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In Bryan Brothers Inc. v. Continental Casualty Co., No. 10-1439 (4th Cir. March 24, 2011)(published per order filed Sept. 6, 2011), the Court held that the prior knowledge provision in an accounting firm’s professional liability policy was a clear and unambiguous condition precedent to recovery under the policy for thefts from client accounts by a former employee of the accounting firm.  Because the former employee had prior knowledge of her thefts, a condition precedent was unfulfilled, and the coverage agreement was not triggered.  In addition, the 4th Circuit held that exclusions and exceptions in the policy cannot provide coverage that is precluded by the prior knowledge exception.  Thus, the Court affirmed Bryan Brothers v Continental in favor of the insurer.

Significantly, the accounting firm’s professional liability policy with Continental included the following Innocent Insureds provision under the Policy conditions:

If coverage under this Policy would be excluded as a result of any criminal, dishonest, illegal, fraudulent, or malicious acts of any of you, we agree that the insurance coverage that would otherwise be afforded under this Policy will continue to apply to any of you who did not personally commit, have knowledge of, or participate in such criminal, dishonest, illegal, fraudulent or malicious acts or in the concealment thereof from us.

The accounting firm argued that since the former employee who committed the thefts was the only person with prior knowledge of her thefts, the innocent insureds provision saved coverage for any insured other than her.  Continental Casualty argued, on the other hand, that the prior knowledge provision in the main insuring clause was a condition precedent that precluded coverage if unfulfilled. 

Applying Virginia law, the 4th Circuit agreed with the insurer.  The Court agreed that based on the plain language and structure of the policy, the prior knowledge provision in the main insuring clause was a condition precedent to coverage.  Thus, the accounting firm’s lack of prior knowledge was a condition of the insurer’s agreement to cover the accounting firm’s liability from acts predating the policy.  The knowledge of the former employee breached that condition.  The Court found that the Innocent Insureds provision was inapplicable, because the insurer did not deny coverage under the bad acts exclusion.  The Court stated that the Innocent Insureds provision “appears to be an exception to the bad acts exclusion”, which was not implicated.

In any event, the Court found that it is elemental that exclusions and exceptions in an insurance policy cannot expand the scope of agreed coverage.

Accounting and law firms should be aware of this decision when negotiating the renewals of their professional liability policies.  The Innocent Insureds provision does not trump the provisions of the main insuring clause.