Tuesday, February 25, 2014

Breach of a Liability Insurer's Duty to Defend Does Not Bar Insurer From Asserting Policy Exclusions to Defend Suit for Indemnification Coverage: New York Court of Appeals Vacates Its K2-I Holding

K2 Investment Grp. LLC v. American Guarantee & Liability Ins. Co.
(Ct. Apps., decided 2/18/2014)

In June 2013 the New York Court of Appeals held, in essence, that if a liability insurer breaches its duty to defend its insured, it may not subsequently assert policy exclusions to deny indemnification coverage.  That decision -- now dubbed K2-I -- sent shockwaves through the insurance industry in New York, with many arguing that the court had upset or ignored its own long-established and controlling precedent on this very question.

The Court of Appeals granted the insurer's motion for reargument and on February 18, 2014 vacated its decision in K2-I and reversed the Appellate Division's order that had affirmed summary judgment in favor of the plaintiffs.

Claims for legal malpractice were brought against American Guarantee's insured, Jeffrey Daniels, which American Guarantee refused to defend. Daniels suffered a default judgment, and then assigned his rights against American Guarantee to the plaintiffs in the suit against him. Those plaintiffs brought this action seeking to enforce American Guarantee's duty to indemnify Daniels for the judgment. In defense, American Guarantee asserted that the loss was not covered, relying on two exclusions in the policy.

The motion court and Appellate Division and Court of Appeals in K2-I held that because American Guarantee had breached its duty to defend Daniels, it was barred from asserting the two policy exclusions in defense of the plaintiffs' claim for indemnification coverage.  That holding appeared to be irreconcilable with the New York Court of Appeals' 1985 holding in Servidone Const. Corp. v Security Ins. Co. of Hartford (64 NY2d 419 [1985]) in which the court unanimously held that a liability insurer's breach of its duty to defend its insured in a personal injury action did not preclude the insurer from asserting policy exclusions to defend itself in a later suit for indemnification coverage.

On reargument, a 4-2 majority of the Court of Appeals  agreed that the Servidone and K2-I holdings cannot be reconciled and declined to overrule Servidone:
Plaintiffs suggest that the cases are distinguishable because in Servidone the insured had settled with the plaintiff in the underlying litigation, whereas here there was a judgment, not a settlement. We do not find the distinction persuasive. A liability insurer's duty to indemnify its insured does not depend on whether the insured settles or loses the case. It is true that a judgment, unlike most settlements, is a binding determination of the issues in the underlying litigation. Thus it can be said here, as it could not in Servidone, that the issues in the suit brought against the insured are now res judicata. But that is irrelevant, because American Guarantee does not seek here, and the defendant in Servidone did not seek, to relitigate the issues in the underlying case. It is well established that such relitigation is not permitted after an insurer has breached its duty to defend (see the authorities discussed in K2-I, 21 NY3d at 390). The issue in Servidone, as here, is whether the insurer may rely on policy exclusions that do not depend on facts established in the underlying litigation.

Plaintiffs also rely, as we did in K2-I, on our decision in Lang v Hanover Ins. Co., 3 NY3d 350, 356 [2004]). We said in Lang that, when an insurer has refused to defend its insured, it "may litigate only the validity of its disclaimer" when it is later sued on a judgment obtained against the insured. But the issue we now face was not presented in Lang. We decided in Lang "that a judgment is a statutory condition precedent to a direct suit against the tortfeasor's insurer" (id. at 352); we did not consider any defense based on policy exclusions. The sentence on which plaintiffs rely was offered as support for our statement 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" (id. at 356). That continues to be sound advice, but Lang should not be read as silently overruling Servidone.

The dissent would read Servidone as being limited to cases in which the defense was "based on noncoverage" rather than "predicated on an exclusion" (dissenting op at 3). It is true, as the dissent says, that we have made such a distinction in cases arising under Insurance Law § 3420, which imposes an obligation of timely disclaimer. It could hardly be clearer, however, that we were not making that distinction in Servidone. Describing the defense asserted by the insurer in that case, we said: "Security responded that, pursuant to an exclusion in the policy, a loss based upon any obligation the insured had assumed by contact was outside coverage" (64 NY2d at 422; emphasis added). Thus, "outside coverage," as Servidone used the term, describes a loss to which a policy exclusion applies.

In short, to decide this case we must either overrule Servidone or follow it. We choose to follow it.

There is much to be said for the rule of K2-I, as our previous opinion shows; but, as the Servidone opinion shows, there is also much to be said for the Servidone rule. Several states follow the Servidone approach (e.g., Sentinel Ins. Co. v First Ins. Co. of Hawai'i, Ltd., 76 Hawaii 277, 290-297, 875 P2d 894, 907-914 [1994]; Polaroid Corp. v Travelers Indemnity Co., 414 Mass 747, 760-766, 610 NE2d 912, 919-923 [1993]), while others adopt a rule like that of K2-I (e.g., Employers Ins. of Wausau v Ehlco Liquidating Trust, 186 Ill2d 127, 150-154, 708 NE2d 1122, 1134-1136 [1999]; Missionaries of Co. of Mary, Inc. v Aetna Cas. and Sur. Co., 155 Conn 104, 112-114, 230 A2d 21, 25-26 [1967]). A federal district judge, writing in 1999, said that "the majority of jurisdictions which have considered the question" follow the Servidone rule (Flannery v Allstate Ins. Co., 49 F Supp 2d 1223, 1227 [D Colo 1999]).

Under these circumstances, we see no justification for overruling Servidone. Plaintiffs have not presented any indication that the Servidone rule has proved unworkable, or caused significant injustice or hardship, since it was adopted in 1985. When our Court decides a question of insurance law, insurers and insureds alike should ordinarily be entitled to assume that the decision will remain unchanged unless or 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.
It is important to note that it remains the rule in New York that a liability which does not defend its insured in an underlying action may not relitigate the issues of that action by relying on policy exclusions that depend on facts established in that underlying action.  But where noncoverage grounds are based on facts not established in the underlying, undefended action, the insurer's breach of its duty to defend will not preclude it from asserting and litigating those noncoverage grounds in an action to recover indemnification coverage.

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