INDEPENDENT COUNSEL ISSUES

UNDER TEXAS INSURANCE LAW

Presenters

ROBERT D. ALLEN, Dallas

Meckler Bulger Tilson Marick & Pearson, LLP

PAUL K. STAFFORD, Dallas

The Stafford Law Firm

Author

ROBERT D. ALLEN

Meckler Bulger Tilson Marick & Pearson, LLP

10,000 North Central Expressway, Suite 1450

Dallas, Texas 75231

State Bar of Texas

9th

ANNUAL

ADVANCED INSURANCE LAW COURSE

April 12-13, 2012

Dallas

CHAPTER 15

ROBERT D. ALLEN

MECKLER BULGER TILSON MARICK & PEARSON, LLP

10,000 North Central Expressway

Suite 1450

Dallas, Texas 75231-2330

Email: bob.allen@mbtlaw.com

Phone: 214-265-6212

Bob Allen is the Partner-in-Charge of the Dallas, Texas office of Meckler Bulger Tilson Marick & Pearson, LLP.

Prior to transferring his practice to Meckler Bulger Tilson Marick & Pearson on September 1, 2007, he served as the

Chair of the Insurance and Reinsurance Disputes Section of Baker & McKenzie‟s North American Litigation Practice

Group. Mr. Allen‟s practice is primarily focused in representing parties in the trial court and appellate proceedings in

insurance and commercial litigation in Texas and other regions of the United States.

Starting in 2002, Mr. Allen has been named to London-based Euromoney Legal Media Group‟s Bi-annual “Guide to

the World‟s Leading Insurance and Reinsurance Lawyers.” He has been acknowledged by Texas Monthly as a

“Super Lawyer” for Insurance Defense—Commercial, from its inception. From 2005 on, he has been listed as one of

The Best Lawyers in America for Commercial Litigation. Mr. Allen enjoys an AV Pre-eminent rating from

Martindale-Hubbell.

PAUL K. STAFFORD E-Mail: paul.stafford@staffordfirm.com Paul K. Stafford earned a Bachelor of Science in Political Science from Texas A&M University in 1990. Mr. Stafford earned a Juris Doctorate from Texas Tech University School of Law in 1994. Mr. Stafford is licensed by the State of Texas and in the Federal District Court, Northern, Eastern, and Western Districts of Texas. Between 1994 and 1998, Mr. Stafford served first as an Assistant District Attorney in Denton County, Texas, followed by service as an Assistant District Attorney in Dallas County, Texas. While in Dallas, Mr. Stafford served as a felony prosecutor in the Organized Crime Division. Mr. Stafford has been practicing general civil litigation since 1998. Currently, he is the proprietor of The Stafford Law Firm in downtown Dallas – a litigation firm focusing on the areas of commercial, business, and insurance litigation. Previously, he practiced at Amis & Bell in Arlington, Texas before joining Werstein, Smith & Wilson in January, 2002. Mr. Stafford then became Senior Trial Attorney in the Dallas office of Hughes & Luce LLP (now Kirkpatrick & Lockhart Preston Gates Ellis LLP) practicing in the areas of Business Litigation, Commercial Litigation, and Insurance Law, as well as White Collar Crime Defense. Mr. Stafford was named a Rising Star by Texas Monthly magazine for three consecutive years (2005; 2006; 2007), and a Super Lawyer in 2009. In 2008, Stafford was named one of the Eight Top Lawyers in Dallas by Eclipse magazine. Mr. Stafford is an active member of the Dallas Bar Association (“DBA”), serving as the Chair of the DBA’s Board of Directors in 2008, and currently serving as the DBA’s Second Vice President. In 2004, Mr. Stafford served as co-chair of the DBA’s Minority Participation Committee, which received the 2004 Jo Anna Moreland Outstanding Committee Award. In 2005, Mr. Stafford served as co-chair of the DBA’s Admissions & Membership Committee. In 2006, Mr. Stafford served as co-chair of the Equal Access to Justice Campaign (raising approximately $540,000 for pro bono legal services in Dallas County) and was named Dallas Bar Association Outstanding Minority Attorney. In 2007, Mr. Stafford served as Chair of the Equal Access to Justice Campaign (raising approximately $575,000 for pro bono legal services in Dallas County). In 2008, Mr. Stafford served as co-chair of the DBA’s Judiciary Committee, co-chair of the DBA’s Bench Bar Committee, and chair of the DBA’s “A Bar For All” bar-assessment committee. This year, Mr. Stafford is co-chair of the DBA’s Mentoring Committee, and serves on the Law Jam II Committee. Mr. Stafford has served on the Board of Trustees of the Dallas Bar Foundation since 2005, and is a member of the Dallas Association of Young Lawyers Foundation. In addition, Mr. Stafford served as 2002 President of J. L. Turner Legal Association. Mr. Stafford is an Adjunct Professor at Texas Tech University School of Law, having taught Insurance Law (2002; 2005; 2008; 2009), Trial Advocacy (2004), and

