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Beware the Covenant Judgment

Posted by Mishal Nasir | Aug 31, 2021 | 0 Comments

An insured defendant's ability to independently negotiate a settlement where its insurer declines to settle is well established. This involves the insured defendant entering into a settlement agreement with the plaintiff in exchange for a covenant not to execute the judgment against the defendant, and assignment to the plaintiff of any potential bad faith claims against the insurer. The settlement agreement then undergoes a reasonableness hearing in the superior court where it is examined for fraud or collusion using a fact-specific inquiry based on the Chaussee factors (from Chaussee v. Maryland Casualty Co., 60 Wn. App. 504, 803 P.2d 1339 (1991)), including the releasing party's damages, the merits of the releasing party's liability theory and released party's defense theory, the relative fault and ability to pay, and evidence of bad faith, collusion, or fraud. Once found reasonable, the settlement amount becomes the presumptive measure of an insured's harm caused by an insurer's tortious bad faith, shifting the burden to prove fraud or collusion on the insurer in any subsequent bad faith action.

While the law on covenant judgments is well settled, the recent decision of the Washington Supreme Court in Wood v. Milionis Constr., Inc., No. 98791-2, 2021 Wash. LEXIS 393 (Aug. 5, 2021) serves as a reminder of the many perils of covenant judgment, and especially, the difficulty of reversing a trial court's finding of reasonableness.

In Wood, Cincinnati Specialty Underwriters challenged a trial court's order approving as reasonable a $1.7 million settlement between plaintiffs and Cincinnati's insureds, Milionis Construction Inc. (MCI). The Court of Appeals reversed, holding that the trial court abused its discretion by crediting a defense expert's evaluation of damages higher than it should have been valued, however, the Supreme Court disagreed and reinstated the trial court's order. The case involved a $1.3 million contract for the construction of a single-family residence for which MCI was the general contractor. Construction was halted after several issues with faulty workmanship, leaving the house substantially incomplete and structurally defective. Plaintiffs sued on various grounds including breach of contract, unjust enrichment, promissory estoppel, negligence, and Consumer Protect Act (CPA) violations. Cincinnati, the general liability insurer, retained an attorney to represent MCI under a reservation of rights, and MCI was also represented by personal counsel.

Experts hired by the parties came up with significantly different valuations, ranging from $2.7 million from plaintiff's expert and $570,000 to $1.2 million from defense experts, before general or consequential damages. The parties participated in three unsuccessful mediations over the course of two years. Prior to the third mediation, defense counsel retained by Cincinnati requested settlement authority of $350,000.00 based on the defense expert's evaluation of damages and attorney fees. Cincinnati declined. At the third mediation, the parties tentatively agreed to settle the case for $399,514.58 contingent on Cincinnati agreeing to fully fund the settlement. Again, Cincinnati refused, despite being advised by defense counsel that this was the best deal possible. Cincinnati asserted that MCI's insurance policy did not cover the damages alleged in the plaintiffs' lawsuit. On this basis, Cincinnati sought to obtain a declaratory judgment relating to the applicability of the “your work” exclusion “for damage to [MCI's] own work.” Cincinnati further argued in the declaratory judgment action that the Independent Contractors Limitation Endorsement barred coverage “for [MCI's] derivative liability for subcontracted work [in the event MCI failed to verify the subcontractors' liability insurance].” The federal district court denied the motion.

Meanwhile, as repair costs mounted, defense counsel reassessed the claim to $1.14 million for contractual claims alone and continued to ask Cincinnati to fund the $399,000 settlement reached in the third mediation. A week before arbitration, the parties stipulated to a $1.7 million settlement with a covenant not to execute and an assignment of claims against Cincinnati.

Cincinnati was allowed to intervene at the reasonableness hearing but its motions for a continuance and additional discovery were denied because the requested discovery did not go to reasonableness of the settlement. At the hearing, defense counsel testified that he had provided an estimate of exposure of $1.14 million. The $1.7 million settlement was found reasonable. The Supreme Court agreed, finding that the plaintiffs had demonstrated that MCI breached tort and contract duties proximately causing injuries, and that the trial court appropriately weighed competing expert testimony on damages. Liability was not disputed, and plaintiffs had a strong case for liability on multiple theories. As to bad faith and collusion, court expressed concern that defense counsel was cut out of the settlement talks but found it more troubling that Cincinnati was not forthcoming with the settlement authority being requested given assessed damages. Cincinnati could not prove collusion. The court recognized the fact that the parties pursued settlement negotiations for almost two years, while damages and attorney fees continued to mount, before ultimately turning to the covenant judgment option.

It is worth remembering that wide discretion and deference is afforded to the trial court's determination of reasonableness. The trial court will consider both sides of the equation, will not rely on the most conservative damage estimates, and will allow for higher end evaluations, extra contractual damages, and attorneys' fee in making its determination. Manifest unreasonableness or untenability must be shown to reverse it. This is a tough standard to meet, and thus, a problem best avoided. 

About the Author

Mishal Nasir

Mishal earned her Bachelor of Laws degree in 2008 and postgraduate diploma in Bar Vocational Course in 2009 to become a Barrister, both from Northumbria University in the United Kingdom.  Prior to moving to Seattle, she practiced civil litigation and corporate law in her hometown of Karachi, Paki...

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