Legal Fees in Declaratory Judgment Actions Against Insurers

Eric Dinnocenzo, New York Law Journal, September 29, 2014

It’s not often that judges encourage litigants to appeal their decisions so they will be reversed. But Manhattan Supreme Court Justice Shirley Kornreich did just that in an April 8, 2014, decision in Madison 96th Associates v. 17 East Owners Corporation, which denied an attorney fee award to a prevailing plaintiff in a declaratory judgment action against its insurer, due to its wrongful refusal to provide it with a defense in a third-party action.^[1]

From the perspective of this author, who is an insurance policyholder advocate, Kornreich was correct—her decision should be reversed. Her invitation highlights an oddity in New York law that a prevailing insured in a declaratory judgment action against its insurer for a breach of the duty to defend is only entitled to an attorney fee award if it is a defendant in the case. This is known as the “Mighty Midgets” rule, having been established by the Court of Appeals in a 1979 decision Mighty Midgets v. Centennial Insurance Company, 47 N.Y.2d 12 (1979).

In short, whether an insured can receive an attorney fee award in a declaratory judgment action is dependent on which side of the “v.” it finds itself. This sounds rather arbitrary, and in fact, Kornreich pointed out that Southern District Magistrate Judge James Francis has observed that this rule “has its peculiarities….[i]t seems anomalous for the entitlement to fees to turn on the fortuity of whether a party to an insurance contract is cast as the plaintiff or defendant.”^[2]

To be clear, the focus of the Mighty Midgets rule (and this article) is on insurance coverage for third-party actions in terms of an insurance company’s duty to defend and indemnify its insured. First-party insurance claims, such as for refusal to pay benefits directly to an insured under a life, disability, or property insurance policy, are a different matter.

Misplaced When Applied

In rationalizing the rule it crafted in Mighty Midgets, the Court of Appeals found it important that in our American system, litigants customarily pay their own legal fees as it provides “freer and more equal access to the courts.”^[3] But the court carved out an exception for when an insured “has been cast in a defensive posture by the legal steps an insurer takes in an effort to free itself from its policy obligations.”^[4]

While the logic of the American rule is sensible in the abstract, it is misplaced when applied to an insurance company that disclaims coverage and then faces a declaratory judgment action from its insured. It can fairly be said that keeping an insurance company in breach of its duty to defend from paying its insured’s legal fees does not contribute to the goal of “freer and more equal access to the courts.”

Kornreich pointed out that, “Over the years, countless insureds have sought to challenge the logic of this rule—which creates a perverse incentive, because allowing fees under these circumstances would create an incentive for the insurer to refuse to defend in the underlying suit, thereby leaving it up to the insured to bring a declaratory action seeking coverage.”^[5]

Indeed, the one-sided nature of the Mighty Midgets rule encourages insurers to send out disclaimer letters and leave their insureds on their own to defend against third-party actions, instead of filing declaratory judgment actions to seek a court ruling on their obligations. After all, if they take the latter course, they might have to pick up the tab for their insureds’ legal fees.

Kornreich summed up this incentive as follows:

The court is mindful of the strong policy reasons against adopting a rule of law that would reduce the incentives for insurance companies to defend in the underlying tort actions and that would likely shift the burden of obtaining a declaratory judgment from the insurance company to the insured. Insurers could simply deny defense as a matter of course, and wait for impending actions by their insureds, without risk of incurring any liability for the insureds’ defense costs in resulting litigation. There is the potential that insurers might shrink from their defense obligations under their policies and categorically deny their insureds’ tenders of defense in an effort to reduce their financial exposure, without risk of incurring any additional liabilities or expenses associated with issuing and maintaining policies. However, until the legislature determines otherwise, this court is constrained to interpret the law as it currently stands.

Of course, a cautious insurance company may still file a declaratory judgment action in certain cases, cognizant that if it disclaims coverage and a hefty judgment is entered against its insured in the third-party action, it may ultimately be responsible for payment. But this is more the exception than the rule, at least if one assumes that insurance companies are generally of the belief that their disclaimers are valid. Thought of another way, if an insurer thinks it has a strong or perhaps even clear cut right to disclaim coverage, it does not make much sense from an economic standpoint to pay a law firm to file a declaratory judgment action to confirm that its decision is correct—especially when the insurer could be on the hook for legal fees if it loses.

Precarious Position

So where does the Mighty Midgets framework leave insureds? They are placed in the precarious, not to mention often financially untenable position of having to pay out of pocket for both the defense of the third-party action and a declaratory judgment action against their insurers. Most small businesses and regular folks do not have the financial resources to litigate on two fronts, never mind just one. So much for “freer and more equal access to the courts,” it would seem.

Some may argue, why should these cases be any different than others under the American rule? In other words, the Mighty Midgets rule gives an advantage to insureds in a specific context that other kinds of litigants do not share, and so why should they receive yet another advantage?

