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Editors’ Note: This article has been updated to reflect a Correction.

Since my last article in the New York Law Journal on Dec. 31, 2013, “What’s So Special About ‘K2′?” the New York Court of Appeals on Jan. 7, 2014, reheard American Guarantee’s appeal in K2 Investment Group v. American Guarantee & Liability Insurance, 21 N.Y.3d 384, 993 N.E.2d 1249, 2013 NY Slip Op 04270 (June 11, 2013) (K2-I). In vacating its decision (See, K2-II, 22 N.Y.3d 578, __ N.E.3d __, 2014 NY Slip Op 01102 (Feb. 18, 2014)), amidst the welter of confusion it generated, the court confirms it never intended to overrule its established precedent which allows a liability insurer to disclaim the duty to indemnify where the defense of non-coverage remains intact, notwithstanding such insurer’s improper refusal to defend.1 The court further reaffirmed that this rule abides unless the grounds for such insurer’s disclaimer would defeat the covered factual and/or legal basis supporting a liability or damages determination already adjudicated against its insured.2

However, in unwittingly allowing American Guarantee to rely on policy exclusions requiring proof of its attorney-insured’s possible financial duplicity in “serving two masters,” the court, oblivious to its own precedent, has impermissibly given American the imprimatur to relitigate the covered factual and legal bases for the negligence determination underlying K2s’ legal malpractice judgment against its insured, embroiling American in a conflict of interest.

This article seeks to explain that, contrary to the court’s holding, American has no valid basis upon which to disclaim coverage independent of the covered negligence allegations underlying K2s’ adjudicated legal malpractice claim.

Facts and Background

Plaintiffs K2 Investment Group and ATAS, two limited liability companies, (hereinafter plaintiffs-K2 or K2s), made loans secured by mortgages totalling $2.83 million to Goldan, a real estate development company. When Goldan went into bankruptcy without repaying the loans, plaintiffs discovered their mortgages had not been recorded, and sued Goldan and its two principals, Mark Goldman and Jeffrey Daniels, asserting, inter alia, claims for legal malpractice against Daniels, American Guarantee’s insured.

Although plaintiffs alleged Daniels, an attorney, was a member of Goldan, and Daniels advised American he only represented Goldan, the basis of the malpractice action was that Daniels agreed to act as plaintiffs’ attorney, and that his negligent failure to record their mortgages rendered plaintiffs’ loans unsecured and thus uncollectible.

Though K2s’ complaint against Daniels unmistakably pleaded a covered claim for legal malpractice, American improperly refused to defend Daniels, claiming that the allegations against him fell within two exclusions under American’s professional liability policy. One exclusion, the “Insured’s Status” exclusion, barred any “Claim” (demand for money or legal services) “in whole or in part” based upon or arising out of the insured’s capacity or status as an officer, director, etc., of a business enterprise. The other exclusion, the “Business Enterprise” exclusion, similarly barred any Claim arising out of the insured’s alleged acts or omissions for any business enterprise in which he had a controlling interest.

Upon Daniels’ failure to appear in the legal malpractice action, plaintiffs obtained a default judgment against him based on his negligent failure to record their mortgages, plaintiffs’ claims based on Daniels’ guarantees of their loans having been discontinued without prejudice. Thereafter, plaintiffs-K2 sued American, seeking to enforce American’s duty to indemnify Daniels for the judgment.

American sought summary judgment based on the above exclusions. Plaintiffs-K2 cross-moved for summary judgment. Supreme court granted plaintiffs’ motion, to the extent of holding that American breached its duty to defend Daniels, and was therefore bound, up to the $2 million limit of its policy, to pay the resulting judgment against him. The Appellate Division affirmed. The majority held that the exclusions American relied on were inapplicable to the malpractice claim on which the default judgment against Daniels was based, while the dissent concluded issues of fact existed as to whether such exclusions applied.

The Court’s Decision in ‘K2-I’

The Court of Appeals affirmed the Appellate Division’s order granting summary judgment in favor of plaintiffs-K2 against American on the unsatisfied legal malpractice judgment. The court held that “by breaching its duty to defend Daniels, American Guarantee lost its right to rely on [the subject] exclusions in litigation over its indemnity obligation” since an “insurer may not assert in its defense grounds that would have defeated the underlying [legal malpractice] claim against the insured….[H]aving chosen not to participate in the underlying lawsuit, the insurance carrier may litigate only the validity of its disclaimer and cannot challenge the liability or damages determination underlying the judgment.” (K2, 21 N.Y.3d, supra, at 390) (Emphasis added.)

