Declaratory judgment actions decide obligations under insurance contracts

A declaratory judgment action is essentially a request — typically by the insurer but often by the insured — that a court examine the relevant insurance policy provisions and declare the rights and obligations of the parties under the insurance contract. The declaration can address whether the insurer is obligated to furnish the insured with a defense in a pending lawsuit arising out of a third-party claim under a liability policy, or it can address the substantive issue of coverage under the policy for any first-party or third-party claim.

For a number of reasons, insurers often prefer that the parties’ rights and
obligations under the policy be decided by a federal judge rather than by a state judge. Questions of insurance coverage are, however, typically questions of state law. Because federal courts exist primarily to decide issues of federal law, the

jurisdiction of the federal courts to hear cases that present issues of state law is limited.

‘Diversity of citizenship’ jurisdiction

Under 28 U.S.C. § 1332, the federal courts have jurisdiction over cases that involve disputes between citizens of different states. This is called “diversity of citizenship” jurisdiction. In order for the federal court to have diversity jurisdiction, the citizenship of each plaintiff must be different from the citizenship of each defendant. A corporation or other entity that is not a natural person is considered a citizen of both the state in which it is incorporated, and of the state in which it maintains its principal place of business. Additionally, in order for diversity jurisdiction to exist the amount in controversy — exclusive of interest and costs — must be at least $75,000.

Diversity must exist at the time the lawsuit is filed. It need not exist earlier, nor must it continue thereafter. In other words, diversity is measured only when the lawsuit is filed.

‘Supplemental jurisdiction’ and third parties

“Supplemental jurisdiction” allows the federal court to maintain jurisdiction over cases in which some of the parties adverse to one another are citizens of the same state. Basically, as long as diversity exists at the time an action is filed, supplemental jurisdiction exists as to third parties later joined by the defendant on claims arising out of the same transaction or occurrence. (See 28 U.S.C. § 1367.) This type of claim is deemed supplemental to the plaintiff’s original claim against the defendant. No independent basis for jurisdiction is required for the defendant’s claims against such third parties.

For example, in State Nat’l Ins. Co. v. Yates, 391 F.3d 577 (5th Cir. 2004), a plaintiff insurer filed a diversity action seeking a declaration of non-coverage under the defendant insured’s liability policy. The insured counterclaimed and also asserted claims against a third-party local insurance agent. The insured claimed that the agent either misrepresented the terms of the policy or was negligent in failing to procure the right coverage.

The trial court dismissed the case, reasoning that the agent was a necessary party and that joinder of the insurance agent destroyed diversity.

On appeal, the Fifth Circuit vacated the dismissal and remanded the case. In doing so, the appellate court held that the trial court had jurisdiction over the defendant insured’s claims against the agent pursuant to 28 U.S.C. § 1367(a).

That statute provides that “the district courts shall have supplemental jurisdiction over all other claims that are so related to claims in the action within such original jurisdiction that they form part of the same case or controversy under Article III of the United States Constitution …” and that “such supplemental jurisdiction shall include claims that involve the joinder … of additional parties.”

The claims against the agent easily satisfied the “same case or controversy” requirement because they arose out of the same dispute or insurance policy. Importantly, the Fifth Circuit held that the claims against the agent did not fall within the jurisdictional limitations of 28 U.S.C. § 1367(b), because those jurisdictional limits refer to claims made by a plaintiff in the action.

Under § 1367(b) the plaintiff cannot later amend his pleading to join non-diverse parties. This prevents plaintiffs from filing lawsuits that initially involve only parties with complete diversity of citizenship, and then later joining additional non-diverse parties, thus avoiding the jurisdictional requirement of complete diversity of citizenship under 28 U.S.C. § 1332.

Because joinder of the agent by the defendant insured did not deprive the trial court of jurisdiction, the Fifth Circuit remanded the case to the trial court. (1)

Declaratory relief is discretionary

A federal court has discretion whether to entertain a declaratory judgment action; the court does not have to resolve the dispute simply because it is asked to do so. The Fifth Circuit has identified seven non-exclusive factors for a trial court to consider when making the determination whether to exercise its discretion to decide or dismiss the action:

1. Whether there is a pending state action in which all of the matters in controversy may be fully litigated;

2. Whether the plaintiff filed suit in anticipation of a lawsuit filed by the defendant;

3. Whether the plaintiff engaged in forum shopping in bringing the suit;

4. Whether possible inequities in allowing the declaratory plaintiff to gain precedence in time or to change forums exists;

5. Whether the federal court is a convenient forum for the parties and witnesses;

6. Whether retaining the lawsuit would serve the purposes of judicial economy; and

7. Whether the federal court is being called on to construe a state judicial decree involving the same parties and entered by the court before whom the parallel state suit between the same parties is pending.

[Sherwin-Williams Company v. Holmes County, 343 F.3d 383, 388 (5th Cir. 2003).]

The court must analyze and balance the facts and circumstances of the case before it against these factors. Probably the most important of these factors is the first one. If there is a parallel state court lawsuit that involves the same parties and the same issues as the federal court case, it is not uncommon for a federal court to decline to entertain the dispute, even if the state court action is filed after the federal court action. This is particularly so if the state court action can afford more complete relief to all parties concerned than the federal court lawsuit. It is therefore important that all parties who have an interest in the outcome of the insurance coverage dispute be joined in the declaratory judgment action.

File as soon as possible

The best practical advice for any party, whether insurer or insured, who may want to have an insurance coverage dispute resolved in the federal courts is to file suit as soon as possible after a controversy arises. The federal court lawsuit should then be prosecuted as expeditiously as possible. The more time that elapses between the filing of the federal court case and the filing of a parallel state court action, and the further along the federal court case has progressed, the better the chances that the court will deny a motion to dismiss the federal court case or abate it in light of the state court lawsuit. The federal court plaintiff should make sure that all parties having an interest in the outcome of the dispute are named as defendants in the declaratory judgment action.

(1) Insurance agents are typically not necessary parties to disputes involving insurance coverage. Typically, the outcome of a declaratory judgment action rests solely on contractual language in the policy. See, e.g., Cornhill Insurance PLC v. Valsamis, Inc., 103 F.3d 80, 84 (5th Cir. 1997); Employers Mutual Casualty Co., et al. v. Juan Miguel Bonilla, 2007 U.S.Dist. LEXIS 72168 (N.D. Tex., Sept. 27, 2007).

Aaron Mitchell is a founding partner of the Dallas-based law firm, Tollefson Bradley Ball & Mitchell LLP. He is licensed in Texas and Arkansas and focuses his practice on insurance coverage and bad faith disputes.

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