The right to a prompt defense of claims is perhaps the most valuable right a policyholder obtains when it purchases a liability insurance policy. A prompt defense can often mean more than merely the difference between winning and losing the underlying litigation. For individual policyholders, it can be the only bulwark against having to wipe out life savings, mortgage or lose a home, or take on crushing debt to mount the defense necessary to defeat even false or frivolous claims. For commercial or corporate policyholders, it can mean having the ability to meet the rising tide of class action lawsuits and bet-your-company litigation that can wreak havoc with a bottom line long before a claim ever comes to trial. In order to fulfill those functions, however, the funds for the defense have to be available when they are needed—payment for a defense delayed can be a defense denied.
New York law has long recognized the critical importance of the timely payment of defense costs by an insurer. In particular, New York courts have uniformly recognized that the duty to defend is "exceedingly broad" and arises if the underlying complaint "contains any facts or allegations which bring the claim even potentially within the protection purchased."1 Nonetheless, because there are circumstances under which a defense is not owed even under those broad standards—such as when the underlying claim falls "solely and entirely" within the scope of a policy exclusion2—there can be uncertainty while the underlying claim is pending as to whether the insurance company is obligated to provide a defense. In some instances, insurers have been able to utilize such uncertainty, whether real or imagined, to hold defense payments hostage while they seek to negotiate settlements that reduce or restrict amounts payable under the policy. Policyholders faced with the immediate need to fund their defense can be at a severe disadvantage in those negotiations.
The recent decision of the New York Court of Appeals in K2 Investment Group v. American Guarantee & Liability Insurance, 2013 N.Y. LEXIS 1461, 2013 N.Y. Slip Op. 4270 (N.Y. June 11, 2013), should serve to even that playing field substantially. Recognizing New York's long-standing protection of the policyholder's contractual right to a contemporaneous defense, the Court of Appeals in K2 Investment enunciated a new rule of preclusion for an insurer that disclaims a defense obligation. "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." 2013 N.Y. Slip Op. 4270, at **5. In large measure, it shifts from the policyholder to the insurer the risks inherent in a questionable defense denial, and increases the likelihood that insurers will choose to defend under a reservation of rights, rather than simply withholding payment of defense costs where questions of coverage exist.
'K2 Investment' Decision
K2 Investment involved an insurance dispute arising from a legal malpractice claim. The underlying plaintiffs alleged that the insured attorney, Daniels, had represented them in a transaction in which the plaintiffs loaned money to a company known as Goldan, LLC (Goldan), of which Daniels was a principal. According to plaintiffs, Daniels had agreed, but negligently failed, to record certain mortgages for the purpose of securing plaintiffs' loans. Goldan ultimately became insolvent, and the promissory notes it had given the plaintiffs became worthless. Plaintiffs sued Daniels, claiming that their loss was a direct result of his breach of professional obligations.
When Daniels tendered the claim to his malpractice insurer, it disclaimed on the ground that the policy excluded coverage for liabilities arising from the insured's "capacity or status" as an officer, manager or employee of "a business enterprise" and from "alleged acts or omissions" for a "business enterprise" in which the insured person had "a Controlling Interest." 2013 N.Y. Slip Op. 4270, at **2-3. Asserting that the malpractice claim related to Daniels' "status" as a principal of Goldan and to his "acts or omissions" on behalf of Goldan, the insurance company refused to defend the claim, and a default judgment was entered against Daniels.
Daniels assigned his insurance claim to the plaintiffs, who brought suit against the insurer. The trial court held that the insurer had breached its duty to defend Daniels because the claim potentially fell within the coverage of the policy. It further held that the insurer was liable for the default judgment entered against Daniels, subject only to its policy limit.
A divided panel of the Appellate Division, First Department, affirmed. See 91 A.D.3d 401 (1st Dept. 2012). Significantly, however, all of the members of the divided panel agreed on one thing: that in contesting its obligation to pay for the default judgment, as opposed to its obligation to pay for the underlying defense, the insurer could rely on the policy exclusions. The majority thus rejected the insurer's exclusion arguments on the merits, holding that the exclusions were "patently inapplicable" to the malpractice claim. 91 A.D.3d at 403. The dissenting justices maintained, to the contrary, that Daniels' alleged dual role as a principal for Goldan and attorney for plaintiffs raised factual issues as to the applicability of the exclusions, which required a trial. Id. at 408.
The New York Court of Appeals affirmed the Appellate Division's order, but took a shorter route to the same result. The court held that it was unnecessary to "reach the question that divided the Appellate Division"—"the applicability of the exclusions"—because the insurer had "lost its right to rely on these exclusions" by "breaching its duty to defend." 2013 Slip Op. 4270, at **3. Significantly, the Court of Appeals did not hold that the insurance company's assertion that the exclusion applied had been a mere sham; to the contrary, it acknowledged that the insurer could have been rightfully skeptical about a loan transaction where a principal for the borrower also served as an attorney for the lenders. See 2013 N.Y. Slip Op. 4270, at **4. Nonetheless, because that skepticism had not negated the duty to defend, the court held that the insurer, having failed to defend, could not assert it as a basis for refusing to pay the resulting judgment.
