Rare NY Court of Appeals Reversal

K2, located on the border between Pakistan and China, is the second-highest mountain in the world behind Mount Everest. Despite its secondary status, however, it is commonly regarded as the most dangerous peak to climb. It is perhaps an ironic coincidence, then, that in the widely reported decision K2 Investment Group, LLC v. American Guarantee & Liability Ins. Co., 21 N.Y.3d 384 (2013) (“K2-I“), the New York Court of Appeals placed in the path of insurers a very high and potentially dangerous new legal standard. Specifically, in the K2-I decision, New York's highest court transformed that state's insurance landscape when it held that an insurer who breaches its duty to defend is precluded from later relying on its policy exclusions in litigation over its indemnity obligation.

Less than three months after rendering its decision, however, the Court of Appeals retraced its path and agreed to rehear K2-I. Upon rehearing, the court found that K2-I improperly departed from well-established New York insurance law and could not be reconciled with existing precedent. Thus, in a rare self-reversal, the court has corrected its decision and returned New York insurance law to its previous state of more level ground. As a result, insurers no longer face potentially automatic liability if they breach their duty to defend a policyholder.

Background

K2-I centered on a New York attorney, Jeffrey Daniels, who was also a principal in a limited liability corporation named Goldan, LLC (“Goldan”). The Plaintiffs, comprised of two investor companies (collectively, “K2″), loaned a total of $2.38 million to Goldan under the expectation that the loans would be secured by mortgages. When an insolvent Goldan later failed to repay the loans, the Plaintiffs discovered that the mortgages were never secured or recorded, and that their loans were therefore uncollectable.

In an unusual twist, K2 brought a lawsuit against Daniels, alleging that he had acted as their attorney in the loan transaction ' even though Daniels was part owner of Goldan, the company that was receiving the loans. The Plaintiffs claimed that Daniels' failure to record the mortgages constituted legal malpractice.

Daniels notified his malpractice carrier, American Guarantee, of the malpractice claim. American Guarantee, however, refused to defend or indemnify Daniels, claiming that Daniels never acted as counsel for K2 and, thus, the allegations against Daniels were not based on the “rendering or failure to render legal services for others,” as required for potential coverage under the malpractice policy issued by American Guarantee.

Daniels defaulted in the action against him and K2 obtained a default judgment in excess of the American Guarantee policy's $2 million limit. Daniels subsequently assigned all of his rights against American Guarantee to K2, which, in turn, then brought an action against American Guarantee for breach of contract, seeking to recover the $2 million policy limit. American Guarantee, however, did not deny it breached its duty to defend and instead moved for summary judgment dismissing the complaint.

Relying on two policy exclusions, American Guarantee argued that the Plaintiffs were not entitled to coverage under Daniels' malpractice policy. Specifically, the American Guarantee policy stated, in relevant part:

This policy shall not apply to any Claim based upon or arising out of '

D. the Insured's capacity or status as:

1. an officer, director, partner, trustee, shareholder, manager or employee of a business enterprise '

E. the alleged acts or omissions by any Insured, with or without compensation, for any business enterprise, whether for profit or not-for-profit, in which any Insured has a Controlling Interest.

According to American Guarantee, the malpractice claim against Daniels arose out of his “capacity or status” as an owner of Goldan and out of his “acts or omissions” on Goldan's behalf ' not as a result of any representation of K2.

The trial court, however, found that American Guarantee breached its duty to defend Daniels and was therefore bound to pay the resulting judgment against him. On appeal, the Appellate Division affirmed (with two justices dissenting in part) and held that the exclusions relied upon by American Guarantee were inapplicable to the malpractice claim. The dissent expressed that there were issues of fact as to whether the exclusions actually applied. American Guarantee then appealed to the Court of Appeals pursuant to New York CPLR 5601(a), which provides that an appeal may be taken as of right when at least two justices dissent on a question of law.

K2-I Presents Insurers with Legal Mountain

In affirming the Appellate Division, the Court of Appeals in K2-I declined to address the issue that divided the lower court ' that is, whether the policy's exclusions actually applied to the facts of the case. Instead, the court found that American Guarantee lost its right to rely on the policy exclusions in litigation over its indemnity obligation because it wrongfully breached its duty to defend Daniels. In so ruling, the Court of Appeals overturned established New York law and imposed a drastic penalty on insurers that wrongfully refuse to defend policyholders.

