The Illinois Court of Appeals recently issued an opinion providing guidance for policyholders seeking insurance coverage under commercial liability policies for settlements to resolve class actions asserted against them.  In Central Mut. Ins. Co. v. Tracy’s Treasures, Inc., the insured, Tracy’s Treasures, used fax advertisements as one of the company’s marketing tools to sell dating and social relationship services.  Although the vendor that was hired to send the faxes assured Tracy’s that all recipients consented to receiving faxes, Tracy’s was named as a defendant in a class action alleging that it had violated the Telephone Consumer Protection Act (“TCPA”) for sending unsolicited fax advertisements.

Tracy’s tendered its claim to its primary and excess insurer, Central Mutual Insurance Co., which denied coverage, but nevertheless provided a “courtesy defense.”  Tracy’s, contending that Central Mutual’s coverage denial created a conflict of interest, hired its own defense counsel.  Central Mutual acquiesced, agreeing to pay for Tracy’s chosen counsel.  Within months, Tracy’s settled the TCPA class action, without obtaining Central Mutual’s consent, for $14 million, the face value of all of Central’s policies in effect during the relevant time period.  Central Mutual then sued for declaratory relief and the dispute eventually ended up before the Illinois Appellate Court for the First District.

One argument that Central Mutual advanced was that the underlying settlement was collusive and unreasonable.  The appellate court held that Tracy’s was free to enter into a settlement without Central Mutual’s consent, given that the insurer surrendered control of Tracy’s defense.  This did not mean, however, that Central Mutual was precluded from contesting the reasonableness of the settlement.

According to the appellate court, determining whether the settlement was reasonable involves two tests.  First, a court must consider whether, given the totality of the circumstances, the insured’s decision to settle “conformed to the standard of a prudent uninsured.”  In other words, would a prudent company that was not insured have entered into the settlement under similar circumstances?

In answering this question, courts may look to what efforts, if any, the policyholder undertook in the underlying litigation to eliminate or minimize its liability, such as: seeking dismissal of some or all of the claims asserted against it; opposing class certification; or filing claims for contribution or indemnification against third parties that may have played some role in the alleged wrongful conduct.  The purpose of this inquiry, according to the Illinois appellate court, was to consider whether the company’s decision to undertake those efforts, or forego them, was reasonable.

Additional factors to consider were the amount of damages the company realistically faced, and whether a prudent company that was not insured would have agreed to the settlement terms.  The underlying settlement Tracy’s agreed to, for example, provided a potentially significant portion of its settlement payment to be donated to charity if it went unclaimed by settlement class members, which the appellate court viewed with skepticism as “extraordinarily generous and extremely helpful to class counsel’s quest for attorney fees.”

The second test courts must apply in considering the reasonableness of an underlying settlement involves the amount of the settlement, specifically, “what a reasonably prudent person in the position of the insured would have settled for on the merits of plaintiff’s claim.”  The appellate court noted that many of the factors relevant to the first test were also relevant to the second.  The analysis also required an inquiry into whether the settlement was the product of arm’s length negotiations, or whether there was evidence of bad faith, collusion or fraud.

The appellate court remanded the case back to the trial court for further consideration of the issue and to make the necessary factual determinations.  In doing so, however, it expressed skepticism regarding the reasonableness of the settlement.

While the appellate court’s opinion in Tracy’s Treasures is limited to the facts in that case, it does provide general guidance to policyholders, especially those seeking coverage for class actions.  Any significant settlement reached with the underlying claimants without full participation of the insurer is likely to be challenged by the insurer–and closely scrutinized by the court.  Moreover, it is the policyholder’s burden to prove that the underlying settlement was reasonable.  Any facts suggesting that the settlement amount was inflated or otherwise structured to take advantage of available coverage may be especially problematic to the insured’s recovery.