A federal court in Maryland has held that a “prior knowledge” provision in a claims-made-and-reported policy applied where, prior to the effective date of the policy, other members of the insured’s real estate firm had suggested that the insured was responsible for the firm’s defense costs in an underlying litigation. McDowell Building, LLC v. Zurich Am. Ins. Co., No. RDB-12-2876 (D. Md. May 7, 2015). The court also found that the insurer had properly denied coverage for a claim on the basis of late notice because the insurer was “actually prejudiced” by the insured’s failure to give notice of a claim until after the insured had signed a settlement agreement releasing a potentially-responsible party from the underlying litigation.

The insured, a partner at a real estate firm, failed to obtain state tax credits for a development project on behalf of his real estate firm. When the other partners in the real estate firm discovered the problem with the tax credits, they suggested payment of legal costs from the insured and filed suit against the state government agency to obtain the tax credits. One of the partners in the real estate firm subsequently asserted a cross-claim and third party complaint against the insured for professional negligence. That cross-claim was stayed, however, pending resolution of the underlying suit against the state agency.

Three years later, the insured first gave notice to the insurer of the stayed cross-claim—after the insured entered into a settlement agreement releasing another potentially-responsible party from all claims in the underlying suit. The insurer denied coverage for the cross-claim on the basis of late notice and, alternatively, on the basis that the prior knowledge provision was not satisfied because the insured had knowledge of the cross-claim prior to the effective date of the relevant policy period. The policy provided coverage for claims first made and reported during the applicable policy period, provided that, “prior to the effective date of th[e] policy, [the] Insured had no knowledge of any ‘claim’ or circumstances, involving an act, error, or omission, which may result in a ‘claim’ under th[e] policy.” In addition, the policy required the insured to provide “prompt notice” in the event of any claim. The insured settled the cross-claim, and the real estate firm, as assignee of the insured, filed a coverage action.

After a three-day bench trial, the court concluded that the “prior knowledge” provision in the policy precluded coverage for the cross-claim. As a preliminary matter, the court stated that it had previously ruled at the summary judgment stage that the provision should be interpreted as applying a subjective standard. In declining to reconsider its previous ruling, the court distinguished several cases decided under Maryland law where the prior knowledge provisions contained “explicit … words triggering an objective standard.” Applying the subjective standard, the court ruled that the prior knowledge provision applied to the cross-claim because the insured had “actual knowledge” of a claim a year before the cross-claim was filed, when the other partners of the real estate firm had suggested that the insured pay the legal costs from the tax credit problem.

The court also held that the insurer had demonstrated “actual prejudice” to justify denying coverage based on late notice. As an initial matter, the court stated that Maryland Code § 19-110, which allows insurers to disclaim coverage on the basis of late notice only if the insurer establishes “actual prejudice,” requires insurers to demonstrate that the insured’s actions have “in a significant way … precluded or hampered [the insurer] from presenting a credible defense to the claim.” According to the court, the insured prejudiced the insurer by settling the underlying suit and forfeiting any rights of contribution that the insurer might have had against the other potentially-responsible parties in the underlying litigation. In so holding, the court rejected the assignee’s argument that, in order to show actual prejudice, the insurer was required to prove that it was entitled to indemnity or contribution from the other parties as a matter of law. The court explained that the Maryland “actual prejudice” standard “does not require [a] level of absolute certainty” but requires the insurer to demonstrate “a credible theory under which [the insurer] could have avoided liability or minimized the damages which it was responsible for paying.”