Quihuis v. State Farm Mutual Automobile Insurance

IN THE

SUPREME COURT OF THE STATE OF ARIZONA

YOLANDA E. QUIHUIS AND ROBERT QUIHUIS, A MARRIED COUPLE,
Plaintiffs,

v.

STATE FARM MUTUAL AUTOMOBILE INSURANCE COMPANY, A FOREIGN
CORPORATION,
Defendant.

No. CV-14-0093-CQ
Filed October 1, 2014

United States District Court for the District of Arizona
No. 4:10-cv-00376-RCC

Certified Question from the
United States Court of Appeals for the Ninth Circuit
Quihuis v. State Farm Mut. Auto. Ins. Co., 748 F.3d 911 (9th Cir. 2014)
QUESTION ANSWERED

COUNSEL:

Stanley G. Feldman (argued), Jeffrey A. Imig, Haralson, Miller, Pitt,
Feldman & McAnally, P.L.C., Tucson, for Yolanda E. Quihuis and Robert
Quihuis

David M. Bell (argued), Howard L. Andari, David Bell & Associates, PLLC,
Phoenix, for State Farm Mutual Automobile Insurance Company

VICE CHIEF JUSTICE PELANDER authored the opinion of the Court, in
which CHIEF JUSTICE BALES, JUSTICE BERCH, JUSTICE BRUTINEL,
and JUSTICE TIMMER joined.
 QUIHUIS V. STATE FARM
Opinion of the Court

VICE CHIEF JUSTICE PELANDER, opinion of the Court:

¶1 The United States Court of Appeals for the Ninth Circuit has
certified the following question for our review:

Whether a default judgment against insured-defendants that
was entered pursuant to a Damron agreement that stipulated
facts determinative of both liability and coverage has
(1) collateral estoppel effect and precludes litigation of that
issue in a subsequent coverage action against the insurer, as
held in Associated Aviation Underwriters v. Wood, [209 Ariz.
137,] 98 P.3d 572 ([] App. 2004), or (2) no preclusive or binding
effect, as suggested in United Services Automobile Association v.
Morris, [154 Ariz. 113,] 741 P.2d 246 ([] 1987).

Quihuis v. State Farm Mut. Auto. Ins. Co., 748 F.3d 911, 912 (9th Cir. 2014).

¶2 We hold that the default judgment does not preclude
litigation of whether coverage exists under the policy. Consistent with
Morris, Wood, and the Restatement (Second) of Judgments (“Restatement”)
§ 58 (1982), however, we also hold that an insurer in a coverage action may
not, in the guise of a coverage defense, litigate what are essentially and
solely liability issues resolved by the default judgment.

I.

¶3 The Ninth Circuit’s certification order states the facts and
procedural history:

Norma Bojorquez (“Norma”) and Carol Cox (“Carol”)
were coworkers in Nogales, Arizona. Norma sought a car for
her daughter, Iliana Bojorquez (“Iliana”), and expressed
interest in Carol’s 1994 Jeep Cherokee (the “Jeep”). By
January 9, 2008, Carol and Norma had executed a written
sales agreement for the Jeep which called for eight monthly
installments totaling $3,000. Carol gave Norma the only set
of keys to the Jeep, and Norma drove the car home. Norma
gave the keys to Iliana so that Iliana could drive the Jeep at
her pleasure. Carol did not transfer the Jeep’s title certificate

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to Norma because she thought it necessary to retain the title
certificate as collateral until Norma paid off the Jeep. The
Coxes never retook possession of the Jeep.

The Coxes maintained insurance coverage on the Jeep
through a policy with State Farm (the “Policy”). The Policy
provided liability coverage for bodily injury caused by
accident[s] resulting from the use of cars owned by the Coxes,
including the Jeep. The Policy covered the Coxes and
permissive users of their cars if the use was within the scope
of their consent. The Policy also imposed a duty to defend on
State Farm. The Coxes did not cancel the [P]olicy until
January 29, 2008.

On January 22, 2008, Iliana was driving the Jeep when
it collided with a car driven by Yolanda Quihuis. In Arizona
state court, Yolanda Quihuis and her husband, Robert
Quihuis, sued Iliana for negligence and the Coxes for
negligent entrustment. The negligent entrustment claim
relied on the Coxes’ alleged ownership of the Jeep at the time
of the accident. State Farm refused to defend the Coxes
because the Jeep’s ownership had transferred to Norma
before the accident.

