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On March 15, 2018, the United States Court of Appeals for the Seventh Circuit issued its opinion in Hyland v. Liberty Mutual Fire Insurance Company, Case No. 17-2712. In Hyland, the dispute involved the amount an insurance carrier was responsible to pay where the insurer denied coverage without seeking a declaratory judgment action with respect to its coverage obligations.

Monteil Hyland was a passenger in a car owned by Kimberly Perkins and driven by Miquasha Smith, who was not lawfully behind the wheel of the vehicle when she crashed into two parked vehicles, seriously injuring Hyland. Smith was convicted of reckless driving, and neither Smith nor her parents had auto insurance. The owner, Perkins, had a policy of insurance with Liberty Mutual, with policy limits of $25,000. The policy provided that it covered Perkins’ family, including her daughter Michiah Risby, plus anyone else driving the car with the family’s permission. Risby claimed she never gave permission to Smith to drive the car. The police reported that Smith told many incompatible stories about the events.

Shannon Hyland, as next friend of Monteil Hyland, sued Smith. Liberty Mutual, believing its insured, Risby, advised that it would not provide a defense or indemnity in the suit. Eventually, Smith defaulted, and a default judgment was entered in the amount of $4.6 million. Smith then assigned to Hyland her claims against Liberty Mutual.

In the proceedings in the United States District Court for the Central District of Illinois before Judge James Shadid, the court ruled that Liberty Mutual was responsible for the entire amount of the judgment, $4.6 million, because Liberty Mutual did not defend Smith or seek a declaratory judgment.

Liberty Mutual appealed, conceding that it should have defended Smith while reserving a right to decline indemnity, but contending that its liability could not exceed the limits of insurance on its policy, $25,000.

The Seventh Circuit analyzed the decision of the District Court. The District Court held that Liberty Mutual was estopped from asserting any policy defenses, and found that the $25,000 maximum indemnity was an example of a defense that an insurer is unable to assert. Additionally, the District Court held that any damages proximately caused by an insurer’s neglect are recoverable, without regard to the policy limit. In the appeal, Hyland renounced the estoppel theory and argued that the District Court’s holding that any damages proximately caused by an insurer’s neglect are recoverable allowed recovery of the full amount of the tort judgment.

Liberty Mutual argued that Illinois law limits recoverable damages to the policy limit, plus a maximum of $60,000 extra if the plaintiff shows that the refusal to defend or indemnify arose from bad faith. Liberty Mutual cited Conway v. Country Casualty Ins. Co., 92 Ill.2d 388, 397 (1982), for the proposition that “mere failure to defend does not, in the absence of bad faith, render the insurer liable for the amount of the judgment in excess of the policy limits.” Liberty Mutual argued that both bad faith and injury proximately caused by the insurer’s conduct are both necessary for an insurer to be liable for a judgment in excess of policy limits. Hyland disagreed, citing other language in Conway that “damages for a breach of the duty to defend are . . . measured by the consequences proximately caused by the breach.”

The Seventh Circuit declined to address the issue of whether proximate cause by itself suffices to create liability on the part of the insurer for a judgment in excess of policy limits. Instead, the court provided an analysis of the facts to show that the insurer’s conduct could not have caused Smith any loss exceeding $25,000, since the best situation for Smith would have been “Liberty Mutual’s provision of a defense lawyer plus the tender of the policy limit toward a settlement or judgment.” The Court stated that Liberty Mutual providing a lawyer would have been valuable to Smith, independent of a policy limits tender, only if a vigorous defense might have defeated Hyland’s claim or held damages under $4.6 million. However, the court found that this outcome was impossible, citing numerous laws broken by Smith and stating that her “liability was too clear for argument.”

According to the Seventh Circuit, only if Smith had a plausible defense to liability or the amount of Hyland’s claim could the insurer’s failure to defend be the proximate cause of the state-court judgment. The Seventh Circuit further held that the judgment against Smith in this case “was inevitable” and that the amount of the judgment must be taken as justified. Thus, the maximum loss caused by Liberty Mutual’s failure to defend was simply the amount of the policy limits, $25,000.

Contrasting Hyland With A Recent Illinois Appellate Decision

The Seventh Circuit’s decision in Hyland can be contrasted with a recent Illinois Appellate Court decision. In Delatorre v. Safeway Ins. Co., 2013 IL App (1st) 120852, the Appellate Court of Illinois for the First District held that an insurer breached its duty to defend its insured when it merely retained an attorney, who then did not meaningfully participate in the case and allowed a default judgment to be entered on behalf of the insured. The attorney filed an appearance and answer, but took no further action to defend the insured after that. The insurer’s only further conduct was to send a copy of the default order, which held that the basis for default was failing to comply with outstanding discovery. After determining that the duty to defend was in fact breached by the insurer, the Delatorre court turned to the question of damages.

