Suppose you represent a small company with limited resources and they are sued for some type of intellectual property infringement. Most veteran practitioners of intellectual property litigation know enough about insurance law to tell the client to review their comprehensive general liability (CGL) policy to see if the policy provides coverage for an “advertising injury.” Such coverage could potentially encompass trademark and/or copyright infringement suits. However, most policies today tend to have exclusions for advertising injuries involving intellectual property, and thus a policy mayappear to preclude any coverage. However, this is only the starting point for your investigation. Some exclusions are unenforceable and others may be construed against the insurer, thus making coverage available.

After reviewing the policy, even if you believe the defense costs are not covered, you should nevertheless have the client send a copy of the complaint to its insurance company, along with a demand for defense and indemnity. If a duty to defend exists, this tender triggers the insurer’s duty to defend. Should the insurer fail to defend in violation of a duty to do so, the insurer has breached the insurance policy and your client may be entitled to certain (sometimes very powerful) remedies. Insurance law is governed by state law and thus the remedies available vary from state to state. The law in most states is that after the insured tenders the suit for defense, if the insurer believes the suit is not covered under the policy, the insurer has three options: (1) defend under a reservation of rights, (2) seek a declaratory judgment that the suit is not covered by the policy, or (3) do nothing. Should the insurer choose option three, and a court ultimately determines that it should have provided a defense, the insurer breached its duty to defend.

You might ask, “So what?” Insurers have duties to the insureds, which for a matter covered under the policy, include the duty to defend and the duty to indemnify. As a general rule, the duty to defend is broader than the duty to indemnify. Since the insurer drafted the insurance agreement, it is strictly construed against it. Any ambiguity in the policy is usually seized upon the court to find a duty to defend exists. Thus, at a minimum, you should search the law of the state of interest to find similar fact patterns where the court held a duty to defend existed. If the insurer does not provide you with a defense, then you should provide it with your legal authority and inquire as to why the insurer is not bound by it. In any event, because the duty to defend is broader than the duty to indemnify, insurers are commonly required to defend the insured, but may not pay any damages should the suit be lost. However, if the insurer breaches its duty to defend, it may subsequently be estopped from asserting any policy defenses or exclusions in litigation between the insurer and the insured, thus entitling the insured to be indemnified for any damages in the underlying suit.

What happens if the insurer decides to provide a defense? Usually where a policy obligates the insurer to defend, then the insurer is entitled to control the defense. This usually results in the insurer hiring an insurance defense firm to defend the insured. While most intellectual property litigators are not pleased about being replaced by an insurance defense firm, the analysis does not stop there. Usually, if the insurer agrees to defend, it does so under a reservation of rights and sends a letter to the insured explaining that it will provide a defense, but reserves all rights to contest any obligation to indemnify should the insured ultimately be held liable for damages.

This reservation of rights may create a conflict of interest between the insured and the insurer, because most intellectual property cases allege both infringement and willful infringement. Should the insured be found liable for infringement, the insurer is required to indemnify the insured. However, as most CGL policies include exclusions for intentional acts and punitive damages, a finding of willful infringement would not be covered. Most states hold that when there is a conflict of interest between the interests of the insurer and insured (sometimes identified by asking if the insurer has the incentive to provide a “less than vigorous” defense), then the insured must relinquish its control of the defense and pay for independent counsel for the insured. An example of an actual case is instructive.

In Standard Mut. Ins. Co. v. Lay,1 a third party plaintiff Locklear Electric, Inc. (Locklear) sued Ted Lay Real Estate Agency (Lay) under the Telephone Consumer Protection Act (TCPA) (47 U.S.C. § 227(b)(3) (2006)). The TCPA provides remedies against a party that sends an unwanted facsimile. The insurer, Standard Mutual Insurance Company (Standard) offered to defend under a reservation of rights and filed a declaratory judgment action against Lay. Both the circuit court and the court of appeals held that coverage was excluded for suits brought under the TCPA.2