On October 29, 2009, the Coxes, the Bojorquezes, [and]
the Quihuises . . . entered into a Damron agreement entitled
“Assignment of Rights, Agreement Not to Execute.” In
pertinent part, they stipulated that the Coxes owned the Jeep
at the time of the accident, that Iliana was incompetent to
drive a motor vehicle and her negligence caused the accident,
and that the Coxes should have known that Iliana was
incompetent to drive and therefore should not have entrusted
the Jeep to her.1 The Coxes and Bojorquezes agreed to
damages in the amount of $275,000. The Coxes assigned their

1 This is not entirely accurate. In the Damron agreement, the Coxes
stipulated that Iliana was driving “in the scope of [their] consent” a vehicle
they owned. But the agreement provided that the Quihuises “claim,” not
that the Coxes stipulate, that the Coxes should have known that Iliana was
incompetent to drive the vehicle and should not have entrusted it to her.
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rights under the Policy to the Quihuises, who agreed not to
execute upon a judgment against the Coxes or the
Bojorquezes. The parties also agreed to request a default
judgment to terminate the case. On December 31, 2009, the
state court entered default judgment in the amount of
$350,000 — $325,000 for Yolanda’s injuries and $25,000 for
Robert Quihuis’ loss of consortium.

The Quihuises, standing in the Coxes’ shoes, then
brought a declaratory judgment action [“DJA”] against State
Farm in Arizona state court for indemnification and failure to
defend. State Farm removed the case to the United States
District Court for the District of Arizona.

In November 2011, the district court granted State
Farm’s motion for summary judgment. Applying Arizona
law, the district court held that the default judgment did not
preclude State Farm from litigating the question of whether
the Coxes owned the Jeep at the time of the accident . . . .
Consequently, State Farm could litigate the question of
coverage, and the court held that the undisputed facts
established that the Bojorquezes owned the Jeep at the time of
the accident as a matter of law.

The Quihuises timely appealed, contending there was
no conflict of interest between the Coxes and State Farm, and
that Arizona case law establishes that an insurer may not
litigate an issue determinative of coverage if that issue is also
determinative of liability and was stipulated to as part of a
Damron agreement that resulted in entry of a default
judgment. They also contended that ownership of the Jeep
was a genuine issue of material fact. 2

2 The Ninth Circuit agreed with the district court’s ruling that the
Coxes did not own the Jeep at the time of the accident. See Quihuis, 748 F.3d
at 914, 918. We do not address that issue because the only question certified
is whether State Farm was allowed to litigate the ownership issue at all.
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Quihuis, 748 F.3d at 912–14 (footnotes omitted); see A.R.S. § 12-1863(2)
(requiring certification order to state all facts relevant to certified question);
Ariz. R. Sup. Ct. 27(a)(3)(B) (same).

II.

¶4 When a liability insurer refuses to defend its insured against
a third party’s tort claims, as State Farm did here, the insured and the
claimant may enter into a Damron agreement “under which the insured
stipulates to a judgment, assigns his rights against the insurer to the
claimant, and receives in return a covenant from the claimant not to execute
against the insured.” Parking Concepts, Inc. v. Tenney, 207 Ariz. 19, 20 ¶ 3
n.1, 83 P.3d 19, 20 n.1 (2004); see Damron v. Sledge, 105 Ariz. 151, 152–53, 460
P.2d 997, 998–99 (1969). An insured may enter into a similar agreement if
the insurer defends the third-party action but reserves its right to later
dispute coverage. Morris, 154 Ariz. at 119, 741 P.2d at 252; see also Ariz. Prop.
& Cas. Ins. Guar. Fund v. Helme, 153 Ariz. 129, 137–38, 735 P.2d 451, 459–60
(1987). We refer to this latter type of agreement as a “Morris agreement.”
See Parking Concepts, 207 Ariz. at 20 ¶ 3 n.1, 83 P.3d at 20 n.1.

¶5 After obtaining a judgment pursuant to a Damron or Morris
agreement, the claimant then seeks payment of the judgment by the insurer
based on the latter’s indemnity obligation under the policy. 1 Allan D.
Windt, Insurance Claims and Disputes: Representation of Insurance Companies
and Insureds § 9.11 (6th ed. 2013) [hereinafter “Windt Treatise”]. The
insurer, in turn, generally may contest any duty to indemnify by asserting
that its policy did not cover the accident or claim. See Morris, 154 Ariz. at
119, 741 P.2d at 252 (adopting “[t]he better result” that “permit[s] the
insurer to raise the coverage defense, and also permit[s] an insured to
protect himself from the risk of noncoverage or excess judgment” when
insurer defends under a reservation of rights). Standing in the insured’s
shoes as assignee, the claimant may also sue the insurer on various claims,
including breach of the insurance contract and bad faith. See Acosta v. Phx.
Indem. Ins. Co., 214 Ariz. 380, 383 ¶ 13, 153 P.3d 401, 404 (App. 2007) (“When
an insurer allegedly acts in bad faith in its duty to indemnify or protect its
insured against liability to third parties, . . . [the bad faith] claim can be
brought either by the insured or the insured’s assignee.”).

