It is not all that uncommon a scenario for insureds to settle without an insurer’s consent and enter into a stipulated judgment whereby the insured’s rights against its insurer are assigned to a claimant and precluding a financial recovery against the insured. Such a settlement may be appropriate where the insurer has wrongfully abandoned a duty to defend and unreasonably withholds its consent to a settlement but, in most cases, the insureds proceed down this route at their peril and to the ultimate detriment of the claimant-assignee.

A recent Eighth Circuit decision is illustrative. U.S. Bank National Ass’n v. Federal Ins. Co., No. 10-3472, 2011 U.S. App. LEXIS 24623 (8^th Cir., December 13, 2011).

The underlying suit was one brought by a creditor’s trust against a bankrupt insured’s former CFO for breaches of fiduciary duty. The suit settled for $56 million with an assignment from the former CFO to the trust of his rights under the D&O policy at issue. The trust agreed not to seek any financial recovery from him in consideration of the assignment of these rights.

The lower federal court for the Eastern District of Missouri ruled in favor of the primary and excess insurers on the basis that the CFO sustained no loss because he was absolved from any payment obligation.

The Eighth Circuit affirmed on the same basis, i.e. the CFO was absolved from payment by virtue of the assignment agreement. The specific policy language contained in the Loss definition provided that Loss “does not include . . . any amount not indemnified by the Insured Organization for which the Insured Person is absolved from payment by reason of any covenant, agreement or court order . . . .” (emphasis added).

The Court rejected the trust’s estoppel defense, stating that there was no reason for the insurers to be estopped because they abandoned the insured by denying a defense or otherwise contesting coverage. Further, such an estoppel theory, even if otherwise available, could not be used to trump the exclusion found in the Loss definition. Importantly for D&O insurers, the Court drew no distinction between duty to defend policies and duty to pay defense costs policies (such as most D&O policy forms) in enforcing the Loss exclusion for non-recourse settlements.

The result and reasoning here was similar to that in a California decision earlier in the year in Liberty Mut. Ins. Co. v. Electronics for Imaging, No. CIV 484539, Superior Court, San Mateo County, California (Decided March 10, 2011). I would be pleased to share a copy of this decision upon request.

This was a decision that involved a policyholder’s attempt to recover the amount of a stipulated judgment under various excess D&O policies despite the fact that the amount was agreed to by way of a stipulated judgment without any right of recourse against the insureds to pay for any part of the stipulated judgment. The underlying litigation was a shareholders derivative suit and rights under the policy were assigned or otherwise transferred to the plaintiff’s counsel, who then sued on behalf of the corporate insured.

As in many D&O policies, the policies at issue here had a definition of Loss that excluded any amounts for which an insured is absolved from payment by reason of a covenant not to execute. By entering into a “non-recourse” settlement, the insureds breached this policy provision and the Court entered summary judgment in favor of the four excess insurer defendants.

Although an unreported lower court decision, this decision is fully in accord with California Supreme Court’s decision in Hamilton v. Maryland Cas. Co. 27 Cal.4^th 718 (2002). The insured there argued that the insurers were barred from relying on this language because these were not duty to defend policies. The Court, however, viewed that as a distinction without a difference in that the insurers had all acknowledged coverage and never declined to pay any defense costs.

Both of these decisions should make policyholders take pause before entering into any stipulated non-recourse judgment with an assignment or transfer of rights to recover against insurers.