In my third year of law school, my “Remedies” professor remarked that no parties are less favored in the law than volunteers and insurers.  The recent decision of New York’s highest court in U.S. Underwriters Ins. Co. v. City Club Hotel LLC, 2004 WL 2902402 (December 16, 2004), certainly affirmed this with respect to insurers.  In U.S. Underwriters, the Court of Appeals ruled that an insured could recover attorneys’ fees expended in defending a declaratory judgment action (“DJ Action”) commenced by the insurer despite the insurer’s provision of a defense in the underlying liability litigation.

On April 27, 2000, while performing the renovation work  an employee, fell from a scaffold and sustained serious injuries.  The employee and his spouse brought a personal injury action in Supreme Court asserting various labor and industrial law claims against Shelby Realty, LLC and others.  Five months after the insurer received notice of the claim, the insurer disclaimed coverage based on the policy’s Employee Exclusion clause.  The insurer nonetheless provided Shelby a defense in the underlying action.

In September 2002, U.S. Underwriters brought a DJ Action in the United States District Court for the Southern District of New York, seeking a declaration that it had no duty to defend or indemnify Shelby pursuant to the employee exclusion clause.  The District Court ruled in favor of Shelby and held that the disclaimer was untimely as a matter of law. The court, however, denied Shelby’s 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 its duty to defend.

The Second Circuit affirmed with respect the untimely disclaimer. As to the issue of attorneys’ fees, the Second Circuit noted a division in interpreting the relevant law and certified this question to New York’s Court of Appeals:

Whether an insured who prevails in an action brought by an insurance company seeking a declaratory judgment that the insurer has no duty to defend or indemnify the insured, may recover attorneys' fees expended in defending against the declaratory judgment action regardless of whether the insurer provided a defense to the insured?
The Court of Appeals explained that it is well settled in New York that a prevailing party may not recover attorneys' fees from the losing party except where authorized by statute, agreement or court rule.  See Chapel, et al. v Mitchell, et al., 84 NY2d 345, 348-49 (1994), quoting Hooper Associates, Ltd. v AGS Computers, Inc., 74 NY2d 487, 491 (1989); Mighty Midgets, Inc. v Centennial Ins. Co., 47 NY2d 12, 21-22 (1979).  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.” 20004 WL 2902402 quoting Mighty Midgets, 47 N.Y.2d at 21.

The court pointed out the expenses incurred by Shelby in defending against the declaratory judgment action arose as a direct consequence of U.S. Underwriters' unsuccessful attempt to free itself of its policy obligations, and, thus, Shelby is entitled to recover those expenses from the insurer. “In other words, Shelby's recovery of attorneys' fees [was] incidental to the insurer's contractual duty to defend.”

This decision has the potential to “chill” insurers who take a proactive approach by initiating a DJ Action while defending the underlying claims.  Query, would the result have differed had the insured initiated the DJ Action?  The above-quoted language suggests as much.  Building on this decision, will insureds next argue that the mere issuance of a reservation of rights letter cast it in a “defensive posture” necessitating a DJ Action of its own?  Arguably, a timely reservation of rights (apparently lacking) would have allowed the insurer to prevail in the DJ action and the issue of attorneys’ fees would never have been addressed.