Avoiding the Pitfalls of Stipulated Settlements

Under a duty to defend policy, as a practical matter, an insurer's first step is to determine whether it is obligated under the applicable policy to provide the insured with a defense. In that regard, depending on the allegations set forth in the complaint, an insurer may elect to: 1) unconditionally defend and indemnify the insured against the lawsuit; 2) deny that the policy affords defense or indemnity coverage against the lawsuit; or 3) defend the insured under a reservation of rights to disclaim coverage at a later date. Because many jurisdictions have held that an insurer's decision to defend unconditionally precludes the insurer from later disclaiming coverage, and because the insured's need for a defense typically arises before the insurer has had an opportunity to complete its coverage analysis, an insurer may be reluctant to unequivocally defend its insured. As for denying coverage in its entirety, given the breadth of the duty to defend and given the fact that many complaints contain 'mixed claims,' this option is rarely available to an insurer. As a result, more often than not, an insurer will determine that the best approach is to defend under a reservation of rights ' an approach that may also include the insurer's commencement of a declaratory judgment action to determine the insurer's coverage obligations under the policy. In the event the insurer defends the insured under a reservation of rights, in order to avoid the risk of significant personal exposure, the insured may be persuaded to shift his allegiance to the plaintiff ' and away from the insurer ' resulting in an unauthorized and unfavorable settlement.

In a subsequent direct action to enforce the stipulated judgment, in addition to coverage-based arguments (to the extent that such arguments apply), the insurer has at least three defenses that it can assert. First, the insurer may assert that an insured's participation in an unauthorized, stipulated judgment breaches the insured's duty to cooperate. Second, the stipulated settlement may be the product of collusion or fraud between the plaintiff and insured. Third, in the event the resulting judgment is inflated, the settlement may be 'unreasonable.' As for a defense based on the insured's duty to cooperate, most, if not all, policies explicitly provide that the insured shall cooperate with the insurer. See The CPCU Handbook of Insurance Policies, Third Edition, 1998. In that regard, several jurisdictions have held that where an insurer was defending its insured under a reservation of rights, the insured breached the cooperation clause when it entered into a settlement agreement with the plaintiff without first providing notice to, or obtaining the consent of, its insurer. See Central Bank v. St. Paul Fire & Marine Ins. Co., 929 F.2d 431 (8th Cir. 1991); Gates Formed Fibre Products, Inc. v. Imperial Cas. and Indem. Co., 702 F.Supp. 343 (D. Me. 1988); Kelly v. Iowa Mut. Ins. Co., 620 N.W.2d 637 (Iowa 2000). In Gates, although recognizing that the 'insurer's reservation of right to assert a policy defense may still leave the insured in the precarious position of having to satisfy an uninsured judgment,' the court held that, under a general liability policy, the uncertainty did not excuse the insured from providing notice to its insurer of the negotiations leading to the settlement. Id. at 347. Similarly, in Central Bank, the Eighth Circuit held that, under a directors and officers' liability policy, where an insured accepted a defense under a reservation of rights, it 'bound itself to cooperate with the insurer and foreclosed its unilateral right to settle the claim.' 929 F.2d at 433. In each instance, as a result of the insured's breach, the insurer was relieved of its obligation to indemnify.

A number of jurisdictions, however, have held that, when an insurer defends under a reservation of rights, the insured is free to act in his own self-interest and negotiate the best deal possible to protect his interests. See USAA v. Morris, 741 P.2d 246 (Ariz. 1987); Miller v. Shugart, 316 N.W.2d 729 (Minn. 1982). In reaching this conclusion, one court explained that 'the insurer's insertion of a policy defense by way of reservation or nonwaiver agreement narrows the reach of the cooperation clause and permits the insured to take reasonable measures to protect himself against the danger of personal liability.' INA v. Spangler, 881 F.Supp. 539, 545 (D.Wyo. 1995). As a result of the conflicting legal authority, an insurer's ability to prevail solely on a lack of cooperation defense will primarily depend on the jurisdiction.

A second line of defense that an insurer should explore is whether the stipulated settlement was the product of collusion or fraud between the parties. A third, and related, defense focuses on the 'reasonableness' of the stipulated settlement. Courts have consistently demonstrated concern about the validity of stipulated settlements between a plaintiff and an insured, especially when coupled with a covenant not to execute against the insured personally. Indeed, several courts have held that such settlements are not binding on an insurer for public policy reasons.

