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Hidden Costs of Declaratory Judgment Action
By: Richard C. Aitken, Esq., and Michael A. Callinan, Esq.

FOR THE DEFENSE

Hidden Costs of Declaratory Judgment Action

By: Richard C. Aitken, Esq., and
Michael A. Callinan, Esq.


In U.S. Underwriters Insurance Company v. City Club Hotel, LLC., et al., 2004 N.Y. LEXIS 3798 (N.Y. December 16, 2004), the Court of Appeals, in answering a certified question posed by the Second Circuit (369 F3d 102, 113 (2nd Cir. 2004)), issued an opinion that has a far reaching impact on insurance companies and their behavior towards their insureds.

The underlying dispute stems from an injury that occurred on a construction site for which U.S. Underwriters issued a policy of insurance to the property holder (Shelby Realty, LLC) and the firm hired to do renovation work (City Club Hotel, LLC). During the course of the renovations, an employee of City Club was injured at the work site, sustaining serious injuries. In July 2000, the injured party’s attorney notified Shelby that it might be sued as a result of this injury. This notification was then forwarded to U.S. Underwriters, who acknowledged receipt of the notice and identified City Club and Shelby as “Our Insured.” Thereafter, in November of 2000, the injured party and his wife brought suit to recover for their injuries in Supreme Court, asserting various labor and industrial law claims. A copy of the verified complaint was forwarded to U.S. Underwriters on December 13, 2000, and by letter dated December 20, 2000, U.S. Underwriters disclaimed coverage based on the “Employee Exclusion” clause of the policy. Even though U.S. Underwriters disclaimed coverage five months after it initially received notification of the claim, it still provided Shelby a defense in the underlying personal injury action.

Thereafter, in a diversity action for declarative relief that it was not obligated to defend its insureds in the underlying personal injury action, the Southern District held, as a matter of law, that U.S. Underwriters was obligated to defend its insureds since the disclaimer of coverage was untimely. The Southern District also denied “defendants’ motion to recover attorneys’ fees incurred in successfully defending the declaratory judgment action, ruling that attorneys’ fees were not warranted because U.S. Underwriters did not breach the duty to defend.” Id. at 3.

An appeal to the Second Circuit ensued: U.S. Underwriters challenging the District Court’s holding that its disclaimer of coverage was untimely; the defendants challenging the Southern District’s denial of attorneys’ fees. The Second Circuit affirmed the Southern District’s determination that the disclaimer of coverage was untimely and held that U.S. Underwriters was obligated to defend and indemnify Shelby in the underlying personal injury action. As to the question of attorney’s fees, the Second Circuit certified the following two questions to the Court of Appeals:

1. Whether, in a case in which an insurance company has brought a declaratory judgment action to determine that it does not have obligations under the policy but has defended in the underlying suit, a defendant prevailing in the declaratory judgment action should be awarded attorneys’ fees expended in defending against that action?
2. Whether, in the special circumstances of this case, attorneys’ fees should be awarded to one or more of the defendants?

The Court of Appeals accepted certification and answered the first question in the affirmative and declined answering the second question, as it was a mater to be determined by the Second Circuit or the Second District.

As to the first question, the Court relied on its prior decision of Mighty Midgets, Inc. v. Centennial Insurance Company, 47 N.Y.2d 12 (N.Y. 1979), wherein the Court held that “an insured who is ‘cast in a defensive posture by the legal steps an insurer takes in an effort to free itself from its policy obligations,’ and who prevails on the merits, may recover attorneys’ fees incurred in defending against the insurer’s action.” U.S. Underwriters, 2004 N.Y. LEXIS 3798, at 6, quoting Mighty Midgets, 47 N.Y.2d at 21. The rationale behind Mighty Midgets “is that an insurer’s duty to defend an insured extends to the defense of any action arising out of the occurrence, including a defense against an insurer’s declaratory judgment action.” U.S. Underwriters, 2004 N.Y. LEXIS 3798, at 6.

Since Shelby prevailed in the declaratory judgment action in which U.S. Underwriters attempted to disclaim coverage, U.S. Underwriters was obligated to pay Shelby’s attorney’s fees stemming from the defense of the declaratory judgment action. Further, even though U.S. Underwriters did provide a defense to Shelby prior to the declarative action, the Court held “that under Mighty Midgets, an insured who prevails in an action brought by an insurance company seeking a declaratory judgment that it has no duty to defend or indemnify the insured may recover attorneys’ fees regardless of whether the insurer provided a defense to the insured.” Id. at 6-7. Further, “Shelby’s recovery of attorneys’ fees is incidental to the insurer’s contractual duty to defend.” Id. at 7.

The end result of the Court’s holding in U.S. Underwriters is that insurance companies need to take heed. If an insurer fails in a declaratory judgment action seeking to uphold a disclaimer of coverage, the insurer may be forced to pay their insured’s attorney’s fees in defending the declarative action even though the are providing a defense to the insured in the underlying action during the declaratory judgment proceeding.


Richard C. Aitken, Esq., is a 1994 graduate of Touro College, Jacob D. Fuchsberg Law Center and a Partner at Bruno, Gerbino & Soriano, LLP, located in Melville, New York. Michael A. Callinan, Esq., is a 2002 graduate of Hofstra University School of Law and an Associate at Bruno, Gerbino & Soriano, LLP.

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