Prior Knowledge Provisions and the Duty to Defend

Prior Knowledge Provision Primer

Claims-made errors and omissions policies typically provide coverage for claims first made against the insured during the policy period. Although errors and omissions policies are not standard form policies along the lines of many commercial general liability policies written on standard Insurance Services Office forms, they almost invariably include a prior knowledge provision. The prior knowledge provision might be stated in the errors and omissions policy’s insuring agreement as a term of the coverage grant, in the conditions section, and/or in the policy’s exclusion section. Wherever located, “a predicate to claims-made coverage is that the insured neither knew of a claim or error, nor could have reasonably foreseen that a known circumstance, act or omission might reasonably be expected to be the basis of a claim or suit.”[2] When applying a prior knowledge provision, most courts will consider the facts and circumstances of which the insured was subjectively aware at the time the policy incepted. Then, the court will consider whether, applying an objective, reasonable person standard, an insured should have expected that those facts or circumstances might give rise to a claim. If so, the prior knowledge provision will bar all coverage, including any defense coverage.[3]

Greenwich Insurance Co. v. Garrell

A South Carolina federal court recently considered extrinsic evidence in evaluating whether a prior knowledge provision in an errors or omissions policy barred a duty to defend.[4] The insureds in Garrell were a group of entities that performed real estate services. In 2006, certain investors entered into a real estate contract using the services of the insureds, but that contract fell through. A management board for the investors then sued the seller for damages associated with the failed deal and openly considered naming at least one of the insureds as a defendant but ultimately never named any of the insureds as a defendant in that suit. The 2006 lawsuit settled around the same time when the insureds obtained the professional liability policy at issue.

Seven months after the insureds obtained the relevant insurance policy, a number of investors filed a lawsuit against the insureds and others, alleging fraud, violation of South Carolina’s Unfair Trade Practices Act, negligence, and other claims. The insureds sought coverage under the professional liability policy then in effect. The insurer agreed to defend under a reservation of rights and filed a declaratory judgment action, seeking a judicial determination that the policy did not afford defense or indemnity to the insureds for the lawsuit. After the insureds answered and counterclaimed, the insurer filed a motion for judgment on the pleadings and the insureds cross-moved for summary judgment.

In its motion for judgment on the pleadings, the insurer asserted that the claims-made professional liability policy at issue did not afford coverage for the lawsuit against the insureds because, among other reasons, the insureds “had knowledge of an act or omission that they might reasonably expect to form a basis of a claim.”[5] In particular, the insurer asserted that the 2006 lawsuit put the insureds on notice that a future claim was likely.[6] Evaluating this argument, the court considered correspondence from a party to the earlier suit, which was attached to the insureds’ answer.[7] The court further considered the pleadings in the coverage action as well as the pleadings in the underlying action and in the 2006 lawsuit.[8] Finally, the court considered the statement of one of the insureds about what counsel and the management board had told him in connection with the 2006 lawsuit.[9] In denying the insurer’s motion for judgment on the pleadings, the court noted that “discovery is not complete [and] there is no such well-developed record.”[10]

What is instructive about Garrell is that the court readily considered facts outside the allegations of the underlying complaint to evaluate whether the prior knowledge provision in the professional liability policy barred coverage, including any duty to defend. These extrinsic facts were undisputedly relevant to the insureds’ subjective awareness of facts and circumstances, at the time when they obtained the insurance policy at issue, which reasonably might be expected to give rise to a claim.

The court’s approach in Garrell is consistent with that of the majority of courts that have considered whether a prior knowledge provision bars a duty to defend. For example, in Eisenhandler v. Twin City Fire Insurance Co.,[11] the insured and insurer did not dispute that the insured knew, before the inception date of the relevant malpractice policy, that he failed to timely file a lawsuit on behalf of his client. The insured submitted an affidavit, however, to explain that his failure resulted from his mistaken belief that he had already settled his client’s case.[12] The court considered additional evidence—although ultimately unpersuasive for the purpose of applying the prior knowledge exclusion—that the client told the lawyer at one point that she would not sue him.[13] After carefully weighing the extrinsic evidence in light of the language of the prior knowledge exclusion, the court held that the exclusion barred coverage, including any duty to defend the insured against the legal malpractice claim.[14] The court further explained that failure to conduct the proper analysis and application of the prior knowledge exclusion would undermine public policy.[15]

Each of these decisions, and many other similar decisions, recognize that facts outside the four corners of the underlying complaint against the insured should be considered to determine the insured’s knowledge of facts and circumstances that might give rise to a claim, even in the context of evaluating whether a duty to defend exists.