Interviewing & Counseling (2007; 2008). In 2007, Mr. Stafford was named an Outstanding Alumnus by the Black Law Student Association at Texas Tech University School of Law. Mr. Stafford is active in the North Texas community, serving on a variety of boards and commissions in the area. Mr. Stafford serves on the Board of Directors of Camp John Marc: Special Camps for Special Kids, as well as being a volunteer with Big Brothers Big Sisters. Mr. Stafford is a proud Aggie, serving as an active member of the Texas A&M Association of Former Students (Board of Directors, 2007 - present), The Black Former Student Network (2007-2008 Chair), the Dallas A&M Club, the Texas A&M Liberal Arts Development Council, and as a founding member of the Department of Political Science Former Student Advisory Board. Mr. Stafford is also an active member of the Texas Tech Alumni Association and the Black Law Students Alumni Association. Mr. Stafford is a 2003 German Marshall Fund, American Marshall Memorial Fellow, and currently serves on the Board of Trustees of the German Marshall Fund of the United States (based in Washington, D.C.). During his Fellowship in 2003, Mr. Stafford traveled to Brussels, Belgium, where he met with officials from the European Union and NATO to discuss a variety of transatlantic issues. Mr. Stafford also traveled to The Netherlands, where he discussed various legal issues with officials from The Hague, The United Nations Criminal Tribunal for Yugoslavia, and the World Court. Mr. Stafford also met with political, professional, and civic leaders in Italy, Slovakia, and France. In 2005, Mr. Stafford traveled to Rome, Italy to attend the Marshall Seminar on Southern European Affairs (February, 2005); he also moderated a panel on ‘Multilateral/Multinational Organizations’ at the Marshall Forum on Transatlantic Affairs, Schloss Elmau, Germany (April, 2005). Paul also attended the Marshall Forum in Tremezzo, Italy (March, 2006) and in Schloss Elmau, Germany (June, 2007). In July of 2007, Mr. Stafford was a guest lecturer on “The State of Transatlantic Relations” at HTW University of Applied Sciences – Saarbrucken, Saarland, Germany. Throughout the years, Paul Stafford has been a speaker and lecturer on a variety of political, social and legal issues of local, national and international significance. These issues and topics have included community affairs, social commentary, terrorism and homeland security, commercial litigation, insurance law, criminal law, trial advocacy and strategy, as well as interacting with the media regarding specific clients, cases, issues, or topics. Mr. Stafford is married to Telea Johnson Stafford and has three daughters.

Independent Counsel Issues Under Texas Insurance Law Chapter 15

TABLE OF CONTENTS

I. WHEN DOES THE INSURED POSSESS THE RIGHT TO INDEPENDENT COUNSEL? .......................... 1 A. Downhole Navigator v. Nautilus ................................................................................................................ 1 B. Partain v. Mid-Continent Specialty ............................................................................................................ 2

II. INTERPLAY OF DUTY TO DEFEND AND THE INSURED‟S PROSECUTION OF CLAIMS FOR

AFFIRMATIVE RELIEF. ................................................................................................................................. 3 A. Standard for Segregating Attorneys‟ Fees.................................................................................................. 3

i

Independent Counsel Issues Under Texas Insurance Law Chapter 15

1

INDEPENDENT COUNSEL ISSUES

UNDER TEXAS INSURANCE LAW

This paper will address two of the developing

issues in Texas Insurance Law regarding independent

counsel issues. First, the paper will analyze the

development of the latest progeny of Northern County

Mut. Ins. Co. v. Davalos, 140, S.W.3d 685, 690 (Tex.

