No Longer on the Hook for Indemnity: NY Court of Appeals Reverses Decision That Held Insurers Liable to Indemnify Where They Wrongly Refused to Defend a Claim. In a decision last year in K2 Investment Group, LLC v. American Guarantee & Liability Insurance Co., the New York Court of Appeals held that a wrongful failure to defend would result in the insurer being on the hook for indemnity, even if there was no coverage because of an applicable exclusion. The decision sent shockwaves through the insurance industry. Earlier this year, the court granted reconsideration on the ground that even a wrongful failure to defend does not create indemnity where there is none. This reversal brings New York back in line with the predominant rule nationally.

The Original Decision. The New York Court of Appeals handed down its first decision in K2 Investment Group, LLC v American Guarantee & Liability Insurance Co., 993 N.E.2d 1249 (N.Y. 2013), on June 11, 2013. The underlying case concerned a legal malpractice claim brought against a NY attorney. The plaintiff, K2, loaned money to a company which subsequently defaulted on the loan. The NY attorney partly owned that company, and had failed to register K2’s mortgages. As a result, K2 faced difficulties in recovering against the assets securing the loan. K2 alleged that the NY attorney had represented it in the transaction and had committed malpractice in failing to register the mortgages.

The NY attorney was insured for malpractice by American Guarantee. American Guarantee refused to defend him, and he suffered a default judgment. American Guarantee later conceded that it was, indeed, required to defend the attorney. The attorney assigned his rights against the insurer to K2, which brought suit against American Guarantee seeking indemnification for the judgment against the attorney.

American Guarantee sought to rely on two exclusions in the policy (the “business enterprise” and the “insured’s status” exclusions) to establish that the loss suffered by the attorney was not covered. In its June 2013 decision, the New York Court of Appeals held that the failure of American Guarantee to fulfill its duty to defend the attorney disentitled it from relying on the exclusions in the policy.

The Reversal. The Court was asked to reconsider its earlier decision, and reversed it in an opinion handed down on February 18, 2014: K2 Investment Group, LLC v. American Guarantee & Liability Insurance Co., 983 N.Y.S.2d 761 (N.Y. 2014).

The New York Court of Appeals held that its earlier decision was in error for failing to give regard to a controlling precedent, Servidone Const. Corp. v. Security Ins. Co. of Hartford, 477 N.E.2d 441 (N.Y. 1985). In Servidone, the Court held that when an insurer wrongfully refuses to defend an insured, that insurer is not precluded from asserting its defences to coverage for indemnity. Servidone concerned an insured who had entered into a settlement. The New York Court of Appeals’ judgment in K2 has now confirmed that the same principle applies equally where judgment has been entered against the insured.

Consequences. The June 2013 decision had elicited widespread concern from the NY insurance industry, prompting many insurance associations to file amicus briefs. The Court of Appeals’ reversal not only brings New York back in line with the predominant national rule, but also removes a precedent that may have proved tempting for courts in other states faced with sympathetic insureds.

Defense Costs at Risk in Australia and New Zealand. Recent developments in Australia and New Zealand have called into question whether insureds can access defense costs to defend a claim against them.

New Zealand and many states in Australia, including New South Wales, have statutes which create charges, in favor of claimants, over insurance funds potentially payable to insured defendants. The provisions were designed decades ago, to address a perceived risk of an insured obtaining a sum from an insurer, and then either disappearing or becoming insolvent. In both situations, even if the claimant obtained a verdict against the insured, the claimant may not recover, or may not recover in full. Until recently, these (somewhat obscure) provisions were rarely considered or invoked.

Liability insurance policies typically provide coverage for the costs incurred by an insured in defending a claim, which are to be paid prior to the resolution of the claim. It is also usual for the limits of the policies to be inclusive of defense costs, meaning that payment of defense costs erodes the limit available to meet any eventual liability. Recent decisions in New Zealand and Australia have considered whether, because the payments erode the limit, they are subject to the statutory charge. If defense costs are subject to the charge, then insurers cannot pay defense costs without subjecting themselves to liability for the payments made. More specifically, if an insurer pays defense costs, and a claimant subsequently establishes liability which exceeds the remaining limit on the policy, then the claimant may enforce the charge against the insurer, thereby requiring the insurer to pay the value of the payments already made. To avoid this issue, an insurer may refuse to pay defense costs. While the insured could sue on the contractual right to defense costs in response, the existence of the statutory charge may be a valid defense. These issues are now the subject of competing jurisprudence in Australia and New Zealand.

In Steigrad & Ors v. BFSL 2007 Ltd. & Ors, [2011] NZHC 1037, the New Zealand High Court held that defense costs could be subject to the statutory charge. The New Zealand Court of Appeal overturned that decision. Subsequently, in Chubb Insurance Company v. Moore [2013] NSWCA 212, the New South Wales Court of Appeal considered an effectively identical New South Wales statute. The case was decided on a preliminary issue, such that it was not necessary to consider whether the statutory charge applied to defense costs. That said, the unanimous obiter dicta of the Justices was that the statutory charge could not attach to defense costs. Following the New South Wales decision, by a 3:2 majority, the Supreme Court of New Zealand overturned the New Zealand Court of Appeal, holding that the statutory charge could attach to defense costs. In doing so, the Supreme Court of New Zealand commented negatively upon the New South Wales Court of Appeal decision. An appeal from the New South Wales decision was pending before the High Court of Australia, but in March a conditional settlement was announced such that it is unlikely the appeal will proceed.

The clear result, in New Zealand at least, is that the statutory charge can apply to defense costs. The position in Australia is more uncertain: the industry is guided only by the obiter dicta of an intermediate appellate court, which has been directly engaged with and rejected by the New Zealand Supreme Court.

The Australian insurance industry has responded by offering separate defense costs only coverage. This approach was endorsed by the New Zealand Supreme Court. The New South Wales Court of Appeal acknowledged that, if the charge did apply to defense costs, splitting the coverage would overcome the problem. However, the Court observed that that “supposed solution” is contrary to “commercial logic.” Split coverage encourages insureds to take out more coverage than they may need (for more premium). It also creates a risk that policy funds will be inaccessible to insureds and claimants, because they are available only for defense costs or only to meet liability.

The statutory charge issue continues to be raised in Australia. Insureds would welcome binding precedent or legislative intervention to resolve the current uncertainty. In New Zealand, some commentators are calling for the Supreme Court’s decision to be reversed by legislation.