IN THE SUPREME COURT OF THE STATE OF KANSAS
No. 95,942
AMERICAN SPECIAL RISK MANAGEMENT CORPORATION
and CONTINENTAL CASUALTY COMPANY,
Appellants,
v.
WILLIAM CAHOW and PEOPLES BANK,
Appellees,
v.
PROGRESSIVE CASUALTY INSURANCE COMPANY,
Appellee.
SYLLABUS BY THE COURT
1. When an application for insurance asks for the identification of any facts, circumstances, or situations which could reasonably be expected to give rise to a claim and the policy excludes any claim arising from an undisclosed risk, an insurance company invoking the exclusion and denying coverage must establish that the applicant failed to disclose known information that an objective person would reasonably perceive as a potential risk. This test requires application of a combined subjective-objective standard: (1) Subjectively, what facts did the applicant know, and (2) objectively, would a reasonable person perceive that the known facts create a potential risk?
2. Under the facts of this case, the insurance applicant had knowledge of facts, circumstances, and situations that could reasonably be expected to give rise to a claim, and the nondisclosure triggered the exclusion for undisclosed risks.
Review of the judgment of the Court of Appeals in an unpublished decision filed July 6, 2007. Appeal from Johnson district court; GERALD T. ELLIOTT, judge. Judgment of the Court of Appeals affirming the district court is affirmed. Judgment of the district court is affirmed. Opinion filed September 12, 2008.
Christopher J. Sherman, of Payne & Jones, Chartered, of Overland Park, argued the cause, and Michael B. Lowe, of the same firm, and Daniel F. Church and Joseph W. Hemberger, of McAnany, Van Cleave & Phillips, P.C., of Roeland Park, were with him on the briefs for appellants Continental Casualty Company and American Special Risk Management Corporation.
Paul Hasty, Jr., of Wallace, Saunders, Austin, Brown & Enochs, Chartered, of Overland Park, argued the cause, and Derek G. Johannsen, of the same firm, was with him on the brief for appellee Progressive Casualty Insurance Company.
The opinion of the court was delivered by
LUCKERT, J.: This appeal examines the standard to be applied when an insurance company denies coverage because the insured failed to disclose a potential claim on an application for insurance. Specifically, we must determine: When an application for insurance asks for the identification of "any facts, circumstances, or situations . . . which could reasonably be expected to give rise to a claim" and the policy excludes any claim arising from an undisclosed risk, must the insurance company invoking the exclusion and denying coverage establish that the applicant (a) committed fraud; (b) failed to disclose information that the applicant subjectively perceived as a potential risk; (c) failed to disclose known information that an objective person would reasonably perceive as a potential risk; or (d) failed to discover circumstances that reasonably should have been known and which, if known, would be perceived as a potential risk by a reasonable person?
We hold that the language of the policy and application–specifically, the request for disclosure of facts, circumstances, or situations which could reasonably be expected to give rise to a claim–requires application of a combined subjective-objective standard: (1) Subjectively, what facts did the applicant know, and (2) objectively, would a reasonable person perceive that the known facts create a potential risk? In other words, an insurance company may invoke a policy exclusion for undisclosed risks if, in completing the application, the applicant failed to disclose known information which would reasonably be perceived as a potential risk.
FACTS AND PROCEDURAL BACKGROUND
The Undisclosed Risk of Loss
The insurance application at issue was completed by Peoples Bank (the Bank) when it applied for an errors and omissions (E&O) endorsement to a directors and officers (D&O) liability insurance policy issued by Progressive Casualty Insurance Company (Progressive). Shortly after the policy was issued, the Bank sought coverage and a defense against allegations made by American Special Risk Management Corporation (American). American alleged that the Bank was guilty of negligence and conversion by failing to exercise ordinary care when it allowed an American employee, William Cahow, to open a business (a doing business as [d/b/a] or a sole proprietorship) account in the name of "Bill Cahow d/b/a American Special Risk Management" and when it honored improperly endorsed checks that were owned by American and presented by Cahow. See K.S.A. 84-3-420 (conversion of instruments). Over an 8-year period, Cahow repeatedly and consistently deposited American's funds in the business account and then transferred funds to his personal account, which was also at the Bank.