2004) on when a “disqualifying conflict” occurs that

will allow an insured to select counsel of its own

choosing to defend it. Also, the paper will discuss

how courts handle the allocation of fees between an

insured‟s prosecution of claims for affirmative relief

and defending covered claims.

I. WHEN DOES THE INSURED POSSESS

THE RIGHT TO INDEPENDENT

COUNSEL?

An ongoing and developing issue in Texas

insurance jurisprudence concerns whether a liability

insurer‟s act of agreeing to defend its insured under a

reservation of rights creates a material conflict of

interest that enables the insured to select counsel of its

own choosing. Indeed, this issue was recently

answered in the negative by a Houston Federal

Magistrate in Downhole Navigator, L.L.C. v. Nautilus

Ins. Co., 2011 WL 4889125 (S.D. Tex. 2011) and by a

Houston Federal Judge in Partain v. Mid-Continent

Specialty Ins. Services, 2012 WL 201864 (S.D. Tex.

2012).

Texas, like many jurisdictions, utilizes an eight

corner analysis in determining whether a liability

insurer owes its insured a duty to defend. See, e.g.,

National Union Fire Ins. Co. of Pittsburgh, Pa. v.

Merchants Fast Motor Lines, Inc., 939 S.W.2d 139,

141 (Tex. 1997). If the underlying Petition or

Complaint alleges a cause of action within the

policy‟s coverage, then the insurer owes a defense to

its insured. See, e.g., Canutillo Independent School

Dist. v. Nat’l. Union Fire Ins. Co. of Pittsburgh, Pa.,

99 F.3d 695, 701 (5th Cir. 1996). Typically, the

policy allows the insurer to select the attorney to

defend the insured.

When an insurer issues a reservation of rights

letter, a question often arises over whether the insurer

can insist on controlling the defense through counsel

of its own choosing. In this regard, the Texas

Supreme Court has held that every “disagreement

about how the defense should be conducted cannot

amount to a conflict of interest,” or the insured “could

control the defense by merely disagreeing with the

insurer‟s proposed actions.” If an insured “rejects[s]

the insurer‟s defense without a sufficient conflict, [it

loses its] right to recover the costs of that defense . . .

[and the insurer does] not breach its duty to defend.”

Northern County Mut. Ins. Co. v. Davalos, 140

S.W.3d 685, 690 (Tex. 2004).

Under Texas law, “when the facts to be

adjudicated in the liability lawsuit are the same facts

upon which coverage depends,” a reservation of rights

creates a “conflict of interest [that] will prevent the

insurer from conducting the defense.” Id. In other

words, a “conflict of interest does not arise unless the

outcome of the coverage issue can be controlled by

counsel retained by the insurer for the defense of the

underlying claim.” Rx.com Inc. v. Hartford Fire Ins.

Co., 426 F. Supp. 2d 546 (S.D. Tex. 2006) (citing

Davalos, 140 S.W.3d at 689).

A. Downhole Navigator v. Nautilus

Downhole Navigator v. Nautilus involves a

dispute between an insured and its insurer over

whether Nautilus‟ reservation of rights deprived it

from insisting that counsel of its choosing defend

Downhole. On the one hand, Downhole contended

that Nautilus‟ “decision to act under a reservation of

rights . . . created a material conflict with respect to

the selection of counsel.” On the other hand, Nautilus

stated that it only “reserved [its] rights while

investigating this matter,” and that “[u]ntil or unless a

coverage issue develops, Downhole is not entitled to

separate counsel.”

In the underlying suit, Downhole, an oil and gas

service provider, was sued for allegedly damaging a

well. Nautilus offered to defend Downhole pursuant

to a CGL policy. However, Nautilus reserved its right

to deny coverage based on three exclusions; to wit: a

Testing or Consulting E&O exclusion; a Professional

Liability exclusion; and a Data Processing Exclusion.

