Reservation of Rights and Waiver of Coverage Issues in Construction Defect Litigation

Construction projects are inherently complicated and often involve scores of parties with potentially conflicting rights and obligations. One of the most confusing areas for clients has been reservation of rights and the differences between Damron and Morris agreements. This article is an attempt to unpack and simplify these terms and the application of these agreements.

The terms Damron and Morris come from two seminal Arizona Court decisions which establish the rights of insureds in cases where an insurer either refuses to defend, or reserves its rights. These cases are relevant in the CD context in Arizona, where the notice and opportunity to repair statute (NOR) requires insurers to defend on the seller's (insured's) receipt of a Notice of Deficiencies. (A.R.S. §12-1362(B)). Under the current statute, a seller (insured) only has sixty days to evaluate the buyer's (plaintiff's) claims and provide a good faith response, in other words, an offer to repair or replace. The offer can be in the form of a monetary equivalent of the value of necessary repairs. However, if this opportunity is missed, the plaintiff can immediately file its complaint, and get the benefit of mandatory fees and costs if she is the prevailing party. In the absence of any offer, it is safe to assume plaintiff will be the prevailing party if she obtains only one dollar at trial. On the other hand, a seller can "set the bar" by offering repairs, or an equivalent amount, which can provide significant leverage later in the case. For this reason and others, it is imperative that carriers immediately undertake a coverage investigation on the receipt of a CD claim under the statute, regardless if that obligation arises for a direct or additional insured. Equally important is the early, thorough evaluation of the value of the CD case to make meaningful use of ADR opportunities provided by the NOR statute.

Early defense and meaningful evaluation of CD cases on behalf of insureds can go a long way toward militating against Damron/Morris assignments, which can result in more headaches and expense for carriers.

In Arizona, an insurer may notify its insured that it is defending under a reservation of its rights to contest coverage and its ultimate liability for a judgment. Damron v. Sledge, 105 Ariz. 151, 460 P.2d 997 (1969). Such a reservation of rights must be "properly communicated" to the insured in a timely manner. In other words, a reservation of rights letter must, in a straightforward manner, fairly inform a reader of average intelligence of the fact that the insurer is providing a defense without waiving its rights to later contest coverage. Equity General Insurance Co. v. C & A Realty Co., 148 Ariz. 515, 715 P.2d 768 (App. 1985). It must also inform the reader of the concerns the insurer has with coverage. Globe Indemnity Co. v. Blomfield, 115 Ariz. 5, 562 P.2d 1372 (App. 1977). A reservation of rights should be sent before the insurer assumes the defense, otherwise the insured may reasonably rely upon the non-existence of policy defenses. Equity General.

It should be noted that if an insurer defends under a reservation of rights, an insured has a right to enter into a Morris agreement as described in United Services Automobile Association v. Morris, 154 Ariz. 113, 741 P.2d 246 (1987). Under a Morris agreement, an insured agrees with the plaintiff to allow judgment to be entered against it (either by default or stipulation). The insured also agrees to assign to the plaintiff all rights it may have under its liability insurance policy. The plaintiff, in turn, gives the insured a covenant not to execute upon any of the insured's assets and agrees to collect the judgment only from the liability insurance. The plaintiff then brings a breach of contract/declaratory judgment action against the insurer as the insured's assignee.

The Arizona Supreme Court held in Morris that an insurer's defense under a reservation of rights narrows the reach of the cooperation clause and allows the insured to take reasonable steps to protect itself from the danger of personal liability. Thus, the insured may enter into a settlement agreement as described above without breaching the cooperation clause. The insured's stipulation to liability and damages under a Morris agreement is not binding upon the insurer unless the insured (or its assignee) can show that the settlement was reasonable and prudent. The insured must give the insurer notice of a proposed Morris agreement and give it the opportunity to defend unconditionally.

In Damron v. Sledge, 105 Ariz. 151, 460 P.2d 997 (1969), the insurer denied coverage under an auto policy and declined to defend the insured. The insured entered into an agreement with the plaintiff under which the plaintiff gave him a covenant not to execute in return for his stipulation to a default being entered against him and an assignment of his bad faith claim against the insurer. A default judgment was entered against the insured after a default hearing.

The Arizona Supreme Court held that the insured's action was a proper self-protective response to the insurer's denial of a defense. It held that the agreement was not collusive under the circumstances even though it resulted in a significant ex parte judgment against the insured. It placed the risk of ultimately having to pay an unduly large judgment on the insurer that refuses to defend.

The case gives name to Damron agreements in Arizona.

In United Services Automobile Ass'n. v. Morris, 154 Ariz. 113, 741 P.2d 246 (1987), the insurer defended an insured under a reservation of rights. The insured entered into an agreement with the plaintiff under which the plaintiff gave him a covenant not to execute in return for a stipulation to allow the entry of a $100,000 judgment against him and an assignment of his rights against his insurer.

The Arizona Supreme Court held the agreement did not constitute a breach by the insured of the cooperation clause because the insurer had not extended unreserved coverage. But it concluded that the stipulated judgment would not be binding on the insurer if it could ultimately prove that there was no coverage. In addition, the insurer could attack a judgment on the basis that the insured's settlement was not fair and reasonable under the circumstances. It could also attack a judgment that was collusive or fraudulent.

Morris also requires that an insurer be given reasonable notice of a proposed settlement and the opportunity to withdraw its reservation of rights.

The case gives name to Morris agreements in Arizona.

Since Damron and Morris and some of the subsequent related cases, there has been an impression that an insurer could be held strictly bound by a stipulated judgment of any amount entered in connection with a Damron agreement (refusal to defend), but could only be bound by a judgment of a reasonable amount entered in connection with a Morris agreement (defense under a reservation of rights). See, Arizona Prop. & Cas. Guar. Fund. v. Helme, 153 Ariz. 129, 735 P.2d 451 (1987).

Recent re-examination of language in Helme (which came before Morris) suggests that a Damron settlement also has to be for a reasonable amount. Thus, whether an insurer refuses to defend or defends under a reservation of rights, the insured should only be able to stipulate to a judgment that is "reasonable." See discussion at 153 Ariz. 138, 735 P.2d 460 (West note 14). The issue may not come up if the agreement allows a neutral fact-finder to determine the amount of the judgment.