The New York Court of Appeals grants reargument in less than 1%of cases and reverses itself even more rarely. On Feb. 18, 2014,the Court of Appeals did just that.

In 2013, in K2 Inv.Group, LLC v. American Guar. & Liab. Ins.Co.^[1], (K2-I), the Court of Appeals of New Yorkissued a controversial decision, unanimously holding that becausean insurer breached its duty to defend, it could not later rely onotherwise potentially applicable exclusions to deny coverage forindemnification. K2-I appeared to adopt the minority “coverage by estoppel” rule, which provides that when aninsurer wrongfully fails to defend, that insurer may be liable inan amount up to its policy limits—even if the policy contains anexclusion that would otherwise preclude coverage forindemnification. This holding represented a drastic deviation fromNew York's well-established insurance law jurisprudence. Needlessto say, the insurance industry was shocked and concerned. Reargument followed.

In a rare reversal, the Court of Appeals issuedK2-II^[2], vacating its prior decision and rejecting thenotion of coverage by estoppel. With K2-II, New York reverted tothe previous rule, pursuant to which New York insurers that breachthe duty to defend will be liable for that breach, but will not beprecluded from relying on policy exclusions to deny coverage forindemnification. New York rejoined the majority of states, whichreject coverage by estoppel.

Some background is helpful for understanding the issue. The K2plaintiffs gave Goldan, LLC, a real estate company, $2.83 millionin loans backed by mortgages. After the company failed torepay the loans, plaintiffs discovered that Goldan's principal,attorney Jeffrey Daniels, had never recorded the mortgages. Plaintiffs sued Daniels for legal malpractice, asserting that hehad acted as plaintiff's attorney with respect to the loans. Thus,plaintiffs alleged, Daniel's failure to record the mortgagesconstituted legal malpractice.

American Guarantee & Liability Insurance Company had issueda professional malpractice insurance policy to Daniels. Danielsnotified his malpractice insurer of the claim, and the insurerdenied defense and indemnity on the grounds that Daniels had notacted as counsel for Plaintiffs and, therefore, his actions did nottrigger the malpractice policy. On these grounds, the insurerrejected Plaintiffs' $450,000 settlement offer—an offer that fellwith the policy's $2 million limit.

Plaintiffs secured a default judgment against Daniels in excessof the policy limit, and Daniels then assigned to Plaintiffs hiscauses of action against the insurer for breach of contract and badfaith failure to settle. Plaintiffs instituted a coverage action,and the insurer moved for summary judgment, arguing that thepolicy's “insured status” and “business enterprise” exclusionsbarred coverage. The insurer contended that because the claimsarose from the insured attorney's capacity or status as a memberand owner of Goldan, and from his acts or omissions on Goldan'sbehalf, they were excluded from coverage under the policy.

The trial court granted Plaintiffs' cross motion, holding thatthe insurer breached its duty to defend Daniels and was obligatedto pay the judgment against the attorney up to the policy limit.The trial court dismissed the bad faith claims, and the AppellateDivision, First Department affirmed both of the trial court'srulings. Two Appellate Division judges dissented, contending thatissues of fact existed regarding the exclusions' application.

The Court of Appeals affirmed the Appellate Division's holdingin K2-I. The court did not address whether the exclusions applied.Rather, it held that by breaching its duty to defend Daniels, theinsurer “lost its right to rely on these exclusions in litigationover its indemnity obligation.” The court relied on itsdecision in Lang v.Hanover Insurance Co.[3], but, in fact, seemed to expand thescope of that holding. In Lang, the court stated“[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.” The Lang holding precluded insurersfrom challenging only those determinations underlying a judgmentagainst the insured. The K2-I court went further, concluding, “Ifthe disclaimer is found bad, the insurance company must indemnifyits insured for the resulting judgment, even if policy exclusionswould otherwise have negated the duty to indemnify.”

The K2-I court then affirmed the dismissal of the bad faithclaims. While the insurer rejected a settlement offer within thepolicy limits, nothing on the record indicated that the insurer“engaged in a pattern of behavior evincing a conscious or knowingindifference to the probability that an insured would be heldpersonally accountable for a large judgment if a settlement offerwithin the policy limits were not accepted.”

In September 2013, the Court of Appeals granted the insurer'sMotion for Reargument. This rare move garnered substantialattention from the insurance industry; the court received numerousamicus briefs. Those challenging the K2-I decision contended thatthe rule of coverage by estoppel contravenes fundamental contractlaw principles because it provides insureds with more coverage thanthey bargained for. Those supporting the K2-I decision argued thatthe rule provides insurers much-needed incentive to provide adefense to their insureds.

On Feb. 18, 2014, following reargument, the Court of Appealsissued a second opinion, K2-II, vacating its prior decision. InK2-II, the court rejected the notion of coverage by estoppel andallowed the insurer to rely on policy exclusions even though it hadbreached its duty to defend its insured.

The court recognized that the K2-I decision could not bereconciled with its oft-cited decision in Servidone Const. Corp. v. SecurityIns. Co. of Hartford,^[4] in which the court heldthat when an insurer breaches its duty to defend, it has not waivedcoverage defenses applicable to indemnification of a settlementreached by the insured. The court also clarified that Lang should not be read tosilently overrule Servidone. The court noted that“in short, to decide this case we must either overrule Servidone or follow it. Wechoose to follow it.”

The court then explained its reasons for preferring theServidone rule.First, a majority of states follow the Servidone approach, includingHawaii and Massachusetts. Second, Plaintiffs presented noevidence that the Servidone rule has “provedunworkable, or caused significant injustice or hardship, since itwas adopted in 1985.” Furthermore, insurers and insureds areentitled to assume that a decision on insurance law will remainintact until the legislature decides otherwise—“In other words, therule of stare decisis, while it is not inexorable, is strong enoughto govern this case.”

The court next held that the status and enterprise exclusionspresented an issue of fact sufficient to defeat summary judgment.Because it was possible that the insured attorney had been “servingtwo masters:” his company and Plaintiffs, the claims against himmay have arisen partly out of his status as principal of hiscompany—the precise situation the status and enterprise exclusionscontemplate. Therefore, the court sided with the Appellate Divisiondissenters and concluded that the lower court should have deniedPlaintiffs' motion for summary judgment.

One justice dissented, arguing that an insurer should be subjectto legal consequences for breaching its duty to defend an insured.The lone dissenter, Justice Graffeo, contended that K2-I providesan insurer with an incentive to defend that policyholder in theunderlying lawsuit. Justice Graffeo further argued thatServidonereconciles with the K2-I decision and that the insurer should beobligated to pay the judgment entered against its policyholder.

The K2-II holding is an insurance-friendly decision that onceagain places New York within the majority of states rejectingcoverage by estoppel. It is now clear that New York insurers thatare found to have breached the duty to defend can nonetheless relyon policy exclusions to deny coverage for indemnification.

Melissa Brill is a Partner in Cozen O'Connor's GlobalInsurance Department.

[1] 21 N.Y.3d 384 (N.Y. 2013).

[2] K2 Inv. Group, LLC v. American Guar. & Liab. Ins. Co.,No. 6, 2014 NY Slip Op 1102(U), 2014 N.Y. LEXIS 201 (N.Y. Feb. 18,2014).

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

[4] 64 N.Y.2d 419 (1985).