In 2006, Lay contacted Business to Business Solutions (BBS) regarding its advertising services. BBS offered a “blast fax” service and told Lay that it had a list of people and entities who wished to receive information by fax. Lay hired BBS, which on Lay’s behalf sent an advertisement to approximately 5,000 fax numbers in Illinois. Unbeknownst to Lay, BBS did not have the consent of the recipients of the fax advertisements. On June 13, 2006, Locklear received one of these unsolicited faxes. Three years later, Locklear’s attorneys brought a class action against Lay alleging violations of the TCPA.3 Locklear represented a putative class of 3,478 people and entities to whom Lay faxed the advertisement. The plaintiffs sought the TCPA-prescribed damages of $500 per violation and injunctive relief.

Lay tendered the suit to Standard. Standard issued a reservation of rights letter to Lay, informing Lay that the insurance policies may not cover the conduct alleged in the class action complaint, because (1) the TCPA “may constitute a penal statute” and the policies excluded coverage for willful violations of penal statutes, and (2) the policies excluded coverage for the allegations of the complaint based on the specific language of several policy provisions. Standard also concluded that a conflict of interest existed if Standard controlled the defense, and due to this conflict, Standard advised Lay that it could (1) choose its own defense attorney at Standard’s expense, or (2) waive the conflict of interest and Standard’s possible coverage defenses and accept counsel provided by Standard. Lay signed a waiver and accepted counsel hired by Standard to defend Lay in the underlying action. However, Lay later retained its own chosen counsel to represent it, and in a letter dated October 30, 2009, private counsel detailed the conflict of interest between Standard and Lay, and asked Standard’s counsel to withdraw from the case. About a month later, Lay and its counsel signed a proposed settlement of the class action. Lay’s attorney then informed Standard’s attorney that Lay had decided to dismiss Standard’s attorney and settle the case. Lay’s private counsel subsequently entered his appearance on behalf of Lay and then settled the matter. Locklear agreed in the settlement not to execute on any property or assets of Lay other than Lay’s insurance policies and further agreed to seek recovery to satisfy the judgment only from those insurance policies.4 In fact, Locklear agreed not to execute against Lay’s noninsurance assets even if a determination was ultimately made that Lay’s insurance carrier did not owe coverage.

Standard’s declaratory judgment suit against Lay included eight counts that sought a declaration of no duty to defend and another declaration of no duty to indemnify.5 For example, in count V, Standard alleged that TCPA-prescribed damages of $500 per violation constituted punitive damages, which it claimed “are not insurable as a matter of Illinois law and public policy.” The Supreme Court reversed the appellate court’s holding that TCPA damages are not insurable as punitive damages and thus Standard’s exclusion for punitive damages was not applicable. After a lengthy discussion of the issues, the Supreme Court held that the “manifest purpose of the TCPA is remedial and not penal.”6 In doing so, the Illinois Supreme Court disagreed with decisions from Colorado and New York, which held the TCPA is penal.7

Whether a duty to defend and/or indemnify exists is often a complex question governed by state law. In the Lay case, review of the standard policy language and existing authority would have led to the (erroneous) conclusion that insurance indemnity coverage was unavailable based upon the standard language of the policy and existing precedent. Indeed, both the circuit and appellate courts agreed that no coverage was available. Yet, Lay’s counsel was able to obtain coverage for Lay’s defense costs, settle the case, and extricate Lay from the litigation. After Lay settled the suit, Locklear’s counsel pursued the collection efforts against the insurer.

As intellectual property attorneys, we may not be familiar with or recognize the issues under the applicable insurance laws due to their complexity and variation from state to state. However, Lay is instructional and provides some general guideposts to follow in trying to help your client. These guideposts include (1) consulting the insurance policy, (2) tendering the suit for defense and indemnification should there be the slightest question of coverage, (3) being alert to potential conflicts of interest between the insurer and the insured, and (4) looking for opportunities to settle with the third-party plaintiff should you believe the insurer violated its duty to defend or if there is a question of coverage.