Unlike a typical settlement, the point of a stipulated settlement is 'not to end the litigation but to prolong it' with '[t]he entire purpose of the arrangement [being to] find a way to recover against' the insurer. State Farm Fire and Cas. Co. v. Gandy, 925 S.W. 2d 696, 712 (Tex. 1996). As a result, courts often apply a heightened level of scrutiny to such settlements precisely because such settlements are rife with the potential for collusion, unreasonableness and bad faith. Continental Cas. Co. v. Westerfield, 961 F.Supp. 1502, 1505 (D. New Mex. 1997) (reasoning that 'cases involving an insurer's duty to indemnify against a stipulated judgment, coupled with a covenant of non-execution, in circumstances replete with collusion ' warrants heightened scrutiny'); Steil v. Florida Physicians Ins. Reciprocal, 448 So. 2d 589, 592 (Fla. Dist. Ct. App. 1984) (noting that the settlement figure in the context of a settlement with a covenant not to execute 'is more suspect' because the insured 'has little or nothing to lose because he will never be obligated to pay'). Recognizing that an insured may settle for an 'inflated amount or capitulate to a frivolous case merely to escape exposure or further annoyance,' a few courts have held that, neither the fact nor the amount of liability is binding on the insurer unless either the insured or plaintiff demonstrates that the settlement was 'reasonable and prudent.' Morris, 741 P.2d at 253.

One disadvantage, however, to raising collusion, fraud or unreasonableness in a subsequent action is the necessity for the insurer, in order to prove its defense, to litigate the merits of the underlying action after a court has approved and entered judgment. Similar to a legal malpractice action, the insurer's defense can often entail a virtual 'trial within a trial' where a fact-finder would be called upon to evaluate whether the stipulated settlement was reflective of the merits of the underlying action. Because the insured generally possesses most, if not all, of the factual information surrounding its defense, the insurer is, of course, at a significant informational disadvantage to challenge the reasonableness of a settlement. Although the insurer should be permitted to conduct extensive discovery to obtain the necessary information, this approach is costly and, unlike a legal malpractice claim, it is doubtful that anyone with pertinent information will be willing to assist the insurer.

As an alternative to litigating reasonableness in a subsequently filed direct action, a handful of courts permit an insurer, when defending under a reservation of rights, to intervene into the liability action prior to the entry of the stipulated judgment so that it may participate in an evidentiary hearing on reasonableness. This approach was recently discussed in Himes v. Safeway Ins. Co., 66 P.3d 74 (Ariz. 2003). In Himes, prior to the entry of the stipulated judgment, the insurer moved to intervene and requested that an evidentiary hearing be conducted to evaluate the 'reasonableness' of the stipulated settlement. The trial court permitted the insurer to intervene, but determined that it was inappropriate for the trial court to substitute its own belief regarding reasonableness for that of the parties. Consequently, the trial court found that, in the absence of any evidence that the agreement was per se unreasonable, judgment would enter for the full amount of the stipulated settlement.

Reversing the trial court, the appellate court explained that, as a preliminary matter, the burden is on the plaintiff and the insured to prove the reasonableness of a stipulated settlement that includes a covenant not to execute. The appellate court further explained that, because there is absolutely no incentive for an insured holding a covenant not to execute to agree to a reasonable settlement, there is a presumption that a stipulated settlement is neither reasonable nor the product of an arms-length negotiation. Indeed, 'the incentive is to accept whatever number is proposed to avoid 'the sharp thrust of personal liability.” Id. at 80.

To rebut the presumption that a stipulated settlement is unreasonable, Himes held that, prior to the entry of judgment, the plaintiff and insured must prove by a preponderance of the evidence that the settlement amount is reasonable. In other words, the parties must establish 'what a reasonably prudent person in the insured's position would have settled for on the merits.' Id. To evaluate reasonableness, Himes found the following factors relevant: '[t]he releasing person's damages; the merits of the releasing person's liability theory; the merits of the released person's defense theory; the released person's relative faults; the risks and expenses of continued litigation [on the merits]; ' any evidence of bad faith, collusion, or fraud; the extent of the releasing person's investigation and preparation of the case; and the interests of the parties not being released.' Notably, because the fact-finder must assume that the settlement would be funded by the insured and, therefore, the insured would have every incentive to keep the settlement as low as possible, the insured's ability, or inability, to pay is entirely irrelevant.

