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I. Introduction

A draconian insurance principle in Illinois is that once an insurer breaches its duty to defend, either by wrongfully denying a defense to its insured or failing to properly and timely reserve its rights and offer independent counsel, the “estoppel doctrine” is triggered to bar that insurer from raising policy defenses to coverage, even defenses to indemnity coverage that may otherwise be valid.  Employers Insurance of Wausau v. Ehlco Liquidating Trust, 186 Ill.2d 127, 152 (1999); Sullivan House v. Federal Ins. Co., 2008 U.S. Dist. LEXIS 10438 (N.D. Ill. 2008).

Unfortunately, the law addressing estoppel in Illinois remains clouded due to conflicting decisions regarding applicability and scope of the doctrine and because it very much depends on the unique facts of a given situation.  Further, legal commentators and coverage attorneys often disagree about the options available to insurers when denying coverage in Illinois or otherwise reserving rights in certain scenarios.  Finally, the concept of estoppel is intertwined with other complex insurance coverage issues, including what constitutes a conflict of interest between the insurer and insured, whether such a conflict triggers an insured’s right to independent counsel, and whether and when an insurer is required to seek a judicial declaration of coverage to confirm the rights of the insurer and insured under the policy.  In light of the broad implications of the estoppel doctrine, caution must be exercised in addressing the basis for any denial or reservation of rights, the engagement of defense counsel when a reservation of rights is contemplated or issued, and implementation of a defense once a duty to defend is acknowledged.

This article provides insurers and their counsel with current Illinois case law regarding the estoppel doctrine.

II. Broad Implications of the Estoppel Doctrine

 A. Conflict of Interest and Breaching of the Duty to Defend

Any analysis of the estoppel doctrine begins with the related issues of “conflict of interest,” “duty to defend,” and “independent counsel.”  In 1976, Illinois courts first established an insured’s right to independent counsel where a conflict of interest exists between the insurer and insured.  Maryland Cas. Co. v. Peppers, 64 Ill.2d 187, 199 (1976).  In Peppers, the Illinois Supreme Court held a conflict of interest arises when a complaint against an insured alleges both negligent and intentional conduct.  The court stated that when there was a conflict, the insurer’s duty to defend was satisfied by reimbursing the insured for the reasonable costs of independent defense counsel (aka Peppers counsel in Illinois), and that the insurer should not be obligated or permitted to participate in the insured’s defense.  Over the past 35 years, the Peppers conflict test has been expanded considerably to include additional situations and coverage issues.  See e.g., Williams v. American Country Insurance Company, 359 Ill.App.3d 128, 833 N.E.2d 971 (1st Dist. 2005); Mobil Oil Corporation v. Maryland Casualty Company, 288 Ill.App.3d 743, 681 N.E.2d 552 (1st Dist. 1997); Nandorf, Inc. v. CNA Insurance Companies, 134 Ill.App.3d 134, 479 N.E.2d 988 (1st Dist. 1985);  Murphy v. Urso, 88 Ill.2d 444, 430 N.E.2d 1079 (Ill. 1981); Thornton v. Paul, 74 Ill.2d 132, 384 N.E.2d 335, 23 Ill. Dec. 541 (1978).

 B. Insurers Beware - Example Cases

1. Central Mutual Insurance Co. v. Kammerling

In 1991, Illinois Appellate Court confirmed that when an insurer fails to properly raise and address a conflict of interest triggering an insured’s right to independent counsel, it has breached the duty to defend, and the estoppel doctrine will apply.  Central Mutual Insurance Co. v. Kammerling, 571 N.E.2d 806, 212 Ill.App.3d 744, 156 Ill.Dec. 826 (1st Dist. 1991).  In Kammerling, the insurer acknowledged the duty to defend, offered to pay defense costs, but failed to fund independent counsel’s defense costs for ten months.  In finding the delay in payment constitutes a breach of the duty to defend, the Court held not only must an insurer allow an insured to select independent counsel and agree to fund independent defense counsel’s reasonable and necessary fees and costs, but the insurer must timely pay independent counsel’s fees and costs “as incurred” so duty to defend is not illusory.  As a result of the delay in payment, the court found the insurer had breached its duty to defend and applied the estoppel doctrine, extinguishing the insurer’s coverage defenses as well as its arguments regarding the reasonableness of the fees and costs incurred by independent counsel.  Kammerling, 212 Ill.App.3d at 749.

