The Insurable Interest

N.Y. Appeals Court Holds That Prior Knowledge Exclusion Does Not Bar Coverage for Claims Arising Out of Client's Conduct

The Pepper Hamilton LLP law firm and one of its members were named as defendants in a civil suit brought by a trustee administrating the bankruptcy of Student Finance Corporation (SFC), one of Pepper Hamilton's former clients. SFC was accused of fraudulent conduct in the packaging and marketing of securities that consisted of bundled student loan obligations. The bankruptcy trustee alleged that Pepper Hamilton was aware of the behavior, had facilitated it in some fashion, and that it was exposed to its own liability as a consequence. Pepper Hamilton had, in fact, discovered various irregularities and had previously withdrawn from representing SFC.

Pepper Hamilton tendered the claims to its primary professional liability carrier, Westport Insurance Co. and its excess carriers, Executive Risk Indemnity, Continental Casualty Co., and Twin City Fire Insurance Co. The primary carrier did not contest its obligation to defend Pepper Hamilton. The excess insurers, however, declined coverage based primarily on their respective "prior knowledge" exclusions. The exclusion provides that the policies do not apply to any claim:

arising out of any act, error or omission

committed prior to the inception date of

the policy which the insured knew or should

have known could result in a claim, but failed

to disclose to the Company at inception.

In the ensuing declaratory judgment actions, Pepper Hamilton argued that, although it learned of the misconduct of its client and concluded that the misconduct could lead to litigation against the law firm, it did not have facts upon which to form a reasonable belief that the firm had committed any acts, errors or omissions. Accordingly, they did not disclose the information to potential insurers.

The trial judge, on motions for summary judgment, held that the "prior knowledge" exclusion applied and entered judgment in favor of the excess insurers. The matter was appealed to the Supreme Court, Appellate Division, First Department. The appellate court reversed in a reported opinion which relies primarily on the distinction between the insured's knowledge of the wrongdoing of its client, as opposed to the insured's knowledge of its own independent malfeasance. The appellate court held that the "act, error or omission" referred to in the exclusion must be the insured's act, error or omission. The court explained that it is "simply unreasonable that in order to protect its liability coverage, a law firm must inform its professional liability carrier as soon as it finds out about its client's possible misconduct, any time the firm believes that it could be subject as a deep pocket to claims by the client's creditors."

Of course, it seems clear that if a "reasonable professional" has information to support a conclusion that he will face a professional liability claim arising out of an act or omission, independent of his client's conduct, he must disclose the potential claim or risk an enforceable disclaimer. Although that situation was not found to exist here, the line between these two classes of "prior knowledge" will likely be quite fuzzy in practice.

Click here for a complete copy of the Court's opinion.