¶6 This case involves (1) a liability insurer’s refusal to defend its
insured against a third-party tort claim after the insurer determined its

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policy did not cover the accident; (2) a stipulated default judgment against
the insured under a Damron agreement; and (3) a question of ownership,
which is both an element of liability for the underlying negligent
entrustment tort claim against the insured and a requirement of coverage
under the insurance policy. The certified question turns on what issue-
preclusion rules apply under these circumstances.3 As the Ninth Circuit
observed, no Arizona case squarely resolves the question presented here.
See Quihuis, 748 F.3d at 914.

¶7 State Farm argues that when the Quihuises served their
complaint on the Coxes, “no insured-insurer relationship existed between
State Farm and the Coxes” because the Coxes sold the Jeep before the
accident. Accordingly, State Farm asserts, the general issue-preclusion rule
set forth in Restatement § 27 governs. See Chaney Bldg. Co. v. City of Tucson,
148 Ariz. 571, 573, 716 P.2d 28, 30 (1986) (applying § 27). Issue preclusion
under that section requires actual litigation of the issue of fact or law in
question, and thus default judgments generally have no preclusive effect.
Id.; see also Restatement § 27 cmt. e (“In the case of a judgment entered by . . .
default, none of the issues is actually litigated.”).

¶8 The Quihuises, in contrast, contend that Restatement § 58,
which specifically concerns indemnitors that have an independent duty to
defend, provides the controlling rule. See Restatement § 58; Farmers Ins. Co.
v. Vagnozzi, 138 Ariz. 443, 448, 675 P.2d 703, 708 (1983) (adopting
Restatement § 58). We agree that § 58 applies and therefore analyze issue
preclusion in this case under that section, applying other relevant principles
established in case law.4

3 “Issue preclusion” and “collateral estoppel” refer to the same
principle. Gilbert v. Bd. of Med. Exam’rs of Ariz., 155 Ariz. 169, 174–75, 745
P.2d 617, 622–23 (App. 1987). We use the modern term “issue preclusion”
in this opinion.

4 State Farm argues that Restatement § 58 does not apply, and hence
it could litigate the ownership issue in the DJA, because the district court
concluded in that action that the Coxes did not own the Jeep and thus it was
not covered at the time of the accident. We reject that circular argument
because it assumes an answer to the certified question — whether the
district court properly allowed State Farm to litigate the ownership issue.
We also find unpersuasive State Farm’s argument, based on State Farm’s
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A.

¶9 Restatement § 58 provides:

(1) When an indemnitor has an obligation to indemnify an
indemnitee (such as an insured) against liability to third
persons and also to provide the indemnitee with a defense of
actions involving claims that might be within the scope of the
indemnity obligation, and an action is brought against the
indemnitee involving such a claim and the indemnitor is
given reasonable notice of the action and an opportunity to
assume its defense, a judgment for the injured person has the
following effects on the indemnitor in a subsequent action by
the indemnitee for indemnification:

(a) The indemnitor is estopped from disputing the
existence and extent of the indemnitee’s liability to the injured
person; and

(b) The indemnitor is precluded from relitigating
those issues determined in the action against the indemnitee
as to which there was no conflict of interest between the
indemnitor and the indemnitee.

(2) A “conflict of interest” for purposes of this Section
exists when the injured person’s claim against the indemnitee
is such that it could be sustained on different grounds, one of
which is within the indemnitor’s obligation to indemnify and
another of which is not.

¶10 In this case, § 58 applies because (1) the Coxes’ insurance
policy imposed on State Farm both an indemnity and a defense obligation;
(2) the Quihuises’ complaint involved a claim that “might be within the
scope of [State Farm’s] indemnity obligation”; (3) the Coxes gave State Farm
reasonable notice of the Quihuises’ lawsuit, thereby providing State Farm
with “an opportunity to assume [the Coxes’] defense”; and (4) “a

post-accident, retroactive cancellation of coverage for the Jeep, that § 58
does not apply because “no indemnity relationship exists.”
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judgment” was entered in favor of the Quihuises and against the Coxes. See
Restatement § 58(1). Thus, we must identify the issues that § 58 precludes
State Farm from litigating in the DJA. Although we “incorporate[d]”
Restatement § 58 in Vagnozzi, 138 Ariz. at 448, 675 P.2d at 708, we have not
yet applied it in a case such as this.

B.

1.

¶11 Section 58(1)(a) precludes State Farm from disputing the
“existence and extent” of the Coxes’ liability to the Quihuises. Although
§ 58 does not define what “existence and extent” of liability means, Arizona
case law provides insight.

¶12 In Morris, the insured settled with a third-party claimant and
stipulated to a judgment after the insurer defended under a reservation of
rights. 154 Ariz. at 115, 741 P.2d at 248. The claimant then sued the insurer
for indemnification, and the insurer sought to litigate “all aspects of the
liability case” in contesting its indemnity obligation. Id. at 120, 741 P.2d at
253. Rejecting that position, we found that the insurer was precluded from
litigating “the fact []or amount of liability,” if the insured’s settlement with
the claimant “was reasonable and prudent.” Id. We concluded, however,
that the insurer could later litigate whether there is coverage under the
policy, stating that “any stipulation of facts essential to establishing
coverage would be worthless.” Id. We stressed that coverage must be open
for later litigation because, otherwise, insureds might be able “to obtain
coverage that the insured did not purchase” simply by entering into a
Damron or Morris agreement. Id.

