Professional liability and D&O insurers regularly rely on “prior knowledge exclusions” to restrict coverage. These exclusions apply if the insured knew, prior to commencement of the policy period, that the activity in which it was involved would result in a claim against it. Typically, cases involving prior knowledge exclusions turn on the extent of the insured’s knowledge of the risk of a claim and whether that knowledge is sufficient to bar coverage.
Recently, in Executive Risk Indemnity Inc. v. Pepper Hamilton LLP, 865 N.Y.S.2d 25, 2008 N.Y. App. Div. Lexis 6885 (N.Y. App. Div. Sep. 23, 2008), the New York Supreme Court, Appellate Division construed a “prior knowledge” exclusion very narrowly in a declaratory judgment action involving a dispute over coverage for alleged legal malpractice. The court held that in order to apply the exclusion to claims against a law firm based on the wrongful conduct of the firm’s client, the insurer must prove not only that the law firm had knowledge of its client’s misconduct, but also that the firm participated in the client’s wrongful conduct in such a way that it believed that it might be subject to liability for that conduct.
The coverage dispute arose from Pepper Hamilton’s representation of Student Finance Corporation, which financed student loans and then securitized and resold them to investors. In March 2002, Student Finance’s principal told a partner in the law firm that the company had been using its own reserve accounts to make forbearance payments for overdue loans. By covering up defaults, Student Finance allegedly made its securities more attractive to investors.
On April 24, 2002, Pepper Hamilton withdrew from its representation of Student Finance. Two years later, Student Finance sought bankruptcy protection. After being contacted by the company’s bankruptcy trustee concerning the firm’s potential liability in connection with its representation of Student Finance, Pepper Hamilton placed its primary and excess insurers on notice of the claim. Ultimately, the bankruptcy trustee and Royal Indemnity Company, which provided credit risk insurance to Student Finance (and was also a client of Pepper Hamilton), brought two separate suits against the firm for its alleged cover-up of Student Finance’s conduct.
Pepper Hamilton’s excess insurers challenged coverage, which resulted in declaratory judgment litigation. The excess insurers moved for summary judgment, relying on the “prior knowledge” exclusion, which stated that the policies did not apply to claims 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 its inception.” The trial court held that the insurers had no duty to indemnify the law firm because the firm had reason to anticipate that its representation of Student Finance could lead to litigation, and as a result, the prior knowledge exclusion barred coverage.
The appellate court disagreed, explaining that:
Here, while evidence strongly suggests that [the firm members] subjectively either believed or feared that the firm might be subjected to professional liability claims by entities claiming injury as a result of Student Finance’s conduct, . . . the firm’s subjective belief that a suit may ensue based upon Student Finance’s misconduct is not enough.
The court further explained, however, that
If it is ultimately established that the law firm participated in the misconduct, such as by preparing documents on behalf of the client knowing that the documents contained false or insufficient information, . . . then application of the prior knowledge exclusion could be justified.
This decision is significant for insureds under professional liability policies, and sets an appropriately high standard for insurers seeking to deny coverage based on a prior knowledge exclusion for claims against an insured based on misconduct of the insured’s client. In order to deny coverage for such a claim under a prior knowledge exclusion, the insurer must do more than prove the insured was aware that claims might arise from its client’s misconduct. The insurer must also prove that the insured participated in the misconduct in a way that would give rise to potential liability.