Case Title: Executive Risk Indemnity Inc. v. Pepper Hamilton LLP/Pepper Hamilton LLP v. Continental Casualty Company

Citation: 

Docket Number: 

State: new-york

Court: New York Appellate Court

Date: 2009-10-20T00:00:00Z

Document:
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This opinion is uncorrected and subject to revision before
publication in the New York Reports.
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No. 130  
Executive Risk Indemnity Inc.,
         Appellant,
        v.
Pepper Hamilton LLP, et al.,
         Respondents,
--------------------------------
Pepper Hamilton LLP, et al.,
         Third-Party Respondents,
        v.
Continental Casualty Company, et 
al.,
         Third-Party Appellants.
William B. Pollard, III, for appellant Executive Risk
Indemnity Inc.
Kevin M. Mattessich, for third-party appellant
Continental Casualty Company.
Catherine E. Stetson, for third-party appellant Twin
City Fire Insurance Company.
Charles A. Gilman, for respondents Pepper Hamilton LLP
and Gagne.
Robert P. Conlon, for respondent Westport Insurance
Corporation.
Philadelphia Bar Association, amicus curiae.
JONES, J.:
We are asked to determine, under Pennsylvania law,
whether excess insurers Executive Risk Indemnity Inc. and Twin
City Fire Insurance Company, based upon their prior knowledge
exclusions, and Continental Casualty Company, based upon 
rescission of its policies, were entitled to summary judgment
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declaring that they have no obligation to indemnify defendants
Pepper Hamilton LLP and one of its members W. Roderick Gagné
(collectively, the law firm defendants) in actions asserted
against them for, among other claims, professional malpractice. 
We conclude that the prior knowledge exclusions apply and modify
the order of the Appellate Division by granting summary judgment
to Executive Risk and Twin City.  We also conclude that
Continental Casualty is not entitled to summary judgment on the
basis of rescission.  
Facts and Procedural History
The underlying actions arose out of the law firm
defendants' representation of non-parties Student Finance
Corporation (SFC), its principal, Andrew Yao, and Royal 
Indemnity Company.  In 1992, Yao founded SFC, a company that
serviced the vocational portion of the student loan market.  SFC
financed loans to students attending vocational schools and 
acquired student loans from other lenders.  It pooled those loans
into certificates and sold them to investors.  Defendant Gagné,
then an associate of a non-party law firm, assisted with SFC's
formation in 1992 and its securitization in 1996.  In 1996, Gagné
became a member of Pepper Hamilton, a law firm based in
Philadelphia, and brought Yao and SFC with him as clients.  In
the course of Pepper Hamilton's representation of SFC, the law
firm prepared eight Private Placement Memoranda (PPMs) in 2000
and 2001, which SFC used in connection with the sale of
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No. 130
*  This policy is a claims made policy, which "protect[s]
against claims made during the life of a policy irrespective of
when the act giving rise to the claim occurred" (Pizzini v Am.
Int'l Speciality Lines Ins. Co., 210 F Supp 2d 658, 668 [EDPa
2002]).  The policy uniquely provides continuous and
uninterrupted coverage.  
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certificates totaling more than $465 million.  Gagné also
participated in discussions concerning SFC's operations with Yao. 
Royal Indemnity, a client of Pepper Hamilton, provided SFC with
credit risk insurance for the pooled loans from 1999 to 2001.  
From April 27, 2001 to October 27, 2002, Pepper
Hamilton had two policies, $20 million of primary coverage under
the Westport policy and $30 million of excess coverage under the
Continental Casualty policy.  In October 2002, the law firm
decreased its coverage from $50 million to $40 million and
obtained policies with two additional insurers, Executive Risk
and Twin City.  In the subsequent years, from October 27, 2002 to
October 27, 2003 and October 27, 2003 to October 27, 2004,
Westport issued a $10 million primary coverage policy to Pepper
Hamilton, and Twin City, Executive Risk and Continental Casualty
each issued Pepper Hamilton $10 million of excess coverage.  Each
excess policy substantially incorporated the terms, conditions,
warranties and exclusions of the Westport policy.  
The Westport policy* excludes:
"any act, error, omission, circumstance or
PERSONAL INJURY occurring prior to the
effective date of this POLICY if any INSURED
at the effective date knew or could have
reasonably foreseen that such act, error,
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omission, circumstance or PERSONAL INJURY
might be the basis of a CLAIM.  This
exclusion does not apply to any INSURED who
had no knowledge or could not have reasonably
foreseen that such act, error, omission,
circumstance or PERSONAL INJURY might be the
basis of a claim." 
