Michael S. Gollub and Steven M. Ziolkowski
Michael S. Gollub and Steven M. Ziolkowski ()

In an article published in this newspaper,1 we questioned whether the initial New York Court of Appeals decision in K2 Investment Group v. American Guarantee & Liability Ins.,2 or K2-I, was radical in its broad pronouncement that “[w]hen 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.”3 We also highlighted that, in the course of hearing argument and issuing this holding, the Court of Appeals had essentially recast the issue on appeal, from how a default judgment against the insured affects the applicability of exclusions for the duty to indemnify, to whether the insurer can even raise those exclusions after breaching its duty to defend.

Some immediately argued that K2-I ignored the court’s previous holding in Servidone Const. Corp. v. Security Ins. Co. of Hartford4—namely, that “an insurer’s breach of [its] duty to defend does not create coverage.”5 Others disagreed, writing that the K2-I holding was consistent with established law.6 We took a middle ground and suggested that K2-I could be viewed as an incremental step, but we also highlighted the difference between the issue actually appealed with the issue actually decided. As our article went to press, reargument had been requested in K2-I. What has happened since then is that the Court of Appeals executed a double reverse.

The Court of Appeals granted reargument and, in K2-II,7 reversed itself on the Servidone issue. However, while it also decided the specific issue on appeal—whether a default judgment on the legal malpractice claim in that case precluded the applicability of policy exclusions for the insured’s acting as manager of, or having a controlling interest in, a real estate company—it provided little guidance regarding the general bearing of the pleadings and a default judgment on the insurer’s duty to indemnify. The Court of Appeals in fact devoted most of its decision in K2-II to explaining that K2-I is incompatible with Servidone and that Servidone should be upheld based on principles of stare decisis. Moreover, while K2-I had upheld the grant of summary judgment to plaintiffs, K2-II reversed that decision as well.

Unfortunately, the court devoted only a few paragraphs addressing the two exclusions at issue. Because only a default judgment was entered against the insured and there was no other factual record, the Court of Appeals simply held that there was an inadequate basis to support the granting of summary judgment.

Thus, after K2-II, Servidone still applies and an insurer may generally raise policy exclusions despite a breach of the duty to defend. If a default judgment is entered against the insured, the insurer may generally litigate facts not established by the underlying factual record with regard to the applicability of those exclusions. What is not clear is the extent to which, if at all, the underlying pleadings and a default judgment serve to confine any of these relevant facts. On this broader issue, the Court of Appeals declined to promulgate any overarching principles. This will likely lead to more litigation.

Issue on Appeal and ‘K2-I’

In K2, plaintiffs, two LLCs, loaned money to Goldan, LLC, a real estate company owned by the insured, attorney Jeffrey Daniels, and Mark Goldman. Plaintiffs claimed that Daniels agreed to represent them in the transaction and committed attorney malpractice by failing to record mortgages securing the loans or obtain title insurance. Daniels’ malpractice carrier, American Guarantee and Liability Insurance Company, reserved its rights to deny coverage based on an Insured’s Status Exclusion, which precluded coverage for the insured acting as manager, and a Business Enterprise Exclusion, which precluded coverage for the acts or omissions of the insured for a business in which the insured had a controlling interest.

After plaintiffs commenced a lawsuit asserting malpractice and other claims, American retained counsel to represent Daniels but then withdrew based on, among other things, the foregoing exclusions. A default judgment was entered against Daniels on the malpractice claims only, and Daniels assigned his rights as against American to plaintiffs.

Plaintiffs brought suit against American to enforce the default judgment pursuant to New York Ins. Law §3420. The Appellate Division, First Department, affirmed the Supreme Court’s entry of summary judgment in favor of plaintiffs against American. In doing so, it considered application of the exclusions but held that they did not apply based on the import of the pleadings and default judgment:

[T]he exclusions did not apply with respect to either the duty to defend which was demonstrated based upon the allegations of legal malpractice or the duty to indemnify for a judgment based on legal malpractice. Thus, defendant cannot at this juncture assert defenses that would have defeated the legal malpractice claims (for example, that Daniels was not performing legal services for plaintiffs but was instead representing Golan) or would have established the applicability of the exclusions, to the extent that the applicability of the exclusions is inconsistent with the judgment determining Daniels’s liability to plaintiffs for legal malpractice.[8]

In K2-I, the Court of Appeals affirmed, but instead of addressing how the pleadings and default judgment bore on applicability of the exclusions, it transformed the issue to one similar to that considered in Servidone: whether an insurer that breached the duty to defend could raise policy exclusions at all to deny its duty to indemnify the insured (and thus the injured parties-judgment creditors) for a default judgment. As discussed at length in our previous article, in contrast to Servidone, the court said “no,” with some exceptions.

