Insurer That Breached Its Duty to Defend Is Bound by the Judgment against Its Insured but Otherwise Free to Contest Its Indemnification Obligation under the Policy

K2 Inv. Grp., LLC v. Am. Guarantee & Liab. Ins. Co., 2014 N.Y. LEXIS 201 (N.Y. Ct. App. Feb. 18, 2014):

American Guarantee & Liability Insurance Company contends, on reargument, that our prior decision in this case, K2 Inv. Group, LLC v Am. Guar. & Liab. Ins. Co. (21 NY3d 384) (K2-I), erred by failing to take account of a controlling precedent, Servidone Const. Corp. v Security Ins. Co. of Hartford (64 NY2d 419 [1985]). We hold that American Guarantee is correct.

I

A brief summary of the case will do for present purposes: Claims for legal malpractice were brought against American Guarantee's insured, Jeffrey Daniels, which American Guarantee -- wrongly, it is now conceded -- refused to defend. Daniels suffered a default judgment, and then assigned his rights against American Guarantee to the plaintiffs in the suit against him. Those plaintiffs brought the present case, seeking to enforce American Guarantee's duty to indemnify Daniels for the judgment. In defense, American Guarantee asserted that the loss was not covered, relying on two exclusions in the policy. (The facts are described in more detail in our K2-I opinion, 21 NY3d at 387-389.)

In K2-I, we affirmed an order granting plaintiffs summary judgment, holding that American Guarantee's breach of its duty to defend barred it from relying on policy exclusions. We later granted reargument (21 NY3d 1049 [2013]), and we now vacate our prior decision and reverse the Appellate Division's order.

II

In Servidone -- a case in which, as in this one, the insurer was relying on policy exclusions in defending against a suit for indemnification -- we stated the question as follows:

"Where an insurer breaches a contractual duty to defend its insured in a personal injury action, and the insured thereafter concludes a reasonable settlement with the injured party, is the insurer liable to indemnify the insured even if coverage is disputed?"

(64 NY2d at 421.)

   We answered the question in Servidone no. In K2-I, we held that "when a liability insurer has breached its duty to defend its insured, the insurer may not later rely on policy exclusions to escape its duty to indemnify the insured for a judgment against him" (21 NY3d at 387). The Servidone and K2-I holdings cannot be reconciled.

Plaintiffs suggest that the cases are distinguishable because in Servidone the insured had settled with the plaintiff in the underlying litigation, whereas here there was a judgment, not a settlement. We do not find the distinction persuasive. A liability insurer's duty to indemnify its insured does not depend on whether the insured settles or loses the case. It is true that a judgment, unlike most settlements, is a binding determination of the issues in the underlying litigation. Thus it can be said here, as it could not in Servidone, that the issues in the suit brought against the insured are now res judicata. But that is irrelevant, because American Guarantee does not seek here,  [*4] and the defendant in Servidone did not seek, to relitigate the issues in the underlying case. It is well established that such relitigation is not permitted after an insurer has breached its duty to defend (see the authorities discussed in K2-I, 21 NY3d at 390). The  [**3]  issue in Servidone, as here, is whether the insurer may rely on policy exclusions that do not depend on facts established in the underlying litigation.

***

In short, to decide this case we must either overrule Servidone or follow it. We choose to follow it.

There is much to be said for the rule of K2-I, as our previous opinion shows; but, as the Servidone opinion shows, there is also much to be said for the Servidone rule. Several states follow the Servidone approach (e.g., Sentinel Ins. Co. v First Ins. Co. of Hawai'i, Ltd., 76 Hawaii 277, 290-297, 875 P2d 894, 907-914 [1994]; Polaroid Corp. v Travelers Indemnity Co., 414 Mass 747, 760-766, 610 NE2d 912, 919-923 [1993]), while others adopt a rule like that of K2-I (e.g., Employers Ins. of Wausau v Ehlco Liquidating Trust, 186 Ill2d 127, 150-154, 708 NE2d 1122, 1134-1136 [1999]; Missionaries of Co. of Mary, Inc. v Aetna Cas. and Sur. Co., 155 Conn 104, 112-114, 230 A2d 21, 25-26 [1967]). A federal district judge, writing in 1999, said that "the majority of jurisdictions which have considered the question" follow the Servidone rule (Flannery v Allstate Ins. Co., 49 F Supp 2d 1223, 1227 [D Colo 1999]).

Under these circumstances, we see no justification for overruling Servidone. Plaintiffs have not presented any indication that the Servidone rule has proved unworkable, or caused significant injustice or hardship, since it was adopted in 1985. When our Court decides a question of insurance law, insurers and insureds alike should ordinarily be entitled to assume that the decision will remain unchanged unless or until the Legislature decides otherwise.  [*7] In other words, the rule of stare decisis, while it is not inexorable, is strong enough to govern this case.

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