As for the insurer's role, Himes found that a stipulated settlement is not binding on an insurer unless the insurer had the opportunity to participate in the reasonableness hearing and contest the evidence offered to support the settlement. Consequently, in the event the plaintiff or insured failed to notify the insurer of the stipulated settlement prior to the entry of final judgment, the judgment would not be binding on the insurer in a subsequent proceeding. Critically, however, Himes suggested that, where an insurer was provided notice of a stipulated settlement and failed to intervene or request an evidentiary hearing, an insurer may waive its right to challenge the reasonableness of the settlement amount.

The approach outlined in Himes has several benefits to the insurer. First, the burden is placed squarely on the plaintiff and insured to prove reasonableness. To satisfy this burden, the parties must overcome the presumption that a stipulated settlement is unreasonable. Second, the insurer may challenge the settlement prior to the court's approval and entry of judgment and, therefore, the insurer is not attempting to, in effect, 'undo' a court-approved, prior judgment. Third, during the evidentiary hearing, the insurer may introduce its own evidence as to the true value of the settlement. By way of example, in Himes, numerous experts testified as to the claim's true settlement value. Fourth, unless the insurer had notice of the stipulated settlement and the opportunity to participate in the evidentiary hearing, the stipulated settlement amount would not be binding in a subsequent action.

A final benefit to the insurer stems from the requirement that the insured provide notice of the settlement to the insurer. The opening, or re-opening, of communications between the insured and the insurer should not be undervalued because it provides the insurer with the opportunity to not only revisit its coverage position, but, more importantly, to attempt to dissuade the insured from entering into such an agreement. Recognizing that a typical insured enters into a stipulated judgment to eliminate the risk of personal exposure, the insurer can use this opportunity to remind its insured that, although he may receive a covenant not to execute from the plaintiff, the entry of a stipulated judgment can have dire consequences on the insured's credit, business transactions and ability to obtain insurance coverage in the future. After evaluating the long-term consequences of the stipulated settlement, an insured may be persuaded that it is more prudent to be aligned with his insurer and pursue their common goal of defeating the plaintiff's claims.

Until, however, courts uniformly recognize, as in Himes, that a stipulated settlement is inherently problematic, the plaintiffs will continue to use an insurer's issuance of a reservation of rights to inflate the true value of their claims. In the meantime, relying on the legal and practical tools that are available, insurers should continue to develop strategies, both offensive and defensive, to respond to stipulated settlement situations.

Kim V. Marrkand, a member of the litigation section in the Boston office of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C., chairs the firm's insurance/reinsurance group and is on the Board of Editors of this newsletter. Nancy D. Adams, CPCU, an associate in the litigation section in Mintz Levin's Boston office, is a member of the firm's insurance/reinsurance group. The authors acknowledge the assistance of Meredith M. Leary and Hemanth C. Gundavaram in the preparation of this article. The views expressed in the article are those of the authors and not necessarily those of Mintz, Levin or its clients.

An officer of a corporation is named as a defendant in a shareholder derivative suit. After reading the complaint, which includes allegations that the officer committed a breach of certain fiduciary duties owed to the corporation, the officer promptly notifies his directors and officers' liability insurer of the lawsuit. Because the applicable policy contains exclusions that may potentially exclude some, if not all, of the claims, the insurer agrees to defend the officer subject to a full and complete reservation of rights.

Upon receipt of the insurer's reservation of rights letter, the officer becomes concerned that, if the insurer later contests coverage, he may face significant personal exposure. To eliminate this risk, the officer explores the possibility of entering into a settlement with the plaintiff. The plaintiff suggests that the parties stipulate to the entry of a judgment, which is vastly in excess of the suit's true value, and the plaintiff will provide the officer with a 'covenant not to execute,' which protects the officer from personal exposure. In return, the officer will assign to the plaintiff his rights under the policy, including any claims that the insurer acted in bad faith. Armed with the stipulated judgment and an assignment from the insured, the plaintiff files a direct action against the insurer to reach and apply the insurance proceeds to satisfy the outstanding judgment and, pursuant to the assignment, seeks extra-contractual damages on the basis that the insurer acted in bad faith. Suddenly, the insurer is faced with not only litigating whether coverage exists for the inflated judgment, but also defending against a bad faith claim.

