Third-Party Claimants and Insurance Coverage Declaratory Judgment Actions

As the framing of the question implies, this article explores some of the key coverage action considerations primarily from the insurer’s perspective, but we also examine issues that are important to third-party claimants (and their lawyers). We begin by reviewing the jurisdictional requirements and how courts have applied them to insurers’ declaratory judgment actions—and how jurisdiction may be lacking where an injured party seeks a declaratory judgment against a liability insurer. Then we look at joinder: whether it is mandatory for the insurer to join third-party claimants and how, even where the underlying claimant is not an “indispensable” party, their presence or absence may factor into a court’s discretionary decision whether to grant declaratory relief. Next, we briefly address the potential for an injured party to intervene in a coverage action in which they were not originally named. Finally, we discuss some important considerations for insurers and for third-party claimants in deciding whether the claimant’s participation in the coverage action is desirable (assuming it is not mandatory) in any given case.

Justiciability of the Injured Party’s Interest

It is generally accepted that a third-party claimant may properly be joined in an insurer’s action to determine coverage (putting aside for now whether joinder is required). The federal Declaratory Judgment Act limits the remedy to “a case of actual controversy,” language which stems from the “cases” and “controversies” requirement in Article III of the Constitution. The U.S. Supreme Court held over 80 years ago, in Maryland Casualty Co. v. Pacific Coal & Oil Co., that an actual controversy existed between a liability insurer and an injured third party to support the insurance company’s inclusion of the injured party in its federal declaratory judgment action against the insured. The Court observed that the “difference between an abstract question and a ‘controversy’ contemplated by the Declaratory Judgment Act is necessarily one of degree, and it would be difficult, if it would be possible, to fashion a precise test for determining in every case whether there is such a controversy.” In holding that the insurer’s request for a declaratory judgment concerning coverage for the injured party’s underlying lawsuit against the insured involved an actual controversy with respect to the injured party, the Court noted that if the injured party obtained a judgment that was not satisfied within 30 days, they would then have a statutory right under state law to proceed directly against the insurer; and if the injured party was not allowed to be joined in the insurer’s action, there would be a risk of inconsistent interpretations of the insurance policy by federal and state courts.

One federal appeals court recently held that the insurer’s inclusion of the injured parties in a declaratory judgment action was improper because the insurer’s duty to defend was the only coverage issue ripe for determination and the named insured was not the “alleged tortfeasor” in the underlying lawsuit. But that appears to be a narrow distinction. Indeed, the court acknowledged that it “has previously allowed an insurer to bring a declaratory-judgment action against both the insured and injured parties,” and “it has recognized that often the ‘real dispute is between the injured third party and the insurance company, not between the injured and an often-times impecunious insured.’”

As in the federal courts, state courts almost uniformly allow insurers to name injured third parties in declaratory judgment actions to address coverage, although there is divergence on the question of whether naming the injured party is mandatory. Note that not all state declaratory judgment statutes contain the express “actual controversy” requirement of their federal counterparts, and not all state constitutions include language limiting court jurisdiction to “cases” and “controversies”—although state courts often look to federal court guidance on issues of justiciability.

An injured party’s ability to pursue a declaratory judgment against a third-party liability insurer is murkier, at least before there is a judgment on the underlying claim against the insured. Depending on the situation and jurisdiction, an injured party’s request for a declaratory judgment might not be found to present an “actual controversy.” This is sometimes framed as a lack of standing, which requires a plaintiff to have suffered an “injury in fact” that is “actual or imminent, not ‘conjectural’ or ‘hypothetical.’” An injured party may not have sustained an injury in fact where their rights with respect to the insured’s liability policy are contingent upon first obtaining a judgment or settlement of the claim against the insured. One federal appeals court remarked that in a case where the injured party filed a prejudgment action against the third-party insurer seeking a declaration on priority of coverage, none of the reasons the Supreme Court found for permitting joinder in Maryland Casualty were present.

In many cases, the determination of whether an injured party’s declaratory judgment action against an insurer presents a justiciable controversy turns on an analysis of state law concerning the nature of the injured party’s interests and rights with respect to liability insurance. Some U.S. states and territories have statutes that expressly create a prejudgment direct right of action by an injured third party against an alleged tortfeasor’s liability insurer, at least in some circumstances. In most jurisdictions, no such right exists unless stated otherwise in the policy, and most “direct action” statutes require a judgment or settlement before the injured party may sue the insurer (and some further require that the judgment remain unsatisfied for a specified period).

