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Fifth Circuit Departs from Precedent to Follow ‘Menchaca’

By Donna Peery; Updated by Zach Bowman

The Fifth Circuit recently acknowledged its precedent had mistakenly established “the opposite rule from that [set forth] in Vail” for the recovery of extra-contractual damages. See Lyda Swinerton Builders, Inc. v. Oklahoma Surety Co., 903 F.3d 435 (5th Cir. Aug. 29, 2018) (quoting In re Deepwater Horizon, 807 F.3d 689, 698 (5th Cir. 2015)). Despite Vail’s holding that “an insurer’s unfair refusal to pay the insured’s claim causes damages as a matter of law in at least the amount of the policy benefits wrongfully withheld,” see Vail v. Texas Farm Bureau Mut. Ins. Co., 754 S.W.2d 129, 136–37 (Tex. 1988), the Fifth Circuit had repeatedly required proof of an independent injury to recover extra-contractual damages. See In re Deepwater Horizon, 807 F.3d at 698; Great Am. Ins. Co. v. AFS/IBEX Fin. Servs., Inc., 612 F.3d 800, 806 (5th Cir. 2010); Parkans Int’l LLC v. Zurich Ins. Co., 299 F.3d 514 (5th Cir. 2002).

Lyda Swinerton presented the Court with the opportunity to reconsider its precedent and to align its holdings with the Texas Supreme Court’s recent opinion in USAA Texas Lloyds Co. v. Menchaca, 545 S.W.3d 479 (Tex. Apr. 13, 2018), which itself was an attempt to clarify earlier opinions. See id. at 489 (“In an effort to clarify these issues, we distill from our decisions five distinct but interrelated rules . . . .”).

In Lyda Swinerton, the Fifth Circuit considered multiple issues, including whether the district court erred in (1) finding Lyda Swinerton Builders (LSB) failed to present evidence of an independent injury caused by Oklahoma Surety Company’s knowing misrepresentation of the policy’s coverage to avoid defending LSB in the state-court suit, (2) holding the anti-stacking rule adopted by the Texas Supreme Court did not apply, and (3) the calculation of penalty interest under Chapter 542 of the Texas insurance Code. Id. at 448–56. Its Menchaca holding is by far the most significant.

“Entitled-to-Benefits” v. “Independent-Injury”

Noting the district court ruled prior to Menchaca and relied on the 2010 Fifth Circuit decision in Great American, the Court stated Menchaca compelled “reexamination of significant aspects of Great American’s reasoning” because the Texas Supreme Court reaffirmed the “entitled-to-benefits” rule announced in Vail. Id. at 452. The Fifth Circuit acknowledged “the Texas Supreme Court expressly stat[ed] that our court was wrong to conclude that Vail had been overruled” in Stoker or in Castenada. Id. (citing Menchaca, 545 S.W.3d at 495–96).

The Fifth Circuit discussed the “entitled-to-benefits” rule and the “independent-injury” rule as clarified in Menchaca. Id. at 452-53. The “entitled-to-benefits” rule provides that “an insured who establishes a right to receive benefits under an insurance policy can recover those benefits as ‘actual damages’ under the Insurance Code if the insurer’s statutory violation causes the loss of benefits.” Id. at 452. The “independent-injury rule” provides that (1) an insurer’s violation of the Insurance Code can entitle the insured to extracontractual damages even if there was not an entitlement to benefits under the policy, and (2) that where there are both benefits owed and code violations, an insured can only recover damages beyond the benefits owed if the code violation causes an injury independent from the loss of benefits. See id. (citing Menchaca, 545 S.W.3d at 499–500).

At the district court level, LSB had claimed Oklahoma Surety violated sections 541.060(a)(1) and 541.061 of the Code by knowingly misrepresenting the policy’s coverage to avoid defending in the state-court litigation. Id. at 453. LSB argued this violation caused it to incur defense costs (entitled-to-benefits) that qualified as extra-contractual damages under Vail. Id.

Finding the district court erred in requiring evidence of an injury separate and apart from the denial of benefits to support LSB’s Insurance Code claims under Vail and “entitled to benefits” rule, the Fifth Circuit explained the function of the independent-injury rule articulated in Menchaca:

As the phrase “beyond policy limits” suggests, the independent-injury rule does not restrict the damages an insured can recover under the entitled-to-benefits rule.  Rather, the independent-injury rule limits the recovery of other damages that “flow” or “stem” from the mere denial of policy benefits.

Id. at 452 (citing Menchaca, 545 S.W.3d at 500). Thus, applying Menchaca, the Fifth Circuit reversed the district court’s denial of LSB’s Chapter 541 claim and remanded for proceedings to determine if LSB could establish that Oklahoma Surety’s alleged misrepresentations caused it to be deprived of defense costs, thereby supporting recovery of such costs “as actual damages under Chapter 541—without limitation from the independent-injury rule.” Id. at 453.

Of course, the most significant impact of Menchaca will be how federal courts that adhered to the Fifth Circuit precedent of Great American will now follow the guidance of Menchaca. As one court has expressed, there may still be a lack of clarity in doing so. See CVR Energy, Inc. v. Am. Zurich Ins. Co., 4:17-CV-1284, 2018 WL 6622226, at *5 (S.D. Tex. Nov. 27, 2018), report and recommendation adopted, 2018 WL 6617829 (S.D. Tex. Dec. 18, 2018) (noting “the independent injury rule is a complex doctrine” and “the Fifth Circuit had itself misconstrued Texas law on the topic”).

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