentially fall within the ambit of the insurance policy in order to The court agreed with the Guaranty Fund and obligate an insurer to assume the duty to defend. rejected Alliance’s argument. In doing so, the court Notwithstanding this fact, some courts have held that an insurer’s duty to defend cannot be recognized a right of allocation on the part of reduced pro rata by the insurer’s “time on the risk” insurers between covered and noncovered claims. or by any other formula. Id. at 605. Any other See LaFarge Corp. v. Hartford Cas. Ins. Co., 61 result, according to the court, would violate the F.3d 389 (5th Cir. 1995) (recognizing the right of insurer’s contractual obligation to provide a full allocation where there is a clear distinction between defense. See id. covered and non-covered claims). In reaching its “no allocation” holding, the Although LaFarge recognized the possibility court specifically rejected two opinions from the of apportionment, the court emphasized the fact that Fifth Circuit that predicted Texas courts would apportionment may not be feasible. For example, apply a “time on the risk” proration. See LaFarge the court noted that “even though some of the claims Corp. v. Hartford Cas. Ins. Co., 61 F.3d 389 (5th were not covered under the policy, apportionment Cir. 1995); Gulf Chem. & Metallurgical Corp. v. would not be feasible in this case because the claims Associated Metals & Minerals Corp., 1 F.3d 365 all arose from a single accident.” Id. at 398. It is (5th Cir. 1993). Accordingly, until the Supreme the insurer’s burden to prove that allocation of Court of Texas rules on the issue, it is unclear how defense costs is feasible. See id. In reality, insurers a federal panel will deal with the allocation issue. will find it extremely difficult to ever meet this burden. XII. LIABILITY FLOWING FROM A BREACH OF THE DUTY TO DEFEND B. Consecutive Policies An insurer that breaches its duty to defend its In Texas Property & Cas. Ins. Guar. Ass’n v. insured faces liability for breach of contract. See Southwest Aggregate, Inc., 982 S.W.2d 600 (Tex. Whatley v. City of Dallas, 758 S.W.2d 301, 309 App.—Austin 1998, no pet.), the court addressed (Tex. App.—Dallas 1988, writ denied). Thus, the the issue of allocation where the alleged damages insurer is liable for any foreseeable damages that occurred partially within and partially outside of an directly result from the insurer’s breach. See id. In insurer’s policy period. The case involved a number general, such damages include all reasonable and of silicosis lawsuits filed against Southwest necessary expenses incurred by the insured in Aggregates. In most cases, the plaintiffs alleged undertaking its own defense, including attorneys’ fees, court costs, and other litigation expenses. See Duty to Defend R - 13

Texas United Ins. Co. v. Burt Ford Enter., Inc., 703 REP. 193, 201 (1997) [hereinafter, Quinn, The Duty S.W.2d 828, 835 (Tex. App.—Tyler 1986, no writ). to Defend]. Moreover, the insurer is liable for the insured’s reasonable and necessary costs and expenses In contrast to the duty of good faith and fair incurred in prosecuting the breach of contract suit dealing, Texas courts have not squarely addressed against the insurer. See id. whether article 21.21 of the Texas Insurance Code provides a statutory remedy for breach of the duty to Although the Supreme Court of Texas has defend. Some commentators have taken the position never squarely addressed the issue, numerous that article 21.21 applies (at least arguably) to an appellate courts and federal courts applying Texas insurer’s breach of the duty to defend. See Pryor, law have concluded that an insurer which breaches Mapping Changing Boundaries, supra; see also the duty to defend is not liable for amounts in excess Quinn, The Duty to Defend, supra at 201 of policy limits—at least absent a showing of bad (“Policyholders may have statutory bad faith claims faith or negligence in failing to settle the claim. See . . . .”). Willcox v. American Home Assur. Co., 900 F. Supp. 850, 856 (S.D. Tex. 1995); United Servs. The issues of what damages an insured can Auto. Ass’n v. Pennington, 810 S.W.2d 777, 784 recover and what consequences flow from an (Tex. App.—San Antonio 1991, writ denied). The insurer’s breach of the duty to defend are constantly courts have done so, however, with little discussion evolving. Accordingly, the Texas precedent that of their rationale. Presumably, an insured who can exists today may soon change—especially as more show a causal connection between an insurer’s jurisdictions expand the remedies afforded to breach of the duty to defend and an excess verdict insureds for breach of the duty to defend. should be able to recover the excess verdict in a breach of contract action. See WINDT, supra, § XIII. ETHICAL CONSIDERATIONS OF 4.36. DEFENSE COUNSEL

