Illinois Court Holds Insured is Entitled to Independent Counsel to Defend Uncovered Punitive Damages Claim

An Illinois appeals court has held that an insured had the right to select independent counsel under a duty to defend policy where the insured faced a substantial, uncovered punitive damages award.  See Xtreme Prot. Servs., LLC v. Steadfast Ins. Co., 2019 WL 1976482 (Ill. App. Ct. May 3, 2019).

The insured, a security services company, was sued for the acts of an employee who allegedly engaged in wiretapping, eavesdropping, and trespassing, and allegedly sent thousands of threatening and harassing text messages.  The insured tendered coverage under a duty to defend policy and requested independent counsel on the basis that a purported conflict of interest existed because the policy excluded intentional acts and punitive damages.  The insurer agreed to defend the insured subject to a reservation of rights but declined to provide independent counsel.

During the resulting coverage action, the insurer advised the insured that it would defend and indemnify the insured for any compensatory damages arising from the lawsuit and would not assert any exclusions or defenses to coverage.  However, the insurer reserved the right to deny coverage for punitive damages.  The trial court held that the insured was entitled to independent counsel based on the insurer’s reservation of rights.

The appeals court agreed, noting that typically an insurer has the right to control the defense.  However, there is a “limited exception” when a conflict of interest exists between the insured and insurer that cannot otherwise be resolved by full disclosure and consent by the parties.  The court noted that “[c]ourts have found a conflict when the facts to be resolved in the underlying case would allow the insurer-retained counsel to ‘lay the groundwork’ for a subsequent denial of coverage.”  In addition, the appeals court held that independent counsel is appropriate where uncovered punitive damages “form a substantial portion of the potential liability.”

In the underlying action, plaintiffs sought $800,000 in compensatory damages and $4 million in punitive damages.  As a result, the appeals court found that potential punitive damages left the insured “with the greater interest and risk in the litigation” and therefore “more of an interest in settling the case prior to trial[.]”  Thus, the court held that a conflict of interest existed entitling the insured to independent counsel.

The appeals court also found that the insured had not breached the policy’s cooperation clause by refusing to retain the insurer’s selected counsel, and in any event, the insurer had not shown prejudice as a result of the insured’s refusal.