An E&O insurance policy’s prior knowledge condition precluded coverage for a negligent retention and supervision claim and the Tenth Circuit therefore affirmed the grant of summary judgment in favor of the insurer. Cohen-Esrey Real Estate Servs., Inc. v. Twin City Fire Ins. Co., No. 10-3159 (10th Cir. Feb. 28, 2011). The Insured’s plausible defense of the claim did not satisfy the policy’s prior knowledge condition.

The Insured, a property management firm, discovered that its employee, a property manager, engaged in a fraudulent scheme to embezzle money by falsifying Department of Housing and Urban Development (HUD) records. Essentially, from 2004 to 2006, the employee would falsify lease documents and HUD documents to incorrectly show that there were qualified tenants who would receive subsidized rent. The employee embezzled the subsidized rent. However, this was not the first instance of that employee’s misconduct. In September 2004, the employee used company money to make a personal purchase of $115 and subsequently lied about the misconduct. Instead of terminating the employee, the Insured reprimanded her and made her return the company money.

In September 2006, after the Insured discovered the employee’s fraudulent scheme, the Insured notified its crime policy insurer, Hartford Fire Insurance Company, and its E&O insurer, Nutmeg Insurance Company. Both notices described the employee embezzlement and approximated a loss of $260,000. However, two months later, the Insured changed its E&O carrier to Twin City Fire Insurance Company (“Twin City”). On November 1, 2006, the Twin City policy became effective and replaced the Nutmeg policy. While the Insured notified the previous insurer, Nutmeg, of the fraudulent scheme, the Insured did not provide Twin City any such notification.

In June 2007, the property owner demanded that the Insured pay its losses from the employee’s scheme asserting that the Insured negligently retained and supervised the employee. The property owner claimed that the Insured knew about the prior fraudulent misconduct and yet retained her as a property manager.

The Insured submitted this claim to Twin City. When Twin City denied coverage, the Insured sued. At issue is whether the Insured satisfied the policy’s prior knowledge condition. The prior knowledge condition provided that: as [a] condition precedent to coverage hereunder[,] … as of the inception date no date no partner, principal, officer, director, or member of the Insured was aware of any Wrongful Act, fact, circumstance or situation that he or she knew or [c]ould reasonably have foreseen might result in a Claim under this Policy.

Twin City moved for summary judgment and the trial court granted Twin City’s motion based on the prior knowledge condition, holding that the Insured could reasonably have foreseen that a claim might result because of the employee’s fraudulent scheme. The Insured appealed to the Tenth Circuit.

On appeal, the Insured argued that the claim for negligent retention and supervision was unforeseeable as that claim was not viable. To support its argument, the Insured noted that the company did not experience a loss in 2004 from the employee’s personal purchase because the employee returned the money, the employee was consequently reprimanded, the Insured passed a HUD audit every year, the Insured passed other audit reviews, and internal controls were never triggered. The Insured argued that it therefore did not believe that the company was negligent and could not have foreseen a claim being made.

The Court rejected the Insured’s argument. The Court applied the two-prong, subjective-objective test under Kansas law to determine whether the prior knowledge condition was satisfied. The Court recognized that Insurers usually incorporate prior knowledge conditions in claims made policies because it guarantees that “only risks of unknown loss are potentially incurred and prevent[s] an insured from ‘obtain[ing] coverage for the risk of a known loss,’ which would be unfair to the insurer.”

Under the Twin City policy, the Court held that a reasonable insured could “reasonably have foreseen [that these facts] might result in a Claim under this Policy.” Even though a negligence claim was not a certainty, the Court held that a claim was “more than colorable” based on the Insured’s knowledge of the fraudulent scheme and the employee’s previous misconduct where the employee was only reprimanded and not terminated.

Notably, the Court found that the Insured’s argument was misplaced and improperly focused on the Insured’s plausible defense of the negligence claim. The insurer’s exposure under the policy is based on the threat of a claim. The only instance in which the Insured’s defense would satisfy the prior knowledge condition is if the “defense is so sure and obvious that a victim would very likely not bother to make the claim.” Consequently, under the objective prong of the test, it was reasonably foreseeable that a claim might result based on the employee’s previous misconduct and the fraudulent scheme. Therefore, the Tenth Circuit affirmed the trial court’s grant of summary judgment in the Insurer’s favor.

Comments

Although the insured here may have subjectively believed that there was no viable claim against it for its employee’s conduct, the court found that a reasonable insured could have foreseen that a claim, whether ultimately successful or not, might be brought. Thus the test under this fairly standard policy language was not whether a plaintiff might win its case, but whether a plaintiff might bring a claim at all. As the court points out, only where an iron-clad defense exists (“so sure and obvious that a victim would likely never bother to make the claim”) would an insured satisfy the prior knowledge condition in this policy.

Ashley L. Christensen, Esq. is an associate in the Chicago office of Tressler LLP; www.tsmp.com/ashley-christensen/; 312-627-4173; achristensen@tresslerllp.com