200 F.3d 1102 (7th Cir. 2000)
CITIZENS FIRST NATIONAL BANK OF PRINCETON,  a nationally chartered bank,    Plaintiff-Appellee,v.CINCINNATI INSURANCE COMPANY, an Ohio corporation, Defendant-Appellant.
Nos. 98-3534, 98-3535 & 98-3957
In the  United States Court of Appeals  For the Seventh Circuit
Argued November 9, 1999Decided January 14, 2000

Appeal from the United States District Court  for the Northern District of Illinois, Eastern Division. No. 96 C 3731--Harry D. Leinenweber, Judge. [Copyrighted Material Omitted]
Before COFFEY, MANION, and EVANS, Circuit Judges.
EVANS, Circuit Judge.


1
When the Cincinnati  Insurance Company sold a directors and officers  liability policy to Citizens Bank covering  breaches of fiduciary duty in the rural bank's  tiny trust department, it probably seemed like a  safe bet that the bank would never make a claim  approaching the policy's $5 million limit. The  odds changed dramatically, however, when  Citizens' trust officer, without fully  understanding the risks involved, began investing  the vast majority of his customers' life savings  in extremely volatile derivative instruments.  Given this combination, before you could say  "collateralized mortgage obligation" Cincinnati  found itself facing a claim for $5 million. The  insurer tried to fend it off, but after a 4-day  bench trial in the district court, Judge Harry  Leinenweber awarded the bank not only $4.9  million under the policy, but also attorneys fees  as a sanction for Cincinnati's efforts to avoid  payment.


2
Cincinnati now appeals the decision, arguing  that the bank's conduct fell under exclusions  covering actions taken in bad faith and  activities related to the funding of trusts. It  also claims that the judge abused his discretion  in awarding attorneys fees because its conduct  was neither "vexatious" nor "unreasonable."  Citizens, in turn, cross-appeals, asking that we  amend its award to include an extra $100,000  under the policy. We begin our review with the  facts.


3
Citizens First National Bank is an agricultural  credit bank located in the town of Princeton,  Illinois (population 7,300). In addition to its  credit operations, the bank runs a trust  department for the farmers and other local  residents who make up its customer base. Like any  trustee, the bank owes the beneficiaries of the  trusts it manages a fiduciary's strict duties of  care and loyalty.


4
To protect itself against claims arising from a  breach of these duties, in late 1993 Citizens  purchased a year's worth of directors and  officers liability insurance from the Cincinnati  Insurance Company. Under the policy, Cincinnati  agreed to cover losses arising from errors and  omissions committed in the administration of the  bank's trust accounts. More specifically, in the  policy's Trust Department Errors and Omissions  Endorsement, the insurer pledged to indemnify  Citizens for any "Loss" that the bank incurred as  a result of a "Wrongful Act" committed by  Citizens as a fiduciary. "Wrongful Act" was  defined to include, inter alia, breach of duty,  neglect, and error. "Loss" described "any amount  which the Insured is legally obligated to pay .  . . for a claim or claims made against the  Insured." Cincinnati agreed to cover 100 percent  of such losses in excess of a $100,000 retention  up to $5 million.


5
While the losses which eventually maxed out the  policy took place during 1994, their roots  stretch back to the bank's hiring of Randall  Rimington nearly a decade before to head up its  trust operations. At the time, Rimington seemed  like a good choice--coming to Citizens from a top  managerial position in a competitor's trust  department, he had hoped that the new position  would allow him to serve Princeton's small,  close-knit community. In retrospect, the bank's  decision to put Rimington in charge of its  customers' trust accounts looks a lot like Mister  Burns' determination that Homer Simpson would  make a fine nuclear safety inspector.


6
Rimington's less-than-prudent nature emerged in  the early 1990's when he began heavily investing  in collateralized mortgage obligations (CMOs). A  CMO is a security backed by a pool of real estate  mortgages. Like a regular bond, it pays fixed  interest on the underlying principal and its  price fluctuates with interest rates--falling  when rates go up, rising when rates decline.  Unlike normal bonds, CMOs do not have a set life-  span. Instead, investors recover their principal  when the underlying mortgages get paid off. This  means that the life of a CMO turns on interest  rates: if rates rise, homeowners tend to hang  onto their mortgages and the life of the CMO  extends; if rates fall, people will likely prepay  their existing obligations to take advantage of  the lower rates and the life of the security will  decrease. Thus, rising rates leave the owner of  a CMO with an investment that is losing value and  won't pay off anytime soon.


