The Appellate Division, First Department, recently dealt with an issue involving a lawyers’ professional liability policy that could have a wide ranging impact on all insurance coverage disputes.  In K2 Investment Group, LLC, et al. v. American Guarantee & Liability Insurance Company, the court, in essence, ruled that the insurer did not have a right to litigate facts in a declaratory judgment action that pertained to its duty to indemnify when the insurer denied coverage at the outset of the litigation of the underlying action and a default judgment was entered against the insured.

Plaintiffs, a group of lending companies, claimed that the insured, Jeffrey Daniels, failed to record mortgages securing a loan that plaintiffs made to Daniels’ company. The insurer denied coverage under its professional liability policy based on a policy exclusion that barred coverage for losses arising out of 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.  Generally, the position of the insurer 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 seeking the judgment amount.  Plaintiffs then moved for summary judgment, which the trial Court granted.

On appeal, the Appellate Division majority found that the exclusions did not apply because, according to the allegations in the complaint, the insured’s liability did not arise out of his ownership interest in his company but instead in his role as attorney to the plaintiffs/lenders. The insurer argued that there was an issue of fact in respect of this issue.  But the Court held that the insurance company 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 the underlying action.

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.

If this decision stands and is given precedent on this issue, it could impact the way insurers handle disclaimers on the issue of indemnity.  Without sufficient factual proof to withstand a motion for summary judgment at the outset, insurers may need to reserve their rights and wait until underlying lawsuits develop before being able to issue effective indemnity disclaimers.  Otherwise, they risk a default being entered in the underlying action and may lose their only opportunity to establish factual support for their coverage positions.

Thanks to Mendel Simon for his contribution to this post.  If you would like further information, please write to Mike Bono at .