In March 2002, months before Executive Risk and Twin
City issued their respective policies to Pepper Hamilton, the law
firm defendants learned that SFC had been involved in securities
fraud in failing to disclose the forbearance payments.  Yao
informed Gagné that SFC was inaccurately representing its default
rate to make its certificates appear more attractive to
investors, underwriters and credit risk insurers.  Specifically,
SFC made forbearance payments from its reserve accounts on
student loans that were more than 90 days past due.  Pepper
Hamilton continued to represent SFC until April 2002.  
On July 22, 2002, Chubb Wilcox, Pepper Hamilton's
general counsel and insurance procurer, sent a memorandum to
Pepper Hamilton attorneys regarding the firm's insurance
application and inquired whether any person was "aware of any
fact or circumstance, act, error, omission or personal injury
which might be expected to be the basis of the claim or suit for
lawyers professional liability."  On August 6, 2002, Gagné
responded: "I am aware [of] the Student Finance Corporation
transactions of which you are familiar . . . two law suits have
been filed in two different states and to date, we have not been
named in either action.  I am not certain as to whether we will
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be joined in the future."  On September 6, 2002, Pepper Hamilton
submitted a signed and dated insurance application to Westport,
which did not include information concerning SFC, and in a letter
to Twin City, dated October 25, 2002, Pepper Hamilton warranted
that it had no material changes to its application.  Pepper
Hamilton did not disclose information concerning SFC to any of
its insurers.   
Eventually, SFC was forced into bankruptcy.  In April
2004, Pepper Hamilton received a proposed tolling agreement from
SFC's bankruptcy trustee, which advised that valid claims and
causes of action could be brought against Pepper Hamilton "on
behalf of the estate and/or creditors of" SFC.  Pepper Hamilton
immediately contacted its primary insurer Westport and excess
insurers Executive Risk, Twin City and Continental Casualty and
informed them of the potential claims.  
In 2005, the bankruptcy trustee and Royal Indemnity
brought separate actions against the law firm defendants,
alleging, among other claims, breach of fiduciary duty, negligent
misrepresentation and professional malpractice.  Pepper
Hamilton's primary insurer, Westport, did not contest its
obligation to defend.  However, the excess insurers denied
coverage. 
Executive Risk commenced this action against the law
firm defendants and Westport, seeking a declaration that it had
no obligation to indemnify defendants in the underlying actions. 
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No. 130
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The law firm defendants counterclaimed for a declaration in their
favor and brought third-party claims against Twin City and
Continental Casualty.  Executive Risk and Twin City relied upon
Westport's prior knowledge exclusion, expressly incorporated into
their policies, and Continental Casualty cross-claimed for
rescission of its excess policies for 2002-2003 and 2003-2004.  
Supreme Court granted summary judgment in favor of the
excess insurers.  The court declared that, based on the policies'
prior knowledge exclusions, which deny professional liability
coverage for undisclosed acts that were known to the insured
prior to the inception of the policies and exposed the insured to
professional liability claims, Executive Risk and Twin City had
no obligation to indemnify the law firm defendants in the
underlying actions.  Additionally, Supreme Court rescinded the
law firm defendants' 2002-2003 and 2003-2004 Continental Casualty
professional liability policies because they did not disclose
information, during the renewal periods of those policies,
concerning known acts that exposed them to the underlying
professional liability claims.  The court further declared that
the underlying actions were not covered under the 2001-2002
Continental Casualty policy.  The Appellate Division reversed the
Supreme Court order and denied all motions and cross motions for
summary judgment.  The Appellate Division granted the excess
insurers leave to appeal and certified the following question to
this Court: "Was the order of this Court, which reversed the
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No. 130
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order of the Supreme Court, properly made?"  We now modify and
answer the certified question in the negative.  
Analysis
Prior Knowledge Exclusions
Under Pennsylvania law, the insured has the burden of
proving that "its claim falls within the policy's affirmative
grant of coverage" (Koppers Co., Inc. v Aetna Cas. and Sur. Co.,
98 F3d 1440, 1446 [3d Cir 1996]).  The insurer, however, carries
"the burden of proving the applicability of any exclusions or
limitations on coverage" (id.).  A court must consider the
