K2: The Court of Appeals Backtracks to Avoid Overturning Well-Settled Precedent

On February 18, 2014, in a split decision (4-2-1), the New York Court of Appeals, in K2 Inv. Group, LLC v American Guaranty & Liability Insurance Company, reiterated the well-settled precedent set forth in Servidone Construction Corp. v. Security Insurance Company of Hartford, 64 N.Y.2d 419 (1985) that an insurer’s denial of defense to its insured will not preclude the assertion of coverage defenses to support said denial in subsequent litigation regarding its duty to indemnify the insured.

As you will recall from our prior June 2013 legal alert, the K2 plaintiffs were two limited liability companies that made loans totaling $2.83 million to Goldan, LLC (“Goldan”), a company owned by the named insured attorney Jeffrey Daniels (“Daniels”), to be secured by mortgages. Upon Goldan’s default in repaying the loans, the K2 plaintiffs discovered that the mortgages had not been recorded, and as a result a legal malpractice action was commenced against Goldan and Daniels. In response to Daniels’ tender of his defense to his legal malpractice carrier, American Guaranty & Liability Insurance Company (“American Guaranty”), a disclaimer of coverage was issued to Daniels based on two policy exclusions. Thereafter, Daniels defaulted and the K2 plaintiffs obtained a default judgment against him for legal malpractice. Daniels then assigned to the K2 plaintiffs all his rights against American Guaranty, and they commenced an action seeking to recover the judgment. In its defense, American Guaranty contended that coverage for the loss to be unavailable due to the application of policy exclusions.

In affirming the lower-court decisions, which created a new rule, the Court of Appeals found an insurer that has breached its duty to defend the insured precluded from raising any coverage defense in subsequent litigation.

American Guaranty sought reconsideration of the June 11, 2013, decision, claiming it was rendered improperly by the Court of Appeals without adequate consideration for the well-settled New York precedent. Absent evidence that the holding of Servidone was unworkable or that since its adoption in 1985 it has resulted in significant injustice or hardship, it remained valid precedent. Thus, the June 11, 2013, decision was vacated and the holding of the Appellate Division reversed.

In reaching its decision, the court disagreed with the plaintiffs’ efforts in distinguishing K2 from Servidone and, further, rejected the plaintiffs’ interpretation of the holding provided by Lang v. Hanover Insurance Company, 3 N.Y.3d 350 (2004). The plaintiffs argued that by breaching its duty to defend its insured, American Guaranty was barred from raising any coverage defenses in the instant coverage action. Contrary to the plaintiffs’ argument, the Court of Appeals found an insurer’s duty to indemnify “does not depend on whether the insurer settles or loses the case.” Rather, an insurer’s coverage defenses will be preserved by the inclusion of the exclusion within the insurance policy itself. It was further argued by the plaintiffs that Lang provided additional support for the overturning of the court’s prior holding in Servidone as it held “an insurance company that disclaims in a situation where coverage may be arguable is well advised to seek a declaratory judgment concerning the duty to defend or indemnify the purported insured.” The Court of Appeals found the holding in Lang to provide nothing more than “sound advice,” which in no way was intended to inhibit an insurer from asserting a coverage defense based upon a policy exclusion.

The Court of Appeals previously refused to address whether there were questions of fact regarding the application of the policy exclusion; however, in light of its recent vacatur, the court has found a question of fact to exist as to whether the malpractice claims arose “in whole or in part” out of the named insured’s status as the manager or out of his “acts or omissions” for the borrower. In line with the Appellate Division’s dissenters, the Court of Appeals has reversed the prior grant of summary judgment to the plaintiffs, finding a question of fact to exist as to the application of the American Guaranty policy exclusion.

The dissenters continue to believe the Appellate Division holding should be affirmed as the holding of Servidone shall have a more restrictive application than that prescribed by the majority. While both the majority and the dissent find a distinction between a defense based upon “noncoverage” as opposed to an “exclusion” for purposes of New York Insurance Law § 3420, which obligates an insurer to timely disclaim coverage. The dissent has found the Servidone holding to provide clarification “that an insurer’s breach of the duty to defend prohibits it from avoiding indemnification on the basis of policy exclusions, but not from demonstrating there was never coverage for the loss in the first instance.” The majority, on the other hand, having found no such distinction to exist, found the term “outside of coverage” to explain a loss to which a policy exclusion applied.cc

In sum, having found Servidone to be the applicable New York standard for coverage disclaimers, the court has disregarded the rule previously articulated by the Appellate Division in this matter. Going forward, as long as a disclaimer is timely, an insurer will not sustain an extra penalty for breach of the duty to defend, and will be permitted to litigate the exclusions in a second action. The Court of Appeals has clarified the holding in Lang to mean that an insurer who disclaims “may litigate only the validity of its disclaimer” shall not be limited to when said disclaimer was made.