Prior Knowledge and the Pitfalls That Come with It

Thomas Behrman and Wendy J. Keenan, Wilson Elser, New York

What evidence is there of your “prior knowledge”? Maybe your admission. Or maybe not. Maybe a jury informs you that you knew because you should have known. When it comes to reading your professional liability policy, it is easy to be inattentive to prior knowledge. What is it, anyway? This article provides brief explanations and anecdotes that can help you recognize a prior-knowledge situation and avoid the pitfalls in failing to deal with it properly.
 
After years of hard work and servicing the needs of your clients, a less-than-satisfied client has asked you to “help” him out of a situation in which you were involved. Actually, your client has been asking your help for a while now, but you just didn’t have time to deal with it and you’d like your professional liability insurance carrier to get involved. Because you never had any interruptions of coverage or issues paying your policy premiums on time, you assume the claim process should run smoothly. But wait one second. Just how long has your client been asking you for help? How was the request made? Face-to-face? Telephone? Email? Text message? What was requested? Have you put yourself in your client’s shoes and considered what is really being sought in this request for help? The answers to questions like these could affect your ability to have your insurance company take over, or its obligation to be involved at all.
 
The “knowledge” component of prior knowledge typically occurs when you knew or should have known that a “claim” had been made against you or could have been made against you. The “prior” component comes into play when your knowledge of a claim or potential claim occurred prior to the effective date of your policy. If you have prior knowledge, insurance coverage for that claim or potential claim will be unlikely. But what is a “claim” or potential claim and when did you become aware of it? The answers to these questions seem self-evident to some insureds; however, many insureds misunderstand that a “claim” against a professional liability policy can be significantly different from a “claim” against a homeowner’s insurance policy or an auto policy, for example.

Yet the difference can be easy to grasp.
 
Policies such as auto policies are sometimes referred to as “first-party” policies. Let’s say that you are walking out of the grocery store and notice that a grocery cart hit your car door and caused a dent. Of course no one saw the incident and no telephone numbers were left on your windshield for you to call the wrongdoer. What do you do? You, as the insured, contact your insurance company and say “I have damage to my car; please pay me to repair it.” In this instance, you are making the claim to your insurance company. In other words, in first-party policies, it is the insured (as the first party) who sustains a direct loss and it is the insured who is paid to repair that loss.
 

Professional Liability Claims

On the other hand, professional liability policies are sometimes referred to as “third-party” policies, which are typically written on a “claims-made” or “claims-made and reported” basis. Generally speaking, these third-party policies come into play when your client (as the third party) points the finger at you and says “you’ve done me wrong, now pay me or do something to fix the problem.” In the third-party context, it is the third party, your client, who is making the claim, not you. In other words, professional liability policies provide coverage for losses sustained by other persons, not the insureds, but for which the insureds may be legally responsible. A “potential claim” is similar to a claim in that you were somehow involved in harming your client, but the situation had not yet developed to where your client asks you to fix the problem. Now that we have a basic distinction of claims and potential claims in third-party policies, what happens next?
 
After your client makes the claim against you or after you become aware of a potential claim that may be made against you, it becomes your obligation to notify your insurance company of the matter. The amount of time you have to notify your insurance company is likely to be mentioned in your professional liability policy, but typically it is best to notify your insurance company immediately after a claim is made or when you become aware of a potential claim. If you fail to notify your insurance company in a timely manner, the insurance company may have a valid basis to deny coverage, such as the claim was made (or you were aware of a potential claim) during Policy A but you did not report the matter until Policy B.

What if the claim is baseless? Do you have to notify your insurance company? Much more likely than not, courts across the country would say yes. As an example, in Rhode Island, an attorney was sued by two former clients in three separate legal malpractice actions relating to the formation of a corporation. 
 
The attorney did not notify his insurance company because he viewed the cases as “so obviously lacking in merit that he never ‘reasonably expected’ to have to make any insurance claim.”  The problem with his viewpoint based on our brief explanation of first-party claims and third-party claims should already be evident.

At any rate, the attorney hired an attorney to defend the lawsuits and ultimately prevailed. After incurring $90,000 in defense fees, he notified his insurance company of the lawsuits and requested reimbursement of his attorney’s fees. The insurance company denied his claim on the grounds that the claims were not reported during the policy in which they were first made against him and because he incurred expenses without the insurance company’s consent.
 
But how could this be fair? How could the insurance company deny coverage when (1) all three actions were successfully defended and (2) the legal fees incurred were reasonable? These were the arguments that the attorney made in the lawsuit he filed against the insurance company in the U.S. District Court, District of Rhode Island (case no. 90-00449). After a 18 months of litigation, including an appeal to the First Circuit Court of Appeals (case no. 91-1678), the attorney learned that it is not relevant whether the claims were baseless, or whether the insurance company was not actually prejudiced, or whether the attorney had maintained continuous coverage for several years with the insurance company. The court limited its analysis of the attorney’s reporting requirements to the terms of the policy, ruling that the insurance company’s denial of coverage was proper because the claims were not reported during the policy period in which they were first made against the insured-attorney. Expensive lesson learned.
 
