A mortgage lender obtained a title insurance policy for its security interest in a property under construction. When the lender failed to disburse a loan to the property’s developer, the developer failed to pay a builder for work completed. The builder filed a mechanic’s lien against the property for the unpaid work. Later, the lender filed for bankruptcy, the property was sold, and the lender’s interest was transferred to its successors in interest. The bankruptcy manager and the builder agreed to a settlement for the amount of the mechanic’s lien through a “Morris agreement.” The lender’s insurance company—now representing the successors—contested the validity of the settlement agreement, arguing that Automobile Ass’n v. Morris, 154 Ariz. 113 (1987) did not apply to title insurance. The insurance company also contested its obligation to provide coverage to the successors based on a common insurance provision that denies coverage for liens created by the insured.
Generally, an insurer may accept defense of a claim against an insured while reserving the right to contest coverage. In such case the insured is contractually bound to cooperate in the defense by allowing the insurer exclusive control over the claims. In Morris, the Arizona Supreme Court recognized that this creates an imbalance disfavoring the insured, who becomes simultaneously unable to settle the claim (without breaching its duty to cooperate) and vulnerable to a judgment that may not ultimately be covered by the insurer.
To remedy this, Morris held that when an insurer accepts defense but reserves its right to contest coverage, the insured may independently settle the claim without breaching its duty to cooperate. The “Morris agreement” between the insured and the claimant “must be made fairly, with notice to the insurer, and without fraud or collusion on the insurer” to be valid. Morris, 154 Ariz. at 119. An insurer is not bound to a Morris agreement unless it is reasonable and prudent. If, on the other hand, the insurer elects not to reserve its right to contest coverage, the insured remains bound by its duty to cooperate.
Here, the trial court found that Morris applies to title insurance policies and to the settlement at issue. It also held that the exclusion did not release the insurer from coverage because the lender’s failure to disburse the loan was appropriate under its contract with the developer. The Court of Appeals affirmed the trial court’s Morris holdings but reversed its ultimate conclusion as to coverage.
In addressing the applicability of Morris to title insurance, the Court of Appeals recognized that although the type of risk associated with third-party liability (at issue in Morris) and first-party liability (at issue in title insurance) differ, the same basic principles of unfair allocation of risk apply in both contexts. The Court reasoned that, in both contexts, fairness requires a trade-off: the insurer can either retain the right to contest coverage and lose the control over the claims, or it can revoke the right to contest coverage and retain exclusive control over the claims.
The Court further affirmed the trial court’s finding that a Morris agreement need not follow the typical form, so long as it follows Morris in substance. Under Arizona Law, an agreement will fall out of Morris only if the insurer elects to give up its right to contest coverage or acts in bad faith—neither of which applied here.
Next, the Court addressed the coverage issues to determine whether the exclusion, which denies coverage for liens or other defects “created, suffered, assumed or agreed to by the insured,” is triggered when a construction lender cuts off funding to a developer, resulting in a mechanic’s lien, where the lender was within its contractual rights under the loan agreement to do so.
The Court found in the affirmative. Under Arizona law, misconduct is not required to trigger the exclusion. In other words, the exclusion applies when the insured intended the act causing the defect, not only when the insured engaged in misconduct. Further, adopting Seventh Circuit reasoning, the Court stated that a construction lender is the party with significant control over the funding issues associated with a construction project and is thus the party to which risk should be allocated in the title insurance context. Because the construction lender here intended to cut off funding to the developer’s project, the exclusion is triggered and the insurer may deny coverage to the successors, who—having derived their status and rights from the lender—stand in the lender’s shoes under the title insurance policy.
Judge Cattani authored the opinion, in which Presiding Judge Maria Elena Cruz and Judge Paul J. McMurdie joined.
Posted by: Payslie M. Bowman