¶13 The Wood case illustrates the boundaries Morris set for
insurers in contesting coverage. In Wood, after a default judgment was
entered against the insured pursuant to a Morris agreement, the insurer
argued that it could “fully litigate all liability and damage issues”
— matters “bearing solely on the insureds’ fault, causation, or the plaintiff’s
damages” — in the coverage action. Wood, 209 Ariz. at 149 ¶¶ 32, 34, 98
P.3d at 584. Applying Morris, the court of appeals precluded the insurer
from litigating, “in the guise of a coverage defense,” the existence and
extent of the insured’s liability. Id. at 150 ¶ 37, 98 P.3d at 585.

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¶14 Wood represents a straightforward application of Restatement
§ 58(1)(a); it precludes an insurer from litigating not only the fact of liability,
but also those issues that “relat[e] strictly to liability and damages [and not]
coverage.” Id. at 152 ¶ 47, 98 P.3d at 587; see also Ariz. Prop. & Cas. Ins. Guar.
Fund v. Martin, 210 Ariz. 478, 481 ¶ 15, 113 P.3d 701, 704 (App. 2005)
(distinguishing Wood because the insurer in that case argued there was no
liability and therefore no coverage, whereas the insurer in Martin sought to
litigate “legitimate coverage issues in a [DJA] based on specific policy
exclusions”).

¶15 Although the facts of this case fall between the situations
presented in Morris and Wood, those cases demonstrate that § 58(1)(a) does
not preclude litigation of pure coverage issues in a DJA. State Farm is not
seeking to litigate the existence or extent of the Coxes’ liability, see Morris,
154 Ariz. at 120, 741 P.2d at 253, nor is it arguing that there is no coverage
because the Coxes are not liable to the Quihuises, see Wood, 209 Ariz. at 150
¶ 37, 98 P.3d at 585. Rather, the ownership issue here not only bears directly
on liability, but also controls whether there is coverage under the policy,
and neither § 58(1)(a) nor any Arizona case applying that section precludes
an insurer from litigating this type of coverage issue. In sum, we have
adopted Restatement § 58 with the limitation recognized in Morris —
insurers generally are not precluded from litigating coverage issues.

2.

¶16 In addition to being precluded from challenging the
“existence and extent” of the Coxes’ liability under Restatement § 58(1)(a),
State Farm is precluded under § 58(1)(b) from “relitigating” any issues that
were “determined in the action” against the Coxes, unless there is a conflict
of interest as defined in § 58(2). Section 58(1)(b) does not define or explain
what “determined in the action” means, but the Restatement does provide
two illustrations that assist in interpreting that phrase:

1. A is injured when struck by a car owned by B and
driven by C. A brings an action against B, contending that C
operated the car with B’s permission. B is insured by I under
a policy covering B’s liability for another’s use of his car with
B’s permission. The policy also imposes on I the duty to
defend B in actions in which a claim within the indemnity
obligation might be sustained. I refuses to assume defense of

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the action. A recovers judgment by default against B. I may
not dispute the existence and extent of B’s liability to A and
may under applicable law be estopped to deny its liability for
indemnification of B.

2. Same facts as Illustration 1, except that I assumes
defense of B. After actual litigation of the issue of permission,
judgment is for A. I is precluded as to the existence and extent
of B’s liability to A and, if the term “permission” has the same
meaning under the policy as under the rule making B
vicariously liable for C’s act, I is precluded as to whether the
loss was within the terms of the policy so far as “permission”
is concerned. Whether I would be estopped to litigate
whether B’s policy had lapsed for failure to pay the premium
is a matter of the law of insurance.

Restatement § 58 cmt. a, illus. 1–2. The first illustration corresponds with
§ 58(1)(a) and contains language that mirrors that subsection. The second
illustration reflects principles presented in both § 58(1)(a) and (1)(b).

¶17 The contrast between the two illustrations sheds light on how
§ 58 applies in different contexts. In the first illustration, the only thing the
insurer clearly “may not dispute” is “the existence and extent of B’s liability
to A.” Neither that illustration nor § 58(1)(a) precludes the insurer from
litigating the permission issue in a later coverage action to determine
whether it must indemnify. Rather, the illustration states that “applicable
law” will determine whether the insurer will “be estopped to deny its
liability for indemnification.” Restatement § 58 cmt. a, illus. 1. As discussed
below, ¶¶ 24–37 infra, “applicable law” in Arizona does not preclude an
insurer from later litigating coverage.