Even so, some states recognize an injured party’s rights in insurance coverage disputes prior to judgment. Some courts have held that state prohibitions on direct actions apply only to actions for collection of damages, not to actions seeking only declaratory relief against the insurer. For example, Illinois courts have held that at the time of the event causing injury, the injured party becomes a beneficiary of the liability insurance contract with a vested interest that gives the injured party a right to seek a declaratory judgment (and requires the injured party to be included in a declaratory judgment action between the insurer and the insured), even though the injured party is prohibited from bringing a direct action for payment against the insurer until after judgment.

There are other reasons that a court may find jurisdiction over an injured party’s declaratory judgment action. For example, one federal appeals court held that an injured party’s claim for declaratory judgment against the tortfeasor’s liability insurer was justiciable—despite state law prohibiting direct actions—because the insurer filed a counterclaim for declaratory judgment against the injured party in the same action, giving rise to a live controversy.

Mandatory Joinder

In some jurisdictions or in certain situations, courts will not allow a coverage action to proceed without the third-party claimant. The majority of states have enacted some version of the Uniform Declaratory Judgments Act (UDJA), which includes a provision stating that “all persons shall be made parties who have or claim any interest which would be affected by the declaration, and no declaration shall prejudice the rights of persons not parties to the proceeding.” State courts applying this language have sometimes held that a third-party claimant is an interested person whose rights would be affected by a declaratory judgment concerning liability coverage, and therefore they must be made a party in the insurer’s action against its insured. In a slight variation, Connecticut’s declaratory judgment statute requires that interested persons be either joined or notified of the action, and courts have held that an insurer’s failure to notify third-party claimants prevents the court from exercising jurisdiction over the insurer’s coverage action.

Other courts have examined the nature of an injured party’s interest in the liability insurance and held that the injured party was not indispensable in the insurer’s declaratory judgment action, despite the “all persons” language in the statute. For example, the Tennessee Supreme Court recently held that an injured third-party driver was not a necessary party in a declaratory judgment action filed by the tortfeasor’s automobile insurance company against its insured, seeking a declaration that the insurer did not owe a duty to defend due to the insured’s noncooperation. The trial court granted a default judgment to the insurer and denied the injured party’s motion (filed nearly two years later) to intervene and set aside the default judgment. The Tennessee Supreme Court reasoned that because Tennessee law and the terms of the insurance policy did not permit a third party to file a direct action against the insurer prior to judgment, the injured party had only a “remote interest” in the insurance policy and therefore was not a necessary party under the declaratory judgment statute.

Under the Erie doctrine, a federal court exercising diversity jurisdiction applies state substantive law and federal procedural law. Federal courts sometimes look to state court decisions concerning whether a third-party claimant is indispensable, but under Erie such deference may be misplaced to the extent that those decisions rely on state declaratory judgment statutes.

The federal Declaratory Judgment Act does not contain the “all persons shall be made parties” language found in most state declaratory judgment statutes. The key question is whether the third-party claimant is both necessary and indispensable in the action under Federal Rule of Civil Procedure 19(a) and (b). This is necessarily a fact-specific inquiry, as the Supreme Court has pronounced: “Whether a person is ‘indispensable,’ that is, whether a particular lawsuit must be dismissed in the absence of that person, can only be determined in the context of particular litigation.” One commentator observed that “it is much more common for courts to hold that, although the injured party should be joined under Rule 19(a), the injured party is not required to be joined under Rule 19(b), allowing the suit to proceed.” There are notable exceptions, including in the Fifth and Eleventh Circuits.

Unwritten Joinder Rules: Discretion and Abstention

Even if the injured claimant is not an indispensable party in the insurer’s declaratory judgment action under the joinder rules, a court might still decline to entertain the action if the claimant is not named. Unlike the “virtually unflagging obligation” to exercise jurisdiction in most actions, the Declaratory Judgment Act expressly confers discretion upon federal courts as to whether to exercise jurisdiction.

Federal courts in the various circuits have elaborated on the factors to be considered in making this determination. For example, courts in the Fourth Circuit follow the so-called Nautilus factors, Sixth Circuit courts apply the Grand Trunk factors, and courts in the Eleventh Circuit look to the Ameritas guideposts. Almost invariably, these tests require the courts to consider, among other factors, whether the requested declaratory judgment will completely resolve the controversy presented.

It can be debated the extent to which a dispute concerning liability insurance coverage can be meaningfully resolved in the absence of third-party claimants who might later seek payment under the insurance to collect a subsequent judgment against the insured. For example, in the Sixth Circuit, courts analyzing whether a coverage action would “settle the controversy” and “clarify the legal relations at issue” (two of the Grand Trunk factors) have reached different conclusions about how to weigh those factors when the injured third party is absent. In one case, the court held that those factors weighed against exercising jurisdiction because although granting the declaratory judgment would settle the scope of the insurers’ coverage and clarify their obligation to defend the insured, “it does nothing to settle the controversy or ‘clarify the legal relationship’ between the other parties.” In a more recent case, the court affirmed a district court’s decision to exercise jurisdiction over the insurer’s coverage action against its insured, without the presence of the third-party claimants. The court opined that “the absence of a state-court party carries most weight when issues relevant to the coverage controversy are actually and concurrently being litigated in state court.” “If there is no such parallel state-court litigation,” the court reasoned, “the federal court is merely predicting that another controversy involving the same legal and factual issues as the declaratory-judgment action will arise in state court—an eventuality that may or may not develop.”