7
Mixed in with the regular CMOs, Rimington added  a variety called "inverse floaters." These  securities share all the characteristics of a  basic CMO except that instead of paying a fixed  return to holders for the life of the bond, the  interest payments fluctuate inversely to changes  in an index. In this case, the inverse floaters'  yields were determined according to a formula  keyed to the London Interbank Offering Rate  (LIBOR)--a well-known index in the financial  markets measuring interest rates. The precise  formula governing the return of Citizens' inverse  floaters lies outside the scope of this opinion,  but it is worth noting its basic effect: even  small interest rate changes would drastically  affect the inverse floaters' returns; a sharp  rise would drop the yield to zero.


8
Surveying the financial landscape, Rimington  decided that CMOs, and particularly inverse  floaters, offered a near-perfect (in his words,  an "aggressively conservative") buying  opportunity. He reasoned that since the  securities provided high rates of return without  risking the underlying capital--the holder would  eventually recover the security's face value when  the mortgages got paid off--he could meet his  customers' income needs without taking any  serious gambles. He also thought that since each  variety of CMO was backed by a separate pool of  mortgages, and these pools varied--each  containing a group of mortgages of differing  lengths from different regions of the country--  the economic and structural factors affecting  each security would cancel out any risk inherent  in creating a monolithic portfolio.


9
To take advantage of this "aggressively  conservative" investment opportunity, Rimington  began to buy. He purchased derivatives for his  parents, other relatives and, most relevantly,  his trust customers.1 One of his customers, an  80-year-old nursing home resident in poor health,  had a portfolio made up of 83 percent CMOs;  others had 100 percent exposure. Taken as a  whole, by the end of Rimington's tenure (more to  come), CMO's accounted for nearly 50 percent of  Citizens' total trust assets, and almost one-  third of these were inverse floaters.


10
For a time, the derivatives brought home nice  returns, and neither Rimington nor anyone else at  Citizens found fault with his strategy. In early  1994, however, interest rates started to rise and  the trust accounts began to show huge paper  losses. As customers watched their life savings  vanish, several wrote letters to the bank stating  that the investments were inappropriate and  asking for their money back. These complaints,  coupled with the mounting losses, caused  Citizens' trust committee to finally focus in a  little more closely on Rimington's activities.  Horrified by what they found, in October of 1994  the bank alerted both the Office of the  Controller of the Currency (OCC) and Cincinnati  that the trust department was in deep trouble.    The OCC promptly investigated, and in late  February 1995 the agency issued a confidential  report to Citizens stating that the bank had  breached its fiduciary duty of care to its trust  customers by purchasing such high-risk  securities. The report concluded that Rimington's  lack of investment expertise and training had  caused him to become overly reliant on broker  recommendations in making investment decisions  and that he had purchased many of the securities  "without full knowledge of the risks involved."  The agency also decried the bank's oversight,  stating that Citizens' trust committee had  approved the purchase of the CMOs without  considering their inherent risks. But despite its  harsh criticism of the bank's multiple screw-ups,  the OCC did not find that anyone at Citizens had  engaged in any intentional wrongdoing or that the  investments created any conflicts of interest  between the bank or its personnel and its trust  customers.


11
In light of its findings, the OCC told Citizens  to liquidate the derivatives and reimburse its  customers for any associated losses. Rimington,  who still argued that the CMOs were "totally  appropriate," strongly disagreed with both the  report's conclusions and the OCC's directives. He  argued that if the bank simply held onto the  investments they would eventually pay off. In  light of this stance, Citizens decided that  Rimington's continued employment would only slow  the trust department's recovery, so he was let  go. The bank then followed the OCC's orders--  liquidating the inverse floaters for a loss of  more than $4.8 million and unloading the  remaining high-risk CMOs for additional losses of  over $565,000.


