The United States Court of Appeals for the Fifth Circuit, applying Texas law, has held that the prior knowledge exclusion contained in a lawyers professional liability policy was unduly broad as written and would be construed to apply to wrongful acts reasonably likely to lead to a malpractice claim.  OneBeacon Ins. Co. v. T. Wade Welch & Assocs., 2016 WL 6694548 (5th Cir. Nov. 14, 2016).  The court also reaffirmed that an insurer may accept a Stowers demand that offers to release fewer than all insureds.

The insured law firm purchased a claims-made malpractice policy from the insurer for the policy period of December 2006 to December 2007.  The policy contained a retroactive date of January 4, 1995.  The policy also contained a prior knowledge exclusion, providing that coverage would be precluded for “any claim arising out of a wrongful act occurring prior to the policy period if … you had a reasonable basis to believe that you had committed a wrongful act, violated a disciplinary rule, or engaged in professional misconduct; [or] you could foresee that a claim would be made against you.”  The policy defined “wrongful act” as “any actual or alleged act, error, omission, or breach of duty arising out of the rendering or the failure to render professional services.”  In applying for the policy (and the subsequent renewal policy), the insured law firm represented that it was not aware of any act, error, or omission that would result in a claim.

In 2006, an attorney at the insured law firm failed to respond to discovery requests within the time limit and subsequently failed to properly verify and supplement discovery responses as required by court order.  Shortly after the effective date of the policy, the insured law firm was served with a motion seeking sanctions for the discovery failures.  The sanctions motion was ultimately granted, and the court awarded sanctions and deemed the claims against the insured law firm’s client established as a matter of law.  Following the entry of the sanctions order, the insured law firm notified the insurer of a potential malpractice claim.  The insurer ultimately rescinded the policy and filed a declaratory judgment action seeking, in relevant part, a declaration that the prior knowledge exclusion barred coverage because the attorney was aware of the discovery misconduct when the policy incepted.  The insured law firm prevailed at trial, and the insurer appealed.

On appeal, the Fifth Circuit held that the prior knowledge exclusion was unduly broad as drafted and unenforceable as a matter of law.  According to the court, the definition of “wrongful act” in the prior knowledge exclusion was overbroad because “[o]n its face, [it] covers every single thing an attorney does or does not do, wrongful or not,” and thus “the exclusion renders the coverage illusory and is facially absurd.”  The court held that the exclusion “must be directed at a ‘wrongful act’ reasonably likely to lead to a malpractice claim.”  In that regard, the court concluded that the attorney (and the insured law firm) did not have knowledge of the potential malpractice claim when the policy incepted, because at that point the misconduct could have been corrected and sanctions could have been avoided.

The court also upheld the district court’s ruling that the insurer was negligent in failing to accept a settlement demand for the policy limits that would have released only the insured law firm.  In opposition, the insurer argued that its refusal to settle was proper because the attorney, one of its insureds, would still have had exposure.  The court rejected this argument, holding that when faced with a Stowers demand with respect to a policy covering multiple insureds, an insurer is free to settle as to one insured even if the potential liability of other coinsureds remains unresolved.