Intervention

An injured party who was not named in an insurer’s declaratory judgment action against its insured still might be able to intervene in the coverage action, regardless of whether the injured party would have had standing to file an action on their own. There are two flavors of intervention: intervention of right and permissive intervention. In federal court, a person has a right to intervene if that person “claims an interest relating to the property or transaction that is the subject of the action, and is so situated that disposing of the action may as a practical matter impair or impede the movant’s ability to protect its interest, unless existing parties adequately represent that interest.”

Courts’ analysis of whether a third-party claimant has a sufficiently protectable “interest” in the insured’s liability coverage sometimes echoes the similar inquiries into whether the claimant has suffered an injury in fact or has a claim that presents an actual controversy. In one case where the insurer filed a declaratory judgment action against its insured, a manufacturer of asbestos-containing products, to determine whether the insurer had exhausted its limits and thus owed no further duties under its primary and umbrella policies, a federal appeals court held that third-party injury claimants were not entitled to intervene because they did not have a legally protectable interest in the insurance prior to obtaining a judgment on their underlying claims. The court held that the claimants’ contingent economic interest was insufficient, and the fact that “the declaratory judgment action may impact their ability to collect any judgment obtained in their personal injury actions” was “not enough to support intervention of right.”

The adequacy of representation factor frequently comes into play in coverage actions. For example, a federal appeals court held that a state court claimant had a right to intervene in the liability insurer’s declaratory judgment action seeking a ruling that it did not have a duty to defend its insured against the state court claim, where the insured failed to appear in the action and the insurer had moved for a default judgment. The court criticized the insurer’s position in seeking a default judgment against its insured while opposing the injured party’s motion to intervene: “[The insurer] wanted to play the Washington Generals and get out of town with a quick win. The district court wisely allowed a more worthy opponent to get into and onto the court.” Other courts have sometimes denied intervention on the ground that the claimant’s interest in preserving insurance coverage was adequately represented by the insured.

Even where there is no right to intervene, courts may permit intervention by anyone who “has a claim or defense that shares with the main action a common question of law or fact.” In practice, most intervention applicants cite both intervention of right and permissive intervention as alternative grounds. By contrast to intervention of right, which is in theory a purely legal determination, permissive joinder is a matter for the discretion of the court. One federal appeals court remarked that “a denial of permissive intervention has virtually never been reversed.”

Desirability of Naming the Injured Party

Let’s start with the insurer’s perspective. You have thoroughly reviewed the law in the relevant jurisdiction, you are satisfied that the injured party is not an indispensable party in the declaratory judgment action you are preparing to file, and you believe the court will not decline jurisdiction over the action if the injured party is absent. The question is now down to desirability: Does the insurance company want to include the claimant?

Why might an insurer want to include the injured party in the coverage action? The main reason is certainty. The insurer wants the court’s coverage rulings to unquestionably bind the third-party claimant and terminate or otherwise resolve the insurer’s potential obligations going forward. This may be particularly important to the insurer in cases where there is a chance that the insured will assign their rights to the injured party, where the underlying lawsuit is approaching a final judgment or a settlement, or where the injured party would have a direct right of action against the insurer.

In a somewhat related vein, including the injured party may provide a mode of communicating to the injured party and their attorney the details of coverage issues the insurer considers to be serious—and of signaling the importance that the insurer places on those issues—in a manner that position letters alone might not sufficiently convey. If the injured party has a direct stake in the declaratory judgment action, the injured party may gain a fuller understanding of the coverage issues and their implications. That can have practical benefits—not just for the insurer but for all involved parties. For example, in some cases, having the injured party involved in the coverage action might help to set expectations and facilitate more open and productive discussions about possible settlement, or allow the parties to better gauge when and how such discussions should take place.

On the other hand, there can be reasons an insurer would prefer not to name the injured third party in the coverage action. Sometimes the task of serving process on third-party claimants can be challenging and cause delay, particularly if the injured party is an individual and their lawyers do not see a benefit to participating in the coverage action. The injured party might add complexity to the coverage action, such as by raising legal issues and asserting facts outside of the insurer’s declaratory judgment petition. Once named, the injured party might be permitted to assert counterclaims that expand the scope of the coverage action, which could affect timing and scheduling—or perhaps even impact the court’s willingness to entertain declaratory relief at all. Perhaps not surprisingly, courts tend to disfavor arguments that an injured party, having been named to the declaratory judgment action by the insurer, is a mere “nominal party” who lacks standing to participate in the action or appeal a ruling of noncoverage. In jurisdictions where an injured third party can independently assert extracontractual or “bad faith” claims against a tortfeasor’s liability insurer, naming the injured party in a declaratory judgment action could result in the bad faith counterclaims that the injured party otherwise might not have been as likely to pursue on their own.

