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February 2011

Leflet v. Redwood Fire and Casualty Ins. Co. ? Arizona Primary Insurer May Not Use a Morris Agreement to Reduce its Liability Below Policy Limits

An Arizona Insured and its Primary Insurer Cannot Reach a Settlement Agreement that Avoids the Primary Insurer's Obligation to Pay Policy Limits and Passes Liability in Excess of Those Limits on to Other Insurers

__ Ariz. __ , ___P.3d__ (App. 2011)

Plaintiff homeowners sued Defendant developer, Hancock Communities, LLC, and HC Builders, Inc., (collectively, "Hancock") in a class-action for construction defect involving their residential development.  Hancock filed a third-party complaint against many of its subcontractors.  Hancock tendered its defense to its insurance carriers (collectively, the "Direct Insurers").  Hancock also tendered its defense to its subcontractors' insurers ("non-participating insurers" or "NPIs").  The NPIs' policies provided Hancock primary coverage for claims arising from the scope of the subcontractors' work.  Under the terms of Hancock's policies, "the Direct Insurers furnished primary coverage to Hancock for its own liability and excess coverage for liability attributed to the Subcontractors."   The NPIs accepted Hancock's tender under reservations of rights. 

Plaintiffs entered into a settlement agreement with Hancock and its Direct Insurers pursuant to United Services Automobile Ass'n v. Morris, 154 Ariz. 113, 121, 741 P.2d 246, 254 (1987) ("Morris") without the knowledge of the NPIs.  Hancock and the Direct Insurers agreed to pay $375,000 and assign their rights against the NPIs.  The settlement was well below the Direct Insurer's policy limits. 

The Arizona Supreme Court in Morris held that an insurer who defends under a reservation of rights may be subject to liability for the amount of a stipulated judgment between the plaintiff and its insured.  The rationale is that the insured has a potential interest adverse to that of the insurer in avoiding personal liability.  Such a settlement does not breach the cooperation clause of the policy and allows an insured to potentially obtain a covenant not to execute in exchange for an assignment of its right to sue the insurer for bad faith.  The Supreme Court, recognizing the extreme potential for fraud and collusion, requires that the insured do the following to obtain an enforceable Morris agreement: (1) provide notice to the insurer of the agreement; (2) demonstrate that the settlement is free from fraud and collusion, and (3) prove that the settlement is reasonable.  

Neither Hancock nor the Direct Insurers provided the NPIs notice of the settlement.  Shortly before the Plaintiffs moved for a determination that the stipulated judgment was reasonable, the NPIs intervened.  The trial court granted the NPIs summary judgment.  The trial court determined that the agreement was a Morris agreement, but the failure to provide notice prejudiced the NPIs and breached the cooperation clause.  The Plaintiffs appealed.  

The Court of Appeals held that an insured and its insurer cannot reach a settlement agreement that avoids the primary insurer's obligation to pay policy limits and passes liability in excess of those limits on to other insurers.  Such agreements are invalid because they do not serve the public policy served by Morris which is to protect the insured who is being defended under a reservation of rights against the "prospect of an excess judgment or a judgment within policy limits for which it may not receive coverage."

Hancock did not seek to merely "protect itself from an insurer's refusal to extend unconditional coverage."  Hancock instead acted as the Direct Insurers' agent seeking to limits the Direct Insurers' liability.  Unlike a typical Morris agreement, Hancock and the Direct Insurers' interests were aligned.  Moreover, Morris agreements usually involve a single insurer and a single occurrence.  Here, this case involved separate coverages from various NPIs that were limited by their terms to the scope of the various subcontractors' work.  The NPIs have legitimate interests in ensuring that their liability was confined to the scope of work covered by their policies.  The NPIs could not properly be expected to extend coverage for Hancock's entire liability because there was no determination as to which subcontractors' work contributed to Plaintiffs' damages. 

The Court of Appeals, therefore, "held that an insurer that reserves its rights may not employ Morris to reduce its liability below policy limits, and an insured that facilitates such an effort breaches its duty to cooperate with its other insurers."  The Court recognized the potential for abuse of Morris agreements and concluded that "a settlement that mimics Morris in form but does not find support in the legal and economic realities that gave rise to that decision is both unenforceable and offensive to the policy's cooperation clause." 

The Court further concluded that even if the agreement qualified as a valid Morris agreement, Plaintiffs' failure to provide the required notice prejudiced the NPIs and rendered the agreement unenforceable.  An insurer must be made aware of a Morris agreement so that "it may waive its reservation of rights and provide an unqualified defense, or defend solely on coverage and reasonableness grounds against the judgment resulting from the Morris agreement."  Here, the NPIs "were not given the protections of this choice before the agreement was entered, and therefore can face no liability for the resulting stipulated judgment." 

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This opinion is not final.  Though it has been certified for publication, it may be modified by reconsideration, or granted review by the Arizona Supreme Court.  Should any of these events occur, the opinion would be unavailable for use as authority in other cases.

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Matthew G. Kleiner