Although the U.S. has a reputation as a litigious society, in reality judges often encourage parties to a lawsuit to settle. When insurers defend their insureds, settling a case is a reasonable trial strategy to limit court costs and attorney fees. What happens when the plaintiffs reach an agreement with the defendant before trial not to pursue all available assets if they win? When a judgment is rendered against the insured in the trial in which the insurer doesn't participate, must the insurer provide coverage?
Case of construction defects
Glen and Marsha Hamel hired Terry Mitchell Builders, Inc., to finish building a single family home in Flower Mound, Texas, which it did in October 1995. In August 2000, the Hamels said they noticed signs of water damage in the home. They sued the builder in April 2002 for breach of implied warranty, negligence, Deceptive Trade Practices Act violations and Residential Construction Liability Act violations, alleging that the builder had failed to perform its services in a good and workmanlike manner. The Hamels also alleged that the water damage had resulted from the home's improper construction or the improper installation of a certain exterior stucco finish.
Great American Insurance Company insured the builder under several commercial general liability policies, one of which excluded property damage “arising out of” the stucco product. The builder notified Great American of the Hamels’ suit, but Great American declined to defend the builder, citing the policy's exterior stucco exclusion because the discovery of the damage fell within that period.
Great American subsequently conceded that this position was erroneous and the insurer had wrongfully refused to defend the builder.
A week before trial, the Hamels reached an agreement with the builder providing that, if they obtained a judgment against the company, they would only go after the assets in the company's name, excepting any “personal tools of the trade and truck.” When the agreement was executed, the company had no assets beyond the excepted “tools of the trade and truck.”
The trial court awarded the Hamels $365,089 in damages, including $50,000 in mental anguish damages, plus prejudgment interest and court costs.
The builder subsequently assigned most of its rights against Great American to the Hamels, who sued Great American for breach of contract and declaratory relief, seeking to recover the judgment from their suit against the builder under the builder's insurance policy.
Ruling against insurer
The trial court rendered judgment for the Hamels, finding the following:
The builder had been negligent.
Great American had waived its right to control the builder's defense.
The builder had defended itself at the Hamels’ trial in good faith. The builder's and the Hamels’ trial strategies and actions had been reasonable and not collusive or fraudulent.
The damage judgment and findings were supported by the evidence and were binding on Great American. Great American had breached its duties to defend the builder in the Hamels’ suit and to indemnify the builder from the judgment.
The trial court awarded judgment to the Hamels for $355,838, plus interest, court costs, and attorneys’ fees.
Great American appealed, arguing the judgment was not binding because it was not rendered in a fully adversarial trial.
Great American loses appeal
The court of appeals affirmed the trial court's judgment in most respects, holding that Great American had breached its duty to defend the builder from the Hamels’ suit, the damage judgment had been the result of a fully adversarial trial, and the builder's assignment of its claims against Great American to the Hamels was valid. The court of appeals reversed the portion of the judgment awarding mental anguish damages, holding they were not compensable as a matter of law.
The dispute reached the Texas Supreme Court, where Great American contended the Hamels’ judgment had not been the product of a fully adversarial trial and, could not be enforced by the Hamels as the builder's assignees.
Great American argued the pretrial agreement and stipulations entered into by the Hamels and the builder ensured that the builder had no real stake in the trial's outcome, resulting in a sham trial shaped entirely by the Hamels and designed to aid in the prosecution of the subsequent insurance litigation.
The Texas Supreme Court's decision
The Texas Supreme Court reversed the court of appeals’ judgment and remanded the case for a new trial.
The court noted that the enforceability of the damage judgment against Great American was valid, given that:
The builder had assigned its claims following, not preceding, a trial and judgment;
Great American had breached its duty to defend; and
Great American had neither accepted coverage nor made a good faith effort to adjudicate coverage before the Hamels’ claims against the builder had been resolved.
The court noted that one way to ensure that a judgment accurately reflected the plaintiff's damages was to require that the loss be determined through a proceeding in which the parties “fully” — “or at least actually and effectively” — opposed and contested each other's positions. The court held that the “controlling factor” was: whether, at the time of the underlying trial or settlement, the insured bore an actual risk of liability for the damages awarded or agreed upon, or had some other meaningful incentive to ensure that the judgment or settlement accurately reflect[ed] the plaintiff's damages and thus the defendant-insured's covered liability loss.
The court ruled that the pretrial agreement between the Hamels and the builder had “eliminated any meaningful incentive” the builder had to contest the judgment. The court pointed out that the Hamels had agreed not to enforce any resulting judgment against Mitchell's personal assets or his truck or “personal tools of the trade ... even if in the name of [the company].” The court added that although the agreement technically had not foreclosed the Hamels from pursuing other assets of the builder, Mitchell himself had testified that the company had no other assets except the insurance policy.
Proceedings lost their adversarial nature when, “by agreement,” one party had “no stake in the outcome and thus no meaningful incentive to defend itself,” the court explained. When a plaintiff agreed “to forgo execution of a judgment against a defendant's assets, whether in conjunction with a settlement or before trial,” the defendant no longer had “a financial stake in the outcome” and thus likely had “no interest in either avoiding liability altogether or minimizing the amount of damages.”
Applying that standard to this case, the court held that the pretrial agreement “effectively removed any financial stake” the builder had in the outcome of the Hamels’ suit, eliminating any incentive to oppose the Hamels’ claims. This turned their suit “into a mere formality — a pass-through trial aimed not at obtaining a judgment reflective of the Hamels’ loss, but instead at obtaining a potentially inflated judgment to enforce against Great American.”
Accordingly, it ruled, the Hamels’ judgment was not binding against Great American in the lawsuit brought by the Hamels as judgment creditors and assignees.
Formal agreement not always required
Significantly, the court added that although a formal, written pretrial agreement that eliminated the insured's financial risk was not always necessary to disprove adversity, the presence of such an agreement created “a strong presumption that the judgment did not result from an adversarial proceeding,” while the absence of such an agreement created “a strong presumption that it did.” An insurer could overcome the presumption by demonstrating that even though the plaintiff and insured defendant had not entered into any formal, written agreement, the evidence established that the defendant had no meaningful stake in the outcome of the underlying litigation.
Finally, the court declared that a lack of adversity in a damages trial against an insured could be cured in a subsequent coverage lawsuit against the insurer — if the parties “properly” litigated the underlying liability issues in the coverage suit.
That had not happened in this case, the court concluded, because the parties had not “thoroughly relitigate[d] all aspects of the Hamels’ claimed damages.” The Texas Supreme Court then remanded the case for a new trial.
Steven A. Meyerowitz, Esq., (firstname.lastname@example.org) is the director of FC&S Legal, the editor-in-chief of the Insurance Coverage Law Report, and the founder and president of Meyerowitz Communications Inc. This story is reprinted with permission from FC&&S Legal (www.fcandslegal.com), the industry's only comprehensive digital resource designed for insurance coverage law professionals.