Prior Knowledge Exclusions in Excess Policies Bar Coverage of Legal Malpractice Claims

 

In Executive Risk Indem. Inc. v. Pepper Hamilton LLP, 2009 WL 3347222 (N.Y.), the Court of Appeals of New York was asked to determine, under Pennsylvania law, whether excess insurers Executive Risk Indemnity Inc. and Twin City Fire Insurance Company, based upon their prior knowledge exclusions, and Continental Casualty Company, based upon rescission of its policies, were entitled to summary judgment declaring that they had no obligation to indemnify defendants Pepper Hamilton LLP and one of its members, W. Roderick Gagné, in actions asserted against them for, among other claims, professional malpractice.

 

The underlying actions arose out of the law firm defendants' representation of non-parties Student Finance Corporation (SFC), its principal, Andrew Yao, and Royal Indemnity Company. Yao founded SFC, a company that serviced the vocational portion of the student loan market. Defendant Gagné, then an associate of a non-party law firm, assisted with SFC's formation and its securitization. Gagné later became a member of Pepper Hamilton and brought Yao and SFC with him as clients. In the course of Pepper Hamilton's representation of SFC, the firm prepared documents which SFC used in connection with the sale of certificates totaling more than $465 million, and Gagné also participated in discussions concerning SFC's operations with Yao. Royal Indemnity, a client of Pepper Hamilton, also provided SFC with credit risk insurance for the pooled loans.

 

Pepper Hamilton originally had two policies, $20 million of primary coverage under a Westport policy and $30 million of excess coverage under a Continental Casualty policy. The law firm later decreased its coverage from $50 million to $40 million and obtained policies with two additional insurers, Executive Risk and Twin City . In the subsequent years, Westport issued a $10 million primary coverage policy to Pepper Hamilton, and Twin City , Executive Risk, and Continental Casualty each issued Pepper Hamilton $10 million of excess coverage. Each excess policy substantially incorporated the terms, conditions, warranties, and exclusions of the Westport policy.

 

In March 2002, months before Executive Risk and Twin City issued their respective policies to Pepper Hamilton, the law firm defendants learned that SFC had been involved in securities fraud in failing to disclose the forbearance payments. Yao informed Gagné that SFC was inaccurately representing its default rate to make its certificates appear more attractive to investors, underwriters, and credit risk insurers. Pepper Hamilton continued to represent SFC until April 2002.

 

In July, 2002, Chubb Wilcox, Pepper Hamilton's general counsel and insurance procurer, sent a memorandum to Pepper Hamilton attorneys regarding the firm's insurance application and inquired whether any person was “aware of any fact or circumstance, act, error, omission or personal injury which might be expected to be the basis of the claim or suit for lawyers professional liability.” Gagné responded that he was aware of the Student Finance Corporation transactions and that two law suits had been filed in two different states and to date, the firm had not been named in either action. He also stated that he was not certain as to whether the firm would be joined in the future. Pepper Hamilton then submitted an insurance application to Westport , which did not include information concerning SFC, and in a letter to Twin City Pepper Hamilton warranted that it had no material changes to its application. Pepper Hamilton did not disclose information concerning SFC to any of its insurers.

 

Eventually, SFC was forced into bankruptcy. Pepper Hamilton received a proposed tolling agreement from SFC's bankruptcy trustee, which advised that valid claims and causes of action could be brought against Pepper Hamilton on behalf of the estate and/or creditors of SFC. Pepper Hamilton immediately contacted its primary insurer Westport and excess insurers Executive Risk, Twin City and Continental Casualty and informed them of the potential claims.

 

The bankruptcy trustee and Royal Indemnity then brought separate actions against the law firm, alleging, among other claims, breach of fiduciary duty, negligent misrepresentation, and professional malpractice. Although Pepper Hamilton's primary insurer, Westport , did not contest its obligation to defend, the excess insurers denied coverage.

 

Executive Risk commenced an action against the law firm defendants and Westport , seeking a declaration that it had no obligation to indemnify in the underlying actions. The law firm defendants counterclaimed for a declaration in their favor and brought third-party claims against Twin City and Continental Casualty. Executive Risk and Twin City relied upon Westport 's prior knowledge exclusion, expressly incorporated into their policies, and Continental Casualty cross-claimed for rescission of its excess policies.

 

The supreme court granted summary judgment in favor of the excess insurers. The court declared that, based on the policies' prior knowledge exclusions, which denied professional liability coverage for undisclosed acts that were known to the insured prior to the inception of the policies and exposed the insured to professional liability claims, Executive Risk and Twin City had no obligation to indemnify the law firm defendants in the underlying actions. Additionally, Supreme Court rescinded the law firm defendants' 2002-2003 and 2003-2004 Continental Casualty professional liability policies because they did not disclose information, during the renewal periods of those policies, concerning known acts that exposed them to the underlying professional liability claims. The court further declared that the underlying actions were not covered under the 2001-2002 Continental Casualty policy. The appellate division reversed the supreme court order and denied all motions and cross motions for summary judgment. The appellate division granted the excess insurers leave to appeal

 

The court of appeals held that, under Pennsylvania law, prior knowledge exclusions in the law firm's excess policies applied to bar coverage of legal malpractice claims asserted against the firm based on its client's securities fraud.

 

The court explained that a court determining whether an insurance policy's prior knowledge exclusion applies must first consider the subjective knowledge of the insured and then the objective understanding of a reasonable attorney with that knowledge. 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.

 

Here, it was undisputed that the law firm defendants knew of SFC's securities fraud months prior to the effective dates of the Executive Risk and Twin City policies. Gagné subjectively believed, and informed Mr. Wilcox, that he and the law firm could be subject to a lawsuit from their representation of SFC. Such a belief, although subjective, was also reasonable, but Pepper Hamilton did not provide that information to its insurers.

 

Further, contrary to the appellate division's holding, the prior knowledge exclusion in this case did not require the known act, error, omission or circumstance to be “wrongful conduct on the part of the insured”. Here, on the effective date of the Executive Risk and Twin City policies, the law firm defendants knew of acts that occurred prior to that date, which they could have foreseen to be the basis of a claim. Thus, the prior knowledge exclusions applied to those policies.

 

The court also held that a genuine issue of material fact as to whether the insurer would have renewed the law firm's excess policy if the firm had disclosed its client's securities fraud precluded summary judgment on the insurer's rescission claim.

According to the court, rescission of an insurance policy may occur only if the 1) applicant made a false statement, 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 The insurer must prove all elements by clear and convincing evidence. Pennsylvania recognizes an omission as a false representation in the context of insurance applications.

 

The court agreed with the appellate division that, even if the law firm's omission of the SFC incident was a known false statement, Continental Casualty failed to establish as a matter of law that the false statement was material to the reinsurance determination and that the false statement was made in bad faith. Thus, the court found that the lower court correctly denied summary judgment on the issue of rescission.