Insurer Cannot Avoid Indemnification Duty After Wrongfully Refusing to Defend Case

By Samson Habte  

Policy exclusions that ordinarily would relieve an insurer of its obligation to indemnify a lawyer from a malpractice judgment cannot be invoked if the insurer wrongfully refused to cover the lawyer's defense to the underlying lawsuit, the New York Court of Appeals declared June 11 (K2 Investment Group LLC v. American Guarantee & Liability Insurance Co., N.Y., No. 106, 6/11/13).

“If [a] disclaimer [of coverage] 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,” the court held in an opinion by Judge Robert S. Smith.

The decision stresses the principle that the duty to defend is much broader than the duty to indemnify.

Penny Wise, Pound Foolish

The defendant, American Guarantee & Liability Insurance Co., was sued for breaching its contractual duty to both defend and indemnify attorney Jeffrey Daniels.

The insurer first disclaimed its duty to defend Daniels, who co-owned a real estate company and was sued for malpractice by two plaintiffs who lent $2.8 million to that enterprise. The loans were to be secured by mortgages that were never recorded, and the malpractice claims were premised on the allegation that Daniels acted as the plaintiffs' attorney during the loan transaction and negligently failed to record the mortgages.

In denying a defense, American Guarantee pointed to two provisions in Daniels's policy: an “insured's status” clause and a “business enterprise” clause. Those exclusions, it argued, applied because the allegations against Daniels were “not based on rendering or failing to render legal services for others.”

The insurer later cited the same reasons in declining to pay a $450,000 settlement offer--which, the court noted, was “significantly less than the $2 million limit of American Guarantee's policy.”

A $3 million default judgment was entered against Daniels, who satisfied his debt by assigning the plaintiffs his claims against American Guarantee.

The assignees then sued the carrier for breach of contract and bad faith failure to settle the underlying lawsuit. They sought to recover the $2 million policy limit on the breach of contract claim and the full amount of the $3 million default judgment on the bad faith claim.

According to the court, American Guarantee at some point conceded that the exclusions it cited did not justify its initial decision to deny Daniels's request for a defense. However, it continued to maintain that the exclusions relieved it of the narrower duty to indemnify the policyholder.

A trial court and divided appellate panel disagreed. Having breached its obligation to defend Daniels, they held, American Guarantee was estopped from relying on coverage exclusions to avoid indemnification.

Accordingly, the trial court granted, and the appellate panel upheld, a summary judgment order in the plaintiffs' favor on the breach of contract claims. The lower courts did not, however, find for the plaintiffs on the bad faith claims.

The court of appeals affirmed both of those rulings.

Tread Carefully

In holding for the plaintiffs on the contract claims, the high court emphasized the well-settled rule that the duty to defend is broader than the obligation to indemnify.

“[A]n insurer will be called upon to provide a defense whenever the allegations of the complaint suggest a reasonable possibility of coverage,” Smith noted. A carrier faced with 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,” he said.

Smith cited Lang v. Hanover Ins. Co., 820 N.E.2d 855 (N.Y. 2004), which established that an insurer that totally disclaims coverage and leaves a policyholder to defend himself cannot later “challenge the liability or damages determination” in the underlying suit.

“If [a] disclaimer [of coverage] 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.”
Judge Robert S. Smith

“While Lang did not involve a situation like the one we have here,” the court added, “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,” Smith wrote.

“This rule,” the court said, “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.”

Smith added: “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.”

Door Left Ajar

The court left open the possibility that there could be “exceptions to the rule that we stated in Lang and now reaffirm.” An insurer that has disclaimed a duty to defend, it said, may in some instances be permitted to raise coverage defenses when litigating its indemnity obligation.

Although it did not identify those possible exceptions, the court stipulated that “we do not necessarily reject (though we do not necessarily endorse)” the decision in Hough v USAA Cas. Ins. Co., 940 N.Y.S.2d 41 (N.Y. App. Div. 2012).

That case 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 decision, Smith said, “could arguably be justified on the ground that insurance for one's own intentional wrongdoing is contrary to public policy.”

No Bad Faith

The court also affirmed the dismissal of the claims that had accused American Guarantee of a bad faith failure to settle. “An insurer's rejection of a settlement offer for less than the full amount of its policy does not by itself establish the insurer's bad faith, even when the insured later suffers a judgment greater than the policy limit,” Smith explained.

“[N]othing in this record,” he added, “suggests that American Guarantee knew or should have known that the malpractice claim against Daniels was worth significantly more than $450,000--let alone more than the $2 million policy limit.”

American Guarantee was represented by Robert J. Kelly, Coughlin Duffy, Morristown, N.J. The plaintiffs were represented by Michael A. Haskel, Mineola, N.Y.

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