Kraft v. Thompson

A Wisconsin appellate court took a different approach to evaluating whether a prior knowledge provision barred a duty to defend in Kraft v. Thompson.[16] In Kraft, an insured accountant provided tax preparation services to a client whose tax returns were then audited by the Internal Revenue Service (IRS). The IRS ultimately assessed penalties against the client, who then fired the insured accountant. The insured thereafter sent a letter to her former client’s attorney, acknowledging that her former client had lost confidence in her. The accountant’s letter stated that, “If there are penalties and interest imposed on [my former client] for any of the work I did based on the information I was supplied on a timely basis, I will use my Error and Omissions Insurance to cover such fines.”[17] After sending the letter to the lawyer, the accountant later renewed her errors and omissions policy but did not inform the insurer about the issues with her former client.[18]

The former client eventually sued the accountant for malpractice in connection with the accountant’s preparation of the audited tax returns. The accountant forwarded a copy of the malpractice complaint to her insurer and requested a defense. The insurer initially agreed to defend but withdrew the defense when, during the course of the insurer’s investigation of the claim, the insured provided her entire work file for the claimant to the insurer and made certain admissions about her mistakes and penalties assessed before the policy incepted.[19] These facts, which developed in the insurer’s investigation, made clear that, at the time the policy incepted, the insured was aware of facts and circumstances that were likely to give rise to a claim.

In the ensuing insurance coverage action, the insurer acknowledged that the four corners of the underlying complaint implicated a potential duty to defend but asserted that the application of the prior knowledge condition in the policy meant that “‘the insurance policy never went into effect.’”[20] The court disagreed with the insurer’s position, explaining that, in considering any duty to defend, it was bound by the four-corners rule and would not depart from that rule to consider extrinsic evidence such as the insured’s admissions or the insured’s correspondence pre-dating the inception of the policy.[21]

Notwithstanding the host of cases relying on extrinsic evidence to evaluate whether a prior knowledge provision bars the duty to defend, some other courts likewise have erroneously clung to the four-corners rule.[22] For example, in American Guarantee & Liability Insurance Co. v. Hoeffner, the court rigidly stated that “‘the duty to defend is not affected by facts ascertained before suit, developed in the course of litigation, or by the ultimate outcome of the suit.’”[23] Although the court acknowledged that “it appears clear from other sources” that, prior to the policy’s inception, the insured “knew that he was breaching a professional duty or had a basis to foresee that his conduct could result in a claim under the Policy,” the court nevertheless insisted that the absence of such allegations in the underlying complaint against the insured required the insurer to defend.[24]

Proper Prior Knowledge Analysis

Contrary to the courts’ approaches in Kraft and Hoeffner, the four-corners rule is not the sole proper method to determine whether a duty to defend exists. As one court recognized, the “suggestion that a trial court is limited solely to a review of the allegations in the tort complaint in ascertaining a duty to defend, while supported by decisions echoing boiler-plate law, is an overstatement.”[25] Indeed, the four-corners “rule” itself is simply a judicial construct. The oft-repeated “rule” is not found in the contractual language of insurance policies or in insurance rules or regulations. While the four-corners rule may apply for determining the duty to defend in many instances, exceptions to the rule are readily identified and unsurprising. For example, few insurance professionals would balk at the notion of considering the actual date when an insured became aware of a claim, rather than simply referring to the four corners of the underlying complaint, to determine whether the insured provided late notice of a claim, which may bar any duty to defend.

