Full Disclosure in Insurance Applications

In Illinois State Bar Association Mut. Ins. Co. v. Law Office of Tuzzolino and Terpinas , 5 N.E.3d 1123 (Ill. 2014), the Illinois Supreme Court held that an insurer could rescind a malpractice policy due to material misrepresentations made in the insurance application, even though the rescission left other attorneys who did not take part in the application and were not involved in the underlying misconduct (innocent insureds) without coverage.

Background Facts

Sam Tuzzolino and Will Terpinas, Jr. were law partners in a law firm organized as a limited liability entity. The legal matter that created the underlying application misconduct issues involved Sam Tuzzolino (Tuzzolino). He represented a client named Anthony Coletta (Coletta) in a variety of matters, including litigation arising from alleged mismanagement of a Chicago nightclub. In that litigation, Tuzzolino failed to timely disclose expert witnesses who would testify about valuation issues, and failed to retain an expert on forensic accounting issues. As a result, the designated experts were barred from testifying at trial.

Subsequently, Tuzzolino allegedly advised Coletta to settle the suit for $30,000, an amount far less than Coletta's alleged losses. Tuzzolino then advised Coletta to try and recover his losses by filing a legal malpractice claim against another attorney who handled a bankruptcy matter, but that lawsuit was found barred by the statute of repose. Coletta alleged that Tuzzolino failed to inform him of the dismissal and that once he learned of the dismissal and confronted Tuzzolino, the latter offered to pay him $670,000 in settlement of any legal malpractice claims. Importantly, the other named partner of the law firm, Will Terpinas, Jr. (Terpinas), did not participate in the representation of Coletta.

Less than three months later, Tuzzolino prepared the renewal application for the insurance policy covering him, Terpinas and their law firm issued by Illinois State Bar Association Mutual Insurance Company (Insurer). As part of the application, Tuzzolino stated that no member of the firm was aware of a circumstance which might give rise to a claim. Tuzzolino also signed the application beneath the following statement:

I/We affirm that after an inquiry of all the members of the applicant firm that all the information contained herein is true and complete to the best of my/our knowledge and that it shall be the basis of the policy of insurance and deemed incorporated therein upon acceptance of this application by issuance of a policy.

Approximately one month after the Insurer issued the policy, Terpinas received a claim notice from an attorney representing Coletta. Terpinas reported the claim to the Insurer.

Litigation History

The Insurer brought suit seeking rescission of the policy, claiming that it would not have issued the policy but for the material misrepresentations made by Tuzzolino regarding the absence of knowledge of potential claims. The Insurer also argued, in the alternative, that it had no duty to defend Tuzzolino or the firm in connection with the claims alleged by Coletta.

On summary judgment motions, the circuit court allowed the Insurer to rescind the policy and further held that it had no duty to defend Tuzzolino, Terpinas or their law firm against the claims asserted by Coletta. Terpinas appealed the circuit court ruling, arguing that he was an “innocent insured” who did not represent Coletta, took no part in the misrepresentations made by Tuzzolino and should not lose his coverage due to acts committed by Tuzzolino. The court of appeals agreed and held that a common law “innocent insured doctrine” preserved coverage as to Terpinas, even though coverage as to Tuzzolino was properly rescinded.

No Common Law 'Innocent Insured' Doctrine Exists

The Illinois Supreme Court reversed the court of appeals and distinguished misrepresentations in an application (which led to the initial formation of a contract) from other misdeeds by an insured that might trigger an exclusion in the policy. In doing so, the court looked to Section 154 of the Illinois Insurance Code, which provides in relevant part:

No misrepresentation or false warranty made by the insured or in his behalf in the negotiation for a policy of insurance ' shall defeat or avoid the policy unless it shall have been made with actual intent to deceive or materially affects either the acceptance of the risk or the hazard assumed by the company. (Emphasis added.)

The court noted that section 154 applies to misrepresentations “by the insured or in his behalf,” indicating that rescission could exist based on representations not made by the insured personally. The court also noted that section 154 would allow rescission in two separate circumstances: 1) when the misrepresentation is made with an actual intent to deceive; or 2) when the misrepresentation materially impacts the risk assumed by the insurer.

