Ill. High Court's Rescission Ruling A Warning For Firms

Ill. High Court's Rescission Ruling A
Warning For Firms
By Jeff Sistrunk

Law360, Los Angeles (February 25, 2015, 6:12 PM ET) ­­ The Illinois Supreme Court's recent
ruling that the “innocent insured” doctrine couldn't prevent an insurer from using rescission to
terminate a law firm's malpractice policy strengthened the defense for insurers and showed
that firms need to be on guard against material misrepresentations on malpractice policy
applications, attorneys say.

In a 6­1 decision, the state high court said the innocent insured doctrine doesn’t apply to
rescission and contract formation, overturning an appellate panel’s ruling that maintained
legal malpractice coverage for Will Terpinas Jr., a Chicago­area lawyer. Terpinas’ partner,
Sam Tuzzolino, allegedly lied to ​
                                 Illinois State Bar Association Mutual Insurance Co​
                                                                                   . when
renewing the policy by saying he was unaware of any potential malpractice claims against
their firm.

Under the innocent insured doctrine, parties covered by an insurance policy can keep their
coverage if they were unaware that the policy was obtained or renewed through deception.

The majority of the court said the doctrine has mostly been wielded in cases that involve
enforcement of policy exclusions, typically for intentional acts committed by an insured who
isn't challenging the exclusion. Conversely, the doctrine appears irrelevant in the context of
the rescission of an insurance policy, "a recognized remedy for even innocent
misrepresentations," the majority said.

"As ISBA Mutual correctly notes, [the innocent insured] doctrine 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," Justice Charles E. Freeman wrote for the majority.

Clausen Miller PC​
                 partner Thomas H. Ryerson called the holding "a long­overdue
pro­insurance industry opinion."

"This kind of an opinion should embolden the insurance industry to stand up for the integrity of
the application process," Ryerson said. "The foundation of any contract is that both parties are
dealing in good faith. If the actual formation of that contract was not made in good faith by the
policyholder, the insurance companies should be encouraged to stand up for their rights and
the public's rights."

In the case, ISBA Mutual said Tuzzolino concealed the fact that he was facing a legal
malpractice claim when he renewed his firm's malpractice policy with the company in May
2008. A month later, Terpinas discovered that Tuzzolino and the firm, the Skokie,
Illinois­based Law Office of Tuzzolino and Terpinas, had been named in a malpractice suit.

ISBA Mutual sued in state court and won summary judgment orders that rescinded the entire
policy for both Tuzzolino and Terpinas. An appellate court panel reversed, saying that the
innocent insured doctrine protects an innocent co­insured even if a misrepresentation was
made when the policy was formed.

The Illinois Supreme Court rejected that holding, agreeing with ISBA Mutual that Section 154
of the state's insurance code allows complete rescission of a policy when a misrepresentation
materially affects the acceptance of risk by the insurer.

Laura Foggan, chair of ​
                       Wiley Rein LLP's​
                                       insurance appellate group, said the ruling is
important because it "informs the basic principles of the rescission defense" and "reflects
basic concepts of how rescission works."

"The focus is on the formation of the contract and effect of the misrepresentation, not the
application of the innocent insured idea," Foggan said.

Justice Thomas L. Kilbride said in a dissenting opinion that he would have applied the
innocent insured doctrine in the case, writing that "Terpinas had a reasonable expectation that
he maintained professional liability insurance based on his history with ISBA Mutual and his
lack of culpability in the misrepresentation." The judge added that he was "troubled by the
scope of consequences" that the decision would have on other law firms, especially midsize
and large firms.

"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," Justice Kilbridge wrote.

Ryerson said midsize and large firms should take note and ensure they conduct adequate
due diligence.

"Responsible law firms poll their partners annually, asking for real or potential malpractice
claims," Ryerson said. "If anything, this sends a message to law firms to upgrade their internal
polling and due diligence processes."

Attorneys also say law firms can avert Terpinas' fate by negotiating more specific severability
clauses than the one in the ISBA Mutual policy to ensure that a material misrepresentation on
the policy application is only imputed to individuals with knowledge of the misrepresentation.
In addition, insureds may be able to negotiate language establishing that a policy isn't
rendered completely void by a misrepresentation.

"These days, lawyers' malpractice policies are being written with much more specific,
nuanced severability provisions, that create a baseline of information for the insurer to

accurately underwrite the risk," said ​
                                      Goldberg Segalla LLP​
                                                          partner Jonathan Schwartz. "More
specifically, these policies tie the innocent insured doctrine to the knowledge of certain people
within the law firm."

Indeed, the issues in the case could have been resolved if the policyholders had negotiated
policy terms regarding misrepresentations in applications up front, said Sherilyn Pastor, the
practice group leader for ​
                          McCarter & English LLP's​
                                                  insurance coverage group.

Another aspect of the ruling that policyholders can take as a "glimmer of hope" is that the
court made it "very clear" that it was applying the ruling in the context of a situation where
there is an actual intent to deceive as opposed to a negligent misrepresentation, Pastor said.

Perkins Coie LLP​
                partner Eric Barber pointed out that the malpractice claim arising from
Tuzzolino's conduct related directly to Tuzzolino's misrepresentation on the policy.

"That allows the court to avoid discussing materiality and sweep aside public policy in favor of
strict contract interpretation," he said. "Materiality of a misrepresentation will be a key issue in
most rescission cases, and we do not know how the court would have decided this case if,
say, Terpinas had noticed his own completely unrelated malpractice claim. That may not have
been material and, further, the public policy rationale would certainly have gotten larger
consideration."

Because intentionality doesn't matter under the law when it comes to rescission for certain
misrepresentations, "you have to worry about insurance companies that bring rescission
cases," Barber said.

"That is, even if you made an innocent but material misrepresentation, is that insurer going to
eviscerate coverage for the law firm or professional services firm?" he said. "That is an
important question law firms need to think very carefully about in purchasing insurance."

­­Editing by John Quinn and Brian Baresch.