Cahow's scheme unraveled when one of American's clients questioned an endorsement on a check the client had issued. The inquiry roused American's suspicions, causing it to begin an investigation. Pursuing the routing of the check, American's president called the Bank and talked with Robert Chenoweth, who was serving as the Bank's senior operations officer, about whether there were any accounts in American's name at the Bank. Chenoweth checked the Bank's records and advised American of the sole proprietorship account. American's president told Chenoweth the account was not authorized by American and no corporate funds should go through the sole proprietorship account.
Chenoweth eventually put a temporary hold on two checks totaling approximately $20,000, one check made payable to "American Special Risk Management c/o Bill Cahow" and the other check made payable to "American Special Risk Management." Chenoweth testified that the funds were not yet collected on the checks; thus, he was able to put a hold on the checks as uncollected funds. He further suggested that American contact the issuers of the checks and request them to stop payment. American followed the suggestion. In addition, American's president asked Chenoweth for the name of a local attorney, and American retained the suggested law firm in pursuit of its investigation against Cahow. An attorney from the firm spoke with Chenoweth on May 2 and May 3, 2001, regarding the hold on the checks.
Chenoweth testified that on May 22, 2001, he was notified by American that criminal charges would be filed against Cahow and that Chenoweth's name would be given to the local sheriff's office as someone familiar with the transactions. According to Chenoweth, American never indicated that it believed the Bank was liable in this matter, and the Bank considered the issue to be a dispute between American and Cahow.
Application for Insurance and the Policy
Approximately 3 weeks after Chenoweth learned of the criminal prosecution, the Bank applied for the D&O and E&O insurance with Progressive. The E&O application asked two questions pertaining to losses, pending litigation, and claims history:
"1. Has there been any actual, threatened or pending litigation against the Applicant or any subsidiary during the past 3 years?
"2. Are there any facts, circumstances or situations involving the Applicant, any subsidiary or any past or present director, trustee, officer or employee which could reasonably be expected to give rise to a claim?"
In response to both questions, the Bank checked the boxes labeled "No." Immediately following these questions, the application stated the following exclusionary language in bold, capital letters:
"PERTAINING TO QUESTION 1, IT IS UNDERSTOOD AND AGREED THAT ANY CLAIM ARISING FROM ANY PRIOR OR PENDING LITIGATION IS EXCLUDED FROM COVERAGE. PERTAINING TO QUESTION 2, IT IS FURTHER UNDERSTOOD AND AGREED THAT IF KNOWLEDGE OF ANY FACT, CIRCUMSTANCE OR SITUATION EXISTS, ANY CLAIM OR ACTION SUBSEQUENTLY ARISING THEREFROM SHALL BE EXCLUDED FROM COVERAGE."
Progressive issued the Bank a D&O claims-made insurance policy with the E&O endorsement. The period for the entire D&O/E&O policy ran from July 1, 2001, through July 1, 2002. The E&O endorsement application was made part of the endorsement. Pursuant to the first page of the E&O application, "the particulars and statement contained in this Application . . . and any material submitted therewith . . . are the basis of the Policy/Bond and are to be considered as incorporated in and constituting a part of this Policy/Bond." See K.S.A. 40-2205(A) (insured not bound by any statement made in application unless copy of "application is attached to or endorsed on the policy when issued as part thereof"). The E&O endorsement incorporated much of the D&O policy language into its terms.
The Claim and Progressive's Position
Just a few months after the policy was issued, American sued both Cahow and the Bank for damages resulting from Cahow's embezzlement and the Bank's negligence. American notified Progressive of the suit. Progressive acknowledged receipt of the claim and, after an investigation, gave a preliminary indication that no coverage existed under the policy. The Bank and Progressive maintained communications about the claim and coverage issue, with Progressive continuing to say that it was not denying coverage and its conclusion was preliminary, but the possibility of coverage was unlikely.
On July 18, 2002, American offered to settle the case with the Bank, and the offer was forwarded to Progressive. In its letter, the Bank stated that it continued to invite Progressive's participation in the case and formally extended "such invitation to the possible settlement negotiations." The Bank gave Progressive until August 2, 2002, to decide; otherwise, "[i]f we have heard nothing by that time, we will presume that your denial is final and we will negotiate on our own." Still, Progressive made no final decision on coverage and took no position on whether the Bank should accept the offer.