As such, it was the premise of my previous article that American’s initial invalid disclaimer, and its consequent breach of the duty to defend, would not bar it from thereafter asserting any valid defense to coverage, unless—as very much appeared to be the case—such disclaimer defeated Daniels’ right to coverage already established by the factual allegations underlying K2s’ legal malpractice judgment. However, many insurance practitioners considered K2-I’s holding to operate more peremptorily, barring American—and, henceforth, any other liability insurer—from subsequently disputing its duty to indemnify as a penalty for having wrongfully abandoned its insured’s defense, even if such insurer had a valid basis for disclaimer!

Amidst this groundswell of confusion, the court granted American leave to reargue its appeal based on the insurer’s claim that the court effectively overruled its prior decision in Servidone Construction v. Security Insurance, 64 N.Y.2d 419 (1985), in having held that by breaching its duty to defend, American could not avoid its indemnity obligation under its policy.

‘K2-II’: Surprising About-Face

Upon rehearing American’s appeal, the Court of Appeals confirmed that in K2-I it never intended to overrule its established precedent, thus recognizing American’s right to potentially disclaim coverage, despite having breached its duty to defend. The court further confirmed that this rule applied, since—in the court’s opinion—American was not seeking to relitigate the covered factual allegations which supported K2s’ adjudicated legal malpractice claim.

Accordingly, in vacating its prior decision in K2-I, and reversing the Appellate Division’s order granting plaintiffs-K2 summary judgment, the court found an issue of fact existed as to the applicability of American’s “Insured’s Status” and “Business Enterprise” exclusions, independent of the factual allegations establishing Daniels’ legal malpractice liability to K2, based on the possibility that Daniels might have acted on behalf of his business enterprise, Goldan, in addition to legally representing plaintiffs-K2. Unfortunately, the court’s decision pretermits how K2s’ covered legal malpractice claim, based on Daniels’ negligent failure to record K2s’ mortgages, can independently morph into an uncovered claim, based on the possibility that Daniels was also acting on behalf of Goldan.

To be sure, Daniels’ controlling interest in Goldan might ultimately have been shown in the underlying malpractice action—had it been defended—to have affected his obligations to plaintiffs-K2 as their lawyer, possibly relieving American of any duty to indemnify under the exclusions of its policy. However, the court stinted at its chore in explaining how American can now disclaim the duty to indemnify, without relitigating and controverting the covered factual and legal bases for the negligence liability determination underlying K2s’ legal malpractice judgment against Daniels.3

A Quantal Dilemma

The problem with the court’s tack is that even had Daniels acted on behalf of and/or represented Goldan in addition to his clients, plaintiffs-K2, regarding the mortgage transactions in question, American cannot rely on policy exclusions requiring proof of its attorney-insured’s possible intentional financial duplicity in “serving two masters,” in contravention of the covered negligence determination underlying K2s’ legal malpractice judgment against its insured.4

Contrary to the court’s opaque holding, American’s exclusions do not disavow coverage for all conduct occurring while Daniels was an owner or officer of Goldan, but only for claims arising out of his capacity as such5 where Daniels’ pecuniary interest in such business enterprise affected his professional judgment as an attorney in conflict with his client’s best interests—be it Goldan or K2, or Daniels otherwise performed legal work for Goldan and would thus directly benefit as its principal from a malpractice recovery in favor of Goldan under the policy.6 The exclusions speak of excluded “Claims.”7 Thus, in determining whether American could possibly exclude coverage, it was not merely Daniels’ status as a principal of Goldan, or his general acts in transacting the loans on its behalf, but rather the character of the specific legal claim against him, that should have been considered by the court.8

Regardless of whether Daniels also legally represented or otherwise served Goldan’s interests in the underlying loan transactions, Goldan in its own right had no viable claim against Daniels, within the context of American’s policy exclusions, arising out of Daniels’ negligent failure to have recorded K2s’ mortgages. Moreover, K2s’ malpractice claim could not have arisen partly out of Daniels’ law practice and partly out of his status with or activity for Goldan sufficient to trigger the subject exclusions,9 since Daniels’ alleged negligent failure to record K2s’ mortgages, in his capacity as K2s’ attorney, bore no causal relationship to his managerial status with or activities for Goldan, notwithstanding that Daniels personally guaranteed payment of K2s’ loans to Goldan, to be secured by such mortgages.10 K2s’ negligence claim for legal malpractice was not directly related to and could exist regardless of Daniels’ activities for Goldan as its principal.11

Rather, the only cognizable claim arising out of the alleged attorney-client relationship between plaintiffs-K2 and Daniels that could also have arisen out of Daniels’ managerial status with, or acts or omissions for, his business enterprise Goldan, within the contemplation of American’s “Insured’s Status” and “Business Enterprise” exclusions, would have to stem from Daniels’ possible intentional self-dealing and consequent breach of fiduciary duty owed to his clients, plaintiffs-K2, in failing to record their mortgages.