In rendering its decision, the court relied heavily on Lang v. Hanover Ins. Co. , 3 N.Y. 3d 350 (2004), which held that when an insurer declines to defend its insured in an underlying lawsuit, the insurer “may litigate only the validity of its disclaimer and cannot challenge the liability or damages determination underlying the judgment.” The Lang holding, however, only prevents an insurer from challenging those determinations made in an underlying judgment against the insured; it does not apply to the coverage action. In expanding the holding in Lang to the case before it, the court went one giant step further and held that an insurer that wrongfully disclaimed its duty to defend “must indemnify its insured for the resulting judgment, even if policy exclusions would have otherwise negated the duty to indemnify.” K2-I at 391.

Applying such a “coverage by estoppel” approach presented a sharp departure from existing New York law. Prior to K2-I , an insurer that breached its duty to defend may be liable for any defense costs or damages that arise as a result of the insurer's breach. After K2-I , however, an insurer could potentially face automatic liability as punishment for wrongfully refusing to defend its policyholder.

Indeed, citing fairness considerations, the K2-I court explained that it sought to incentivize insurers to defend cases they “are bound by law to defend” and provide insureds with the “full benefit of their bargain.” It is unclear, however, whether the court intended to align New York with the small number of states that recognize coverage by estoppel. Nevertheless, the court left no ambiguity as to its holding, beginning its opinion by explicitly stating 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 387.

K2-II : Servidone Provides Insurer Lifeline

The breadth and magnitude of K2-I engendered a forceful response from the insurance industry. American Guarantee quickly filed a motion for reargument and the court also accepted an amicus brief filed by the Complex Insurance Claims Litigation Association and American Insurance Association. Perhaps recognizing its error, the court granted American Guarantee's motion for reargument ' a motion that it historically grants less than one percent of the time.

On reargument, American Guarantee argued that the court misapplied its decision in Lang and overlooked its decision in Servidone Construction Corp. v. Security Ins. Co. of Hartford, 64 N.Y.2d 419 (1985) (“Servidone “). In Servidone, the Court of Appeals held that when an insurer breaches a contractual duty to defend and the insured thereafter concludes a reasonable settlement, the insurer is not liable to indemnify its insured when coverage is disputed. By contrast, in K2-I, the court held that when a liability insurer breaches its duty to defend, the insurer may not later rely on policy exclusions to escape its duty to indemnify.

In opposition, K2 argued that Servidone involved a case where the policyholder settled with the plaintiff in the underlying litigation, whereas here, there was a judgment, not a settlement ' a distinction the court did not find persuasive. K2 once again relied on Lang ' specifically, its language that states when an insurer refuses to defend its insured, it “may litigate only the validity of its disclaimer” when later sued on a judgment obtained against the insured.

The court ultimately held that it erred by failing to take account of controlling precedent in Servidone when deciding K2-I . K2 Investment Group, LLC v. American Guarantee & Liability Ins. Co., 22 N.Y.3d 578 (2014) (“K2-II “). To that end, the court found that the K2-I and Servidone holdings could not be reconciled. Moreover, the court noted that when deciding Lang , it did not consider any defenses based on policy exclusions. Accordingly, the court reasoned that Lang should not be read in a manner that silently overrules Servidone. Accordingly, rather than overrule Servidone ' which has stood since 1985 ' the court chose to follow it and vacate its decision in K2-I.

In the end, the Plaintiffs' arguments were not strong enough to overcome 30 years of precedent. Applying the rule of stare decisis, the Court of Appeals noted that when it “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 decided otherwise.” K2-II at 587. As a result, insurers who mistakenly and/or wrongfully deny a defense are once again allowed to assert policy exclusions in defenses to coverage for indemnity.

Conclusion

The potential impact of the court's K2-I decision should not be underestimated. Faced with such a departure from established New York insurance law, insurers would have likely been forced to defend significantly more cases simply out of an abundance of caution. At the very least, insurers might have chosen to seek declaratory judgments in any case where the duty to defend was called into question. Fortunately, the Court of Appeals recognized its error and New York once again joins the many states that have adopted the rule espoused in Servidone and that reject the coverage by estoppel approach. Nevertheless, the next legal mountain to climb is potentially only ever a case away.

Daren S. McNally is the Managing Partner, Matthew I. Gennaro is Senior Counsel and John Vieira is an Associate in the New Jersey office of Clyde & Co US LLP. Mr. McNally, a member of this newsletter's Board of Editors, maintains a practice that is intensely focused on insurance coverage litigation and counseling, with an emphasis in complex insurance and reinsurance litigation, trials and arbitrations in both domestic and foreign arenas. Messrs. Gennaro and Vieira focus their practice in the areas of insurance coverage law and litigation.

