April 05, 2017 Top Story

Broad Exclusion Won’t Save Insurer Offering Illusory Coverage

Decision refuses to apply prior-knowledge exclusion for claims based on past wrongful acts

Stephen Carr

A federal circuit court of appeals decision recognized important limits on the ability of malpractice insurers to use prior-knowledge exclusions to shield themselves from covering many claims. The U.S Court of Appeals for the Fifth Circuit declined to enforce the plain language of an exclusion that would have barred coverage of almost any malpractice claim.

As written, the broad exclusion made the policyholder's retroactive coverage "illusory and facially absurd," the court's opinion found. The decision limited the ability of insurers to alter the terms of policy through contractual provisions. Yet the case also underscored the need for a law firm to contact insurance providers when indications of a potential claim arises.

According to John Mumford, Richmond, VA, cochair of the ABA Section of Litigation's Insurance Coverage Litigation Committee, "prior-knowledge coverage disputes are very fact intensive. The issue courts grapple with is whether there was some objective indication to the attorney or firm of a potential claim. This court essentially took the position that not every bad outcome in litigation rises to the level of notice of a potential claim, but that something more is required."

Typical Discovery Dispute Spins Out-of-Control Resulting in Sanctions

The malpractice claim arose after the trial court entered "death penalty" discovery sanctions against the law firm's client, Dish Network, in a suit brought by Russian Media Group (RMG). After the firm failed to respond to discovery requests, a magistrate judge issued so-called "death penalty sanctions" that precluded Dish from contesting the claims against it or challenging the damages award. RMG's damages could have been as much as $25 million.

The insurer repeatedly asked the law firm whether it, or any of its attorneys, knew of any circumstances that could give rise to a malpractice claim. Each time the firm responded no. The firm's attorney whose conduct led to the death penalty sanctions did not communicate about the matter to others in the firm. He resigned soon after the firm learned about the sanctions.

The law firm then notified its insurer, One Beacon Insurance Company. Dish offered to settle its malpractice suit against the law firm for the firm's policy limit, but One Beacon believed the policy did not cover the claim. It rescinded its policy based on the prior-knowledge exclusion in the policy.

One Beacon had issued a claims-made policy for the years 2006–2007, which the law firm had renewed for 2007–2008. The policy was retroactive to 1995 and covered any claim made against the law firm during the policy period. Yet the policy excluded any claim for wrongful acts that occurred before the insurer issued the policy if the firm had a reasonable basis to believe it had committed a "wrongful act." The policy defined "wrongful act" to include any "actual or alleged act, error, omission, or breach of duty arising out of the rendering or the failure to render professional legal services."

The trial court rejected One Beacon's argument and found that whether there was a reasonable basis to foresee a claim against the firm was a jury question. Finding for the law firm, the trial court then reduced the jury's award to $5 million.

Broad Insurance Exclusion Makes Coverage Illusory

First, the Fifth Circuit had to decide whether to apply the plain language of the policy's prior-knowledge exclusion. The appellate court dismissed this argument, finding the policy's definition of a wrongful act would cover anything an attorney does, "wrongful or not." The court insisted the wrongful act be "likely to lead to a malpractice claim." By excluding from coverage any act by an attorney, One Beacon had attempted to avoid insuring against even unforeseeable malpractice claims.

After that issue, the court's analysis was fact specific. The court emphasized that before entry of the death penalty sanctions there was no warning this was more than a standard discovery dispute. All parties agreed that had the firm's former attorney complied with the order at any time before the court entered sanctions, the firm could have avoided significant sanctions.

Takeaways for Policyholders and Insureds

For policyholders, the Fifth Circuit's decision underscores the importance of establishing effective oversight of attorneys and good communication within the firm.

Yet insurers can also take heart from the decision. As Mumford pointed out, "The court didn't say that just because the prior-knowledge exclusion was overly broad the insurer loses. Instead, the court made an effort to give effect to the intent of the exclusion but held that the evidence did not support the application of the exclusion under the facts before the court."

Dylan C. Black, Birmingham, AL, cochair of the ABA Section of Litigation's Professional Liability Litigation Committee explained, "There are lessons for both insured attorneys and malpractice insurers here. The facts underlying the malpractice claim show what can happen when lawyers don't communicate 'bad news' to the client, or even to other lawyers in their firm. But the case also shows that an insurer won't necessarily be able to deny coverage based on an overly broad definition of an exclusion."

 

Stephen Carr is a contributing editor for Litigation News.


Keywords: insurance, malpractice, prior-knowledge, claims-made

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