12616526435_a0e1d4824b_zA law firm partner innocently repeats a misrepresentation by one of his or her partners on a renewal form for the firm’s malpractice insurance. Can the misrepresentation be grounds for completely rescinding the policy? On February 20, a divided Illinois Supreme Court held that the answer was “yes,” reversing an Appellate Court judgment in Illinois State Bar Association Mutual Insurance Co. v. Law Office of Tuzzolino & Terpinas. Our detailed description of the facts and lower court rulings is here. Our report on the oral argument is here.

Tuzzolino arose from litigation over a limited liability corporation which owned a Chicago nightclub. One of the partners in a two-partner law firm represented an investor in the litigation, but allegedly made various errors in handling the case, resulting in a lower-than-expected settlement. The partner convinced his client to try to recover his losses by suing the lawyer who handled the LLC’s bankruptcy for malpractice, but that action was dismissed as time-barred. Client and lawyer had a confrontation, and the partner allegedly offered a substantial sum to settle any possible malpractice claim.

Less than three months later, the firm’s malpractice coverage came up for renewal. The other partner checked the “no” box in response to the form’s question about whether there were any known circumstances which might result in a malpractice claim. About a month after submitting the form, the innocent partner learned of the dispute for the first time when he received a lien letter from an attorney representing the former client. He reported the claim to the malpractice carrier, but a little less than a year later, the insurer sued to rescind the policy – with respect to the firm and both partners.

The insurer successfully moved for summary judgment at the trial court. On appeal, the First District reversed in part, holding that the policy had been properly rescinded as to the allegedly guilty party, but that the innocent insured doctrine operated to preserve coverage with respect to the innocent partner.

The Supreme Court reversed. The issue turned, according to the Court, on Section 154 of the Insurance Code (215 ILCS 5/154), which provides a two-prong test for evaluating claims for rescission based on misrepresentation: (1) the statement must be false; and (2) it must be made with “actual intent to deceive or materially affects either the acceptance of the risk or the hazard assumed by the company.”

The innocent partner didn’t really dispute that the misrepresentation “materially affect[ed] . . . the acceptance of the risk.” Instead, he focused on public policy issues: the possibility that not only the client originally involved in the dispute but other clients of the firm would be left with impaired recoveries, or no recovery at all, in the event of further disputes, simply because the partner who participated in the nightclub litigation failed to inform his partner of what was going on. The innocent partner relied on the innocent insured doctrine, which provides that a breach by one of multiple insured does not necessary eliminate coverage for other insureds not involved in the breach. But there was a material difference between the primary innocent insured case, Economy Fire & Casualty Co. v. Warren, and Tuzzolino, the majority wrote – Economy Fire involved the possible application of a policy exclusion, not an issue of whether the entire policy should be rescinded. The innocent insured’s conduct is relevant to determining the duty to defend an innocent insured pursuant to a policy that was indisputably in effect, the Court wrote – but rescission was a recognized remedy for even innocent misrepresentations in the making of an insurance policy.

Having held that rescission was a permissible remedy pursuant to Section 154 of the Code, the Court then turned to the Appellate Court’s holding that the policy was severable to preserve the innocent partner’s coverage. The Court acknowledged that a severability clause in the policy created a separate agreement with each insured, but the clause also made the statements in the application part of each policy. Thus, the Court held that there was no basis for splitting the policy off from the application, even with respect to to the innocent partner.

Justice Kilbride dissented. He argued that courts have long taken into account a policyholder’s reasonable expectations, as well as the coverage intended by the policy, in determining the scope of coverage. Particularly given that there was nothing in the application or policy expressly imputing the alleged wrongdoing of the partner involved in the nightclub litigation to the innocent partner, Justice Kilbride argued that the innocent insured doctrine should have been applied to preserve the innocent insured’s coverage. Justice Kilbride was also disturbed by the increased exposure of other clients of the firm brought about by the total rescission of the policy.

Image courtesy of Flickr by Brett Jordan (no changes).