Prologue

“The farther down the continuum from contested judgment to voluntary payment the facts lie, the more difficult it will be to prove the existence of an ‘amount which the insureds are legally obligated to pay.”[1]

Introduction

Collusion is a species of fraud that is difficult to define[2], creates a limited defense[3], but is easily distinguished from proper cooperation.[4] While perhaps hundreds of reported opinions mention in passing that the law will not tolerate collusion, a more limited but manageable body of California law describes the utility and boundaries of collusion. Collusion is usually a question of fact. It appears that often triers of fact, trial courts and courts of appeal are as influenced by a party’s lack of courtesy and decorum as they are with what actually happened.

A policyholder whose liability insurer wrongfully fails to defend is free to resolve a plaintiff’s lawsuit without the consent or participation of the defaulting insurer. Numerous reported California opinions have examined a wide variety of resolution options that illuminate whether a defaulting insurer may assert the collusion defense, and if so, under what circumstances the defense has been successful. The picture that emerges from this vast body of law seems to be that there is a continuum of resolution options ranging from a vigorously contested trial at one end of the spectrum all the way down to fabricated liability and damages at the other end of the spectrum. The more objectively trustworthy the mode of resolution of the plaintiff’s lawsuit appears to be, the more likely it is that the court in a coverage fight will find the defaulting insurer to be bound by it. On the other hand, the more suspicious the circumstances of settlement of the plaintiff’s lawsuit appears to be, the more likely it is that the court in a coverage fight will require a trial on the issues of the policyholder’s liability to the plaintiff and/or the amount of the plaintiff’s damages. More severely, the court in the coverage fight may deny any recovery for a collusive settlement.

The law seems clear that an abandoned policyholder and a plaintiff are afforded free latitude to communicate with one another and to cooperate with each other. However, they may not hold an insurer (notwithstanding its wrongful failure to defend) responsible to pay if the policyholder’s legal liability to the plaintiff is not genuine or if the amount of damages to which the parties agree is determined to be unreasonable. Even a defaulting insurer will be permitted to avoid liability for a collusive settlement because any other result would operate as a fraud – not just against the insurer, but also against the justice system.[5]

The following collection of “collusion” cases surveys the spectrum of resolution options available to an abandoned policyholder.[6]

Substance Over Form – Has Due Process Been Served?

The courts tend to honor a genuine adjudication of issues over a fast and loose settlement. Also a settlement that results in a stipulated judgment is not likely to garner any greater respect from the courts than a lone settlement agreement that omits the procedural formality of a judgment. The courts do not hesitate to look beyond the form of a judgment to dissect the substance of the agreement to reach the merits of the outcome. “The facts and circumstances which will lead a court to conclude that either [fraud or collusion] are present are limited only by the imagination of those who would cheat and deceive.”[7] In one case, a plaintiff recovered nothing where a jury found a settlement to be collusive.[8]

Adjudicated Resolution Is Preferred

Contested Trial

A fully contested trial usually provides the most convincing evidence that the resulting judgment is free of collusion. “The judgment recovered in such a case is the mode by which the insured proves to the insurer that the intrinsic character of the accident was such that he was liable for the consequences of it, and the judgment is conclusive evidence that the insured was liable, and to the extent of the amount of the judgment.”[9]

In Xebec[10], a D&O insurer failed to defend a series of related liability lawsuits, whereupon the policyholders entered into a settlement with the plaintiffs. Procedurally, the parties underwent an arbitration and court proceeding implemented the settlement, but neither the arbitration nor the judicial approval of the outcome altered the substance of the settlement agreement negotiated by the parties. In a subsequent suit against the insurer, a jury found that the settlement was not collusive. Nonetheless, the court of appeal remanded the matter to the trial court for further proceedings as to the amount of damages. The court stated: “[T]he easiest case for assessment of indemnity damages almost certainly would be one in which the third party claimant had forced the insured to trial and had obtained a fully litigated judgment fixing the amount due on the claim. Such a judgment, in contested proceedings, would provide relatively persuasive evidence of both the obligation and its amount.”[11]

