We previously posted about the potential significance of the K2 Investment Group, LLP v. American Guarantee & Liability Ins. Co. case, and now the Court of Appeals has issued an important ruling that will impact how insurance companies approach the decision whether to disclaim coverage. Previously, if a New York court disagreed with the insurer’s decision not to defend a case, the court still undertook an analysis as to whether the insurer owed indemnification. Now, however, the Court of Appeals has held that “when a liability insurer has breached its duty to defend its insured, the insurer may not later rely on Policy exclusions” to avoid indemnification.
In K2, plaintiffs brought a legal malpractice action against their attorney, Daniels, for his failure to record mortgages. Daniels’ malpractice insurer immediately denied coverage for the lawsuit based on a policy exclusion that barred coverage for Daniels’ acts for a business enterprise in which he had a controlling interest. The insurer contended that Daniels’ liability arose out of his actions to obtain a loan for his own company. The policy also excluded claims arising out of Daniels’ status as a shareholder of a business enterprise. The thrust of the insurer’s argument was that Daniels was not acting as plaintiffs’ attorney, but rather in furtherance of his own company — acts that were excluded from the malpractice policy.
When the insurer failed to pick up Daniels’ defense, the insured defaulted and assigned his rights under the policy to the plaintiffs, who then commenced a declaratory judgment action against the insurer and were awarded summary judgment by the trial court.
The Appellate Division, First Department, issued a split decision affirming the trial court’s denial of the motion. The majority of the appellate panel found that that the exclusions did not apply because, according solely to the allegations in the complaint, the insured’s liability did not arise out of Daniel’s ownership interest in his company but instead in his role as attorney to the plaintiffs/lenders. The First Department held that the insurer did not have a right to litigate this factual issue in the declaratory judgment action because a default judgment had already been entered in the underlying suit due to the insurer’s failure to defend Daniels.
In their dissent, the two dissenting judges argued that the insurer’s duty to indemnify is based on a determination of all applicable facts and because the issue was not litigated in the underlying action, the insurer was entitled to litigate the issue in the DJ action.
Upon review, the Court of Appeals did not even analyze whether the exclusions applied, holding instead that the insurer “lost its right to rely on these exclusions in litigation over its indemnity obligation” because it breached its duty to defend the insured Daniels. The Court’s stated purpose was so that “[t]his rule will give insurers an incentive to defend the cases they are bound by law to defend, and thus to give insureds the full benefit of their bargain.” The Court of Appeals did recognize the possibility of some exceptions, such as where indemnifying the insured would be against public policy (e.g. where the insured is liable for intentional conduct).
Based on this decision, in many circumstances insurers will need to strongly consider agreeing to defend the insured under a reservation of rights and then immediately commence a declaratory judgment action to supports its coverage position. Otherwise, they risk being precluded from asserting policy exclusions that very well may apply to the facts of the loss.
Thanks to Steve Kaye for his contribution to this post. If you would like more information please write to Mike Bono.