Internet discussions and article writing aplenty ensued. The Court of Appeals eventually granted a request for reargument.

The K2-II Ruling

In K2-II, the Court of Appeals admitted it dropped the ball in K2-I: “American Guarantee & Liability Insurance contends, on reargument, that our prior decision in” K2-I “erred by failing to take account of a controlling precedent,” Servidone. “We hold that American Guarantee is correct.”9 The Court of Appeals then spent the bulk of its decision explaining that K2-I is not compatible with Servidone, and that Servidone should be upheld based on principles of stare decisis.

Oh, and on the issue actually appealed in the first place? The Court of Appeals held that there were fact issues which, in contrast to its decision in K2-I, now precluded summary judgment:

The Appellate Division majority’s rationale for granting summary judgment was, essentially, that a case arising out of the alleged attorney-client relationship between plaintiffs and Daniels could not also arise out of [his managerial status with Goldan or his acts or omissions for Goldan]. But the claims could arise out of both. Because the malpractice case was resolved on default, the record tells us little about the substance of the claims; it 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 principal.[10]

Two points follow from the Court of Appeals K2-II ruling: (1) an insurer may generally raise policy exclusions despite any breach of the duty to defend; and (2) if a default judgment is entered against the insured, the insurer may generally litigate facts not established by the factual record with regard to the applicability of those exclusions. The Court of Appeals, however, missed an opportunity to expound on the relationship between the pleadings and underlying judgment on the one hand, and the duty to indemnify on the other hand.

K2-II upholds the following general principle as applied to default judgments: The duty to indemnify is determined by the underlying factual basis for liability, and an insurer may litigate coverage issues not determined in the underlying lawsuit.11K2-II indeed failed to announce any express limits imposed by the nature of the pleadings and a default judgment. For example, if the complaint alleges only negligence and a default judgment is entered, may the insurer nevertheless present facts that the insured acted intentionally such that there was no “occurrence” or the exclusion for expected or intended injury applies? We would argue that K2-II would absolutely allow it. We imagine that some will argue that K2-II should be strictly limited to its facts. Because the Court of Appeals gave only cursory attention to the actual issue on appeal before it, it is likely that more litigation on this kind of issue will ensue.

Michael S. Gollub is a member, and Steven M. Ziolkowski is an associate, of Marshall, Conway & Bradley.

Endnotes:

1. Gollub, Michael S. and Ziolkowski, Steven M., “‘K2 Investment Group’ Ruling: Radical…or Not?” NYLJ, July 31, 2013.

2. 21 N.Y.3d 384 (2013) (K2-I).

3. K2 I, 21 N.Y.3d at 387.

4. 64 N.Y.2d 419 (1985).

5. Servidone, 64 N.Y.2d at 423; see, e.g., Kohane, Dan D. and Peiper, Steven E., “Draconian Penalty Adopted for Wrongfully Refusing to Defend,” NYLJ, June 24, 2013.

6. See, e.g., Booth, Charles A. & Anania, Michael L., “‘K2′ Ruling on Insurer Refusal to Defend Fits Within Established Law,” NYLJ, July 8, 2013.

7. K2 Investment Group v. American Guarantee & Liability Ins., 2014 WL 590662 (N.Y. Feb. 18, 2014) (K2-II).

8. See K2 Investment Group v. American Guarantee & Liability Ins., 91 A.D.3d 401, 402 (1st Dept. 2012).

9. K2-II, 2014 WL 590662.

10. Id.

11. See, e.g., Servidone, 64 N.Y.2d at 424-25.