     Case: 11-20469   Document: 00511904997       Page: 1    Date Filed: 06/29/2012




           IN THE UNITED STATES COURT OF APPEALS
                    FOR THE FIFTH CIRCUIT  United States Court of Appeals
                                                    Fifth Circuit

                                                                       FILED
                                                                      June 29, 2012

                                    No. 11-20469                      Lyle W. Cayce
                                                                           Clerk

DOWNHOLE NAVIGATOR, L.L.C.,

                                               Plaintiff–Appellant
v.

NAUTILUS INSURANCE COMPANY,

                                               Defendant–Appellee



                  Appeal from the United States District Court
                       for the Southern District of Texas



Before REAVLEY, PRADO, and OWEN, Circuit Judges.
EDWARD C. PRADO, Circuit Judge:
        Plaintiff–Appellant Downhole Navigator, L.L.C. (“Downhole”) appeals
from the magistrate judge’s grant of partial summary judgment for
Defendant–Appellee Nautilus Insurance Company (“Nautilus”).1 Nautilus (the
insurer) had issued Downhole (the insured) a commercial general liability policy;
after a third party, Sedona Oil and Gas Corporation (“Sedona”), sued Downhole,
Downhole rejected the representation offered by Nautilus under the policy on the
ground that Nautilus’s reservation-of-rights letter had created a conflict of


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         The parties consented to proceed before a magistrate judge for all proceedings,
including entry of final judgment.
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interest. Downhole hired its own independent counsel; when Nautilus refused
to reimburse Downhole for the cost of its independent counsel, Downhole filed
this action, seeking a declaratory judgment that Nautilus had a contractual duty
to defend and indemnify Downhole in the Sedona lawsuit. The magistrate judge
rejected Downhole’s claim, ruling that Nautilus was not required to reimburse
Downhole for the cost of independent counsel. Downhole timely appealed that
ruling. For the reasons stated below, we AFFIRM.
                                        I.
      Downhole services the oil drilling industry. Sedona, an oil well operator,
hired Downhole around November 2008 to help redirect an oil well toward a
better location within a desired reservoir. According to Sedona’s complaint,
Downhole developed the plan to conduct the deviation and participated directly
in the deviation process, but around December 2008, Downhole negligently
executed the deviation plan, causing damage to the well. On March 3, 2009,
Sedona brought a negligence action against Downhole in Texas state court.
      Downhole had a one-year general commercial liability policy with
Nautilus, running from mid-June 2008 to mid-June 2009. Downhole submitted
its notice of claim and indemnification to Nautilus on March 24, 2009. Nautilus
responded on March 30, 2009, and tendered a qualified defense under a
reservation of rights. Nautilus reserved its right to decline indemnity coverage
if, after further investigation, the underlying suit fell under one of three policy
exclusions: (1) the “expected or intended injury” exclusion, which excludes
“‘bodily injury’ or ‘property damage’ expected or intended from the standpoint of
the insured”; (2) the “property damage” exclusion, which excludes certain
“physical injury to tangible property”; (3) the “testing or consulting” exclusion,
which excludes damages arising from “[a]n error, omission, defect, or deficiency
in . . . any test performed or . . . [in] [a]n evaluation, a consultation or advice
given, by or on behalf of any insured.” Additionally, though not referenced in the

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                                  No. 11-20469

letter, two other exclusions are relevant to this case: the “professional liability”
exclusion, which excludes damages arising from “the rendering of or failure to
render any professional services,” including “the preparing, approving, or failing
to prepare or approve . . . opinions, reports, surveys, . . . or drawings and
specifications,” and “supervisory, inspection, architectural or engineering
activities”; the “data processing” exclusion, which excludes damages arising from
“the rendering of, or failure to render, electronic data processing . . . services,
advice or instruction . . . .”
      On April 27, 2009, in response to the reservation-of-rights letter, Downhole
notified Nautilus that it was rejecting Nautilus’s proffered defense, writing:
“Your decision to act under a reservation of rights has created a material conflict
with respect to the selection of counsel. . . . Downhole has been left with no
choice but to select its own representation. Pursuant to Texas law, Downhole
expects and demands that you cover all damages related to this claim, including
attorneys’ fees, up to the applicable limits of [the policy].” On May 11, 2009,
Nautilus responded that it had “reserved [its] rights while investigating the
matter,” and insisted that “[u]ntil or unless a coverage issue develops, Downhole
is not entitled to separate counsel.”
      On March 3, 2010, Downhole filed this action, seeking a declaratory
judgment that Nautilus has a contractual duty under the policy to defend
Downhole, cover the cost of Downhole’s independent counsel, and indemnify
Downhole in the underlying Sedona suit. The parties filed cross-motions for
summary judgment.         The magistrate judge denied Downhole’s motion for
summary judgment, and granted in part and denied in part Nautilus’s motion:
the magistrate judge granted the portion of Nautilus’s motion relating to its duty
to defend, ruling that Nautilus was not required to reimburse Downhole for the
cost of hiring independent counsel to defend Downhole in the Sedona suit; but