 2. Utica Mutual Insurance Co. v. David Agency Insurance, Inc.

In Utica Mutual Insurance Co. v. David Agency Insurance, Inc., 327 F.Supp.2d 922 (N.D.Ill. 2004), the Court determined the insurer breached its duty to defend by not effectively reserving its rights or advising the insured regarding a potential conflict of interest and its resulting right to independent counsel, thus destroying the insurer’s coverage arguments against indemnity.  In reaching this conclusion, the Court held: (1) Utica had a duty to defend; (2) Utica’s reservation of rights created a conflict of interest, requiring independent counsel; (3) Utica’s reservation of rights was defective because it failed to disclose the conflict and misinformed the insured that the insured would have to pay the cost for retaining independent counsel; (4) the ineffective reservation of rights was a breach of the duty to defend; (5) the insured was prejudiced by Utica’s failure to disclose the conflict; and (6) due to the breach, the insurer was estopped from raising coverage defenses to the damages awarded against the insured in the underlying case.

In addition to the above, the Court cited these following principles: 

• If a conflict of interest exists and the insurer nonetheless chooses to defend the insured, the insurer must do so under a proper reservation of rights or risk being estopped from raising all coverage defenses;
• A proper reservation of rights is one that allows the insured to choose intelligently between accepting the insurer’s defense counsel and retaining its own counsel (at the expense of the insurer);
• If the insurer proceeds to defend the insured in the face of a conflict of interest, it must reserve its rights in a manner that will fairly inform the insured of the insurer’s position;
• In informing the insured of the conflict, the insurer must act openly and with the utmost loyalty to its insured, both in initially explaining the insurer’s position in the matter and in the actual defense of the tort litigation; and
• Bare notice of a reservation of rights (i.e., a “general reservation”) is insufficient unless it makes specific reference to the policy defense that may ultimately be asserted and to the potential conflict of interest.

In finding Utica was estopped from denying indemnity coverage for the compensatory and punitive damages, the Court noted the estoppel doctrine in Illinois was extremely broad once the insurer breaches its duty to defend.  Id., 327 F.Supp.2d at 930, citing Mobil Oil Corp. v. Maryland Casualty Corp., 288 Ill.App.3d 743, 681 N.E.2d 552, 224 Ill.Dec. 237 (1st Dist. 1997) (insurer was estopped from denying coverage for otherwise uncovered damages and attorneys fees after it failed to make specific reference to potential conflict of interest in its initial reservation of rights letter to the insured); Royal Insurance Co. v. Process Design Associates, Inc., 331.Ill.App.3d 966, 582 N.E.2d 1234, 1239, 164 Ill.Dec.290 (1st Dist. 1991) (insurer estopped from raising coverage defenses to punitive damages because it did not properly reserve rights).

C. Estoppel Doctrine Expanded

In 2010, the Illinois Appellate Court clarified additional issues relating to the estoppel doctrine.  Uhlich Children’s Advantage Network and Darlene Sowell v. National Union Fire Company of Pittsburgh, PA and AIG Domestic Claims, Inc., 398 Ill.App.3d 710, 929 N.E.2d 531, 340 Ill. Dec. 880 (1st Dist. 2010). 

In the underlying case against the insured, a former employee of Uhlich Children’s Advantage Network (“UCAN”) (Andrew Leonard), filed a discrimination charge against UCAN with the EEOC in January 2005 alleging violations of the Americans with Disabilities Act.  After Leonard filed an amended charge against UCAN in July 2005 alleging retaliation, he requested and received a right-to-sue letter in August 2005.  Thereafter, on September 29, 2005, Leonard filed a civil complaint in the United States District Court for the Northern District of Illinois against UCAN and its Vice President of Human Resources, Darlene Sowell alleging disability discrimination and retaliatory discharge.  The Leonard complaint was filed and served upon UCAN and Sowell on October 10, 2005.   The case settled in 2007.

The insurer (“AIG”) received a copy of the Leonard complaint on November 3, 2005. AIG had issued two consecutive management liability insurance policies to UCAN for policy periods July 1, 2004 through July 1, 2005 (the “first policy”) and July 1, 2005 through July 1, 2006 (the “second policy”).  The two policies were claims-made-and-reported policies, with no retroactive date or provision for limited reporting in consecutive AIG policies.  Further, the policies lacked traditional “interrelated” or “relatedness” language.  In addition, the policies did not include a standard “duty to defend” provision.  As the court explained, the policies contained the following hybrid language:

The Insurer does not assume any duty to defend. The insureds shall defend and contest any Claim made against them." It further provides that "[n]otwithstanding the foregoing, the Insureds shall have the right to tender the defense of any Claim to the Insurer, which right shall be exercised in writing by the Named Organization on behalf of all Insureds to the Insurer pursuant to Clause 7 of this policy. This right shall terminate if not exercised within 30 days of the date the Claim is first made against an Insured, pursuant to Clause 7 of the policy.

As the Leonard claim was made during the first policy period, but not reported until the second policy period, AIG denied coverage on March 2, 2006, stating that proper notice was a condition precedent under the policies.  AIG issued one declination of coverage letter which did not substantively distinguish between coverage for UCAN and Sowell.

