Why it matters

Last June New York’s highest court held that a liability insurer that breached its duty to defend is barred from later relying on policy exclusions to deny coverage. The court thereafter agreed to rehear argument in the case based on the insurer’s contention that the original decision failed to take account of prior New York precedent. On rehearing, the court found that its two decisions were irreconcilable and, based on the doctrine of stare decisis, reversed itself. The court thus held that when an insurer breaches the duty to defend, it is not barred from invoking policy exclusions to avoid the duty to indemnify, provided the application of the exclusion does not depend on disputing facts established in the underlying litigation. This rule is consistent with the rule adopted in Hawaii and Massachusetts, but stands in contrast to the rule adopted in Connecticut and Illinois. On that basis, the court determined there was an insufficient basis to reject stare decisis and the prior decision.

Detailed Discussion

Two LLCs made a total of $2.83 million in loans secured by mortgages to a third LLC, which failed to repay the loans. Jeffrey Daniels, a lawyer for the mortgagee, failed to record the mortgages. When the loans went unpaid, one of the companies – K2 Investment Group – filed a malpractice action against Daniels.

Daniels turned to his insurer, American Guaranty and Liability Insurance Company, which refused to provide either defense or indemnity coverage. K2 eventually settled with Daniels for $450,000. He assigned his rights against the insurer to K2, which filed suit against American Guaranty.

The insurer again refused to pay, relying on two policy exclusions concerning “insured’s status” and “business enterprise.” In K2-I, the court had found that because American Guaranty’s refusal to defend was wrongful, the insurer was barred from relying on policy exclusions to avoid indemnifying the policyholder.

American Guaranty moved for rehearing, arguing that the New York high court had already decided the same issue in a 1985 decision, Servidone Const. Corp. v. Security Ins. Co. of Hartford. Specifically, the court framed the issue as “Where an insurer breaches a contractual duty to defend its insured in a personal injury action, and the insured thereafter concludes a reasonable settlement with the injured party, is the insurer liable to indemnify the insured even if coverage is disputed?”

In Servidone, the court answered in the negative. The issue in K2 was the same: whether a legal malpractice insurer that wrongfully breached its duty to defend nevertheless was free to dispute coverage.

“The Servidone and K2-I holdings cannot be reconciled,” the K2-II court concluded.

“[T]o decide this case we must either overrule Servidone or follow it.” In a 4-2 decision, the court elected to follow Servidone. Even though “[t]here is much to be said for the rule of K2-I,” the court found “no justification for overruling Servidone. Plaintiffs have not presented any indication that the Servidone rule has proved unworkable, or caused significant injustice or hardship, since it was adopted in 1985. 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 the process of rendering its decision, the Court of Appeals reaffirmed the settled principle under New York law that when an insurer has breached its duty to defend, it cannot relitigate or second-guess the resolution of the underlying case. Nevertheless, the court remanded for purposes of determining the applicability, as a matter of fact, of the two exclusions.

To read the decision in K2 Investment Group v. American Guaranty & Liability Co., click here.