In the underlying dispute that gives rise to K2, plaintiffs loaned the insured's company $2.83 million backed by mortgages. When the company failed to repay the loans, plaintiffs discovered that the insured's principle, an attorney, never recorded the mortgages. Plaintiffs sued, alleging that the insured attorney acted as their attorney in regard to the loans and that his failure to record the mortgage constituted legal malpractice.

The insured notified his malpractice insurer of the claim, and the insurer denied coverage for defense and indemnity, saying the allegations were not based on the rendering or failing to render legal services for others. The insurer rejected plaintiffs' $450,000 settlement offer on the same basis. Plaintiffs secured a default judgment in excess of the policy limits. The insured attorney assigned to underlying plaintiffs his causes of action for breach of contract and bad faith failure to settle against the malpractice insurer, resulting in the K2 coverage action.

In the K2 coverage action, the insurer moved for summary judgment, arguing that the policy's “insured status” and “business enterprise” exclusions barred coverage because the claims arose from the insured attorney's capacity or status as a member and owner of the defaulting company, and from his acts or omissions on the company's behalf. The trial court disagreed and granted plaintiffs' cross motion, holding that the insurer breached its duty to defend the insured attorney, and was obligated to pay the judgment against him up to the policy's limit. The trial court dismissed the bad faith claims. The Appellate Division, First Department, affirmed both rulings, with two judges dissenting on the basis that issues of fact existed regarding the exclusions' application.                        

The Court of Appeals affirmed the Appellate Division's ruling without addressing whether the exclusions applied. Instead, the court held that by breaching its duty to defend the insured attorney, the malpractice insurer lost its right to rely on policy exclusions in litigation over its obligation to indemnify the insured.

In its K2 decision, the Court of Appeals seems to implicitly overrule Servidone Construction Corporation v. Security Insurance Company of Hartford, in which the Court of Appeals held that an insurer's breach of the duty to defend does not create coverage for indemnification. Coincidentally, on the day the K2 decision was issued, the U.S. Court of Appeals for the Second Circuit issued its decision in CGS Industries, Inc. v. Charter Oak Fire Insurance Company, citing Servidone, and holding that, although an insurer breached the duty to defend, it did not owe the insured indemnification. In CGS Industries, the insured has sought a rehearing, relying in part on theK2 decision.

Before K2, the Court of Appeals' holding in Lang v. Hanover Insurance Company, provided the standard: “[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.” Under Lang, an insurer could litigate its disclaimer for indemnification even if it had breached its duty to defend—unless the issue determinative of the insurer's duty to indemnify was already decided in the underlying action for which it failed to provide a defense.

Insureds may argue the K2 court has expanded Lang to preclude any insurer that has breached its duty to defend from litigating its duty to indemnify. In response, insurers may take the position that K2 is consistent with Lang, because the apparent expansion was not necessary to the holding, and is merely dictum. In K2, the claims against the insured attorney included a claim for malpractice in the representation of the underlying plaintiffs. Although the claim was likely groundless, it arguably triggered the duty to defend. It was on this claim alone that the default judgment was entered.

Thus, the K2 court could have held that 1) the malpractice claim triggered the duty to defend; 2) the insurer breached that duty; 3) the default judgment determined that the insured was liable for malpractice; and 4) the insurer could not litigate the issue of whether the insured was liable for malpractice, which is covered, because that was determined in the underlying litigation. Yet, the court went on to state, perhaps unnecessarily, that if an insurer breaches its duty to defend, it must indemnify its insured for the resulting judgment, even though policy exclusions may apply.

The K2 decision leaves open the argument that breaching a duty to defend would not create indemnity coverage where no coverage existed in the first instance, as opposed to where a policy exclusion applies. The decision also creates a possible exception, where indemnification of an insured is against public policy.

In Hough v. USAA Casualty Insurance Company, the First Department recently held that an insurer's breach of its duty to defend does not preclude it from denying coverage for indemnity where the insured intentionally injured the underlying plaintiff. The K2 court justified the Hough decision on public policy grounds, but stated that such grounds did not exist in the K2 matter.

Although the K2 court affirmed the dismissal of the bad faith claims, the court has arguably awarded extra-contractual damages—loss of reliance on policy exclusions. It remains to be seen how broadlyNew York courts will apply this new rule, which was formed without express consideration of longstanding precedent.

A motion to reargue the K2 decision is pending. If the decision stands, before denying coverage, an insurer would be well-advised to consider defending its insured under a reservation of rights, and filing a declaratory judgment action to determine its obligations.

Melissa F. Brill is a member in Cozen O'Connor's Global Insurance Group and a resident in the firm'sNew Yorkoffice. She may be reached at [email protected].