The Court of Appeals further noted that that conclusion was the logical extension of its earlier holding in Lang v. Hanover Insurance, 3 N.Y.3d 350, 356 (2004), that an insurance company "cannot challenge the liability or damages determination underlying the judgment" against its insured once it has breached the duty to defend. The court acknowledged that K2 Investment addressed a slightly different question from Lang—not whether the insurer can challenge the merits of the underlying claim, but whether it can raise policy-related bars to indemnity after having failed to provide a defense. The court nonetheless concluded that barring the insurer from raising substantive coverage defenses to indemnity once it wrongfully fails to defend serves the same purposes as the Lang preclusion: "[The rule] give[s] insurers an incentive to defend the cases they are bound by law to defend" and 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." Id. at *5.
Implications for Policyholders and Insurers
K2 Investment plainly raises the financial stakes for a liability insurer that believes that a policy exclusion supports a decision to disclaim defense coverage. As noted, even before the decision in K2 Investment, the insurer bore the burden of proving that the underlying claim falls "solely and entirely" within the scope of the exclusion. But as a result of K2 Investment, an insurer who makes the wrong call on this issue is now confronted with a significant downside; it loses the ability to contest its obligation to indemnify. That factor alone could shift an insurer's "default" setting from denying a defense to defending under a reservation of rights, subject to its right to challenge its duty to pay a later judgment or settlement.
Moreover, the ruling in K2 Investment is by no means limited to situations where the insurer bases its disclaimer on a policy exclusion. Language in the opinion suggests that the court's holding applies irrespective of the basis on which the insurer declines to defend. See 2013 N.Y. Slip Op. 4270, at **5 ("[W]e 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 the disclaimer'") (quoting Lang, 3 N.Y.3d at 356).
This distinction is significant because insurers often contend that policy language other than exclusions—most commonly, language that appears in policy insuring grant provisions—relieves them of a duty to defend particular claims. For example, insurers have argued that the terms "loss" and "damages" limit coverage to certain types of monetary relief3 (and, by extension, that an insurer should owe no duty to defend a claim that seeks only uncovered "loss" or "damages"). Future cases likely will address whether disclaimers premised on insuring clause language fall within the K2 Investment preclusion rule to the same extent as disclaimers that are premised on policy exclusions.
On the other hand, insurers will surely note that the K2 Investment court itself raised the possibility that the general rule of preclusion may be subject to certain exceptions. Most notably, the Court of Appeals mentioned—but declined to reject or endorse—the Appellate Division's ruling in Hough v. USAA Casualty Insurance, 93 A.3d 405 (1st Dept. 2012), that an insurer cannot be barred from contesting its obligation for a judgment on the ground that the policyholder had acted with an intent to cause injury. 2013 N.Y. Slip Op. 4270, at **5. The Court of Appeals observed only that "[t]he Hough decision could arguably be justified on the ground that insurance for one's own intentional wrongdoing is contrary to public policy." Id.
Insurers also may argue that K2 Investment only applies to policies that contain "duty to defend" language but has no application to policies that provide for the payment of defense costs while absolving the insurer of any duty to furnish a defense (such as by selecting and overseeing defense counsel). See, e.g., Fed. Ins. v. Kozlowski, 18 A.D.3d 33, 40-41 (1st Dept. 2005) (discussing the distinctions and similarities between "duty to defend" and "duty to pay defense costs" policies); Stonewall Ins. v. Asbestos Claims Mgmt., 73 F.3d 1178, 1218 (2d Cir. 1995) (addressing excess policies that were subject to a defense payment obligation but also contained language that relieved the insurers of any duty to "assume charge" of the policyholder's defense), modified on other grounds, 85 F.3d 49 (2d Cir. 1996).
Finally, issues may arise as to whether, and to what extent, K2 Investment bars insurers from contesting coverage for settlements of litigation. K2 Investment and Lang both addressed situations where default judgments were entered against policyholders after their insurers had refused to defend. Neither case addressed the equally common situation where a policyholder settles a case following an insurer's disclaimer—whether or not that settlement was prompted by the lack of funds to mount an effective defense to the claim.
Despite these open questions, which policyholders and insurers surely will litigate over the next few years, K2 Investment is a significant reaffirmation and extension of New York's commitment to the policyholder's right to a timely defense. By giving teeth to the law's demand that the insurer defend now, and argue later, it helps to level the playing field between insurers and policyholders when disputes exist as to the duty to defend.
Robin L. Cohen is a partner at Kasowitz, Benson, Torres & Friedman and head of the firm's insurance recovery practice. Elizabeth A. Sherwin is partner and Jack P. Winsbro is special counsel with the group.
1. BP A.C. v. One Beacon Ins., 8 N.Y.3d 708, 714 (2007) (quoting Auto. Ins. of Hartford v. Cook, 7 N.Y.3d 131, 137 (2006)), and Technicon Elecs. v. Am. Home Assur., 74 N.Y.2d 66, 73 (1989))..
2. See, e.g., Auto. Ins. of Hartford v. Cook, 7 N.Y.3d 131, 137 (2006) (quoting Allstate Ins. v. Mugavero, 79 N.Y.2d 153, 159 (1992)); Slayko v. Security Mut. Ins., 98 N.Y.2d 289 (2002) (claim falling within "criminal activity" exclusion).
3. See, e.g., Avondale Indus. v. Travelers Indem., 887 F.2d 1200, 1206-07 (2d Cir. 1989) (addressing argument over the meaning of "damages"); Vigilant Ins. v. Credit Suisse First Boston, 10 A.D.3d 528, 528-29 (1st Dept. 2004) (addressing argument over "loss").