In K2 Investment Group, LLC v. American Guarantee & Liability Insurance Co., No. 6, 2014 N.Y. LEXIS 201 (N.Y. Feb. 18, 2014) (K2-II), the New York Court of Appeals reversed its June 2013 ruling and reaffirmed well-established New York law that a liability insurer who chooses not to defend, even if determined to be wrongful, may still contest its duty to indemnify based on the basic insuring agreement as well as exclusions to coverage.

The underlying lawsuit in K2 involved a questionable legal malpractice claim against the policyholder, which the insurer later conceded on appeal it had wrongfully refused to defend.  Id. at *2.  The policyholder had taken a default judgment and assigned his rights against the insurer to the underlying plaintiffs, who brought a lawsuit against the insurer to enforce the judgment.  Id.  The insurer asserted that two exclusions in its policy precluded coverage for the loss.  Id.  After the Appellate Division held that the plaintiffs were entitled to summary judgment because the exclusions did not apply, the Court of Appeals affirmed on the alternative ground that “the insurer’s breach of the duty to defend barred it from relying on policy exclusions.”  Id. (citing K2 Inv. Grp., LLC v. Am. Guar. & Liab. Ins. Co., 993 N.E.2d 1249 (N.Y. 2013) (K2-I).

The Court of Appeals subsequently granted a request for re-hearing, and in a 4-2 decision vacated its decision in K2-I and reversed the Appellate Division.  In vacating K2-I, the court acknowledged that it had failed to “take account of a controlling precedent,” Servidone Constr. Corp. v. Security Ins. Co. of Hartford, 477 N.E.2d 441 (N.Y. 1985), where it had held that an insurer that had breached its duty to defend was not required to indemnify its policyholder for a reasonable settlement if coverage was disputed.  2014 N.Y. LEXIS 201, at *2-3.  The court recognized that the holding in Servidone could not be reconciled with its ruling in K2-I that “when a liability insurer has breached its duty to defend its insured, the insurer may not later rely on policy exclusions to escape its duty to indemnify the insured for a judgment against him.”  Id. at *3.

The court rejected the plaintiffs’ argument that the entry of a default judgment in K2’s favor distinguished the case from Servidonet, which involved an underlying settlement.  The court reasoned that both cases involved coverage issues independent of the facts established by the outcome of the underlying litigations.  Id. at *3-4.  The court reaffirmed, however, the “well established” principle that “relitigation [of issues resolved by settlement or litigation in the underlying case] is not permitted after an insurer has breached its duty to defend.”  Id. at *4.

The court also declined to rely on Lang v. Hanover Ins. Co., 820 N.E.2d 855 (N.Y. 2004), as it had in K2-I, on the ground that Lang held that “a judgment is a statutory condition precedent to a direct suit against the tortfeasor’s insurer,” and that the court in Lang “did not consider any defense based on policy exclusions.”  Id. at *4 (citation and internal quotes omitted).  Thus, the court warned that “ Lang should not be read as silently overruling Servidone.”  Id. at *5.  The court also rejected the two dissenters’ attempt to limit Servidone to cases where the insurer’s defense is based on noncoverage rather than a policy exclusion.  Id.

The court summed up by stating that “to decide this case we must either overrule Servidone or follow it.  We choose to follow it.”  Id.  The court held that plaintiffs had provided no reason to overrule its precedent, explaining that “[w]hen 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.”  Id. at *6.

By vacating K2-I on these grounds, the Court of Appeals eliminated a great deal of uncertainty within the insurance bar, and returned New York to the majority rule that an insurer that breaches its duty to defend is not estopped from contesting its duty to indemnify a policyholder for an underlying settlement or judgment, so long as the insurer’s indemnity defenses do not seek to relitigate facts determined by the underlying lawsuit.  As before, insurers are strongly advised to consider filing a declaratory judgment action when taking the position that they are not obligated to defend their insureds.  In the words of the court, this “continues to be sound advice.”  Id. at *5.