In ruling that Nautilus‟ reservation of rights did not

deprive it of controlling the defense, the Houston

Federal Magistrate opined:

The question for this court, then, is whether

the “facts to be adjudicated” in the Sedona

suit are the “same facts upon which

coverage depends . . . . ”

Comparing the allegations in the Sedona

complaint to [Nautilus‟] reservation of rights

letter, the “facts to be adjudicated” in the

Sedona suit are not the same facts “upon

which coverage depends.” At issue in the

Sedona suit is whether Downhole performed

its work negligently. But Nautilus did not

reserve its right to disclaim coverage based

on whether Plaintiff‟s work was negligent. .

. . Downhole has not shown that an insurer-

hired lawyer in the Sedona suit could control

the “outcome” of the coverage issue before

this court. . . . [H]ere, . . . [Nautilus‟]

Independent Counsel Issues Under Texas Insurance Law Chapter 15

reservation of rights letter invoked the

Testing Exclusion, which bars coverage for,

among other things, an “error, omission,

defect or deficiency in . . . a consultation.”

Downhole worries that an insurer-hired

attorney “could direct the facts to indicate

Plaintiff‟s relationship was that of a

consultant rather than a vendor hired to

perform specific work.” But even if the

attorney developed such facts, the

underlying fact-finder will not decide

whether the type of work Downhole

performed constitutes “testing” or

“consulting,” as those terms are used in the

Testing Exclusion. If the . . . fact-finder

concludes that Downhole was negligent,

Nautilus will still have to convince the fact-

finder in this forum that Plaintiff‟s negligent

work constituted an “error, omission, defect

or deficiency in . . . a consultation” that

triggers the Testing Exclusion. No finding

in the Sedona suit will control the outcome

of the coverage issue in this court.

Accordingly, the court held that Nautilus‟ reservation

of rights “did not create a conflict of interest that

entitled Downhole to hire independent counsel [and]

[f]or that reason, Nautilus is not obligated to

reimburse the cost of those attorneys.”

B. Partain v. Mid-Continent Specialty

Earlier this year, Houston Federal Judge Keith P.

Ellison analyzed a similar issue of whether an

insurer‟s reservation of rights correspondence allowed

the insureds to select counsel of their own choosing in

Partain v. Mid-Continental Specialty Ins. Svcs., Inc.,

2012 WL 201864 (S.D. Tex. 2012). The underlying

suit giving rise to the coverage/bad faith action was a

claim against insureds for copyright infringement.

Since copyright infringement arising out of an

insured‟s advertising activity was potentially covered

under its policy, Mid-Continent agreed to provide a

defense to the insureds under a reservation of rights.

From this, the insureds and Mid-Continent disputed

whether this reservation of rights “create[d] a conflict

of interest that allowed [the insured] to select his own,

independent counsel.” Id. at *3.

The district court made several interesting rulings

on Mid-Continent‟s Motion to Dismiss the insureds

statutory bad faith claims, including requiring the

insured to meet the pleading requirements of Fed. R.

Civ. P. 9(b) in connection with the Insured‟s

misrepresentation claims. After conducting that

analysis, the court considered the nature of the alleged

conflict of interest that was created by Mid-

Continent‟s reservation of rights. As a threshold

matter, the court noted that “Mid-Continent never

denied [the insureds] claim; it denied only [the

insureds] demand to retain [counsel of the insureds‟

choosing] to defend [the insureds].” Id. at 7. Also,

the court quoted from Darwin Select Ins. Co. v.

Laminack, Pirthe & Martines, LLP, 2011 WL

2174970 *3 (S.D. Tex. 2011) for the proposition that

the insurer possesses “the right to appoint defense

counsel, to determine reasonable claims expenses, to

control settlement and to determine whether the matter

is litigated or arbitrated”. Regardless, when a

disqualifying conflict of interest arises, “insureds may

select their own, independent counsel, thereby

protecting them from „an insurer-hired attorney who

may be tempted to develop facts or legal strategy that

could ultimately support the underlying lawsuit facts

within a policy exclusion‟”. Partain 2012 WL

201864 at *14 (quoting Rx.com v. Hartford Fire Ins.

