The New York Court Of Appeals Considers The Consequences Of A Liability Insurer’s Breach Of The Duty To Defend

What are the consequences of a liability insurer's breach of the duty to defend its insured against a potentially covered claim? Recent decisions from the New York Court of Appeals highlight differing views nationwide on whether the breaching insurer is prevented subsequently from contesting its duty to indemnify the insured.

An insured's right to legal representation and the general liability insurer's parallel duty to defend suits, however groundless, false or fraudulent, together provide the insured with the important benefit of "litigation insurance." This opportunity to call upon the insurer's substantial resources and expertise to defend against third-party claims is an oft-cited motive for the purchase of liability insurance. The duty to defend is broad; if at least some of the claims asserted against the insured potentially are covered, the insurer must defend without regard for whether the insured ultimately is liable to the third-party claimant. Given the importance of the insurer's duty to defend to the liability insurance contract, what are the consequences if that duty is breached?

The K2 Decisions

The New York Court of Appeals answered this question with two recent decisions in the same case, the second of which reversed the first. K2 Inv. Grp., LLC v. Am. Guarantee & Liab. Ins. Co., 2014 WL 590662, at *1 (N.Y. Feb. 18, 2014) (K2-II), vacating 993 N.E.2d 1249 (N.Y. 2013) (K2-I). This insurance coverage dispute arose out of a lawsuit between a real estate entity and its investors, who alleged that the real estate entity did not repay loans made by the investors. One of the owners of the real estate entity—a lawyer—tendered the dispute to his professional-liability insurer, which disclaimed a duty to defend or indemnify. The investors obtained a default judgment against the lawyer, who assigned all rights under the policy to the investors. The investors filed a coverage action on behalf of the lawyer, alleging breach of the policy and bad faith failure to settle the underlying dispute.

The trial court entered summary judgment for the investors on their claims that the insurer breached the policy in failing to defend the lawyer, but dismissed the bad faith claim. The intermediate appellate court affirmed this result, holding inapplicable the exclusions relied upon by the carrier. The Court of Appeals affirmed but on a completely different ground. The court began with a principle that most would concede is universal and that is enshrined in New York by Lang v. Hanover Ins. Co., 820 N.E.2d 855 (N.Y. 2004): disclaiming a duty to defend limits precludes an insurer from challenging the underlying liability or damages determination. The court went further, however, holding that if the disclaimer of the duty to defend is not sustained, then "the insurance company must indemnify its insured for...