The New York Court of Appeals' recent decisionin K2 Investment Group, LLC, et al. v American Guarantee &Liability Insurance Company may—or may not—be a game changer.Under New York law, the duty to defend is exceedingly broad. If thecomplaint contains any facts or allegations that bring the claimpotentially within the policy, then the insurer must defend. Theduty to defend arises when the allegations within the four corners of the complaint potentially give riseto a covered claim, or where the insurer has knowledge of factsestablishing a reasonable possibility of coverage. Even if apurportedly covered claim is frivolous or groundless, theallegations still trigger the duty to defend.

Generally, an insurer has no duty to defend where theallegations in the complaint raise no possibility that the insurerwould be required to indemnify its insured. While facts beyond thecomplaint cannot be used to disclaim the duty to defend, they mustbe taken into account if the insurer has actual knowledge of factsthat, if pled, would trigger its duty to defend. The duty toindemnify is narrower, arising only where the claim for which theinsured is liable falls within the policy's coverage.

The K2 Decision

In K2, the Court of Appeals recently held—in what maybe new law—that because an insurer breached its duty to defend, itcould not later rely on otherwise potentially applicable exclusionsto deny coverage for indemnification. In other words, an insurer'swrongful failure to defend may mean that the insurer is liable inan amount up to its policy limits, even if a policy exclusion mightpreclude coverage for indemnification. The unanimous rulingpotentially expands insurers' indemnity obligations beyond thecoverage afforded by the policy and, as the court suggests, makes apre-denial declaratory judgment action an important strategicconsideration.

In the underlying dispute that gives rise to K2,plaintiffs loaned the insured's company $2.83 million backed bymortgages. When the company failed to repay the loans, plaintiffsdiscovered that the insured's principle, an attorney, neverrecorded the mortgages. Plaintiffs sued, alleging that the insuredattorney acted as their attorney in regard to the loans and thathis failure to record the mortgage constituted legal malpractice.

The insured notified his malpractice insurer of the claim, andthe insurer denied coverage for defense and indemnity, saying theallegations were not based on the rendering or failing to renderlegal services for others. The insurer rejected plaintiffs'$450,000 settlement offer on the same basis. Plaintiffs secured adefault judgment in excess of the policy limits. The insuredattorney assigned to underlying plaintiffs his causes of action forbreach of contract and bad faith failure to settle against themalpractice insurer, resulting in the K2 coverageaction.

In the K2 coverage action, the insurer moved forsummary judgment, arguing that the policy's “insured status” and“business enterprise” exclusions barred coverage because the claimsarose from the insured attorney's capacity or status as a memberand owner of the defaulting company, and from his acts or omissionson the company's behalf. The trial court disagreed and grantedplaintiffs' cross motion, holding that the insurer breached itsduty to defend the insured attorney, and was obligated to pay thejudgment against him up to the policy's limit. The trial courtdismissed the bad faith claims. The Appellate Division, FirstDepartment, affirmed both rulings, with two judges dissenting onthe basis that issues of fact existed regarding the exclusions'application.                      

The Court of Appeals affirmed the Appellate Division's rulingwithout addressing whether the exclusions applied. Instead, thecourt held that by breaching its duty to defend the insuredattorney, the malpractice insurer lost its right to rely on policyexclusions in litigation over its obligation to indemnify theinsured.

In its K2 decision, the Court of Appeals seems toimplicitly overrule Servidone Construction Corporation v.Security Insurance Company of Hartford, in which the Court ofAppeals held that an insurer's breach of the duty to defend doesnot create coverage for indemnification. Coincidentally, on the daythe K2 decision was issued, the U.S. Court of Appeals forthe Second Circuit issued its decision in CGS Industries, Inc.v. Charter Oak Fire Insurance Company, citingServidone, and holding that, although an insurer breachedthe duty to defend, it did not owe the insured indemnification. InCGS Industries, the insured has sought a rehearing,relying in part on theK2 decision.

Before K2, the Court of Appeals' holding in Lang v.Hanover Insurance Company, provided the standard: “[H]avingchosen not to participate in the underlying lawsuit, the insurancecarrier may litigate only the validity of its disclaimer and cannotchallenge the liability or damages determination underlying thejudgment.” Under Lang, an insurer could litigate itsdisclaimer for indemnification even if it had breached its duty todefend—unless the issue determinative of the insurer's duty toindemnify was already decided in the underlying action for which itfailed to provide a defense.

Insureds may argue the K2 court has expandedLang to preclude any insurer that has breached its duty todefend from litigating its duty to indemnify. In response, insurersmay take the position that K2 is consistent with Lang,because the apparent expansion was not necessary to the holding,and is merely dictum. In K2, the claims against theinsured attorney included a claim for malpractice in therepresentation of the underlying plaintiffs. Although the claim waslikely groundless, it arguably triggered the duty to defend. It wason this claim alone that the default judgment was entered.

Thus, the K2 court could have held that 1) themalpractice claim triggered the duty to defend; 2) the insurerbreached that duty; 3) the default judgment determined that theinsured was liable for malpractice; and 4) the insurer could notlitigate the issue of whether the insured was liable formalpractice, which is covered, because that was determined in theunderlying litigation. Yet, the court went on to state, perhapsunnecessarily, that if an insurer breaches its duty to defend, itmust indemnify its insured for the resulting judgment, even thoughpolicy exclusions may apply.

The K2 decision leaves open the argument that breachinga duty to defend would not create indemnity coverage where nocoverage existed in the first instance, as opposed to where apolicy exclusion applies. The decision also creates a possibleexception, where indemnification of an insured is against publicpolicy.

In Hough v. USAA Casualty Insurance Company, the FirstDepartment recently held that an insurer's breach of its duty todefend does not preclude it from denying coverage for indemnitywhere the insured intentionally injured the underlying plaintiff.The K2 court justified the Hough decision onpublic policy grounds, but stated that such grounds did not existin the K2 matter.

Although the K2 court affirmed the dismissal of the badfaith claims, the court has arguably awarded extra-contractualdamages—loss of reliance on policy exclusions. It remains to beseen how broadlyNew York courts will apply this new rule, which wasformed without express consideration of longstanding precedent.

A motion to reargue the K2 decision is pending. If thedecision stands, before denying coverage, an insurer would bewell-advised to consider defending its insured under a reservationof rights, and filing a declaratory judgment action to determineits obligations.

Melissa F. Brill is a member in Cozen O'Connor's GlobalInsurance Group and a resident in the firm'sNew Yorkoffice. She maybe reached at [email protected].