However, in Jordache[12], an insurer refused to defend a lawsuit against its insured. On the eve of trial, the plaintiff and defendant settled on terms that included filing a second amended complaint for negligence and defamation based on facts of which the insurer had no prior notice. Two days later, the policyholder notified the defaulting insurer of the amendment and trial. Two more days later, the plaintiff and defendant conducted a 25 minute trial in which the defendant offered no defense and the defaulting insurer did not participate. The court stated: “The question is difficult, but clearly something seems amiss in the circumstances surrounding the ‘trial’: the last-minute stipulation to amend the complaint with new causes of action arguably covered by the policy and the extremely perfunctory trial itself with virtually no opposition from defendant. It appears that the trial was substituted for a stipulated judgment, in order to provide unchallengeable findings of negligence and defamation, with the aim of creating some form of policy coverage.”[13] The court of appeal remanded the matter for further proceedings on the merits stating: “we conclude [that the insurer] has presented an adequate case for relief from the judgment due to the surprise of the second amended complaint.”[14]

The Rose[15] case is full of peculiarities. The insurer did pay to defend the policyholder, who was not wrongfully abandoned. Liability was adjudicated in bankruptcy court, but following a trial on the merits, the case was settled by way of a stipulated judgment under the supervision of the trial judge specifying that $30k in damages was attributable to intentional conduct while $1M was for negligence. In a subsequent coverage action to collect the stipulated judgment, the injured plaintiff recovered nothing because the judgment was not entered following an “actual trial.” The court concluded that “[a] consent judgment does not satisfy the requirement of a judgment after actual trial as a condition precedent to the maintenance of an action against the insurer.”[16] “[A] judgment against the insured after actual trial eliminates the possibility of collusion since it imposes the requirement of an actual contest of issues and does not include a judgment entered by the court after the approval of a compromise settlement agreement by the insured and the injured party. The requirement of judgment after actual trial thus is necessary for the protection of the insurer. It is also a requirement that the insured readily can meet by refusing to enter into a settlement or compromise agreement with the injured party absent the knowledge and consent of the insurer.”[17]

Default Prove-Up

A default judgment requires the plaintiff to present evidence proving the elements of a cause of action but lacks the presentation of contrary evidence usually available in a fully contested trial. Nonetheless, courts tend to enforce default judgments against insurers that wrongfully failed to defend because any shortcomings of this procedure are a direct result of the insurer’s failure to defend. Thus, where the policyholder suffers a default judgment because the insurer fails to defend, the courts are not likely to grant relief to an insurer for a result of its own making.

In Amato[18] the court held “that where an insurer tortiously breaches the duty to defend and the insured suffers a default judgment because the insured is unable to defend, the insurer is liable for the default judgment, which is a proximate result of its wrongful refusal to defend.” “Having defaulted, the company is manifestly bound to reimburse its insured for the full amount of any obligation reasonably incurred by him. It will not be allowed to defeat or whittle down its obligation on the theory that plaintiff himself was of such limited financial ability that he could not afford to employ able counsel, or to present every reasonable defense, or to carry his cause to the highest court having jurisdiction. Sustaining such a theory would tend to encourage insurance companies to similar disavowals of responsibility with everything to gain and nothing to lose.”

In Clemmer[19], the Supreme Court held that an insurer that disclaimed coverage was bound by a default judgment thereafter entered notwithstanding the fact that the insurer was first notified “on the day before the hearing on default judgment.” The Court specifically found that the insurer failed to demonstrate that it was prejudiced by late notice.[20]

However, a default judgment is not always honored by the courts. In Xebec, the court expressed concern over the binding effect on an insurer of a stipulated judgment with a covenant not to execute. The court stated that such a judgment “should bind the insurer only to the extent it represents a true independent adjudication of the insured’s liability.”[21] The court observed that a “default [judgment] proving-up proceeding preserve[s] a semblance of independent adjudication under court supervision which is wholly lacking” in the context of a stipulated judgment for a covenant not to execute.[22]

Uncontested Trial

Several reported opinions have addressed cases where the terms of settlement called for some form of judicial hearing at which little or no defense was presented. While this procedure may be quite similar to a default prove-up, the results are mixed.

In Garamendi[23], the court stated: “(A) trial does not have to be adversarial to be considered an ‘actual trial’ under the ‘no action’ clause, or to be considered binding against the insurer in a section 11580 proceedings.[24] [Citation.] In deciding whether a judgment involving the injured party and the insured is binding on the insurer, courts focus on whether the facts have been adjudicated independently in a process that does not create the potential for abuse, fraud or collusion.”

