The Appellate Division of the New Jersey Superior Court has ruled that a settlement that an insured negotiated without the participation or consent of its insurer violated the insured's duties to the insurer and thus was not binding on the insurer. N.J. Eye Center v. Princeton Ins. Co., 2007 WL 2012311 (N.J. Super. Ct. App. Div. July 13, 2007).

The insured ophthalmology practice group sought coverage for a series of malpractice actions under a policy insuring the practice. The insurer agreed to defend the practice under a reservation of rights. The practice brought a declaratory judgment action to resolve a dispute as to whether liability for the acts of the individual physicians was covered under the policy.

While the coverage action was pending, the parties in the underlying litigation engaged in settlement discussions. When the parties appeared to have reached an impasse in a settlement meeting, counsel for the insurer left the meeting. However, after counsel for the insurer left, the parties continued to negotiate and ultimately reached a settlement. Among other things, claimants and the malpractice defendants agreed to an arrangement pursuant to which the defendants conceded liability and assigned to the claimants their insurance coverage rights in exchange for an agreement not to execute against any non-insurance assets of the defendants. Under the agreement, damages were to be determined through an arbitration proceeding. The trial court issued an order confirming the settlement over the insurer's objections.

Soon after, the court in the coverage action found that the insurer was obligated to defend and indemnify the practice group for the vicarious liability of the physician defendants. The arbitration of the malpractice action proceeded and resulted in individual damage awards to the various claimants. After the arbitration awards were issued, a trial court held a hearing to determine whether the settlement was the product of collusion and whether the damages awards were fair and reasonable. The trial court entered judgment in favor of the plaintiffs and against the insurer for the amounts awarded in the arbitration, less payments made by another insurer. The insurer appealed the judgment.

On appeal, the claimants maintained that the insurer had abandoned its insured and thus could not contest the settlement. The appellate court rejected the argument. Noting that the insurer had agreed to defend the practice, the court held that the fact that the insurer "was proceeding under a reservation of rights" could "in no way be deemed an abandonment of its insured." The court also rejected the argument that the insurer was obligated to commence a declaratory judgment suit after reserving its rights.

The court further held that the settlement agreement was "a complete derogation of [the insured's] obligations . . . under its policy with [the insurer]." The court pointed out that the policy imposed a duty on the insured to "[c]ooperate . . . in the investigation, settlement, or defense of the claim or suit" and not to "assume any obligation . . . without [the insurer's] consent." The court explained that "an insured cannot take any meaningful steps toward an early settlement of the claim without risking loss of coverage pursuant to the provision prohibiting it from voluntarily compromising liability or independently settling the claim." The court found that whether the procedure adopted was the product of bad faith or collusion was immaterial because the settlement represented a "fundamental breach" of the practice's obligations to the insurer. The court therefore concluded that the insurer had no obligation to fund the unauthorized settlement.