The New York Court of Appeals' recent decision in K2Investment Group, LLC, et al. v American Guarantee & LiabilityInsurance Company¹ may—or may not—be a gamechanger.

First, here is some background on the duties to defend andindemnify in New York. Under New York law, the duty to defendis exceedingly broad.² If the complaint containsany facts or allegations that bring the claim potentially withinthe policy, then the insurer must defend.³ 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.⁴ Evenif a purportedly covered claim is frivolous or groundless, theallegations still trigger the duty to defend.⁵

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.⁶ While factsbeyond the complaint cannot be used to disclaim the duty to defend,they must be taken into account if the insurer has actual knowledgeof facts that, if pled, would trigger its duty todefend.⁷ The duty to indemnify is narrower, arising onlywhere the claim for which the insured is liable falls within thepolicy's coverage.⁸

The K2 Decision

Now, back to the K2 decision. In K2, the Courtof Appeals recently held—in what may be new law—that because aninsurer breached its duty to defend, it could not later rely onotherwise potentially applicable exclusions to deny coverage forindemnification. In other words, an insurer's wrongful failureto defend may mean that the insurer is liable in an amount up toits policy limits, even if a policy exclusion might precludecoverage for indemnification. The unanimous ruling potentiallyexpands insurers' indemnity obligations beyond the coverageafforded 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 backedby mortgages. When the company failed to repay the loans,plaintiffs discovered that the insured's principle, an attorney,never recorded the mortgages. Plaintiffs sued, alleging that theinsured attorney acted as their attorney in regard to the loans andthat his failure to record the mortgage constituted legalmalpractice.

The insured notified his malpractice insurer of the claim, andthe insurer denied coverage for defense and indemnity, sayingthe allegations were not based on the rendering or failing torender legal services for others. The insurer rejectedplaintiffs' $450,000 settlement offer on the same basis. Plaintiffssecured a default judgment in excess of the policy limits. Theinsured attorney assigned to underlying plaintiffs his causes ofaction for breach of contract and bad faith failure to settleagainst the malpractice insurer, resulting in the K2coverage action.

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,the court 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,⁹ in whichthe Court of Appeals held that an insurer's breach of the duty todefend does not create coverage for indemnification.Coincidentally, on the day the K2 decision was issued, theU.S. Court of Appeals for the Second Circuit issued its decision inCGS Industries, Inc. v. Charter Oak Fire InsuranceCompany,¹⁰ citing Servidone, and holdingthat, although an insurer breached the duty to defend, it did notowe the insured indemnification. In CGS Industries, theinsured has sought a rehearing, relying in part on the K2decision.

Before K2, the Court of Appeals' holding in Lang v.Hanover Insurance Company,¹¹ provided the standard:“[H]aving chosen not to participate in the underlying lawsuit, theinsurance carrier may litigate only the validity of its disclaimerand cannot challenge the liability or damages determinationunderlying the judgment.” Under Lang, aninsurer could litigate its disclaimer for indemnification even ifit had breached its duty to defend—unless the issue determinativeof the insurer's duty to indemnify was already decided in theunderlying action for which it failed to provide a defense.

Insureds may argue that the K2 court has expandedLang to preclude any insurer that has breached its duty todefend from litigating its duty to indemnify. In response,insurers may take the position that K2 is consistent withLang, because the apparent expansion was not necessary tothe holding, and is merely dictum. In K2, the claimsagainst the insured attorney included a claim for malpractice inthe representation of the underlying plaintiffs. Although the claimwas likely groundless, it arguably triggered the duty to defend. Itwas on 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 InsuranceCompany,¹² the First Department recently held thatan insurer's breach of its duty to defend does not preclude it fromdenying coverage for indemnity where the insured intentionallyinjured the underlying plaintiff. The K2 court justifiedthe Hough decision on public policy grounds, but statedthat such grounds did not exist in 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 broadly New York courts will apply this new rule, whichwas formed without express consideration of longstandingprecedent.

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.

Footnotes

[1] 2013 WL 2475869, 2013 N.Y.Slip Op. 04270 (N.Y.)

[2] BP A.C. Corp. v. OneBeacon Ins. Grp., 8 N.Y.3d 708, 840 N.Y.S.2d 302 (2007).

[3] Technicon Elecs. Corp.v. Am. Home Assurance Co., 74 N.Y.2d 66, 544 N.Y.S.2d 531(1989).

[4] Allianz Ins. Co. v.Lerner, 416 F.3d 109, 115 (2d Cir. 2005).

[5] Servidone Constr. Corp.v. Security Ins. Co., 64 N.Y.2d 419, 488 N.Y.S.2d 139(1985).

[6] Avondale Indus., Inc.v. Travelers Indem. Co., 774 F. Supp. 1416 (S.D.N.Y.1991).

[7] Fitzpatrick v. Am.Honda Motor Co., 78 N.Y.2d 61, 571 N.Y.S.2d 672 (1991).

[8] Allianz Ins. Co.,supra.

[9] Servidone,supra.

[10] 2013 U.S. App. LEXIS11700 (2d Cir.)

[11] 3 N.Y. 3d 350 (2004).

[12] 940 N.Y.S.2d 41h (1stDept. 2012).