Under Texas law, “when the facts to be adjudicated in [a] liability lawsuit are the same facts upon which coverage depends, the conflict of interest will prevent the insurer from conducting the defense.” N. Cnty. Mut. Ins. Co. v. Davalos, 140 S.W.3d 685, 688 (Tex. 2004). In Unauthorized Practice of Law v. American Home Assurance Company, the Texas Supreme Court observed that “the most common conflict between an insurer and an insured” is whether a claim falls within the policy, and that “coverage issues may … depend on facts developed in the litigation.” 261 S.W.3d 24, 40 (Tex. 2008). Does Unauthorized Practice suggest that an insured is entitled to independent counsel any time an insurer issues a reservation of rights letter? Not according to the U.S. Court of Appeal for the Fifth Circuit.
In Downhole Navigator, L.L.C. v. Nautilus Insurance Company, — F.3d —, 2012 WL 2477846 (5th Cir. June 27, 2012), Downhole was hired by an oil well operator (“Sedona”) to help redirect an oil well into a reservoir. Downhole negligently executed the redirection plan, and Sedona sued Downhole. Downhole tendered the lawsuit to Nautilus, which had issued Downhole a one-year commercial general liability insurance policy. Nautilus offered to defend Downhole subject to a reservation of rights, but Downhole rejected Nautilus’ defense offer, claiming that Nautilus’ offer to defend under a reservation of rights “created a material conflict with respect to the selection of counsel.” After Nautilus refused to reimburse Downhole for defense costs incurred by its independent counsel, Downhole filed an action against Nautilus in the U.S. District Court for the Southern District of Texas seeking a declaration that Nautilus was obligated to reimburse Downhole for those costs.
The magistrate judge determined that Nautilus did not have a duty to reimburse Downhole’s independent counsel fees, and Downhole appealed. On appeal, Downhole argued that the Texas Supreme Court’s statement in Unauthorized Practice that “coverage issues may … depend on facts developed in [underlying] litigation” meant that a conflict of interest arises any time facts that could be developed in an underlying litigation are the same facts upon which coverage depends. Specifically, Downhole claimed that if an insurer defended its insured under a reservation of rights, the insurer-appointed counsel could develop facts in the underlying litigation to bolster the insurer’s coverage defenses. Rejecting Downhole’s “strained reading” of this “[o]ne inconsequential line of dicta” in Unauthorized Practice, the Fifth Circuit held that Davalos permitted Nautilus to defend Downhole under a reservation of rights, writing:
Applying the principle from Davalos to this case, we agree … that “the facts to be adjudicated” in the underlying Sedona litigation are not the same “facts upon which coverage depends.” The underlying Sedona litigation concerns whether Downhole negligently performed its deviation work. If the insurance policy between Downhole and Nautilus excluded coverage for Downhole’s negligent conduct, and Nautilus accordingly reserved its right to disclaim coverage based on whether Downhole had negligently performed its work, then the “facts to be adjudicated” in the [underlying] litigation would be equivalent to the “facts upon which coverage depends.” But no such equivalency exists, as Downhole’s negligence is not a coverage issue between Downhole and Nautilus.
… Neither in Unauthorized Practice nor elsewhere has the Texas Supreme Court ever held that a conflict arises any time the attorney offered by the insurer could be tempted – in violation of his duty of loyalty to the insured – to develop facts in the underlying lawsuit that could be used to exclude coverage. The mere observation that coverage issues may turn on facts developed in the litigation does not necessarily entail that a conflict of interest will arise if the facts that could be developed in the underlying litigation are the same facts upon which coverage depends. Proceeding from the former observation to the latter conclusion requires an illogical leap.
If Downhole had been correct in arguing that the mere fact that coverage issues may turn on facts developed in an underlying litigation required an insurer to retain independent counsel on behalf of the insured, it would have functionally eviscerated an insurer’s rights to conduct its insured’s defense of an underlying action. Through its opinion in Downhole, the Fifth Circuit correctly limited the need to retain independent counsel to situations where liability and coverage issues so overlap that deciding liability issues practically resolved coverage issues. Defending insurers, therefore, need not fear having to permit an insured to retain independent counsel every time an insurer offers to defend the insured subject to a reservation of rights, but should be mindful of the possibility of a conflict of interest.