NY Court to Insurers: If You Breach Your Duty to Defend, You May Lose Your Defenses to Indemnification

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The New York Court of Appeals, New York’s highest state court, recently held – in what appears to be a new position in New York – that an insurer that breached its duty to defend could not later rely on otherwise applicable exclusions to deny coverage for indemnification.  In other words, an insurer’s wrongful failure to defend may mean the insurer is liable in an amount up to its policy limits, even though a policy exclusion could preclude coverage for indemnification.  The unanimous ruling potentially expands the indemnity obligation beyond the coverage afforded by the policy and, as the court suggests, makes a pre-denial declaratory judgment action an important strategic consideration.

In the underlying dispute that gives rise to K2 Investment Group, LLC v American Guar. & Liab. Ins. Co., 2013 NY Slip Op 4270 (N.Y. 2013), the plaintiffs loaned the insured’s company $2.83 million in loans backed by mortgages.  When the company failed to repay the loans, the plaintiffs discovered that the insured’s principle, an attorney, never recorded the mortgages.  Plaintiffs sued, alleging that the insured attorney acted as their attorney in regard to the loans and that his failure to record the mortgage constituted legal malpractice.  The insured notified its malpractice insurer of the claim, and the insurer denied defense and indemnity, claiming that the allegations were not based on the rendering or failing to render legal services for others.  The insurer then rejected the plaintiffs’ $450,000 settlement offer on the same basis even though it fell well within the policy’s $2 million limit.  Plaintiffs secured a default judgment in excess of the policy limits.  The insured attorney assigned his causes of action for breach of contract and bad faith failure to settle against the malpractice insurer to the underlying plaintiffs, resulting in the current coverage action.

In the coverage action, the insurer moved for summary judgment, arguing that the policy’s “insured status” and “business enterprise” exclusions barred coverage because the claims arose from the insured attorney’s capacity or status as a member and owner of the defaulting company, and from his acts or omissions on the company’s behalf.  The trial court disagreed and granted plaintiffs’ cross motion, holding that the insurer breached its duty to defend the insured attorney, and was obligated to pay the judgment against him up to the policy’s limit. The trial court dismissed the bad faith claims. 

The Appellate Division, First Department, affirmed both rulings, with two judges dissenting on the basis that issues of fact existed regarding the exclusions’ application.

The Court of Appeals affirmed the Appellate Division’s ruling without addressing whether the exclusions applied.  Instead, the court held that by breaching its duty to defend the insured attorney, the malpractice insurer “lost its right to rely on these exclusions in litigation over its indemnity obligation.”

Previously, the Court of Appeals’ holding in Lang v. Hanover Insurance Company, provided the standard: “[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.”  3 N.Y. 3d 350, 356 (2004).  The holding in K2 Investments Group is an apparent expansion of this standard because the court has held that: “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 Investment Group court left open at least one possible exception to its ruling, where indemnification of an insured is against public policy.  In Hough v. USAA Casualty, the First Department recently held that an insurer’s breach of its duty to defend does not preclude it from denying coverage for indemnity where the insured intentionally injured the underlying plaintiff. 93 A.D. 3d 405 (1st Dept. 2012).  The K2 Investment Group court stated that the Hough decision can be justified on public policy grounds, but that such grounds did not exist in the instant matter.

The court also affirmed the dismissal of the bad faith claims.  Noting that the insurer rejected a settlement offer within the policy’s limits, the court held that nothing on the record suggested 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 K2 Investment Group, the court appears to have awarded extracontractual damages – loss of reliance on policy exclusions – without a finding of bad faith. It remains to be seen how broadly New York courts will apply this new rule, which was formed without express consideration of longstanding precedent.1 We will watch for whether the K2 Investment Group decision leads to a motion to reargue.