Then, on September 4, 2002, an attorney for the Bank sent a letter to Progressive, stating that the Bank would enter into a consent judgment with American within 5 days unless Progressive confirmed indemnification coverage or agreed to defend the Bank in the case. Having received no response from Progressive, the Bank entered into a settlement agreement with American and, after the district court held a hearing on the matter, judgment was entered in favor of American.
Garnishment Action
After obtaining the monetary judgment against the Bank, American filed a garnishment action against Progressive and others. Later, Continental Casualty Company, as bond carrier for American, intervened. The garnishment action went to trial on four issues: (1) whether, at the time of applying for insurance with Progressive, there were any facts, circumstances, or situations involving the Bank or any past or present officer or employee which could reasonably be expected to give rise to a claim; (2) whether the Bank breached the insurance policy by settling its case with American; (3) whether the settlement was reasonable; and (4) whether American was entitled to attorney fees. The district court ruled in favor of Progressive.
With regard to the first issue (which is the only issue before us), the district court concluded the application and policy language imposed a combined subjective-objective standard: "The issue . . . must be resolved based on the subjective knowledge of the bank and from an objective determination of whether such knowledge could reasonably be expected to give rise to a claim." Applying this standard the district court concluded:
"In a situation where an employee is known to have had an account open at the bank, in the name of the employer, without authority for eight years and is known to have deposited corporate funds in the account, it is a situation that could reasonably be expected to give rise to a claim. The bank knew that one check had cleared the account and been paid by the drawer bank because Peoples Bank guaranteed that the money had been deposited into a corporate account. Two checks were stopped before that happened, but with the account open for eight years, and with the information the bank had, the Court finds that there were facts, circumstances or situations known to the bank which could reasonably be expected to give rise to a claim in the future and the claim is therefore excluded from coverage."
The court found it "almost inconceivable" that Bank personnel, with their knowledge of the banking industry and the facts known in this case, would not have checked Cahow's accounts to ascertain the Bank's maximum exposure.
Although the district court stated it was unnecessary to resolve the three other issues in light of its finding that coverage was excluded, the court addressed the merits of two of the remaining issues "to avoid having to try the case, again, should there be a reversal on appeal." Specifically, the court found that the Bank breached the insurance policy by entering into a settlement with American without first obtaining Progressive's written consent and that Progressive had no duty to defend under the terms of the D&O/E&O policy. The district court did not determine whether the settlement was reasonable and also denied American's claim for attorney fees.
Court of Appeals Decision
American appealed to the Court of Appeals, contending that the district court erred in finding its claim against the Bank was excluded from coverage under Progressive's E&O endorsement. American raised three arguments regarding the coverage issue: (1) It was immaterial whether the Bank could have reasonably expected a claim because, under Kansas law, the issue was whether the Bank made a knowing misrepresentation (fraud) on the E&O endorsement application; (2) even if its first argument lacked merit, the nature of question two in the endorsement application was purely subjective and the district court erred in applying an objective standard; and (3) even under an objective standard, the facts did not support the district court's decision.
The Court of Appeals panel rejected the arguments and affirmed the district court. American Special Risk Management Corp. v. Cahow, No. 95,942, unpublished decision filed July 6, 2007. The panel first noted the district court's decision was not based on a determination of fraud, and the appellate briefs failed to show that fraud was ever alleged before the district court. Then, the panel determined that a two-prong subjective-objective analysis was appropriate in examining the language of the E&O endorsement and adopted the following standard: "(1) We subjectively examine the facts known to [the Bank] when it completed the insurance application; and (2) the test of whether the known facts 'could reasonably be expected to give rise to a claim' entails a classic objective criterion." American, slip op. at 13.
Applying the initial, subjective part of the inquiry, the Court of Appeals panel examined the Bank's knowledge of the situation before it completed the application for the E&O endorsement. Next, delving into the second, objective part of the inquiry, the panel examined whether the facts supported the district court's objective determination that the Bank's knowledge at the time of the application "'could reasonably be expected to give rise to a claim.' Colliers Lanard & Axilbund v. Lloyds of London, 458 F.3d 231, 233 (3d Cir. 2006)." American, slip op. at 13-14. The panel concluded that the district court properly balanced the interests in this case and correctly found that, because the facts known by the Bank at the time of its application, the Bank should have reasonably expected a potential claim concerning Cahow's improper use of a proprietorship account. Slip op. at 19.