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the magistrate judge denied the portion of the motion related to indemnity,
ruling that it was premature to rule on the issue of indemnification.
                                       II.
      The parties agree that Texas law governs this dispute. Because federal
jurisdiction in this case is based on diversity, we follow Texas’s substantive law.
See Preston Exploration Co., L.P. v. GSF, L.L.C., 669 F.3d 518, 522 (5th Cir.
2012) (citing Erie R.R. v. Tompkins, 304 U.S. 64, 78–79 (1938)). We review a
district court’s grant of summary judgment de novo, applying the same
standards as the district court. Hernandez v. Yellow Transp., Inc., 670 F.3d 644,
650 (5th Cir. 2012). Summary judgment is appropriate where the movant shows
that there is no genuine issue of material fact and that the movant is entitled to
judgment as a matter of law. Id. (citing Anderson v. Liberty Lobby, Inc., 477 U.S.
242, 247 (1986); Fed. R. Civ. P. 56(a)). In reviewing the record, all facts and
inferences are construed in the light most favorable to the non-movant. Id.
Nonetheless, “[i]f the record, taken as a whole, could not lead a rational trier of
fact to find for the non-moving party, then there is no genuine issue for trial.”
Id. (internal quotation marks omitted).
                                       III.
      Under Texas law, it is well-settled that the insurer owes a duty to defend
its insured against any allegation that is potentially covered by the policy. See
Nat’l Union Fire Ins. Co. of Pittsburgh, Pa. v. Merchants Fast Motor Lines, Inc.,
939 S.W.2d 139, 141 (Tex. 1997). It is also well-settled that an insurer’s “right
to conduct the defense includes the authority to select the attorney who will
defend the claim and to make other decisions that would normally be vested in
the insured as the named party in the case.” N. Cnty. Mut. Ins. Co. v. Davalos,
140 S.W.3d 685, 688 (Tex. 2004). “Under certain circumstances, however, an
insurer may not insist upon its contractual right to control the defense.” Id. In
Davalos, the Texas Supreme Court noted one such circumstance:

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       In the typical coverage dispute, an insurer will issue a reservation
       of rights letter, which creates a potential conflict of interest. And
       when the facts to be adjudicated in the liability lawsuit are the same
       facts upon which coverage depends, the conflict of interest will
       prevent the insurer from conducting the defense.
Id. at 689 (citation omitted).2
       Applying the principle from Davalos to this case, we agree with Nautilus
and with the magistrate judge below that “the facts to be adjudicated” in the
underlying Sedona litigation are not the same “facts upon which coverage
depends.”      The underlying Sedona litigation concerns whether Downhole
negligently performed its deviation work. If the insurance policy between
Downhole and Nautilus excluded coverage for Downhole’s negligent conduct, and
Nautilus accordingly reserved its right to disclaim coverage based on whether
Downhole had negligently performed its work, then the “facts to be adjudicated”
in the Sedona litigation would be equivalent to the “facts upon which coverage
depends.” But no such equivalency exists, as Downhole’s negligence is not a
coverage issue between Downhole and Nautilus. Indeed, although the policy
excludes coverage for “testing” or “consulting” services, the facts about whether
Downhole breached a duty to Sedona by failing to act as a reasonably prudent
provider of deviation-correction services are not equivalent to the facts that could
determine whether Downhole was “testing” or “consulting” for Sedona. Unlike
the former category of facts, the latter category of facts will not be adjudicated



       2
          Although the Texas Supreme Court has not clarified the meaning of “facts to be
adjudicated,” the term “adjudicate” plainly means “to rule upon judicially.” Black’s Law
Dictionary (9th ed. 2009); see also Rx.com Inc. v. Hartford Fire Ins. Co., 426 F. Supp. 2d 546,
559 (S.D. Tex. 2006) (citing Davalos for the proposition that “[a] conflict of interest does not
arise unless the outcome of the coverage issue can be controlled by counsel retained by the
insurer for the defense of the underlying claim”); Partrain v. Mid-Continent Speciality Ins.
Servs., Inc., Civ. No. H-10-2580, 2012 WL 201864, at *15 (S.D. Tex. Jan. 20, 2012)
(interpreting Davalos to stand for the proposition that “[i]n order for a disqualifying interest
to exist . . . it must be apparent that facts upon which coverage depends will be ruled upon
judicially in the Underlying Suit”).

