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Fifth Circuit Interprets Texas’s No-Direct-Action Rule As Applied To Third Party Plaintiffs With Underlying Default Judgment

By Beth Kressel Itkin*

It is well-settled Texas law that plaintiffs are prevented from directly suing a defendant’s insurer unless and until a final judgment or settlement has resolved the litigation at issue. A related line of cases sets out when a third party (not the insured) can bind a non-participating insurer to an underlying judgment or settlement. The Fifth Circuit has now analyzed both principles to anticipate how the Texas Supreme Court would rule on what it described as an unsettled question of law: Is a plaintiff who obtains a judgment that is not “fully adversarial” barred from suing its adversary’s insurer for the judgment under the no-direct-action rule?

The Fifth Circuit answered a qualified “no,” holding that an insurance coverage suit brought by an underlying plaintiff who obtained only a default judgment against the underlying defendant-insured could proceed on jurisdictional grounds (though it then determined the insurance policy excluded the claim).

The case is Turner v. Cincinnati Insurance Co., 9 F.4th 300 (5th Cir. 2021). In Turner, the plaintiffs sued the insured, ATI, a for-profit-operator of trade schools, for fraud, unjust enrichment and under the Texas Deceptive Trade Practices Act, among other causes of action, related to their marketing and operations of the schools (“Underlying Action”). 9 F.4th at 305. The Underlying Action (and related lawsuits) were stayed pending ATI’s bankruptcy proceeding. Id. at 306. ATI’s bankruptcy trustee filed an insurance coverage action against Cincinnati but settled the case before trial in exchange for a release and discharge of Cincinnati for liability “arising out of or related to” the coverage lawsuit, the former-student lawsuits, and insurance policy. Id. The plaintiffs then filed a motion seeking a lift of the stay of the Underlying Actions, which was granted. Id. They then obtained a default judgment against ATI, who did not appear at trial or offer any defense. Id. The plaintiffs filed this insurance coverage lawsuit and both sides moved for summary judgment. Id.

The No Direct Action Rule Explained

The Fifth Circuit’s holding is based on the “no direct action” rule in Texas and a line of cases requiring “fully adversarial” underlying proceedings. With respect to the “no direct action” rule, the rationale is that, unless and until a final decision on the underlying liability has occurred, a third-party plaintiff (the party who sued the insured-defendant) has no ripe claim. Turner v. Cincinnati Insurance Co., 9 F.4th 300, 309 (5th Cir. 2021); see, e.g., In re Essex Ins. Co., 450 S.W.3d 524, 525 (Tex. 2014).

The “Fully Adversarial” Rule Explained

The issues posed by the “fully adversarial requirement” are more complicated. The general rule is that “if an insurer wrongfully denies coverage and its insured then enters into an agreed judgment, the insurer is barred from challenging the reasonableness of the settlement amount.” Evanston Ins. Co. v. ATOFINA Petrochemicals, Inc., 256 S.W.3d 660, 671 (Tex. 2008) (citing Emp’rs Cas. Co. v. Block, 744 S.W.2d 940 (Tex. 1988)).

However, in Texas, the situation becomes more complicated when a third-party beneficiary is suing for coverage. See, e.g., Great Am. Ins. Co. v. Hamel, 525 S.W.3d 655 (2017); State Farm Fire & Cas. Co. v. Gandy, 925 S.W.2d 696, 714 (Tex. 1996).

In Gandy, the insured-defendant assigned his rights to policy proceeds to the plaintiff in the underlying litigation in exchange for the plaintiff agreeing never to collect judgment from the insured-defendant. 925 S.W.2d at 698. The Court held the assignment invalid and set forth the following rule:

a defendant’s assignment of his claims against his insurer to a plaintiff is invalid if (1) it is made prior to an adjudication of plaintiff’s claim against defendant in a fully adversarial trial, (2) defendant’s insurer has tendered a defense, and (3) either (a) defendant’s insurer has accepted coverage, or (b) defendant’s insurer has made a good faith effort to adjudicate coverage issues prior to the adjudication of plaintiff’s claim. We do not address whether an assignment is also invalid if one or more of these elements is lacking. In no event, however, is a judgment for plaintiff against defendant, rendered without a fully adversarial trial, binding on defendant’s insurer or admissible as evidence of damages in an action against defendant’s insurer by plaintiff as defendant’s assignee.

Id.

