Reversing the intermediate appellate court, New York’s highest court recently granted summary judgment in favor of two excess insurers based upon their policies’ prior knowledge exclusion. In Executive Risk Indemnity Inc. v. Pepper Hamilton LLP, et al., No. 130 (Oct. 20, 2009), a case governed by Pennsylvania law, the insured law firm sought coverage for various malpractice claims asserted against it in connection with its representation of Student Finance Corp. (“SFC”), whose principal was subsequently convicted of securities fraud.
According to the decision, in March of 2002, the insured and one of its partners reportedly learned that SFC and its principal had engaged in securities fraud in connection with SFC’s securitization of student loans, and ended their representation of the company shortly thereafter.
In October of 2002, the insured’s professional liability insurance came up for renewal. The renewal application included a question as to whether any of the insured’s attorneys were “aware of any fact or circumstance, act, error, omission or personal injury that might be expected to be the basis for a professional liability claim.” A partner reportedly brought the SFC incident to the attention of the firm’s general counsel, but the insured reportedly did not disclose its involvement with SFC.
In April 2004, SFC’s bankruptcy trustee proposed that the insured enter into a tolling agreement with respect to potential claims against the firm by the bankruptcy estate of SFC and its creditors. The insured first gave notice to its primary and excess insurers at that time. Beginning in 2005, lawsuits were commenced against the insured for breach of fiduciary duty, negligent misrepresentation and professional malpractice, which was defended by its primary insurer.
The insured’s excess insurers denied coverage and a declaratory judgment action was subsequently commenced to determine the parties’ rights and obligations. Two of three excess insurers sought a declaration that they did not owe coverage based on the primary policy’s prior knowledge exclusion, which was incorporated into the excess policies and provided as follows: “any act, error, omission, circumstance or personal injury occurring prior to the effective date of this policy if any insured at the effective date knew or could have reasonably foreseen that such act, error, omission, circumstance or personal injury might be the basis of a claim….”
In its decision, the Court explained that under Pennsylvania law, “[a] court must consider the following two-pronged test when determining whether a prior knowledge exclusion applies. It must first consider the subjective knowledge of the insured and then the objective understanding of a reasonable attorney with that knowledge…. Specifically, it must be shown that the insured knew prior to effective date of the policy of certain facts that occurred prior to that effective date. Then, a court must determine that a reasonable attorney in possession of such facts would have a basis to believe that the insured might expect such facts to be the basis of a claim against the insured.” (Citations and quotations omitted).
Accordingly, the Court held that the insured firm’s “knowledge of its client’s fraudulent payments prior to its application for excess coverage coupled with the fact that a reasonable attorney would have concluded that the law firm defendants would likely be included in the litigation because of their role in their client’s business satisfy the [foregoing] test…and create an obligation for the law firm to inform its insurers of this potential litigation.” Moreover, the Court stated that “[c]ontrary to the Appellate Division’s holding, the prior knowledge exclusion in this case does not require the known of act, error, omission or circumstance to be ‘wrongful conduct on the part of the insured.’”
The third excess insurer involved in the declaratory judgment action sought to deny coverage based on a rescission theory. Under Pennsylvania law, rescission of an insurance policy may occur only if the insurer proves by clear and convincing evidence that “(1) applicant made a false statement [which includes an omission], (2) the false statement was material to the risk, (3) the applicant knew the statement was false and (4) the statement was made in bad faith.” Based on this standard, the Court held that “[E]ven if the law firm defendants’ omission of the SFC incident is a known false statement, [the third excess insurer] failed to establish as a matter of law that the false statement was material to the reinsurance [sic] determination and that the false statement was made in bad faith. Here, the self-serving affidavit of [the third excess insurer’s] underwriter -- that [the firm’s] renewal application would have been treated differently had it disclosed the underlying circumstances which led to the denial of coverage -- is insufficient to meet the insurer’s heightened burden of proof.”