The New York Court of Appeals rarely hears reargument of its decisions, let alone reverses itself. On February 18, 2014, the Court of Appeals did just that.
Last year, in K2 Inv. Group, LLC v. American Guar. & Liab. Ins. Co.1, (K2-I), the Court of Appeals of New York issued a highly controversial decision — it held that when an insurer breaches its duty to defend, it cannot later rely on policy exclusions to deny coverage for indemnification. Pursuant to K2-I, an insurer’s wrongful failure to defend meant that the insurer may be liable up to its policy limits — even if the policy contains an exclusion that precludes coverage for indemnification.
Then, in a rare reversal, the Court of Appeals issued K2-II2, vacating its prior decision and rejecting the notion of coverage by estoppel. With K2-II, New York reverted to the previous rule, pursuant to which New York insurers that breach the duty to defend will be liable for that breach, but will not be precluded from relying on policy exclusions to deny coverage for indemnification. New York rejoined the majority of states, which reject coverage by estoppel.
The K2 plaintiffs gave another company $2.83 million in loans backed by mortgages. Plaintiffs subsequently discovered, after the company failed to repay the loans, that the borrower’s principal, an attorney, had never recorded the mortgages. Plaintiffs brought suit for malpractice, contending that the attorney had acted as their attorney with respect to the loans, even though he was an owner of the borrower in the transaction.
The attorney notified his malpractice insurer, which denied coverage and rejected the plaintiffs’ settlement demand of $450,000. The insurer denied coverage on the basis that the attorney had not acted as counsel for K2, and thus, did not trigger the malpractice policy. The insurer also relied on policy exclusions for legal malpractice claims arising out of the attorney’s status as owner of the business.
After plaintiffs secured a default judgment in excess of the policy limit, the insured/attorney assigned to plaintiffs his causes of action against his insurer for breach of contract and bad faith failure to settle. Plaintiffs instituted a coverage action.
The trial court granted plaintiffs’ cross motion, holding that the insurer breached its duty to defend the attorney, and found the insurer liable for the judgment against the insured attorney up to the policy limit. The Appellate Division, First Department affirmed the trial court’s rulings. Two judges dissented, arguing that issues of fact existed regarding the exclusions’ application.
The Court of Appeals Decisions
In K2-I, the Court of Appeals affirmed the Appellate Division’s ruling. The court did not address whether the exclusions applied, instead holding that by breaching its duty to defend the insured attorney, the insurer waived its right to rely on policy exclusions in litigation over its indemnity obligation.
In K2-II, the Court of Appeals vacated its decision, reversed the Appellate Decision’s order, and denied plaintiff’s motion for summary judgment. In doing so, the court rejected the notion of coverage by estoppel, concluding that an insurer that breaches its duty to defend is not barred from relying on policy exclusions applicable to its duty to indemnify.
The court held that K2-I could not be reconciled with the court’s oft-cited Servidone decision3, in which the court held that when an insurer breaches its duty to defend, it has not waived coverage defenses applicable to indemnification of an insured’s settlement. The court noted that “in short, to decide this case we must either overrule Servidone or follow it. We choose to follow it.”
The court explained its reasons for preferring Servidone. First, a majority of states follow the Servidone approach. Second, plaintiffs presented no indication that the Servidone rule has “proved unworkable, or caused significant injustice or hardship.” Third, insurers and insureds are entitled to assume that a decision on insurance law will remain intact until the legislature decides otherwise. “In other words, the rule of stare decisis, while it is not inexorable, is strong enough to govern this case.”
Next, the court concluded that the status and enterprise exclusions present an issue of fact sufficient to defeat summary judgment. The court found it possible that the insured attorney had been “serving two masters:” his company and plaintiffs. If that were the case, the claims against him would have arisen partly out of his status as principal of his company, which is precisely the situation the status and enterprise exclusions contemplate. Thus, the court agreed with the Appellate Division dissenters that plaintiffs’ motion for summary judgment should have been denied.
Justice Graffeo dissented, arguing that an insurer should be subject to legal consequences for breaching its duty to defend an insured. Justice Graffeo argued that K2-I should be upheld because it provides insurers with an incentive to defend their policyholders in underlying actions.
The K2-II decision once again places New York squarely within the majority of states that reject coverage by estoppel, and settles months of uncertainty and speculation in the insurance industry.