The Pitfalls of Rejecting a Defense Under Texas ‘Same Facts’ Test

Texas law recognizes that an insurer’s reservation of rights can create a potential conflict of interest. (Northern County Mut. Ins. Co. v. Davalos, 140 S.W.3d 685 (Tex. 2004)).

Although there is a potential for conflict in this situation, the assertion of the reservation of rights alone does not create a conflict between the insured and insurer; it only creates the possibility that such a conflict may arise in the future. (Unauthorized Practice of Law Committee v. American Home Assur. Co., Inc., 61 S.W.3d 24, 40 (Tex. 2008))

Under Texas law, the test to apply in determining whether a conflict of interest exists, permitting the selection of independent counsel by the insured is whether the facts to be adjudicated in the underlying lawsuit are the same facts upon which coverage depends. (Davalos).

Graper v. Mid-Continent

A recent decision from the United States Fifth Circuit Court of Appeals interpreting Texas law demonstrates that if an insured is going to refuse a defense offered by the insurance company under a reservation of rights, that decision should be made carefully and could result in the insured being unable to pursue reimbursement for independent counsel expenses.

In Graper v. Mid-Continent Cas. Co., 756 F.3d 388 (5th Cir. 2014), the court found that the mere assertion of a reservation of rights by the insurer did not require the appointment of independent counsel. The court found that the insureds had unreasonably refused the insurer’s offer of a reservation of rights defense when it concluded that there was no disqualifying conflict of interest. As a result, the insureds were obligated to pay their own independent counsel for the defense costs that were incurred.

In Graper, the insureds argued that a disqualifying conflict of interest arose between the insureds and Mid-Continent, entitling them to their choice of counsel at Mid-Continent’s expense. Mid-Continent had offered a reservation of rights defense to the insured. The reservation of rights raised two potential bases for excluding coverage: (1) that the injury might not have occurred during policy coverage dates and (2) that the infringing conduct in question may have been intentional or willful.

The court began its analysis by acknowledging that if the duty to defend arises, liability insurance policies grant to the insurer the complete, absolute control over the defense. (Unauthorized Practice of Law Committee v. American Home Assur. Co.)

The right to defend the insured included the right to select counsel to defend the lawsuit. In situations where the insurer acknowledges that it has a duty to defend the insured but still questions whether it has a duty to indemnify, insurers would usually issue a reservation of rights letter to the insured accepting the defense under reservation. “Therein reside the seeds of a conflict of interest. Even though the insurer’s chosen counsel owes a duty of unqualified loyalty to its insured, that duty can be threatened where the insured’s interests contrast sharply with those of the insurer.” (State Farm Mut. Auto. Ins. Co. v. Traver, 980 S.W.2d 625, 628 (Tex. 1998))

Where a conflict of interest actually exists, the insured can reject the limited representation under Texas law and hire its own lawyer while looking to the insurance company for the payment of the attorney’s fees. (Britt v. Cambridge Mut. Fire Ins. Co., 717 S.W.2d 476, 481 (Tex. App.-San Antonio 1986))

The question before the Fifth Circuit was: When will a conflict of interest under Texas law entitle the insured to select its own counsel?

The court held that the “same facts” standard under Texas law controlled the analysis. In doing so, the court rejected the insureds’ argument that the “same facts” rule was not a strict rule but was a flexible rule that permitted a disqualifying conflict of interest to arise when insurer-hired attorneys may be tempted to develop facts or legal strategy that ultimately could support the insurer’s coverage position. The court expressly rejected that argument and reaffirmed that the “same facts” standard controlled the conflict of interest analysis.

The circumstances giving rise to the underlying dispute were that Kipp Flores Architects (KFA) sued the insureds for using KFA copyrighted designs when constructing homes and used those same designs for promotional materials, seeking damages pursuant to the Copyright Act of 1976.

Mid-Continent reserved the right to deny coverage as the insured’s alleged acts of infringement occurred outside the policy term period. In addition, the insureds were defending the copyright claims on grounds that the claims “accrued” outside the applicable time provided by the statute.

The insureds argued that the timing related to coverage of the claims and the timing relating to the accrual of the claims ran on the same factual track which created a disqualifiable conflict because the adjudication of many of the same facts would determine both the insureds’ liability and the insureds’ coverage.

The court rejected this argument upon the facts. The claimants in the underlying litigation brought claims under the copyright act. In litigating the insureds’ statute of limitation defense, the insurer’s chosen counsel would only needed to have adjudicated the fact of when the claim accrued, not the fact of when the facts of infringement occurred. (Makedwde Pub. Co. v. Johnson, 37 F.3d 180, 181 (5th Cir. 1994))

Under the law, a claim accrues once the plaintiff knows or has reason to know of the injury upon which the claim is based. (Jordan v. Sony BMG Music Entm’t Inc., 354 Fed.Appx. 942, 945 (5th Cir. 2009))

The concepts of occurrence and accrual were two different concepts. Occurrence determined the date of the actual injury and accrual determined the date of the discovery of the injury.

The court in Graper found that the only common fact between the timing of the two determinations is that the occurrence inevitably occurred before the discovery. Although the adjudication of the date when the claimant discovered the injury would signal, in subsequent litigation, that the infringing conduct occurred before the date of discovery, that determination would only be a general finding, and would lack the specificity necessary to decide whether the claim was covered under the insureds’ policy.

The court also noted that an adjudication of the accrual date (the fact to be adjudicated in the underlying lawsuit) did not need to be a judicial ruling necessarily deciding the date of when the infringing conduct occurred (the fact upon which coverage depended). Therefore, under the “same facts” test, there was no disqualifiable conflict of interest between the insureds and the insurer in litigation the statute of limitations defense.

The insureds also argued that a separate “same fact” creating a disqualifying conflict involved the willfulness of the insureds’ conduct. The question of the insureds’ willfulness arose under the policy exclusion for knowing conduct that violated the rights of another. The insureds argued that because willfulness necessarily encompassed knowing conduct, the underlying court would, in deciding willfulness, necessarily adjudicate whether the infringement was knowing and thereby determine an issue of coverage under the policy. The court rejected this argument as well.

The Graper court found that the exclusionary provision in the insurer’s policy extended only to knowing violations of the rights of another. A finding of willfulness in the underlying lawsuit would not adjudicate the fact of whether the infringement was knowing because a finding of willfulness under the copyright act did not require proof of knowing conduct. Therefore, a finding of willful conduct under the copyright act would not be the equivalent to a finding of knowing conduct necessary to settle the issue of whether the policy’s exclusion applied.

Additionally, the Graper court found that a broad interpretation of the copyright act required a finding that willful encompassed more than just knowing infringements and would include reckless infringements as well. The Graper court concluded that the insureds were not entitled to reimbursement of its attorney’s fees for hiring its own independent counsel.

The Graper case demonstrates that insureds should be careful in rejecting the opportunity to have the insurance company defend the insured even under a reservation of rights. At least under Texas law, the mere assertion of a reservation of rights did not create an immediate disqualifying conflict of interest. The allegations asserted against the insured, together with the actual facts to be proved needed to be carefully juxtaposed to the policy restrictions or exclusions upon which the reservation was based to determine if the proof involved the “same facts.”