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Liability Insurer May Not Deny Defense Coverage Based On Extrinsic Evidence “Bound Up With the Merits of the Underlying Case”

On December 22, 2022, Judge Failla of the SDNY issued a decision in 622 Third Ave. Co., L.L.C. v. National Fire Ins. Co. of Pittsburgh, Pa., 21 Civ. 6050, ruling that a liability insurer could not deny defense coverage to an additional insured based on extrinsic evidence that was “bound up with the merits of the underlying case” against the insured.

The Plaintiff in 622 Third Ave., a property owner, was sued by an employee of a subcontractor who was allegedly injured while working on a project at the Plaintiff’s building.  Plaintiff sought coverage as an additional insured under its general contractor’s CGL policy.  The insurer (Harleysville) initially acknowledged coverage based on the facts alleged in the complaint.  However, four years after assuming the defense, Harleysville reversed course, arguing that facts developed in the underlying litigation demonstrated that the plaintiff was not entitled to additional insured coverage because the GC was not performing any work for the plaintiff at the time of the injury, and the injury did not occur at the designated location.  The insured brought an action for a declaratory judgment.

Judge Failla granted the insured’s motion for partial summary judgment on the duty to defend, explaining:

Under New York law, the duty of an insurer to defend its insured is exceedingly broad and far more expansive than the duty to indemnify its insured.  The insurer’s duty to provide a defense is invoked whenever the allegations in a complaint against the insured fall within the scope of the risks undertaken by the insurer, regardless of how groundless those allegations might be.  Thus, the general rule in determining whether an insurer has a duty to defend is to compare the allegations of the complaint with the operative insurance policy.  An insurer must defend even if facts outside the four corners of those pleadings indicate that the claim may be meritless or not covered.  If the allegations of the complaint are even potentially within the language of the insurance policy, there is a duty to defend.

However, the insurer’s duty to defend is not an interminable one, and will end if an when it shown unequivocally that the damages alleged would not be covered by the policy.  In other words, where an insurer’s duty to defend turns on an unresolved factual dispute, the duty to defend lasts only until the factual ambiguity is resolved in favor of the insurer.

The question of when facts extrinsic to a complaint my either trigger a duty to defend or terminate that duty at a subsequent date remains somewhat unclear under New York law.  Still, the Second Circuit has suggested that extrinsic evidence may terminate the duty to defend in certain circumstances, including when extrinsic evidence unrelated to the merits unambiguously shows that there is no possibility of coverage.

For this exception to apply, the extrinsic evidence relied upon may not overlap with the facts at issue in the underlying case.  Even when a Court is permitted to consider such extrinsic evidence, an insurer may deny its insured a defense only if it could be concluded as a matter of law that there is no possible factual or legal basis on which the insurer might eventually be held to be obligated to indemnify the insured under any provision of the insurance policy.

In line with this rule, an insurer generally may not use the admissions of an insured to defeat a duty to defend.

(Citations and internal quotation marks omitted).

The Court found that the extrinsic evidence the insurer purported to rely on here—admissions in the insured’s motion papers in the underlying action—were bound up with the merits of the underlying litigation and therefore could not be used to defeat the duty to defend.  The Court further explained: “Defendant’s remedy for terminating the duty to defend that it owes to Plaintiff is not to seek this Court’s resolution of the merits of the underlying case, but to defend Plaintiff until Defendant proves—if it can—facts showing that Plaintiff has no possible claim for indemnification.”

The rule that insurers may not litigate the merits of the underlying dispute in a collateral coverage action makes good sense and is an important protection for policyholders.  Notably, New York law does not permit the insurer to employ a “wooden application of the ‘four corners of the complaint’ rule” “when it has actual knowledge of facts establishing a reasonable possibility of coverage”—even if those facts are not pled in the complaint. See Fitzpatrick v. American Honda Motor Co., 78 N.Y.2d 61, 66-67 (1991).  So while the consideration of extrinsic facts to deny coverage is sharply curtailed, such facts must be considered when they support coverage.

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