May a liability insurance carrier that breached its duty to defend thereafter refuse to pay a judgment based upon a policy exclusion?  Answer:  No.

In K2 Investment Group, LLC v. American Guarantee & Liability Insurance Company, 2013 NY Slip Op. 04270 (June 11, 2013), the Court of Appeals held 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 1-2.

Plaintiffs made two mortgage-secured loans totaling $2.83 million to Goldan, LLC.  After Goldan defaulted, plaintiffs learned that the mortgages had not been recorded.  Goldan was subsequently forced into bankruptcy.

According to the Court of Appeals: “Plaintiffs brought a lawsuit against Goldan and two of its principals, Mark Goldman and Jeffrey Daniels, asserting a number of claims.  One claim was asserted by each plaintiff against Daniels, a lawyer, for legal malpractice.  Plaintiffs alleged that Daniels acted as their attorney with respect to their loans to Goldan, and that his failure to record the mortgages was ‘a departure from good and accepted legal practice’.”  Id. at 2.

After receiving notice of the malpractice claim from Daniels, American Guarantee, his malpractice carrier, refused to provide “either defense or indemnity coverage”.  Id. One of the stated reasons for denial of coverage was that “the allegations [of the claims] against Daniels ‘[were] not based on the rendering or [failing] to render legal services for others[.]”  Id.

After this disclaimer was sent, a settlement demand on Daniels was made for $450,000 – significantly less than the $2 million limit of American Guarantee’s policy.  Daniels sent the demand to American Guarantee, which rejected it stating the same reasoning as before.  Id.

Plaintiffs adverse to Daniels subsequently obtained a default judgment on the malpractice claims against Daniels in excess of the $2 million limit.  Daniels thereafter “assigned to plaintiffs all of his rights against American Guarantee and plaintiffs, as Daniels’s assignees, brought the present action against American Guarantee for breach of contract and bad faith for failure to settle the underlying lawsuit.”  Id.

Upon cross motions for summary judgment, the Supreme Court granted Daniels’ breach of contract claims, holding that “American Guarantee breached its duty to defend Daniels, and was therefore bound, up to the $2 million limit of its policy to pay the resulting judgment against him.”  Id. at 3.  The Supreme Court dismissed the bad faith claims, and a divided Appellate Division affirmed.

The Court of Appeals affirmed summary judgment “in plaintiffs’ favor on the breach of contract claims[.]”.  Id. The Court of Appeals held that, “by breaching its duty to defend Daniels, American Guarantee lost its right to rely on [certain policy] exclusions in litigation over its indemnity obligation.”  Id.

The Court of Appeals noted that “it is well settled that an insurance company’s duty to defend is broader than its duty to indemnify” [and that] when an insurer has breached its duty to defend and is called upon to indemnify its insured for a judgment entered against it, the insurer may not assert in its defense grounds that would have defeated the underlying claims against the insured[.]”  Id.

In conclusion the Court of Appeals admonished that “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.”  Id. Explaining the rationale for the decision, the Court of Appeals stated that “this rule will give insurers an incentive to defend the cases they are bound by law to defend, and thus 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”.  Id.