following two-pronged test when determining whether a prior
knowledge exclusion applies.  It must "first consider the
subjective knowledge of the insured and then the objective
understanding of a reasonable attorney with that knowledge"
(Coregis Insurance Company v Baratta & Fenerty, LTD, 264 F3d 302,
306 [3d Cir 2001]).  Specifically, "it must be shown that the
insured knew [prior to effective date of the policy] of certain
facts" that occurred prior to that effective date (id., quoting
Selko v Home Ins. Co., 139 F3d 146, 152 [3d Cir 1998]).  Then, a
court must determine that a "reasonable attorney in possession of
such facts would have a basis to believe that the insured" might
expect such facts to be the basis of a claim against the insured
(id.).  
Here, it is undisputed that the law firm defendants
knew of SFC's securities fraud months prior to the effective
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dates of the Executive Risk and Twin City policies.  The courts
below noted that Gagné subjectively believed, and informed Mr.
Wilcox at least one month prior to the submission of one of the
law firm's insurance applications, that he and the law firm could
be subject to a lawsuit from their representation of SFC.  Such a
belief, although subjective, was also reasonable, but Pepper
Hamilton did not provide that information to its insurers.  Given
the law firm defendants' role in the securitization of the loans
and Gagné's close involvement with SFC, a reasonable attorney
with the law firm defendants' knowledge should have anticipated
the possibility of a lawsuit, particularly when millions of
dollars may have been lost from activities of which they were
aware.  Here, the law firm's knowledge of its client's fraudulent
payments prior to its application for excess coverage coupled
with the fact that a reasonable attorney would have concluded
that the law firm defendants would likely be included in the
litigation because of their role in their client's business
satisfy the test of Coregis and create an obligation for the law
firm to inform its insurers of this potential litigation.
Contrary to the Appellate Division's holding, the prior
knowledge exclusion in this case does not require the known of
act, error, omission or circumstance to be "wrongful conduct on
the part of the insured" (Executive Risk Indem. Inc. v Pepper
Hamilton LLP, 56 AD3d 196, 204 [1st Dept]).  It excludes coverage
of "any act, error, omission, circumstance . . . occurring prior
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to the effective date of the [policy] if any [insured] at the
effective date knew or could have reasonably foreseen that such
act, error, omission, circumstance . . . might be the basis of a
[claim]."  Here, on October 27, 2002, the effective date of the
Executive Risk and Twin City policies, the law firm defendants
knew of acts that occurred prior to that date, which they could
have foreseen to be the basis of a claim.  Thus, the prior
knowledge exclusions apply to those policies.    
Recission
It is well-settled under Pennsylvania law that
rescission of an insurance policy may occur only if the (1)
applicant made a false statement, (2) the false statement was
material to the risk, (3) the applicant knew the statement was
false and (4) the statement was made in bad faith (Allstate Ins
Co v Stinger, 163 A2d 74, 78 [Pa 1960]).  The insurer must prove
all elements by clear and convincing evidence (Justofin v
Metropolitan Life Insurance Co., 372 F3d 517, 521 [3d Cir 2004]). 
Pennsylvania recognizes an omission as a false representation in
the context of insurance applications (id. at 522).
We agree with the Appellate Division that, even if the
law firm defendants' omission of the SFC incident is a known
false statement, Continental Casualty failed to establish as a
matter of law that the false statement was material to the
reinsurance determination and that the false statement was made
in bad faith.  Here, the self-serving affidavit of Continental
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Casualty's underwriter -- that Pepper Hamilton's renewal
application would have been treated differently had it disclosed
the underlying circumstances which led to the denial of coverage
-- is insufficient to meet the insurer's heightened burden of
proof.  The Appellate Division correctly denied summary judgment
on the issue of rescission.   
Accordingly, the order of the Appellate Division should
be modified, without costs, in accordance with the opinion herein
and, as so modified, affirmed, and the certified question
answered in the negative. 
*   *   *   *   *   *   *   *   *   *   *   *   *   *   *   *   *
Order modified, without costs, in accordance with the opinion
herein and, as so modified, affirmed, and certified question
answered in the negative.  Opinion by Judge Jones.  Chief Judge
Lippman and Judges Ciparick, Graffeo, Read and Pigott concur. 
Judge Smith took no part.
Decided October 20, 2009