Examples involving actual claims, or prior knowledge of claims, are by their tangible nature more obvious than those involving potential claims or, even more obscure, circumstances that should have made you aware that a claim could have been made. In a recent case, the U.S. District Court for the District of Columbia ruled that the insurance company was relieved of any obligation to cover a legal malpractice claim under a policy’s “known risk exclusion” provision. At the time the insured law firm applied for a new policy, it was on notice that it had committed a breach of professional conduct or otherwise should have foreseen a legal malpractice claim since, prior to when the insurance application was completed, the insured law firm had filed two medical malpractice suits on behalf of a client, one of which was dismissed for failure to correctly caption a pleading and the other for filing outside the statute of limitations. 
 
The court did not limit its analysis to the insured law firm’s subjective knowledge, but instead analyzed the facts in terms of what an objectively reasonable attorney might have foreseen at the time. The ruling was upheld on appeal. 
 
While this case seems to have a fairly acceptable result, less discernible events may exist that require you to be more careful in evaluating circumstances that could be potential claims. However, if you timely notify your insurance company of a circumstance that may develop into a claim during Policy A, you will typically preserve your right to coverage under Policy A if the circumstance later develops into a claim, even years later.
 
Alternatively, if you fail to do so, the insurance company may have, practically speaking, valid grounds to deny coverage as it does when an insured fails to timely notify the insurance company of a claim.
 

Inaccurate Disclosures and Misrepresentations

Another of the many coverage pitfalls involves inaccurate disclosures on the insurance application. Here are a few questions that you may be asked on an application:

• Does any proposed Insured have knowledge of any act, error or omission that might reasonably give rise to a claim against any Insured? 
• Have any claims been made or legal action been brought against your firm, its predecessor(s) or any current or former principal, partner, director, officer or employee in the past five years? 
• After a complete investigation and inquiry, do any of the principals, partners, directors, officers, employees or insurance managers have knowledge of any act, error, omission, fact, incident, situation, unresolved job dispute, accident or any other circumstance that is or could be the basis for a claim under this proposed insurance policy? 
• Report knowledge of all such incidents to your current insurance company prior to your current policy expiration. The proposed insurance being applied for will not respond to incidents about which you had knowledge prior to the effective date of the policy nor will coverage apply to any claim or circumstance identified or that should have been identified in this application.

Many insureds have insurance agents who are willing to complete these applications on their behalf. However, that may not be advisable given the depth of inquires that are made. Whatever your situation may be, if a disclosure is viewed by the insurance company as a misrepresentation, the insurance company may not only seek to deny coverage for the claim or potential claim but also seek to rescind the policy altogether, leaving you not only with no insurance coverage for the claim but also with no policy.
 
Under New York law, an insurance company is entitled to rescind an insurance policy “if it was issued in reliance on material misrepresentations.”  A misrepresentation in an application for insurance is a false “statement as to past or present fact, made to the insurer by … the applicant for insurance … as an inducement to the making thereof.”  “A misrepresentation is material if the insurer would not have issued the policy had it known the facts misrepresented.”  Furthermore, “even an innocent misrepresentation, if material, will support rescission.”  The rescission of an insurance policy typically requires the insurance company to commence a lawsuit against its insured, an action and associated expense that an insured may not anticipate at the time it is purchasing insurance. If a policy is rescinded, an insured may have the added hardship of attempting to find another insurance company that would be willing to issue a policy to the insured. This may be devastating to an insured’s business if the insured is required to carry insurance.
 
To avoid these hardships, review the application carefully and make sure that the disclosures are candid and accurate. If your policy is expiring, use this as what may be your last opportunity to notify the insurance company of claims or potential claims that may be made against you.
 
To summarize, become familiar with how the word “claim” is defined under your professional liability policy.
Familiarize yourself with your obligations in reporting a claim or potential claim to your insurance company, and be sure to report those matters timely. Be careful when applying for insurance or renewal insurance. Think objectively about circumstances involving your professional services and be sure to notify your insurance company of those that may become claims. By doing so, you can be spared headaches and avoid situations that may cause financial hardship.
 
¹ See Thomas A. Diluglio v. New England Insurance Company, 959 F.2d 355 (1st Cir. 1992).
² Id. at 35
³ See Chi. Ins. Co. v. Paulson & Nace, PLLC, 37 F. Supp. 3d 281, 2014 U.S. Dist. LEXIS 49616 (D.D.C.,
  2014).
⁴ See Chi. Ins. Co. v. Paulson & Nace, PLLC, 783 F.3d 897; 2015 U.S. App. LEXIS 6529.
⁵ See Interboro Ins. Co. v. Fatmir, 933 N.Y.S.2d 343, 345 (2d Dep’t 2011).
⁶ See Fid. & Guar. Ins. Underwriters, 540 F.3d at 139 (quoting N.Y. Ins. Law § 3105(a)).
⁷ See Interboro, 933 N.Y.S.2d at 345.
⁸ See In Re Worldcom, Inc. Securities Litigation, 354 F. Supp.2d 455, 465 (S.D.N.Y. 2005).
 

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Wendy Keenan is a partner in the New York office of Wilson Elser Moskowitz Edelman & Dicker, LLP.  She is part of Wilson Elser’s Program Management team, a dedicated group of attorneys who specifically offer claims management, insurance coverage and analysis, and risk management services for domestic and foreign insurers.  Wendy can be reached at wendy.keenan@wilsonelser.com             
 
Thomas Behrmann is Of Counsel to Wilson Elser Moskowitz Edelman & Dicker, LLP and is located in the New York office.  He serves as claims, coverage and monitoring counsel for international and domestic insurers for policies covering attorneys, real estate professionals, architects and engineers, and other miscellaneous professionals.  Thom can be reached at thomas.behrmann@wilsonelser.com