In March 2002, the insured sent an email to the client expressing concern about the propriety of the client’s practices and advising that it “may rise to the level of criminal fraud.” One month later, the attorney responsible for the client’s account informed the insured’s finance and ethics committees that the client had lied to investors and failed to disclose its practice of “propping up” to avoid default. The attorney warned of the “possibility that [the] firm will be sued, as a deep pocket associated with [the client].” At that time, the attorney also opined as to the client’s and the insured’s “first line of defense” in response to any suit. The attorney recommended that the insured law firm distance itself from, and cease representation of, the client. Shortly thereafter, the insured’s general counsel directed the firm’s attorneys to retain all records relating to the client and not to discuss the matter with anyone outside the firm and within the firm only to those who are involved in protecting the firm’s interests. The attorney who handled the client’s account then prepared a memorandum to assist general counsel’s assessment of any potential claims “that were [or] could have been filed by [the client] against [the insured].”
When the firm prepared its insurance application in July 2002, the same attorney prepared a memorandum referring to his and the firm’s work for the client as a fact or circumstance that may give rise to a claim, stating that, although the firm had not been sued in any pending action arising from the client’s conduct, he was “not certain as to whether we will be joined in the future.” However, the actual renewal application denied awareness of any fact or circumstance which might be expected to be the basis of a professional liability claim. The insured was thereafter named in two suits arising from its work for the client and tendered the claims to its professional liability insurers.
The New York Supreme Court, applying Pennsylvania law, held that a Prior Knowledge Exclusion in the primary policy applied, where the insured (a) knew of certain facts that (b) would lead a reasonable attorney to foresee that those facts might be the basis of a claim. The trial court determined that in light of the statements made by the attorney and the firm as noted above, the insured “knew and reasonably foresaw” that its work on the client’s account would expose the firm to litigation and therefore granted two of the insurers’ motions for summary judgment based on the Prior Knowledge Exclusion.
On appeal, the First Department agreed with the trial court’s statement of the test used to determine whether the Prior Knowledge Exclusion applied, but disagreed with the trial court’s application of it to the facts presented. The Appellate Division held that the insured must be shown to have had a belief that it may be sued for its own conduct in breach of a professional duty, not awareness of the conduct of its client that could render the insured subject to a claim. The Court reversed the grant of summary judgment, but certified the question of law to the Court of Appeals.
The Court of Appeals reversed, holding that application of Pennsylvania’s mixed subjective-objective test, requiring consideration of the insured’s subjective knowledge and the objective understanding of a reasonable attorney with that knowledge showed as a matter of law that the insured should have anticipated the possibility of a lawsuit given the insured’s role the client’s business, regardless of whether the insurers could establish actual breach of a professional duty by the insured.