¶18 In contrast, the second illustration states that the insurer will
generally be precluded from litigating the permission issue in arguing that
the loss was not covered. The only significant factual difference between
the first and second illustration is the process by which judgment was
obtained: the first illustration involves a default judgment, while the
second involves a judgment on the merits “[a]fter actual litigation.” Only
in the second situation is the insurer precluded from litigating an issue that
was “determined in the action” between A and B. Restatement § 58(1)(b).

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Thus, the phrase “determined in the action” in § 58(1)(b) refers to a judicial
determination of issues actually litigated.

¶19 This understanding of § 58’s illustrations finds support in the
language used in § 58(1)(b), which states that an insurer is precluded from
“relitigating” issues, instead of just “litigating” issues. “Relitigation”
implies that there was some prior litigation on the issue, which means that
“determined in the action” refers to a judicial determination after some
prior litigation.

¶20 Restatement § 57 uses similar language and also supports our
interpretation. Under § 57, an indemnitor without an independent duty to
defend is only “precluded from relitigating issues determined in the action
against the indemnitee if . . . the indemnitor defended the action . . . or . . .
the indemnitee defended the action with due diligence and reasonable
prudence.” Restatement § 57(1)(b). Section 57 thus prohibits the
indemnitor from relitigating only those issues determined after prior,
actual litigation, as long as one of two conditions not applicable in this case
is met. Section 58, on the other hand, does not impose the same conditions.
Thus, while both sections refer to prior litigation, § 58 applies even if during
the actual litigation, the insurer did not defend and the insured did not
defend with due diligence or reasonable prudence. See Restatement
§ 58(1)(b).

¶21 Based on this analysis, we reject the Quihuises’ assertion that
issue preclusion “arises from the entry of a judgment against insureds
whether after trial or by default.” Section 58(1)(b) does not preclude State
Farm from litigating the ownership issue in the DJA. That issue was not
“determined in the action” because it was not actually litigated and decided
by the trial court that entered the stipulated default judgment. This is not
to say that the default judgment has no preclusive effect or is meaningless.
It precludes State Farm from denying the “existence and extent” of the
Coxes’ liability — established by the default judgment
— under § 58(1)(a), ¶¶ 11–15 supra, and it prevents State Farm from
avoiding that result simply by crafting a coverage argument that, in
essence, merely disputes the Coxes’ tort liability. Wood, 209 Ariz. at 150
¶ 37, 98 P.3d at 585.

¶22 The result does not change simply because the issue that
determines coverage also happens to be an element of the liability claim

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against the Coxes. In Restatement § 58’s illustrations discussed above, the
permission issue was just as essential to B’s liability as the ownership issue
is to the Coxes’ liability for negligent entrustment in this case. Yet it is only
in the second illustration, which contemplates actual litigation, that the
insurer is precluded from litigating the permission issue. These
illustrations therefore support the principle that, even when a coverage
requirement is also an essential element of the insured’s liability, an insurer
may later litigate that issue in disputing coverage as long as it was not
“determined in the action” through actual litigation.

¶23 Because ownership was not actually litigated in the
underlying tort case, § 58(1)(b) does not preclude State Farm from litigating
that issue in the DJA, regardless of whether State Farm and the Coxes had
a “conflict of interest” in the underlying case under § 58(2). We note,
however, that an insurer generally may contest coverage even if the
allegations in the tort action do not themselves create a conflict of interest
within the meaning of § 58(2)’s definition. Cf. Vagnozzi, 138 Ariz. at 446,
448, 675 P.2d at 706, 708 (adopting Restatement § 58 but also observing that
a “conflict of interest” arises “when investigation by the insurer reveals
facts which tend to place the claim outside coverage of the policy, yet the
question of coverage depends on facts to be litigated in the tort suit,” and
that “the better rule is to suspend the operation of collateral estoppel where
there is an adversity of interests”). Although the allegations of a plaintiff’s
complaint generally trigger a liability insurer’s duty to defend, see ¶ 27 infra,
they should not dictate whether issue preclusion applies. Cf. Navajo Freight
Lines, Inc. v. Liberty Mut. Ins. Co., 12 Ariz. App. 424, 430, 471 P.2d 309, 315
(1970) (holding that insurer’s contractual obligation to defend or indemnify
was not governed by allegations of complaint against alleged omnibus
insured because the creation of such obligations “cannot be left to the
imagination of the drafter of a complaint”). Just as a settlement agreement
“should not be used to obtain coverage that the insured did not purchase,”
nor should the choice of allegations in a complaint. Morris, 154 Ariz. at 120,
741 P.2d at 253.

C.

¶24 The Quihuises, however, argue that the Restatement § 58’s
first illustration, ¶ 16 supra, is directly on point and supports their assertion
that State Farm is precluded from litigating the ownership issue in the DJA.
That illustration provides that, “under applicable law,” the insurer might

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be precluded from contesting its liability for indemnification. The
Quihuises contend that under Arizona law, State Farm is precluded from
litigating the ownership issue because (1) it breached its duty to defend the
Coxes; and (2) the Quihuises obtained a default judgment, like the injured
party A in the first illustration.

