Fifth Circuit Clarifies Limitation on Policyholder’s Right to Independent Counsel When Insurer Agrees to Defend Under Reservation of Rights
In Downhole Navigator, LLC v. Nautilus Insurance Co., ___ F.3d ___, 2012 WL 2477846 (5th Cir. June 29, 2012), the Fifth Circuit Court of Appeals, applying Texas law, held that a recent Texas Supreme Court case, Unauthorized Practice Of Law Committee v. American Home Assurance Company, 261 W.W.3d 24, (Tex. 2008), did not change the applicable legal standard for determining when a conflict exists between the insurer and the insured that prevents the insurer from controlling the defense of a case and obligates the insurer to pay for independent counsel to represent the insured, affirming the decision by the District Court for the Southern District of Texas that a policyholder was not entitled to independent counsel when the insurance company agreed to defend under a reservation of rights because the facts to be litigated in the liability lawsuit were not the same facts upon which coverage depended.
An oil well operator sued Downhole, a drilling service provider, alleging that Downhole negligently performed its work resulting in damage to an oil well. Downhole’s insurer, Nautilus, agreed to defend the company under a reservation of rights and reserved its right to decline coverage based on three policy exclusions: 1) the “expected and intended injury” exclusion, 2) the “property damage” exclusion, and 3) the “testing and consulting” exclusion. Id. at *1-2. Downhole rejected the proffered defense and asserted it was entitled to independent counsel due to the conflict. Id. at 2. Downhole then sued Nautilus seeking payment for its independent attorneys and indemnity for the underlying suit. Id. Upholding the lower court, the Fifth Circuit recognized that a defense provided under a reservation of rights creates a potential conflict of interest that prevents the insurer from conducting the defense when the facts to be adjudicated in the underlying action are the same as those upon which coverage depends. Id. The court held, however, that the negligence allegations against the policyholder in the underlying case did not implicate the same facts as the potential exclusions upon which the insurance company reserved its rights, so there was no conflict of interest requiring independent counsel. Id. at *3.
The Downhole decision is important because in it, the court declined to apply a new standard for determining when a conflict exists based on a recent Texas Supreme Court case, Unauthorized Practice of Law Committee v. American Home Assurance Company and clarified the test for determining when an insurance company must provide independent counsel, providing a sound rationale for why it must do so. In the decision, the Fifth Circuit refused to expand the situations under which independent counsel must be offered by rejecting Downhole’s argument that independent counsel must be provided when facts could be developed in the underlying litigation that could be used against the policyholder. Id. at 4. Accordingly, the decision provides guidance that it is not the ability to develop facts that determines when independent counsel must be provided, but the need to adjudicate them as part of the liability case. The decision also confirms that it is improper to assume that counsel provided under a reservation of rights will not fulfill its duties to its client, the insured. Specifically, the court stated that Texas law has never 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.” Id. at 4. While based on Texas law, the Fifth Circuit’s reasoning in Downhole is applicable to the general standards for when and why independent counsel must be provided where an insurer defends under a reservation of rights due to potential coverage exclusions.