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Insurer Pushing Settlement Off the Rails? A Covenant Not to Execute May Put Things Back on Track

iStock-1026097380-covenant-rails-300x200As coverage counsel, we see the situation arise time and again: facing down substantial potential liability in a pending lawsuit, a policyholder engages in good-faith settlement discussions with the plaintiff. After animated negotiations between the parties, the plaintiff finally makes a reasonable offer, only for the policyholder’s insurance carrier to throw up a roadblock by refusing to fund or consent to the settlement. But policyholders need not always resign themselves to continuing costly and time-consuming litigation—a “covenant not to execute” may be the switch to put the settlement back on track.

A covenant not to execute is a contract where a defendant admits to liability and a set amount of damages, and the plaintiff agrees not to seek a judgment against the defendant based on that admission. In the context of settling an insurance-related claim, the policyholder, often in addition to paying some settlement amount to the plaintiff out-of-pocket, will stipulate to some or all of the allegations in the underlying complaint and the amount of damages owed to the plaintiff. The policyholder will also assign to the plaintiff its rights to recover for the loss under the relevant insurance policy. In return, the plaintiff agrees not to pursue the policyholder for the remaining amount in damages; instead, the plaintiff may sue the uncooperative insurance carrier for the recovery rights assigned to the plaintiff by the policyholder. Importantly, while liability policies usually contain clauses prohibiting the assignment of the policies themselves, they are not generally interpreted to prohibit the right to recover an accrued loss under the policies.

Where available, this strategy can be a win-win for the policyholder: the underlying litigation settles, and the underlying plaintiff takes on the burden of seeking additional amounts from the insurance carrier. But policyholders should be cautious before stipulating to any judgment or assigning their rights.

For one thing, the circumstances where this strategy can be used may be limited. For example, in California (which follows the majority approach), for a covenant not to execute and assignment of rights to be valid, the insurance carrier must first deny coverage and defense to the policyholder, and the settlement agreement with the plaintiff must be reasonable, non-collusive and in good faith. But, when those requirements are satisfied, the stipulated amount of damages will be presumptive evidence of the amount owed to the plaintiff in a subsequent suit against the insurance carrier.

Also, some jurisdictions place limitations on when use of a covenant not to execute is permissible, and some do not recognize its use at all. For example, North Carolina courts have taken a minority approach, holding that, where an insurance carrier’s liability is triggered by damages a policyholder is “legally obligated to pay,” an insurer has no liability to pay a stipulated judgment where the policyholder is protected by a covenant not to execute. Because the “legally obligated to pay” language is a ubiquitous requirement to trigger coverage, the covenant not to execute strategy is essentially foreclosed under North Carolina law.

Although not available in every situation or jurisdiction, a covenant not to execute, paired with a stipulated amount in damages, can be a powerful tool to reach a favorable settlement. Policyholders should coordinate with coverage counsel to ensure the strategy is implemented properly and effectively.