This scenario has become more prevalent in the directors and officers' context as plaintiffs have recognized the benefits of a stipulated judgment and non-recourse agreement whereby the plaintiffs can maximize, if not increase, the value of their claims without ever having to fully litigate the merits. Additionally, a stipulated judgment moves the litigation directly into a collection phase; a phase where the insurer's defenses are more limited than in the liability action since liability has been conceded. Given both the frequency of stipulated settlements and the fact that the law in this area has become increasingly conflicting, an insurer needs to be aware of the legal tools that it has available to implement either an offensive or defensive strategy to respond to stipulated settlement situations.

Under a duty to defend policy, as a practical matter, an insurer's first step is to determine whether it is obligated under the applicable policy to provide the insured with a defense. In that regard, depending on the allegations set forth in the complaint, an insurer may elect to: 1) unconditionally defend and indemnify the insured against the lawsuit; 2) deny that the policy affords defense or indemnity coverage against the lawsuit; or 3) defend the insured under a reservation of rights to disclaim coverage at a later date. Because many jurisdictions have held that an insurer's decision to defend unconditionally precludes the insurer from later disclaiming coverage, and because the insured's need for a defense typically arises before the insurer has had an opportunity to complete its coverage analysis, an insurer may be reluctant to unequivocally defend its insured. As for denying coverage in its entirety, given the breadth of the duty to defend and given the fact that many complaints contain 'mixed claims,' this option is rarely available to an insurer. As a result, more often than not, an insurer will determine that the best approach is to defend under a reservation of rights ' an approach that may also include the insurer's commencement of a declaratory judgment action to determine the insurer's coverage obligations under the policy. In the event the insurer defends the insured under a reservation of rights, in order to avoid the risk of significant personal exposure, the insured may be persuaded to shift his allegiance to the plaintiff ' and away from the insurer ' resulting in an unauthorized and unfavorable settlement.

In a subsequent direct action to enforce the stipulated judgment, in addition to coverage-based arguments (to the extent that such arguments apply), the insurer has at least three defenses that it can assert. First, the insurer may assert that an insured's participation in an unauthorized, stipulated judgment breaches the insured's duty to cooperate. Second, the stipulated settlement may be the product of collusion or fraud between the plaintiff and insured. Third, in the event the resulting judgment is inflated, the settlement may be 'unreasonable.' As for a defense based on the insured's duty to cooperate, most, if not all, policies explicitly provide that the insured shall cooperate with the insurer. See The CPCU Handbook of Insurance Policies, Third Edition, 1998. In that regard, several jurisdictions have held that where an insurer was defending its insured under a reservation of rights, the insured breached the cooperation clause when it entered into a settlement agreement with the plaintiff without first providing notice to, or obtaining the consent of, its insurer. See Central Bank v. St. Paul Fire & Marine Ins. Co. , 929 F.2d 431 (8th Cir. 1991); Gates Formed Fibre Products, Inc. v. Imperial Cas. and Indem. Co. , 702 F.Supp. 343 (D. Me. 1988); Kelly v. Iowa Mut. Ins. Co. , 620 N.W.2d 637 (Iowa 2000). In Gates, although recognizing that the 'insurer's reservation of right to assert a policy defense may still leave the insured in the precarious position of having to satisfy an uninsured judgment,' the court held that, under a general liability policy, the uncertainty did not excuse the insured from providing notice to its insurer of the negotiations leading to the settlement. Id. at 347. Similarly, in Central Bank, the Eighth Circuit held that, under a directors and officers' liability policy, where an insured accepted a defense under a reservation of rights, it 'bound itself to cooperate with the insurer and foreclosed its unilateral right to settle the claim.' 929 F.2d at 433. In each instance, as a result of the insured's breach, the insurer was relieved of its obligation to indemnify.