In Hamel the validity of the assignment was not in question because it post-dated the underlying litigation and because the insurer admitted that it breached the insurance policy. 525 S.W.3d at 663-64. Rather, the question was whether the trial met the “fully adversarial” requirement for coverage actions brought by third parties. The court concluded that the trial was not fully adversarial because the insured had assigned its right to recover from the breaching insurer to the plaintiff in exchange for the plaintiff agreeing not to pursue the personal assets of the defendant if judgment was rendered against it. Id. at 667. Although the insurer was not bound by the underlying judgment, the court still held that “we will not preclude the parties from properly litigating the underlying liability issues in a subsequent coverage suit.” Id. at 669.

Turner Decision Explained

Turning back to the Turner case, the district court, relying on Hamel, held for Cincinnati that plaintiffs had no standing to sue Cincinnati because:

a claimant against an insurer obtains standing to litigate a coverage trial through either a judgment resulting from a fully adversarial trial or a valid assignment. Here, Plaintiffs satisfy neither requirement to confer standing in this coverage action.[1]

The Fifth Circuit disagreed after analyzing whether the no-direct-action rule and the Hamel line of cases requiring that the underlying litigation be “fully adversarial” precluded the coverage suit.[2]

With respect to the no-direct-action rule, the court noted that it arose from “the frequent usage of no-action clauses in insurance policies and the Texas courts’ willingness to enforce such provisions.”[3] It also stated that “there also is a public-policy reason against allowing a third-party plaintiff to sue an insured-defendant’s insurer before liability has been established, as the lawsuit would create a conflict of interest for the insurer.”[4]

The Fifth Circuit then analyzed a state appellate decision that “applied the no-direct action rule and Hamel together” holding that there was no ripe claim brought by a judgment creditor against the debtor’s insurer because the underlying judgments were not sufficiently adversarial. 9 F.4th at 311 (analyzing Landmark Am. Ins. Co. Eagle Supply & Manufacturing L.P., 530 S.W.3d 761 (Tex. App.—Eastland 2017, no pet.)). However, the Fifth Circuit distinguished Landmark from the present situation based on a difference in the “no action” clauses in the respective insurers’ policies. The Landmark policy prohibited a direct action against the insurer until liability was established through “actual trial.” 9 F.4th at 311. In contrast, the Cincinnati policy required only an “adjudication.” Id. Therefore, the court held that “the Plaintiffs’ default judgment against ATI is an adjudication that satisfies the no-action clause.” Id. at 313. Relying on Hamel, however, the court held that Cincinnati could still relitigate the amount of the underlying judgment. Id. (citing Hamel, 525 S.W.3d at 668).[5]

It remains to be seen how the Texas Supreme Court will choose to apply Turner but it is possible that it could reach the same result in a simpler manner. The Turner case is distinguishable from both Hamel and Gandy in that there was no assignment. Thus, the sole basis of plaintiffs’ standing was the default judgment. But did the Fifth Circuit need to analyze whether it was “fully adversarial” in order to establish jurisdiction? Possibly not since there was no assignment and the insurer had already denied coverage, eliminating the need for a Gandy-type analysis. The only real question was the insurer’s ability to litigate the reasonableness of the settlement, which became moot upon a finding that there was no coverage under the insurance policy. In a similar factual scenario, future decisions on the “no direct-action” aspect of the decision could possibly be based on just the “no action” clause in the insurance policy. Either way, everyone will be more attuned to the specific wording of insurance policies’ “no action” clauses thanks to the Fifth Circuit’s Turner decision.

*Beth Kressel Itkin is an associate at Tollefson Bradley Mitchell & Melendi LLP. She previously practiced as an attorney in New York and has also worked as an academic book editor at Vanderbilt and Rutgers Universities.

[1] No. 6-19-CV-00642, 2020 WL 1216419 (W.D. Tex. March 12, 2020).

[2] 9 F.4th at 311 (“From the Texas Supreme Court’s no-direct-action rule decisions, we know that ‘the general rule is that an injured party cannot sue the [insured-defendant’s] insurer directly until the [insured-defendant’s] liability has been finally determined by agreement or judgment.’. . . Texas’s highest court, though, has not decided a case involving the no-direct-action rule in the context of plaintiffs obtaining a judgment that is potentially insufficient. At the same time, the court decided each of the cases in the Hamel line . . . without any reference to the no-direct-action rule. We must determine whether there is any overlap.”).

[3] Id. at 309.

[4] Id.

[5] Despite ruling for the plaintiffs on jurisdictional grounds, the Fifth Circuit determined the Underlying Litigation was related to a prior lawsuit that predated the Cincinnati policy and was thus excluded as a claim “first made” prior to the policy. Id. at 317.

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