Terpinas conceded that Tuzzolino's misrepresentations about potential claims materially affected the Insurer's acceptance of the risk, but argued that Illinois public policy precluded his loss of coverage. Terpinas pointed out that he did not participate in Tuzzolino's misdeeds, either in the representation of Coletta or in the policy application. Therefore, as an “innocent insured,” his loss of coverage would defeat Illinois public policy of ensuring coverage to protect the interests of the public.

The Illinois Supreme Court rejected Terpinas's argument, noting that the typical “innocent insured” case arose from different facts, such as arson or vandalism. In these cases, the court opined, the bad actions of one insured (the arsonist) should not be imputed to the “innocent insured” so as to impair the “innocent insured's” policy rights. Such cases also ordinarily involve the application of policy exclusions, such as the intentional acts exclusion. In these instances, the carrier denies coverage due to some excluded conduct. The court ruled, however, that rescission of a policy based on misconduct in the application is distinctly different from a denial of coverage based on misconduct after the policy issues. Where there has been misconduct in the application, the carrier denies coverage because coverage should never have existed in the first place. In reaching its holding, the court limited the application of the “innocent insured” rationale to instances involving application of a policy exclusion.

Also noteworthy is the court's rejection of several additional arguments raised by Terpinas. First, Terpinas argued that the policy contained a “severability of insureds” clause which he characterized as being an independent obligation. The court rejected this argument, noting that the severability clause, like all other coverage afforded by the policy, was contingent on the valid issuance of the policy. Second, Terpinas argued that the purpose of rescission was to restore the parties to the status quo as it existed at the time the contract for insurance was made. Terpinas argued that a mere premium refund was insufficient to restore the status quo, unless Terpinas also held the insurance coverage which he possessed at that time. The court rejected this argument as well, holding that restoration of the status quo only requires a return of benefits received, i.e. , the premium paid. The court also noted that Terpinas received a benefit from the Insurer in that the insurance provided enabled him to practice as a limited liability company. Finally, Terpinas argued that section 154 should not apply, as a renewal form is not the same as an “application.” The court rejected this distinction roundly.

Dissenting Opinion

In Illinois State Bar, one justice dissented. Justice Thomas L. Kilbride argued that Terpinas had a reasonable expectation of coverage, as he had continuously held insurance with the Insurer for several years and no policy provision suggested that any wrongdoing of Tuzzolino would be imputed to him. Justice Kilbride also argued that Illinois law requires attorneys to carry malpractice insurance in order to protect consumers of legal services. Given these policies, Justice Kilbride found persuasive the ruling of the New Jersey court in First American Title Ins. Co. v. Lawson, 827 A.2d 230 (N.J. 2003), where the court declined to allow rescission of a legal malpractice policy as to an innocent insured uninvolved in the wrongful activities of his colleagues. Justice Kilbride also expressed concern about the potential repercussions of the majority rule:

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. Furthermore, as the size of the affected firm increases, so does the potential harm to the public.

Implications

Illinois State Bar provides some important guidance regarding policy rescission. First, rescission actions must look to the statutory guidelines provided in the relevant insurance code. Many states have enacted legislation restricting the circumstances under which a policy can be rescinded and the timing for when a misrepresentation claim may be asserted. Second, Illinois State Bar recognizes that all policyholder misconduct is not the same, and misconduct that leads to the formation of a contract will have broader consequences than misconduct that occurs after the formation of a contract. Finally, the implications noted by Justice Kilbride simply were not present in this matter, where the malpractice claim was united with the misrepresentation and the size of the law firm was small. Those considerations could present a substantially more difficult case in the presence of other facts, as where a carrier seeks to rescind a policy after an unrelated claim is reported or where the policy being rescinded would impact a much larger law firm.

Alicia Curran is a member in Cozen O'Connor's Global Insurance Department with the Dallas office. Gregory S. Hudson is a member in the firm's Global Insurance Department with the Houston office.

