Lawyer's Lie on Insurance Application Eviscerates Coverage for Innocent Partner

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April 13 — A lawyer who on his firm's insurance application falsely denied knowing of any circumstances that might lead to a malpractice claim thereby invalidated the policy as to every other member of the firm, the Illinois Supreme Court held in a decision released March 31.

In a 6-1 ruling, the court decided that the “innocent insured” doctrine does not apply when a lawyer's material misrepresentation on an insurance application prevents a valid contract from being formed in the first place.

Moreover, the wording of the severability clause in this policy foreclosed the possibility of carving out an innocent partner's coverage to preserve it, Justice Charles E. Freeman said.

Justice Thomas L. Kilbride dissented, saying the majority ignored the innocent partner's reasonable expectations as a member of a limited liability firm. The court's decision undermines the purpose of Illinois rules that require limited liability firms to carry malpractice insurance, he stated.

Insurer Gets Rescission

The decision allows ISBA Mutual—the Illinois bar's mutual insurance company—to rescind a malpractice policy it issued in May 2008 to the Law Office of Tuzzolino & Terpinas and its principals, Sam Tuzzolino and Will Terpinas Jr.

When Tuzzolino filled out the firm's insurance application, the court said, one of his clients was very unhappy with him, yet he answered no to a question asking if any attorney in the firm was aware of conduct that might give rise to a malpractice claim.

The court held that ISBA was entitled to revoke the policy under an Illinois insurance statute authorizing rescission for a false statement “by or on behalf of the insured” if the misrepresentation was intended to deceive or materially affected the risk.

Tuzzolino was disbarred on consent in 2010, the court noted.

Innocence Not Relevant

The court decided that the “innocent insured” doctrine did not apply under these circumstances to preserve coverage for Terpinas, even though he insisted he was unaware of the client's grievances until he received a lien letter from the client's new attorney shortly after the policy was issued.

In reaching this conclusion, the court relied heavily on Home Ins. Co. v. Dunn, 963 F.2d 1023 (7th Cir. 1992), which held that Illinois law allowed rescission of a policy a lawyer obtained without disclosing his embezzlement of client funds, even though other attorneys in the firm did not know of the lawyer's criminal activities.

The court embraced a distinction suggested in Dunn between rescission of an insurance policy because of a misrepresentation on the application, on the one hand, and denial of insurance coverage because of excluded wrongdoing, on the other.

The innocent insured doctrine is relevant, the court said, 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.

But the question of whether an insurance policy should be enforced in the first place is governed by statute and considers the effect of the misrepresentation on the validity of the policy as a whole, the court said.

The innocent insured doctrine, Freeman wrote, “is relevant to issues of policy exclusions and insurance coverage, but it is unsuited to the case at bar, which deals with rescission and contract formation.”

Not Severable

The court also ruled that under the wording of the severability clause in the insurance contract, the policy could not be partially severed to salvage coverage for Terpinas.

Freeman pointed out that while the severability clause created a separate agreement with each insured, the provision stated that each separate agreement was made up of the details and statements in the application for the policy. The application contained the false statement that no member of the firm was aware of the potential for a then-unreported claim, the court noted.

Thus, Freeman said, even if the policy was treated as a separate contract with each insured, nothing would permit the application—or the misrepresentation it contained—to be split off from any individual contract.

Dissent: Public Policy Snubbed

In his dissenting opinion, Kilbride argued that the innocent insured doctrine applied because Terpinas reasonably believed he had professional liability insurance and was not culpable in the misrepresentation.

Kilbride found persuasive First Am. Title Ins. Co. v. Lawson, 827 A.2d 230, 19 Law. Man. Prof. Conduct 419 (N.J. 2003), which held that a managing partner's dishonesty in an insurance application did not void coverage for a member of the firm who was unaware of the deceit.

Kilbride pointed out that Illinois rules require attorneys in limited liability entities to maintain at least a minimum level of professional liability insurance coverage or else face joint and several liability. Rescission of Terpinas's professional liability insurance is inconsistent with the policies underlying those rules, which benefit both lawyers and clients, he said.

“In addition, I am troubled by the scope of the consequences resulting from the majority's holding on other law firms and especially midsize and large firms,” Kilbride said.

“Under the majority's view, a material misrepresentation on an insurance application could cause rescission of the policy as to each and every attorney, despite their reasonable expectations of continued professional liability insurance coverage,” Kilbride said. Furthermore, he added, “as the size of the affected firm increases, so does the potential harm to the public.”

Taft Stettinius & Hollister LLP and Pretzel & Stouffer Chtd. represented ISBA Mutual. Roach, Johnston & Thut and Franco & Moroney LLC represented Terpinas and the firm.

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