ARTICLE
27 January 2023

Insurer Deemed To Waive Right To Rescind But Commingling Exclusion Bars Coverage For Claims Against "Innocent" Insureds

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Wiley Rein

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Applying New Mexico law, the Tenth Circuit has held that an insurer that waits over a year to seek rescission after learning of the insured's actual fraud has waived its right to do so.
United States Insurance
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Applying New Mexico law, the Tenth Circuit has held that an insurer that waits over a year to seek rescission after learning of the insured's actual fraud has waived its right to do so. Evanston Ins. Co. v. Desert State Life Mgmt., 2022 WL 17998401 (10th Cir. Dec. 30, 2022). The court nonetheless reversed in favor of the insurer, holding that a commingling exclusion applied to bar coverage for an entire lawsuit despite additional negligence allegations against "innocent" insureds.

The policyholder, a corporation acting as a trustee for disabled individuals, obtained a professional liability policy from the insurer. The CEO had submitted an application in 2016 stating that no one was "aware of any fact, circumstance, situation, incident or allegation of negligence or wrongdoing, which might afford grounds for any claim such as would fall under th[e] proposed insurance." Also, the policy contained an exclusion for Claims "[b]ased upon or arising out of any conversion, misappropriation, commingling [of] or defalcation of funds or property."

Unbeknownst to the insurer, the policyholder's CEO was engaged in an embezzlement scheme in which he intentionally misappropriated and commingled approximately $5 million of the policyholder's disabled clients' money. A regulatory investigation revealed the scheme in March 2017, and in November 2017, the CEO pled guilty to wire fraud and money laundering in connection with the scheme. Soon after, former clients of the insured brought a class action lawsuit against the policyholder, the CEO, his ex-wife, and one of the insured's former directors, alleging breach of fiduciary duty and negligence. The insurer denied coverage under the policy and filed suit seeking rescission and a declaration that the policy did not cover the class action.

Following a bench trial, the trial court held that the insurer did not timely rescind the policy because it waited over a year after learning of the alleged scheme to file suit seeking rescission and instead notified the policyholder that it was not planning to renew. The court also held that the policy covered the class action lawsuit for the policyholder corporation and the "innocent" director but not for the CEO and his wife, rejecting the insurer's argument that the conversion/commingling exclusion applied to bar coverage for the entire suit.

On appeal, the Tenth Circuit affirmed the district court's determination that the insurer had not sought rescission in a timely manner, but it reversed on the coverage issue. The appellate court rejected the insureds' argument that the commingling exclusion did not apply to bar coverage for the entire class action because the complaint contained additional causes of action against the policyholder and the "innocent" director for mismanagement of client accounts and failure to monitor the financial health of the insured company. The Tenth Circuit explained that the exclusion barred overage for the entire class action because "the origin of the damages ar[ose] out of [the CEO's] commingling," even though "the legal theory undergirding the class-action claims" was the "innocent" director's negligence.

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