We explained in recent blogs that, thus far into 2020, the Supreme Court of Texas had already addressed in two separate opinions the issue of whether an exception to the eight-corners rule exists in evaluating the duty to defend.

Particularly, on March 20, 2020, the Supreme Court issued its opinion in Richards v. State Farm Lloyds (“Richards”), rejecting arguments that the eight-corners rule did not apply to insurance policies that did not include an obligation to defend claims even if they were “groundless, false or fraudulent”—i.e., a “policy language” exception to the rule.[1] For the full details and commentary of the Richards opinion, please see the following link. Then, on May 1, 2020, in Loya Insurance Company v. Avalos (“Avalos”), the Supreme Court of Texas recognized a very narrow “collusive fraud” exception—the first time the Court ever adopted an exception to the rule.[2] In that case, the Court stated that an insurer can rely on extrinsic evidence if 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.”[3] For an analysis of the Avalos opinion, please see the following link.

For many years prior to the foregoing, the Supreme Court of Texas was presented with opportunities to adopt an exception to the eight-corners rule in evaluating the duty to defend. For instance, in its 2006 opinion in GuideOne Elite Insurance Co. v. Fielder Road Baptist Church, the Court recognized the existence of an exception that had been employed by other courts in certain limited circumstances.[4] The Court, citing to the Fifth Circuit’s opinion in Northfield Ins. Co. v. Loving Home Care, Inc., explained that other courts “have drawn a very narrow exception, permitting the use of extrinsic evidence only when relevant to an independent and discrete coverage issue, not touching on the merits of the underlying third-party claim,” and only “when it is initially impossible to discern whether coverage is potentially implicated and when the extrinsic evidence goes solely to a fundamental issue of coverage which does not overlap with the merits of or engage the truth or falsity of any facts alleged in the underlying case."[5] This became known and referred to colloquially as the “Northfield Exception.”

On May 12, 2020, the U.S. District Court for the Northern District of Texas issued an opinion in National Liability & Fire Insurance Company v. Young, in which it evaluated Richards, Avalos, and the Northfield Exception, all in one.[6] There, the court declined to allow an insurer to rely on extrinsic evidence in evaluating its duty to defend.

In the case, John Young d/b/a Rio Restaurant (“Young”) was insured under a business auto policy issued by National Liability & Fire Insurance Company (“National Liability”).[7] The policy provided liability coverage for any “auto” that the insured “do[es] not own while used with the permission of its owner as a temporary substitute for a covered ‘auto’ you own that is out of service because of its: a. Breakdown; b. Repair; c. Servicing; d. ‘Loss’; or e. Destruction.”[8] The insuring agreement of the policy stated that National Liability would cover all sums that the insured “legally must pay as damages because of ‘bodily injury’ or ‘property damage’ to which this insurance applies,” and that National Liability has “the right and duty to defend any ‘insured’ against a ‘suit’ asking for such damages . . . .”[9]

On February 6, 2019, Gustina Penna (“Penna”) was operating a vehicle rented from Enterprise Rent-A-Car to Young when she was involved in a collision with Rogelio Castellanos. Mr. Castellanos suffered fatal injuries from the collision.[10] A state court lawsuit was filed against Young, Penna, and another entity where Plaintiffs sought damages for negligence and gross negligence arising from the collision.[11]

National Liability subsequently filed a declaratory judgment action in federal court, seeking a judgment that it had no duty to defend or indemnify the defendants in the underlying state-court lawsuit.[12] National Liability conceded that the First Amended Petition in the underlying lawsuit “specifically alleges the vehicle operated at the time of the incident in question was rented temporarily to . . . Young . . . and was being used temporarily as a substitute for one of his permanent vehicles that was being repaired or serviced at the time of the incident.”[13] Additionally, there were allegations that Young gave Penna permission to use the vehicle and that she was operating it in connection with her employment by Young’s business. Based on this, the court stated:

Application of the eight-corners rule to this case is therefore straightforward. The First Amended Petition alleges that the vehicle Penna was driving at the time of the accident was a temporary substitute auto within the meaning of the insurance policy. National Liability has not identified any applicable exclusion within the policy’s text, and the Court has not located any such exception. Thus, the First Amended Petition implicates the policy’s coverage.[14]

Nevertheless, National Liability argued that the rented vehicle that Penna drove at the time of the accident was not covered under the terms of the policy because Young rented the vehicle continuously between August 2018 and February 2019 and because “none of [the insured’s] Specifically Described ‘Autos’ under the Policy were being repaired.”[15]