In Zander[25], an insurer repudiated any obligation to defend a personal injury action. After notifying the insurer of its intention to settle, the plaintiff settled with policyholders who gave a covenant not to execute, whereupon the policyholders did not appear nor defend at the trial. The court ruled that the “fact alone that the insured permitted (plaintiff) to take an uncontested judgment and that (plaintiff), unopposed, proved a case under which a . . . judgment was pronounced by a trial court does not establish fraud.”[26]

In Samson[27], a primary insurer defended and paid its policy limits to settle litigation against its insured. The settlement included a covenant not to execute and an assignment of rights from the policyholder to the plaintiff. Another insurer, Transamerica, failed to defend and refused a policy limit settlement demand. At a short cause trial, no defense was presented and a judgment was entered in excess of Transamerica’s limits. Transamerica was held liable for the entire judgment.

In Lynette. C.[28], judgment was entered in a sexual molestation case following the presentation of evidence of liability and damages in an uncontested court proceeding. The insurer provided a defense to the policyholder through Cumis counsel, who agreed to the uncontested trial. Dependent counsel was present in court for the trial, but remained neutral, neither supporting nor opposing the procedure. In a subsequent direct action by the plaintiff to recover the judgment, the court required the insurer to pay for the outcome of the uncontested trial. “In deciding whether a judgment involving the injured party and the insured is binding on the insurer, courts focus on whether the facts have been adjudicated independently in a process that does not create the potential for abuse, fraud or collusion.”[29]

However, an uncontested trial does not guarantee that a settlement is free of collusion. In Andrade,[30] the defendant had a primary liability policy with limits of $1 million. However, the primary insurer was insolvent and did not participate in the defense nor settlement of the third party liability suit. The defendant also had an excess liability policy. The excess policy did not require the insurer to defend its policyholder. The excess insurer was only obligated to pay for liability in excess of $1 million. The third party plaintiff suffered bodily injuries that the court concluded were objectively valued in the range of $200k to $350k. During the pendency of the liability suit, the plaintiff offered to settle for $950k, a sum that was insufficient to trigger the excess insurer’s duty to indemnify. The plaintiff and defendant ultimately negotiated settlement for $1.5M. Significantly, this negotiated figure exceeded both the objective valuation of the plaintiff’s injuries and the sum for which the plaintiff was previously willing to settle, but it invaded the excess insurer’s limits. A jury found that the settlement for $1.5M was collusive. As a result, the injured plaintiff recovered nothing and the excess insurer paid nothing.

Arbitration

Some liability policies include a provision that prohibits resolution by arbitration unless the insurer consents to this form of alternative dispute resolution. However, this contractual provision may be abrogated when the insurer refuses to defend.[31] In Parks[32], an insurer failed to defend an insured who was sued by a badly injured bodily injury plaintiff. The abandoned policyholder resolved the matter by binding arbitration that was vehemently defended by counsel. The arbitration award was confirmed as a court judgment. In a subsequent action to recover the judgment from the defaulting insurer, the court held that it was not error to refuse to give a jury instruction on collusion where the insurer presented “no viable evidence to support” collusion.[33]

Settlements Are Scrutinized

While an abandoned policyholder is not required to submit the dispute with the plaintiff to judicial resolution, settlements appear to be subject to greater judicial scrutiny than are adjudicated resolutions in subsequent coverage litigation against the insurer.

Settlement May Raise Rebuttable Presumptions Of Liability And Damages

Dicta in Lamb, recognized that an abandoned policyholder may settle with an evidentiary presumption. “[W]here there is no trial and no judgment establishing the liability of the insured, but a settlement of the litigation has been made. . . , the question as to the fact of liability and the extent thereof . . . may be litigated and determined in the action brought by the insured to recover the amount so paid in settlement. The settlement, or a judgment rendered upon a stipulation of such a settlement, becomes presumptive evidence only of the liability of the insured and the amount thereof, which presumption is subject to being overcome by proof on the part of the insurer.”[34]

In Kershaw[35], the court stated: “the law is well settled that, where one is bound either by law or agreement to protect another from liability, he is bound by the result of a litigation to which such other is a party, provided he had notice of the suit and an opportunity to control and manage it.” The court of appeal approved the following Jury Instruction: “The burden is on the [insurer] to overcome the presumptive evidence that the settlement made by the [policyholder] was reasonable and made in good faith.”

