State Appellate Courts Are Split Re. Recouping Defense Costs

Does An Insurer Have An Entitlement to Recoup Defense Costs When No Duty to Indemnify Exists?

In a case of first impression for the New York Supreme Court, Appellate Division, Second Department, the court chose not to follow prior decisions of its sister court and federal courts applying New York law. The Second Department held that an insurer could not recover defense costs under its reservation of rights where no indemnity obligations exist, resulting in a split with the First Department.

In American Western Home Insurance Co. v. Gjonaj Realty & Management Co., 192 A.D.3d 28, 30, 138 N.Y.S.3d 626, 628 (2020), the Second Department had to decide whether an insurance company could recover the costs of defending its insureds “where there has been a reservation of rights by the insurance company and a determination by the court that the insurance company has no obligation to defend and provide insurance coverage to the insureds in an underlying personal injury action commenced against them.” The Second Department held that an insurer may not recoup defense costs under a reservation of rights unless the insurance policy expressly allows it to do so.

This holding is different from that of other New York cases. In 2018, the New York Supreme Court, Appellate Division, First Department, held that an insurance company was entitled to recoup incurred expenses that were not covered by the policy because it had reserved the right to do so.[1] Similarly, in 2013, the First Department affirmed an order awarding the insurance company defense costs against the defendants because the insurance company had reserved its right to recoup expenses in the event of a finding of no coverage.[2] Several federal courts applying New York law have followed these First Department decisions.[3]

The events culminating in the Second Department’s decision in American Western spanned nearly ten years. They began when American Western Home Insurance Company issued a policy to Gjonaj Realty & Management Co. and 28—47 Webb Associates, LLC that provided general liability coverage where, upon timely notice of an underlying claim, the insureds were entitled to defense and indemnity by the company for suits alleging personal injury.[4] In 2011, the insureds were sued after a person fell from a ladder at the premises owned by 47 Webb and managed by Gjonaj Realty.[5] The insureds did not notify American Western of the accident or the lawsuit until four years later, in 2014, by which time an inquest on damages had already occurred and a $900,000 judgment had been entered against the insureds.[6] American Western advised the insureds that it would not defend or indemnify them and denied coverage based on their failure to comply with the notice provision of the policy.[7] American Western did state, however, that it would reconsider its disclaimer if the default judgment against the insureds was set aside.[8]

In 2015, the default judgment was vacated, and American Western notified the insureds that it would defend and indemnify them in the underlying action.[9] It also reserved its rights under the policy to deny coverage because it was unaware if it had been prejudiced in its investigation or its ability to defend due to the insureds’ late notice.[10] A few months later, after the defendant in the action appealed the vacatur of the default judgment, American Western notified the insureds that it was further reserving its rights to refuse to defend or indemnify.[11]

After the vacatur of the default judgment was reversed, American Western notified the insureds that it was denying coverage and reserving its right to recover any fees and costs incurred in defending the insureds.[12] American Western then commenced an action for declaratory relief and moved for summary judgment declaring that it: (1) had no obligation to defend the insureds, (2) had no obligation to indemnify the insureds for any judgment against the them in the underlying action, and (3) was entitled to recover defense fees and costs incurred on behalf of the insureds in the underlying action after the judgment was reinstated.[13]

The trial court granted American Western’s motion. The Second Department held that while the insurer had no duty to defend or indemnify, it was unable to recoup the defense fees and costs it had already expended.[14] The court’s decision was guided by two predominant factors.

First, none of the other New York decisions relied on by the insurer considered whether reimbursement of defense costs was appropriate or authorized.[15] Second, the court observed that there had been a shift in precedent, citing two recent decisions from the United States District Court for the Eastern District of New York holding that it is inappropriate to allow an insurance company to recoup expenses where the policy language does not explicitly allow for recoupment of defense costs.[16]

Persuaded by these decisions from the Eastern District of New York, the Second Department reasoned that an insurance company cannot recoup expenses absent express language in the policy. In reaching this result, the court relied on the basic principle that a contract’s provisions must be adhered to as written.

The American Western policy language stated, in relevant part:

NEW YORK CHANGES —

COMMERCIAL GENERAL LIABILITY COVERAGE FORM

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1. Insuring Agreement
2. We will pay those sums that the insured becomes legally obligated to pay as damages because of “bodily injury” or “property damage” to which this insurance applies. We will have the right and duty to defend the insured against any “suit” seeking those damages even if the allegations of the “suit” are groundless, false or fraudulent. However, we will have no duty to defend the insured against any “suit” seeking damages for “bodily injury” or “property damage” to which this insurance does not apply.

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(2) Our right and duty to defend end when we have used up the applicable limit of insurance in the payment of judgments or settlements….No other obligation or liability to pay sums or perform acts or services is covered unless explicitly provided for under Supplementary Payments….

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SUPPLEMENTARY PAYMENTS — COVERAGES A AND B
1. We will pay, with respect to any claim we investigate or settle, or any “suit” against an insured we defend:
2. All expenses we incur.

* * *

1. All reasonable expenses incurred by the insured at our request to assist us in the investigation or defense of the claim or “suit”, including actual loss of earnings up to $250 a day because of time off from work.
2. All costs taxed against the insured in the “suit.”[17]

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