The Delatorre case is similar to the Hyland matter in that a default judgment was entered against the insured. The court in Delatorre stated that a default order against the insured was entered on October 4, 1994. A prove-up hearing was held in November 1995, and the plaintiff w¶as awarded $250,000 in damages. The Delatorre court analyzed several cases decided in the Illinois Supreme Court and Illinois Appellate Courts and ultimately held that “irrespective of bad faith, an insurer may be liable for damages beyond the policy limits if its breach of duty caused the excess judgment.” 2013 IL App (1st) 120852 at ¶ 34. The court held that “the entry of the final judgment by default in the underlying personal injury action, including that portion in excess of policy limits, directly flows from the breach of contract; that is, the proximate cause of the default judgment, entered about 13 months following the default order, was [the insurer’s] breach.” Id. at ¶ 35.

The court further held that “the general rule is that damages for breach of contract should place the injured party in the position it would have been in had the contract been fully performed.” Id. at ¶ 36. The Delatorre court stated that if the insurer had performed, there would have been no default and no default judgment. Id. Thus, importantly, the Delatorre court did not engage in a significant part of the analysis performed by the Seventh Circuit in Hyland: the question of whether the insured would have been found liable and whether the amount of the judgment would have been the same with or without the insurer’s breach of duty.

The dissent in Delatorre addressed this issue at length. Delatorre, 2013 IL App (1st) 120852, J. Sterba, concurring in part and dissenting in part. After agreeing that the duty to defend was breached by the insurer, Judge Sterba stated, “I believe the better question is whether a lesser judgment would have been entered absent [the insurer’s] breach.” Id. at ¶ 46. He also notes that the court cited the general rule for damages in breach of contract cases: that damages for breach of contract should place the injured party in the position it would have been in had the contract been fully performed. However, the majority then failed to follow the general rule, since if the insured had been properly defended, the maximum indemnity by the insurer would have been the policy limits. Judge Sterba’s dissent stated that “[d]amages in excess of these limits are a windfall.” Id. at ¶ 47. The Seventh Circuit’s decision in Hyland squares more fully with the dissent in Delatorre than the majority opinion.

Implications For Insurers on Excess Judgments

There are several implications of the Hyland decision for insurers. First, in the event an insured or an underlying plaintiff who has been assigned the rights of an insured asserts a breach of the duty to defend, federal court is now a more favorable jurisdiction than Illinois state courts to litigate the issue, since the Illinois Appellate Court decisions on point held that the damages to the insured are the amount of the judgment ultimately entered against the insured, if in excess of policy limits. To the extent an insurer meets the requirements for diversity of citizenship and amount in controversy, an insurer should attempt to remove such a case to federal court to limit potential recovery.

However, the Hyland decision also essentially provides a “road map” for underlying plaintiffs who obtain an assignment of policyholders’ claims against an insurer to show that breach of the duty to defend caused the insured’s damages. The Hyland court held: “If Smith had a plausible defense, either to liability or to the amount of Hyland’s claim, then the insurer’s failure to send a lawyer to help Smith make those arguments could be seen as a proximate cause of the state-court judgment. But some judgment against Smith was inevitable and the amount of the judgment must be taken as justified.” Therefore, to avoid the result reached by the court in Hyland, a party adverse to an insurer would need to attempt to show that there were defenses to liability or damages relevant to the underlying plaintiff’s claim. For example, alleging contributory negligence by the underlying plaintiff would allow the court to make a determination that damages actually resulted from the insurer’s breach.

The other important implication of this matter for insurers to consider is that under Illinois state law and pursuant to the plaintiffs’ road map discussed above in Seventh Circuit cases interpreting Illinois law, it is very risky to disclaim coverage without filing a declaratory judgment action. An insurer may still avoid breach of the duty to defend by either defending under a reservation of rights or seeking a declaratory judgment that there is no coverage. Employers Ins. Co. v. Ehlco Liquidating Trust, 186 Ill. 2d 127 (1999). Even without committing bad faith, an insurer can be held liable for a judgment in excess of its policy limits where a court determines it has breached its duty to defend and the breach is the proximate cause of additional damages. Therefore, insurers should take a conservative approach where their policies would be interpreted under Illinois law, either defending their insureds under reservation of rights and refusing to indemnify where there is a potentially applicable coverage defense, or filing a declaratory judgment action in support of a denial of coverage where there is any doubt regarding the application of an exclusion. By taking these actions, an insurer can avoid the risk of being found liable for an excess judgment.