In Ritchie[36], the court stated: “defendant improperly refused to defend. This gave plaintiffs the right to make any reasonable and bona fide compromise of the action against them.”[37]

In Isaacson[38], the court stated: “Further, if an insurer wrongfully fails to provide coverage or a defense, and the insured then settles the claim, the insured is given the benefit of an evidentiary presumption. In a later action against the insurer for reimbursement based on a breach of its contractual duty to defend the action, a reasonable settlement made by the insured to terminate the underlying claim against him may be used as presumptive evidence of the insured’s liability on the underlying claim, and the amount of such liability. (Citations omitted.)”

In Xebec, the court found that “it is now clear that the settlement will not inevitably fix the amount the insured can recover but will instead give rise only to a presumption as to the fact and amount of injury to the insured.”[39]

Settlement Approved Pursuant to Code of Civil Procedure § 877.6

There is a split of authority whether a good faith settlement that passes muster pursuant to Code of Civ. Proc. §877.6 will conclusively bind a defaulting insurer. However, the correct rule is likely to be that a settlement approved under §877.6 does not conclusively bind a defaulting insurer.

In Roman[40], the court found a “stipulated judgment and assignment . . . was specifically approved as a good faith settlement under Code of Civil Procedure section 877.6 after a thorough hearing” and approved a stipulated judgment for $1.3M. “[W]e conclude there is no basis for concern, therefore, that the parties engaged in collusive or abusive conduct.”[41]

In Diamond Heights[42], primary insurers negotiated a settlement for a sum that exceeded its policy limit without an excess insurer’s consent. “We conclude . . . that the primary insurer may enter into such settlement binding upon the excess insurer without the excess insurer’s consent. . . . In a somewhat analogous situation, when a primary insurer wrongfully denies coverage, unreasonably delays processing a claim, or refuses to defend an action against the insured as required by the policy, the insured is entitled to make a reasonable settlement of the claim in good faith and then sue for reimbursement, even though the policy prohibits settlements without the consent of the insurer.”[43] The court concluded that the excess insurer could have participated in the good faith hearing to voice its objections, but failed to do so. The court held that the excess insurer’s “claims of bad faith and collusion in the instant action are therefore barred as a matter of law under section 877.6.”[44]

In Pacific Estates[45], the parties tried to settle a large construction defect case on terms by which certain insurers paid $2.75M and a stipulated judgment was entered for $9M that the parties could seek to collect from non-participating insurers. The court of appeal ruled that “a good faith finding by a trial court should . . . be given the benefit of an evidentiary presumption in a later suit against an insurer who wrongfully denies a defense or indemnity”[46], but that “the nonparticipating insurers are not conclusively bound by a stipulated judgment by principles of res judicata or collateral estoppel. We further hold the statutory provisions of section 877.6 provide no authority for binding nonparticipating insurers to a stipulated judgment as ‘co-obligors on a contract debt.’”[47]

In Pruyn[48], the court concluded that judicial participation under §877.6 is not sufficient to bind a defaulting insurer. “A nonparty insurer must be given a fair opportunity to litigate the question of whether the settlement was unreasonable or was the product of fraud or collusion between a settling insured and the claimant. To hold otherwise would in effect treat a determination of good faith under section 877.6 as the procedural equivalent of a judgment entered after a default hearing or uncontested trial. This we cannot do.”[49] Rejecting the analysis of the court in Diamond Heights, the court stated: “Finally, it does all of this in a procedural context in which the insurer has no right to participate. An insurer is not a party entitled to oppose a good faith motion (citation) and for it to do so might, in addition, unfairly and unreasonably interfere with a settlement which could well be in the best interests of its insured, particularly if a covenant not to execute is a part of that settlement.”[50]

Although not technically an §877.6 case, in Sanchez[51], the court of appeal found no collusion where “the trial court found that the amount of the settlement was ‘in the ballpark’ with the tortfeasor’s liability, that there was an absence of fraud or collusion, and that the settlement was made in good faith. Additionally, the terms of the settlement agreement provided that the corporation remained liable for $25,000 in damages if the direct action against the insurer proved unsuccessful (e.g., if the insurer could prove an exclusion in the policy applied.)”[52]

Covenants Not To Execute Are Closely Scrutinized

Some reported opinions have approved settlements that included a covenant not to execute. Zander held that a settlement including a covenant not to execute that resulted in an uncontested trial “does not establish fraud.”[53] Samson found “nothing fraudulent or collusive ”[54] in a settlement that included a covenant not to execute.