In Illinois State Bar Association Mut. Ins. Co. v. Law Office of Tuzzolino and Terpinas , 5 N.E.3d 1123 (Ill. 2014), the Illinois Supreme Court held that an insurer could rescind a malpractice policy due to material misrepresentations made in the insurance application, even though the rescission left other attorneys who did not take part in the application and were not involved in the underlying misconduct (innocent insureds) without coverage.

Background Facts

Sam Tuzzolino and Will Terpinas, Jr. were law partners in a law firm organized as a limited liability entity. The legal matter that created the underlying application misconduct issues involved Sam Tuzzolino (Tuzzolino). He represented a client named Anthony Coletta (Coletta) in a variety of matters, including litigation arising from alleged mismanagement of a Chicago nightclub. In that litigation, Tuzzolino failed to timely disclose expert witnesses who would testify about valuation issues, and failed to retain an expert on forensic accounting issues. As a result, the designated experts were barred from testifying at trial.

Subsequently, Tuzzolino allegedly advised Coletta to settle the suit for $30,000, an amount far less than Coletta's alleged losses. Tuzzolino then advised Coletta to try and recover his losses by filing a legal malpractice claim against another attorney who handled a bankruptcy matter, but that lawsuit was found barred by the statute of repose. Coletta alleged that Tuzzolino failed to inform him of the dismissal and that once he learned of the dismissal and confronted Tuzzolino, the latter offered to pay him $670,000 in settlement of any legal malpractice claims. Importantly, the other named partner of the law firm, Will Terpinas, Jr. (Terpinas), did not participate in the representation of Coletta.

Less than three months later, Tuzzolino prepared the renewal application for the insurance policy covering him, Terpinas and their law firm issued by Illinois State Bar Association Mutual Insurance Company (Insurer). As part of the application, Tuzzolino stated that no member of the firm was aware of a circumstance which might give rise to a claim. Tuzzolino also signed the application beneath the following statement:

I/We affirm that after an inquiry of all the members of the applicant firm that all the information contained herein is true and complete to the best of my/our knowledge and that it shall be the basis of the policy of insurance and deemed incorporated therein upon acceptance of this application by issuance of a policy.

Approximately one month after the Insurer issued the policy, Terpinas received a claim notice from an attorney representing Coletta. Terpinas reported the claim to the Insurer.

Litigation History

The Insurer brought suit seeking rescission of the policy, claiming that it would not have issued the policy but for the material misrepresentations made by Tuzzolino regarding the absence of knowledge of potential claims. The Insurer also argued, in the alternative, that it had no duty to defend Tuzzolino or the firm in connection with the claims alleged by Coletta.

On summary judgment motions, the circuit court allowed the Insurer to rescind the policy and further held that it had no duty to defend Tuzzolino, Terpinas or their law firm against the claims asserted by Coletta. Terpinas appealed the circuit court ruling, arguing that he was an “innocent insured” who did not represent Coletta, took no part in the misrepresentations made by Tuzzolino and should not lose his coverage due to acts committed by Tuzzolino. The court of appeals agreed and held that a common law “innocent insured doctrine” preserved coverage as to Terpinas, even though coverage as to Tuzzolino was properly rescinded.

No Common Law 'Innocent Insured' Doctrine Exists

The Illinois Supreme Court reversed the court of appeals and distinguished misrepresentations in an application (which led to the initial formation of a contract) from other misdeeds by an insured that might trigger an exclusion in the policy. In doing so, the court looked to Section 154 of the Illinois Insurance Code, which provides in relevant part:

No misrepresentation or false warranty made by the insured or in his behalf in the negotiation for a policy of insurance ' shall defeat or avoid the policy unless it shall have been made with actual intent to deceive or materially affects either the acceptance of the risk or the hazard assumed by the company. (Emphasis added.)

The court noted that section 154 applies to misrepresentations “by the insured or in his behalf,” indicating that rescission could exist based on representations not made by the insured personally. The court also noted that section 154 would allow rescission in two separate circumstances: 1) when the misrepresentation is made with an actual intent to deceive; or 2) when the misrepresentation materially impacts the risk assumed by the insurer.

