New York Court of Appeals Holds Insurers Cannot Rely on Policy Exclusions to Escape Coverage Duties

In K2 Investment v. American Guarantee, 2013 WL 2475869 (N.Y. Ct. App. June 11, 2013), the Court of Appeals of New York, relying on dicta in its prior decision in Lang v. Hanover Insurance Co., 3 N.Y. 3d 350, 356 (2004), held that when an insurance company wrongfully refuses to provide a defense to its insured, it cannot later rely on an exclusion in the policy to avoid its indemnity obligations even if it is established in the underlying action that the exclusion is applicable.

In K2 Investment, the plaintiffs brought a legal malpractice lawsuit against Jeffrey Daniels. Daniels’ malpractice carrier, American Guarantee, refused to provide Daniels with a defense, contending that Daniels was not covered for the allegations in the lawsuit against him. After this disclaimer, the plaintiffs made a settlement demand on Daniels for $450,000 — significantly less than the $2 million limit of American Guarantee’s policy. Daniels transmitted the demand to American Guarantee, which rejected it for the reasons that it had previously given for denying coverage. Daniels then defaulted in the lawsuit, and the plaintiffs obtained a default judgment against him in excess of the policy’s limit.

Daniels then assigned to the plaintiffs all of his rights against American Guarantee. The plaintiffs brought two claims against American Guarantee: breach of contract and bad faith failure to settle the underlying lawsuit for $450,000. The parties made cross-motions for summary judgment, with American Guarantee relying on certain policy exclusions under the policy. The trial court and Appellate Division held that American Guarantee had breached its duty to defend, but that it was not liable for bad faith.

The Court of Appeals affirmed. It began by citing the general rule that an insurance company’s duty to defend is broader than its duty to indemnify. In other words, where any of the allegations of a complaint fall within the insuring agreement of the policy, and not all of the claims are clearly excluded, even where those claims are groundless, false, or baseless (e.g., contradicted by extrinsic evidence), the insurer must nevertheless defend its insured. Here, American Guarantee had a duty to defend Daniels because the legal malpractice claim triggered the insurer’s defense obligations under the policy.

The Court relied upon dicta set forth in the penultimate paragraph of its prior decision in Lang v. Hanover Insurance Co., supra. Lang involved the issue of whether an injured claimant could bring a direct action against an insured’s insurance company. The Court in Lang held that, under NY Insurance Law § 3420, the claimant must first obtain a judgment against the insured, serve it upon the insured and his insurance company, and not receive payment within 30 days after serving notice of entry of the judgment before commencing an action directly against the insurer. In closing, the Lang Court stated in dicta, without citing to any authority, in part, as follows:

Finally, we note that 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. * * * (H)aving 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.

Lang, 3 N.Y. 3d at 356.

The K2 Investment Court relied upon this dicta in Lang as the basis for its holding:

While Lang did not involve a situation like the one we have here, we now make clear that Lang, at least as it applies to such situations, means what it says: an insurance company that has disclaimed its duty to defend “may litigate only the validity of its disclaimer.” If the disclaimer is found bad, the insurance company must indemnify its insured for the resulting judgment, even if policy exclusions would otherwise have negated the duty to indemnify. This 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. It would be unfair to insureds, and would promote unnecessary and wasteful litigation, if an insurer, having wrongfully abandoned its insured’s defense, could then require the insured to litigate the effect of policy exclusions on the duty to indemnify.

K2 Investment, 2013 WL 2475869, Section II (page numbers not yet available).

Moreover, in dicta, the K2 Investment Court vaguely left open the possibility of exceptions to the foregoing rule:

Perhaps there are exceptions to the rule that we stated in Lang and now reaffirm. Thus, we do not necessarily reject (though we do not necessarily endorse) the decision of the Appellate Division in Hough v. USAA Cas. Ins. Co. (93 A.D.3d 405, 940 N.Y.S.2d 41 [1st Dept. 2012] ). There, the court held that an insurer’s “disclaimer of its duty to defend its insured in the underlying action does not bar it from asserting that its insured injured plaintiff intentionally.” The Hough decision could arguably be justified on the ground that insurance for one’s own intentional wrongdoing is contrary to public policy (see Messersmith v. American Fid. Co., 232 N.Y. 161, 165 [1921]).

Id.

The K2 Investment Court concluded that the bad faith claims against American Guarantee had been properly dismissed, as the plaintiffs had not alleged any facts showing that the “insurer had engaged in a pattern of behavior evincing a conscious or knowing indifference to the probability that an insured would be held personally accountable for a large judgment if a settlement offer within the policy limits were not accepted.” Id., Section III (quoting Pavia v. State Farm Mutual Automobile Insurance Co., 82 N.Y. 2d 445, 453–54 [1993]). Therefore, American Guarantee was not held liable for the judgment in excess of the policy limit of $2 million. The Court stated, again in dicta, that for an insurer to be held liable in excess of policy limits for failing to defend its insured, “(s)uch a claim would require the insured to show, at a minimum, that the judgment against him would not have been entered if the insurer had defended the case.” Id. No such facts, however, were alleged here.

The New York Court of Appeal’s decision in K2 Investment is important for insureds and insurers. For insureds, if an insurer wrongly denies its duty to defend, the insured may be entitled to indemnity coverage in a situation where, under the true facts, it should not have such coverage. Conversely, insurers must be certain that the allegations of the complaint do not potentially trigger coverage, as an error in this regard may render them liable for a judgment that should have been excluded by the policy. Arent Fox LLP, with offices in Los Angeles, New York, San Francisco, and Washington, DC, is well placed to assist its clients in understanding the details of their coverage rights under such circumstances.

Feel free to contact Elliott M. Kroll, Julius A. Rousseau, III, Michael S. Cryan, or James M. Westerlind from Arent Fox’s Complex Litigation and Insurance & Reinsurance practice groups to further discuss this decision or any of the issues raised therein.