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in the Sedona litigation; the underlying fact-finder will not decide whether
Downhole’s work constituted “testing” or “consulting.” Likewise, while several
other issues—whether Downhole provided “professional” or “data processing”
services to Sedona, whether Downhole should have expected the damage to the
well resulting from its work, or whether Downhole was occupying the property
while providing its deviation-correction services—could be critical coverage
issues, they are irrelevant to whether Downhole acted negligently.
      According to Downhole, however, a more recent case from the Texas
Supreme Court has changed the applicable standard. In Unauthorized Practice
of Law Committee v. American Home Assurance Company, the Texas Supreme
Court held that a liability insurer may use its staff attorneys to defend a claim
against an insured without being deemed to have engaged in unauthorized
practice of law, provided that the interests of the insured and the insurer are
congruent. 261 S.W.3d 24, 39 (Tex. 2008). In the course of its reasoning, the
court examined when and how those interests diverge; the court observed that
“the most common conflict between an insurer and an insured” is whether a
claim falls within the policy, and then stated:
      Other coverage issues may also depend on facts developed in the
      litigation. When an insurer is concerned that there may be a
      coverage issue, it usually issues a reservation-of-rights letter when
      it accepts the defense, agreeing to defend the insured without
      waiving its right to decline coverage later. . . . [W]e cannot say as a
      blanket rule that a staff attorney can never represent an insured
      under a routine reservation of rights.
Id. at 40 (emphasis added). Here on appeal, Downhole seizes on the word
“developed” to argue that Unauthorized Practice relaxed the Davalos standard.
Now, according to Downhole, a conflict of interest arises if facts that could be
developed in the underlying litigation are the same facts upon which coverage
depends. Based on this new standard, Downhole warns that if Nautilus were
permitted to select Downhole’s attorney, that attorney could steer the defense

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to develop facts—by formulating questions and written responses during
discovery—supporting the theory that Downhole was providing testing,
consulting, professional, or data processing services. Likewise, the attorney
could develop facts showing that Downhole should have expected the damage to
the well resulting from its work, thereby bolstering the applicability of the
“expected or intended injury” exclusion; or the attorney could develop facts
showing that Downhole was occupying the property while providing its deviation
services, thereby bolstering the applicability of the “property” exclusion.
       Nonetheless, we decline to follow Downhole’s strained reading of
Unauthorized Practice. One inconsequential line of dicta—“[o]ther coverage
issues may also depend on the facts developed in the litigation,” id.—surely did
not usher in a doctrinal change. Neither in Unauthorized Practice nor elsewhere
has the Texas Supreme Court ever held that a conflict arises any time the
attorney offered by the insurer could be tempted—in violation of his duty of
loyalty to the insured—to develop facts in the underlying lawsuit that could be
used to exclude coverage. The mere observation that coverage issues may turn
on facts developed in the litigation does not necessarily entail that a conflict of
interest will arise if the facts that could be developed in the underlying litigation
are the same facts upon which coverage depends. Proceeding from the former
observation to the latter conclusion requires an illogical leap.3


       3
          Of course, the attorney hired by the insurer to represent the insured is duty-bound
to defend the interests of the insured. State Farm Mut. Auto. Ins. Co. v. Traver, 980 S.W.2d
625, 628 (Tex. 1998) (“[B]ecause the lawyer owes unqualified loyalty to the insured, the lawyer
must at all times protect the interests of the insured if those interests would be compromised
by the insurer’s instructions.” (Citation omitted.)). Downhole’s concern is thus somewhat
overblown. Although the prospect that the attorney provided by Nautilus could develop facts
harmful to Downhole’s pursuit of coverage does not itself raise an actual conflict, if the
attorney (at Nautilus’s direction) improperly advanced Nautilus’s interests at the expense of
Downhole’s interests, Nautilus would breach its duty to defend Downhole; such breach would
free Downhole to reject the counsel provided by Nautilus and entitle Downhole to
reimbursement for the cost of its own independent counsel. See 1 Allan D. Windt, Insurance
Claims and Disputes § 4.25 (5th ed. 2007).

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      Downhole also argues that by focusing on the “facts to be adjudicated,”
rather than on the “facts to be developed,” a conflict will arise in only one
circumstance: where the policy exclusion is for intentional conduct and the third
party is alleging intentional wrongdoing. An attorney sent by the insurer to
defend the insured in such a case would be conflicted, for a finding of intent
would disqualify coverage. But in no other case, according to Downhole, will the
facts to be adjudicated be equivalent to the facts upon which coverage depends.
Downhole thus suggests: “[T]he Davalos rule becomes meaningless because it
would never apply to [a] conflict created by any policy exclusion except an
exclusion for intentional conduct, which may, in special cases, be the only
situation in which an underlying fact-finder specifically answers questions that
would also dispose of a coverage issue.” Yet, Downhole’s assumption is incorrect.
The facts to be adjudicated may be the same facts upon which coverage depends
in other situations, such as where the insurer reserves the right to deny coverage
based upon a breach of contract exclusion and the underlying litigation raises
a claim for breach of contract, or where the insurer reserves the right to deny
coverage for damages taking place outside the contract period and the
underlying action involves the issue of when damages took place. The Davalos
standard, as applied here, is not so “meaningless.”
       Because the facts to be adjudicated in the Sedona lawsuit are not the
same facts upon which coverage depends, the potential conflict in this case does
not disqualify the attorney offered by Nautilus to represent Downhole. We agree
with the magistrate judge’s ruling and hold that Downhole is not entitled to
reimbursement from Nautilus for the cost of hiring independent counsel.
      AFFIRMED.




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