Coverage Disputes Give Rise to "Independent" Counsel

Northern County Mut. Ins. v Davalos

The Texas Supreme Court squarely addressed the issue of independent counsel for the first time in Northern County Mutual Ins. Co. v. Davalos, 140 S.W.3d 685 (Tex. 2004). Davalos was an insured of Northern County and a resident of Matagorda County. While in Dallas County, he was injured in an automobile accident. Davalos sued the driver of the other vehicle in Matagorda County. The other driver and his wife sued Davalos and another person who was involved in the accident in Dallas County.

Davalos sent the Dallas petition in which he was named as a defendant to the attorneys who were representing him as a plaintiff in the Matagorda action. These attorneys moved to transfer the case to Matagorda County. After filing such a motion, they then notified Northern of the Dallas litigation and tendered the petition to Northern. Northern responded to the tender in writing and told Davalos they did not wish to engage the attorneys he had selected to defend the action and had chosen a different law firm to represent him in the Dallas action. They also indicated that they were opposed to transferring the case to Matagorda County.

The letter also set forth the cooperation clause and indicated that if the motion to withdraw was not withdrawn, the coverage could be jeopardized. Northern requested that Davalos have his attorneys withdraw from the Dallas County case and allow the attorneys suggested by Northern replace them. Northern did indicate to Davalos that he was free to obtain his own attorney at his own expense and that Northern would cooperate with that lawyer to the extent that he did not jeopardize the defense of the case.

The attorneys representing Davalos did not withdraw from the case. Davalos's attorneys wrote to reject the defense tendered by Northern and suggested that Northern had only offered a qualified defense which was insufficient to satisfy the obligations owed under the policy. The attorneys advised Northern that it could not select defense counsel because of the conflict with Davalos over the venue motion, and that they expected Northern to pay their fees in defending Davalos. Northern ultimately settled the claims against Davalos approximately a year after the suit was filed, obtaining a full and final release with no payment being made by Davalos. Davalos sued Northern County Mutual in Matagorda County asserting breach of the duty to defend, bad faith, as well as violations of the insurance code.

The Appeal

The supreme court in Davalos made five holdings regarding the conduct of the defense:

1. The right to conduct the defense by the insurer is a matter of contract. Under most policies, the right to conduct the defense includes the authority to select the attorney who will defend the claim and make other decisions that would normally be vested in the insured as the named party in the case. [Davalos at 688.]
2. The supreme court held that this right to conduct the defense is not without its limits. The court then addressed what situations would and would not give rise to the right of the insured to control its own defense.
3. Generally, disagreement about how the defense should be conducted would not amount to a conflict of interest. [Davalos at 689.]
4. The supreme court held that where there is a question regarding the existence of scope of coverage, there may exist a right for disqualifying conflict. A disqualifying conflict exists when the facts to be adjudicated in the liability lawsuit are the same facts upon which coverage depends. [Davalos at 689.]
5. Finally, the court referenced other types of conflicts which may also justify an insured's refusal to a defense which are outside the scope of coverage. These are as follows:
   • When the defense tendered "is not a complete defense under circumstances in which it should have been."
   • When the "attorney hired by the carrier acts unethically and, at the insurer's direction, advances the insurer's interest at the expense of the insured's."
   • When "the defense would not come under the governing law, satisfy the insurer's duty to defend"; and
   • When, though the defense is nevertheless proper, "the insurer intends to obtain some type of concession from the insured before it will defend." ²

Test Employed by Davalos for Independent Counsel

The test was announced in Davalos as to what coverage questions give rise to independent counsel:

• An insurer can lose its right to select the insured's defense counsel only if a conflict of interest exists between the insurer and the insured as to the defense,
• Such a conflict of interest does not exist simply because the insurer has issued a reservation of rights letter, and
• A conflict of interest exists only if the facts that will be adjudicated in the lawsuit against the insured are the same facts upon which the existence of coverage depends.

When Independent Counsel Is Required

The supreme court in Davalos held that an insured might rightfully refuse to accept the insured's defense and appoint counsel of their own choosing at the expense of the insurer in certain situations.

