If the New York Court of Appeals upholds its recent “coverage byestoppel” decision on reargument, then it will likely change theway claims professionals handle New York duty-to-defendmatters.

Should the court uphold the decision, as it is commonlyunderstood, an insurer will be far more likely to initiatedeclaratory judgment actions where it has concluded that its policydoes not provide a duty to defend to its insured.

In this article, we will examine the meaning of the court'sdecision, the Jan. 7 reargument, and the positions that theparties, and amici curiae, have taken in their briefingfor that reargument.

The K2 Decision

In K2 Investment Group, LLC v. American Guar. &Liab. Ins. Co., 21 N.Y.3d 384 (2013), the Court of Appealsheld that because an insurer breached its duty to defend, it “lostits right” to rely on policy exclusions to deny coverage forindemnification. This unanimous ruling arguably rewrote NewYork law and placed New York in the small minority of states thatrecognize the doctrine of coverage by estoppel.

With the K2 holding, the Court of Appeals may also have(intentionally or unintentionally) expanded its decision inLang v. Hanover Insurance Co., 3 N.Y.3d 350, 356(2004). Under Lang, when an insurer breaches its dutyto defend, it may still litigate its defenses to indemnificationunless the issue determinative of the duty to indemnify was alreadydecided in the underlying action. In K2, the courtappears to have gone a big step further, holding that, underLang, if the insurer breaches its duty to defend, it mustindemnify its insured, “even if policy exclusions would otherwisehave negated the duty to indemnify.” 21 N.Y.3d at 391. UnderK2, this rule arguably applies, even if the exclusions areunrelated to the underlying judgment.

In K2, the Court of Appeals may also have overlooked,or overruled, its oft-cited decision in Servidone ConstructionCorp. v. Security Insurance Co., 64 N.Y.2d 419 (1985). InServidone, the court held that an insurer's breach of theduty to defend does not create coverage forindemnification. Without even mentioning theServidone decision, the court may have overruled it.

Needless to say, the K2 decision generated morequestions than answers. It also generated dozens of articlesaddressing whether the Court of Appeals intended to create coverageby estoppel in New York.

The Court of Appeals Grants Reargument

In New York, a court will grant reargument where the courtoverlooked or misapprehended relevant material or legal issues inits decision. The New York Court of Appeals grants reargumentless than one percent of the time—fewer than onceevery 10 years.

In K2, American Guarantee sought reargument, assertingthat the court misapprehended Lang and overlookedServidone. American Guarantee took the position that,under Lang and Servidone, an insurer thatbreached its duty to defend was permitted to rely upon exclusionsapplicable to its duty to indemnify so long as the insurer did notchallenge the findings from the underlying judgment. AmericanGuarantee argued that the court's interpretation of Langis inconsistent with its prior unwillingness to confer upon theinsured more coverage than it bargained for. AmericanGuarantee asserted that the different standards for an insurer'sduty to defend and indemnify should prohibit courts from expandingthe bargained-for coverage as a penalty for breach of duty todefend.

The Court of Appeals granted reargument in K2. OnJanuary 7, 2014, the New York Court of Appeals will hear reargumentof its controversial decision. The parties to K2, aswell as amici curiae, have filed briefs in anticipation ofreargument.

Positions on Reargument

On reargument, American Guarantee emphasizes that courts shouldrefrain from making a determination on the duty to indemnifywithout a finding as to the facts that may determine whetherexclusions apply.

American Guarantee also argues that the court overlooked theapplication of the policy exclusions to the insured's claim forindemnification: the insured status and business enterpriseexclusions. In the Appellate Division, although the Justicesdisagreed as to whether the exclusions applied, all Justices agreedthat American Guarantee could raise the exclusions in defense ofthe claim for indemnification, even if it had wrongfully disclaimedits defense obligation. The Court of Appeals did not evenaddress these exclusions.

