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January 20, 2021

NYS Appellate Division Holds Insurer Not Entitled to Recoupment of Defense Costs for Uncovered Claims

The NYS Appellate Division, Second Department recently issued a significant ruling as to whether an insurer is entitled to reimbursement of defense attorney fees paid by the insurer to defend its insureds in an underlying personal injury action, when those fees were paid under a reservation of rights. In American Western Home Insurance Co. v. Gjonaj Realty & Management Co., the Second Department addressed this “novel issue of law” against the insurer, finding that the insurer was not entitled to recoup defense costs, even where it was determined that the claim was not covered under the insurance policy.

In American Western, the insureds were named as defendants in an underlying personal injury action. Four years after the accident, and after a default judgment had been rendered against the insureds, the insurer was first notified of the claim. The insurer denied coverage based on the insureds’ failure to comply with the policy conditions requiring timely notice of the underlying accident and lawsuit. The insurer, however, advised the insureds that, should the default judgment be vacated, the insurer would reevaluate the request for coverage. The insureds’ motion to vacate the default judgment was subsequently granted by the trial court, at which time the insurer agreed to provide a defense to the insureds. The insurer advised the insureds that it reserved the right to deny coverage should the default judgment later be reinstated by an appellate court.

The appellate court in the underlying action did, in fact, reinstate the default judgment against the insureds, at which time the insurer immediately advised the insureds that it was denying coverage for the claim and reserving its right to seek reimbursement of any counsel fees paid on the insureds’ behalf in the underlying action. The insurer also commenced a declaratory judgment action seeking a declaration that it was not obligated to defend or indemnify the insureds and seeking reimbursement of all legal fees incurred after the insurer denied coverage. The trial court agreed with the insurer.

On appeal, the NYS Appellate Division, Second Department reversed the trial court and concluded that the insurer was not entitled to reimbursement of counsel fees incurred to defend the insureds after the default judgment was reinstated. In doing so, the court first agreed that the insurer’s denial of coverage based on late notice was correct. The court, however, disagreed that the insurer was entitled to recoup the legal fees it incurred to defend the insureds. After restating the well-settled law that an “insurer’s duty to defend is broader than the duty to indemnify,” the court held that the policy did not include any provision permitting the insurer to seek reimbursement of counsel fees. The court also declined to find that insurer’s “unilateral” reservation of rights could create an implied right to reimbursement of legal fees. Finally, the court rejected the insurer’s equitable unjust enrichment claim, finding that such an equitable claim is not permitted when an express contract (i.e., the policy) governs the dispute and where, as here, the insurer had a legal obligation to defend the insureds after the default judgment was vacated by the trial court.

It is significant to note that the coverage defense at issue in the case—the insured’s failure to provide timely notice of an underlying accident and lawsuit to the insurer—was central to the court’s decision and may serve as a basis for distinguishing the court’s holding in this matter moving forward when insurers attempt to rely upon other coverage defenses. Here, when the default judgment was vacated by the trial court, the prejudice to the insurer had arguably been alleviated (albeit temporarily), triggering a duty to defend the insureds under the policy; when the default judgment was reinstated on appeal, the insurer’s rights were prejudiced, permitting the insurer to disclaim coverage and forcing the insurer to commence a declaratory judgment action to be relieved from providing the insureds with a defense in the underlying action.

Consequently, moving forward, it still remains to be seen whether an insurer may be entitled to seek recoupment of defense costs when the insurer disclaims coverage from the outset of the claim based on an express policy provision, such as a policy exclusion, but nevertheless agrees to provide the insured with a courtesy defense while awaiting a final ruling on its coverage obligations in a declaratory judgment action. If the insurer provides the insured with a defense as a courtesy, as opposed to any legal obligation owed under the policy, then the insurer may have a stronger argument for seeking recoupment, particularly on an unjust enrichment theory. Last, it should be stressed that a key question is whether the insurance policy at issue includes a provision permitting the insurer to seek reimbursement of counsel fees.

If you have any questions regarding this alert, please contact Mark Whitford, partner, at mwhitford@barclaydamon.com, or another member of the Insurance Coverage & Regulation Practice Area.

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