¶25 The Quihuises’ argument finds some support in the comment
to § 58, which refers to rules in some jurisdictions that “creat[e] strong
disincentives against default in performance of the duty [to defend].”
Restatement § 58 cmt. a. Alluding to the “applicable law” some states have
adopted, the comment states:

One such rule is that if the indemnitor fails to assume defense
of an action involving a claim that “might be found to be”
within the indemnity obligation, [the indemnitor] is
precluded from contesting not only the existence and extent
of the indemnitee’s liability to the injured person but also the
obligation to indemnify. . . . The terms of these supportive
rules are beyond the scope of this Restatement.

Id. Thus, the first illustration’s statement that “applicable law” might
preclude an insurer from “deny[ing] its liability for indemnification”
merely refers to the approach some states have taken in this area. The
question, then, is whether Arizona law precludes an insurer that refuses to
defend its insured from denying its obligation to indemnify, even though
§ 58 does not itself call for such preclusion.

1.

¶26 We turn first to the Quihuises’ argument that Arizona law
precludes State Farm from litigating the ownership issue in the DJA
because it breached its duty to defend. This case differs from Morris and
Wood in that State Farm refused to defend the Coxes in the Quihuises’ tort
action, even under a reservation of rights. The Quihuises contend that
“State Farm’s choice not to defend its insured precludes it from collaterally

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attacking a default judgment against its insured.” They presume that State
Farm had and breached a duty to defend the Coxes.5

¶27 It is well settled that a liability insurer’s duty to defend is
separate from, and broader than, the duty to indemnify. See Morris, 154
Ariz. at 119, 741 P.2d at 252; see also Restatement § 58 cmt. a. A liability
insurer’s duty to defend generally arises “[i]f the complaint in the action . . .
upon its face alleges facts which come within the coverage of the liability
policy.” Kepner v. W. Fire Ins. Co., 109 Ariz. 329, 331, 509 P.2d 222, 224 (1973);
see also Morris, 154 Ariz. at 117, 741 P.2d at 250 (“[T]he insurer must defend
claims potentially not covered and those that are groundless, false, or
fraudulent.”).

¶28 Unlike in some states, in Arizona “there is no absolute duty
to defend,” especially when “the alleged facts [in the complaint] ostensibly
bring the case within the policy coverage but other facts which are not
reflected in the complaint plainly take the case outside the policy coverage.”
Kepner, 109 Ariz. at 331, 509 P.2d at 224. Although Kepner involved a policy
exclusion rather than a coverage condition, its reasoning is pertinent here.
The Quihuises’ complaint alleged in conclusory fashion that the Coxes
owned the Jeep at the time of the accident. State Farm’s post-accident
investigation, however, revealed facts outside the complaint
— including Carol Cox’s written sales agreement with, and transfer of the
Jeep’s only set of keys to, Norma Bojorquez two weeks before the accident
— indicating the Coxes’ lack of ownership and therefore lack of coverage
for the Jeep. (The policy endorsement stated that “Your car does not include
a vehicle that you no longer own.”)

¶29 Contrary to the reasoning in Kepner, the proposition urged by
the Quihuises would impose on insurers an absolute duty to defend in cases
like this in order to avoid being precluded from denying coverage in a DJA,
even if a policy clearly does not cover the underlying tort claim against the
insured. For example, in this case, if before the accident the Coxes had
executed a sales agreement with Bojorquez, received full payment for the
Jeep, and transferred its title and all of the Jeep’s keys to Bojorguez, one
could not reasonably argue that the Coxes still owned the vehicle. But

5 Although the Quihuises alleged in the DJA that State Farm breached
its duty to defend the Coxes, the district court did not expressly address or
rule on that claim.
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Opinion of the Court

under the Quihuises’ argument, the bare allegation of ownership in the
complaint, State Farm’s refusal to defend the Coxes, and the Quihuises’
acquisition of a default judgment against the Coxes pursuant to a Damron
agreement would preclude State Farm from litigating the ownership issue
in a later coverage DJA. Such a result defies logic and law. Even had State
Farm promptly filed a DJA to establish that the Jeep was not owned and
therefore not covered, that scenario could engender the “’race to the
courthouse’” that we disapproved of in Vagnozzi, 138 Ariz. at 447, 675 P.2d
at 707.