One response is that an insured who is wrongfully disclaimed against has not received the benefit for which it contracted. The insured purchased a policy, dutifully paid premiums, and when it needed coverage its insurer left it unprotected. Even if the insured ends up prevailing in a declaratory judgment action, it has suffered harm in the form of paying legal fees to get what it should have had in the first place.^[6] The insured is simply not made whole.

Then there is the important consideration that when an insurance company wrongly refuses to provide coverage, an innocent injured party may be harmed because he or she will have no way to obtain compensation.

Moreover, as opposed to a typical contract for money, the insured is not paying for something of value, but instead for a safeguard against an unfortunate event that may or may not occur in the future. As put by the Court of Appeals, insurance coverage provides “peace of mind, or comfort, of knowing that [the insured] will be protected in the event of catastrophe.”^[7] This is fundamentally different than a regular consumer transaction such as buying a car or hiring a house painter that does not entail the possibility of such dire consequences.

In addition, there is the unilateral aspect to how insurance companies may fulfill or not fulfill their policy obligations in this context. They either do or do not provide coverage for a third-party action. In contrast, in most consumer transactions there is often at least a partial or substantial performance which can alleviate the hardship incurred. For instance, if you buy a used car and the brakes do not work, it is not a total loss—you still have a car with value—but this is not so for an insurance disclaimer.

There is also a stark difference in economic resources between insurance companies and most of their customers, such as individuals and small businesses, who often are unable to challenge disclaimers unless they can be reimbursed for their legal fees if they prevail.

The insured in the case before Kornreich made an interesting argument for the expansion of the Mighty Midgets rule to encompass insureds who affirmatively file declaratory judgment actions against their insurance companies. Contending that the legal landscape for bad-faith insurance denials in New York has and continues to evolve based on the Court of Appeals decisions in Bi-Economy Market v. Harleysville Insurance Company of New York, 10 N.Y.3d 187 (2008) and Panasia Estates v. Hudson Insurance Company, 10 N.Y.3d 200 (2008), which allowed for an award of consequential damages to an insured that was greater than the policy limits, the insured suggested that the Mighty Midgets rule should also evolve to encompass insureds who file declaratory judgment actions, because the foreseeable result of a disclaimer is that the insured is forced to file the action.

Kornreich rejected this argument on the more technical grounds that the insured had failed to properly raise this theory in the complaint. But significantly, the judge went on to state that: “even absent bad faith, public policy strongly militates in favor of forcing [the insurer] to pay the DJ fees…The court encourages [the insured] to appeal this decision so its counsel can find out if its purported foresight is correct or if the penumbras of Bi-Economy and Panasia are illusory.”

The word “penumbra” of course hearkens back to how Justice William O. Douglas famously used it in the 1965 Supreme Court decision, Griswold v. Connecticut, 381 U.S. 479 (1965), which expanded our notions of privacy as well as the method and technique for interpreting the Bill of Rights—suggesting the law of bad faith in New York, which has historically been less consumer-friendly than in other states, can be more broadly interpreted.

It is noteworthy that some states take a more pro-consumer position. For instance, New Jersey allows an insured to recoup its legal fees if successful in a declaratory judgment action against its insured, no matter who is the plaintiff or defendant.^[8] In fact, New Jersey even allows injured persons to recover counsel fees if successful in a coverage action against a tortfeasor’s insurer.^[9]

In conclusion, from a policyholder perspective, while the Mighty Midgets rule is better for insureds than no possibility of recovering legal fees in declaratory judgment actions, the shortcoming of the rule is that it does not discourage meritless disclaimers. The critical question comes down to whether the goal of “freer and more equal access to the courts” is directed to insurance companies or their insureds.

Endnotes:

^[1]. 43 Misc. 3d 1210(A).

^[2]. Danaher Corp. v. Travelers Indemn. Co., 10-cv-0121, 2013 U.S. Dist. LEXIS 27214, at *10 (S.D.N.Y. Jan. 31, 2013) (quotation omitted).

^[3]. 47 N.Y.2d at 22 (citation omitted).

^[4]. Id. at 21 (citations omitted).

^[5]. Quoting Folksamerica Reinsurance Co. v. Republic Ins. Co., 2004 U.S. Dist. LEXIS 21703, at *6-7 (S.D.N.Y. Oct. 29, 2004) (Baer, J.) quoting U.S. Underwriters Ins. Co. v. City Club Hotel, 369 F.3d 102, 110 (2d Cir. 2004).

^[6]. Liberty Village Assoc. v. West American Insurance Co., 308 N.J.Super. 393, 406, 706 A.2d 206 (App.Div.), certif. denied, 154 N.J. 609, 713 A.2d 500 (1998).

^[7]. Bi-Economy Market, Inc. v. Harleysville Ins. Co. of N.Y., 10 N.Y.3d 187, 194 (2008).

^[8]. See Myron Corp. v. Atlantic Mut. Ins. Corp., 407 N.J. Super. 302, 311, 970 A.2d 1083, 1088 (N.J. App. Div. 2009).

^[9]. Id. citing Sears Mortgage Corp. v. Rose, 134 N.J. 326, 356 (1993).