American v. Cahow

• Decision Date: 12 September 2008
• Docket Number: No. 95,942.,95,942.
• Parties: AMERICAN SPECIAL RISK MANAGEMENT CORPORATION and Continental Casualty Company, Appellants, v. William CAHOW and Peoples Bank, Appellees, v. Progressive Casualty Insurance Company, Appellee.
• Court: Kansas Supreme Court

192 P.3d 614

AMERICAN SPECIAL RISK MANAGEMENT CORPORATION and Continental Casualty Company, Appellants, v. William CAHOW and Peoples Bank, Appellees, v. Progressive Casualty Insurance Company, Appellee.

No. 95,942.

Supreme Court of Kansas.

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...