A number of jurisdictions, however, have held that, when an insurer defends under a reservation of rights, the insured is free to act in his own self-interest and negotiate the best deal possible to protect his interests. See USAA v. Morris , 741 P.2d 246 (Ariz. 1987); Miller v. Shugart , 316 N.W.2d 729 (Minn. 1982). In reaching this conclusion, one court explained that 'the insurer's insertion of a policy defense by way of reservation or nonwaiver agreement narrows the reach of the cooperation clause and permits the insured to take reasonable measures to protect himself against the danger of personal liability.' INA v. Spangler , 881 F.Supp. 539, 545 (D.Wyo. 1995). As a result of the conflicting legal authority, an insurer's ability to prevail solely on a lack of cooperation defense will primarily depend on the jurisdiction.

A second line of defense that an insurer should explore is whether the stipulated settlement was the product of collusion or fraud between the parties. A third, and related, defense focuses on the 'reasonableness' of the stipulated settlement. Courts have consistently demonstrated concern about the validity of stipulated settlements between a plaintiff and an insured, especially when coupled with a covenant not to execute against the insured personally. Indeed, several courts have held that such settlements are not binding on an insurer for public policy reasons.

Unlike a typical settlement, the point of a stipulated settlement is 'not to end the litigation but to prolong it' with '[t]he entire purpose of the arrangement [being to] find a way to recover against' the insurer. State Farm Fire and Cas. Co. v. Gandy , 925 S.W. 2d 696, 712 (Tex. 1996). As a result, courts often apply a heightened level of scrutiny to such settlements precisely because such settlements are rife with the potential for collusion, unreasonableness and bad faith. Continental Cas. Co. v. Westerfield , 961 F.Supp. 1502, 1505 (D. New Mex. 1997) (reasoning that 'cases involving an insurer's duty to indemnify against a stipulated judgment, coupled with a covenant of non-execution, in circumstances replete with collusion ' warrants heightened scrutiny'); Steil v. Florida Physicians Ins. Reciprocal , 448 So. 2d 589, 592 (Fla. Dist. Ct. App. 1984) (noting that the settlement figure in the context of a settlement with a covenant not to execute 'is more suspect' because the insured 'has little or nothing to lose because he will never be obligated to pay'). Recognizing that an insured may settle for an 'inflated amount or capitulate to a frivolous case merely to escape exposure or further annoyance,' a few courts have held that, neither the fact nor the amount of liability is binding on the insurer unless either the insured or plaintiff demonstrates that the settlement was 'reasonable and prudent.' Morris, 741 P.2d at 253.

One disadvantage, however, to raising collusion, fraud or unreasonableness in a subsequent action is the necessity for the insurer, in order to prove its defense, to litigate the merits of the underlying action after a court has approved and entered judgment. Similar to a legal malpractice action, the insurer's defense can often entail a virtual 'trial within a trial' where a fact-finder would be called upon to evaluate whether the stipulated settlement was reflective of the merits of the underlying action. Because the insured generally possesses most, if not all, of the factual information surrounding its defense, the insurer is, of course, at a significant informational disadvantage to challenge the reasonableness of a settlement. Although the insurer should be permitted to conduct extensive discovery to obtain the necessary information, this approach is costly and, unlike a legal malpractice claim, it is doubtful that anyone with pertinent information will be willing to assist the insurer.

As an alternative to litigating reasonableness in a subsequently filed direct action, a handful of courts permit an insurer, when defending under a reservation of rights, to intervene into the liability action prior to the entry of the stipulated judgment so that it may participate in an evidentiary hearing on reasonableness. This approach was recently discussed in Himes v. Safeway Ins. Co. , 66 P.3d 74 (Ariz. 2003). In Himes, prior to the entry of the stipulated judgment, the insurer moved to intervene and requested that an evidentiary hearing be conducted to evaluate the 'reasonableness' of the stipulated settlement. The trial court permitted the insurer to intervene, but determined that it was inappropriate for the trial court to substitute its own belief regarding reasonableness for that of the parties. Consequently, the trial court found that, in the absence of any evidence that the agreement was per se unreasonable, judgment would enter for the full amount of the stipulated settlement.