12
With Rimington out of the picture, the  derivatives out of the trust holders' portfolios,  and the bank out more than five million bucks,  the rest of our story concerns Citizens' attempt  to recoup its losses from Cincinnati under the  D&O policy. As we said, this effort began in  October 1994 when the bank first alerted  Cincinnati of the trust department's troubles.  This notification was not a formal claim;  Citizens simply forwarded to Cincinnati the  customers' letters of complaint and mentioned  that the problems which gave rise to the letters  existed in a number of other accounts. In a  prompt response, Cincinnati acknowledged  Citizens' missive as a "notice of potential  claims," stated that it would begin an  investigation, and noted that "a determination of  actual coverage applicable will have to await the  actual filing of a lawsuit against the bank,  directors and officers or plan administrators."


13
After meetings with Citizens in November and  December (in both of which, Rimington assured  Cincinnati that the investments were appropriate  and that the claims might well go away),  Cincinnati restated its determination that the  situation presented a notice of potential claims  and requested further information allowing it to  evaluate its coverage obligations if and when the  customers filed suit. However, the insurer also  expressed an interest in resolving any coverage  issues short of a customer suit if this would  enable Citizens to reach a favorable settlement  with its disgruntled customers. Finally,  Cincinnati once again clearly set forth that it  reserved all defenses under the policy if and  when the claims were to arise.


14
When Citizens responded that the letters  constituted claims under the policy, Cincinnati  again disagreed. This time, however, the insurer  decided that the parties should turn to case law  to settle the dispute. Thus, in an April 1995  letter, Cincinnati explained that in Harbor  Insurance Co. v. Continental Bank Corp., 922 F.2d  357 (7th Cir. 1991), "the Seventh Circuit  intimated that a claim is not made until an  insured is specifically named in a lawsuit." It  then invited Citizens to reply in kind, stating  that it would be happy to consider any cases upon  which the bank relied to contest the point.


15
Rather than respond to this invitation, in  August 1995 Citizens decided to skirt the problem  by sending Cincinnati a "formal demand for  indemnity" outlining its losses and the reasons  it believed they fell under the policy. To this,  Cincinnati replied that it did not possess enough  information about the liquidation to determine  whether it constituted the settlement of a claim.  Instead, it stated that based on its current  knowledge, the liquidation appeared to be a  business decision designed to deflect the  negative publicity that would accompany the  release of the OCC's report and would thus not  constitute a "Loss" derived from a claim. In  addition, Cincinnati asserted that despite its  limited understanding of the facts, it appeared  that if the demand were to constitute a claim, it  would fall under exclusion 4(c) which denied  coverage for claims that arose from actions taken  in bad faith. With that, the insurer once again  requested the information it deemed necessary to  process the claims.


16
Convinced that no amount of information could  get Cincinnati to pay the claim voluntarily,  Citizens failed to provide its insurer with any  new facts. This began a standoff in which  Citizens continually repeated its demands for  repayment while Cincinnati responded that it  could not assess the claims without a better  understanding of the context in which the losses  arose.


17
In June 1996 the logjam broke when a frustrated  Citizens filed suit. At trial, Cincinnati  acknowledged that the bank had breached its  fiduciary obligation to its trust customers. It  also abandoned its position that Citizens had  failed to make a claim. Instead, the insurer  continued to assert that the claims were barred  by exclusion 4(c) and added two new defenses: (1)  that exclusion 4(a) operated to deny the claims  because they arose out of "dishonest, fraudulent,  criminal, or malicious acts"; and (2) that  exclusion 4(j) precluded Citizens' recovery  because the claims arose from the "method of  funding" the trust accounts.


18
As we said, Judge Leinenweber rejected these  defenses. He decided that exclusions 4(a) and  4(c) did not apply because Rimington acted with  "a pure heart, but an empty head" and that  neither he nor the bank had engaged in any sort  of intentional wrongdoing. He then found that  since the meaning of "funding" was ambiguous,  Cincinnati could not rely on exclusion 4(j) to  deny coverage. He thus awarded Citizens $4.9  million under the policy. Then, stating that he  believed Cincinnati had "unreasonably and  vexatiously" denied the bank's claim, the judge  hit the insurer with Citizens' attorneys fees and  costs.


19
The first issue for review is whether Judge  Leinenweber's finding that Rimington possessed a  "pure heart, but empty head" constituted clear  error. Cincinnati claims that the record offered  no support for the judge's finding and ample  support for its opposite. In its most basic form,  its argument boils down to an assertion that,  given the level of understanding Rimington  displayed about the structure and behavior of the  derivatives during trial, he must have known he  was playing Russian roulette with his customers'  life savings. As this would show a deliberate  disregard for his customers, his fiduciary  responsibilities, and Citizens' internal rules,  Cincinnati believes that "Rimington could not  possibly have acted with a pure heart."


