Under the applicable Illinois statute, an insurer may seek to rescind a policy if it was procured by an application misrepresentation if the misrepresentation was “made with the actual intent to deceive or materially affects either the acceptance of the risk or the hazard assumed by the company.” But even if rescission is otherwise warranted, may the insurer rescind the policy even as to an “innocent insured” who was unaware of the application misrepresentation? That was the question raised before the Illinois Supreme Court in Illinois State Bar Association Mutual Insurance Company v. Law Offices of Tuzzolino and Terpinas. In a February 20, 2015 opinion (here), the Court rejected the ruling of the intermediate appellate court, which had applied the “innocent insured” doctrine to preserve coverage for a law firm partner who was unaware of the a misrepresentation in the law firm’s legal malpractice insurance renewal application, and held that the insurer was entitled to rescind the policy as to all insured persons, even the innocent insured. As discussed below, I have a problem with the circumstances this case presents.
Sam Tuzzolino, a partner in the law firm of Tuzzolino and Terpinas, represented Anthony Coletta in a several lawsuits referred to as the Baja litigation. Coletta later alleged that his claim in one of the Baja lawsuits was undermined because Tuzzolino failed to timely identify an expert witness on valuation issues. Coletta also alleged that in a separate lawsuit Tuzzolino failed to file the complaint before the statute of limitations expired. When Coletta confronted Tuzzolino about these concerns, Tuzzolino allegedly offered $670,000 to settle any potential claim of legal malpractice. (Coletta never received the money.)
Less than three months later, Tuzzolino completed an application to renew the law firm’s malpractice insurance. Question 4 on the form asked “Has any member of the firm become aware of a past or present circumstance(s), act(s), error(s) or omission(s), which may give rise to claim that has not been reported?” Tuzzolino checked “no” and signed his name as “owner/partner,” beneath the following statement “I/We affirm that after an inquiry of all the members of the applicant firm that all the information contained herein is true and complete to the best of my/our knowledge and that it shall be the basis of the policy of insurance and deemed incorporated therein upon acceptance of this application by issuance of a policy.”
Terpinas contends he first became aware of Tuzzolino’s malfeasance shortly after the application was submitted, when the law firm received a lien letter from an attorney representing Coletta. Terpinas reported the claim to the malpractice insurer, which in turn filed a lawsuit seeking rescission of the policy based on the application misrepresentation.
The circuit court granted the insurer’s motion for summary judgment holding that the insurer was entitled to rescind the policy. However, the intermediate appellate court reversed the lower court, holding that because Terpinas was an “innocent insured,” the policy should not have been rescinded as to him, based on its conclusion that a common law “innocent insured doctrine” applied to misrepresentations made on the renewal application. The insurer appealed the intermediate appellate court’s ruling to the Illinois Supreme Court.
The February 20, 2015 Opinion
On February 20, 2015, in a majority opinion written by Justice Charles Freeman, the Illinois Supreme Court reversed the intermediate appellate court’s opinion and affirmed the judgment of the circuit court rescinding the policy in its entirety. Justice Thomas Kilbride dissented.
Terpinas argued that it would be “patently unfair” to apply the rescission to him, as he was unaware of the application misrepresentation. In making this argument, he relied on the common law innocent insured doctrine, which as recognized by Illinois courts allows an insured who is innocent of wrongdoing to recover despite the wrongdoing of other insureds.
The Court rejected the applicability to the innocent insured doctrine to the rescission question in this case. The Court said that coverage cases applying the doctrine “usually involve the enforcement of policy exclusions” adding that “the innocent insured doctrine makes sense in that context because the insured’s innocence is relevant to whether an intentional act invokes an exclusion to coverage. But the innocent insured doctrine appears irrelevant to rescission, a recognized remedy for even innocent misrepresentations.”
The Court said that “unlike in a rescission case, the innocence of an insured matters a great deal when another insured’s wrongdoing triggers a policy exclusion, and a dispute arises over whether the insured has a duty to defend the innocent insured under a policy that indisputably was in effect.” But the issues of insurance coverage governed by common law rules of policy language interpretation are “significantly different from the question of whether an insurance policy should be enforced in the first place.” The court added that
In the case of a misrepresentation that materially affects the acceptance of the risk, the issue is the effect of that misrepresentation on the validity of the policy as a whole. A misrepresentation on the policy application goes to the validity of the policy as a whole. The innocent insured doctrine, on the other hand, has a narrower focus, typically dealing with situations where an insured’s wrongdoing triggers a policy exclusion, and the question is whether the insurer has a duty to defend the innocent insured under a policy that is still in effect.
The Court also rejected the argument of Terpinas that the clause the Court described as the “severability clause” requires a different result. The clause provides, among other things, that “The particulars and statements contained in the Application will be construed as a separate agreement with and binding on each Insured.” The court concluded that “even if the policy is treated as a separate contract with each insured, there is nothing to permit the application – or the misrepresentation it contains – to be split off from an individual contract it contained.”
