“Prior Knowledge” Exclusion, Law Firm Coverage and Client Fraud

Issues of fraud arise in numerous contexts in the insurance industry.  Not only are questions of fraud often relevant to determining the validity of claims, they also arise in determining if a claim was timely disclosed at the inception of the insuring relationship. 

Professional liability insurance policies purchased by lawyers and other professionals typically contain a “prior knowledge” exclusion that bars coverage for claims that the policyholders knew about before the policy was issued. A typical prior knowledge exclusion might say that the policy does not apply to claims “arising out of any error, omission, negligent act or personal injury occurring prior to the inception date of this policy if any insured prior to the inception date knew or could have reasonably foreseen that such error, omission, negligent act or personal injury might be expected to be the basis of a claim or suit.”[1]

In many instances, and probably in most instances, where the prior knowledge exclusion is at issue, the claims brought against a law firm are malpractice claims. For example, in Liberty Ins. Underwriters Inc. v. Corpina Piergrossi Overzat & Klar LLP,[2] the insurance carrier argued that it was not obligated to defend or indemnify attorneys in an underlying malpractice action because, prior to the effective date of the first legal malpractice policy issued by the insurer to the attorneys in July 2004, the attorneys had a reasonable basis to foresee that their former client would make a claim against them.

The underlying legal malpractice action arose out of the attorneys’ representation of the former client in connection with a medical malpractice claim for personal injuries allegedly caused by vaccinations administered to the former client in 1991, when he was an infant. The Appellate Division, First Department, decided that neither the insurance carrier nor the attorneys were entitled to summary judgment.

The typical prior knowledge exclusion requires notification of potential claims against the insured that go beyond malpractice claims and includes potential claims against professionals arising out of their clients’ fraudulent conduct.  Since the economy faltered in 2008, with the concomitant disclosure of the Madoff fraud and other instances of financial fraud, lawyers and other professionals must be cognizant that the prior knowledge exclusion may be relevant in more than just malpractice actions. These policyholders are discovering that the exclusion may block insurance coverage for claims against them arising from their clients’ underlying fraud.

A recent case analyzing this issue was decided in October 2009 by the New York Court of Appeals. The decision, in Executive Risk Indemnity Inc. v. Pepper Hamilton LLP,[3] highlights the risks law firms face when clients are involved in fraud and the firms choose not to disclose their involvement with the client to their insurer.

Executive Risk

The case involved the representation by Pepper Hamilton LLP and one of its partners, W. Roderick Gagné (collectively, the law firm defendants), of Student Finance Corporation (SFC), its principal, Andrew Yao, and Royal Indemnity Company. As the Court explained, in 1992, Mr. Yao founded SFC, a company that serviced the vocational portion of the student loan market. SFC financed loans to students attending vocational schools and acquired student loans from other lenders. It pooled those loans into certificates and sold them to investors. Mr. Gagné, then an associate at another law firm, assisted with SFC’s formation in 1992 and its securitization in 1996.

In 1996, Mr. Gagné became a member of Pepper Hamilton and brought Mr. Yao and SFC with him as clients.

In the course of Pepper Hamilton’s representation of SFC, the law firm prepared eight private placement memoranda in 2000 and 2001, which SFC used in connection with the sale of certificates totaling more than $465 million. Mr. Gagné also participated in discussions concerning SFC’s operations with Mr. Yao. Royal Indemnity, a client of Pepper Hamilton, provided SFC with credit risk insurance for the pooled loans from 1999 to 2001.

Among the insurance policies that Pepper Hamilton had during this time period were policies from Executive Risk Indemnity Inc. and Twin City Fire Insurance Company that substantially incorporated the terms, conditions, warranties and exclusions of a primary policy issued by Westport Insurance Corporation. The Westport policy excluded from coverage “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. This exclusion does not apply to any INSURED who had no knowledge or could not have reasonably foreseen that such act, error, omission, circumstance or PERSONAL INJURY might be the basis of a claim.”

In March 2002, before Executive Risk and Twin City issued their respective policies to Pepper Hamilton, the law firm defendants learned that SFC apparently had been involved in securities fraud. Mr. Yao informed Mr. Gagné that SFC was inaccurately representing its default rate to make its certificates appear more attractive to investors, underwriters and credit risk insurers. Specifically, the Court said, Mr. Yao told Mr. Gagné that SFC made forbearance payments from its reserve accounts on student loans that were more than 90 days past due.

On July 22, 2002, Pepper Hamilton’s general counsel 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.” On August 6, 2002, Mr. Gagné responded, “I am aware [of] the Student Finance Corporation transactions of which you are familiar . . . [T]wo law suits have been filed in two different states and to date, we have not been named in either action. I am not certain as to whether we will be joined in the future.” On September 6, 2002, Pepper Hamilton submitted a signed and dated insurance application to Westport that did not include information concerning SFC, and in a letter to Twin City, dated October 25, 2002, 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. In April 2004, 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 Westport, Executive Risk and Twin City and informed them of the potential claims.

In 2004 and 2005, the bankruptcy trustee and Royal Indemnity brought separate actions against the law firm defendants, alleging, among other claims, breach of fiduciary duty, negligent misrepresentation and professional malpractice. Pepper Hamilton’s primary insurer, Westport, did not contest its obligation to defend. However, the excess insurers denied coverage.