Reservation of Rights Letter—Some Causes of Action Covered; Some Not

In a situation where an insurer tenders a defense pursuant to a reservation-of-rights letter to an insured, where some of the causes of action are covered and some are not, the right to independent counsel is triggered. In Steel Erection Co. v. Travelers Indemnity Co., 392 S.W.2d 713 (Tex. Civ. App.—San Antonio 1965, writ ref'd, n.r.e.), the allegations included that the crane which had been damaged was under the care, custody, and control of the insured (which would be excluded), or was being operated by an independent contractor (which would not be excluded). The court of appeals held that in that situation, because coverage could depend on the outcome of the underlying case, the insured had a right to control its own defense.

Similarly, in Rhodes v. Chicago Ins. Co., 719 F.2d 116 (5th Cir. 1983), the allegations included sexual misconduct (which would be excluded) as well as allegations of professional negligence (which would not be excluded). Again, the court in Rhodes found that because the outcome of the underlying case could determine the coverage issue, that the insured would have a right to independent counsel. ³ Allan D. Windt opines that this situation would likewise create a conflict of interest that would require independent counsel:

This is not to say, however, that a conflict of interest will not, under certain circumstances, arise with regard to the conduct of the insureds' defense. Specifically, a conflict over the existence of coverage will serve to create a conflict of interest with regard to the insured's defense when the insurers' potential liability could be reduced if the insured were defended in a particular manner.

Manner of Defense

The Texas Supreme Court in Davalos listed four other situations which might justify an insured's refusal of an offer of defense. With respect to these four instances, the court held that an insured might rightfully refuse to accept the insured's defense and appoint counsel of its own choosing at the expense of the insurer. These four situations are as follows:

• When the defense tendered "is not a complete defense under the circumstances in which it should have been,"
• When "the attorney hired by the carrier acts unethically and, at the insurer's direction, advances the insurer's interest at the expense of the insured's,"
• When "the defense would not, under the governing law, satisfy the insurer's duty to defend," and
• When though the defense is otherwise proper, "the insurer attempts to obtain some type of concession from the insured before it will defend." [1 WINDT § 4.25 at 393.]

The supreme court concluded that the insured may rightfully refuse an inadequate defense and may also refuse any defense conditioned on an unreasonable, extra-contractual demand that threatens the insured's independent legal rights. One example given by the court in Davalos was that Northern could not have required Davalos to dismiss his Matagorda suit as a condition for defending him. If such a demand had been made by Northern, Davalos would have been justified in rejecting the defense.

When Independent Counsel Is Not Required

There are, however, situations when independent counsel is not required, and these are outlined below.

Punitive Damages

Some states have adopted statutes to specifically provide that no independent counsel is required solely on the basis of the plaintiff seeking punitive damages. ⁴ In Texas the issue is unclear. Where there is a claim for punitive damages, and the claim for actual damages is covered, the interest of the insured and the insurer are completely aligned. By statute, there can be no recovery of punitive damages unless there is a recovery of actual damages. ⁵ Allan D. Windt also concurs in the proposition that an allegation of punitive damages will not trigger the right to independent counsel:

Since, under those circumstances, the interest of the insured and the insurer would parallel each other with respect to the plaintiff's claims for compensatory damages, the fact that the insured might be liable for additional damages would not create a conflict of interest between the insured and the carrier. [1 WINDT §4.20 AT 376-77.]

Excess Demand

As in the case of punitive damages, an excess demand will not trigger the right of the insured to independent counsel. Again, the reason for this result is that there is no conflict between the insured and the insurer. Both the insured and the insurer have the joint goal of seeking that little or no damages are awarded by the jury. If there is a verdict in excess of the policy limits, the insurer will have its entire limits exposed.

Courts in other jurisdictions have adopted this approach. In Pekin Ins. v. Home Ins., 479 N.E.2d 1078 (Ill App 1985), the insurer paid its policy limits but continued defending the insured. The insured asserted that the exhaustion of the limits of liability created a conflict of interest for the insurer. The insured argued that the insurer had an interest in keeping the litigation costs as low as possible. On the other hand, the insured believed that a full and vigorous defense was required. This contention by the insured was rejected by the court. The court held that the insured's concerns about the zealousness of the defense tendered by the insurer were insufficient to create a right to independent counsel.

At least two states, California and Alaska, have adopted statutes that hold a claim in excess of the policy limits does not create a conflict of interest. ⁶ Allan D. Windt also agrees that an excess demand will not create the right to independent counsel. He argues that:

The insured's defense counsel would not, under the foregoing circumstances, be able to reduce the insurer's liability by the manner in which he or she defended the lawsuit. [1 WINDT § 420 at 377.]

