7th Circuit Holds Excess Insurer Has No Duty to Indemnify Punitive Damages

by Traub Lieberman Straus & Shrewsberry LLP

In its recent decision in Fox v. Am. Alternative Ins. Corp., 2014 U.S. App. LEXIS 12799 (7th. Cir. July 7, 2014), the United States Court of Appeals for the Seventh Circuit, applying Illinois law, had occasion to consider whether following a breach of certain duties owed to its insureds, an excess insurer can be liable for payment of punitive damages awarded against its insureds in an underlying lawsuit.

In 2004, Kevin Fox was arrested and charged with the sexual assault and murder of his three-year-old daughter. Will County detectives coerced Fox into a confession and then delayed the testing DNA evidence, leaving Fox imprisoned for almost eight months. When the DNA was tested at a private lab, the results excluded Fox as a suspect and the prosecution dropped the charges against him. Fox then sued Will County and the detectives in federal court seeking compensatory and punitive damages, alleging that the detectives arrested and prosecuted him without probable cause and in violation of his due process rights. Fox also asserted state law claims for malicious prosecution and intention infliction of emotional distress.

As employees of Will County, the detectives were insureds under the County’s insurance policies. St. Paul Fire & Marine Insurance Company (“St. Paul”) issued a primary policy to Will County with a policy limit of $1 million. American Alternative Insurance Corp. (“AAIC”) issued to Will County its first layer of excess coverage, which had policy limits of $5 million, and Essex Insurance issued Will County a second layer of excess coverage. AAIC was not required to “assume charge of settlement or defense” until the aggregate Limit of Liability of the scheduled underlying policy (here, the St. Paul policy) was exhausted by payment of claims. None of the policies provided coverage for punitive damages.

At trial, the detectives received joint representation retained by St. Paul, but no one informed the detectives of any potential conflict or their entitlement to independent counsel at the insurer’s expense. After a jury trial, a verdict in the amount of $15.5 million in damages (including $6.2 million in punitive damages) was entered in favor of Fox on the false arrest, due process, malicious prosecution, and emotional distress claims. Both before and after the jury’s verdict on liability, Fox offered to settle their claims for less than that sum, but the offers were rejected. After the verdict, the district court reduced $2.6 million of the punitive damages awarded to Fox.

Sometime after the conclusion of trial, St. Paul exhausted its $1 million policy limit by satisfying the judgment against one of the detectives. AAIC then assumed control of the defense and appeal for the remaining detectives. As part of their strategy on appeal, the detectives assigned Fox all claims that they might have had against Will County’s three insurers in exchange for a covenant not to execute the awards of punitive damages against the detectives’ personal assets. Then the detectives negotiated a supplemental deal with Fox that involved the detectives agreeing to withdraw their appeal challenging the punitive damage awards in exchange for a full and complete release of personal liability for punitive damages.

After securing the assignments, Fox filed an action against St. Paul, AAIC, and Essex in the Circuit Court of Cook County seeking damages for their breach of duty to the detectives in the amount of punitive damages awarded against the detectives. Hoping to limit any exposure to liability in the state court action, AAIC and Essex intervened in the pending federal appeal of the wrongful prosecution judgment in order to contest the punitive damage awards. The Seventh Court of Appeals, however, affirmed the judgment in favor of Fox and against the detectives on all but Fox’s due process claim, and upheld $8,166,000 of the damages awarded (including $3.4 million in punitive damages.)

Fox then filed suit seeking a declaratory judgment that AAIC breached its good faith duties to (1) reasonably settle the claims against the detectives within the policy limits, and (2) inform the detectives of the conflicts of interest. Fox took the position that, as assignee of the detectives’ rights against their insurers, his damages for AAIC’s breach of duty was equal to the punitive damages awarded against the three detectives. AAIC moved to dismiss Fox’s complaint for failure to state a claim. The district court held that AAIC, as an excess insurer, never had any control over the detectives’ defense before judgment and therefore had no duty to settle the claims against the detectives, or to alert them of any potential conflicts of interest. Fox appealed.

On appeal, the Seventh Circuit first questioned whether Fox’s suit was an impermissible “end run” around Illinois’ public policy ban on coverage for punitive damages. That issue did not have to be decided, however, because the claims asserted by Fox could not stand even if a claim for such punitive damages was permissible.

The court held that Fox did not state a claim that AAIC breached any duty owed to the detectives. AAIC did not violate its duty to settle within policy limits because Fox did not make a settlement demand within AAIC’s policy limits after the duty to defend passed from St. Paul to AAIC. The court further reasoned that AAIC was not required to “seek out or initiate fresh negotiations.”

As to a potential conflict of interest, the court held that a conflict of interest does not arise simply because a plaintiff seeks punitive and compensatory damages. Because there was no assertion that AAIC’S self-interest in fighting compensatory damages would have been “furthered by providing a less than vigorous defense of the punitive damages on appeal,” the inclusion of a punitive damage claim did not, in and of itself, create a conflict of interest. The court further reasoned that even if there was a potential conflict of interest regarding punitive damages, none existed by the time AAIC controlled the defense because the detectives negotiated with Fox a covenant not to execute.

Finally, the court held that AAIC had no conflict in using the same law firm for joint representation of the detectives because the detectives’ interests were not “diametrically opposed,” and the detectives did not suffer harm as the result of the joint representation. Therefore, the court affirmed the district court’s dismissal of the suit against AAIC.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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