¶30 We do not decide if State Farm had a duty to defend the
Coxes. But even if State Farm had and breached that duty, that
determination would not necessarily control the question of issue
preclusion. See Windt Treatise § 4.37 (“The vast majority of cases have
properly held that an insurer’s unjustified refusal to defend does not estop
it from later denying coverage under its duty to indemnify.”); see also
Flannery v. Allstate Ins. Co., 49 F. Supp. 2d 1223, 1227–28 (D. Colo. 1999)
(“The majority of jurisdictions . . . do not preclude an insurer from
contesting coverage because it breached its duty to defend.”) (collecting
cases). Although breaching the duty to defend will give rise to “liab[ility]
for the damages that the insured thereby incurs, . . . [t]he insurer’s breach
of contract should not . . . be used as a method of obtaining coverage . . .
that the insured did not purchase.” Windt Treatise § 4.37; cf. Morris, 154
Ariz. at 120, 741 P.2d at 253.

¶31 Citing Vagnozzi and Wood, in which the insurers defended
under a reservation of rights, the Quihuises argue that “[w]hen an insurer
refuses to defend, and no conflict of interest exists [under Restatement § 58],
it is bound by the facts that are essential to the judgment of liability against
its insured.” Although dicta in Vagnozzi might support that assertion, 138
Ariz. at 445, 675 P.2d at 705, we find that case of limited help because its
holding was confined to conflict of interest principles. Id. at 448, 675 P.2d
at 708 (holding that “where there is a conflict of interest between an insured
and his insurer, the parties will not be estopped from litigating in a
subsequent proceeding those issues as to which there was a conflict of
interest, whether or not the insurer defended in the original tort claim”).
Nor did Vagnozzi address the meaning or application of Restatement § 58
in a situation like this.

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Opinion of the Court

¶32 Referring to “the interplay and confusion of the doctrine of
collateral estoppel and the insurer’s duty . . . to defend an insured,” the
Court in Vagnozzi stated:

If the insurance company refuses to defend an action under
circumstances where it has a duty to defend, it is bound under
the doctrine of collateral estoppel by the facts determined in
the trial of such action which are essential to the judgment of
tort liability. A party will not be precluded from litigating
policy coverage in a subsequent proceeding if the question of
coverage turns on facts which are nonessential to the
judgment of tort liability.

138 Ariz. at 445, 675 P.2d at 705 (citations omitted). Those statements do
not support a finding of issue preclusion here, however, as there was no
“trial” in which the ownership issue was actually litigated and determined.
In addition, ownership of the Jeep was essential to the Coxes’ liability for
negligent entrustment only because the Quihuises chose to specifically
allege and limit the claim to that element, which fell within the policy’s
coverage, rather than alleging negligent entrustment more generally or
including an alternative element (control) that would not have been
covered. See Acuna v. Kroack, 212 Ariz. 104, 110 ¶ 22, 128 P.3d 221, 227 (App.
2006) (negligent entrustment claim may be based on defendant’s ownership
or control of a vehicle); Tissicino v. Peterson, 211 Ariz. 416, 419 ¶¶ 8–10, 121
P.3d 1286, 1289 (App. 2005) (same, citing cases); Restatement (Second) of
Torts §§ 308, 390 (1965).

¶33 Moreover, applying issue preclusion to deprive an insurer of
its coverage defense because the insurer allegedly breaches its duty to
defend “subverts any meaningful distinction between the duty to defend
and the separate duty to indemnify, and, in many cases, serves no more
than to punish the insurer for the breach of a contractual duty.” Sentinel
Ins. Co. v. First Ins. Co. of Haw., 875 P.2d 894, 912 (Haw. 1994). Because “the
two duties are truly separate and distinct, . . . an insurer’s wrongful failure
to defend should not result in a loss of an indemnity defense.” Flannery, 49
F. Supp. 2d at 1228 (internal quotation marks omitted). Thus, we reject the
Quihuises’ argument that State Farm is precluded from litigating the
ownership issue in the DJA based solely on its refusal to defend the Coxes
in the tort action.

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Opinion of the Court

2.

¶34 We turn next to the Quihuises’ contention that because they
obtained a default judgment, and thus had more than just a Damron
agreement, State Farm should be precluded from litigating any coverage
issues subsumed in that judgment. Our cases have not made this
distinction, nor does Restatement § 58. In addition, the Quihuises have not
shown why the preclusion rules should change depending on whether the
injured party took the further step of having a judge reduce the Damron
agreement to a stipulated default judgment, without any actual litigation or
court finding on the facts that directly pertain to both liability and coverage.
Cf. Morris, 154 Ariz. at 120, 741 P.2d at 253 (“‘Plainly, the [stipulated]
‘judgment’ does not purport to be an adjudication on the merits; it only
reflects the settlement agreement.’”) (alteration in Morris) (quoting Miller v.
Shugart, 316 N.W.2d 729, 735 (Minn. 1982)). Our statements in Morris that
“any stipulation of facts essential to establishing coverage would be
worthless,” and that “[a]n insured’s settlement agreement should not be
used to obtain coverage that the insured did not purchase,” are just as
apropos when a default judgment based on stipulated facts is entered
pursuant to a Damron agreement. Id.

D.