Another exception to the four-corners rule is where the underlying complaint contains demonstrably false allegations. For example, a court may look past the allegations in an underlying complaint where the complaint alleges negligent, and therefore potentially covered, conduct, but the insured has admitted to or been convicted of intentional conduct that is not covered by the policy.[26] Similarly, if the true facts are not disputed, the court may consider those and not be bound by the allegations in the underlying complaint. In Guaranty National Insurance Co. v. C de Baca,[27] the court held that an allegation in the underlying complaint concerning the date of the accident did not control with respect to when the accident happened, for the purpose of determining which insurer had a duty to defend.

Most critically for the purposes of applying a prior knowledge provision, courts also have recognized an exception to the four-corners rule “when the facts alleged in the complaint ostensibly bring the case within the policy’s coverage, but other facts that are not reflected in the complaint and are unrelated to the merits of the plaintiff’s action plainly take the case outside the policy coverage.”[28] Vermont’s Supreme Court explained its reasoning in Blake v. Nationwide Insurance Co.:

For example, in Fred Shearer & Sons, Inc. v. Gemini Insurance Co.,[30] the Oregon Court of Appeals held that a court may consider extrinsic evidence to determine who qualifies as an insured. The court expressly held that “the inquiry as to whether [the party seeking coverage] was an insured under the policy was not limited to the pleadings and the text of the policy.”[31] The Fred Shearer court distinguished between evaluating complaint allegations to determine whether any conduct within the scope of the policy is alleged and the separate determination of who qualifies as an insured under the policy, which is not dependent on the allegations of the underlying complaint.[32]

This widely accepted exception to the four-corners rule is not limited to evaluation of whether a claim falls within the scope of the policy’s insuring agreement. For example, in Talen v. Employers Mutual Casualty Co.,[33] an insured bank officer asserted that the insurer wrongly denied coverage based on an employment practices exclusion because the underlying complaint alleged only that the insured had disparaged the claimant, not that the disparaging comments necessarily related to the claimant’s performance as an employee of the bank. The court rejected the argument that the vague allegations of the complaint alone triggered a duty to defend, stating “it is permissible for a liability insurer, in determining whether to accept a tendered defense to consider facts beyond the allegations of the petition.”[34] It went on to state:

While it would not have been relevant to the underlying action in Talen whether the alleged disparagement was made in the course of the insured’s employment, that issue was directly relevant to the application of a policy exclusion that would otherwise bar the insurer’s duty to defend. The insurer therefore correctly relied on information beyond the face of the underlying complaint to determine the application of the employment practices exclusion.

These principles are particularly applicable to claims where a policy’s prior knowledge provision may apply. In a typical prior knowledge scenario, as illustrated by Westport Insurance Co. v. Albert[36] and similar to the facts in the Kraft case discussed above, an insured accountant began receiving complaints before the professional liability policy at issue incepted. In August 1999, the insured accountant sued the decedent’s nephew to challenge an annuity agreement devised by the nephew. The nephew, in turn, demanded that the insured withdraw the suit challenging the annuity agreement and stop “wasting” estate funds.[37] The nephew filed a petition in court in November 2001 to remove the insured as personal representative of the estate. The filings in the removal proceeding accused the insured of being a “‘malfeasant,’ providing ‘sketchy and inadequate accounting statements,’ ‘breach[ing] his fiduciary duties,’ ‘mismanag[ing] Estate property,’ and ‘failing to perform material duties of his office.’”[38] The nephew then filed a malpractice complaint against the accounting firm on January 30, 2002.

The Albert court correctly considered facts outside the malpractice complaint in evaluating the application of the prior knowledge exclusion. There is no reason why the underlying malpractice complaint considered by the court in Albert would have to recite the bitter history between the accountant and the nephew, given the bare notice pleading requirements for complaints. Nor would the dates of the accusations and interactions between the nephew and the accountant necessarily be stated in the underlying complaint. The accounting malpractice complaint could have been resolved on the merits without ever addressing the separate factual questions about all of the facts and circumstances known to the accountant that reasonably might be expected to give rise to a claim. For all of these reasons, the court’s prior knowledge provision analysis correctly considered facts extrinsic to the underlying complaint to determine whether the insurer had any defense obligation.

