Prior Knowledge Exclusion in Application Bars Coverage for Undisclosed Claim that Led to Litigation

In a win for Wiley Rein’s client, a Maryland federal district court has ruled that a prior knowledge exclusion contained in a policy application barred coverage for a lawsuit filed during the policy period because it arose from a demand letter received by the insured before the application was completed.  Madison Mechanical, Inc. v. Twin City Ins. Co., No. 1:17-cv-01357-GLR (D. Md. Mar. 30, 2018).

Principals of the insured, a closely-held company, formed a new company that excluded one of the former company’s owners.  Before the policy period, the excluded owner sent a letter to the principals asserting that the purpose of the new company was to “divert the business and client base of [the old company] for the benefit of [the new company].”  The letter also claimed that these actions “could lead to a cause of action for breach of fiduciary duty, interference with a contractual relationship, interference with an economic relationship, civil conspiracy, and other potential causes of action,” and it put the principals “on notice of the potential litigation liability of such actions both on a corporate and personal level.”  The insured then terminated the excluded owner’s employment, which the excluded owner claimed was “an attempt to force a transfer of his stock” in the old company.  The excluded owner later sued the principals during the policy period.

The original company purchased two D&O policies from the same insurer for consecutive policy periods.  Towards the end of the first policy period, and about six weeks after its principals received the excluded owner’s demand letter, the insured submitted an application to add the new corporate entity to the first policy.  The insured answered “no” to a question regarding whether any insured had “any knowledge or information … of any error, misstatement, misleading statement, act, omission, neglect, breach of duty or other matter that may give rise or could give rise to a claim.”  Directly underneath, the application excluded coverage for “any claim based on, arising from, or in any way relating to such error, misstatement, misleading statement, act, omission, neglect, breach of duty, or other matter of which there was knowledge” (the “Prior Knowledge Exclusion”).  When the excluded owner’s lawsuit was filed and tendered to the insurer during the second policy period, the insurer denied coverage on grounds including the Prior Knowledge Exclusion.

On cross motions for summary judgment in the ensuing coverage action, the court ruled in favor of the insurer, holding that the Prior Knowledge Exclusion barred coverage under the relevant (second) policy.  The court first ruled that the application materials had been “deemed” part of the Policy pursuant to a provision defining “Application” to include prior applications as well as “any material or information submitted” with the application or otherwise made available to the insurer in the underwriting process.  The court also noted that the excluded owner’s letter described the principals’ conduct as “legally improper,” stated that the excluded owner was putting the principals “on notice of the potential litigation liability of such actions,” and listed specific causes of action that could be asserted – and which were ultimately asserted in the lawsuit filed after the policy incepted.  According to the court, there was no dispute of material fact that the excluded owner’s letter provided sufficient notice of conduct that “may give rise or could have given rise to a claim” and that the ultimate suit was “any claim based on, arising from, or in any way relating to” that conduct.  On that basis, the court ruled that the Prior Knowledge Exclusion barred coverage for the litigation.