Hunton Insurance Recovery Blog

Liability insurance typically affords broad defense coverage.  But insurers sometimes reserve their right to challenge the insured’s right to a defense, or even outright terminate the defense.  When this occurs after the insurer has been in exclusive control of the defense, some courts recognize that the consequences can be catastrophic for the insured defendant.  Insurers, therefore, may be estopped from denying coverage where doing so will prejudice the insured.  This is exactly what transpired in RLI Ins. Co. v. AST Engineering Corp., No. 20-214 (2d Cir. Jan. 12, 2022), where the Second Circuit affirmed the district court’s decision that an insurer’s attempt to withdraw the defense it had provided to its insured for three years would prejudice the insured.

In AST Engineering, RLI sought a declaration that it did not have to defend the insured, AST, in two underlying cases in which AST was sued as a third-party defendant.  The underlying cases concerned a construction project in New York City for which AST provided engineering drawings on October 28, 2012.

The insurer argued that there was no coverage under a professional liability insurance policy it issued to AST that covered claims made against AST between March 22, 2013, and March 22, 2014, provided that the “Wrongful Act” alleged against AST occurred after March 22, 2013.  The first underlying action against AST was filed on October 10, 2013.  AST notified RLI of the claim on October 28, 2013.  RLI agreed to defend AST against the lawsuit and did so for nearly three years before reserving its rights on September 21, 2016, contending there was no coverage for the suits since the “Wrongful Act” alleged against AST—the submission of the engineering drawings—predated the policy.  AST countered that RLI was estopped from denying coverage because it delayed too long before reserving its rights.  The trial court agreed and granted summary judgment for AST.

On appeal, RLI argued that the district court erred in granting summary judgment for AST because it incorrectly determined that New Jersey law applied to the parties’ dispute, which has a lower standard for estoppel than New York. The choice of law question was dispositive.  The Court explained that “[u]nder New York law, an insurer that delays disclaiming coverage is estopped from later denying coverage only if ‘the insured suffers prejudice as a result of that delay.’” Id. at 2.  The Court also explained that “[p]rejudice is established only where the insurer’s control of the defense is such that the character and strategy of the lawsuit can no longer be altered.” Id.  On the other hand, under New Jersey law, prejudice is presumed where the insured is deprived of complete control of its defense.  While RLI and AST disagreed about whether the character and strategy of the lawsuit could be altered, they agreed that AST was deprived of complete control of its defense.  Thus, the appellate court reasoned that if New Jersey law applies, then prejudice is presumed and RLI is estopped from disclaiming coverage.

RLI argued that New York law governed the dispute because (i) the construction project was in New York, (ii) the litigations were pending in New York courts, and (iii) AST used its licensure to practice engineering in New York.  AST claimed that New Jersey law controlled mainly because it is domiciled in New Jersey.  The appellate court explained that, as a federal court sitting in diversity, it must apply the choice-of-law rules of the forum state for the coverage action, New York.

Because there was a true conflict between the estoppel laws of New York and New Jersey, the Court applied New York’s “center of gravity” or “grouping of contacts” test for its choice-of-law analysis.  Under that test, “the law of the place which has the most significant contacts with the matter” governs the dispute. Id. at 2.  In the context of liability insurance contracts, courts in New York generally apply the law of “the jurisdiction which the parties understood was to be the principal location of the insured risk unless with respect to the particular issue, some other jurisdiction has a more significant relationship.” Id.  Further, where the policy covers risks in two or more states, “the state of the insured’s domicile should be regarded as a proxy for the principal location of the insured risk.” Id.  Since the location of the insured risk for AST included, at a minimum, the two states where AST was licensed to practice—New York and New Jersey—the appellate court found that the district court correctly applied the domicile-as-proxy rule to conclude that New Jersey law governed.

Since RLI was defending AST, and thus AST could not completely control its defense, RLI did not even dispute estoppel under New Jersey law.  It simply conceded that it would be estopped from denying coverage under New Jersey law.  Thus, the Second Circuit affirmed the trial court’s decision that RLI was estopped from denying coverage because RLI’s three-year delay in reserving its right to deny coverage was presumed to prejudice AST under New Jersey law.

Aside from granting summary judgment for AST, the trial court rejected RLI’s request for leave to amend its complaint to add a fraud claim against AST.  RLI argued that it recently obtained an email showing that by March 11, 2013, before the policy incepted, AST had notice of one of the two underlying cases.  In affirming the trial court’s decision, the appellate court explained that in New Jersey, waiver, rather than estoppel, is the controlling doctrine when an insurer raises a late “claim of misrepresentation or fraud in the inception of the coverage.” Id. at 3.  An insurer must act with “reasonable diligence” to investigate once it receives information suggesting fraud and must decide whether to nevertheless provide coverage “within a reasonable period.” Id.  The Second Circuit, however, determined that RLI had enough information to warrant investigation for years.  Thus, it concluded, as the district court did, that RLI failed to exercise reasonable diligence in investigating AST’s claim, and therefore waived its right to assert fraud as a defense to coverage.

AST also appealed the district court’s denial of its request for attorneys’ fees.  The appellate court explained that its review of the lower court’s denial of attorneys’ fees was confined to abuse of discretion.  Because the Court did not discern any abuse in the district court’s refusal to award fees based on the evidence that AST knew of and failed to disclose likely claims against it when it applied for insurance from RLI, the Second Circuit affirmed the district court’s denial of fees.

AST Engineering is a significant win for policyholders.  Among other things, the decision illustrates a critical exception to the general rule that coverage cannot be created by estoppel, showing that coverage may indeed be extended – here, to a claim based on a Wrongful Act that purportedly occurred before the inception of coverage – where the insurer’s actions prejudice the policyholder’s interests.  It is also an example of the importance of involving coverage counsel throughout the claims handling process, and a reminder that policyholders should not hesitate to obtain independent review of any claim denial or insurer reservation.