Second Circuit Holds That a Default Judgment by an Insurer Against Insured Did Not Preclude Claims by Other Parties

The US Court of Appeals for the Second Circuit, in its reversal in 2939, LLC v. Continental Indem. Co.,¹ addressed whether a default judgment by an insurer against its own insured could have preclusive effect against other parties that had obtained a judgment against the insured, which is an important issue that arises regularly in insurance coverage disputes.

This action stemmed from a personal injury claim in which a construction worker suffered a spinal cord injury while working at a construction site. The worker sued the owners of the property in the Supreme Court of New York for Kings County and ultimately obtained a judgment in the amount of $21 million. The owners filed a third-party complaint against the worker’s purported employer for contribution and indemnity. The employer sought coverage from its liability insurer for a defense and indemnification of the underlying claims.

While the personal injury action was pending, the insurer sued the employer in the US District Court for the Southern District of New York, arguing that the employer had failed to disclose the worker as an employee on its payroll, in violation of its insurance policy. The insurer sought a declaratory judgment that it thus was entitled to a declaration that it owed no coverage for the underlying claims brought against the employer. The employer failed to appear or respond to the insurer’s lawsuit, and the insurer moved for a default judgment, which was granted.

A month after the entry of default judgment, the property owners filed a separate suit against the liability insurer for breach of contract under New York’s “direct action” statute,² claiming that the insurer was obligated to provide coverage to the employer, including a defense and indemnification of the underlying claims. The insurer moved to dismiss the owners’ lawsuit, arguing that the claims were precluded by the insurer’s default judgment against the employer in the prior action. The district court granted the insurer’s motion to dismiss, holding that the owners’ lawsuit was based on the insurer’s obligation to insure the employer, so the insurer’s default judgment to the contrary precluded the claims.

On appeal, the Second Circuit reversed the dismissal and remanded the case to the district court on several grounds. First, the Second Circuit held that the district court improperly concluded that a default judgment against one party (the employer) had preclusive effect against a different party (the owners). Second, the Second Circuit held that a nonparty cannot be bound by a judgment unless it shares a “substantive legal relationship” with a party to the judgment. To that end, the Second Circuit reasoned that at the time the default judgment was granted, the owners and the employer did not share a “substantive legal relationship” because the owners had not yet been awarded a judgment against the employer in the state action, which came after the insurer’s default judgment against the employer in the district court action. As such, the insurer was entitled to a dismissal based on claim preclusion.

This decision is an important reminder for liability insurers and their attorneys that an insurer may still be exposed to a claim by a third-party claimant even if the insurer obtains a default judgment against its own insured. Consequently, to bind a third-party claimant to any ruling regarding the insurer’s obligations under the insurance policy, the insurer may be best served by naming the third-party claimant as a defendant in any declaratory judgment action. If the third-party claimant is a party to the declaratory judgment action, then any ruling in that action should be binding on the third-party claimant—even if the third-party claimant later secures a judgment against the insured. 

If you have any questions regarding the content of this alert, please contact Nick Constantino, associate, at nconstantino@barclaydamon.com; Tony Piazza or Mark Whitford, Insurance Coverage & Regulation Practice Area co-chairs, at apiazza@barclaydamon.com and mwhitford@barclaydamon.com; or another member of the firm’s Insurance Coverage & Regulation Practice Area.
                                                                                                        
¹2024 U.S. App. LEXIS 26783, *6 (2d Cir. Oct. 23, 2024).
²See Insurance Law § 3420.