The Prior Knowledge Coverage Defense

September 11th, 2009

Is The Subjective Standard Gaining Momentum?

by David A. Grossbaum, Esquire, Hinshaw & Culbertson LLP

“Originally published in the Journal of the Professional Liability Underwriting Society, July 2009, Volume XXII, Number 7.
Reprinted here by permission.”

Issues relating to whether an insured was aware of a potential claim before an insurance policy commenced, so as to allow a carrier to disclaim coverage or rescind the policy, continue to dominate recent professional liability coverage decisions. The debate can be summarized as follows: does a court determine the insured’s awareness of a potential claim by simply determining if the insured subjectively appreciated the potential for a claim, or does the court consider what the insured actually knew and then determine what the hypothetical “objectively reasonable” insured would have appreciated? Although the majority still appears to follow the objective test, a number of recent cases from some of the more populous states have adopted approaches that do not follow the objective standard. These cases could signal a trend away from the objective test and are undoubtedly of concern to insurers.

Questions About Potential Claims Always Ask for Subjective Opinions

One case characterized all application questions about potential claims to require subjective opinions. James River Insurance Company v. Hebert Schenk, P.C., 523 F.3d 915 (9^th Cir. 2008) (Arizona law). In that case, the insured agreed to provide his clients a budget and to return original documents that they had provided to him. After the meeting, the clients tried to reach the insured many times, all to no avail.

The insured thereafter applied for an insurance policy and answered the following question in the negative: “. . . are any [lawyers] aware of any circumstances . . . which may result in a claim being made against the applicant . . . ?” About a week after the insured submitted the application, the clients terminated his services based on his lack of responsiveness. The clients demanded the return of their file and demanded that the insured waive about $1,000 in legal fees. The insured acknowledged his fault and agreed to waive the fees.

The insurer agreed to issue a policy, conditioned upon the insured providing a “no known claims and no known claim incidents” statement. Id. at 919. The policy excluded coverage for any conduct occurring before the policy period if “any insured knew or could have reasonably foreseen” that a claim could arise from it. Id.

The clients later threatened to sue the insured for legal malpractice for the reasons stated in their earlier letter. The insurer defended under a reservation and filed a coverage action on the basis that the claims were foreseeable and yet were not disclosed on the application for the policy, and were banned by the “prior knowledge” exclusion. Id. at 920. The trial court granted summary judgment for the insurer.

On appeal, both parties acknowledged that the recission claim hinged on whether: 1) the insured was asked questions within his personal knowledge; 2) the insurer would naturally interpret the response as containing actual facts (rather than opinion); and 3) the response was false. Id. at 921.

The Court of Appeals overruled the trial court. Although it agreed that the part of the application question asking whether the insureds were “aware of” circumstances might call for a factual response, the question of whether those circumstances “may result” in a claim elicited opinions, not facts. Id. at 921. “Reasonable persons could thus find that the omission of [the clients’] communications from [the application] reflected [the insured’s] opinion that the [clients’] dissatisfaction would not result in a claim.” Id. at 922. In forming this opinion, the insured was entitled to consider such factors as the merits of the potential claim, the degree of the clients’ dissatisfaction, and the “character of the specific attorney-client relationship.” Id. at 922, n. 2.

Although the Court recognized that other courts had applied objective tests in determining whether insureds appropriately responded to these type of questions, it refused to so. Rather, the Court held that the specific question involved was ambiguous, while not identifying the ambiguity. But most surprising was the Court’s statement that, even if an objective standard applied, there was no “meaningful difference” between a subjective and objective standard because the insured was always required to “exercise judgment in applying that [objective] standard to the facts concerning particular clients.” Id. at 922. The Court also found that the “prior knowledge” exclusion did not apply because the claim was not “reasonably foreseeable” as the clients never threatened suit before the policy was issued and the insured met their demands for return of the file and waiver of his fees.

The Court’s characterization of the question as always seeking a subjective opinion from the insured is a departure from the majority of cases. Additionally, the Court permitted an insured to consider such subjective factors as the merits of any potential claim, the level of the client’s anger, and the insured’s relationship with the client, while most courts specifically find these factors irrelevant because insurers have to defend even meritless claims, and whether the client is upset enough to bring suit is hard to gauge and the insured was ultimately wrong in assuming the client would not sue. Although the result may have been the right one because the an objectively reasonable insured would not have anticipated a claim where he met the clients’ demands, by characterizing any inquiry about potential claims as calling for a subjective opinion, this case diverges from similar cases elsewhere.

The Insured’s Subjective Belief That It Will Be Sued Does Not Defeat Coverage

In a New York case, the Court precluded a number of excess insurers from relying on a “prior knowledge” exclusion, even though the insured law firm admittedly anticipated claims against it before the policies commenced. The Court found that the “prior knowledge” exclusion did not bar coverage for the firm because it justifiably believed it had done nothing wrong, and there were issues of fact precluding rescission. Executive Risk Indemnity, Inc. v. Pepper Hamilton LLP, 865 N.Y.S.2d 25 (App. Div. 1^st 2008).

In this case, the insured was aware of its client’s misconduct and of the likelihood that claims would be made against the firm based upon its representation of that client. The motion judge granted summary judgment to the insurers on the basis of a “prior knowledge” exclusion that barred coverage for any claim “arising out of any act, error, or omission … which the insured knew or should have known could result in a claim.” Id. at 29. He also granted rescission of some policies.