In dissent, Justice Kilbride said he would have applied the innocent insured doctrine here, reasoning that the doctrine “operates to preserve insurance coverage if a reasonable person would not have understood that the wrongdoing of a coinsured would be imputed to him.” Justice Kilbridge said that, because the coverage had first incepted in 2005 and had been continuously in place through the time of the 2008 application that had the misrepresentation, Terpinas had a “reasonable expectation” that he was insured and that his policy would remain in effect.
Justice Kilbride added that “nothing in the policy explicitly stated each insured would face rescission of their professional liability insurance coverage due to a misrepresentation by another member of the firm.” If the insurer intended to impute the wrongdoing of Tuzzolino onto Terpinas, Kilbride reasoned, it should have expressly stated so in the terms of the policy.
Finally, Justice Kilbride said that he was “troubled by the scope of the consequences resulting from the majority’s holding on other law firms and especially midsize and large firms,” where an application misrepresentation could cause rescission as to each and every attorney.
There is a serious problem with what happened here, but it isn’t any of the concerns that Kilbride identified in his dissent, or at least the problem isn’t exactly the ones Kilbride identified – although the anxiety Kilbride expresses about the possibility that in a larger law firm, every attorney’s legal malpractice coverage could be a risk of rescission if the application contains even a negligent misrepresentation, is as Kilbride correctly says, troubling.
Before I get to the serious problem lurking here, I want to comment on Kilbride’s suggestion that if the insurer intended to impute the application misrepresentation of one partner in the law firm to another partner at the law firm, it should have said in the policy that it was going to do so.
Kilbride could review a universe of policies before he would find any policy with the type of imputation clause he proposes. Indeed, in recent times, quite the reverse type of clause has become common in many types of management and professional liability insurance policies. In these types of provisions, the policy states that in determining the effect of an application misrepresentation, coverage is precluded only for individuals with knowledge of the misrepresentation, and further that the knowledge of others will not be imputed to anyone else. So, rather than the type of imputation clause Kilbridge proposes many policies now have non-imputation clauses. (Many policies are also expressly non-rescindable, and a misrepresentation only precludes coverage, but it does not vitiate the contract of insurance). If this law firm’s policy had had this type of non-imputations provision, Terpinas might have been able to preserve his coverage under the policy.
Which brings me to what I see as the real problem here – the misrepresentation on which the insurer relied in seeking rescission was in a renewal application. In an application for the renewal of a claims- made insurance policy, the insurer should not be asking and the policyholder should not be answering a question about the existence of acts, circumstances, errors or omissions that could give rise to a claim.
A claims made insurance policy covers claims made during the policy period based on acts that occurred at any time (usually subject to a past acts or retroactive date). It is appropriate for the insurer to ask the known circumstances question when the coverage first incepts, as the insurer should not be asked to cover known claims. But after the coverage is in place, when it comes up for renewal, it is no longer appropriate for the insurer to ask the known circumstances question. The renewal policy should provide coverage for claims made during the renewal policy period, even if the claims involve wrongful acts that occurred before the renewal policy incepted (and after the retroactive date).
If the insurer is able to ask the known circumstances question in a renewal application and use that as a defense to coverage – or as here as the basis of a policy rescission — the claims made policy is converted into a sort of hybrid occurrence/claims made policy, where coverage is secure only when a claim made during the policy period involves only acts that occurred during the policy period. At a minimum, by asking the known circumstances question, the fundamental notion that coverage under a claims made policy should apply to claim made during the policy period regardless of when the acts underlying the claim occurred is defeated.
In my humble opinion, the problem with this case is that the insurer should not have been asking the known circumstances question. If as should have been the case the question had not been asked, there would have been no misrepresentation on which the insurer could base its rescission case.
I do not mean to find fault with anyone who was involved in this policy renewal. The insurance marketplace in 2008 was different than it is today, and the marketplace for small law firms is in some ways its own sphere. I do not mean to judge former circumstances by today’s standards or by conditions applying elsewhere but perhaps not here. But even allowing for all of that, I find the inclusion of the knowledge question in a claims-made policy renewal application surprising, troubling, and arguably inconsistent with the very nature of claims made coverage.
In his dissent, Kilbride sensed this problem. He pointed out that the coverage had been in place for three years prior to the renewal in connection with which the application misrepresentation had been made. He didn’t get to the point that the known circumstances question should not have been asked in the first place, but he was on the right track with his suggestion that after the renewals the insureds had a reasonable expectation of coverage. Of course, even though the question shouldn’t have been asked, it was answered, and there was little that could be done about it by the time the case came before Justice Kilbridge and the other members of the Illinois Supreme Court.
Rescission has been a hot button issue in the management liability insurance industry for nearly fifteen years. Policy language and policy practices about insurance application and application misrepresentations have evolved significantly during that time. Many of the industry changes in recent years have made rescission much less likely than it once was. However, as this case demonstrates, rescission remains a very serious issue. For that reason, the importance of the relevant language and of the application process cannot be overlooked.
For an earlier post in which I discussed the problem with asking the prior circumstances question in a renewal application, refer here.
Break in the Action: I am on the road for the rest of this week so there will be a break in the publication schedule for The D&O Diary. Normal publication will resume next week.