K2, located on the border between Pakistan and China, is the second-highest mountain in the world behind Mount Everest. Despite its secondary status, however, it is commonly regarded as the most dangerous peak to climb. It is perhaps an ironic coincidence, then, that in the widely reported decision K2 Investment Group, LLC v. American Guarantee & Liability Ins. Co. , 21 N.Y.3d 384 (2013) (“ K2-I “), the New York Court of Appeals placed in the path of insurers a very high and potentially dangerous new legal standard. Specifically, in the K2-I decision, New York's highest court transformed that state's insurance landscape when it held that an insurer who breaches its duty to defend is precluded from later relying on its policy exclusions in litigation over its indemnity obligation.

Less than three months after rendering its decision, however, the Court of Appeals retraced its path and agreed to rehear K2-I. Upon rehearing, the court found that K2-I improperly departed from well-established New York insurance law and could not be reconciled with existing precedent. Thus, in a rare self-reversal, the court has corrected its decision and returned New York insurance law to its previous state of more level ground. As a result, insurers no longer face potentially automatic liability if they breach their duty to defend a policyholder.

Background

K2-I centered on a New York attorney, Jeffrey Daniels, who was also a principal in a limited liability corporation named Goldan, LLC (“Goldan”). The Plaintiffs, comprised of two investor companies (collectively, “K2″), loaned a total of $2.38 million to Goldan under the expectation that the loans would be secured by mortgages. When an insolvent Goldan later failed to repay the loans, the Plaintiffs discovered that the mortgages were never secured or recorded, and that their loans were therefore uncollectable.

In an unusual twist, K2 brought a lawsuit against Daniels, alleging that he had acted as their attorney in the loan transaction ' even though Daniels was part owner of Goldan, the company that was receiving the loans. The Plaintiffs claimed that Daniels' failure to record the mortgages constituted legal malpractice.

Daniels notified his malpractice carrier, American Guarantee, of the malpractice claim. American Guarantee, however, refused to defend or indemnify Daniels, claiming that Daniels never acted as counsel for K2 and, thus, the allegations against Daniels were not based on the “rendering or failure to render legal services for others,” as required for potential coverage under the malpractice policy issued by American Guarantee.

Daniels defaulted in the action against him and K2 obtained a default judgment in excess of the American Guarantee policy's $2 million limit. Daniels subsequently assigned all of his rights against American Guarantee to K2, which, in turn, then brought an action against American Guarantee for breach of contract, seeking to recover the $2 million policy limit. American Guarantee, however, did not deny it breached its duty to defend and instead moved for summary judgment dismissing the complaint.

Relying on two policy exclusions, American Guarantee argued that the Plaintiffs were not entitled to coverage under Daniels' malpractice policy. Specifically, the American Guarantee policy stated, in relevant part:

This policy shall not apply to any Claim based upon or arising out of '

D. the Insured's capacity or status as:

1. an officer, director, partner, trustee, shareholder, manager or employee of a business enterprise '

E. the alleged acts or omissions by any Insured, with or without compensation, for any business enterprise, whether for profit or not-for-profit, in which any Insured has a Controlling Interest.

According to American Guarantee, the malpractice claim against Daniels arose out of his “capacity or status” as an owner of Goldan and out of his “acts or omissions” on Goldan's behalf ' not as a result of any representation of K2.

The trial court, however, found that American Guarantee breached its duty to defend Daniels and was therefore bound to pay the resulting judgment against him. On appeal, the Appellate Division affirmed (with two justices dissenting in part) and held that the exclusions relied upon by American Guarantee were inapplicable to the malpractice claim. The dissent expressed that there were issues of fact as to whether the exclusions actually applied. American Guarantee then appealed to the Court of Appeals pursuant to New York CPLR 5601(a), which provides that an appeal may be taken as of right when at least two justices dissent on a question of law.

K2-I Presents Insurers with Legal Mountain

In affirming the Appellate Division, the Court of Appeals in K2-I declined to address the issue that divided the lower court ' that is, whether the policy's exclusions actually applied to the facts of the case. Instead, the court found that American Guarantee lost its right to rely on the policy exclusions in litigation over its indemnity obligation because it wrongfully breached its duty to defend Daniels. In so ruling, the Court of Appeals overturned established New York law and imposed a drastic penalty on insurers that wrongfully refuse to defend policyholders.