The Supreme Court of Texas has addressed A. The Tripartite Relationship whether a breach of the duty to defend also constitutes a breach of the duty of good faith and When an insurer assumes its insured’s defense, fair dealing. In Maryland Ins. Co. v. Head Indus. it generally has the right to select defense counsel. Coatings & Services, Inc., 938 S.W.2d 27 (Tex. Moreover, if no conflict of interest exists, the 1996), the court rejected an extracontractual cause insurer may have exclusive control over the defense. of action for breach of the duty to defend. Id. at 28 When a conflict of interest exists (e.g., when the (holding that Texas law only recognizes one tort outcome of a coverage issue can be affected by the duty—that being a Stowers duty—in the liability manner in which the underlying action is defended), insurance context); see also Snug Harbor, Ltd. v. however, one must be cognizant of the relationship Zurich Ins., 968 F.2d 538, 546 (5th Cir. 1992). Such among the liability insurer, its insured and the a rule fails to recognize the importance of the duty defense counsel selected by the liability insurer to to defend and the devastating effects a breach of the defend the insured. The relationship among these duty can have on an insured. See St. Paul Ins. Co. v. parties is known as the “tripartite relationship.” Rahn, 641 S.W.2d 276, 282 (Tex. App.—Corpus Christi 1982, no writ) (noting that an insurer’s A big debate exists as to whether Texas is a wrongful refusal to assume its duty to defend is like “one client” or “two client” state. Essentially, the sending “its insured, standing hat in hand at its door, debate focuses on whether the insurer is also the packing”). Moreover, such a rule fails to recognize client of defense counsel hired by the insurer to that the Stowers doctrine does not address or represent the insured. See Charles Silver, The remedy situations where the insurer breaches the Professional Responsibilities of Insurance Defense duty to defend. Finally, by not permitting an Lawyers, 45 DUKE L.J. 255 (1995); Charles Silver extracontractual cause of action for breach of the & Michael Quinn, Wrong Turns on the Three-Way duty to defend, the court overlooks the fact that the Street: Dispelling Nonsense about Insurance duty to defend is truly a “first-party” duty within a Defense Lawyers, COVERAGE, Nov.–Dec. 1995, at third-party policy. See Michael S. Quinn, The Duty 1. Texas law is far from clear on this point. Texas to Defend: New Texas Developments, 19 INS. LITIG. law is clear, however, that defense counsel owes R - 14 9th Annual Ultimate Insurance Seminar

“unqualified loyalty” to the insured. See State Farm Another ethical issue that has come to the Mut. Auto. Ins. Co. v. Traver, 980 S.W.2d 625, 628 forefront as of late is the use of “captive firms” to (Tex. 1998); Employers Ins. Cas. Co. v. Tilley, 496 defend insureds. A captive firm is a law office S.W.2d 552, 558 (Tex. 1973). As the Supreme staffed by lawyers who are actually employees of Court of Texas pointed out in Traver, “the lawyer the insurance company. The use of captive firms must at all times protect the interests of the insured has increased over the past few years as insurers . . . .” Traver, 980 S.W.2d at 628. have searched for ways to be cost-effective. See State Farm Mut. Auto. Ins. Co. v. Traver, 980 Despite the fact that defense counsel S.W.2d 625, 633 (Gonzalez, J., concurring and undeniably owes its unqualified loyalty to the dissenting). insured, the fact remains that the “so-called tripartite relationship has been well documented as The Unauthorized Practice of Law Committee a source of unending ethical, legal, and economic has waged war against the use of so-called “captive tension.” Traver, 980 S.W.2d at 633 (Gonzalez, J., firms” to defend insureds. According to the UPLC, concurring and dissenting). As Justice Gonzalez the use of captive firms raises serious ethical issues. further noted, In particular, the UPLC questions whether captive lawyers will truly look out for the best interests of The duty to defend in a liability policy at the insureds. The use of captive firms has also times makes for an uneasy alliance. The caught the attention of the Supreme Court of Texas. insured wants the best defense possible. See Traver, 980 S.W.2d at 633 (Gonzalez, J., The insurance company, always looking concurring and dissenting) (noting that “it is at the bottom line, wants to provide a probably impossible for an attorney to provide the defense at the lowest possible cost. The insured the unqualified loyalty that Tilley requires” lawyer the insurer retains to defend the where the insured is being represented by a captive insured is caught in the middle. There is a firm). lot of widsom in the old proverb: He who pays the piper calls the tune. The lawyer For now, the future of captive firms is in the wants to provide a competent defense, yet hands of the courts. The UPLC has filed suit knows who pays the bills and who is most against Allstate seeking to prevent it from using likely to send new business. captive firms. Moreover, the UPLC is actively investigating other large insurance companies. Id. Recently, Nationwide Mutual Insurance Company has responded to the UPLC investigation by filing The import of Traver and Tilley in the duty to a suit seeking a declaration that the UPLC statute is defend context is that an insurer should never use unconstitutional. the same counsel to review coverage as it does to defend the insured. See Employers Cas. Co. v. XIV. CONCLUSION Mireles, 520 S.W.2d 516 (Tex. Civ. App.—San Antonio 1975, writ ref’d n.r.e.) (holding that the The state of the law with respect to the duty to employment of separate firms to defend the insured defend is constantly developing. In the near future, and to address coverage issues eliminates conflicts one can certainly expect caselaw discussing hot of interest). Accordingly, where an insurer offers a issues such as recoupment of defense costs, qualified defense and proceeds by hiring defense allocation of defense costs, and recoverable counsel, the defense counsel should remain damages flowing from an insurer’s breach of the “independent.” More precisely, where a qualified duty to defend. Moreover, as the caselaw develops defense is provided, defense counsel should never and as states pass and/or amend their insurance communicate with the insurer with respect to codes, new issues are likely to come to the forefront. “coverage” issues. See Rhodes v. Chicago Ins. Co., 719 F.2d 116 (5th Cir. 1983). Although this paper has discussed several of B. The Use of Captive Firms the more common issues relating to the duty to defend, it has by no means addressed all of the duty Duty to Defend R - 15 to defend issues that arise everyday in the world of insurance law. For a more in-depth discussion of the duty to defend and its many facets, please see Professor Ellen Pryor’s soon to be published article in the Texas Tech Law Review.