RESERVATION OF RIGHTS LETS INSURED SETTLE CLAIM WITHOUT CARRIER'S OK

August 2, 2004

Steven P. Garmisa
Hoey & Farina Attorney
garmisa@hoeyfarina.com
1-888-425-1212

Sometimes an insured gets to settle a third-party claim without permission from the insurance company. It depends on whether there was a breach of contract by the insurer, such as when the carrier abandons its insured by breaching its duty to defend. But settling a third-party party claim without permission from the insurance company can be a risky proposition if the insurer's alleged breach is not clear-cut.

In a new case involving an insurance policy that required permission from the insurance company before the insured settled a third-party claim, two important questions were:

• Can the insured settle without permission from the insurance company when the insurer issues a reservation of rights and informs the insured of its conclusion that a third-party claim is not covered by its insurance policy?
• Can the insured get a declaratory judgment, before signing a settlement with the third-party, on whether there was a breach of contract by the insurance company and whether the proposed settlement is reasonable?

Ruling in a case involving a third-party claim against the former chief executive officer of an insolvent company, U.S. Bankruptcy Judge Carol A. Doyle concluded that:

• The insured CEO was not obligated to secure permission for a settlement from the insurance company that issued a directors' and officers' liability policy because the insurer issued a reservation-of-rights and notified the insured of its belief that a policy exclusion eliminated coverage for the third-party claim. It did not matter that the D&O policy created no obligation for the insurance company to defend the insured.
• The CEO could get a declaratory judgment -- before signing the settlement -- on whether there was a breach of contract by the insurer.
• The insured could not get a declaratory judgment on whether the proposed settlement was reasonable.

In re HA 2003 (formerly known as HA-LO Industries) v. Federal Insurance Co., 2004 WL 1354244 (Bankr. N.D. Ill., June 9).
Zurich American Insurance Co. provided $10 million of excess D&O coverage for HA-LO Industries.

After HA-LO filed a petition under Chapter 11 of the Bankruptcy Code, it sued (as debtor-in-possession) its former CEO, John Kelley, for breach of fiduciary duty and corporate waste.

Federal Insurance -- the carrier that provided primary coverage -- reimbursed Kelley for defense costs and issued a reservation of rights letter. According to Federal and the excess carriers (including Zurich), there was no coverage for the lawsuit that HA-LO filed against Kelley because of the insured vs. insured exclusion.

HA-LO and Kelley argued that this exclusion did not apply, however, because HA-LO was acting as debtor-in-possession in asserting a claim that would otherwise be prosecuted by a bankruptcy trustee (which would not have triggered the insured vs. insured exclusion).
There was a tentative settlement between HA-LO and Kelley, but Zurich refused to approve the settlement. So HA-LO filed a complaint seeking a declaratory judgment that the insured vs. insured exclusion did not apply; that they could settle without seeking permission from Zurich; and that the settlement was reasonable.

Here are some highlights of Doyle's opinion (with various omissions not noted in the quoted text):

First, Doyle concluded that an exception to the insured vs. insured exclusion applied because HA-LO was acting as debtor-in-possession.

Next, Doyle recounted:

"HA-LO seeks a declaratory judgment in count 2 that Kelley has the right to enter into a settlement even though the insurers will not approve it; and in count 3 that the proposed settlement that HA-LO has negotiated with Kelley is reasonable.

"Zurich asks the court to dismiss both counts for failing to present an actual case or controversy.

"The court agrees with Zurich with regard to count 3, but concludes that count 2 is ripe for adjudication.

"In count 2 of the complaint Kelley seeks to define his rights under the insurance contract. He asks this court to determine that, because Zurich has refused to acknowledge coverage and to approve a settlement within the policy limits, he may enter into a reasonable settlement without Zurich's consent and without breaching the consent clause of the insurance contract.

"This is an actual controversy because Kelley is presently threatened by the possibility that his proposed settlement with HA-LO without Zurich's approval will cause him to lose coverage under the policies. The issue can be decided based on events that have already occurred, not based on hypothetical facts or speculative contingencies. Thus, this determination falls squarely within the purpose of the Declaratory Judgment Act, which is to prevent avoidable damages to a party not certain of his rights.

"Zurich contends that this case is similar to Maryland Insurance Co. v. Attorneys' Liability Assurance Society Ltd., 748 F.Supp. 627 (N.D. Ill. 1990), in which the District Court found a declaratory action by an insurance company non-justiciable because the underlying case had not yet settled. However, in that case, the insurance company simply wanted a definition of what its future rights would be if the case actually settled -- not what its current rights were under a specific contract.

"Unlike this case, there was no imminent threat in Maryland that a contract would be breached or that avoidable damages would occur. Thus, Maryland is not instructive with regard to count 2.

"In count 3, however, HA-LO asks the court to declare that the proposed settlement with Kelley is reasonable. This count seeks a declaration based on events that have not yet occurred -- namely the signing of a settlement agreement between Ha-LO and Kelley. Count 3 is therefore similar to the facts of Maryland.

"As the court in Maryland concluded, 'After all, the world is full of people who would much prefer to have their courses of future conduct defined by advice from courts, rather than by advice from their own lawyers predicting what courts are likely to do.'

