On May 1, 2020, the Texas Supreme Court recognized its first exception to the eight-corners rule regarding an insurer’s duty to defend.  Given the significant interplay between insurance and many types of construction related disputes, the exception is noteworthy, even if narrow in its application.

1.    What is the eight-corners rule?

One of an insurance company’s primary duties towards an insured is a duty to defend the insured against claims or suits seeking damages covered by the insurance policy.  For instance, an insurance company that issues a commercial general liability policy to a general contractor may have a duty to hire and pay an attorney to defend the contractor against a lawsuit that alleges a subcontractor installed defective or non-conforming work that resulted in property damage.  

To determine whether an insurance company’s duty to defend is triggered, the Texas Supreme Court has used the so-called eight-corners rule.  Under this rule, the insurance company may only look at the insurance policy (if printed out, the first set of four corners) and the complaint or petition (again, if printed out, the second set of four corners) when determining whether it owes a defense to its insured.  

The flip side of the eight-corners rule is that when making that determination, an insurance company may not consider “extrinsic evidence”, that is evidence outside the eight-corners that contradicts the allegations in the complaint or petition.  Following that concept to its logical conclusion, Texas courts have repeatedly held that an insurance company owes a duty to defend even if the person suing the insured makes fraudulent, false or groundless allegations. 

2.    The exception to the rule

In Loya Insurance Company v. Avalos, the Texas Supreme Court recognized its first ever exception to the eight-corners rule, the “collusive fraud” exception.  Under this exception, “an insurance company 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.”  

The facts of Avalos are relatively straightforward, if not egregious.  Loya Insurance Company (Loya) issued an automobile policy to Guevara that specially excluded coverage for her husband, Flores.  While moving Guevara’s car, Flores collided with another car carrying Avalos and Hurtado (collectively, the Hurtados).  The Hurtados, Guevara and Flores all agreed to tell the responding police officer and Loya that Guevara was driving the car at the time of the accident.

The Hurtados later sued Guevara.  Guevara sought coverage from Loya; Loya assigned defense counsel.  Early in the discovery process, Guevara disclosed that Flores was driving the car at the time of the accident.  Guevara’s defense counsel cancelled Guevara’s deposition and Loya, without filing a declaratory judgment action, denied defense and coverage under the insurance policy.  On motion for summary judgment, the trial court rendered judgment for the Hurtados and against Guevara for slightly more than $450,000.  

Guevara assigned her claims against Loya to the Hurtados, who pursued the usual litany of “bad faith” claims against Loya.  The bad faith lawsuit and Loya’s counterclaims for breach of contract and fraud are the dispute that the Texas Supreme Court ultimately considered.

In the bad faith lawsuit, Guevara was deposed, recanted her earlier statement, and testified that Flores was driving the car at the time of accident.  The Hurtados argued that the deposition testimony was extrinsic evidence that Loya could not consider under the eight-corners rule.  Instead, the Hurtados argued that Loya’s determination of whether to defend was confined to the petition, which made no mention of Flores driving the car, and the insurance policy. 

The Texas Supreme Court, in carving out the collusive fraud exception to the eight-corners rule noted that at the trial court level, Loya had conclusively proven that (1) Flores, an excluded driver under the insurance policy, was driving the car, and (2) Guevara and the Hurtados conspired to lie about who was driving the car to trigger insurance coverage.  This was sufficient for Loya to use extrinsic evidence to deny a defense to its insured, Guevara.  

As an important aside, the Court also held that Loya was not obligated to file a declaratory judgment action against Guevara prior to withdrawing its defense.  Since the evidence conclusively showed Guevara lied to secure insurance coverage, the Court reasoned that requiring Loya to file a declaratory judgment action prior to withdrawing its defense would have “undermined its ability to make prompt determinations of its coverage and defense obligations—an important benefit of the eight-corners rule.”  Nonetheless, the Court “encouraged” insurance companies to seek a declaratory judgment before withdrawing a defense in cases where a real controversy exists regarding the duty to defend.

3.    Broader Implications

Although Avalos deals with a relatively simple two-party car accident, it has broader application to complex, multi-party construction litigation in the COVID-19 era.  During severe downturns in the economy and the beginning stages of recovery, some contractors and subcontractors go out of business, either by formally filing for bankruptcy or by informally shutting off the lights and locking the doors.  In those instances, the only available asset may be a commercial liability policy.  However, those policies have numerous exclusions to coverage and an improperly pleaded lawsuit may result in the insurance company denying coverage.  

Claimants looking for compensation and contractors with seemingly nothing to lose may be tempted to work together to creatively spin facts that trigger the insurance company’s duty to defend.  As defense costs are very large in multi-party litigation, triggering the duty to defend provides a claimant with leverage against the insurance company to settle claims of even questionable liability.  Depending on the degree of the claimant’s and contractor’s collaboration and the extent of their interpretive spin of the facts, the contractor may find itself without any coverage due the application of the collusive fraud exception to the eight-corners rule.

Whether a particular set of facts falls within the newly recognized collusive fraud exception to the eight-corners rule is a decision fraught with significant legal consequences.  As such, you should consult with qualified coverage counsel in determining whether the exception applies.  The attorneys in our Austin and Dallas offices are available to answer any questions you may have and to provide referrals, as necessary, to qualified construction coverage counsel.   

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