New York Court of Appeals Sets Forth New Rule for Breach of Duty to Defend

In its recent decision in  K2 Investment Group, LLP v. American Guarantee & Liability Ins. Co., 2013 N.Y. LEXIS 1461, 2013 NY Slip Op. 4270 (NY June 11, 2013), New York's Court of Appeals – New York’s highest court – announced a new rule regarding the consequences for breaching a duty to defend under New York law.

Prior to the decision in K2, New York courts at both the state and federal level consistently rejected the notion that by having breached a duty to defend, an insurer is estopped from relying on coverage defenses for the purpose of contesting an indemnity obligation.  See, e.g., Servidone Construction Corp. v. Security Ins. Co., 488 N.Y.S.2d 139 (NY 1985) (holding it is impermissible for a court to enlarge a policy’s coverage on the basis of an insurer’s breach of a duty to defend); Hotel des Artistes, Inc. v. Gen. Accident Ins. Co. of Am., 775 N.Y.S.2d 262 (1^stDep’t 2004); Robbins v. Michigan Millers Mut. Ins. Co., 633 N.Y.S.2d 975 (3d Dep’t 1997); Hugo Boss Fashions, Inc. v. Fed. Ins. Co., 252 F.3d 608 (2d Cir. 2001). In fact, this rule was reaffirmed as recently as June 11, 2013 – the same day as the K2 decision – by the United States Court of Appeals for the Second Circuit in CGS Industries, Inc. v. Charter Oak Fire Ins. Co., 2013 U.S. App. LEXIS 11700 (2d Cir. June 11, 2013). 

The New York Court of Appeals’ June 11, 2013 decision in K2, however, departs from this long-established jurisprudence.  K2 involved loans made by two limited liability companies to a third company, Goldan.  The loans were to be secured by mortgages, but the mortgages were not properly recorded.  The two LLCs subsequently brought suit against Goldan and its two principals, one of whom, Jeffrey Daniels, was an attorney.  The suit asserted a claim of legal malpractice against Mr. Daniels for having failed to record the mortgages.  Mr. Daniels sought coverage from his errors and omissions carrier, American Guarantee, but American Guarantee disclaimed coverage on several grounds. Mr. Daniels subsequently defaulted in the underlying action, and plaintiffs took a judgment in excess of the policy limits of the American Guarantee policy.  The LLCs then asserted a direct action against American Guarantee for breach of contract and failure to settle within policy limits.

American Guarantee moved for summary judgment on the basis of its policy’s “business enterprise” exclusions. It argued that the claim against Mr. Daniels arose out of his capacity or status as a member or owner of Goldan, and that as such, the exclusions applied.  The trial court granted summary judgment in favor of the claimants, and on appeal, New York’s First Department held that the exclusions were “patently inapplicable,” at least for duty to defend purposes, since the essence of the underlying claim was that Mr. Daniels committed legal malpractice.  The Appellate Division, however, was divided as to whether the exclusions applied for the purposes of American Guarantee’s duty to indemnify. 

On appeal to the New York Court of Appeals, American Guarantee essentially conceded that it had breached its duty to defend Mr. Daniels, but argued that it could still rely on the exclusions to avoid a duty to indemnify.  The Court of Appeals disagreed, holding that by having breached its duty to defend Mr. Daniels, American Guarantee “lost its right” to rely on the exclusions for indemnity purposes.  Relying on its decision in Lang v. Hanover Ins. Co., 787 N.Y.S.2d 211 (NY 2004) – a case involving the insurer’s right to contest the insured’s liability for underlying loss after breaching a duty to defend – the court articulated its new rule:

… we 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 its disclaimer." 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. This rule will give insurers an incentive to defend the cases they are bound by law to defend, and thus to give insureds the full benefit of their bargain. 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.  (Emphasis supplied.)

The K2 Court conceded that there may be exceptions to this new rule, such as where public policy precludes indemnification for an underlying loss.  Further, the ruling appears limited in its reach to consideration of whether exclusions can apply after a duty to defend has been breached.  Presumably, this rule will not apply where the underlying loss is covered in the first instance, i.e., not when the loss falls outside the scope of a policy’s insuring agreement. These and other questions, and the reach of K2, will undoubtedly be the subject of future controversy and litigation.