As a result of this ruling, the Court of Appeals found moot American's remaining contention that the district court erred in holding that the Bank had breached its obligations under the insurance policy by failing to obtain Progressive's written consent before settling with American. Slip op. at 21.
American and Continental Casualty as its bond carrier (referred to collectively as American) filed a petition seeking this court's discretionary review of the Court of Appeals decision, and review was granted.
TWO-PRONG, SUBJECTIVE-OBJECTIVE ANALYSIS
In its petition for review, American contends that the Court of Appeals panel erred in affirming the district court's use of the two-prong, subjective-objective analysis for determining whether the Bank was entitled to coverage for American's claim. American urges this court to apply a purely subjective analysis to the examination of the Bank's prior knowledge. Further, in applying that standard, American argues that it must be shown that the Bank knowingly, and with the intent to deceive, made a false representation in the application. In other words, fraudulent misrepresentation must exist in order for Progressive to avoid its obligations under the E&O endorsement–an issue American did not present to the district court.
Standard of Review
As we review these arguments, a mixed standard of review applies. To the extent we are reviewing the district court's findings of fact, we examine whether the findings are supported by substantial competent evidence and are sufficient to support the district court's conclusions of law. Substantial evidence is such legal and relevant evidence as a reasonable person might regard as sufficient to support a finding. And our appellate review of the district court's conclusions of law is unlimited. Owen Lumber Co. v. Chartrand, 283 Kan. 911, 915-16, 157 P.3d 1109 (2007); LSF Franchise REO I v. Emporia Restaurants, Inc., 283 Kan. 13, 19, 152 P.3d 34 (2007); Nicholas v. Nicholas, 277 Kan. 171, 177, 83 P.3d 214 (2004).
The unlimited standard of review applies for another reason as well: Resolution of the issue before us requires us to interpret the provisions of an insurance contract, and such an interpretation is a question of law over which we have unlimited review. Marshall v. Kansas Med. Mut. Ins. Co., 276 Kan. 97, 111, 73 P.3d 120 (2003). Our construction of the insurance policy is governed by well-known rules. First, a court should consider the instrument as a whole and try to ascertain the parties' intention from the language used, taking into account the situation of the parties, the nature of the subject matter, and the purpose to be accomplished. O'Bryan v. Columbia Ins. Group, 274 Kan. 572, 575, 56 P.3d 789 (2002). Second, if a provision is ambiguous, the insurance policy language is tested by what a reasonably prudent insured would understand the language to mean, not by what the insurer intended the language to mean. Liggatt v. Employers Mut. Casualty Co., 273 Kan. 915, Syl. ¶ 3, 46 P.3d 1120 (2002). Third, limiting or exclusionary insurance provisions are to be construed narrowly against the insurer. Marquis v. State Farm Fire & Cas. Co., 265 Kan. 317, 327, 961 P.2d 1213 (1998).
Claims-Made Policy
In considering the policy coverage, it is noteworthy that the D&O/E&O policy obtained by the Bank was a claims-made liability policy. Under a claims-made policy, coverage is only triggered when, during the policy period, an insured discovers and notifies the insurer of either claims against the insured or occurrences that might give rise to such claims. This differs significantly from an occurrence policy, in which the coverage becomes effective if the negligent or omitted acts occur during the term of the policy. LaForge v. American Cas. Co. of Reading, Pa., 37 F.3d 580, 583 (10th Cir. 1994); see Marshall, 276 Kan. at 101-02; St. Paul Fire & Marine Ins. v. House, 315 Md. 328, 332-33, 554 A.2d 404 (1989) (discussing differences between occurrence and claims-made policies).
