Insurers Welcome New York Court’s Reversal in K2 Breach Liability Case

February 24, 2014 by Young Ha

Insurance trade groups are welcoming the New York Court of Appeals’ reversal of its June 11, 2013, decision on K2 Investment Group, LLC v. American Guarantee & Liability Insurance Co., a case that has been closely watched by the industry.

Last June, the New York Court of Appeals, the state’s highest court, ruled that when a liability insurer breaches its duty to defend its insured, the insurer may not later rely on policy exclusions to escape its duty to indemnify for a judgment against its insured. The court affirmed the summary judgment in favor of the plaintiffs without reaching the policy exclusions’ applicability.

But on Feb. 18, the Court of Appeals vacated its earlier ruling upon reargument. The court also decided that the applicability of the policy exclusions in this case presents an issue of fact sufficient to defeat summary judgment. The case has been sent to the trial court.

The insured in this case is attorney Jeffrey Daniels, who had malpractice coverage from American Guarantee. In the underlying case, the plaintiffs were two companies that made loans to a third company where American Guarantee’s insured Daniels was a principal. The two companies brought claims for legal malpractice against Daniels, alleging that Daniels represented them in the transaction but that he failed to record mortgages that the borrowing company had to given to plaintiffs.

Court papers show that when claims for legal malpractice were brought against Daniels, American Guarantee — wrongly, it is now conceded — refused to defend. Daniels suffered a default judgment. He then assigned his rights against American Guarantee to the plaintiffs in the lawsuit against him. Those plaintiffs brought the current case against American Guarantee, seeking to enforce American Guarantee’s duty to indemnify Daniels for the judgment.

In defense, American Guarantee asserted that the loss was not covered, relying on two exclusions in the policy, the “insured’s status” and “business enterprise” exclusions. The Court of Appeals ruled in its initial decision last June that American Guarantee’s breach of its duty to defend barred it from relying on policy exclusions. But the Court of Appeals stated this week that after reargument, “we now vacate our prior decision and reverse the Appellate Division’s order.”

A Controlling Precedent

The Court of Appeals said in its Feb. 18 opinion that, “American Guarantee & Liability Insurance Company contends, on reargument, that our prior decision in this case, K2 Inv. Group, LLC v Am. Guar. & Liab. Ins. Co. (21 NY3d 384) (K2-I), erred by failing to take account of a controlling precedent, Servidone Const. Corp. v Security Ins. Co. of Hartford (64 NY2d 419 [1985]).”

“We hold that American Guarantee is correct,” the Court of Appeals said.

The Court of Appeals explained how taking account a controlling precedent, Servidone Const. Corp. v Security Ins. Co. of Hartford, led to reversing its ruling. In Servidone, the court weighed the following question: “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?” The court’s answer was “no” in the Servidone case.

But in the K2 case, the Court of Appeals initially held last June 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.” These different decisions from Servidone and K2 cannot be reconciled, the court said in explaining why it decided to vacate last year’s ruling.

Plaintiffs in the K2 case have argued the cases are distinguishable because in Servidone the insured had settled with the plaintiff in the underlying litigation, whereas in the K2 case, there was a judgment, not a settlement. But, the Court of Appeals said, “We do not find the distinction persuasive. A liability insurer’s duty to indemnify its insured does not depend on whether the insured settles or loses the case.”

The court said, “It is true that a judgment, unlike most settlements, is a binding determination of the issues in the underlying litigation. Thus it can be said here, as it could not in Servidone, that the issues in the suit brought against the insured are now res judicata [“a matter judged”]. But that is irrelevant, because American Guarantee does not seek here, and the defendant in Servidone did not seek, to relitigate the issues in the underlying case.”

It is well established that such relitigation is not permitted after an insurer has breached its duty to defend, the court said. “The issue in Servidone, as here, is whether the insurer may rely on policy exclusions that do not depend on facts established in the underlying litigation.”

“In short, to decide this case we must either overrule Servidone or follow it. We choose to follow it,” the court said. “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.”

And having decided that American Guarantee is not barred from relying on policy exclusions as a defense to this lawsuit, the Court of Appeals also ruled that the applicability of the policy exclusions in this case presents an issue of fact sufficient to defeat summary judgment.

Commenting on the “insured’s status” and “business enterprise” exclusions, the court noted that the insured was one of the two principals of the company that received the loan from the plaintiffs; thus it is fair to infer that he was at least a “manager” of the company, and had a “controlling interest” in it, within the meaning of the policy, the court said.

Groups Welcome Reversal

The New York Insurance Association (NYIA), which had filed an amicus brief to call for a reargument following last year’s decision, announced it was pleased with the Court of Appeals’ latest ruling. This new decision upholds the important principle that an insurance policyholder is entitled to all coverage purchased as part of a policy but no additional coverage, the association said.

NYIA said its amicus brief made the point that an insurance company needs to have the ability to uphold a contract as written. The court decided after the reargument that an insurance company’s failure to defend does not prevent the company from raising legitimate exclusions to coverage, NYIA said.

“If the Court of Appeals had not reversed course and instead stood by its original decision made last year, there would have been great uncertainty in the New York property and casualty insurance market,” NYIA President Ellen Melchionni said. “The reversal keeps New York in line with the predominant rule nationally regarding coverage exclusions. The original decision would have greatly increased litigation costs for the entire New York court system and led to inevitable delays for injured parties.”

“AIA and other trade associations joined together in an amicus brief, and American Guarantee took the lead as the defendant in this case, and we asked for reargument,” NYIA Vice President Marc Craw added. “The Court of Appeals agreed, and after hearing oral arguments, they reversed their first decision and said, ‘Yes, it’s correct that Servidone is still a good law in New York State. Even if you wrongfully denied defense to your policyholder, you are still able as a liability insurer to raise any exclusion.'”

The National Association of Mutual Insurance Companies (NAMIC) also issued a statement welcoming a corrective decision by the New York Court of Appeals maintaining that insurance policy provisions govern the scope of coverage even when a liability insurer wrongfully declines to defend an insured.

NAMIC said it joined with other insurance organizations in filing an amicus brief that urged the court to withdraw its earlier decision. The brief asserted that more than 30 years of New York case law establishes that, while an insurer that wrongfully declines to defend an insured is bound by the facts necessarily decided in the underlying action, the terms of the insurance policy nevertheless determine the scope of coverage.

“Last year’s decision by the New York Court of Appeals was troubling and great cause for concern regarding its potential impact on insurance costs,” commented Paul Tetrault, state and policy affairs counsel for NAMIC. “The court is to be commended for listening to the concerns expressed, agreeing to reconsider the case, and ultimately issuing a corrective decision.” NAMIC said the court has come to recognize that in its first analysis, it failed to take proper account of a previous case which had answered the same essential question addressed in the current case.

The case is K2 Investment Group, LLC v. American Guarantee & Liability Insurance Co., 21 N.Y.3d 384, 387 (N.Y. 2013)., Court of Appeals, State of New York.