New York Court of Appeals Reconsiders and Holds That an Insurer May Invoke Policy Exclusions Despite Wrongful Refusal to Defend

The New York Court of Appeals has vacated its recent decision in K2 Investment Group, LLC v. American Guarantee & Liability Insurance Co., reverting to the majority position that an insurer breaching its duty to defend an insured is not barred from relying on policy exclusions to defend a later claim for indemnification.

The case originated from a related lawsuit where K2 Investment Group, LLC and ATAS Management Group, LLC (collectively, the “LLCs”) sued an attorney for legal malpractice. The attorney’s insurer, American Guarantee & Liability Insurance Company (“American Guarantee”), refused to defend, which refusal was later conceded to be wrongful. After defaulting, the attorney assigned his rights against American Guarantee to the LLCs which, in turn, filed the present action against American Guarantee seeking to enforce the insurer’s duty to indemnify and to recover damages based upon its bad faith refusal to defend and settle the initial claim. American Guarantee argued it had no duty to indemnify, citing certain exclusions contained in the policy. The Supreme Court granted summary judgment to the LLCs on the breach of contract claim but dismissed the bad faith claim. The Appellate Division affirmed.

The New York Court of Appeals affirmed initially, holding 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.” K2 Inv. Group, LLC v. Am. Guar. & Liab. Ins. Co., 21 N.Y.3d 384, 387 (2013), vacated and reversed by Slip Op. No. 6, February 18, 2014. The Court reasoned, “American Guarantee, having chosen to breach its duty to defend, cannot rely on policy exclusions to escape its duty to indemnify.” Id. at 391.

American Guarantee moved for reargument, arguing that the Court’s decision conflicted with Servidone Construction Corp. v Security Insurance Co. of Hartford, 64 NY2d 419 (1985), a case the Court had not initially taken into account. Upon reargument, in a 4-2 decision, the Court vacated its prior ruling and reversed, finding that Servidone did indeed control. Servidone holds that 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,” the insurer is not automatically “liable to indemnify the insured . . . if coverage is disputed.” 64 NY2d at 421. In Servidone, the Court overturned an award of summary judgment for an insured because, “[b]y holding the insurer liable to indemnify on the mere ‘possibility’ of coverage perceived from the face of the complaint — the standard applicable to the duty to defend — the court has enlarged the bargained-for coverage as a penalty for breach of the duty to defend, and this it cannot do.” Id. at 424. The Court in K2 found this analysis persuasive, noting it is followed by “the majority of jurisdictions which have considered the question[.]”

Justice Graffeo dissented from the rare self-reversal, reasoning that an “insurer should be subjected to some legal consequence for breaching its duty to defend an insured.” Justice Graffeo pointed out that the Court’s original ruling encouraged insurers to: (1) defend their insureds as contracted and (2) file declaratory judgment actions on the issue of indemnification consolidating all interested parties.

The result of the Court’s reversal is that the LLCs’ motion for summary judgment is denied, and American Guarantee can assert its policy exclusion defenses. More broadly, New York has realigned with the majority of jurisdictions that permit an insurer to breach its duty to defend with impunity, putting the burden on policyholders to pursue coverage for both defense and indemnity under the policy. However, while this decision allows insurers to breach the duty to defend without waiving their right to contest indemnity, insurers are still at risk of liability for wrongful refusal to defend under the applicable policy provisions.