FKB Client Advisory by Andrew R. Jones .

FKB Professional Liability Practice Alert: New York’s Highest Court rules that a liability insurer who improperly disclaims coverage and declines to defend an insured is precluded from later asserting otherwise valid indemnity coverage exclusions. (“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 … even if policy exclusions would otherwise have negated the duty to indemnify.”).

Professional liability insurers often face the issue of whether to provide coverage for “professional malpractice” claims which, in fact, arise from acts unrelated to the practice of an insured’s profession. In an effort to trigger professional liability coverage, savvy plaintiff’s attorneys often assert claims for professional malpractice even when the insured’s alleged misconduct does not arise from the practice of the insured’s profession; for example, when an insured attorney acts in the capacity as an investor, investment advisor, buyer, seller or broker.

In cases where a professional malpractice claim seemingly arises from acts unrelated to the practice of an insured’s profession, insurers are faced with a difficult coverage decision. A foundational concept of insurance coverage holds that “the duty to defend is broader than the duty to indemnify.” An insurer usually has a duty defend whenever a complaint suggests a reasonable possibility of coverage, regardless of facts outside of the “four corners” of the complaint. In K2 Inv. Group, LLC v. American Guarantee & Liability Ins. Co., 2013 N.Y. Slip Op. 04270 (2013), the New York Court of Appeals (New York’s highest court) not only affirmed the broad application of an insurer’s duty to defend, it also amplified the significant consequences for an insurer who improperly disclaims that duty to defend.

Facts:

“K2” (Decision attached) involves the familiar business deal “gone bad.” Plaintiffs were two limited liability companies that made loans to another such company, called Goldan, LLC (“Goldan”). Goldan failed to repay the loans and a bankruptcy petition was later filed against it. The plaintiffs brought a lawsuit against Goldan and its two principals, one of whom was an attorney (“Attorney”). Among other claims, the plaintiffs asserted a legal malpractice action against the Attorney, alleging that he had acted as the plaintiff’s lawyer with respect to their loans to Goldan and committed malpractice by failing to secure the loans.

The Attorney notified his malpractice carrier (“Insurer”), and the Insurer refused to provide “either defense or indemnity coverage” on the basis that the claims were “not based on the rendering or failing to render legal services for others.” The Attorney defaulted and plaintiffs obtained judgment on the legal malpractice claim in excess of the policy limit, while the other claims were discontinued. The Attorney assigned his rights against the Insurer to the plaintiffs, who then brought a direct action against the Insurer for breach of contract and bad-faith failure to settle. The Insurer moved for summary judgment on the basis of two policy exclusions. Plaintiffs cross-moved for summary judgment in their favor. The trial court granted plaintiffs’ motion, holding that the Insurer breached its duty to defend and was therefore bound to pay the resulting judgment up to the policy limit. The Appellate Division affirmed.

The Court of Appeals Holding:

In affirming the Appellate Division and upholding summary judgment in plaintiffs’ favor, the Court of Appeals held that “by breaching its duty to defend, [the Insurer] lost its right to rely on [the policy] exclusions in litigation over its indemnity obligation.” The Court first noted that the Insurer clearly breached its duty to defend, as the complaint asserted a claim for legal malpractice. It then noted that in Lang v. Hanover Ins. Co, 3 N.Y.3d 350 (2004), the Court of Appeals had previously held that where an insurer disclaims its duty to defend and the underlying plaintiff/judgment-holder seeks payment of its judgment from the insurer, “the insurance carrier may litigate only the validity of its disclaimer and cannot challenge the liability or damages determination underlying the judgment.” Id. at 356.

The Court extended its reasoning in Lang by holding that “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.” In other words, an insurer in such a situation is barred from litigating any issue other than the validity of the disclaimer, including the applicability of certain coverage exclusions, “even if policy exclusions would otherwise have negated the duty to indemnify.” The Court noted that the “rule will give insurers an incentive to defend the cases they are bound by law to defend, and thus to give insured the full benefit of their bargain.”

The Court noted that an exception to the rule may exist where there is a public policy argument against coverage. For example, in Hough v. USAA Cas. Ins. Co., 93 A.D.3d 405 (1st Dept. 2012), the Appellate Division 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.” However, the Court in K2 held that “no public policy argument is available to [the Insurer] here, and there is no reason to make this case an exception to the general rule.”

Conclusion

The K2 decision demonstrates the broad application of an insurer’s duty to defend. From a risk-management perspective, the decision further demonstrates that an insurer should consider erring on the side of defending under reservation of rights, as an improper disclaimer could have damaging later consequences.

The decision also provides some practical “advice” for insurers, which we believe to be double-edged – i.e. “[A]n 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.” We caution that if an insurer does file a declaratory judgment and loses, the insurer may be liable for the insured’s costs of defending the declaratory action for “placing the insured in a defensive posture.” See Andrew S. Kowlowitz, Esq., Mighty Midgets’ Fee Shifting Rule: A Study in Exceptions, NYLJ (2011). Therefore, it is critical for insurers to accurately assess their ultimate chances of prevailing on the coverage issues at hand, and to carefully weigh that assessment against the overall risk and cost considerations presented.

To discuss the K2 decision or this area of law generally, please feel free to contact Andrew R. Jones.