Insurers frequently rely on “prior knowledge” exclusions in an effort to avoid coverage under claims-made liability insurance policies. In OneBeacon Insurance Co. v. T. Wade Welch & Associates et al., the Fifth Circuit recently affirmed a $28 million judgment following a jury verdict against One Beacon Insurance Company, finding that the insurer had wrongfully declined to indemnify a law firm in a legal malpractice case based on a prior knowledge exclusion in its policy. The court held that the prior knowledge exclusion in the policy was overly broad and that “[a]s written . . . the exclusion renders the coverage illusory and is facially absurd.”

The Policies: OneBeacon issued a series of professional liability policies to T. Wade Welch & Associates (the “Welch Firm”) beginning in December 2006. In the application for the first policy, Wade Welch, the principal of the firm, represented that after inquiring of each lawyer in the firm, he was not aware of “any fact or circumstance, act, error, omission or personal injury which might be expected to be the basis of a claim or suit” against the firm.”

Each of the One Beacon policies contained a prior knowledge exclusion barring coverage for

any claim arising out of a wrongful act occurring prior to the policy period if, prior to the effective date of the first Lawyers’ Professional Liability Insurance Policy issued by [OneBeacon] to [the Welch Firm] and continuously renewed and maintained in effect to the inception of this policy period … you had a reasonable basis to believe that you had committed a wrongful act, violated a disciplinary rule, or engaged in professional misconduct; [or] you could foresee a claim would be made against you.

For an additional premium, the Welch Firm purchased a retroactive date for the policy of January 4, 1995. The retroactive date set the earliest possible date when a wrongful act or omission could occur and still be covered under the policy.

The Welch Firm renewed the 2006-2007 policy in subsequent years, making the same representations about its knowledge of potential claims.

The Malpractice Claim: The Welch Firm represented DISH Network Corp. in a lawsuit filed against it by Russia Media Group (“RMG”). During the course of discovery in the DISH lawsuit, the Welch Firm failed to timely serve discovery responses after the court had ordered DISH to respond. In February 2007, RMG moved for “death penalty” sanctions for DISH’s failure to respond to the discovery. In February 2008, the district court affirmed an order entered by the magistrate judge granting sanctions. Specifically, the court held that DISH could not oppose RMG’s three primary claims and barred DISH from challenging RMG’s damages.

The Coverage Dispute: Prior to Welch’s application for the renewal of the initial OneBeacon policy for a subsequent (2007-2008) year, the firm failed to respond to the discovery giving rise to the subsequent sanctions motion. Mr. Welch was not aware of this fact and noted in the policy application that the firm was not “aware of any fact, circumstance, or situation which might reasonably be expected to give rise to a claim.”

After the entry of the death penalty order, Wade Welch learned for the first time of the discovery dispute and the sanctions motion and order. He then notified OneBeacon of a potential malpractice claim. OneBeacon acknowledged the claim.

In June 2008 the Welch Firm informed OneBeacon that RMG had made a demand of $105,800,000 to DISH to settle the underlying lawsuit. In December 2010, DISH requested that OneBeacon make its policy limits available for a potential settlement with RMG and in June 2011 DISH offered to settle and release the Welch Firm in exchange for OneBeacon’s policy limits.

OneBeacon responded in August 2011 and declined DISH’s settlement offer. OneBeacon then rescinded the Welch Firm’s policy and filed suit seeking a declaration that the prior-knowledge exclusion in its exclusion barred coverage. The Welch firm counterclaimed, and DISH intervened. In the interim, DISH demanded arbitration against the Welch firm for malpractice.

The parties filed motions for summary judgment, including cross-motions regarding the policy’s prior-knowledge exclusion. The Welch Firm argued that the court should enforce the prior-knowledge exclusion only if a reasonable attorney with defense counsel’s subjective knowledge at the time of application could have reasonably expected his acts, errors and omissions could lead to a malpractice claim. The trial court agreed and rejected OneBeacon’s argument that the that the prior-knowledge exclusion should be read in isolation. The court found ruled that it must consider the context of the policy as a whole, because to do so would render the policy’s retroactive coverage illusory.

The case proceeded to trial and based on this standard, a Houston jury found that the prior knowledge exclusion did not bar coverage, because OneBeacon had not shown that a reasonable attorney, given defense counsel’s knowledge in December 2006 − the date of the first application for coverage − could have reasonably expected his actions to result in a malpractice claim. The jury awarded the Welch Firm $33 million, which the district judge reduced to $28 million.

On appeal, the Fifth Circuit upheld the trial court’s ruling on the prior-knowledge exclusion. The court found that the prior-knowledge exclusion must be read in conjunction with the required disclosures in policy application and that the exclusion applied only to a claim arising out of a wrongful act that the insured could reasonably foresee at the time of the application would result in a claim. The court of appeals clearly rejected OneBeacon’s arguments, holding:

The district court could not apply the literal policy language because of the extreme overbreadth of the wrongful act definition used in the exclusion: ‘any actual or alleged act, error, omission or breach of duty arising out of the rendering or the failure to render professional legal services.’ On its face this covers every single thing an attorney does or does not do, wrongful act or not. As written, then, the exclusion renders the coverage illusory and is facially absurd.”

Impact: Insurers issue claims-made policies on many different policy forms, and these policies often include endorsements that alter the terms of the core policy firm. In Welch, OneBeacon issued a policy where the prior-knowledge exclusion was so broad that it subsumed the coverage afforded by the main policy form. The insurer has control over the wording of its policy, and in this case it issued a policy with contradictory terms and then tried to enforce it in a way that made the coverage illusory. It paid a price for doing so.

Policyholders with claims-made coverages should take note of this decision. It is important to review your policy form at renewal and to focus on the key timing elements of claims-made forms – the retroactive date in the policy, the terms of the grant of the “claims-made” coverage, the reporting requirements in the policy, and the exclusions. The insured also should compare the representations it is asked to make in its application to the terms and exclusions in the policy to make sure that the coverage offered is consistent with the insured’s expectations.