The appellate court purported to apply an objective standard and held that, notwithstanding the insured’s subjective belief that it might be sued, the record disclosed nothing “constituting objective evidence permitting a reasonable professional to conclude that [the insured] itself did anything that would subject it to suit or other claim. Certainly no wrongful conduct on [the insured’s] part is established as a matter of law….” Id. The Court, thus, limited the reporting obligation as follows: “the firm must have itself acted improperly, so as to have itself created the possibility of professional liability claim against it.” Id. at 31. As to the rescission claims, in the Court’s opinion, these raised factual issues that could not be decided on summary judgment. Id. at 32.

The Court’s exclusive reliance on whether the firm actually acted improperly sharply deviates from the majority rule. To being with, whether the firm actually acted improperly will not be determined until the trial of the matter and insurers are entitled to know about any expected claims, even frivolous ones, because they must defend all claims. Moreover, if the insured subjectively anticipates a claim, this has typically been sufficient to trigger both the insured’s reporting obligation and a “prior knowledge” coverage defense. Such a rule makes perfect sense: there is no undue burden on the insured to give notice once the insured forms the belief it will likely be sued and insurers need this information to protect their interests and assess their exposure.

A Subjective Test That Is Really An Objective Tests

In Minnesota Employers Mutual Insurance Company v. Larson, 2007 WL 2688443 (S.D. Ill. 2007), the Court determined that policy language limiting coverage to situations where “the insured had no knowledge of facts which could reasonably support a claim at the effective date of this policy” required the application of a subjective standard. Id. at *5 n. 4, *8-9. The Court applied the subjective standard because the insurer referred to the insured’s “knowledge of facts.” It distinguished the case from those applying an objective standard, in which cases the insurers referred to an insured’s “basis to believe” that a claim could be brought. Id. at *8. Notwithstanding the Court’s adoption of a subjective standard, it still denied coverage on the basis of the insured’s prior knowledge, even though the insured asserted he had no such knowledge.

In this case, the insured informed his client of problems with the matter he was handling for the client (including dismissals without prejudice of some defendants and the exclusion of an expert witness for failing to timely disclose him) and the client had a new lawyer look at the case. Id. at *2. The insured also instructed his secretary to make an extra copy of the file to possibly send to his insurance company. Id. The client continued with the insured (no other lawyer wanted the case) and accepted a $15,000 settlement offer.

The insured argued that these circumstances negated any knowledge on his part that he would be sued by his client. Id. at *9. The court rejected this logic, stating that the insured knew of “facts that could reasonably support a claim” because he “knew that [the client] could file suit after the settlement agreement; that [the client] never threatened to do so, or that [the insured] assumed [the client] would not do so, is irrelevant.” Id. at *9. Still further, the court noted that the insured had not re-filed lawsuits against the dismissed defendants while he could have done so. Id. at *10.

Notwithstanding that this case seems to reach the right result, the employment of a subjective standard, even in name only, is troubling precedent for later cases. If insureds can convince courts to adopt a subjective standard, it is more likely that courts will make coverage determinations based on what is in the insured’s mind, a subject that is difficult to divine and even to challenge.

An Objective Test That Is Really A Subjective Test

In a recent New York case, the Federal District Court employed an objective test, but then considered the factors commonly rejected by courts adopting this approach. United National Insurance Co. v. Granoff, Walker & Forlenza, P.C., 598 F. Supp. 2d 540 (S.D.N.Y. 2009). In that case, the firm represented the client in a failed real estate transaction. The “potential of a malpractice action” was discussed with co-counsel after a court found against the client in litigation over the deal, and while an appeal was pending. Id. at 544 & n. 3. Before the appeal was decided against the client, the firm renewed its policy and answered “no” to the question “are attorneys in your firm aware …of any incidents that might reasonably be expected to lead to a claim…?” Id. at 544. Furthermore, the policy excluded all claims where the insured “could have reasonably foreseen that such WRONGFUL ACT might reasonably be expected to be the basis of a CLAIM.”

The Court considered whether the insured or a “reasonable attorney in the [the insured’s] shoes could have reasonably foreseen a claim,” clearly articulating the objective test. Id. at 547. Nonetheless, the Court’s ruling that the insured did not forfeit coverage was based on the fact that an appeal was pending that could negate the claim, that the insured had solid defenses to any claim, and the client continued to use the firm in the litigation after the deal failed. Id. at 547-548. The Court interpreted the “prior knowledge” question as requiring a positive response “only as to matters that involve a clear breach of duty such as the failure comply with the statute of limitations, attorney neglect, criticism by the court or disciplinary proceedings, or explicit threats of litigation.” Id. at 549.

The factors considered by the Court have been roundly rejected by prior courts as being inappropriate to the objective standard, as they leave it to the insured to make determinations as to the possibility of a future suit, when it is the carrier that bears the primary risk of such a suit. Additionally, the possible success of an appeal should not excuse the insured from reporting a potential claim as the likelihood of success on appeal is always questionable, and the client can sue for delay damages and appellate attorneys fees even if the appeal succeeds. Still further, questions about “potential claims” have not been limited to matters involving “a clear breach of duty,” as this issue cannot be determined until a later trial.

Conclusion

Although the objective test is still the majority rule, these recent decisions from states that influence insurance coverage opinions throughout the country are troubling. Carriers and coverage counsel alike need to watch this area of the law to understand the strength of the “prior knowledge” coverage defense in the future. Insurers should also look carefully look at the “prior knowledge” wording of their application questions and policies and to make sure they have phrased them in a way that gives them the best chance of arguing for an objective standard.

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