20
Judge Leinenweber's determination that  Rimington's heart was pure is a finding of fact  that we review only for clear error. We will not  reverse his determination unless it strikes us as  wrong with the force of a 5-week-old,  unrefrigerated, dead fish. See Parts and Elec.  Motors, Inc. v. Sterling Elec., Inc., 866 F.2d  228, 233 (7th Cir. 1988) (Bauer, J.). Cincinnati  cannot clear this titanic olfactory hurdle. While  it strains credulity to believe that Rimington  could have understood how the derivatives worked  (he did) and still think them an appropriate,  "conservatively aggressive" investment, it  appears that this was just the case. Not only  were his pure intentions underlined by his  willingness to pile his family's and colleagues'  fortunes into the securities, but it seems he  might have held onto his job had he admitted his  mistakes. Instead, he stuck by his risk analysis  and went down with the ship. In fact, Rimington  still hasn't lost his affinity for the CMOs. At  trial, after a passionate defense of the  derivatives, he stated, "I believed in those  securities and I still do." Judge Leinenweber  accepted this explanation, and as he had ample  evidence to do so, his finding was not clearly  erroneous.


21
Cincinnati next appeals the court's  interpretation of the term "bad faith" in  exclusion 4(c). In his opinion, Judge Leinenweber  looked to Black's Law Dictionary to find that bad  faith "implies some level of intentional  malfeasance." He then explained that if  Cincinnati had intended the term to cover  innocent breaches of fiduciary duty, it could  have drafted the policy to expressly address such  situations. Without such a clause, he found that  the insurer's efforts to rely on the exclusion  were simply an attempt to equate bad faith with  breach of fiduciary duty--an untenable position  for a policy expressly covering fiduciary  breaches.


22
Cincinnati argues that Judge Leinenweber's  analysis not only robs bad faith of its natural  meaning within the context of the contract, but  that it contradicts a number of trust cases  holding that a trustee who has recklessly  disregarded the limits on her powers cannot  defend a suit for breach of duty on good faith  grounds (i.e., she's liable because she acted in  bad faith). See, e.g., United States Nat'l Bank  & Trust Co. v. Sullivan, 69 F.2d 412, 415 (7th  Cir 1934). Based on this line of authority, the  insurer asserts that in the context of trusts,  bad faith should cover a reckless breach of duty.  And since it believes both Rimington and the  trust committee acted recklessly, Cincinnati  concludes that the exclusion must preclude the  bank's recovery.


23
Since interpreting an insurance contract is a  question of law, we review Judge Leinenweber's  decision de novo. See River v. Commercial Life  Ins. Co., 160 F.3d 1164, 1169 (7th Cir. 1998). To  begin this inquiry, we note that both sides agree  that bad faith has no set meaning within the  context of D&O insurance policies covering  fiduciary breaches in Illinois. However, Illinois  law is settled on one relevant point:  exclusionary clauses may only deny coverage where  their application is clear and free from doubt.  See, e.g., Continental Cas. Co. v. McDowell & Colantoni, Ltd., 282 Ill. App. 3d 236, 241, 668  N.E.2d 59, 62 (1996). If two reasonable interpretations of a policy term exist, the  ambiguity must be settled in favor of coverage.  See e.g., River, 160 F.3d at 1169. Thus, we  examine Cincinnati's arguments to determine if  its interpretation is so obvious that Citizens  would have been unreasonable to believe that  pure-hearted, empty-headed conduct would fall  under the policy.


24
Cincinnati asserts that since exclusion 4(a)  covers "dishonest, fraudulent, criminal, or  malicious acts"--all of which require some degree  of intentional wrongdoing-- reading bad faith to  impose the same requirement would render 4(a)  unnecessary. As Illinois law requires that each  clause of an insurance policy must be presumed to  have been inserted for a purpose, see Home and  Auto Ins. Co. v. Scharli, 10 Ill. App. 3d 133,  136, 293 N.E.2d 914, 916 (1973), Cincinnati  concludes that we must define bad faith so as to  give both exclusions 4(a) and 4(c) distinct  meanings.


