NY High Court Holds that "Self-Serving" Testimony from Underwriter is Insufficient for Rescission

This post was written by J. Andrew Moss

The New York Court of Appeals rejected an effort by Continental Casualty Company (CNA) to rescind an excess professional liability (E&O) policy issued to the law firm Pepper Hamilton LLP, in a decision under Pennsylvania law that also affirmed summary judgment in favor of two of the firm’s other excess E&O insurers based on the application of a “prior knowledge” exclusion in their policies. Executive Risk Indemnity Inc. v. Pepper Hamilton LLP, No. 130 (N.Y. Oct. 20, 2009).

The dispute centered on Pepper Hamilton’s work on behalf of the now-defunct Student Finance Corporation, which eventually led to significant litigation against Pepper Hamilton. According to the opinion, in March 2002 Pepper Hamilton and one of its partners learned that SFC and its principal (the now twice convicted Andrew Yao),

had engaged in securities fraud in connection with SFC’s securitization of student loans. The firm terminated its representation of SFC one month later and in June SFC was forced into involuntary bankruptcy. Pepper Hamilton’s professional liability (or E&O) insurance came up for renewal the following October. In connection with its renewal process, the firm’s general counsel asked all its attorneys whether any were aware of any fact or circumstance, act, error, omission or personal injury that might be expected to be the basis for a professional liability claim. In early August, the partner who was aware of the SFC fraud advised the firm accordingly, but the application submitted by the firm in September did not disclose any information concerning SFC. In April 2004, a new bankruptcy trustee proposed that Pepper Hamilton enter into a tolling agreement with respect to potential claims against the firm by the estate and its creditors. At that point, the firm gave notice to its insurance companies. Lawsuits were filed against the firm in early 2005 and the firm’s primary insurer, Westport, defended the claims.

The Pepper Hamilton ruling on rescission is instructive. CNA had submitted an affidavit from its underwriter stating that he would have treated the application differently had the information been disclosed. The court concluded that CNA failed as a matter of law to meet its high burden, which requires proof by “clear and convincing evidence,” for rescission:

[E]ven if the law firm defendants' omission of the SFC incident is a known false statement, [CNA] failed to establish as a matter of law that the false statement was material to the reinsurance [sic] determination and that the false statement was made in bad faith. Here, the self-serving affidavit of [CNA'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.

On the “prior knowledge” exclusions, the court reversed the pro-policyholder ruling of the intermediate appellate court. Rather than the First Department’s requirement that the insurer had to prove knowledge of "wrongful conduct on the part of the insured" (Executive Risk Indem. Inc. v Pepper Hamilton LLP, 56 AD3d 196, 204 [1st Dept]), the New York high court held that the prior knowledge exclusion

excludes coverage of "any act, error, omission, circumstance ... occurring prior 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]."

On the basis of this stricter standard, the court granted summary judgment to the two excess insurance companies with policies containing this exclusion.