C. The Judgment.
The linchpin of any pre-judgment agreement entered into without the insurers consent is a judgment establishing the insured's liability and the injured party's damages. Even where courts focus on the assignment or covenant not to execute, their real concern appears to be not the assignment or covenant standing alone, but the potential for fraud and collusion when the judgment to which they apply results from something less than a full, adversarial trial. Indeed, the division in Ross made specific reference to the fact that the judgment did not result from a contested proceeding in concluding that it was not binding on the insurer.
There are at least three ways in which a judgment creating liability on behalf of the insured can be obtained: (1) a stipulated or consent judgment; (2) an actual judgment by a judge or following an adversarial trial or the insured's default; or (3) a judgment entered by a court following a judicial or quasi-judicial proceeding (e.g., arbitration) confined to certain issues or otherwise limited in the manner or scope of presentation of evidence. The manner in which the judgment creating liability is obtained may be a significant factor in determining whether it should be binding on the insurer; it may lend credibility to the outcome of the process or, on the other hand, it may cause a court to question the result.
In some Colorado cases, a consent or stipulated judgment, when coupled with a covenant not to execute, has been viewed with a skeptical eye. By contrast, a judgment entered following a contested trial or a damages hearing held after the entry of a default judgment seems unassailable. Given the potential for abuse that exists when a judgment is entered following something less than a contested trial or a default damages hearing, many courts allow the insurer to attack the judgment on grounds that it was procured through fraud or collusion. It has been noted, however, that there is nothing inherently fraudulent or collusive about a pre-judgment agreement.
Nor is there is anything inherently fraudulent or collusive about a stipulated or consent judgment. For instance, a stipulated or consent judgment in the amount of $2.0 million may be quite reasonable if the insured's own expert witness or lawyer placed likely damages in this range, or even higher, and advised the insurer that its insured had a 90% chance of being found liable at trial. By contrast, a stipulated judgment in that same amount may not seem reasonable if the insured's lawyer or expert evaluated the case and gave the insured only a 10% chance of losing at trial and indicated that the damages would likely be in the range of $300,000.
In determining issues of fraud or collusion, or deciding whether a given settlement is reasonable, courts in other jurisdictions have fashioned various procedures to address the competing interests of the insurer and the insured. In Arizona, for instance, the procedure employed to determine whether a judgment is binding on an insurer depends on the nature of the insurers misconduct. When the insurer denies its defense obligations, and is subsequently found to have done so wrongfully, it will not be permitted to question the reasonableness of the judgment amount, whether it was stipulated to or reached by any other mechanism. However, when the insurer refuses to settle a case while defending under a reservation of rights, and it is later determined that coverage exists, the insurer will be bound by a judgment when: (1) the insurer is fairly notified by the insured of its intent to enter into a pre-judgment agreement; (2) the agreement is created fairly; and (3) is not the result of fraud or collusion. Further, even when these factors are established, the insured will bear the burden of establishing that the settlement was reasonable and prudent.
The Iowa Supreme Court has adopted a similar test to be used when determining whether an insurer may be held liable for a stipulated judgment:
[I]n settlements like the one here, an insurer, relying on fraud or collusion, must plead and prove these defenses. If either defense is proven, the settlement is invalid and unenforceable against the insurer. The injured party, however, has the burden to prove by a preponderance of the evidence that (1) the underlying claim was covered by the policy, and (2) the settlement which resulted in the judgment was reasonable and prudent. The test the fact finder must apply on this issue is what a reasonable and prudent person in the position of the defendant . . . would have paid to settle the plaintiff's . . . claim. In applying this test, the fact finder must consider facts bearing on the liability and damage aspects of the claim as well as the risks of going to trial.
While judicial approaches vary, the majority of courts have recognized that the risk of collusion and fraud can be lessened . . . if not avoided altogether by placing a requirement upon the plaintiff to prove that the settlement it reached with the insured was reasonable before that settlement can have any binding effect upon the insurer. Despite the abundance of authorities approving of pre-judgment agreements in instances where an insurer wrongfully refuses to defend or settle a third-party lawsuit, Colorado's approval of these agreements remains uncertain, particularly considering the Serna, Seco/Warwick, and Ross decisions. The Colorado Supreme Court may or may not clear up the confusion when it renders its opinion in Ross.