Generally, insurance contracts will include a “duty to defend”, which gives an insurer both the right and obligation to defend a policyholder against lawsuits. To determine whether this duty exists, Texas courts use the “eight-corners rule”. This rule limits courts to the terms of the policy and the pleadings against the insured when deciding whether an insurer must defend a policyholder. A recent Texas Supreme Court decision has created an exception to this rule, which allows evidence extrinsic to the policy or pleadings in cases where the insured and a third party have colluded in order to manufacture coverage.
This exception was created in Loya Ins. Co. v. Avalos, ___ Tex. ___ slip op. (May 1, 2020) (avail. at https://cases.justia.com/texas/supreme-court/2020-18-0837.pdf?ts=1588341898/). Avalos dealt with two main issues: (1) whether courts may consider extrinsic evidence suggesting collusion when determining the existence of a duty to defend, and (2) whether an insurer needs to pursue a declaratory judgment action to determine the non-existence of a duty to defend before terminating the policyholder’s defense.
Avalos involved a wife with insurance coverage and a husband who was excluded from that coverage. While moving the wife’s car, the husband got in an accident with Avalos. To ensure coverage, the parties to the accident colluded, and claimed that the wife was driving the car when the accident occurred. Avalos sued the wife, and the insurer provided an attorney to defend her. After the collusion was revealed, the insurer denied both a defense and coverage. The trial court granted summary judgment in favor of Avalos against the wife, and the wife assigned her rights against her insurer to Avalos.
That brings us to this suit, where Avalos alleged that the denial of defense and coverage “was negligent, breached the insurance contract, breached the duty of good faith and fair dealing, and violated the Texas Deceptive Trade Practices-Consumer Protection Act (DTPA).” The insurer brought a declaratory judgment that it owed neither coverage nor a defense, because the husband was excluded from the policy. The insurer deposed the wife, who admitted that her husband was driving at the time of the accident. The insurer used this deposition as evidence in their motion for summary judgment, which was granted by the trial court. Avalos appealed, arguing that summary judgment was improper because the deposition was outside of the pleading and the insurance policy, and thus was excluded under the eight-corners rule. The court of appeals reluctantly agreed that nothing within the eight-corners rule supported summary judgment and reversed.
The Texas Supreme Court analyzed the history of the eight-corners rule. The court reiterated that, generally, “only the four corners of the policy and the four corners of the petition against the insured are relevant in deciding whether the duty [to defend] applies.” Past precedence tells us that the eight-corners rule excludes extrinsic evidence from any party. And the duty to defend exists regardless of whether the third party’s allegations are “groundless, false, or fraudulent.” The court pointed out that no exception has been recognized, but that the possibility of an exception has been left open in the case law.
Now, that exception has been carved out. Earlier cases rejected a broad “true-facts exception” to the eight corners rule, which would have allowed extrinsic evidence to prevent fraud by a third party, who lies about the facts surrounding a conflict to get it under coverage. See GuideOne Elite Ins. Co. v. Fielder Rd. Baptist Church, 197 S.W.3d 305 (Tex. 2006). The court worried that the exception would lead to adversarial action between the insurer and the policyholder, when both should be working together. Thus, the exception was rejected in GuideOne because the record did “not suggest collusion or the existence of a pervasive problem in Texas with fraudulent allegations designed solely to create a duty to defend.” This reasoning left open the possibility for a narrower collusion exception, which we see articulated in Avalos.
The court reasoned that the collusion present in Avalos was conclusively proven, and that no factual dispute existed over whether the parties had worked together to create coverage. Notably, any evidence in the record indicating that there was a factual dispute over who the driver was would have made summary judgment inappropriate. But contrary to that, we had a deposition admitting not only that the husband was driving, but that the parties had colluded in order to have the accident covered. When the policyholder pays for a contract, they in part pay for the duty to defend, even against fraudulent claims from a third party. But they have not paid for a defense against fraudulent allegations by the policyholder themselves, and the insurer has not agreed to provide such a defense. Thus, the Texas Supreme Court held that “an insurer owes no duty to defend when there is conclusive evidence that groundless, false, or fraudulent claims against the insured have been manipulated by the insured’s own hands in order to secure a defense and coverage where they would not otherwise exist.”
Next, the court looked at whether the insurer could terminate its defense of the policyholder without a declaratory judgment action. The Texas Supreme Court believed such an action to be unnecessary in cases where there is undisputed evidence of fraud, for two reasons. First, the case law says that declaratory judgment actions can be pursued only “if a justiciable controversy exists.” If the evidence is undisputed, there is no controversy. Requiring the action would waste judicial resources and subject the parties to unnecessary expense. This would directly contradict the goal of a declarative judgment action, which is supposed to be for the prompt resolution of disputes.
Second, the Texas Supreme Court recognized that there are many statutory provisions which create a cause of action for insurers who incorrectly withdraw a policyholder’s defense. An improper withdrawal could subject the insurer to chapter 541 of the insurance code for unfair or deceptive acts or practices, or an action under chapter 542 for wrongfully refusing to promptly pay a defense benefit. The DTPA also can provide relief, which was alleged to be violated in this case. The court believed that these consequences were enough to deter insurance companies from terminating representation when a dispute over the evidence exists, and therefore decided that a declaratory judgment action was not necessary before withdrawing from defending a policyholder. The court still suggests that insurers seek such an action, to protect themselves from liability.
Thus, Avalos allows for a limited exception to the eight-corners rule, permitting extrinsic evidence in cases where collusion between the policyholder and a third party exists. This is the first exception to the eight-corners rule that this court has created, but the potential for this exception has existed in the case law for some time. Avalos also raised a collateral estoppel argument on appeal, arguing that this case sought to relitigate facts already decided in the earlier case against the wife, but this argument was not preserved for review. This means that there is a potential defense that has yet to be litigated, found under footnote 3 of the case. Finally, if the evidence of collusion is undisputed, the insurer can withdraw immediately, without filing an action for declaratory judgment.
If you or your business have been denied a defense by your insurer, contact our lawyers today. We are here to help!