Terpinas conceded that Tuzzolino's misrepresentations about potential claims materially affected the Insurer's acceptance of the risk, but argued that Illinois public policy precluded his loss of coverage. Terpinas pointed out that he did not participate in Tuzzolino's misdeeds, either in the representation of Coletta or in the policy application. Therefore, as an “innocent insured,” his loss of coverage would defeat Illinois public policy of ensuring coverage to protect the interests of the public.

The Illinois Supreme Court rejected Terpinas's argument, noting that the typical “innocent insured” case arose from different facts, such as arson or vandalism. In these cases, the court opined, the bad actions of one insured (the arsonist) should not be imputed to the “innocent insured” so as to impair the “innocent insured's” policy rights. Such cases also ordinarily involve the application of policy exclusions, such as the intentional acts exclusion. In these instances, the carrier denies coverage due to some excluded conduct. The court ruled, however, that rescission of a policy based on misconduct in the application is distinctly different from a denial of coverage based on misconduct after the policy issues. Where there has been misconduct in the application, the carrier denies coverage because coverage should never have existed in the first place. In reaching its holding, the court limited the application of the “innocent insured” rationale to instances involving application of a policy exclusion.

Also noteworthy is the court's rejection of several additional arguments raised by Terpinas. First, Terpinas argued that the policy contained a “severability of insureds” clause which he characterized as being an independent obligation. The court rejected this argument, noting that the severability clause, like all other coverage afforded by the policy, was contingent on the valid issuance of the policy. Second, Terpinas argued that the purpose of rescission was to restore the parties to the status quo as it existed at the time the contract for insurance was made. Terpinas argued that a mere premium refund was insufficient to restore the status quo, unless Terpinas also held the insurance coverage which he possessed at that time. The court rejected this argument as well, holding that restoration of the status quo only requires a return of benefits received, i.e. , the premium paid. The court also noted that Terpinas received a benefit from the Insurer in that the insurance provided enabled him to practice as a limited liability company. Finally, Terpinas argued that section 154 should not apply, as a renewal form is not the same as an “application.” The court rejected this distinction roundly.

Dissenting Opinion

In Illinois State Bar, one justice dissented. Justice Thomas L. Kilbride argued that Terpinas had a reasonable expectation of coverage, as he had continuously held insurance with the Insurer for several years and no policy provision suggested that any wrongdoing of Tuzzolino would be imputed to him. Justice Kilbride also argued that Illinois law requires attorneys to carry malpractice insurance in order to protect consumers of legal services. Given these policies, Justice Kilbride found persuasive the ruling of the New Jersey court in First American Title Ins. Co. v. Lawson , 827 A.2d 230 (N.J. 2003), where the court declined to allow rescission of a legal malpractice policy as to an innocent insured uninvolved in the wrongful activities of his colleagues. Justice Kilbride also expressed concern about the potential repercussions of the majority rule:

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. Furthermore, as the size of the affected firm increases, so does the potential harm to the public.

Implications

Illinois State Bar provides some important guidance regarding policy rescission. First, rescission actions must look to the statutory guidelines provided in the relevant insurance code. Many states have enacted legislation restricting the circumstances under which a policy can be rescinded and the timing for when a misrepresentation claim may be asserted. Second, Illinois State Bar recognizes that all policyholder misconduct is not the same, and misconduct that leads to the formation of a contract will have broader consequences than misconduct that occurs after the formation of a contract. Finally, the implications noted by Justice Kilbride simply were not present in this matter, where the malpractice claim was united with the misrepresentation and the size of the law firm was small. Those considerations could present a substantially more difficult case in the presence of other facts, as where a carrier seeks to rescind a policy after an unrelated claim is reported or where the policy being rescinded would impact a much larger law firm.

Alicia Curran is a member in Cozen O'Connor's Global Insurance Department with the Dallas office. Gregory S. Hudson is a member in the firm's Global Insurance Department with the Houston office.