In rendering its decision, the court relied heavily on Lang v. Hanover Ins. Co. , 3 N.Y. 3d 350 (2004), which held that when an insurer declines to defend its insured in an underlying lawsuit, the insurer “may litigate only the validity of its disclaimer and cannot challenge the liability or damages determination underlying the judgment.” The Lang holding, however, only prevents an insurer from challenging those determinations made in an underlying judgment against the insured; it does not apply to the coverage action. In expanding the holding in Lang to the case before it, the court went one giant step further and held that an insurer that wrongfully disclaimed its duty to defend “must indemnify its insured for the resulting judgment, even if policy exclusions would have otherwise negated the duty to indemnify.” K2-I at 391.

Applying such a “coverage by estoppel” approach presented a sharp departure from existing New York law. Prior to K2-I , an insurer that breached its duty to defend may be liable for any defense costs or damages that arise as a result of the insurer's breach. After K2-I , however, an insurer could potentially face automatic liability as punishment for wrongfully refusing to defend its policyholder.

Indeed, citing fairness considerations, the K2-I court explained that it sought to incentivize insurers to defend cases they “are bound by law to defend” and provide insureds with the “full benefit of their bargain.” It is unclear, however, whether the court intended to align New York with the small number of states that recognize coverage by estoppel. Nevertheless, the court left no ambiguity as to its holding, beginning its opinion by explicitly stating 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 387.

K2-II : Servidone Provides Insurer Lifeline

The breadth and magnitude of K2-I engendered a forceful response from the insurance industry. American Guarantee quickly filed a motion for reargument and the court also accepted an amicus brief filed by the Complex Insurance Claims Litigation Association and American Insurance Association. Perhaps recognizing its error, the court granted American Guarantee's motion for reargument ' a motion that it historically grants less than one percent of the time.

On reargument, American Guarantee argued that the court misapplied its decision in Lang and overlooked its decision in Servidone Construction Corp. v. Security Ins. Co. of Hartford , 64 N.Y.2d 419 (1985) (“ Servidone “). In Servidone, the Court of Appeals held that when an insurer breaches a contractual duty to defend and the insured thereafter concludes a reasonable settlement, the insurer is not liable to indemnify its insured when coverage is disputed. By contrast, in K2-I, the court held that when a liability insurer breaches its duty to defend, the insurer may not later rely on policy exclusions to escape its duty to indemnify.

In opposition, K2 argued that Servidone involved a case where the policyholder settled with the plaintiff in the underlying litigation, whereas here, there was a judgment, not a settlement ' a distinction the court did not find persuasive. K2 once again relied on Lang ' specifically, its language that states when an insurer refuses to defend its insured, it “may litigate only the validity of its disclaimer” when later sued on a judgment obtained against the insured.

The court ultimately held that it erred by failing to take account of controlling precedent in Servidone when deciding K2-I . K2 Investment Group, LLC v. American Guarantee & Liability Ins. Co. , 22 N.Y.3d 578 (2014) (“ K2-II “). To that end, the court found that the K2-I and Servidone holdings could not be reconciled. Moreover, the court noted that when deciding Lang , it did not consider any defenses based on policy exclusions. Accordingly, the court reasoned that Lang should not be read in a manner that silently overrules Servidone. Accordingly, rather than overrule Servidone ' which has stood since 1985 ' the court chose to follow it and vacate its decision in K2-I.

In the end, the Plaintiffs' arguments were not strong enough to overcome 30 years of precedent. Applying the rule of stare decisis, the Court of Appeals noted that when it “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 decided otherwise.” K2-II at 587. As a result, insurers who mistakenly and/or wrongfully deny a defense are once again allowed to assert policy exclusions in defenses to coverage for indemnity.

Conclusion

The potential impact of the court's K2-I decision should not be underestimated. Faced with such a departure from established New York insurance law, insurers would have likely been forced to defend significantly more cases simply out of an abundance of caution. At the very least, insurers might have chosen to seek declaratory judgments in any case where the duty to defend was called into question. Fortunately, the Court of Appeals recognized its error and New York once again joins the many states that have adopted the rule espoused in Servidone and that reject the coverage by estoppel approach. Nevertheless, the next legal mountain to climb is potentially only ever a case away.

Daren S. McNally is the Managing Partner, Matthew I. Gennaro is Senior Counsel and John Vieira is an Associate in the New Jersey office of Clyde & Co US LLP. Mr. McNally, a member of this newsletter's Board of Editors, maintains a practice that is intensely focused on insurance coverage litigation and counseling, with an emphasis in complex insurance and reinsurance litigation, trials and arbitrations in both domestic and foreign arenas. Messrs. Gennaro and Vieira focus their practice in the areas of insurance coverage law and litigation.