The Second Department, Appellate Division, for the Supreme Court of New York, recently held in a matter of first impression, that an insurance company with a duty to defend may not recover defense costs after a determination that no duty to indemnify or further defend exists—even though the insurer expressly reserved its right to recoup such defense costs—unless the policy explicitly provides for such recovery. See American W. Home Ins. Co. v. Gjonaj Realty & Mgt. Co., 2018-03435, 2020 WL 7767944 (2d Dept., Dec. 30, 2020).

In the underlying personal injury action, commenced in January 2011, Victor Gecaj sought to recover damages for injuries he allegedly sustained when he fell from a ladder at a property owned and operated by the insureds. The insureds failed to notify its insurance company about Gecaj’s accident until October 2014—more than four years after the incident, and after an inquest on damages had occurred, and judgment had been rendered against the insureds in the sum of $900,000. The insurance company denied coverage based on late notice. However, the default judgment was then vacated, and the insurance company agreed to provide a defense under a reservation of rights to deny coverage if the default judgment was later reinstated. When the default judgment was reinstated, the insurance company advised the insureds and Gecaj that it was denying coverage, and reserving its right to recover any fees and costs incurred in defending the insureds in the underlying action. The insurance company then initiated a declaratory judgment action, seeking a declaration that it had no duty to indemnify, no further duty to defend, and was entitled to recover defense costs incurred to date. The Supreme Court granted the insurance company’s motion for summary judgment, and the insureds appealed.

The Appellate Division agreed with the Supreme Court that the insurance company had no obligation to indemnify, and no further obligation to defend; however, the court held that the insurer was not entitled to recoup the defense costs incurred to date, because the policy did not expressly provide for such reimbursement. The Appellate Court declined to follow New York state and federal precedent permitting recoupment of defense costs, noting that no prior case addressed the specific issue of whether recoupment was appropriate. The Court also noted a recent shift in federal courts on this issue. See, e.g., Crescent Beach Club LLC v. Indian Harbor Ins. Co., 468 F. Supp. 3d 515, 554–555 (E.D. N.Y.) and Century Sur. Co. v. Vas & Sons Corp., 2018 WL 6164724, 2018 U.S. Dist LEXIS 151209 (E.D. N.Y., No. 17–CV–5392 (DLI)) (determining insurers with duty to defend had no right to recoup absent an express contractual provision permitting recoupment). In so holding, the Appellate Division provided the following reasoning:

• First, allowing recoupment of defense costs would risk “eroding” the “well-established” broad duty to defend doctrine, and “would make the duty to defend merely coextensive with the duty to indemnity.”

• Second, under the law of contracts, the insurance company should have included language in its policy permitting recoupment of defense costs. An insurer’s reservation of rights to recover defense costs does not create a new “implied” contract.

• Third, the insurer’s broad duty to defend prevents a finding that the insureds were unjustly enriched as the result of a defense of claims later found to be uncovered, and under New York law, claims for unjust enrichment are precluded where an insurance policy governs.

This decision will have a significant impact on a carrier’s ability to accept a duty to defend under a reservation of rights. Given this recent development under New York law, underwriters and claims handlers should examine whether their duty to defend policies provide for recoupment of defense costs.