An amici curiae brief in support of AmericanGuarantee's position was filed jointly by the New York InsuranceAssociation, Inc., The National Association of Mutual InsuranceCompanies, Property Casualty Insurers Association of America andthe Federation of Defense and Corporate Counsel. Theamici argue that while an insurer that rejects a validrequest for defense is bound by facts decided in the underlyingaction, the terms of the policy determine the scope ofcoverage. They note that precedent spanning 30 yearsestablishes an insurer's right to litigate the applicability of itscoverage defenses. The amici contend that an insurerthat wrongfully declines to defend its insured does not therebyexpand its policy to provide coverage beyond the contract it made.

The amici next assert that policy provisions shouldcontrol an insurer's obligation to indemnify. They note thatin some situations, facts established by the underlying judgmentresolve the coverage questions. However, in other situations,they do not. An example given by the amici involves abusiness pursuits exclusion in a homeowners policy. A personis injured in the basement of an insured's home. The insurerdiscovers that the insured was operating a hair salon in herbasement; the policy excludes coverage for businesspursuits. The insurer declines to defend the insured and adefault judgment for negligence is entered against theinsured. Lang instructs that, if the insurer breachedits duty to defend, it will be bound by the finding of negligencein a later action to determine indemnity coverage. However, thequestion as to whether the business pursuits exclusion appliesremains open.

An amici curiae brief in support of AmericanGuarantee's position was also filed jointly by the AmericanInsurance Association and the Complex Insurance Claims LitigationAssociation. These organizations point out that the remedyfor breach of the duty to defend should relate to the harmresulting from that breach – namely, the cost of the defense. They note that the “vast majority” of jurisdictions (20 of them)hold that an insurer's wrongful refusal to defend does not bar theinsurer from later denying coverage for indemnification. TheK2 decision, they conclude, places New York in theminority.

Next, the amici argue that conflating the duties ofdefense and indemnification contradicts fundamental contractprinciples by placing an insured in a better position than if theinsurer had performed. Negating a policy's terms andconditions related to indemnity, they assert, amounts to aninappropriate extra-contractual penalty. The amicialso note important policy considerations against coverage byestoppel, including permitting insurers to accurately appraisetheir exposure and avoiding increased premiums.

In its brief, K2 Investment Group contends that the court'sdecision was correct, and that reargument is notappropriate. K2 Investment Group argues that the K2decision provides guidance for insurers considering denying theirduty to defend an insured and to New York courts determiningliability for an insurer's wrongful disclaimer. K2 Investment Groupalso asserts that the K2 decision furthers public policyby giving insurers an incentive to defend cases and giving insuredsthe full benefit of the policy for which they bargained. K2Investment Group goes on to argue that the court did notmisapprehend Lang, but clarified how it requires theresult reached in this case. Additionally, K2 Investment Grouptakes the position that the court did not overlook Servidone;rather, it is inapplicable to the facts of K2.

United Policyholders submitted an amicus brief insupport of K2 Investment Group and policyholders, asserting thatthe K2 decision applies a remedy that was already setforth in Lang and its progeny. United Policyholderstakes the position that, after Lang, courts instructedinsurers to seek declaratory relief before denying a defense totheir policyholders. They contend that “[i]t is entirelyappropriate for the insurance company to bear the consequences ofits wrongful decision to disclaim coverage by later facing therelated obligation to pay the judgment entered against itspolicyholder.” Brief at p. 12.

If the K2 decision is reaffirmed following reargumentin January, then insurers will be well-advised to consider filing adeclaratory judgment action before disclaiming the duty to defendin New York. Regardless of the outcome, the court's decisionon reargument will affect claims handling in New York for years tocome.

Cozen O'Connor GlobalInsurance Department Attorney Melissa Brillrepresents insurers in first- and third-party insurance coveragelitigation nationwide. Practicing in the firm's New York office,Brill also renders coverage opinions and advises insurers on manyinsurance-related matters.