"This court may not prospectively declare that Kelley and HA-LO have negotiated a fair settlement. Count 3 does not address an actual case or controversy, but rather seeks a hypothetical advisory opinion. Count 3 should therefore be dismissed. Because the court lacks jurisdiction over this non-justiciable matter, it will directly dismiss this count without referring recommended findings to the District Court."

Turning to the merits of count 2, Doyle continued:

"The parties also do not dispute that Federal, the primary insurer, has reimbursed Kelley for his defense costs while reserving its rights to contest coverage, even though the insurance contract does not require payment of defense costs.

"In Illinois, as in most states, when a complaint against the insured alleges facts within or potentially within the scope of the policy coverage the insurer denying coverage must defend the suit under a reservation of rights or seek a declaratory judgment that there is no coverage. If the insurer fails to do either it is later estopped from denying coverage in a suit to collect the judgment.

"Thus, because the insurers in this case did not file a declaratory judgment action to determine coverage, they had to defend Kelley's lawsuit under a reservation of rights or risk later losing the right to deny coverage.

"The issue presented in count 2 is whether Zurich has lost the right to consent to a settlement by denying coverage of HA-LO's claims against Kelley. HA-LO contends that, because Federal was paying Kelley's defense costs subject to a reservation of rights and Zurich has denied coverage, Zurich is not protected by the general rule which holds that, in the absence of a breach of the duty to defend, an insured must obtain the consent of the insurer before settling with an injured plaintiff.

"The court agrees. Zurich may not deny coverage and still maintain control over the settlement between HA-LO and Kelley."

Illinois Law

"The general rule in Illinois is that if an insurer does not breach the insurance contract, the insured must get the insurer's approval before settling the case," Doyle noted. "An insurer does not breach the policy simply by providing defense costs subject to a reservation of rights.

"Zurich argues that it has not breached the contract and therefore that Kelley must obtain its consent before settling with HA-LO. However, the majority of courts addressing this issue convincingly holds that the rules change once an insurer reserves its rights and takes a position that coverage does not apply.

"The only Illinois court addressing this specific issue has adopted the majority approach. Commonwealth Edison Co. v. National Union Fire Insurance Co., 323 Ill.App.3d 970, 985 (2001), held that when an insurer that defended while reserving its right to contest coverage lost the right to consent to a settlement. The court quoted extensively from Cay Divers Inc. v. Raven, 812 F.2d 866 (3d Cir. 1987), which held that, by providing the insured with independent counsel while reserving a right to contest coverage, an insurer renounces control of the litigation and thrusts responsibility for the litigation on the insured, who is then free to enter into a reasonable settlement.

"Zurich argues that these cases do not apply here because it had no duty to defend under the insurance contracts. While this is true, it is irrelevant. Zurich has done more than reserve its right to contest coverage; it has flat-out denied coverage and it litigating that issue to judgment in this case. Thus, there is little question that the holding of Commonwealth Edison applies to Zurich.

"Although the facts of Commonwealth Edison are more complex and involve a relinquishment of control by the insurance carrier because of a conflict of interest between two insureds, the court's holding is a clear acceptance of the majority view addressed below."

Other Jurisdictions

"Many courts in other jurisdictions agree with the logic of Commonwealth Edison and hold that once an insurer has reserved its rights to contest coverage, or is actually contesting coverage, as is the case here, the insured has the right to settle without consent of the insurer. For example, Cay Divers Inc. v. Raven, 812 F.2d 866, 870 (3d Cir. 1987), discussed above, held that 'an insurer's discharge of its duty to defend by providing independent counsel, even though reserving the right to contest coverage, relieves it of control over the litigation, and a reasonable settlement effectuated by the insured does not bar an action for indemnification against the insurer.'

"In other words, an insurer cannot have it both ways; it cannot simultaneously tell an insured he must handle his own defense (and possibly pay the final judgment himself) and, at the same time, maintain ultimate control over the litigation by retaining the right to deny settlement.

"Similarly, the Supreme Court of Arizona has recognized that while an insurer technically has not breached the contract by defending under a reservation of rights, 'neither did it accept full responsibility for [the insured's] liability exposure.' United Services Automobile Association v. Morris, 154 Ariz. 113, 741 P.2d 246, 251 (Ariz. 1987). Insurers who defend under a reservation of right thus place their insureds in the 'precarious position' between obeying the wishes of their maybe insurers or protecting themselves from the 'sharp thrust of personal liability' that could well arise if coverage is ultimately denied.

"Furthermore, allowing the insurers simultaneously to protest or deny coverage and to control the course of the litigation 'hamstrings insureds while granting the insurer a double bite at escaping liability.' The insurer will not have to pay if either the insured wins at trial or if the insurer wins its dispute over coverage.

" 'The insureds risk financial catastrophe if they are held liable, while the insurer may save itself by litigating both issues the insured's liability and the coverage defense -- and winning either.' Therefore the Arizona Supreme Court held that 'the cooperation clause prohibition against settling without the insurer's consent forbids an insured from settling only claims for which the insurer unconditionally assumes liability under the policy.'

"This court concludes that the Illinois Supreme Court would agree with Commonwealth Edison and adopt the reasoning of Cay Divers, United Services and like-minded cases.

"Zurich's reservation of rights precludes it from dictating the course of this litigation. Kelley may thus settle with HA-LO without breaching the consent clause of the insurance contract."

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