On February 4, 2008, UCAN filed a complaint for declaratory judgment against AIG seeking a declaration that AIG had a duty to defend the Leonard complaint, and seeking attorneys’ fees and settlement amounts incurred in the underlying litigation.  The trial court granted summary judgment for AIG, relying upon Graman v. Continental Casualty Company, 87 Ill.App.3d 896, 899, 409 N.E.2d 387, 42 Ill. Dec. 772 (1980), which held that compliance with the notice provision in a claims-made-and-reported policy is a condition precedent to coverage.  The trial court did not evaluate the potential estoppel issue.

On appeal, the Illinois Appellate Court reversed the trial court, noting the lack of “relatedness” language in the AIG policies.  The appellate court concluded AIG improperly denied coverage for Sowell because the Leonard lawsuit was made and reported during the second policy period.  Further, the appellate court expressly rejected the trial court’s reliance on Graman, noting there is no exception to the estoppel doctrine for a late-notice defense.  Therefore, even though notice to AIG was technically late under the terms of the first policy with respect to UCAN, AIG’s breach of the duty to defend triggered the broad application of the estoppel doctrine to bar AIG from raising valid defenses to coverage for both Sowell and UCAN.

The holding in UCAN not only underscores aspects of the estoppel doctrine in Illinois, but raises new, disturbing arguments.  The UCAN court ruling contains the following “rules” which had been addressed by prior courts:

•  The estoppel doctrine applies equally to both occurrence-based and claims-made policies;
• The estoppel doctrine is applied broadly to extinguish all coverage defenses once the duty to defend is breached by an insurer;
• An insurer’s failure to properly address coverage for one insured breaches the duty to defend, triggering estoppel for coverage defenses against other insureds; and
• Poor policy drafting and/or a lack of knowledge/understanding of the subject policy can have drastic consequences under the Illinois estoppel doctrine.

However, in addition UCAN raises several area that may cause additional concern to insurers, including that, when raising a late notice defense in Illinois (particularly in the First District), an insurer may need to file a declaratory judgment action to protect its coverage defenses¹ ; and estoppel can be triggered under hybrid “duty to defend” language, resulting in exposure to insurers writing D&O and other lines which do not include traditional “duty to defend” language.

III. All Is Not Lost – Exceptions to the Estoppel Doctrine

Notwithstanding the above, certain exceptions to the estoppel doctrine remain.  First, when an insurer does not have a duty to defend, estoppel does not operate to “create coverage where coverage otherwise never existed.”  Nationwide Mut. Ins. Co. v. Filos, 285 Ill.App.3d 528, 534 (1st Dist. 1996).  In this regard, there is no estoppel where the insurer stands on a clear denial: “where the insurer was given no opportunity to defend; where there was no insurance policy in existence; and where, when the policy and the complaint are compared, there clearly was no coverage or potential for coverage.”  Zurich Specialties London Ltd. v. Vill. of Bellwood, Ill., 07 CV 2171, 2011 WL 248444 at *10 (N.D. Ill. 2011) citing Mutlu v. State Farm Fire and Casualty Co., 337 Ill.App.3d 420 (1st Dist. 2003).

Further, Illinois courts continue to carve out limited additional exceptions to the estoppel doctrine where policyholders and their lawyers have attempted to exploit the estoppel doctrine.  In this connection, several courts interpreting Illinois law have concluded the estoppel doctrine does not block an insurer from contending it had so little time to respond to a tender that, even acting diligently, it could not have supplied a defense or commenced a suit for a declaratory judgment before the underlying litigation reached judgment (or settlement).  Am. Safety Cas. Ins. Co. v. City of Waukegan, Ill., 678 F.3d 475, 486 (7th Cir. 2012) citing State Automobile Mut. Ins. Co. v. Kingsport Development, LLC, 364 Ill.App.3d 946, 960 (2006) (entitling insurer to a “reasonable time” in which to decide and act);  see also Northern Insurance Co. of New York v. Chicago, 325 Ill.App.3d 1086, 1095 (2001) (there is no duty to defend, and no estoppel, if the client does not give the insurer “an opportunity to participate” in the underlying suit).  Also, an insurer does not breach the duty to defend when it fails to pay all of independent counsel’s fees and costs immediately.  Santa's Best Craft, LLC v. Zurich Am. Ins. Co., 408 Ill.App.3d 173, 941 N.E.2d 291 (4th Dist. 2010) appeal denied, 949 N.E.2d 665 (Ill. 2011) (insurer maintains contractual right under the policy to pay “reasonable and necessary” defense costs).

In light of the above, each coverage determination must be decided on its own unique facts and circumstances, using the above case law as a guideline to the outer bounds of what has been found to result in not only a breach of contractual obligations but to carry the heavy burden of estopping an insurer from asserting otherwise valid coverage defenses.