K2: New York Court of Appeals Vacates Decision, Rejects 'Coverage by Estoppel'

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 York issued a controversial decision, unanimously holding that because an insurer breached its duty to defend, it could not later rely on otherwise potentially applicable exclusions to deny coverage for indemnification. K2-I appeared to adopt the minority “coverage by estoppel” rule, which provides that when an insurer wrongfully fails to defend, that insurer may be liable in an amount up to its policy limits—even if the policy contains an exclusion that would otherwise preclude coverage for indemnification. This holding represented a drastic deviation from New York's well-established insurance law jurisprudence. Needless to say, the insurance industry was shocked and concerned.  Reargument followed.

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

Some background is helpful for understanding the issue. The K2 plaintiffs gave Goldan, LLC, a real estate company, $2.83 million in loans backed by mortgages.  After the company failed to repay the loans, plaintiffs discovered that Goldan's principal, attorney Jeffrey Daniels, had never recorded the mortgages.  Plaintiffs sued Daniels for legal malpractice, asserting that he had acted as plaintiff's attorney with respect to the loans. Thus, plaintiffs alleged, Daniel's failure to record the mortgages constituted legal malpractice.

American Guarantee & Liability Insurance Company had issued a professional malpractice insurance policy to Daniels. Daniels notified his malpractice insurer of the claim, and the insurer denied defense and indemnity on the grounds that Daniels had not acted as counsel for Plaintiffs and, therefore, his actions did not trigger the malpractice policy. On these grounds, the insurer rejected Plaintiffs' $450,000 settlement offer—an offer that fell with the policy's $2 million limit.

Plaintiffs secured a default judgment against Daniels in excess of the policy limit, and Daniels then assigned to Plaintiffs his causes of action against the insurer for breach of contract and bad faith failure to settle. Plaintiffs instituted a coverage action, and the insurer moved for summary judgment, arguing that the policy's “insured status” and “business enterprise” exclusions barred coverage. The insurer contended that because the claims arose from the insured attorney's capacity or status as a member and owner of Goldan, and from his acts or omissions on Goldan's behalf, they were excluded from coverage under the policy.

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

The Court of Appeals affirmed the Appellate Division's holding in K2-I. The court did not address whether the exclusions applied. Rather, it held that by breaching its duty to defend Daniels, the insurer “lost its right to rely on these exclusions in litigation over its indemnity obligation.”  The court relied on its decision in Lang v. Hanover Insurance Co.[3], but, in fact, seemed to expand the scope of that holding. In Lang, the court stated “[H]aving chosen not to participate in the underlying lawsuit, the insurance carrier may litigate only the validity of its disclaimer and cannot challenge the liability or damages determination underlying the judgment.” The Lang holding precluded insurers from challenging only those determinations underlying a judgment against the insured. The K2-I court went further, concluding, “If the disclaimer is found bad, the insurance company must indemnify its insured for the resulting judgment, even if policy exclusions would otherwise have negated the duty to indemnify.”

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

In September 2013, the Court of Appeals granted the insurer's Motion for Reargument.  This rare move garnered substantial attention from the insurance industry; the court received numerous amicus briefs. Those challenging the K2-I decision contended that the rule of coverage by estoppel contravenes fundamental contract law principles because it provides insureds with more coverage than they bargained for. Those supporting the K2-I decision argued that the rule provides insurers much-needed incentive to provide a defense to their insureds.

On Feb. 18, 2014, following reargument, the Court of Appeals issued a second opinion, K2-II, vacating its prior decision. In K2-II, the court rejected the notion of coverage by estoppel and allowed the insurer to rely on policy exclusions even though it had breached its duty to defend its insured.

The court recognized that the K2-I decision could not be reconciled with its oft-cited decision in Servidone Const. Corp. v. Security Ins. Co. of Hartford,^[4] in which the court held that when an insurer breaches its duty to defend, it has not waived coverage defenses applicable to indemnification of a settlement reached by the insured. The court also clarified that Lang should not be read to silently overrule Servidone. The court noted that “in short, to decide this case we must either overrule Servidone or follow it. We choose to follow it.”

The court then explained its reasons for preferring the Servidone rule. First, a majority of states follow the Servidone approach, including Hawaii and Massachusetts.  Second, Plaintiffs presented no evidence that the Servidone rule has “proved unworkable, or caused significant injustice or hardship, since it was adopted in 1985.” Furthermore, insurers and insureds are entitled to assume that a decision on insurance law will remain intact until the legislature decides otherwise—“In other words, the rule of stare decisis, while it is not inexorable, is strong enough to govern this case.”   

The court next held that the status and enterprise exclusions presented an issue of fact sufficient to defeat summary judgment. Because it was possible that the insured attorney had been “serving two masters:” his company and Plaintiffs, the claims against him may have arisen partly out of his status as principal of his company—the precise situation the status and enterprise exclusions contemplate. Therefore, the court sided with the Appellate Division dissenters and concluded that the lower court should have denied Plaintiffs' motion for summary judgment.

One justice dissented, arguing that an insurer should be subject to legal consequences for breaching its duty to defend an insured. The lone dissenter, Justice Graffeo, contended that K2-I provides an insurer with an incentive to defend that policyholder in the underlying lawsuit. Justice Graffeo further argued that Servidone reconciles with the K2-I decision and that the insurer should be obligated to pay the judgment entered against its policyholder.

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

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