25
This argument would be persuasive if the term  had two equally reasonable (and readily apparent)  definitions in the context of the parties'  contract. But Cincinnati's assertion that bad  faith covers reckless breaches of fiduciary duty  does not offer such an alternative. The trust  cases it cites in support of this definition  simply hold that a fiduciary who has acted  recklessly cannot avoid liability because she has  performed inappropriate acts in good faith. In  these cases, the good faith defense protects  trustees who have carried out their  responsibilities in accordance with their  fiduciary duty but have made mistakes. In other  words, if they acted in good faith they did not  breach a fiduciary duty. Thus, even if we accept  Cincinnati's assertion that bad faith is simply  the mirror image of good faith, the cases it  cites would define bad faith to describe a simple  breach of fiduciary duty. Because the contract  primarily covers such breaches, Cincinnati does  not push this position. Instead, it argues that  bad faith refers only to reckless breaches. But  since the insurer points to nothing that supports  a definition that distinguishes between ordinary  fiduciary breaches and reckless ones, its  argument fails.


26
In so holding, we do not attempt to define bad  faith for Illinois insurers--that is a job best  left to the state's courts. Rather, we conclude  only that Citizens' (and Judge Leinenweber's)  proposed definition of the term to include some  sort of intentional wrongdoing was reasonable  under the circumstances. Exclusion 4(c) was  insufficiently clear to preclude recovery under  Illinois law.


27
Cincinnati's next claim--that exclusion 4(j)  should have operated to deny coverage--falls  victim to the same analysis. Cincinnati argues  that "method of funding" includes anything  related to investing a trust account's money.  Citizens counters that the term typically refers  only to the initial method of placing money into  the trust. Both sides agree that no Illinois  court has interpreted the exclusion.


28
Once again, we need not define the term to  decide the case. We must only determine if  Citizens attached a bizarre meaning to the phrase  or if Cincinnati's proposed alternative was  pellucid. Because we agree with Judge  Leinenweber--both parties offered reasonable  interpretations--Cincinnati cannot look to the  exclusion to deny coverage under Illinois law.  And the law makes sense: If Cincinnati wants to  rely on exclusions to deny coverage--especially  where it seeks to reject a claim arising from an  inherent risk in the insured's core activity--it  should either write its exclusions with terms  whose meanings are not subject to debate, or  define the terms within the policy.2


29
Next, we take up Judge Leinenweber's award of  attorneys fees and costs under sec. 155 of the  Illinois Insurance Code, a decision we review for  abuse of discretion. Smith v. Equitable Life  Assurance Soc'y, 67 F.3d 611, 618 (7th Cir.  1995). The judge found that Cincinnati  "unaccountably mishandled the bank's claim." He  explained that while exclusion 4(j) provided a  legitimate defense at trial, Cincinnati could not  explain why it waited until suit was filed to  press it. Instead, he noted that Cincinnati only  turned to exclusion 4(j) because it's primary  defense--that Citizens could not recover because  no claim had been made against the bank under the  policy--was "found to be of no value whatsoever."  Also, he noted that Cincinnati never tried to  cast doubt on the amount of Citizens' losses.


30
Section 155 provides that an award of attorneys  fees and costs is appropriate if insurers'  actions are "vexatious and unreasonable." 215  Ill. Comp. Stat. 5/155 (West 1999). Because this  statute is "penal in nature" its provisions must  be strictly construed. Morris v. Auto-Owners Ins.  Co., 239 Ill. App. 3d 500, 509, 606 N.E.2d 1299,  1305 (1993). Attorneys fees may not be awarded  simply because an insurer takes an unsuccessful  position in litigation, but only where the  evidence shows that the insurer's behavior was  willful and without reasonable cause. Id. This  means that an insurer's conduct is not vexatious  and unreasonable if: (1) there is a bona fide  dispute concerning the scope and application of  insurance coverage, Green v. International Ins.  Co., 238 Ill. App. 3d 929, 935, 605 N.E.2d 1125,  1129 (1992); (2) the insurer asserts a legitimate  policy defense, Cummings Foods, Inc. v. Great  Central Ins. Co., 108 Ill. App. 3d 250, 259, 439  N.E.2d 37, 44 (1982); (3) the claim presents a  genuine legal or factual issue regarding  coverage, Lazzara v. Esser, 622 F. Supp. 382, 386  (N.D. Ill. 1985); or (4) the insurer takes a  reasonable legal position on an unsettled issue  of law. Martz v. Union Labor Life Ins. Co., 573  F. Supp. 580, 586 (N.D. Ill. 1983), rev'd on  other grounds, 757 F.2d 135 (1985).


