Executive Risk Indemnity Inc. v. Pepper Hamilton LLP, 2010 NY Slip Op 00310 (2010)

An insurance policy’s prior knowledge exclusion bars coverage when the insured knew of acts, errors, or omissions prior to the policy’s effective date that could reasonably be foreseen as the basis of a claim.

Summary

This case concerns whether excess insurers must indemnify the law firm Pepper Hamilton for malpractice claims. The New York Court of Appeals held that Executive Risk and Twin City were entitled to summary judgment based on the policies’ prior knowledge exclusions, as the firm knew of potential claims before the policies’ effective dates. The court also held that Continental Casualty was not entitled to summary judgment on its rescission claim because it failed to prove materiality and bad faith. The law firm’s knowledge of its client’s fraudulent activities triggered the prior knowledge exclusion, negating the insurers’ obligation to indemnify.

Facts

Pepper Hamilton represented Student Finance Corporation (SFC). In March 2002, the firm learned that SFC was involved in securities fraud by misrepresenting its default rate. Despite this knowledge, Pepper Hamilton prepared private placement memoranda for SFC and did not disclose this information when applying for insurance coverage with Executive Risk and Twin City in October 2002. SFC later faced bankruptcy, leading to lawsuits against Pepper Hamilton for, among other claims, professional malpractice. The insurers denied coverage, citing prior knowledge exclusions.

Procedural History

Executive Risk sued Pepper Hamilton, seeking a declaration that it had no duty to indemnify. Pepper Hamilton counterclaimed and brought third-party claims against Twin City and Continental Casualty. The Supreme Court granted summary judgment to the excess insurers, finding no obligation to indemnify based on the prior knowledge exclusion and rescinding the Continental Casualty policies. The Appellate Division reversed. The Court of Appeals modified the Appellate Division order, granting summary judgment to Executive Risk and Twin City but denying it to Continental Casualty, answering the certified question in the negative.

Issue(s)

1. Whether the prior knowledge exclusion in the insurance policies of Executive Risk and Twin City bars coverage for Pepper Hamilton’s potential liability, given their knowledge of SFC’s fraudulent activities prior to the policy’s effective date.

2. Whether Continental Casualty is entitled to rescind its insurance policies based on Pepper Hamilton’s failure to disclose the SFC incident during the policy renewal period.

Holding

1. Yes, because Pepper Hamilton knew of acts, errors, or omissions prior to the policies’ effective date that could reasonably be foreseen as the basis of a claim.

2. No, because Continental Casualty failed to establish, as a matter of law, that Pepper Hamilton’s omission was material to the reinsurance determination and made in bad faith.

Court’s Reasoning

Regarding the prior knowledge exclusions, the court applied Pennsylvania law, which places the burden on the insurer to prove the applicability of any exclusions. The court cited the two-pronged test from Coregis Ins. Co. v. Baratta & Fenerty, Ltd., requiring consideration of both the insured’s subjective knowledge and the objective understanding of a reasonable attorney with that knowledge. The court found that Pepper Hamilton knew of SFC’s securities fraud before the policies’ effective dates and that a reasonable attorney would have foreseen the possibility of a lawsuit, triggering the exclusion. The court emphasized that the exclusion applied to “any act, error, omission [or] circumstance,” not just wrongful conduct by the insured.

Regarding rescission, the court again applied Pennsylvania law, stating that rescission requires proving a false statement, materiality to the risk, knowledge of falsity, and bad faith by clear and convincing evidence. The court agreed with the Appellate Division that Continental Casualty failed to prove materiality and bad faith, finding the underwriter’s self-serving affidavit insufficient to meet the heightened burden of proof. The court stated: “Here, the self-serving affidavit of Continental Casualty’s underwriter—that Pepper Hamilton’s renewal application would have been treated differently had it disclosed the underlying circumstances which led to the denial of coverage—is insufficient to meet the insurer’s heightened burden of proof.”