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Insurer’s Wrongful Failure to Defend Lawyer Doesn’t Make Policy Exclusions Inapplicable

Wednesday, February 26, 2014

By Samson Habte  

Feb. 18 --The New York Court of Appeals Feb. 18 said that it erred when it held last year that an insurer that wrongly refused to defend an attorney against a malpractice claim was prohibited from subsequently invoking potentially applicable policy exclusions to escape its corollary duty to indemnify the lawyer against the losses he suffered when the malpractice case was litigated without the insurer's participation (K2 Inv. Grp., LLC v. Am. Guarantee & Liab. Ins. Co., 2014 BL 41350, N.Y., No. 6, 2/18/14, on reconsideration in 29 Law. Man. Prof. Conduct 402).

In the earlier opinion, the court held that when a liability carrier refuses to defend a policyholder and that “disclaimer is found bad, the insurance company must indemnify [the] insured for the resulting judgment, even if policy exclusions would otherwise have negated the duty to indemnify.”

Writing for a 4-2 majority, Judge Robert S. Smith said the earlier holding failed to “take account of a controlling precedent” and must be vacated.

Accordingly, the court reversed a summary judgment ruling against an insurance carrier that was sued by a lawyer's assignee after the insurer refused to defend him in a malpractice action on grounds that the claims related to the attorney's business dealings and thus were excluded from coverage under his policy.

Two dissenting judges said the court got it right the first time and should stick to that ruling.

Twice Denied

Attorney Jeffrey Daniels co-owned a real estate company, Goldan LLC, that received $2.8 million in loans from K2 Investment Group LLC. K2 claimed that Daniels acted as its attorney during loan negotiations, even though his status as a Goldan principal also put him on the other side of the transaction.

K2 further alleged that the loans were to be secured by mortgages on property, but that Daniels failed to record those mortgages or obtain title insurance, rendering the loans unsecured. Goldan subsequently became insolvent, and K2, unable to recoup its money, sued Daniels for malpractice.

American Guarantee & Liability Insurance Co. refused to defend Daniels. The carrier said the claims against Daniels were “not based on rendering or failing to render legal services for others,” and thus were excluded from coverage under an “insured's status” clause and a “business enterprise” clause in his policy. The carrier cited the same exclusions in rejecting an offer to settle the claims for $450,000.

After Daniels failed to appear in the malpractice action, a default judgment of $3 million was entered in favor of K2. Daniels satisfied the debt by assigning his claims against American Guarantee to K2, which filed a lawsuit seeking to collect the default judgment and accusing the carrier of breach of contract and bad faith failure to settle the underlying lawsuit.

In moving for summary judgment American Guarantee argued that the exclusions in Daniels's policy relieved the carrier of its duty to indemnify him.

A trial court and divided appellate panel held that American Guarantee breached its duty to defend Daniels, and therefore was bound to pay the resulting judgment up to the $2 million limit of its policy.

The Court of Appeals affirmed in K2 Inv. Grp., LLC v. Am. Guarantee & Liab. Ins. Co., 993 N.E.2d 1249, 29 Law. Man. Prof. Conduct 402 (N.Y. 2013) (“K2-1”). “We hold that, by breaching its duty to defend Daniels, American Guarantee lost its right to rely on these exclusions in litigation over its indemnity obligation,” it held.

Oops

American Guarantee moved for reargument, contending that the June 2013 decision erred in failing to take account of a controlling precedent, Servidone Constr. Corp. v. Sec. Ins. Co. of Hartford, 477 N.E.2d 441 (N.Y. 1985). The court agreed.

The Servidone court considered the following question: “Where an insurer breaches a contractual duty to defend its insured in a personal injury action, and the insured thereafter concludes a reasonable settlement with the injured party, is the insurer liable to indemnify the insured even if coverage is disputed?”

The court answered “no.” But in K2-1, the court held that “when a liability insurer has breached its duty to defend its insured, the insurer may not later rely on policy exclusions to escape its duty to indemnify the insured for a judgment against him.”

Those holdings “cannot be reconciled,” Smith said.

The majority rejected the contention that the cases are distinguishable on the basis that in Servidone the insured had settled the underlying litigation, whereas here there was a judgment. “A liability insurer's duty to indemnify its insured does not depend on whether the insured settles or loses the case,” Smith explained.

The plaintiffs also relied on Lang v. Hanover Ins. Co., 820 N.E.2d 855 (N.Y. 2004), which held that insurers that totally disclaim coverage and leave a policyholder to defend himself “may litigate only the validity of its disclaimer” when later sued on a judgment obtained against the insured.

But Lang did not overrule Servidone, the court said. Nor did it compel the conclusion in K2-1 that when an insurer wrongly disclaims the duty to defend, it forfeits the right to invoke potentially applicable policy exclusions to escape its narrower duty to indemnify.

On Remand, Consider Exclusions

Although some states follow the K2-1 rule, the court said, the majority of jurisdictions follow the Servidone rule. “Under these circumstances, we see no justification for overruling Servidone,” the majority concluded.

Having decided that American Guarantee is not barred from invoking policy exclusions as a defense to K2's action, the court addressed “whether the applicability of the exclusions it relies on presents an issue of fact sufficient to defeat summary judgment.”

“We conclude that it does,” Smith wrote.

“Because the malpractice case [against Daniels] was resolved on default, the record tells us little about the substance of the claims,” the court acknowledged. “[I]t is at least possible, however, that the alleged malpractice occurred because Daniels was serving two masters--plaintiffs, his clients, and Goldan, the company of which he was a principal,” Smith said.

“If that is the case,” Smith added, “it can fairly be said that the malpractice claims arose partly out of Daniels's law practice and partly out of his status with or activity for Goldan--precisely the situation that the insured's status and business enterprise exclusions seem to contemplate.” Accordingly, the court remanded so that the policy exclusions at issue could be considered.

Breach Should Be Punished

Dissenting, Judges Victoria A. Graffeo and Eugene F. Pigott Jr. said they would “adhere to the general principle that a breach of a liability insurer's duty to defend prohibits it from subsequently invoking policy exclusions to escape its corollary duty to satisfy a judgment entered against the insured by a third party.” Such a rule “makes sense for several reasons,” they said in an opinion by Graffeo.

One reason is that an insurer “should be subjected to some legal consequence for breaching its duty to defend an insured,” Graffeo wrote. “Prohibiting exclusions from being collaterally invoked provides an insurer with an incentive to appear on behalf of the policyholder in the underlying lawsuit, as it agreed to do in return for the payment of premiums.”

“A contrary rule encourages unnecessarily repetitive judicial proceedings by allowing an insurer to wrongfully abandon its policyholder's defense, subsequently forcing the insured to later litigate the effect of a policy exclusion on the duty to indemnify,” she added.

Kevin T. Coughlin of Coughlin Duffy LLP, Morristown, N.J., argued for K2. Michael A. Haskel, Mineola, N.Y., argued for American Guarantee.

To contact the reporter on this story: Samson Habte in Washington at shabte@bna.com

To contact the editor responsible for this story: Kirk Swanson at kswanson@bna.com


Full text at http://www.bloomberglaw.com/public/document/K2_Inv_Group_LLC_v_American_Guar__Liab_Ins_Co_2014_NY_Slip_Op_011.

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