Tenth Circuit Holds Underlying Securities Claims Interrelated

In its recent decision in Brecek & Young Advisors, Inc. v. Lloyds of London Syndicate 2003, 2013 U.S. App. LEXIS 9599 (10^th Cir. May 13, 2013), the United States Court of Appeals for the Tenth Circuit, applying New York law, had occasion to consider whether an underlying securities arbitration related back to claims first made prior to the policy’s inception date, and if so, whether the insurer was estopped from denying coverage on this basis.

Lloyds insured Brecek & Young Advisors, Inc. (“BYA”) under a claims-made and reported broker/dealer professional liability policy in effect for the period December 1, 2006 to December 1, 2007.  The policy contained an “Interrelated Wrongful Acts” provision stating that all claims based on the same wrongful act or interrelated wrongful acts would be deemed a single claim.  The policy also contained an exclusion applicable to claims arising out of wrongful acts for which notice had been given under any prior policy or “any other Wrongful Act whenever occurring, which together with a Wrongful Act which has been the subject to such claim or notice, would constitute Interrelated Wrongful Acts.”  The policy defined “Interrelated Wrongful Acts” as wrongful acts that are:

1.   similar, repeated or continuous; or

2.   connected by reason of any common fact, circumstance, situation, transaction, casualty, event, decision or policy or one or more series of facts, circumstances, situations, transactions, casualties, events, decisions or policies.

The Brecek decision addressed the interrelatedness of three underlying proceedings.  The first, referred to as the “Wahl Arbitration” was a claim first made against BYA while the Lloyds policy was in effect.  The claim alleged that BYA sold unsuitable investment products and that BYA and a co-defendant engaged in practices of churning investments during the period 1999 through 2005.   The claim alleged causes of action against BYA for various theories of agency liability and failure to supervise.   The complaint filed in the Wahl Arbitration was subsequently amended to add twenty-five additional claimants who claimed similar injuries as a result of similar misconduct.

Relevant to coverage for the Wahl Arbitration was a claim first made against BYA in September 2005, referred to as the Knotts Arbitration.  The Knotts Arbitration contained similar allegations and causes of action as alleged in the Wahl Arbitration, and identified the same individual defendants as those identified in the Wahl Arbitration.  Also relevant was a claim first made against BYA in June 2006, referred to as the Colaner Arbitration, which also contained allegations of unsuitability and churning over the same time period by the same group of individual defendants. 

Lloyds initially took the position that the Wahl Arbitration was interrelated to the Colaner Arbitration and therefore should be covered under BYA’s prior policy which had been issued by Fireman’s Fund.  Lloyds subsequently advised, however, that it had determined the Wahl and Colaner matters were not interrelated.  Lloyds thereafter agreed to provide BYA with a defense in the Wahl Arbitration, but took the position that each claimant in the proceeding represented an entirely unrelated claim subject to a separate $50,000 self-insured retention.  While BYA eventually settled with each of the claimants in the Wahl Arbitration, Lloyds prorated the defense costs among all claims and paid indemnity on those claims which exceeded the $50,000 retention.  As a result, Lloyds indemnified BYA for only $385,000 of some $932,000 incurred by BYA in legal fees and settlement payments.

The issue of multiple-retentions eventually was briefed to the United States District Court for the District of Kansas, where the declaratory judgment action was filed.  On motion for summary judgment, Lloyds argued that there was not a sufficient factual nexus between the claimants in the Wahl Arbitration such that they could be considered interrelated, notwithstanding the fact that the claimants were part of the same lawsuit.  In a footnote, Lloyds argued that in the alternative, if the claims asserted in the Wahl Arbitration were found to have arisen from interrelated wrongful acts, then they would necessarily relate back to claims made in the Knotts Arbitration or the Colaner Arbitrations, and therefore excluded by the Lloyds policy.  The district court ruled against Lloyds on the number of retentions, but ordered briefing on Lloyds “relation back” theory.  BYA argued that the Wahl Arbitraiton did not relate back to the earlier claims, but that even if they did, Lloyds was precluded from taking this position based on the doctrines of waiver or estoppel.  The district court ruled against BYA on the issues of waiver and estoppel, but ultimately concluded that the three arbitrations were not interrelated for the purpose of the policy’s exclusion.

