In its February 18, 2014 decision in K2 Investment Group, LLP v. American Guarantee & Liability Ins. Co., New York’s Court of Appeals – New York’s highest court – had occasion to revisit its prior ruling concerning the effect of an insurer’s breach of the duty to defend.
By decision dated June 11, 2013, the Court of Appeals seemingly articulated a new rule regarding the consequences of an insurer’s breach of the duty to defend. K2 Inv. Group, LLC v. American Guar. & Liab. Ins. Co., 21 N.Y.3d 384 (NY 2013). Specifically, the Court held that by having wrongfully denied a defense to its insured under a professional liability policy, American Guarantee “lost its right” to rely on certain policy exclusions for indemnity purposes. Relying on its decision in Lang v. Hanover Ins. Co., 3 N.Y.3d 350 (NY 2004) – a case involving the insurer’s right to contest the insured’s liability for an underlying loss after breaching the duty to defend – the Court explained the new rule as follows:
… we now make clear that Lang, at least as it applies to such situations, means what it says: an insurance company that has disclaimed its duty to defend "may litigate only the validity of its disclaimer." 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 Court justified this rule on fairness grounds, explaining that:
This rule will give insurers an incentive to defend the cases they are bound by law to defend, and thus to give insureds the full benefit of their bargain. It would be unfair to insureds, and would promote unnecessary and wasteful litigation, if an insurer, having wrongfully abandoned its insured's defense, could then require the insured to litigate the effect of policy exclusions on the duty to indemnify.
In so ruling, the K2 Court notably did not cite to its prior decision in Servidone Construction Corp. v. Security Ins. Co., 64 N.Y.2d 419 (NY 1985), wherein the Court held that an insurer’s breach of the duty to defend cannot operate to enlarge a policy’s coverage. Thus, the decision in K2 stood in direct conflict with Servidone.
Following the Court’s June 11, 2013 decision, American Guarantee moved for reargument, primarily on the basis that the Court failed to address the decision in Servidone, and thus created an inconsistency in the case law. The Court granted American Guarantee’s motion for reargument – a relief afforded by the Court of Appeals on only rare occasions – and a second round of oral argument was held on January 7, 2014.
In its February 18, 2014 decision, Judge Robert Smith, writing for a four-judge majority (two judges dissented and one judge abstained) acknowledged that the Court’s June 11, 2013 holding was irreconcilable with its prior decision in Servidone. While the Court reaffirmed its prior holding in Lang that an insurer is not permitted to relitigate issues in the underlying case if it breaches its duty to defend, the Court recognized that this issue is distinct from whether an insurer is permitted to litigate its indemnity obligation subsequent to a wrongful denial of its duty to defend.
In so holding, the Court noted that “[t]here is much to be said for the rule” it articulated in its initial June 11th decision. The Court nevertheless acknowledged that the majority of jurisdictions follow the Servidone rule – the principle exceptions being Illinois and Connecticut. The Court further observed that K2 failed to present “any indication that the Servidone rule has proved unworkable, or caused significant injustice or hardship, since it was adopted in 1985.” Under the circumstances, the Court found it preferable to follow its prior holding in Servidone, explaining:
When our Court decides a question of insurance law, insurers and insureds alike should ordinarily be entitled to assume that the decision will remain unchanged unless or 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.
With this in mind, the Court turned to the application of the policy exclusions, and concluded that these exclusions presented a sufficient question of fact to defeat K2’s underlying motion for summary judgment.
Writing for a two-judge dissent, Judge Victoria Graffeo expressed her belief that an insurer should be penalized for breaching the duty to defend. In her opinion, Servidone should be limited to questions of coverage “in the first instance,” i.e., whether a loss falls within a policy’s insuring agreement. While she agreed that an insurer that breaches a duty to defend should not be made to indemnify a loss not falling within the scope of a policy’s insuring agreement (i.e., “a homeowner's policy would not provide malpractice liability coverage”), she reasoned that this rule should not apply to policy exclusions. As she explained, “[p]rohibiting exclusions from being collaterally invoked provides an insurer with an incentive to appear on behalf of the policyholder in the underlying lawsuit, as it agreed to do in return for the payment of premiums.”
With the Court of Appeals’ decision to vacate its earlier ruling in K2, New York now returns comfortably to the majority rule that acknowledges an insurer's right to contest its indemnity obligation is separate and apart from any issue of its duty to defend.