In asserting that it was allowed to resort to this extrinsic evidence in assessing the duty to defend, National Liability relied “heavily” on the “policy language” exception that had been proposed by the district court in State Farm Lloyds v. Richards.[16] The court summarily rejected this argument in light of the Supreme Court of Texas’ opinion from Richards: “[T]he omission of a groundless-claims clause from the insurance policy that is at issue here cannot support an exception to the eight-corners rule.”[17]

The court then moved to whether the Northfield Exception would allow National Liability to introduce extrinsic evidence. In support of its position, National Liability asserted “that the issue of whether the vehicle Penna was driving at the time of the accident ‘qualified as a temporary substitute pursuant to the Policy’s terms’ does not ‘overlap with the merits of the Underlying Lawsuit or engage the truth or falsity of any substantive facts bearing upon liability.’”[18] The court disagreed, noting that the “facts demonstrate otherwise,” and that it was possible to discern from the allegations in the First Amended Petition that coverage was implicated because the vehicle was a “temporary substitute for a covered ‘auto.’” As a result, the court found that the Northfield Exception did not apply.[19]

Moreover, the court concluded that the “collusive fraud” exception outlined in Avalos also was inapplicable. The court recognized:

National Liability does not allege that the insured . . . conspired to manipulate a groundless, false, or fraudulent claim against National Liability. Rather, National Liability attacks the alleged ‘gamesmanship of the underlying plaintiffs in amending their original petition after this coverage action was filed.’ [citation omitted]. Moreover, National Liability lacks “conclusive evidence” that any manipulation occurred.[20]

Continuing, the court explained that “[a]rtful pleading, in which National Liability effectively alleges that the plaintiffs in the underlying lawsuit engaged, does not give rise to an exception to the eight-corners rule.”[21] Rather, if an insurer knows that the allegations in the underlying pleading are untrue, the insurer has a “duty to establish such facts in defense of its insured, rather than as an adversary in a declaratory judgment action.”[22]

The court then recognized that the insured had not moved for summary judgment. Because there were no genuine issues of material fact on the duty to defend, the court notified National Liability that it had thirty days to provide a response as to why the court should not enter judgment as a matter of law that National Liability has a duty to defend.[23] Additionally, the court denied National Liability’s motion for summary judgment on the duty to indemnify as premature, given that the underlying lawsuit was still ongoing.[24]

COMMENTARY

The Northern District case is, to our knowledge, the first case to address Richards, Avalos, and the Northfield Exception. In doing so, the Northern District correctly recognized that the eight-corners rule remains alive and well and that the use of extrinsic evidence applies only in a narrow set of circumstances.

We explained in our last blog that, while Avalos and the “collusive fraud” exception presented interesting developments in the coverage world, the ruling should not be much of a surprise, especially when evaluated under the facts and circumstances of the case. The very narrow exception to the eight-corners rule carved out in that case requires conclusive proof of collusion and insurance fraud by the insured and the third-party claimant.

The Northern District expressly recognized the significant distinction between circumstances where there is collusive fraud and circumstances where there is “artful” pleading. It may be that many insurers have a difficult time meeting the Avalos standard to show that collusive fraud should allow introduction of extrinsic evidence.

In Richards, the Supreme Court of Texas specifically referred to the Northfield Exception (by name) and outlined the narrow circumstances under which courts have applied it in other cases. The Supreme Court of Texas then, again, declined to express an opinion on the Northfield Exception, noting that it was only addressing the narrow question certified as to whether a “policy language” exception exists. While the Court recognized but expressly declined to analyze the Northfield Exception in Richards, it did not even mention the Northfield Exception in Avalos.

This presents an interesting question: Is the Northfield Exception good law? If so, why did the Court not—at the very least—discuss that rule (much less even mention its existence) in Avalos, which was the first time the Court actually acknowledged that there are circumstances where extrinsic evidence is admissible in analyzing the duty to defend?

The Northern District recognized that, although the Supreme Court of Texas did not address the Northfield Exception in Avalos, that rule remains binding on Texas federal district courts: “Neither Texas case law nor a change in statutory authority has displaced the Fifth Circuit’s Northfield [E]xception.”[25] It appears, if the Northern District case is any indication, that the Northfield Exception will continue to be applied on a narrow basis (at least in federal courts). And, the “collusive fraud” exception will be applied only in extreme cases.

Stay tuned…

Sincerely,

Lee Shidlofsky
Member

Douglas P. Skelley
Member

Rebecca DiMasi
Member

Blake Crawford
Senior Counsel