However, other reported opinions have expressed grave scepticism. The court in Doser[55], a jury found reverse bad faith and the court wrote a scathing indictment of a collusive settlement (“worthless paper transaction”[56]) that “bootstrapped their damages with the ingenious assistance of counsel.”[57] In Xebec, the court noted that “a true independent adjudication of the insured’s liability”[58] “is wholly lacking”[59] with a stipulated judgment for a covenant not to execute. In Pruyn, the court noted that “[a] nonparty insurer must be given a fair opportunity to litigate the question of whether the settlement was unreasonable or was the product of fraud or collusion”[60], “particularly if a covenant not to execute is a part of that settlement.”[61] In Smith[62], the court held that “[a] stipulated judgment with a covenant not to execute will not bind the insurer. . . . The covenant not to execute shields the insured from such liability. Similarly, the stipulated judgment will not bind the insurer through the doctrine of res judicata because the insurer is not a party to the judgment.”[63] The court reasoned “that to sanction such a transaction ‘would be to invite collusion between the claimants and the insured’ by allowing them to ‘bootstrap[] their damages with the ingenious assistance of counsel.’”[64]

Burden of Proof

The presumption of liability and damage that results from a good faith settlement by an abandoned policyholder relieves the policyholder of the burden of satisfying typical policy language such as: “We will pay those sums that the insured becomes legally obligated to pay as damages”. “We also conclude the insured is not required, in these circumstances, to conduct a ‘trial [of the underlying case] within a trial,’ in order to recover the amount of the default judgment from the insurer who wrongfully refused to defend.”[65]

Practice Pointer

In a suit against a defaulting insurer to recover a judgment or settlement of a third party liability action, the policyholder’s burden should be satisfied by proof of: 1) a policy; 2) notice of suit to the insurer; 3) the insurer’s wrongful failure to defend, and 4) the fact of liability and damage pursuant to the terms of the judgment or settlement. In the case of an adjudicated judgment in the liability suit, the insurer’s liability is usually conclusively established. In the case of a settlement, the insurer’s liability is subject to a defense of collusion, for which the insurer carries the burden of proof. In contrast, a judgment debtor’s burden should be satisfied by proof of: 1) the insurer’s wrongful failure to defend; 2) a duty to indemnify pursuant to the terms of a policy; and 3) the fact of liability and damage pursuant to the terms of the judgment or settlement.

Table of Cases

Amato v. Mercury Casualty Co. (1997) 53 Cal.App.4th 825

Andrade v. Jennings (1997) 54 Cal.App.4th 307

Clemmer v. Hartford Ins. Co. (1978) 22 Cal.3d 865

Diamond Heights Homeowners Assn. v. National American Ins. Co. (1991) 227 Cal.App.3d 563

Doser v. Middlesex Mutual Ins. Co. (1980) 101 Cal. App. 3d 883

Garamendi v. Golden Eagle Ins. Co. (2004) 116 Cal.App.4th 694

Hone v. Climatrol Industries, Inc. (1976) 59 Cal.App.3d 513

Isaacson v. California Ins. Guarantee Assn. (1988) 44 Cal.3d 775

Kershaw v. Maryland Casualty Co. (1959) 172 Cal.App.2d 248

Lamb v. Belt Casualty Co. (1935) 3 Cal.App.2d 624

Lipson v. Jordache Enterprises, Inc. (1992) 9 Cal. App.4th 151

National Union Fire Ins. Co. v. Lynette. C. (1994) 27 Cal.App.4th 1434

Pacific Estates, Inc. v. Superior Court (1993) 13 Cal.App.4th 1561

Pruyn v. Agricultural Ins. Co. (1995) 36 Cal.App.4th 500

Ritchie v. Anchor Casualty Co. (1955) 135 Cal.App.2d 245

Roman v. Unigard Ins. Group (1994) 26 Cal. App.4th 177

Rose v. Royal Ins. Co. of America (1991) 2 Cal.App.4th 709

Safeco Ins. Co. of America v. Parks (2009) 170 Cal.App.4th 992

Samson v. Transamerica Ins. Co. (1981) 30 Cal.3d 220

Sanchez v. Truck Ins. Exchange (1994) 21 Cal. App.4th 1778

Smith v. State Farm Mut. Auto. Ins. Co. (1992) 5 Cal. App. 4th 1104

Xebec Development Partners, Ltd. v. National Union Fire Ins. Co. (1993) 12 Cal. App.4th 501

Zander v. Texaco, Inc. (1968) 259 Cal.App.2d 793