Conclusion

Thus, the evaluation of the facts and circumstances known to the insured before a policy incepts for the purposes of applying a prior knowledge provision should not be limited to the allegations stated in the underlying complaint even for the purpose of determining whether a duty to defend exists. This approach fits squarely within a well-recognized exception to the general four-corners rule for determining the duty to defend. The facts and circumstances that are known to the insured and relevant to a potential claim would not necessarily be set forth by the claimant in the underlying complaint. Given that the relevant facts will not necessarily be determined in the underlying action against the insured, the insurer fairly may look beyond the allegations of the underlying complaint to resolve any question about the duty to defend.

Keywords: litigation, insurance coverage, exclusion, condition, extrinsic evidence, reservation of rights

Mary E. Borja is with Wiley Rein LLP, Washington, D.C.

[1] Not all courts apply the four-corners rule. See, e.g., Advantage Homebuilding, L.L.C. v. Md. Cas. Co., 470 F.3d 1003, 1013 (10th Cir. 2006) (Kansas law) (rejecting four-corners rule in determining duty to defend because, among other reasons, “there is no language in the Policy that limits [the insurer’s] ability to consider extrinsic evidence”).
[2] 5 Ronald E. Mallen & Jeffrey M. Smith, Legal Malpractice § 38:14, at 96 (2012 ed.).
[3] See, e.g., Prof’l Asset Strategies, LLC v. Cont’l Cas. Co.,447 F. App’x 97, 99–100 (11th Cir. 2011) (prior knowledge provision in professional liability insurance policy barred coverage because an objective person in an insured employee’s position should have expected that his theft of money from client accounts might form the basis of a claim); Ross v. Cont’l Cas. Co., 420 B.R. 43, 49 (Bankr. D.D.C. 2009), aff’d 393 F. App’x 726 (D.C. Cir. 2010) (D.C. law) (prior knowledge provision “unambiguously requires an objective inquiry into what might have been reasonably expected to form a claim based on the knowledge [the insured] possessed when the policy took effect”).
[4] Greenwich Ins. Co. v. Garrell, No. 4:11-cv-02743-RBH, 2013 U.S. Dist. LEXIS 31491  (D.S.C. Mar. 7, 2013).
[5] Garrell, 2013 U.S. Dist. LEXIS 31491, at *18.
[6] Garrell, 2013 U.S. Dist. LEXIS 31491, at *21.
[7] Garrell, 2013 U.S. Dist. LEXIS 31491, at *21 n.11.
[8] Garrell, 2013 U.S. Dist. LEXIS 31491, at *28.
[9] Garrell, 2013 U.S. Dist. LEXIS 31491, at *30.
[10] Garrell, 2013 U.S. Dist. LEXIS 31491, at *29 .
[11] No. CV095031716S, 2011 Conn. Super. LEXIS 2694 (Conn. Super. Ct. Oct. 21, 2011).
[12] Eisenhandler, 2011 Conn. Super. LEXIS 2694, at *13.
[13] Eisenhandler, 2011 Conn. Super. LEXIS 2694, at *14–15.
[14] Eisenhandler, 2011 Conn. Super. LEXIS 2694, at *19.
[15] Eisenhandler, 2011 Conn. Super. LEXIS 2694, at *18 . See also Greenwich Ins. Co. v. Darrell, No. 4:11-cv-02743-RBH, 2013 U.S. Dist. LEXIS 31491 (D.S.C. June 11, 2013) (considering various underlying claim pleadings and correspondence in evaluating whether the prior knowledge provision barred duty to defend); Ulster Cnty. v. CSI, Inc., 945 N.Y.S.2d 480 (N.Y. App. Div. 2012) (reviewing various extrinsic evidence relevant to the prior knowledge provision that the insurer properly could cite to support its dispositive motion); Darwin