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Does a Policyholder Have a Right to Select Independent Counsel To Represent It When the Insurance Company Reserves Its Rights?

Dear Insured

Most liability insurance policies – whether they be commercial general liability, business owners, errors and omissions, homeowners or auto – require the insurance company to defend the policyholder against lawsuits where the plaintiff is seeking damages potentially covered by the insurance policy.

When the lawsuit gets filed, and the policyholder is served with suit papers, the policyholder is required to tender those suit papers to the insurance company and request a defense if it desires one.  When the insurance company receives such a request, it will often agree to provide the policyholder with a defense to the lawsuit through the attorney it hires (often referred to as panel counsel) while at the same time “reserving its rights.”  The insurance company can reserve its rights for a number of reasons, but it is usually because the insurance company has determined that one or more of the claims asserted in the lawsuit may not be covered by the insurance policy.  What the insurance company is actually doing is preserving its right to ultimately deny any responsibility to pay any judgment or settlement for damages that are not covered by the policy.

      As a lawyer who has practiced in the insurance arena for many years, I am often asked by policyholders whether they are required to accept the panel counsel offered by the insurance company that is reserving its rights. The answer I give is one that you will often hear lawyers give in a variety of circumstances:  it depends.  You see, when an insurer provides a defense under a reservation of rights, it creates a potential conflict of interest.  The potential conflict arises from the fact that the attorney hired to defend the policyholder owes an unqualified duty of loyalty to the policyholder, yet is getting his fees paid by the insurance company.  Consequently, the existence of this potential conflict will sometimes prevent the insurance company from providing a defense through its panel counsel and will give the policyholder the right to select its own attorney to defend it in the lawsuit, with the insurance company to pick up the tab.

            The Texas Supreme Court explained when such a right arises in a case called Northern County Mutual Ins. Co. v. Davalos, 140 S.W.3d 685 (Tex. 2004):

In the typical coverage dispute, an insurer will issue a reservation of rights letter, which creates a potential conflict of interest. And 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.

            In a subsequent case, the U.S. 5th Circuit Court of Appeals clarified what it believed the Supreme Court meant when it used the words “facts to be adjudicated.”  See Downhole Navigator, LLC v. Nautilus Ins. Co., 686 F.3d 325 (5th Cir. 2012). The Court held that the term “adjudicate” plainly means “to rule upon judicially.”  Accordingly,  a policyholder will have the right to select independent counsel to represent it in a lawsuit – at the insurance company’s expense – when the court or jury in the underlying suit will be required to decide the same facts upon which coverage depends.

            When might this occur? The court in Downhole Navigator provided a few examples. One is where the lawsuit alleges intentional wrongdoing and the policy contains an exclusion for intentional conduct.  Another example is where the underlying lawsuit raises a claim for breach of contract, and the insurer reserves the right to deny coverage based upon a breach of contact exclusion in the policy. Yet another example is where the insurer reserves the right deny coverage for damages taking place outside the contract period and the underlying lawsuit involves the issue of when damages took place. These were just some of the examples provided by the court in Downhill Navigator; there obviously may be others depending on the terms of the particular policy at issue and the factual allegations of the particular lawsuit.

            The right to select independent counsel can be a valuable right, especially when the policyholder already has competent counsel which it knows and trusts.  Therefore, whenever a policyholder is sued and the insurance company offers a defense to the lawsuit under a reservation of rights, it behooves the policyholder to carefully analyze whether it might be entitled to select independent counsel to represent it due to the existence of the potential conflict.  Case law in this area demonstrates that it is not always easy to determine whether the same facts to be adjudicated in the liability suit are the same facts upon which coverage hinges.  Consequently, it is always best to have an attorney well-versed in insurance matters conduct this analysis.