In a claims-made policy, the notice is the trigger that invokes coverage. Clear notice of a claim or occurrence during the policy period is crucial because allowing actual notice beyond the policy period would "'constitute[ ] an unbargained-for expansion of coverage, gratis, resulting in the insurance company's exposure to a risk substantially broader than that expressly insured against in the policy.'" American Cas. Co. v. Continisio, 17 F.3d 62, 68 (3d Cir. 1994) (quoting Zuckerman v. Nat. Union Fire Ins., 100 N.J. 304, 310-13, 495 A.2d 395 [1985]). Claims-made policies can provide more underwriting certainty for risks like professional responsibility because the notice requirements allow an insurer to "'close its books' on a policy at the expiration date and thus 'attain a level of predictability unattainable under standard occurrence policies.' [Citations omitted.]" LaForge, 37 F.3d at 583. To ensure that only risks of unknown loss are potentially incurred, claims-made policies are generally written to eliminate coverage for claims arising out of "negligent acts or omissions known to the insured prior to policy inception, notwithstanding that the claim is made during the policy period." Wade & Essoff, Lawyers Professional Liability: A Primer on Prior Knowledge, 30 ABA Brief 29, 35 (Fall 2000); see also SCA Services, Inc. v. Transportation Insurance Co., 419 Mass. 528, 532, 646 N.E.2d 394 (1995) ("It follows from the general principle that an insured cannot insure against the consequences of an event which has already begun.").
This attempt to limit certain risks explains why Progressive questioned the Bank about whether there were any "facts, circumstances or situations" which could "reasonably be expected to give rise to a claim." It further explains why the E&O endorsement application specifically excluded any claim or action arising out of any such fact, circumstance, or situation known to exist.
Often, the exclusion for known facts, circumstances, or situations is referred to as the "known loss," "fortuity," or "loss-in-progress" doctrine. The doctrine "embod[ies] the concept that one may not obtain insurance for a loss already in progress, or for a loss that the insured either knows of, planned, intended, or is aware is substantially certain to occur." 43 Am. Jur. 2d, Insurance § 479; see 3 Bjorkman, Leitner & Simpson, Law & Prac. of Ins. Coverage Litig. § 35:9 (2008) ("When a policyholder knew, or reasonably should have known, of a substantial probability of loss prior to the inception of an insurance policy, that policy should not cover the loss."); Jerry & Richmond, Understanding Insurance Law § 63, pp. 437-38 (4th ed. 2007). Simply put, whether enforced through policy language or through a rescission of the insurance policy, an insured cannot obtain coverage for the risk of a known loss.
Much controversy in this area dances around the extent or definition of "prior knowledge." Parties quibble over whether the insured's prior knowledge should be analyzed by a fraud standard, a subjective standard, an objective standard, or some combination thereof.
Fraudulent Misrepresentation
American advances the position that Progressive cannot avoid its obligation to the Bank under the E&O endorsement unless Progressive proves by clear and convincing evidence that the Bank knowingly made a false statement on the application; in other words, it argues that a fraud standard applies. In support of this argument, American cites Kansas cases involving the rescission of insurance contracts. One such case is Scott v. National Reserve Life Ins. Co., 143 Kan. 678, 56 P.2d 76, modified 144 Kan. 224, 58 P.2d 1131 (1936).
In Scott, the insured falsely and knowingly denied that he had previously been turned down by other life insurance companies. Consequently, the Scott court found the evidence contained all the elements required to show fraud as a matter of law. 144 Kan. at 227. The court ultimately held the insurer was not liable on the life insurance policy and upheld the insurance company's rescission of the contract. 144 Kan. at 227; see also Waxse v. Reserve Life Ins. Co., 248 Kan. 582, 587, 809 P.2d 533 (1991) (using the standard for fraudulent misrepresentation, finding that insured's failure to disclose information about positive HIV test not sufficient to rescind insurance contract); Nordstrom v. Miller, 227 Kan. 59, Syl. ¶ 10, 605 P.2d 545 (1980) ("Rescission is an equitable remedy designed to afford relief from contracts entered into through mistake, fraud or duress.").
Under the reasoning of Scott, American argues that to exclude its claim against the Bank, Progressive has the burden to show that the Bank committed fraud in filling out its insurance application. This argument fails, however, because, unlike the situation in Scott, Progressive did not attempt to rescind the entire contract.
Rescission was an option available to Progressive because Section IX(C)(3) of the D&O policy granted the right to void the policy ab initio for misrepresentation. The provision stated in part:
"[I]n the event the Application contains misrepresentations made with the actual intent to deceive, or contains misrepresentations which materially affect either the acceptance of the risk or the hazard assumed by the Insurer under this Policy, this Policy shall be void ab initio in its entirety and of no effect whatsoever."
