In Schlather, Stumbar, Parks & Salk, LLP, et al. v. One Beacon Ins. Co., No. 5:10-cv-0167, 2011 U.S. Dist. LEXIS 147931 (N.D.N.Y. Dec. 22, 2011), the court held that an insurer breached its duty to defend when it withdrew from the defense of an underlying legal malpractice action against its insured, notwithstanding the fact that a “known claims” exclusion extinguished the duty to indemnify, because the applicability of the exclusion was not clear based on the allegations in the underlying complaint. 

The underlying legal malpractice complaint alleged that an attorney at the insured law firm dismissed the client’s wrongful death action without notifying the client of the dismissal.  When the client learned of the dismissal, she sent letters to the law firm that criticized the performance of her attorney and stated that the client did not consent to the dismissal.  More than a year after receiving the letters from the client, the law firm completed an application for professional liability insurance in which it checked the box labeled “No” in response to a question that asked, “Are you or any members or employees aware of any fact, circumstance or situation which may give rise to a claim?”  After receiving the application, One Beacon issued a policy to the firm. 

After the policy was issued, the client brought a legal malpractice claim against the firm.  The firm sought defense and indemnification from One Beacon.  One Beacon initially defended the firm subject to a reservation of rights, but withdrew from the defense while the claim was pending.   In coverage litigation initiated by the law firm, One Beacon moved for summary judgment, arguing that the policy’s “known claims” exclusion barred coverage. 

Applying a two-pronged test to determine the applicability of the “known claims” exclusion, the court found that One Beacon had no duty to indemnify the firm because: (1) there was no factual dispute that the attorney knew before the policy application was signed that the former client had been dissatisfied with the firm’s representation; and (2) a reasonable attorney with knowledge of those facts might expect a claim to arise because the firm's alleged conduct fell below the minimum level of professional conduct expected of attorneys.

The court held that the exclusion did not extinguish the duty to defend, however, because the allegations in the underlying complaint gave rise to claims that were potentially covered by the One Beacon policy, and it could not be determined “with certainty” based on those allegations that the “known claims” exclusion applied because its “applicability required determining whether a reasonable attorney could expect a claim to arise.”  As the court explained, a court “should only excuse an insurer from its duty to defend if it can be concluded as a matter of law that there is no possible factual legal basis on which the insurer might eventually be held liable to indemnify the insured.” (emphasis in original).

The court held that the law firm was entitled to general and consequential damages stemming from the insurer's breach of its duty to defend, which included both its unreimbursed defense costs and damages for “the loss of peace of mind as a result of [One Beacon’s] breach of its contractual duty to defend.”  The court reasoned that damages for “loss of peace of mind” were foreseeable because an insured that enters into an insurance contract may “bargain for peace of mind, or comfort, knowing that it will be protected in the event of a catastrophe.”