That Pesky Question: Do You Know of Any Circumstances…?

William Cahow worked at American Special Risk Management Corporation (American). He opened an account in the name of “Bill Cahow d/b/a American Special Risk Management” at Peoples Bank, and over the course of eight years he improperly endorsed checks that belonged to American and deposited them into his own account. His practice of taking his employer’s funds began to fall apart when one of American’s clients became suspicious about the endorsement on a check the client had issued.

American’s president called the senior operations officer of the bank to ask whether there were any accounts in American’s name at the bank. The banker informed him of Cahow’s account, and American’s president told the banker that it was an unauthorized account and no American funds should go through that account. The bank put a temporary hold on two checks and referred American’s president to a local attorney. The bank officer said he later spoke with the attorney representing American and also was told by American that criminal charges would be filed against Cahow. The banker said, however, that American never indicated it believed the bank was liable for the money that had passed through the account.

Three weeks after the banker learned of the criminal prosecution of Cahow, the bank applied for D&O and E&O insurance from Progressive Casualty Insurance Company (Progressive). The E&O application asked whether there were any facts, circumstances or situations involving the bank and its officers and employees which could reasonably be expected to give rise to a claim. The bank answered “no.”

Immediately following the question and answer, the application contained this language, in bold capital letters: “If knowledge of any fact, circumstance or situation exists, any claim or action subsequently arising therefrom shall be excluded from coverage.”

The insurance policy was issued a couple of weeks later. Not long after that, American sued Cahow for embezzlement and sued the bank for negligence.

The bank’s insurer gave a preliminary indication no coverage existed. When settlement negotiations began, the insurer opted not to participate. The bank’s attorney notified the insurer that the bank would consent to a judgment against itself unless the insurer agreed to defend or indemnify the bank within five days. The insurer did not respond, a consent judgment was entered as promised, and American filed a garnishment action against the insurer in Kansas.

The trial court ruled that a two-part test applied with respect to the answer the bank gave on the insurance application: (1) what did the bank actually know, from a subjective perspective, and (2) could that knowledge, from an objective standpoint, reasonably be expected to give rise to a claim?

Applying that test, the trial court found that bank personnel knew at the time the application was completed that an account had been opened by American’s employee without authority, that the account had been open for eight years and that it had been used for deposit of corporate funds. Given those facts, the court found it “almost inconceivable” that the bank did not consider the bank’s exposure.

American appealed. The Kansas Court of Appeals stood with the trial court. The Kansas Supreme Court was the next stop and American argued that in order to rescind a policy in Kansas, intentional misrepresentation had to be proven and that should be the standard in this case. The Kansas Supreme Court ruled, however, that while the bank’s insurer was entitled to seek rescission, it instead had opted to enforce it’s exclusion. “Progressive was contractually entitled to enforce the exclusion rather than seek to void the policy; in other words, nothing required Progressive to invoke [the provision permitting rescission] rather than the exclusion.” And the exclusion did not require the insurer to prove the bank had intentionally misled the insurer.

American also argued that the circumstances question called for a subjective opinion from the bank – whether the bank, when answering the question, thought a claim might result. The court reviewed cases from a few other states where courts had applied such a subjective standard. But the Kansas Supreme Court found that the courts that had applied a subjective standard were looking at different policy language or that they had failed to explain the basis of their decision. In one case, for example, the policy said coverage applied only if “the insured had no basis to believe” that it had done something that might generate a claim. The Kansas case said Progressive’s policy was different because it asked about circumstances “which could reasonably be expected to give rise to a claim.”

The Kansas Supreme Court ruling held that the two-prong test applied by the trial court was the modern and preferred approach, calling for an evaluation of what the insured knew at the time the application was completed and then determining whether a reasonable person in the position of the insured might expect a claim to result.

In holding that Progressive’s policy did not cover the claim against the bank, the court did not need to address another situation that can arise but which should be kept in mind. Some applications impose a continuing duty upon an insured to provide information. In that situation, an insured completing an application a month before a policy takes effect would be obligated to update the insurer if in the intervening month it acquired information that would result in a different answer. And the policy’s exclusion or coverage trigger may well apply the test of knowledge of circumstances as of the policy’s inception date, not the date the application was completed.