Co., 426 F. Supp. 2d 564, 559-60 (S.D. Tex. 2006)

and Hous. Auth. of the City of Dallas, Tex. v.

Northland Ins. Co., 333 F. Supp. 2d 595, 601 (N.D.

Tex. 2004).

The court defined a disqualifying conflict of

interest as occurring when “the facts to be adjudicated

in the liability lawsuit are the same facts upon which

coverage depends.” Partain 2012 WL 201864 at *15

(citing to Davalos, 140 S.W. 3d at 689). After

conducting this analysis, the district court held that the

underlying case did not present a disqualifying

conflict and so, Mid-Continent was permitted to insist

that the insured be defended with counsel selected by

Mid-Continent. In so doing, the court focused on the

proposed jury questions by the party suing the insured

for copyright infringement and determined that the

answers to those questions would not determine a fact

upon which coverage depends. The court opined that

even if “some of the same facts might be „developed

and presented‟ in the Underlying Suit is irrelevant as

Davalos requires the same facts to be actually

adjudicated.” Id. at 19.

After obtaining this positive ruling, Mid-

Continent sought the district court to rule that the

insureds alleged breaches of the policy‟s

cooperation‟s clause and notice provisions excused

Mid-Continent from its duty to defend, even with

counsel of Mid-Continent‟s choosing. In a subsequent

slip opinion, the district court expounded on its earlier

opinion and stated “to conclude that [the insureds‟]

position that a conflict arises any time the facts

developed in the underlying lawsuit would raise facts

that could be used to exclude coverage is incorrect;

rather, it must be apparent that facts upon which

coverage depends will be ruled upon judicially in the

underlying lawsuit.”

Next, the district court rejected Mid-Continent‟s

claims that the Insured repudiated the contract and

2

Independent Counsel Issues Under Texas Insurance Law Chapter 15

that the Insureds‟ breaches of the cooperation‟s clause

and notice provisions prejudiced Mid-Continent as a

matter of law. The parties and the court focused on

the language in Davalos that if an insured “reject[s]

the insurers‟ defense without sufficient conflict, [it

loses its] right to recover the costs of that defense.

Davalos, 140 S.W.3d at 690. In this regard, the

district court held:

That portion of Davalos is inapplicable here.

The Court reads this statement in Davalos to

mean that, if an insured rejects an insurer‟s

defense without sufficient conflict, it loses

its right to recover the costs of that

defense—the one that it elects to use in the

underlying suit. Here, for example, if

Plaintiffs elect to proceed in the underlying

suit using their own counsel to defend them,

they will be unable to recover the costs of

that defense, as the Court has concluded

there was not a sufficient conflict of interest.

Davalos did not hold that plaintiffs who

reject an insurer‟s defense with a good faith

basis for believing that a sufficient conflict

exists lose their right to a defense altogether

once it is found that no sufficient conflict

exists.

The court found that the insureds possessed “a

good faith belief that they were entitled to select their

own counsel” and that “[t]hough the Court concluded,

under Texas law, no sufficient conflict exists, the case

was a close one.” The court also “recognized that [the

insureds] had a good faith basis for their position.”

Accordingly, held that the insured‟s conduct did not

allow Mid-Continent to avoid defending the insureds;

albeit with counsel of its own choosing.

These opinions and results are noteworthy

because: 1) the courts found that the conflicts were

not material (i.e., disqualifying), so that the insurers

did not lose its right to provide a defense to their

insureds with their choice of counsel; and 2) the

insurers were not obligated to reimburse the insureds

for the costs they incurred in paying the attorneys they

retained. The reasoning appears favorable to insurers

because it recognizes a material disqualifying conflict

in very limited circumstances, i.e., when the jury‟s

answer on a liability issue will directly decide a

coverage issue. Examples of this might be the

potential for a finding of fraud against the insured

when the policy contains a fraud exclusion, the

potential for an assault/battery finding against the

insured when the policy contains an assault/battery

exclusion and whether a putative insured was acting in

the course and scope of his/her employment because a

negative finding on course and scope would negate

coverage for the putative insured under the employer‟s

policy.