31
Under these standards, the sec. 155 ruling  constituted an abuse of discretion. The judge did  not find that Cincinnati failed to present  reasonable defenses at trial, but rather that the  insurer could not wait until trial to raise a  valid defense. But this was not the case. While  the judge correctly concluded that Cincinnati  could likely have asserted its position with  respect to exclusion 4(j) earlier, the point is  only relevant if the insurer's reasons for  denying coverage up to that point were baseless.  They were not.


32
From August 1995 until trial, Cincinnati  asserted that without a better understanding of  the facts it could not determine whether the  bank's claims fell under the policy. Citizens  asserts that it cannot be blamed for Cincinnati's  lack of knowledge because it could not disclose  the contents of the OCC report. But while the  contents of the report were restricted, this does  not excuse the bank's less than stellar efforts  to provide Cincinnati with the information it  requested. Cincinnati had a right to try to  figure out what happened in the trust department.  Waste Management Inc. v. International Surplus  Lines Ins. Co., 144 Ill. 2d 178, 204, 579 N.E.2d  322, 333 (1991). And it was right to inquire--  Judge Leinenweber stated that Rimington's  behavior "seemed suspicious" and that the losses  could be traced to the trust department's  "ineffective . . . oversight, lax supervision,  weak risk management practices, inadequate  internal audit function, lack of expertise, and  poor portfolio practices." While the judge  correctly determined that the losses stemming  from these activities fell under the policy, this  required him to decide a number of hotly  contested legal and factual issues. To expect  Cincinnati to make its coverage decision without  access to the facts which gave rise to such close  questions would be, we think, a bit too much to  ask.


33
Prior to August 1995 Cincinnati argued that the  customer's letters did not constitute claims. Its  argument in support of this position would not  have set the legal community on fire, but it was  presented with reasoned support. Furthermore, the  insurer did not vexatiously assert the defense to  deny Citizens' claims. On the contrary,  Cincinnati more than once statedthat it would be  interested in exploring any settlement  opportunities in spite of its position, and it  extended an invitation to the bank to provide it  with support for Citizens' alternate  interpretation of the term. Cincinnati cannot be  faulted because Citizens declined to follow up on  these offers.


34
It seems to us that the judge's assessment of  Cincinnati's assertion that the letters did not  present claims was driven largely by Cincinnati's  failure to continue to press the defense at  trial. But by that point Citizens had responded  to Cincinnati's argument from Harbor, and the  insurer realized that it had superior defenses in  its arsenal. Cincinnati was entitled to change  strategy.


35
Cincinnati's failure to contest the amount of  Citizens' losses also cannot support the sec. 155  award. As stated, the insurer asserted  meritorious defenses at trial once it possessed  a full understanding of the facts. In light of  these defenses, its decision not to contest  Citizens' losses is irrelevant.


36
This brings us to Citizens' cross-appeal. The  bank claims that Judge Leinenweber erred in  subtracting the $100,000 retention from its award  since it presented over $5.4 million in losses.  Cincinnati concedes that this was error but,  without citation, argues that since Citizens  failed to file a corrective motion to the trial  court, it should lose its ability to contest the  award. We know of no such rule.


37
Judge Leinenweber correctly found Cincinnati  liable under the policy, but the award should  have been for $5 million, not $4.9 million.  However, Citizens' award of attorneys fees and  costs under sec. 155 of the Illinois Insurance  Code is vacated. So, more than 90 percent of this  judgment is affirmed, and the case is remanded  for the entry of an amended judgment consistent  with this opinion. Each side shall bear its own  costs.


38
SO ORDERED.



Notes:


1
 Rimington even recommended the investment to  several colleagues who, unfortunately for them,  took him up on the advice.


2
 Because Citizens offered a reasonable definition  of the funding exclusion, Cincinnati's  (meritless) claim that Judge Leinenweber  inappropriately considered extrinsic evidence in  determining the meaning Cincinnati attached to  the phrase is moot.