¶35 The Quihuises also rely on Dairyland Insurance Co. v. Richards,
108 Ariz. 89, 492 P.2d 1196 (1972), in arguing that State Farm may not
litigate the ownership issue in the DJA. We are not persuaded. The Court
in Dairyland held that a default judgment entered in a third-party tort action
against the insured, based on his negligent driving of a vehicle allegedly
owned by another, precluded the insurer “from later questioning [in a
garnishment action on coverage] the ownership of the vehicle [the insured]
was operating.” Id. at 91, 492 P.2d at 1198. Dairyland’s continued authority
is questionable, having been eroded by later case law.

¶36 First, after Dairyland this Court rejected the notion that an
insurer has an “absolute duty” to defend its insured when, despite a
complaint’s factual allegations that would bring a claim within coverage,
investigation reveals facts outside the complaint that clearly indicate a lack
of coverage. Kepner, 109 Ariz. at 331, 509 P.2d at 224. At a minimum, Kepner
qualifies any implication in Dairyland regarding the insurer’s failure to
defend the insured. 108 Ariz. at 90, 492 P.2d at 1197. Second, Dairyland

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Opinion of the Court

blurs the distinction between issue and claim preclusion, and the Court’s
reliance on “res judicata,” id. at 91, 492 P.2d at 1198, to support its
conclusion conflicts with current Arizona law. See Cheney Bldg. Co., 148
Ariz. at 573, 716 P.2d at 30 (distinguishing claim preclusion from issue
preclusion and finding the latter requires actual litigation under
Restatement § 27). Third, and most importantly, Dairyland did not involve
a Damron or Morris agreement and preceded Restatement § 58, Vagnozzi,
and Morris, all of which reconfigured the applicable issue-preclusion
principles.

¶37 In light of more recent case law and our interpretation and
application of Restatement § 58 here, Dairyland’s result would likely differ
were that case decided today. Dairyland involved a default judgment
obtained without actual litigation. 108 Ariz. at 90, 492 P.2d at 1197. At most,
then, Restatement § 58(1)(a) would have prevented the insurer from
litigating the existence and extent of the insured’s liability. Section 58(1)(b),
however, would not have precluded the insurer from litigating the
ownership issue because that issue was not “determined in the action”
between the insured and the claimant. For all these reasons, Dairyland is
overruled.

E.

¶38 In sum, consistent with our prior cases, we hold that when an
injured party obtains a default judgment against an insured pursuant to a
Damron or Morris agreement, that judgment will bind the insurer in a
coverage case as to the existence and extent of the insured’s liability. With
the limitation recognized in Morris and Wood, however, the judgment will
not preclude the insurer from litigating its identified basis for contesting
coverage, irrespective of any fault or damages assessed against the insured.
More specifically, we conclude on the facts presented here that, having
determined that coverage on the Jeep ceased to exist before the accident
(and thus there was no coverage regardless of any fault or liability of the
insureds), State Farm is not bound by the stipulation between the Coxes
and the Quihuises as to a fact essential to establishing coverage, despite
State Farm’s refusal to defend and the entry of a default judgment pursuant
to the Damron agreement.

¶39 We take this opportunity, however, to emphasize our prior
admonition that when an insurer refuses to defend, as State Farm did here,

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Opinion of the Court

it does so “at its peril,” Kepner, 109 Ariz. at 332, 509 P.2d at 225, and if a
court later finds coverage, the insurer must pay the damages awarded in
the default judgment (at least up to the policy limits) unless it can prove
fraud or collusion. Parking Concepts, Inc., 207 Ariz. at 22 ¶ 15 n.3, 83 P.3d at
22 n.3 (“[I]n cases where the insurer has refused to defend and the parties
enter into a Damron agreement, the insurer has no right to contest the
stipulated damages on the basis of reasonableness, but rather may contest
the settlement only for fraud or collusion.”).

¶40 An insurer that refuses to defend additionally opens itself up
to the possibility of contract damages if it is found to have breached its duty
to defend. See Vagnozzi, 138 Ariz. at 448, 675 P.2d at 708; see also Windt
Treatise § 4.33. And, depending on whether reasonable grounds exist for
refusing to defend and denying coverage, the insurer could also face bad
faith tort claims. See Rawlings v. Apodaca, 151 Ariz. 149, 153–55, 160, 726 P.2d
565, 569–71, 576 (1986); Acosta, 214 Ariz. at 383 ¶ 13, 153 P.3d at 404; see also
Windt Treatise § 9.15. Thus, in cases like this, the prudent practice is for an
insurer to defend its insured under a reservation of rights and expeditiously
pursue a determination on coverage. This opinion is based on the unique,
limited facts presented here and should not be viewed as curtailing a
liability insurer’s broad duty to defend or permitting insurers to refuse to
defend whenever coverage is denied or disputed.

III.

¶41 We answer the certified question by holding that State Farm
is not precluded from litigating, for coverage purposes, who owned the
Jeep at the time of the accident.

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