Insurance company Insco insures a technology company that makes parts for computers. The company sells those parts to Compco for incorporation into Compco's computers, which are then sold in the retail market. After Compco installs a number of the company's parts into its computers, the parts allegedly fail and cause physical damage to the computers sold by Compco.

Compco refuses to pay the insured its outstanding invoices for the purchase of the allegedly defective parts, and then it sues the insured for breach of contract and negligence to recoup the $13 million in costs associated with repairing and replacing the damaged computers. The insured counterclaims against Compco for $10 million — the value of the unpaid invoices — contending that its parts did not fail. The insured technology company tenders defense and indemnity of the lawsuit to Insco under the terms of its general liability policy, which accepts the defense under a reservation of rights, paying for defense counsel of the insured's choice.

After limited discovery in the litigation, representatives from Compco and the insured technology company agree to meet in an attempt to settle the litigation. A representative from Insco will not be at the meeting because Insco was only notified of the meeting via an e-mail sent after business hours the night before the meeting. In the e-mail, the insured tells Insco that it does not intend to make any cash payment to Compco to settle the matter, and that it is entirely possible the parties will agree to a “walk-away” settlement. The insured asks for Insco's position on indemnification of the insured for the settlement under these circumstances. The insured also tells Insco that it is reserving all rights to pursue covered losses not incorporated into the settlement. The morning of the meeting, Insco reads the e-mail and responds that it consents to further settlement negotiations, but because it will not be present at the settlement meeting, it reserves its rights to review the settlement for coverage and reasonableness of consideration offered by the insured.

The insured and Compco meet and agree on a “walk-away” settlement. The insured sends a copy of the proposed settlement agreement to Insco. Under the terms of the proposed settlement, Compco will dismiss the lawsuit and the insured will dismiss the counterclaim, and both parties will agree to do business with one another in the future. No money changes hands. Insco does not object to the terms of the settlement, the parties settle, and Insco closes its file.

A happy ending? Maybe not.

Six weeks later, the insured notifies a surprised Insco that it is seeking reimbursement under its general liability policy for the value of the counterclaim it gave up in the settlement of the lawsuit. The insured contends that in dismissing its counterclaim as part of the settlement, it “paid,” albeit as non-cash consideration, $10 million in waived invoices. The insured further contends that Insco consented to the settlement terms and therefore consented to its payment of this non-cash consideration.

Questions of Coverage

Could such a “payment” of non-cash be considered damages the insured becomes legally obligated to pay under the terms of a general liability policy? Relying on a lone California appellate decision entitled Earth Elements, Inc. v. Nat. Am. Ins. Co. (1995), the insured and its counsel think so, arguing that an insured's dismissal of a counterclaim as part of a settlement is legally sufficient to be considered damages under the terms of a third-party liability policy. The Earth Elements decision may be misread in such a manner to support this argument.

In Earth Elements, Mission American Insurance Company issued a liability insurance policy to Earth Elements, Inc. and its president, Jeffrey Bennett. A business competitor of Earth Elements filed a complaint in federal court against Earth Elements for false and misleading advertising, unfair competition, dilution, trade disparagement, and interference with prospective business relations. Earth Elements filed an answer and a counterclaim against the competitor. Earth Elements tendered its defense to Mission. Mission breached the insurance contract by failing to defend and indemnify Earth Elements. Left on its own, Earth Elements settled the case, with the competitor dismissing its claim, and Earth Elements dismissing its counterclaim. Earth Elements then sued Mission's successor-in-interest, National American Insurance Company, for failure to defend and to indemnify it for its dismissed counterclaim. The trial court entered judgment in favor of National, finding that the claim was not covered.

Relying on the case of Isaacson v. California Insurance Guar. Assoc. (1988), the appellate court reversed, finding that National had a duty to pay Earth Elements for the stipulated value of the counterclaim as a measure of damages for its breach of the insurance contract. Thus, the Earth Elements decision does not state that dismissal of a counterclaim by an insured would be equivalent to the payment of covered “damages.” Instead, that decision has a very narrow application. By its own terms, the Earth Elements court only reached its result entitling the insured to be compensated for the value of the consideration paid in settlement of the third-party claim due to the insurer's breach of its duties to defend and indemnify the insured for a covered claim. Thus, but for the breach by the insurer of its duties to defend and indemnify, there would have been no finding in favor of Earth Elements. In short, the Earth Elements court found that consideration for a settlement was compensable only as legal damages stemming from a breach of the contract. At best, Earth Elements stands for the proposition that, when an insurer breaches one of its duties, the insured may recover damages for harm arising from it, including non-cash consideration that it paid a third party in settlement. It does not hold that such non-cash consideration is “damages the insured becomes legally obligated to pay,” under the terms of a third-party liability policy.

Despite the fact that Earth Elements does not hold that dismissal of a counterclaim by an insured constitutes payment of “damages” under the terms of a third-party policy, and despite the fact that we could not locate any law from any American jurisdiction holding that coverage exists for such a claim under a third-party liability policy, at least one trial court in a bad-faith lawsuit has found the potential for coverage in a similar situation, citing to the holding in Earth Elements. Specifically, that trial court determined as a matter of law that an insured's dismissal of a counterclaim as part of a “walk-away” settlement is compensable as damages under a third-party liability policy. (It should be noted that the trial court left it to the trier of fact to determine whether the insured obtained consent to settle, and to determine the value, if any, of the dismissed counterclaim.)

Preventative Measures

In high stakes litigation, it has become routine for the defendant to file counterclaims seeking some recovery against the plaintiff, often in the form of money damages. As the saying goes, the best defense is a good offense. When it comes time to settle the suit, it almost invariably includes dismissal of the entire action, including the complaint and any counterclaims. Where the insured/defendant is being defended by his insurer, what preventative steps can an insurer take to help manage an after-the-fact claim by an insured for the alleged value of dismissed counterclaims?

First, when an insurer accepts the tender of defense under a third-party liability policy, it should notify the insured in its reservation-of-rights letter that the insured's prosecution of its affirmative claims are not covered under the policy. The attorneys' fees and costs spent in pursuit of those claims will not be paid as defense costs, and the insurer should spell out that dismissal or waiver of those claims will not constitute payment for “damages the insured becomes legally obligated to pay” under the terms of a third-party liability policy, and that the insurer will not pay to its own insured the alleged value of those claims if they are dismissed as part of any settlement.

Second, if possible, an insurer should avoid giving approval for an insured to settle a matter if a representative from the insurer is not present at the settlement meeting, or if the insurer has not discussed in detail with the insured what portions of the anticipated settlement are covered under the terms of the policy. Although an insurer does not want to hinder its insured's ability to settle litigation, in the case discussed above where the insurer consented to further negotiations, the insured may argue that it notified the insurer of its intentions, the insurer knew what the insured intended to do (i.e., that the insured was “paying” non-cash consideration by waiving the invoices), the insurer consented to settlement under these terms, and the insured relied on this consent when it agreed to the walk-away settlement.

In short, although there is no clear law providing that the forbearance of a claim or counterclaim constitutes damages under the terms of a third-party liability policy, it pays to be mindful of the types of disputes that may arise after an insured dismisses its affirmative claim.

Marjie D. Barrows and Kathleen M. DeLaney are both attorneys at the law firm of Rudloff Wood & Barrows. They can be reached at www.rwblaw.com.

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