K2: Court of Appeals Meant What it Said in Lang — Beware of Letting Insureds Default

On June 11, 2013, in a unanimous decision, the New York Court of Appeals, in K2 Inv. Group, LLC v American Guar. & Liab. Ins. Co., reiterated the rule in New York that where an insurer disclaims defense coverage, relying upon a policy exclusion, and the disclaimer is invalid, the insurer may not rely on the exclusion to dispute indemnity coverage, when the insured defaults in the underlying action.

It is well-settled in New York that disclaimer is unnecessary when a claim falls outside the scope of a policy’s coverage portion, since “requiring payment of a claim upon failure to timely disclaim would create coverage where it never existed.” Matter of Worcester Ins. Co. v. Bettenhauser, 95 N.Y.2d 185, 188 (2000).

But once complaint allegations fall within the scope of a policy’s coverage portion, caution is warranted. In Lang v. Hanover Ins. Co., 3 N.Y.3d 350, 356 (2004), the Court of Appeals noted in dicta that where an insurer wrongly disclaims coverage and a default judgment is rendered against its insured, “having chosen not to participate in the underlying lawsuit, the insurance carrier may litigate only the validity of its disclaimer and cannot challenge the liability or damages determination underlying the judgment.”

The K2 decision now makes clear that the discussion in Lang was more than mere dicta and that the court meant what is said when it limited insurers who have refused to defend their insured, resulting in a default judgment, to litigating the validity of the disclaimer.

The K2 plaintiffs were two limited liability companies that made loans totaling $2.83 million to Goldan, LLC, a company owned by the named insured attorney Jeffrey Daniels. The loans were to be secured by mortgages. When Goldan failed to repay the loans, the K2 plaintiffs discovered that their mortgages had not been recorded. The K2 plaintiffs then sued Goldan and Daniels, as to the latter asserting that Daniels had acted as an attorney for the K2 plaintiffs with respect to the loan transaction and that his failure to record the mortgages was “a departure from good and accepted legal practice.”

When Daniels tendered the defense of the suit to his legal malpractice insurer, American Guaranty, it declined coverage, citing an exclusion for “[c]laims … arising out of … the Insured’s capacity or status as an ‘an officer, director, partner, trustee, shareholder, manager or employee of a business enterprise.'” Daniels defaulted, and the K2 plaintiffs obtained a judgment against him for legal malpractice only. Daniels then assigned to the K2 plaintiffs all his rights against American Guaranty, and they commenced an action seeking to recover the judgment.

Both the trial court and the Appellate Division, First Department, found that the exclusions were inapplicable, although a dissenter in the Appellate Division concluded that issues of fact existed as to whether the exclusions applied. It seems that American Guaranty’s position on appeal was that there were questions of fact regarding the application of the policy exclusion precluding summary judgment in favor of the plaintiffs.

The Court of Appeals rejected the invitation to reach the dispute whether there were questions of fact or not. It reasoned that American Guaranty’s position that there were questions of fact regarding the application of the policy exclusion was tantamount to an admission that it wrongfully disclaimed the duty to defend its insured, and since American Guaranty admitted its disclaimer on the duty to defend was invalid, it was required to indemnify its insured for the underlying judgment.

Practically speaking, we were not surprised by K2 because of the Court’s admonition in Lang. Since Lang, our practice has been to advise insurers to disclaim coverage on the duty to defend only when: (i) the claim falls outside the policy’s coverage portion (without considering exclusions); or (ii) an exclusion clearly applies based upon either the complaint allegations themselves, or undisputed facts. In summary, unless the insurer is confident that, based upon the evidence on hand at the time of the disclaimer, it can win a summary judgment motion on the duty to defend, the insurer should not disclaim coverage.

As a side note, some commentators have suggested that K2 may be drastically changing the law by overruling Servidone Const. Corp. v Sec. Ins. Co. of Hartford, 64 N.Y.2d 419, 423-25(1985), which held that “an insurer’s breach of [its] duty to defend does not create coverage and that, even in cases of negotiated settlements, there can be no duty to indemnify unless there is first a covered loss.”

We are not sure K2 will have such a broad effect. Although the K2 decision is broadly worded, it is not clear that Lang and K2 apply when the insured (or another insurer) defends the underlying action, and there is no default judgment against the insured. In Servidone, the insured did defend the case, and in that situation the Court of Appeals permitted the insurer to litigate whether the settlement payment was for a covered loss. K2 does not explicitly overrule Servidone, and may be simply clarifying the rules in the situation where the insured defaults. This will be an issue to watch.