Executive Risk filed suit against the law firm defendants and Westport, seeking a declaration that it had no obligation to indemnify the defendants in the underlying actions. The law firm defendants counterclaimed for a declaration in their favor and brought third party claims against Twin City. Executive Risk and Twin City relied upon Westport’s prior knowledge exclusion, expressly incorporated into their policies.

The Supreme Court, New York County, 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. A divided Appellate Division, First Department, reversed, and the dispute reached the Court of Appeals.

Court of Appeals’ Ruling

In its decision, the Court explained that, under governing Pennsylvania law,[4] there is a two-pronged test to determine whether a prior knowledge exclusion applies. First, a court must consider the subjective knowledge of the insured. Then, it has to examine the objective understanding of a reasonable attorney with that knowledge.  Referencing the decision by the U.S. Court of Appeals for the Third Circuit in Coregis Insurance Company v. Baratta & Fenerty, LTD,[5] the Court said that “it must be shown that the insured knew [prior to the effective date of the policy] of certain facts” that occurred prior to that effective date, and then the court must determine that a “reasonable lawyer in possession of such facts would have had a basis to believe that the insured” might expect such facts to be the basis of a claim against the insured.

In this case, the Court found, it was “undisputed” that the law firm defendants knew of SFC’s alleged securities fraud months prior to the effective dates of the Executive Risk and Twin City policies. Mr. Gagné subjectively believed, and informed the firm at least one month prior to the submission of one of the law firm’s insurance applications, that he and the law firm could be subject to a lawsuit from their representation of SFC. The Court found that this belief, although subjective, also was reasonable – but the law firm did not provide that information to its insurers.

Given the law firm defendants’ role in the securitization of the loans and Mr. Gagné’s close involvement with SFC, the Court ruled that a reasonable attorney with the law firm defendants’ knowledge should have anticipated the possibility of a lawsuit, particularly when millions of dollars may have been lost from activities of which they were aware. Here, the law 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 satisfied the Coregis test and created an obligation for the law firm to inform its insurers of this potential litigation.

The Court concluded that on October 27, 2002, 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, it held, the prior knowledge exclusions applied to those policies.

A CPA Case

A more recent decision, in CPA Mut. Ins. Co. of Am. Risk Retention Group v. Weiss & Co.,[6] reached the same conclusion with respect to the prior knowledge exclusion. In this case, the Supreme Court, New York County, granted summary judgment in favor of a professional liability insurance company declaring that the insurance company did not have an obligation to defend or indemnify a CPA firm against a professional liability claim asserted in federal court. According to the First Department, the Supreme Court correctly had found that the “unambiguous prior knowledge exclusion,” which entitled the insurance carrier to disclaim its obligation to defend or indemnify the CPA firm for “any Interrelated Acts or Omissions” that, before the effective date of the policy, it “believed or had a basis to believe might result in a “Claim,” applied in this case.

The First Department found that the record established that the firm, prior to the policy’s effective date, “had subjective knowledge of numerous facts pertaining to a fraudulent scheme undertaken by their clients, which involved or implicated [the firm] as well.” Given this evidence, the First Department concluded, it was unreasonable for the firm to have failed to foresee that these facts “might form the basis of a claim” against it.

Moreover, the appellate court decided, the firm’s “subjective belief” it was not facing a claim in connection with the fraud committed by its clients “would not have warranted a different result” because such a belief “would not have been reasonable under the circumstances.”

Conclusion

The Executive Risk rule does not necessarily require that law firms notify their professional liability insurance carrier any time they discover that a client may be perpetrating a fraud or other illegal act. Indeed, such a broad ruling would implicate various ethical obligations owed by an attorney to its clients, especially in regard to privileged information. 

While the scope of a law firm’s responsibilities in this area remains somewhat obscure, in view of the growing likelihood of attorneys and other professionals becoming parties to litigation involving their clients’ activities, it would seem prudent, at the least, for a firm, when applying for a new policy or a renewal of an existing policy, to carefully consider the scope of the prior knowledge exclusion to determine the information it should provide to its insurance carrier.

[1] See, e.g., St. Paul Fire & Marine Ins. Co. v. Sledjeski & Tierney, PLLC, 2009 U.S. Dist. LEXIS 61393 (E.D.N.Y. July 17, 2009).

[2] 78 A.D.3d 602 (1st Dep’t 2010).

[3] 13 N.Y.3d 313 (2009).

[4] While the dispute was governed and resolved under Pennsylvania law, there is no indication in the decision that New York law would be any different. Indeed, one recent district court ruling predicted that New York would apply the same legal test. See Quanta Lines Ins. Co. v. Investors Capital Corp., 2009 U.S. Dist. LEXIS 117689 (S.D.N.Y. Dec. 17, 2009).

[5] 264 F.3d 302 (3d Cir. 2001).

[6] 2011 N.Y. Slip Op. 00018 (1st Dep’t Jan. 4, 2011).

This article is reprinted with permission from the March 4, 2011 issue of the New York Law Journal. Copyright ALM Properties, Inc. Further duplication without permission is prohibited. All rights reserved.