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Insurance Law Alert: Texas Supreme Court Fleshes Out Gandy "Fully Adversarial Trial" Requirement

June 19, 2017

In a recent decision, the Texas Supreme Court concluded that the Gandy “fully adversarial trial” requirement (under which an assigned underlying judgment against a defendant-insured is only binding on an insurer if the judgment is the product of an adversarial trial) could apply outside of the specific facts in Gandy to: (1) an insurer who had improperly denied a defense to its insured and (2) an underlying judgment in which the insured entered into agreements concerning the evidence, but did not assign its rights until after the judgment was entered. Great American Insurance Company, et al v. Glen Hamel, et al, Case No.14-1007 (Tex. June 16, 2017). Applying the fully adversarial trial standard, the Court held that the underlying judgment was not the result of a fully adversarial trial because pretrial agreements between the insured and the plaintiffs eliminated any incentive for the insured to mount a real defense against the plaintiffs’ claims.

In the underlying action, the insured builder was sued by homeowners after the homeowners discovered water intrusion damage in their house allegedly attributed to the builder’s defective work. The builder tendered the suit to its insurer who declined to defend the builder based on an “EIFS” exclusion. Before trial, the builder and the homeowners entered into an agreement under which the builder’s principal agreed to testify in exchange for a promise that the homeowners would not personally execute the judgment against him or try to pierce the corporate veil. The builder also stipulated that it was responsible for the defects in the home.

During the bench trial in the underlying action, the builder’s attorney called no witnesses, but did cross-examine the homeowners’ witnesses. Following trial, the judge entered a judgment against the builder for $365,089.70. The builder then assigned its rights to pursue claims against its insurer to the homeowners.

The insurer relied upon the general rule from a 1996 Texas Supreme Court case, Gandy, to argue that the homeowners could not recover on their assigned judgment based on collusion between them and their builder. In the Gandy decision, the Texas Supreme Court held that an insured-defendant’s assignment of his claims against his insurer to an underlying plaintiff is invalid if: (1) it is made prior to an adjudication of the underlying plaintiff’s claim against defendant in a fully adversarial trial, (2) the insurer offered a defense, and (3) either (a) the insurer accepted coverage, or (b) the insurer made a good faith effort to adjudicate coverage issues prior to the adjudication of plaintiff's claim. The Court further held in Gandy that in no event, however, is a judgment, rendered without a fully adversarial trial, binding on a defendant’s insurer or admissible as damages in an action against the insurer by the plaintiff as defendant’s assignee. Both the trial court and appellate court in Hamel disagreed with the insurer, holding that Gandy was distinguishable because the insurer had not defended the builder and there was no pretrial assignment of rights. Both courts also found that the judgment was the product of a fully adversarial trial.

On appeal, the Texas Supreme Court reversed. The Court did not invalidate the assignment because it found that the insurer had wrongfully failed to defend its insured. However, the Court held that the underlying judgment was not binding on the insurer, and that the insurer was therefore able to attack the reasonableness of the judgment, because the underlying judgment was not the result of a fully adversarial trial. It held that the “controlling factor” on whether a fully adversarial trial had occurred was “whether, at the time of the underlying trial or settlement, the insured bore an actual risk of liability for the damages awarded or agreed upon, or had some other meaningful incentive to ensure that the judgment or settlement accurately reflects the plaintiff’s damages and thus the defendant-insured’s covered liability loss.” Applying this standard to the facts, the Court held that the parties’ pretrial agreement eliminated any meaningful incentive the builder had to contest the judgment because it removed any financial stake the builder had in the outcome.

In the aftermath of Hamel, insureds who are denied a defense from their insurers must do more than go through the motions of a trial with an underlying plaintiff to ensure that the insurer cannot later attack the reasonableness of the resulting judgment. In situations in which the insured has the resources to mount a defense, Hamel will likely have little or no impact. In situations in which the only potential funding for a defense would come from the wrongfully denying insurer, however, an insured’s attempts to circumvent the parameters set in Gandy by doing everything but a pretrial assignment of rights will not protect the judgment from attack by the insurer.