On appeal, the Tenth Circuit reasoned that the matters would be deemed interrelated if they shared a “sufficient factual nexus,” which is the standard articulated by New York courts in considering similar “interrelated wrongful act” provisions.  Applying this standard, the court found sufficient common facts to establish interrelatedness.  As the court explained:

Several common facts connect the Wahl, Knotts, and Colaner Arbitrations. All named as respondents BYA, B&G Financial Network, Gergel, and Snyder. Further, both the Wahl and Colaner arbitrations included claims against broker/agents Brandt and Farrar. All of the misconduct was alleged to have taken place during roughly the same time period-from the late 1990s to the mid 2000s. All claims allege the respondents sold unsuitable investment products including various types of annuities. Further, all claims involved allegations of churning or flipping of investment accounts in order to enrich the broker/agents at the expense of account holders. Finally, BYA's liability was predicated on theories of vicarious liability and failure to supervise its broker/agents in each of the claims.

The court concluded that the three arbitrations were connected by common facts, circumstances, decisions and policies such that they were “interrelated” for the purpose of the exclusion in the Lloyds policy.

The court, however, also concluded that Lloyds was potentially estopped from relying on the exclusion as a defense to coverage since it undertook BYA’s defense in the Wahl Arbitration with knowledge of the coverage defense, but only asserted the defense for the first time late in the coverage litigation.  The court agreed BYA was potentially prejudiced in the form of detrimental reliance as a result of Lloyd’s control of BYA’s defense without having properly reserved rights on the “relation back” coverage defense.  The Tenth Circuit, therefore, remanded the proceedings for further consideration of whether BYA detrimentally relied on Lloyds’ conduct, and if so, whether it was entitled to further recovery under the policy notwithstanding the otherwise applicable coverage defense.

D.C. Court Holds No Prejudice Resulting From Insurer’s Control of Defense

In its recent decision in Capitol Specialty Ins. Corp. v. Sanford Wittels & Heisler, LLP, 2011 U.S. Dist. LEXIS 68171 (D.D.C. June 27, 2011), the United States District Court for the District of Columbia had occasion to consider whether the insurer, as a result of its actions, was estopped from denying coverage to its insured.

The policy at issue in Capitol Specialty was a lawyers’ professional liability policy issued to a firm that was sued for malpractice in connection with its prosecution of a class action.  The insurer, Capitol Specialty, agreed to provide the firm with a defense in the malpractice suit under a reservation of rights.  While the insured initially selected defense counsel of its own choice, Capitol Specialty subsequently exercised its right under the policy to pick counsel.  In doing so, Capitol Specialty specifically advised that if the insured did not want to cede control of the defense, Capitol Specialty would “disengage counsel and close this matter.”  Capitol Specialty’s letter regarding selection of counsel reiterated its earlier reservation of rights.  Nearly seven months later, Capitol Specialty denied coverage for the matter based on the policy’s prior knowledge exclusion.

In a subsequent declaratory judgment action, Capitol Specialty was successful in showing that the exclusion operated to preclude coverage.  The insured, however, argued that Capitol Specialty was estopped from denying coverage after having controlled the defense.  The court noted that while Capitol Specialty did control the insured’s defense, it did so under a proper reservation of rights.  Under the circumstances, explained the court, estoppel will lie only where the insured can show that it was actually prejudiced as a result of the insurer’s conduct.  Such prejudice could be shown by demonstrating that the insurer’s control of the defense harmed or hindered the insured by undermining its ability to defend itself.

The insured argued that Capitol Specialty was estopped from denying coverage because: (1) it initially advised that coverage was available for the underlying suit; (2) it assumed the defense of the underlying suit; (3) it waited too long before disclaiming coverage and (4) it prejudiced the insured’s defense.  The court easily rejected the first three points, explaining that these arguments were “not evidence of prejudice” in light of Capitol Specialty’s proper reservation of rights.  Turning to the fourth point, the court held that the insured failed to demonstrate that it had been actually prejudiced.  While Capitol Specialty did cause the insured to terminate its initial counsel, the court explained that this would be prejudicial only if the insured could demonstrate that counsel selected by the insurer performed demonstrably worse than preferred counsel would have performed.  Because the insured alleged no facts of “poor representation or malpractice” and because the insured never objected to Capitol Specialty’s conditional defense, the court concluded that the insured failed to show that it had been prejudiced.