Although professional negligence was directly alleged, alternatively the only other claim plaintiffs-K2 possibly could have relied on would have had to derive from Daniels’ arguable conflict of interest in failing to record K2s’ mortgages which were intended to secure K2s’ loans to Goldan, whose indebtedness Daniels personally guaranteed. Indeed, the dissent at the Appellate Division, upon which the court in K2-II based its holding, observed that such covered legal malpractice claim could not have assumed a new face within the purview of American’s policy exclusions if not for Daniels’ intentional failure to record such mortgages as a business decision to benefit his company at the expense of his clients’ best interests:

…[T]he complaint states that Daniels was a principal of Goldan, and American contends that Daniels engaged in self-dealing by representing one, if not both, of the parties to the loan transaction and also acting as the principal of the business enterprise receiving the loans. Thus, even if plaintiffs’ allegations of malpractice triggered the policy’s insuring clause, …a question exists as to whether Daniels’s failure to record the mortgage was, in whole or in part, a business decision to benefit his company, Goldan.…New York’s public policy prohibits indemnification for intentionally caused injuries (see Public Serv. Mut. Ins. Co. v Goldfarb, 53 NY2d 392, 399 [1981]). American should be allowed discovery to determine if Daniels intentionally failed to record the mortgages. To hold otherwise and allow the insured to shift liability to the insurer would allow the wrongdoer to evade responsibility for his actions. Accordingly, … issues of fact exist as to whether the Insured’s Status Exclusion or the Business Enterprise Exclusion applies.12

Thus, in having held that American’s assertion of its policy exclusions did not depend on the facts established in the underlying legal malpractice litigation, the court has impermissibly allowed American to adduce proof requiring evidence of Daniels’ possible intentional self-dealing and consequent breach of fiduciary duty owed to his clients, plaintiffs-K2, in having “serv[ed] two masters,” which directly contradicts the covered factual and legal bases for the negligence legal malpractice determination already adjudicated against him.13

Conflict of Interest

Furthermore, in allowing American to collaterally attack the covered liability determination underlying the legal malpractice default judgment against Daniels, the court has enabled American to retroactively “take control” of its insured’s defense and subordinate Daniels’ interests to those of its own, notwithstanding that American would have been ethically barred in the underlying malpractice action from seeking to shift liability for the loss to Daniels regarding potentially uncovered grounds for recovery.14

Although K2s’ malpractice claim did not allege facts sufficient to find, on its face, that it was subject to American’s policy exclusions, American would have had a duty to pay for counsel selected by Daniels to pursue an unqualified defense that was in his best interests where American’s interests based on the exclusions of its policy were in potential conflict with those of Daniels, its insured.15 Here, in serving to “legitimize” its obvious desire to shift liability for the loss to Daniels, American, in disclaiming coverage, as well as thereafter, contended that the allegations of Daniels’ covered professional negligence instead stemmed from his uncovered intentional self-dealing in having failed to record K2s’ mortgages as a business decision to benefit his company.16 Hence, even if American complied with its duty to defend, an issue of material fact would have likely remained as to whether Daniels’ alleged failure to have recorded K2s’ mortgages possibly arose out of his status and/or acts as a “member” of Goldan within the context of American’s policy exclusions.17 Moreover, plaintiff-K2s’ other uncovered causes of action based on Daniels’ personal guarantees of K2s’ loans, had only first been discontinued without prejudice upon plaintiffs’ application for a partial default judgment on their malpractice causes of action.

Thus, in an effort to safeguard Daniels against personal liability for the loss as to the potentially uncovered grounds for recovery in K2s’ complaint, ethical considerations would have required independent defense counsel to shift liability for the loss to American by refraining from successfully mounting a vigorous—if any—defense as to those causes of action and potential grounds of legal malpractice liability that would inevitably have been covered under American’s policy.18 Otherwise, had counsel been successful in dismissing K2s’ legal malpractice action based on the defense that Daniels was acting and/or performing legal work solely on behalf of Goldan, Daniels would likely have been subject to personal liability to plaintiffs based on his uncovered guarantees of K2s’ loans, within the ambit of American’s policy exclusions.

