Does the innocent insured doctrine – which provides that one of multiple insureds doesn’t necessarily lose coverage if he or she wasn’t involved in a breach – apply to renewal applications? That’s the question the Illinois Supreme Court debated during its November term in Illinois State Bar Association Mutual Insurance Co. v. Law Office of Tuzzolino & Terpinas. Our detailed summary of the underlying facts and lower court hearings is here.

Tuzzolino began when a former client filed a malpractice claim against one of the partners. The attorney persuaded the former client to drop the suit and instead retain him to sue the attorney who handled a related bankruptcy. That suit was dismissed. When the client discovered the dismissal, the attorney offered to settle the malpractice claim, but the offer was rejected. Not long after, the same partner filed a renewal form with the firm’s malpractice carrier. In response to a question on the form about whether he was aware of any circumstance which might give rise to a claim, the partner checked “no.” The second partner was not required to sign the form. The insurer filed suit seeking rescission of the policy as to both partners and the firm, arguing that the misstatement on the application voided the policy ab initio.

The plaintiff moved for summary judgment on all counts. The trial court granted the motion, finding that the insurance contract was indivisible, and must stand or fall as a whole with respect to both partners and the firm.

The Appellate Court reversed, holding that the common law innocent insured doctrine protected the innocent partner. The Court further held that the policy was merely voidable, not void. The Court found that Section 154 of the Insurance Code (215 ILCS 5/154) – which provides that no misrepresentation or false warranty in an insurance application can defeat coverage unless material or made with an intent to deceive – supported application of the common law innocent insured doctrine.

Counsel for the insurer began the argument. It was undisputed that the insurer had issued the policy in reliance on a material misrepresentation in the policy application, counsel argued. Insurance Code 154 permits rescission on that basis. Counsel argued that the second partner’s innocence was irrelevant, since Section 154 permits equitable rescission for even an innocent misrepresentation. The only issue is whether the innocent party entered into a contract that would not have been made but for the misrepresentation. Counsel argued that appellees claimed that rescission was a penalty for wrongdoing. But in fact, counsel argued, it was a remedy for the making of an agreement that wouldn’t have otherwise been made. Counsel argued that the innocent insured doctrine has never been applied outside of policy exclusions. Justice Theis asked, if the insurer was correct that the misrepresentation of one partner defeats coverage for the entire firm, how other lawyers in a large firm should protect themselves. Counsel answered that the application said that inquiry had been made of other lawyers in the firm. Justice Theis asked whether there was any way for an innocent lawyer to protect him- or herself? Counsel answered that firms should have a loss management procedure requiring attorneys to come forward if there are any potential claims. That wasn’t done here, counsel argued – the person with knowledge of the claim didn’t report it. Only the innocent attorney appealed – not the other partner or the law firm. Justice Burke pointed out that the insurer had included the innocent insured clause, so shouldn’t it be construed in favor of the insured? Counsel responded that there is a severability clause and an innocent insured clause. Justice Burke asked whether the policy was voidable rather than void. Counsel answered that it didn’t matter – there was a basis for rescission based on the misrepresentation. Severability means that there is a separate policy with each insured – but in this case, each was based on an application which was fraught with fraud. Justice Burke asked whether there was a difference between a renewal and an application. Counsel answered no, the net result is the same. Chief Justice Garman noted that the Court doesn’t mandate malpractice coverage, but does require disclosure on an ARDC application – what about clients relying on that information in hiring counsel? Counsel answered that the statute is very clear – there is nothing carved out based on who made the misrepresentation. Defendants speak at length about public policy, but in fact, Section 154 of the Code is the public policy for rescission. Justice Burke pointed out that Section 154 references misrepresentations in negotiations for the policy – that was the basis for her question about whether it made a difference between a renewal and an application. Counsel responded that the statute refers both to renewals and first issuance policies. If certain circumstances exist, the insurer has a right to rescind. Counsel argued that neither the appellee nor the Appellate Court had pointed to any aspect of Section 154 which had not been met. The defendants and the Appellate Court had obscured the difference between a rescission and the intentional act exclusion, according to counsel. Justice Kilbride asked whether the insurer’s argument began and ended with Section 154. Counsel said yes. Justice Kilbride asked whether, under Section 154, one needs actual intent or not? Counsel responded that here, the misstatement had gone to the risk to be assumed – why should any court tolerate an insurance policy procured by fraud? Justice Kilbride suggested that the second sentence of the statute seems to say that a misrepresentation doesn’t defeat the policy unless made with an actual intent to deceive or materially affect the risk to be assumed. Counsel answered that the insurer was not asserting an intent to deceive. Justice Kilbride asked whether a material misrepresentation justifies rescission regardless of intent. Counsel responded yes.

