Houston, Texas (May 4, 2020) - On May 1, 2020, the Texas Supreme Court adopted an exception to the State's eight-corners rule, a vital tenet of Texas insurance law that governs the determination of an insurer's duty to defend. First applied in 1956, the rule states that an insurer's duty is determined solely by the allegations in the petition and the policy language, with extrinsic evidence generally not permitted. However, following the Texas Supreme Court's decision in Loya Insurance Company v. Avalos, courts in the Lone Star State may now consider evidence regarding collusive fraud between an insured and third-party to secure coverage where it does not exist. Importantly, the insured must be a participant in the fraud. Fraudulent claims by third-parties that do not involve fraud on the part of the insured are not within the scope of this new exception.

This matter arose out of an insurance policy sold by Loya Insurance Company (Loya) to Karla Guevara, wherein her husband Rodolfo Flores was expressly excluded from coverage. When Flores collided with Osbaldo Hurtado Avalos and Antonio Hurtado (the Hurtados), all three agreed to tell the responding police officer and Loya that Guevara was driving the vehicle rather than Flores. When the Hurtados sued Guevara, Loya appointed an attorney to defend her in the suit.

During discovery, Guevara disclosed the lie to her attorney and identified Flores as the true driver. Loya subsequently withdrew the defense and denied coverage. The Hurtados obtained summary judgment and an award of $450,343.34. Guevara assigned her rights against Loya to the Hurtados, who sued Loya for breach of the insurance contract, breach of the duty of good faith and fair dealing, and violations of the Texas Insurance Code and DTPA. Loya brought counterclaims for fraud and breach a contract, and a declaratory judgment that it owed no duties under its policy. Loya deposed Guevara in the litigation, and she recanted her initial statement that she, rather than Flores, was driving.

The trial court granted summary judgment for Loya, noting that the Hurtados were asking the court to "help perpetuate a fraud." The Hurtados appealed, arguing that Loya had a duty to defend based on the eight-corners rule because the petition at issue alleged Guevara was the driver of the vehicle. The court of appeals reversed the trial court's judgment in favor of Loya, strictly adhering to the eight-corners rule.

In its Loya opinion, the Texas Supreme Court noted it has never expressly recognized an exception to the eight-corners rule, though it has "left open the question whether to do so in an appropriate case." To that end, the high court has twice mentioned collusive fraud as a potential exception. See GuideOne Elite Ins. Co. v. Fielder Rd. Baptist Church, 197 S.W.3d 305, 311 (Tex. 2006); Pine Oak Builders, Inc. v. Great Am. Lloyds Ins. Co., 279 S.W.3d 650, 654 n.23 (Tex. 2009).

Following its earlier inclinations, the court in Loya held the eight-corners rule "does not bar courts from considering extrinsic evidence regarding collusive fraud by the insured in determining the insured's duty to defend." Going even further, the high court held that an insurer faced with undisputed evidence of collusive fraud "should not be required to pursue a declaratory judgment action before withdrawing its defense...." The justification for this holding was two-fold: (1) requiring a declaratory judgment would subject the parties to unnecessary time and expense and waste judicial resources, and (2) the fact that an insurer withdrawing a defense can be held liable for substantial damages and attorneys' fees is sufficient to discourage insurers from doing so "only in clear-cut cases."

The Loya case marks the first time the Texas Supreme Court has expressly recognized and outlined an exception to the eight-corners rule. Indeed, though the year is young, 2020 has been a busy year for high-profile eight-corners decisions, with the Texas Supreme Court already declining to find a policy language exception in Richards v. State Farm Lloyds back in March. In that case, the court declined to hold that the eight-corners rule is triggered by and/or conditioned upon policy language requiring an insurer to defend any suit "even if the allegations of the suit are groundless, false, or fraudulent."

Many insurers have encountered instances of collusion between the insured and third-party plaintiffs to plead into coverage, and this exception has been long discussed and awaited, especially since the court's first allusion to it in 2006 in the GuideOne case. It remains to be seen how the body of case law will develop around this exception, including what constitutes undisputed evidence of collusive fraud and how far the insured has to go to be engaged in collusive fraud. The line between artful pleadings at the suggestion of the insured and actual collusive fraud may be blurry in some instances, and will certainly provide for interesting coverage litigation in the future.

For more information on this decision, contact the author of this alert. You can find additional alerts on our Insurance Law Practice page.

Originally published 4th May 2020.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.