Under the clear language of this provision, Progressive would have to establish that the Bank had an intent to deceive, meaning that fraud would have to be established. See Alires v. McGehee, 277 Kan. 398, 403, 85 P.3d 1191 (2004) (elements of fraud include an untrue statement of fact, known to be untrue by the party making it, made with the intent to deceive or with reckless disregard of the truth, upon which another party justifiably relies and acts to his or her detriment).
Nevertheless, Progressive did not attempt to meet this standard; it did not allege that the Bank made misrepresentations with "the actual intent to deceive," and it did not seek rescission of the contract.
Instead, Progressive sought to invoke the specific disclaimer and exclusionary language in the E&O endorsement application in order to deny coverage for the claim related to Cahow. Progressive clearly asserts in its appellate brief that this case "has nothing to do with fraud. Coverage for this claim is simply excluded."
Progressive was contractually entitled to enforce the exclusion rather than seek to void the policy; in other words, nothing required Progressive to invoke Section IX(C)(3) rather than the exclusion. See American Guarantee and Liability Ins. v. Fojanini, 90 F. Supp. 2d 615, 619 n.7 (E.D. Pa.) (rejecting notion that fraudulent misrepresentation had to be proven when complaint merely invoked policy exclusion), recons. granted in part on other grounds 99 F. Supp. 2d 558 (E.D. Pa. 2000).
Hence, the standard is governed solely by the language of the nondisclosure exclusion, and that exclusion does not include any of the elements of fraud. For example, even though there is a requirement that the applicant have knowledge of facts, the exclusion does not require that the failure to disclose that information be intentional or reckless. Rather, as was alleged by Progressive, the Bank's failure to disclose the risk could have resulted from negligence, and the exclusion would apply. See Myers v. Lashley, 44 P.3d 553, 563 n.54 (Okla. 2002) ("In civil law the element of 'prior knowledge' is not always tantamount to willfulness of conduct. Willfulness stems from 'guilty knowledge' which is synonymous with 'culpable knowledge' or 'scienter.'"); cf. K.S.A. 2007 Supp. 40-2,118 (defining "fraudulent insurance act"); Ortiz v. Biscanin, 34 Kan. App. 2d 445, Syl. ¶ 8, 122 P.3d 365 (2004) ("Pursuant to K.S.A. 40-2,118[a], in order to establish fraud on the part of the insured, an insurer must prove by clear and convincing evidence that its insured knowingly and with intent to deceive signed an application the insured knew contained materially false statements.").
We, therefore, reject the argument that Progressive must establish the Bank committed fraud in completing the application.
Subjective Standard
American argues that even if Progressive is not required to prove that the Bank had an "intent to deceive," the plain language on the application implicated the Bank's subjective belief about whether the known facts or circumstances could reasonably be expected to give rise to a claim. American contends that the language called for the insured to express an opinion.
Further, American argues that the Bank answered the questions on the application honestly, based on the Bank's subjective belief, and should not be punished for doing so. American suggests that the district court's decision has set the "prior knowledge" bar so low that applicants will be deemed to have knowledge of virtually all potential claims relating to prepolicy coverage, such that no coverage will exist for those claims–effectively turning a claims-made policy into an occurrence policy. And, in American's view, the fact that hindsight revealed a claim would ultimately be made does not mean the Bank believed that a claim could reasonably be expected when it completed the policy application.
Progressive counters that Kansas public policy should not require persons or entities to have an actual awareness that a claim will be made before the exclusion applies. This would, in effect, set the bar too high.
American's position that a purely subjective standard applies has some support, although it has been endorsed by only a minority of courts. One case frequently cited for its rationale in the application of the subjective standard is Estate of Logan v. Northwestern Nat., 144 Wis. 2d 318, 424 N.W.2d 179 (1988). Logan involved a professional liability policy that provided coverage for claims first made during the policy period by reason of any act, error, or omission in professional services rendered: "'PROVIDED ALWAYS THAT such act, error or omission . . . happens: (aa) during the policy period, or (bb) prior to the policy period, provided that prior to the effective date of