Counsel for the claimant was next. He argued that the insurer’s argument was merely an attempt to void insurance after the insurer received notice of a claim. The exclusion of coverage must be clear and free from doubt. Counsel argued that a policy is not void ab initio under these sorts of circumstances. The Chief Justice asked wasn’t that what rescission means? Counsel answered not necessarily – rescission is an equitable remedy. The Chief Justice asked whether this went to contract formation. Counsel answered that it does, but the question is whether there is coverage for the innocent insured. And under that doctrine, the most germane authority is Micelli v. State Farm. Counsel argued that Micelli was a declaratory judgment action to void a policy based upon a policy clause relating to misrepresentation of any material fact. There, only the insured who engaged in misconduct was deprived of coverage. Justice Theis asked whether there was a difference between coverage and contract formation. Counsel answered no, because this was a contract for liability insurance. Justice Theis suggested that there was a difference between the scope of the contract and whether there even was a contract. Counsel pointed out that the insurer in MIcelli had argued that the entire contract was void. Justice Theis asked counsel to state his position in terms of contract formation.  Counsel answered that a contract was formed as to the innocent partner, but not the guilty partner or the firm. The innocent partner made no misrepresentations when the contract was formed. Justice Thomas pointed out that the statute says “or materially affects either the acceptance of the risk or the hazard assumed,” and suggested that the statute seems to be aimed at helping insurers avoid risks they hadn’t contracted for. Counsel answered that the statute simply doesn’t give a right to rescission. Justice Thomas asked what the statutory language meant then. Counsel answered that the statute means that the insurer is limited in seeking the remedy of rescission. Justice Thomas pointed out that the insurer was arguing that the factual misrepresentation had affected their decision to accept the risk. Counsel said he understood that. Justice Thomas asked then what does the statute give them the right to do? Counsel answered that the insurer could rescind as to the guilty partner and the firm, but as to the innocent insured. Justice Thomas suggested that that was quite a bit of unwanted risk for the insurer – it would be on the hook for 399 of the 400 lawyers in a 400 lawyer firm, even when the renewal was based on a misrepresentation. Counsel agreed. Justice Thomas asked what that does to premiums. Counsel answered that the insurer should be aware of the possibility. Chief Justice Garman asked whether the insurer should therefore have to get a separate application from every member of the 400 lawyer firm. Counsel said yes, but he doubted that the insurer here insured many 400 lawyer firms. The Chief Justice asked whether the outcome would be different if the innocent insured had signed the application. Counsel answered that the innocent insured could have signed the representation truthfully. The Chief Justice asked whether, in that event, the innocent partner would have been covered. Counsel answered maybe, maybe not. The Chief Justice pointed out that the form says “I affirm that after inquiry of all members of the firm the aforementioned information is true.” Counsel answered that if the innocent insured had signed that, the case wouldn’t be before the Court.

Counsel for the innocent partner argued next. Counsel argued that the Court had pointed out the important issue – how should lawyers protect themselves. If one looks at the policy, there is a severability clause. The Appellate Court said that there were effectively three separate policies, and one applicable to the innocent insured. Counsel argued that there was nothing in the policy imputing the representation of one to all, and the record is clear that the innocent partner had no knowledge of the situation. Justice Kilbride asked what about the “after inquiry” language? Counsel answered that if the innocent partner had gone to his partner and asked, he doubted that the other partner would have stated the facts. Thus, the innocent partner’s statements were true – he misrepresented nothing. Justice Thomas asked how the facts play into the situation. Counsel argued that the insurer wanted to apply Section 154 as a one-size-fits-all solution. In this case, there was no knowledge, counsel insisted, so the innocent lawyer is protected, just as the policy says. Justice Thomas asked whether the partner who had been involved in the malpractice dispute benefited from counsel’s approach to the case. Counsel said no.

In rebuttal, counsel for the insurer argued the outcome would have been the same if the innocent partner had signed the application, given that the statute doesn’t have a carve-out for who makes the misrepresentation. Counsel argued that the liberal construction concept goes to the existence of the duty to defend – not something at issue here. Counsel noted earlier discussions about whether the document was a renewal application or invoice, and pointed out that it was headed “Renewal Invoice and Acceptance Form.” Counsel argued that there was no merit to the severability argument because all separate contract were tied into a fraudulent application. Otherwise, one would have to ask who knew what when; but that’s not how policy formation works. As for the 400-lawyer hypothetical, counsel argued that it’s inconceivable that the industry has a duty to send the application to all 400 lawyers. A person in a position of trust signs the application. Counsel concluded by arguing once again that the Court should not tolerate the absurdity of a policy procured by fraud.

We expect Tuzzolino & Terpinas to be decided in ninety to one hundred twenty days.

Image courtesy of Flickr by David HIlowitz (no changes).