Nat’l Assurance Co. v. Hellyer, No. 10 C 50224 , 2011 U.S. Dist. LEXIS 60592 (N.D. Ill. June 7, 2011) (considering extrinsic evidence, including contracts made by claimants with third parties, as part of analysis of prior knowledge condition); Nat’l Cas. Co. v. Franklin Cnty., 718 F. Supp. 2d 785 (S.D. Miss. 2010) (considering grand jury testimony in evaluating whether a prior knowledge exclusion relieved insurer of duty to defend); Westport Ins. Co. v. Albert, 208 F. App’x 222 (4th Cir. 2006) (considering pleadings from the underlying case to evaluate the insured’s prior knowledge as a possible bar to any duty to defend); Am. Guarantee & Liab. Ins. Co. v. Fojanini, 90 F. Supp. 2d 615  (E.D. Pa. 2000) (in addition to the extrinsic evidence that the insurer had cited in support of its coverage position, additional evidence outside of the underlying complaint, including correspondence, deposition testimony, or affidavits, could be used to establish the insured’s subjective knowledge of circumstances that might lead to a claim).
[16] 346 Wis. 2d 733 , 2013 Wisc. App. LEXIS 173 (Wis. Ct. App. 2013).
[17] Kraft,2013 Wisc. App. LEXIS 173, at *2 .
[18] Kraft,2013 Wisc. App. LEXIS 173, at *2.
[19] Kraft,2013 Wisc. App. LEXIS 173, at *3–4.
[20] Kraft,2013 Wisc. App. LEXIS 173, at *9.
[21] Kraft,2013 Wisc. App. LEXIS 173, at *7–8, *12.
[22] See, e.g., Am. Guarantee & Liab. Ins. Co. v. Hoeffner, No. H-08-1181, 2009 U.S. Dist. LEXIS 3047  (S.D. Tex. Jan. 16, 2009).
[23] Hoeffner, 2009 U.S. Dist. LEXIS 3047, at *4  (quoting Zurich Am. Ins. Co. v. Nokia, Inc., 268 S.W.3d 487, 491  (Tex. 2008)).
[24] Hoeffner, 2009 U.S. Dist. LEXIS 3047, at *10–11.
[25] Oakley Transp., Inc. v. Zurich Ins. Co., 271 Ill. App. 3d 716, 719 n.2 (Ill. App. Ct. 1995).
[26] See, e.g., Home Mut. Ins. Co. v. Lapi, 596 N.Y.S.2d 885, 886–87 (N.Y. App. Div. 1993) (insurer has no duty to defend where insured admitted he intended to cause injury); Or. Ins. Guar. Ass’n v. Thompson, 760 P.2d 890, 893   (Or. Ct. App. 1988) (where policy precluded coverage for intentional conduct, prior ruling that insured’s conduct was intentional defeated the duty to defend).
[27] 907 P.2d 210, 214–15 (N.M. Ct. App. 1995).
[28] Allan D. Windt, Insurance Claims & Disputes § 4:4 (5th ed. March 2012).
[29] Blake v. Nationwide Ins. Co., 904 A.2d 1071, 1076–77 (Vt. 2006).
[30] 240 P.3d 67  (Or. Ct. App. 2010).
[31] Fred Shearer & Sons, Inc., 240 P.3d at 78.
[32] But see Devino v. Md. Cas. Co., No. CV03180185S, 2004 Conn. Super. LEXIS 2134, *12–13 (Conn. Super. Ct. July 30, 2004) (declining to look at evidence outside the underlying complaints when determining whether an entity was an insured); Chandler v. Doherty, 299 Ill. App. 3d 797, 802–4 (Ill. App. Ct. 1998) (insurer disputing a duty to defend barred from introducing extrinsic evidence to show that insured was not driving the car covered by policy where underlying complaint incorrectly asserted that the insured was driving “his motor vehicle”).
[33] 703 N.W.2d 395  (Iowa 2005).
[34] Talen, 703 N.W.2d at 405 (citing McAndrews v. Farm Bureau Mut. Ins. Co., 349 N.W.2d 117, 119  (Iowa 1984)).
[35] Talen, 703 N.W.2d at 406  (internal citations omitted).
[36] 208 F. App’x 222 (4th Cir. 2006).
[37] Albert,208 F. App’x at 224.
[38] Albert,208 F. App’x at 224.

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