Claim Against Multiple Insureds

Some courts have held that where there are claims against multiple insureds, the right to independent counsel may arise. This includes cases where insureds are insured under the same policy or the insureds are insured under different policies. ⁷ Other courts find this reasoning erroneous, for several reasons. First, no conflict exists between the insurer and the insureds. Rather, the conflict is between the two insureds. Regardless of which insured is found to be liable, the insurer in that case would have a responsibility to pay. Also any payment of a judgment or settlement on behalf of one insured would benefit the other. ⁸

Insured versus Insured Suits

Similarly, some states have held that where the plaintiff and the defendant are represented by the same insurer, the conflict exists. O'Norrow v. Borad, 167 P.2d 483 (Cal 1946). Likewise, in Hoffman v. Austin Ins., 188 N.Y.S.2d 408 (Sup. Ct. 1959), the court held that in a suit by one insured against the other, the insurer had an obligation to appoint independent counsel. There is not a conflict between the insurer and the respective insured.

Persons Insured

On many occasions, an insurer may reserve rights on the issue as to whether or not a person is an insured under the policy. In many of those cases, coverage will depend on determinations in the underlying lawsuit. For example, whether a person was an employee acting in the course and scope of employment not only is an issue for liability but also is an issue for coverage. In that situation, the employee should have the right to independent counsel.

Policy Period

On numerous occasions, an insurer may reserve its rights based on whether there was a trigger during the particular insured's policy period. In most cases, this will not be an issue which will be determined in the underlying case. When bodily injury or when property damage occurred, in most cases, is not an issue to be determined in the underlying case. However, there could be circumstances, particularly where the statute of limitations is involved, where a conflict could exist and the issue is to be determined in the underlying case. In those circumstances, then the insured would have the right to independent counsel.

Conditions

On many occasions, reservation-of-rights letters contain reference to breach of conditions by the insured. The most frequent reference is to the failure of the insured to give prompt notice of the occurrence, claim, or suit. The issue is presented as to whether a reservation-of-rights letter that sets a breach of condition would be sufficient to justify the use of independent counsel. Again, in most cases, the answer is no. With respect to late notice, the issue of whether the occurrence, claim, or lawsuit was timely reported to the insurer is not going to be an issue in the underlying case. If it is ever to be determined, it will be determined separately in a declaratory judgment action. In the defense of the underlying case, the insurer would have every incentive to obtain a favorable ruling on behalf of the insured in order to obviate a later coverage battle with the insured.

Mr. Windt also agrees that a dispute over compliance with the condition will not give rise to the right to independent counsel. He states that:

With rare exceptions, those issues are irrelevant to the issues involved in defending the insured against the plaintiff's claims. [1 WINDT § 4:20 at 376.]

Coverage Issues Where Facts Will Not Be Decided in the Underlying Case

Under the Davalos decision, if the coverage issue involves facts that will not be decided in the underlying case, there is no conflict of interest which would entitle the insured to independent counsel. The reason there is no conflict of interest is that the defense counsel could not be in a position to move the case toward coverage or noncoverage by the conduct of the defense.

Independent Wrongdoing

Mr. Windt also asserts that there is no right to independent counsel where the complaint contains more than one cause of action, each of which is based on a different, independent alleged wrongdoing by the defendant-insured. The fact that the insurance policy does not provide coverage with respect to every cause of action does not create a conflict of interest between insured and an insurer, insofar as the insured's defense is concerned. [1 WINDT § 4:20 at 375.]

Disagreement on Potential Exposure

Finally, a disagreement over the potential exposure of the insured will not create a conflict of interest which will give rise to the right of independent counsel. [1 WINDT § 4:20 at 378.]

Conclusion

The Davolos case provided us with an insight as to how generally the Independent Counsel Rule should be applied. This Texas Supreme Court case set out a test as to what coverage questions will give rise to independent counsel. There still remains a tremendous amount of disagreement regarding the breadth of this court's opinion and what circumstances do trigger the right of an insured to independent counsel. Various other states have adopted statutes regulating the type of situations in which an insured is entitled to select his counsel and control his defense due to a conflict of interest with his insurer, to alleviate this problem. It appears that the courts will continue wrestle with this controversy over independent counsel.