Conversely, if counsel had not been successful in dismissing K2s’ malpractice action, the trier of fact might have found that Daniels’ misconduct as K2s’ attorney did not occur merely as a result of his negligent failure to record plaintiff-K2s’ mortgages—within the coverage of American’s policy—but rather that his professional judgment in allegedly failing to record such mortgages was affected by his financial interest in Goldan, amounting to an intentional breach of his fiduciary duty owed to plaintiffs. In either eventuality, Daniels’ right to coverage would have been defeated under the subject exclusions, exposing him to personal liability for the mounting $3 million loss!

Accordingly, then as now, the question of coverage remains intertwined with the question of Daniels’ liability, embroiling American in a potential conflict of interest with its insured,19 barring American from doing indirectly what it originally could not have done directly had it defended the underlying malpractice action20: defeat the very claims for which it would have been required to indemnify Daniels by relying on theories and defenses disingenuously enhancing his personal liability for the loss as to potentially uncovered grounds of recovery!21

Conclusion

Thus, within the framework of the above ethical rule of law, which would have precluded American from taking control of the defense of the underlying tort action and subordinating the insured’s interests to its own, American should be barred from relitigating the identical negligence claim already adjudicated against Daniels in the underlying malpractice action by relying on exclusions whose grounds, ineluctably requiring proof of Daniels’ intentional self-dealing in having “serv[ed] two masters,” controvert the covered factual and legal bases for such negligence legal malpractice determination.

Matthew Siegel is president of Telesis Liability Insurance Coverage Software, which develops insurance coverage software for attorneys and claims professionals. He can be reached at SIEGELM@Prodigy.net.

Endnotes:

1. See, e.g., Schiff Associates v. Flack, 51 N.Y.2d 692 (1980); Servidone Construction v. Security Ins., 64 N.Y.2d 419 (1985); See also, Colon v. Aetna Life & Cas., 66 N.Y.2d 6 (1985).

2.Lang v. Hanover Ins., 3 N.Y.3d 350, 356.

3. Id.

4. Oot-v-Home Ins., 244 A.D.2d 62, 70 (4th Dept., 1998); Darwin Natl. Assur.-v-Hellyer, 2011 WL 2259801, *5, 2011 US Dist LEXIS 60592, *15-16 (N.D. Ill., 2011); Minn. Lawyers Mut.-v-Antonelli, Terry, Stout & Kraus, 2010 WL 4853300, *10, 2010 U.S. Dist. LEXIS 122836, *26-27 (E.D. Va., 2010).

5. Cf., RJC Realty Holding-v-Republic Franklin Ins., 2 NY3d 158, 165.

6. See, fn. “4.”

7. Niagara Fire Ins. v. Pepicelli, Pepicelli, Watts & Youngs, 821 F.2d 216, 220 (3d Cir., 1987).

8. Id.

9. See, K2-II, 22 N.Y.3d 578, 588.

10. Niagara Fire Ins., supra; See, Worth Constr. v. Admiral Ins., 10 N.Y.3d 411, 415-416.

11. See, Cone v. Nationwide Mut. Fire Ins., 75 N.Y.2d 747, 748-749.

12. K2 Investment Grp., 91 A.D.3d 401, 408-411 (1st Dept. 2012) (dissenting opn.) (Emphasis added).

13. See, note 2.

14. See, Public Serv. Mut. v. Goldfarb, 53 N.Y.2d 392, 401 n.; Hartford Acc. & Indem. v. Village of Hempstead, 48 N.Y.2d 218, 228-229; Prashker v. U.S. Guar., 1 N.Y.2d 584, 593; Nelson Electrical Contracting v. Transcontinental Ins., 231 A.D.2d 207 (3d Dept. 1997), lv. denied 91 N.Y.2d 802; Ladner v. American Home Assur., 201 A.D.2d 302 (1st Dept. 1994).

15. Ladner, 201 A.D.2d, supra, at 303-304; See, Public Serv., 53 N.Y.2d, supra, at 401 n.; Prashker, 1 N.Y.2d, supra, at 593.

16. See, note 12.

17. K2-II, supra, at 587-588.

18. See, note 14.

19. See, Public Serv., 53 N.Y.2d, supra, at 401 n.

20. See, QBE Insurance v. Jinx Proof, 22 N.Y.3d 1105, 1109-1110 (Feb. 18, 2014) (dissenting opn., Pigott, J.; Lippman, Ch. J., concurring).

21. See K2-II, supra, at 588.