Who knew what and when did they know it?

No, I am not talking about the Wall Street bailout; I am talking about something really interesting, prior knowledge exclusions in insurance policies (well, interesting to me anyway). Prior knowledge exclusions basically work like this: they say that there is no coverage under a liability policy if the insured knew or should have known, prior to commencement of the policy period, that activity it was involved in would result in a claim against it. But how much knowledge the insured must have had, and how certain it must have been that its activities would lead to a claim in the future, have always been the tricky questions in applying these types of exclusions. Set the standard too low and the exclusion encompasses too many prior events, deleting coverage for losses that the insured may have literally had to be prescient to have anticipated; set the standard too high and the exclusion loses its intended effect of preventing insureds from buying policies to protect itself from things that it, but not the insurer selling the policy, knows is lurking in the closet.

This story here concerns the interesting case of a large law firm that apparently knew a client was engaged in misconduct with regard to securities, thereafter bought a professional liability policy, and wanted coverage under that policy for the claim eventually made against it as a result of its legal work for the client engaged in the misconduct. A New York appeals bench concluded that the standard for denying coverage on the basis of a prior knowledge exclusion had to require more than just knowledge of the client misconduct and the ability to anticipate that claims against the insured might possibly arise as a result, but also some level of participation in the misconduct by the insured law firm itself that would justify a belief on its part that it might be subject to liability. As the article describes the court’s conclusion:

Here, while evidence strongly suggests that defendant Gagne and other 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 SFC’s conduct, his or the firm’s subjective belief that a suit may ensue based upon SFC’s misconduct is not enough," Saxe wrote.

"In our view, the policy cannot be properly read to require Pepper Hamilton to notify its potential insurers of its client’s misconduct and its own recognition that it may be subjected to legal claims brought by those insureds as a result of its client misconduct," the judge added.

However, the panel held 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, or by knowingly creating the forbearance payment mechanism … then application of the prior knowledge exclusion could be justified."

Frankly, from where I sit, that finding seems to put the bar a little high, essentially concluding that evidence of an active role by an insured in actual wrongdoing is necessary to invoke this bar to coverage. The exclusion itself, which is contained in a policy purchased by a quite sophisticated and knowledgeable insured, does not state that it only applies to active wrongdoing before the policy period that leads to a claim, but is instead written more broadly and for broader purposes. Moreover, this interpretation leaves coverage in place for losses, such as this one, where it is fair to say that the insured could have foreseen the exposure before issuance of the policy but it does not appear that the insurer could have done so and thereby built the risk of it into the premium charged for the policy.