Reversing the trial court, the appellate court explained that, as a preliminary matter, the burden is on the plaintiff and the insured to prove the reasonableness of a stipulated settlement that includes a covenant not to execute. The appellate court further explained that, because there is absolutely no incentive for an insured holding a covenant not to execute to agree to a reasonable settlement, there is a presumption that a stipulated settlement is neither reasonable nor the product of an arms-length negotiation. Indeed, 'the incentive is to accept whatever number is proposed to avoid 'the sharp thrust of personal liability.” Id. at 80.

To rebut the presumption that a stipulated settlement is unreasonable, Himes held that, prior to the entry of judgment, the plaintiff and insured must prove by a preponderance of the evidence that the settlement amount is reasonable. In other words, the parties must establish 'what a reasonably prudent person in the insured's position would have settled for on the merits.' Id. To evaluate reasonableness, Himes found the following factors relevant: '[t]he releasing person's damages; the merits of the releasing person's liability theory; the merits of the released person's defense theory; the released person's relative faults; the risks and expenses of continued litigation [on the merits]; ' any evidence of bad faith, collusion, or fraud; the extent of the releasing person's investigation and preparation of the case; and the interests of the parties not being released.' Notably, because the fact-finder must assume that the settlement would be funded by the insured and, therefore, the insured would have every incentive to keep the settlement as low as possible, the insured's ability, or inability, to pay is entirely irrelevant.

As for the insurer's role, Himes found that a stipulated settlement is not binding on an insurer unless the insurer had the opportunity to participate in the reasonableness hearing and contest the evidence offered to support the settlement. Consequently, in the event the plaintiff or insured failed to notify the insurer of the stipulated settlement prior to the entry of final judgment, the judgment would not be binding on the insurer in a subsequent proceeding. Critically, however, Himes suggested that, where an insurer was provided notice of a stipulated settlement and failed to intervene or request an evidentiary hearing, an insurer may waive its right to challenge the reasonableness of the settlement amount.

The approach outlined in Himes has several benefits to the insurer. First, the burden is placed squarely on the plaintiff and insured to prove reasonableness. To satisfy this burden, the parties must overcome the presumption that a stipulated settlement is unreasonable. Second, the insurer may challenge the settlement prior to the court's approval and entry of judgment and, therefore, the insurer is not attempting to, in effect, 'undo' a court-approved, prior judgment. Third, during the evidentiary hearing, the insurer may introduce its own evidence as to the true value of the settlement. By way of example, in Himes, numerous experts testified as to the claim's true settlement value. Fourth, unless the insurer had notice of the stipulated settlement and the opportunity to participate in the evidentiary hearing, the stipulated settlement amount would not be binding in a subsequent action.

A final benefit to the insurer stems from the requirement that the insured provide notice of the settlement to the insurer. The opening, or re-opening, of communications between the insured and the insurer should not be undervalued because it provides the insurer with the opportunity to not only revisit its coverage position, but, more importantly, to attempt to dissuade the insured from entering into such an agreement. Recognizing that a typical insured enters into a stipulated judgment to eliminate the risk of personal exposure, the insurer can use this opportunity to remind its insured that, although he may receive a covenant not to execute from the plaintiff, the entry of a stipulated judgment can have dire consequences on the insured's credit, business transactions and ability to obtain insurance coverage in the future. After evaluating the long-term consequences of the stipulated settlement, an insured may be persuaded that it is more prudent to be aligned with his insurer and pursue their common goal of defeating the plaintiff's claims.

Until, however, courts uniformly recognize, as in Himes, that a stipulated settlement is inherently problematic, the plaintiffs will continue to use an insurer's issuance of a reservation of rights to inflate the true value of their claims. In the meantime, relying on the legal and practical tools that are available, insurers should continue to develop strategies, both offensive and defensive, to respond to stipulated settlement situations.

Kim V. Marrkand, a member of the litigation section in the Boston office of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C., chairs the firm's insurance/reinsurance group and is on the Board of Editors of this newsletter. Nancy D. Adams, CPCU, an associate in the litigation section in Mintz Levin's Boston office, is a member of the firm's insurance/reinsurance group. The authors acknowledge the assistance of Meredith M. Leary and Hemanth C. Gundavaram in the preparation of this article. The views expressed in the article are those of the authors and not necessarily those of Mintz, Levin or its clients.