Finally, it should be noted that Downhole

Navigator was not appealed and the word (from a

Linked-In discussion) is that Partain will be appealed

to the Fifth Circuit. Thus, it will be interesting to see

how this issue develops judicially under Texas law.

II. INTERPLAY OF DUTY TO DEFEND AND

THE INSURED’S PROSECUTION OF

CLAIMS FOR AFFIRMATIVE RELIEF.

Yet another issue that arises in the independent

counsel situation occurs when insured is prosecuting

an affirmative claim for relief in the same action

where the insured is being sued for damages

potentially covered by their liability policy. Since an

insurer is not responsible for funding the prosecution

of claims for affirmative relief, litigation occurs over

how to allocate the fees attributable to claims for

affirmative relief, from the fees incurred in the

defense of potentially covered claims.

A. Standard for Segregating Attorneys’ Fees.

Although not an insurance case focusing on the

distinction between an insured‟s defense from the

insured‟s prosecution of claims for affirmative relief,

in 2006 the Texas Supreme Court analyzed how

parties should allocate fees attributable to causes of

action permitting the recovery of attorneys‟ fees (e.g.

breach of contract) from the fees attributable to causes

of action that do not allow for a prevailing party to

recover their fees (e.g. negligence). Tony Gullo

Motors I, L.P. v. Chapa, 212 S.W.3d 299 (Tex. 2006).

In Chapa, the Texas Supreme Court held that when a

party incurs attorney‟s fees relating solely to a claim

for which such fees are unrecoverable, a claimant

must segregate recoverable from unrecoverable fees.

Id. at 313. Intertwined facts do not convert

unrecoverable fees to recoverable. Id. at 313-14. In

other words, just because recoverable and

unrecoverable claims depend upon the same set of

facts or circumstances, that does not mean those

claims require the same research, discovery, proof, or

legal expertise. Id. at 313. Therefore, the Court

overruled the previous rule in Stewart Title Guar. Co.

v. Sterling, 822 S.W.2d 1 (Tex. 1991), stating that

Sterling went too far in suggesting that a common set

of underlying facts necessarily made all claims arising

therefrom “inseparable” and all legal fees recoverable.

Id. Here, the Texas Supreme Court held that it is only

when discrete legal services advance both a

recoverable and unrecoverable claim that they are so

intertwined that they need not be segregated. Id. at

313-14. “But when, as here, it cannot be denied that

at least some of the attorneys‟ fees are attributable to

claims for which fees are not recoverable, segregation

3

Independent Counsel Issues Under Texas Insurance Law Chapter 15

of fees ought to be required and the jury ought to

decide the rest.”

Texas caselaw specifically addresses allocating

fees between defending claims and prosecuting claims

for affirmative relief for purposes of an insurer‟s duty

to defend. For example, in Landmark American Ins.

Co. v. Ray, 2006 WL 4092436 (W.D. Tex.) (decided

the day before Chapa), Federal Judge Royal Ferguson

analyzed an insurer‟s obligation to pay the costs

attributable to an insured‟s prosecution of

counterclaims for affirmative relief in a suit where the

insured was sued, in part, for a covered claim. Here,

the insured took the position that “her counterclaims

were so inextricably related to her defense that

Landmark is obligated to also reimburse her for the

cost of prosecuting such counterclaims.” Judge

Ferguson rejected the insured‟s argument and held a

bench trial to determine three categories: 1) the fees

attributable solely to the defense of the plaintiff‟s

claims against the insured; 2) the fees attributable

solely to prosecuting the insured‟s claims for

affirmative relief; and 3) the fees attributable to both

the defense of the insured against the plaintiff‟s claims

and the insured‟s prosecution of her claims for

affirmative relief. In this regard, the court awarded

the insured all of her fees attributable to defending the

plaintiff‟s claims against her; none of the fees

attributable solely to prosecuting the insured‟s claims

for affirmative relief and 50% of the fees attributable

to both defending the plaintiff‟s claims and

prosecuting the insured‟s claims for affirmative relief.

4