Ethics

Protecting the Innocent: Wrongdoing by One Lawyer Can Affect Insurance Coverage for Others


Nearly all lawyers’ professional liability insurance policies exclude coverage for fraudulent or criminal conduct. But the typical policy also contains a provision that preserves coverage for other lawyers at a firm who did not engage in such conduct, or who didn’t know about or acquiesce in the misconduct of a colleague. This provision generally is referred to as the “innocent insured clause.”

Although innocent-insured clauses in LPL policies are intended to protect innocent attorneys from losing coverage when another lawyer at the firm commits a wrongful act, there are variations in these clauses that may lead to dramatically different results as to when, and even whether, coverage is preserved for the innocent lawyers.

Moreover, the “prior knowledge clause” may strip innocent insureds of coverage where another firm lawyer intentionally commits a wrongful act. Most LPL policies don’t cover claims if any insured knew about a potential claim when the insurance policy was purchased. Because a wrongdoing lawyer knows about the potential claim when committing the bad act, everyone else at the firm could be excluded from coverage, as well.

Similarly, an entire insurance policy can be declared void, and rescinded, if the application contains material misrepresentations. LPL applications always ask whether the insureds are aware of any acts or omissions that could lead to a claim. Wrongdoing insureds don’t typically disclose their own dishonesty, so applications frequently contain misstatements in those circumstances. Once a policy is declared void, it may not provide cover age for anyone at the firm, including innocent insureds.

These issues become particularly important when firms merge. You may not know everything there is to know about all of the other firm’s members who will be joining your firm. It is always possible that one of your new partners or associates has been up to no good and has not told anyone. When the new, merged firm buys an insurance policy, all of these clauses come into play.

A DEFENSE FOR ALL

The innocent-insured clause often is found in the intentional-acts exclusion in the LPL policy. Many policies have one much like the following, which only applies once there is an actual judgment that an insured committed the intentional wrongful act. The effect is that all insureds, even the alleged wrongdoer, are provided with a defense to the claim:

“Exclusions: This policy shall not apply to any claim based upon, arising out of, attributable to, or directly or indirectly resulting from … any intentional, criminal, dishonest, malicious or fraudulent act, error, omission or personal injury committed by an insured. This exclusion does not apply to any insured who is not so adjudged. This exclusion also does not apply to any insured who did not commit, know or acquiesce in such wrongful act which is the basis of the claim.” (Emphasis added.)

Some exclusions only apply where there is an “adjudication” that an intentional act has been committed, while others apply where such an act has occurred “in fact.” If an innocent-insured clause requires an adjudication, the insurer may be allowed to deny coverage to the wrongdoer only after an actual court judgment in the liability case against the insured. If there is a settlement and no adjudication, the insurer might not be able to apply the exclusion. On the other hand, if the exclusion applies where there is an intentional act in fact, this may allow the insurer to prove the intentional act in a suit that it brings after a settlement.

WRONGDOER PAYS FIRST

Innocent-insured clauses frequently require that assets belonging to the wrongdoer be exhausted to pay the judgment before the insurer has to pay on behalf of the innocent insureds. Here is some typical language: “The company’s obligation to pay damages under this provision will be excess of the full extent of the assets of any insured involved in such dishonest, fraudulent or malicious conduct. Nothing in this paragraph shall be deemed to provide coverage for any insured for criminal conduct.” (Emphasis added.)

Under another variation of this clause, the law firm only has to use any firm assets belonging to the wrongdoer before the insurer will pay.

How innocent insureds attempting to obtain coverage under this type of clause would determine the assets of a dishonest and, in all likelihood, uncooperative attorney is problematic and would likely lead to challenging litigation. Calculating the interest of the wrong doer in firm assets such as computer equipment, furniture and accounts receivable can be an accounting nightmare, especially where some of the receivables are for contingent-fee cases or are otherwise for cases where the firm might not be paid some or all of its fees. In addition, firm liabilities attributed to the wrongdoer have to be subtracted. In one case, the firm was forced to file a lawsuit against a partner seeking a judgment that would exhaust his assets in order to trigger the coverage for the remaining innocent insureds.

Even where a judgment is obtained against the wrongdoer, collecting from a firm member who hides or fraudulently transfers assets is a time-consuming, expensive and arduous process.

THE SEARCH FOR EQUITY

Although most courts have held that a misrepresentation on an application will void the policy for innocent and wrongdoing lawyers alike, a small number of courts have extended coverage to the innocent insureds. Those courts have relied on principles of equity, as well as the harshness of depriving them of coverage where, for example, an innocent insured worked in a different branch office than the wrongdoer and therefore had no knowledge of the misdeeds, and where the firm was set up as a limited liability entity so that each partner would be shielded from the bad acts of the other partners.

Courts also have reached different conclusions as to whether a law firm, as an entity, may qualify as an innocent insured because it can only act through its employees and partners. But most courts looking at this issue have refused to grant the status of innocent insured to the firm.

Finally, the prior-knowledge exclusion may deprive an innocent insured of coverage. Because these clauses bar coverage whenever any insured, including a wrongdoer, knows of a potential claim at the beginning of the policy, the concealed knowledge of the wrongdoer spoils coverage for everyone. This exclusion, like the rescission problem, comes into play if the wrongdoer’s scheme started some time before the inception of the policy under which coverage is sought.

Although it may seem harsh to deprive innocent insureds of coverage for intentional misconduct of their partners or associates, they are protected at the expense of the insurer, which cannot reasonably protect itself from insuring law firms whose members already have committed these acts.

Because of the variations in the protection for innocent lawyers, firms should carefully evaluate these various clauses to see just how much protection they have.

Taking the time to thoroughly review your LPL policy and becoming educated about the different types of LPL policies available will give you the best opportunity to ensure that your firm has the insurance protection it needs.

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