Legal Malpractice Insurance Policy Rescinded Due To Fraud in the Application

In Minnesota Lawyers Mutual Ins. Co. v. Hancock, 2009 U.S. Dist. LEXIS 20536 (E.D. Va. March 3, 2009), Judge Henry E. Hudson granted summary judgment in an insurer's rescission action based on fraud in the application. The policy at issue was a legal malpractice insurance policy issued by Minnesota Lawyers Mutual Insurance Company. One of the partners in a two-man firm had for several years been engaged in a practice of embezzling money from his clients by moving money from his client escrow account to his operating account without his clients' authority and without having earned the money. The funds were used in part to cover the firm's overhead and operating expenses. The attorney voluntarily reported his misconduct and surrendered his law license to the Virginia State Bar, and subsequently he was indicted by a grand jury for embezzlement.

His partner was unaware of all this until reviewing pleadings filed by the Virginia State Bar. Meanwhile, applications for the firm's professional liability insurance had been submitted without any disclosure of the basis for possible claims. The insurer brought a rescission action, arguing that the misrepresentations made on behalf of the firm warrented rescission of the Policy, and moved for summary judgment.

The policy contained an exclusion for claims arising ouf of the dishonest, criminal, malicious or deliberately fraudulent act, error, or omission of the insured. However, that exclusion was qualified by an "Innocent Insured" provision, which afforded coverage for any insured who did not personally participate in or acquiesce to any actual or alleged dishonest, criminal, malicious, or deliberately fraudulent act, error, or omission of another insured.

The policy also contained language that specifically incorporated the application for coverage as part of the policy.

The defendant attorneys argued that because the application required the firm's representative to certify that "a reasonable inquiry has been made . . . to ensure the accuracy of all information contained herein", the firm had only been required to answer the application to the best of its knowledge. Therefore, defendants argued, the insurer must among other things demonstrate by clear proof that the insured's statements were knowingly false to obtain rescission.

The Court rejected that argument, saying that the provision imposed upon the firm an additional affirmative duty to investigate the truthfulness of the statements made to the insurer. That was not the equivalent of language permitting an insured to warrant that its statements are only true to the best of its knowledge. Accordingly, the insurer was not required to demonstrate that any of the insureds knowingly made a false representation; rather, the insurer only needed to demonstrate by clear proof that the application contained a false statement and that the false statement was material to the company's decision to issue the policy. The insurer easily satisfied its burden on those points.

The Court concluded by observing that the innocent partner's lack of awareness of the embezzlement did not prevent rescission of the policy as to all insureds. The policy did contain an Innocent Insureds provision which, absent rescission, may have afforded the innocent partner coverage under the facts of this case. But the policy's Innocent Insured provision did not reference or preclude the remedy of rescission for a material misrepresentation in the application. Therefore, the policy was rescinded as to all insureds notwithstanding the innocent partner's lack of personal knowledge of the embezzlement.