Whether the insurer is seeking a federal or state court forum can also be an important consideration. If the underlying claimant shares citizenship with the insurer, the insurer will not be able to maintain a declaratory judgment action in federal court if the nondiverse claimant is named as a defendant. Notably, the same may not be true when an insured files a declaratory judgment action against their insurer and names an injured third party who shares citizenship with the insured. In one recent case, a federal court of appeals held that even though the underlying third-party claimants were indispensable parties in the insured’s action against the insurer, the claimants were correctly realigned as plaintiffs for purposes of diversity jurisdiction. And in a case from a different jurisdiction, a federal appeals court held that an insured’s state court declaratory judgment action against its insurer concerning the duty to defend was properly removed to federal court because the nondiverse third-party claimant was a dispensable party in the insured’s coverage action.

The Claimant’s Perspective

What about desirability from the third-party claimant’s perspective? Why would an injured party want to be included or want to intervene in the insurer’s coverage action? For some lawyers representing plaintiffs, an insurance coverage declaratory judgment action presents an unwelcome distraction from their pursuit of the liability claim against the insured. Participating in a coverage action requires extra time and investment. In some cases, it may be advisable to engage additional counsel to focus on the coverage issues, creating additional expense for the claimant or requiring fee-sharing accommodations among the attorneys.

Also, the injured party does not always share the insurer’s interest in establishing certainty. Generally, a declaratory judgment is not binding on anyone who is not a party to the action. Most state declaratory judgment statutes expressly provide that no declaration shall prejudice the rights of persons not parties to the proceeding. Absent special circumstances, it is generally agreed that a third-party claimant is not in privity with the insured, and therefore a declaration of coverage in an action solely between the insurer and insured would not be binding on the claimant under the doctrines of res judicata/claim preclusion or collateral estoppel/issue preclusion.

Nevertheless, as a practical matter, a declaratory judgment might affect an injured party’s ability to relitigate coverage even when they were not named in the insurer’s coverage action. When the issue being litigated in a prejudgment coverage action is the insurer’s duty to defend its insured, courts often state that the duty to defend is separate from the duty to indemnify for a judgment or settlement, and that the duty to indemnify may not be considered ripe for adjudication or part of the “actual controversy” between the insurer and the insured. But while the duty to defend is certainly different from the duty to indemnify, the duty to defend is not entirely separate from the duty to indemnify. In virtually every jurisdiction, whether an insurer owes a duty to defend is analyzed on the basis of whether any of the underlying claims against an insured might lead to a judgment that would result in a duty to indemnify under the terms of the insurance policy. Therefore, a declaration that an insurer does not have a duty to defend represents a legal determination that the insurer cannot possibly be required to indemnify the insured against the underlying claims pending at the time of the coverage ruling. Even though the injured party may technically not be bound by the coverage ruling, the result may create a persuasive precedent—if not one with stare decisis effect—that might cast a shadow over any subsequent coverage litigation and make it challenging for the injured party to relitigate the indemnity issue on even footing. A declaration that an insured breached the conditions of the insurance policy or misrepresented facts to the insurer during the application process or the claim investigation could present similar challenges for an injured party seeking to revisit those issues in a postjudgment action against the insurer.

As we discussed in the context of intervention, adequacy of representation of the injured party’s interest in preserving coverage is another important consideration. In situations where the insured is defunct or for other reasons might not be motivated to actively litigate the insurer’s coverage action, the injured party may want to participate and oppose the insurer’s arguments (in fact, in such situations, the injured party’s presence may even be required in some jurisdictions).

Conclusion

The question of whether a third-party claimant should be involved in an insurance company’s declaratory judgment coverage action against its insured is not as straightforward as it might seem. There is no one-size-fits-all-situations-and-jurisdictions answer. In some jurisdictions, joining the injured party is mandatory, and a coverage action cannot proceed without them. In jurisdictions where joinder of the injured party is not mandatory, insurers must carefully consider the scope and goals of the coverage action, the nature of the specific coverage issues to be raised, the dynamics of the underlying claim against the insured, and the potential risks of including or excluding the injured party in the coverage action. Where an insurer has filed a coverage action without naming the third-party claimant, the claimant and their lawyers would be well-advised to make sure they understand the coverage issues being raised and may want to consider intervening in the coverage action.