Wade Clark Mulcahy LLP

In Peleus Insurance Company v. Milestone Construction Corp., et al., the United States District Court for the Southern District of New York held that an insured’s failure to realize the difference between a coverage action (in which it was sued by its insurer) and the underlying action (for which the insurer was seeking to disclaim coverage) was not sufficiently “willful” to prohibit the insured from setting aside the default.

Peleus Insurance Company, the plaintiff in the coverage action, issued two commercial insurance policies to the owner of the premises and the general contractor. The Peleus policy required any contractor retained by the owners of the property to maintain “adequate insurance” including commercial general liability insurance, workers’ compensation insurance, and employer’s liability insurance. As is the case in nearly any New York Labor Law claim, the general contractor, in turn, hired a subcontractor to perform the work. The subcontractor was insured by Northfield Insurance Company.

The facts underlying the coverage action are familiar: an employee of the subcontractor was injured while performing work at the construction site and he sued the contractor and the owner. Peleus initially agreed to provide coverage to its insureds for the lawsuit. On the other hand, Northfield disclaimed coverage to the subcontractor.

Because of Northfield’s disclaimer, Peleus sought to disclaim coverage under its own policy because, it argued, its insureds did not ensure that its subcontractor maintained adequate insurance as required by the Peleus policy. Northfield sued its insureds in a separate coverage action. The insureds did not answer or otherwise respond to Northfield’s complaint because, they asserted, “a non-lawyer did not understand that a separate suit had been filed.”

Peleus defaulted its insureds in accordance with federal court rules. The non-attorney member of the insured company asserted that he was not even aware what a declaratory judgment action was until his defense counsel became aware of the pending default. After becoming aware of the distinction between the underlying personal injury action and the coverage action, the insureds moved to set aside the default.

The district court set forth the three-part test used to analyze whether a default should be set aside: (i) whether the defendant’s failure to appear in the case was “willful”, (ii) whether the defendant can demonstrate a complete defense in the case, and (iii) whether setting aside the default would prejudice the plaintiff.

The court’s holding was threefold. First, it held that the insureds’ initial failure to realize the distinction between the underlying lawsuit and the coverage action was not “willful.” Second, it held that, even though the insureds could not demonstrate a “completely meritorious defense” in the coverage action, that failure did not warrant the entry of default against them. Finally, it held that, in light of New York’s strong presumption in favor of adjudicating a case on the merits, mere litigation costs were insufficient to constitute “prejudice” to Peleus.