Arizona Appellate Court Holds Insured May Settle a Third-Party Claim When Insurer Defends Under a Reservation of Rights

The Court of Appeals for Arizona, Division 1, recently held that in the title insurance context, when an insurer agrees to defend its insured against a third party but reserves the right to challenge coverage, the insured may independently settle with the third-party claimant without violating the insured’s duty of cooperation under the insurance contract. Fid. Nat'l Title Ins. Co. v. Osborn III Partners LLC, 483 P.3d 237 (Ariz. Ct. App. 2021). In 2006, a Mortgagee loaned a developer $41.4 million to fund the construction of a condominium complex, and secured the loan by a deed of trust in order to ensure the priority of its security interest, including over later-recorded mechanics liens. Mortgagee suffered financial problems, resulting in its cutting off of funding to the developer, and later, in an involuntary bankruptcy proceeding and attendant restructuring. Over the course of the bankruptcy, Mortgagee’s interest in the loan was transferred to Successors, including Defendant, and ML Manager was created to manage Successors as well as the restructuring of the original mortgagee. Meanwhile, the developer had hired a general contractor for the construction on the project but had stopped paying them (in part because Mortgagee had cut off funding), leading to a filing of mechanics’ liens against the property by the contractor and its subcontractors seeking payment for completed but unpaid work. Developer and some of these contractors then filed a lien foreclosure action in Superior Court, asserting that their mechanics’ liens had priority over the original deed of trust. Defendant’s title insurer accepted the defense of this action on behalf of Successors but did so under a reservation of rights. After the sale of the underlying property by ML Manager pursuant to a trustee’s sale, ML Manager, on behalf of Successors, and Developer agreed to settle the lien priority case. This agreement was known as a Morris agreement, named after the Arizona Supreme Court case United Services Automobile Ass’n vs. Morris, which held that in the liability insurance context, an insured may settle a third-party claim while being defended under a reservation of rights. 751 P.2d 246 (1987). The Title Insurer objected to approval of the settlement in Bankruptcy Court and intervened in the lien priority case itself, arguing (1) that Morris did not apply to title insurance and (2) that notwithstanding Defendant’s ability to settle the case with the Developer, it was not covered under the insurance policy. The trial court entered judgment for Defendant, holding that Morris indeed applies to title insurance, and that Defendants were also covered under the title insurance policy. The title insurer appealed, and the appellate court affirmed in part and reversed in part.

The Court first affirmed the trial court’s finding that Morris is applicable in the title context. The Court found that Morris recognizes the tension between an insurer’s interest in not wishing to pay a third-party claim as well as the insured’s interest in protecting itself financially, especially when the insurer has not yet accepted full responsibility for a particular claim. These underlying principles, the Court found, were equally applicable to title insurance as liability; although title insurance insures a different kind of risk, the ultimate scenario Morris was intended to mitigate against, a completely uncovered loss, was equally applicable. The Court also noted that under Morris, an insured is still required to provide notice to its insurer before entering into a settlement agreement, allowing the insurer to potentially withdraw its reservation of rights and retain full control over the litigation, and that the ultimate settlement must be reasonable. This, the Court found, balances the rights of the insurer and insured and prevents the insurer from “hamstring[ing] the insured’s ability to negotiate a settlement even though it ha[d] not accepted full responsibility for the insured’s loss.” After making this finding, however, the Court found that as it pertained to this fact pattern, the trial court had erred in finding coverage under the policy and entering a judgment in favor of Defendant. It found that the original Mortgagee’s cutting off of funding to Developer had led to the mechanics’ liens that had later arisen, and therefore, coverage was barred by exclusion 3(a), liens “suffered by” the Insured. As a result, the Court affirmed the trial court’s rulings as it pertained to Morris, but reversed its coverage determination and the resulting judgment in favor of the Successors.

For a copy of the decision, please contact Michael O’Donnell at modonnell@riker.com, Michael Crowley at mcrowley@riker.com, Desiree McDonald at dmcdonald@riker.com, or Andrew Raimondi at araimondi@riker.com.