In Fox v. American Alternative Insurance Corporation, ___ F.3d ___, 2014 WL 3015759 (7th Cir, 2014), the court, applying Illinois law, held that an excess insurer had no duty to settle claims against its insureds or alert them to conflicts of interest before it assumed control of the defense.  The court also held that: (1) the excess insurer was not required to “seek out or initiate fresh [settlement] negotiations” when it assumed control of the defense; (2) a punitive damages award did not create a conflict of interest requiring the excess insurer to appoint independent counsel on appeal because the punitive damages were not disproportionate to compensatory damages; and (3) joint representation of multiple insureds did not create a conflict of interest or harm the insureds.  Id. at *4-*6.  More fundamentally, the court expressed doubt about whether, under Illinois law, a third-party bad faith suit could be used to shift the burden of paying punitive damages to an insurer where public policy prohibits insurance coverage for punitive damage awards, but determined that it did not need to decide this matter of first impression.  Id. at *4, *6.

The case arose from a third-party claimant’s malicious prosecution and abuse of process claims against several Illinois police detectives.  Id. at *1.  The detectives were insured under their employers American Alternative Insurance Corporation (AAIC) policy, which provided excess coverage once $1 million in primary coverage was exhausted through settlement or judgment.  Id.

The third-party claimant obtained a judgment against the insureds for $15.5 million, including $6.2 million in punitive damages.  Id.  Neither the excess nor primary insurance policies covered punitive damages.  Id.  While appeal of the punitive damages award was pending, the insureds assigned their rights against their excess and primary insurers to the third-party claimant in exchange for a covenant not to execute the punitive damages award against their personal assets.  Id.  Later, the insureds agreed to drop their appeal of the punitive damages award in exchange for a full release.  Id.  Since the insureds were no longer contesting the punitive damages award, AAIC intervened in the underlying action and contested punitive damages itself.  Id.  Ultimately, the punitive damages award was affirmed.  Id

As the insureds’ assignee, the third-party claimant brought suit against AAIC for bad faith, alleging that AAIC had breached the duty to settle and failed to alert the detectives to potential conflicts of interest.  Id

The court held that AAIC had no duty to settle the claims against its insureds or alert them to potential conflicts until after it assumed control of the defense during the appeal.  Id. at *4.  The court found that under Illinois law an insurer’s duty to settle did not arise unless the third-party claimant made a settlement demand within policy limits.  Id.  The only settlement demand within policy limits was made before AAIC took control of the defense; therefore AAIC had no duty to settle.  Id.  Moreover, the court found that AAIC had no duty to “seek out or initiate fresh [settlement] negotiations” after it assumed control of the defense.  Id.

The court likewise held that AAIC had no duty to alert the insureds of a potential conflict or hire independent counsel to represent them because the punitive damages award did not create a conflict of interest.  Id.  First, the court held that punitive damages only create a conflict of interest if they are “vastly in excess of” compensatory damages.  Id. Here, the punitive damages award at issue on appeal was less than compensatory damages.  Second, by the time AAIC took control of the defense, the detectives had negotiated a covenant not to execute against their assets.  Accordingly, “neither [AAIC] nor the [insureds] faced any harm from the prospect of a punitive damages award.”  Id. at *5.  Although the covenant not to execute did not “erase” the judgment against the [insureds], any recovery on the judgment in violation of the covenant not to execute would “revert back to the [insureds] by virtue of their contract remedy.”  Id.

The court also held that the joint representation of multiple insureds on appeal did not create a conflict of interest.  Id. at *5.  Such a conflict only arises where the insureds’ positions are “diametrically opposed.”  Id.  But the insureds had “pursued a joint defense at trial” and there was no evidence of “antagonistic arguments that separate counsel could have made on their behalf on appeal.”  Id.  In any event, the insureds suffered no harm from any conflict of interest because they were “fully released from personal liability for punitive damages and the compensatory damages awarded to Fox have been paid in full.”  Id.

Finally, the court expressed skepticism about the viability of a bad faith claim by a third-party assignee seeking punitive damages that would not have been covered under the policy.  Id. at *3, *6.  The court noted that Illinois public policy precludes insurers from covering punitive damages arising from the insureds’ misconduct.  Id. at *3.  The court collected cases from three other jurisdictions holding that third-party claimants could not “shift” the “wrongdoers’ duty to pay punitive damages” to an insurance company through an assigned bad faith suit.  Id.  However, the court noted that those cases were all “split decisions reached over robust dissents.”  Id.  The court ultimately determined that it did not need to decide how Illinois would resolve the issue because the trial court’s dismissal of the case was adequately supported on other grounds.  Id.

This case is important because it clarifies the duties excess insurers owe to policyholders when the excess carrier assumes defense of litigation, as well as the effect of a release and covenant not to execute against an insureds’ assets on assigned bad faith claims.