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The Texas Supreme Court this year reviewed the 2002 Corpus Christi Court of Appeals decision in Northern County Mutual Insurance Co. v. Davalos, 84 S.W.3d 314 (Tex. App. – Corpus Christi 2002), rev’d, 140 S.W.3d 685 (Tex. 2004) and confronted the issue of the unqualified defense that is owed to an insured. The Davalos decision from the court of appeals relied in part on State Farm Mutual Automobile Insurance Co. v. Traver, 980 S.W.2d 625 (Tex. 1998), which found that even though an insurer hires an attorney to represent its insured and has a certain amount of control over the defense, the insurer does not control the defense to the extent that it should be held vicariously liable for that attorney’s malpractice. The Supreme Court used Davalos to better define the limited circumstances in which a conflict arises during an insurer’s defense of the insured.

Northern County Mutual Insurance Co. v. Davalos

In Davalos, the Corpus Christi court of appeals found that the insurer (Northern) breached its contractual duty to defend the insured (Davalos). Davalos hired independent counsel to defend him, and filed a motion to transfer venue to a court closer to his home. Northern insisted that the insured withdraw its motion to transfer venue and allow the insurer’s choice of counsel to represent him. However, the court noted that in Texas, an insurer only has four options when faced with the dilemma of whether or not to defend a claim: 1) completely decline to assume the insured’s defense; 2) seek a declaratory judgment as to its obligations and rights; 3) defend under a reservation of rights or a non-waiver agreement; or 4) assume the insured’s unqualified defense. See Farmers Tex. County Mut. Ins. Co. v. Wilkinson, 602 S.W.2d 520, 522 (Tex. Civ. App. – Austin 1980 writ ref’d n.r.e). Northern did not refuse to defend, it did not bring a declaratory judgment action, and it did not defend under a reservation of rights. Rather, Northern suggested to Davalos that it would take the position that the claim would not be covered if he failed to substitute Northern’s counsel for his own and refused to allow the lawsuit to remain in the county of Northern’s choice.

Quoting Traver, the Davalos appellate court found that a conflict of interest existed between the insurer and the insured. Under the rule enunciated in Traver, because of the conflict of interest between the parties, Northern forfeited its control of the defense and the choice to settle. Thus, by attempting to control the defense of the case when there was a conflict of interest, Northern breached its contractual duty to defend the insured.

The Texas Supreme Court reversed the court of appeals, finding that the disagreement over venue was an insufficient reason to take the contractual right to conduct the defense away from the insurer. See N. County Mut. Ins. Co. v. Davalos, 140 S.W.3d 685 (Tex. 2004). The Supreme Court went on to discuss in dicta the situations in which a disagreement over the defense results in a conflict of interest. The court explained that its opinion in Traver did not mean that every disagreement about how the defense should be conducted amounted to a conflict of interest. If it did, the insured, not the insurer, could control the defense by merely disagreeing with the insurer’s proposed actions. Rather, the court indicated that a disqualifying conflict may result when a coverage dispute arises, or (1) when the defense tendered is not a complete defense when under the circumstances it should have been, (2) 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, (3) when the defense would not, under the governing law, satisfy the insurer’s duty to defend, or (4) when though the defense is otherwise proper, the insurer attempts to obtain some type of concession from the insured before it will defend.

While Davalos is a positive decision for insurers, the Supreme Court did state in Davalos that a reservation of rights letter creates a potential conflict of interest, and that “when the facts to be adjudicated in the liability lawsuit are the same facts upon which coverage depends, the conflict of interest will prevent the insurer from conducting the defense.” See Davalos, 140 S.W.3d at 689 (citing Allan D. Windt, Insurance Claims and Disputes § 4.20 at 369 (4th ed. 2001)). Even so, the Supreme Court rejected the idea that Northern’s actions in threatening to withdraw its defense deprived Davalos of an unqualified defense. The court explained that the insurer’s actions did not deprive Davalos of his defense attorney’s independent counsel on any issue, and it suggested that a strategic decision such as a venue decision may never amount to a disqualifying conflict of interest. According to the court, only a disagreement which will impact “the insured’s legitimate interests under the policy” will constitute a conflict of interest.

Traver and Davalos and the Unqualified Defense

It now seems that under Davalos, a conflict of interest may only exist when a reservation of rights is issued and the defense of the underlying case could be directed toward non-covered claims. Traver and Davalos are both positive decisions for insurers, in that insurers may now make most decisions on behalf of the insured without being concerned with having compromised the insured’s right to an unqualified defense. At the same time, insurers will not be held vicariously liable for improper acts committed by the attorney it hires for the insured.

While this is true, the counter-argument is that Davalos always allows the insured to select defense counsel. For example, in the recent case of Housing Authority of the City of Dallas v. Northland Insurance Co., 333 F.Supp.2d 595 (N.D. Tex 2004), the court granted summary judgment for the insured after the insurer reserved its right to disclaim coverage on, among other things, a willful violation of a statute. Dallas Housing Authority held that under Davalos, the insured had a right to select its own defense counsel, because the insurer agreed to defend under a reservation of rights and “the facts to be adjudicated in the liability lawsuit [were] the same facts upon which coverage depend[ed].” The plaintiff in the underlying lawsuit alleged willful acts of employment discrimination, and the court found that the facts to be decided in the underlying lawsuit were the same facts upon which coverage depended. Under the Dallas Housing Authority opinion, the insured will always be permitted to select defense counsel when the insurer agrees to defend under a reservation of rights.

The Davalos court did not intend for every defense under a reservation of rights to result in a disqualifying conflict of interest that will automatically result in the insured’s right to select defense counsel and control the defense. Rather, Davalos held, and other courts should hold in the future, that a reservation of rights letter creates a potential conflict of interest, and that the insured’s legitimate interests under the policy must be impacted for an actual conflict to arise.

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Stephanie S. Rojo

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