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Policyholders Receive Needed Guidance on Use of Extrinsic Evidence in Texas When Enforcing an Insurer's Duty to Defend

In Short

The Situation: The Texas Supreme Court in February 2022 adopted a limited exception based upon a three-prong test allowing the use of extrinsic evidence when applying the "eight-corners" rule to determine an insurer's duty to defend third-party claims.

The Result: The U.S. Court of Appeals for the Fifth Circuit recently applied the Texas Supreme Court's ruling, and held that it could not consider extrinsic evidence offered by an insurer to prove that the "occurrence" took place outside of the insurer's policy period. This ruling provided more guidance on when the use of extrinsic evidence outside of the eight-corners of the policy and the governing complaint is permissible.

Looking Ahead: Policyholders should carefully consider whether circumstances exist where the use of extrinsic evidence to determine coverage issues does not overlap with issues relating to the merits of the underlying claim, particularly where an insurer might seek to use such evidence to avoid defense obligations. Also, because the Texas Supreme Court recognized that parties could draft contract language applying different rules governing the duty to defend, policyholders should review their policies carefully to assess whether an insurer has sought to avoid the application of the common-law eight-corners test, and the recently adopted limited exception regarding the use of extrinsic evidence to determine the duty to defend.

The U.S. Court of Appeals for the Fifth Circuit recently applied the newly adopted Texas Supreme Court decision outlining those circumstances in which extrinsic evidence may be used to determine an insurer's duty to defend third-party claims pursuant to the so-called "eight- corners" rule. In Bitco Gen. Ins. Corp. v. Monroe Guar. Ins. Co., 31 F.4th 2022 WL 1090800 (April 12, 2022) ("BITCO"), the Fifth Circuit applied the ruling handed down by the Texas Supreme Court on February 11, 2022. 

Specifically, in BITCO, the Fifth Circuit had certified two questions to the Texas Supreme Court because "the question of extrinsic evidence [was] paramount . . .": (i) whether the Northfield [Ins. Co. v. Loving Home Care, Inc., 363 F.3d 523, 528 (5th Cir. 2004)] exception to the "eight-corners" rule is permissible under Texas law; and (ii) whether the date of occurrence is the type of extrinsic evidence that the court may consider. 

Answering a question that Texas policyholders and insurers have been debating for approximately 20 years, the Texas Supreme Court held that "Texas law permits consideration of extrinsic evidence provided the evidence: (1) goes solely to an issue of coverage and does not overlap with the merits of liability; (2) does not contradict facts alleged in the pleading; and (3) conclusively establishes the coverage fact to be proved." Monroe Guar. Ins. Co. v. BITCO Gen. Ins. Corp., No. 21-0232, 2022 WL 413940, at *7 (Tex. Feb. 11, 2022). Under the "eight-corners rule," a court can generally only compare the four corners of a complaint with the four corners of an insurance policy to determine the insurer's duty to defend. 

The Fifth Circuit's decision adopting and applying the three-prong test will provide more guidance to policyholders who had ongoing questions about the scope of the exception to the eight-corners test following the Texas Supreme Court's decision of February 2022.

In BITCO, a farm owner hired a drilling company, 5D, to drill an irrigation well. He subsequently sued 5D in June 2016, alleging that the company had damaged his property and the aquifer after a drill bit had become stuck beneath the surface of his property. The farm owner's complaint alleged that the drilling company's actions rendered the well "practically useless."  5D sought coverage for the lawsuit from its two insurers, and one, BITCO, agreed to defend. Monroe, the other insurer, denied coverage on the grounds that the damage took place outside of its policy period of October 2015 to October 2016, and that two policy exclusions also applied to bar coverage (the court's rejection of the two asserted exclusions is beyond the scope of this discussion). The underlying suit settled, but Monroe and BITCO continued to litigate their coverage dispute. The U.S. District Court for the Western District of Texas ruled that Monroe also had a duty to defend, and Monroe subsequently appealed.

Monroe argued that it should have been permitted to rely upon extrinsic evidence through the use of a stipulation between the parties stating that 5D's drill bit became stuck in the well "in or around November 2014," almost one year before the inception of its policy. Monroe asserted that this fact would have precluded coverage. BITCO, at 7. The Fifth Circuit recognized that the eight-corners rule, as it existed, would prevent the court from considering the stipulation, which led the Fifth Circuit to certify the two questions listed above. Applying the three-prong test handed down by the Texas Supreme Court, the Fifth Circuit found that "the Texas Supreme Court confirms that we may depart from the strict limitations of the eight-corners rule," and adopted the Texas Supreme Court's holding that that the Fifth Circuit could not consider the stipulation because, although "evidence of the date of an occurrence may be considered if it meets the [three-prong test]," the stipulation "does not pass the test." BITCO, at 8, quoting 2022 WL 413940, at *7. 

The Fifth Circuit found that the stipulation would impermissibly overlap with determining the merits of liability because a dispute as to when property damage occurs also implicated whether property damage occurred on that date. This overlap could force the insured "to confess damages at a particular date to invoke coverage, when its position may very well be that no damage was sustained at all." Id., quoting 2022 WL 413940, at *7. Monroe acknowledged that the Texas Supreme Court's decision foreclosed its argument that it had no duty to defend based on when the damage occurred, and the Fifth Circuit held that the farm owner's pleading sufficiently alleged damage to trigger Monroe's duty to defend. Id.

While policyholders pursuing defense coverage under Texas law were unclear about the scope of the Texas Supreme Court's ruling on the use of extrinsic evidence, the Fifth Circuit's decision in BITCO provides needed guidance that the eight-corners rules remains the primary rule, and that extrinsic evidence cannot be considered where coverage issues overlap with issues relevant to the merits of the underlying claim.

TWO KEY TAKEAWAYS 

  1. While the eight-corners rule remains the primary, and guiding, rule for determining an insurer's duty to defend in Texas, parties may now seek to introduce extrinsic evidence consistent with the newly adopted exception to that rule, especially when the extrinsic evidence conclusively establishes the coverage fact to be proved. 
  2. The Fifth Circuit's ruling provided important guidance to policyholders when insurers ask courts to consider the use of extrinsic evidence to avoid a duty to defend ruling. Policyholders, therefore, should carefully consider whether the offered extrinsic evidence meets all three prongs of the newly adopted test and whether the eight-corners rule alone, without the use of limited extrinsic evidence, is the correct standard to be applied in a duty to defend dispute. 

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