Liar, Liar, Pants on Fire

There is More Than One Way to Skin A Fraudster

DELAYED RESCISSION FAILS BUT EXCLUSION APPLIES

Evanston Insurance Company appealed from a bench trial on an insurance-coverage dispute. After determining that Evanston failed to timely rescind the policy after learning that the insured lied on the application to avoid discovery of his embezzlement scheme, and that a policy exclusion did not apply, the district court required Evanston to continue defending Desert State Life Management against a class action arising from its former CEO's embezzlement scheme.

In Evanston Insurance Company v. Desert State Life Management; Christopher Moya, et al, No. 21-2145, United States Court of Appeals, Tenth Circuit (December 30, 2022) the Tenth Circuit issued what it believed to be a Solomon-like decision that did justice to Evanston and Desert State.

BACKGROUND

Four things underlie the appeal:

Paul Donisthorpe's application for the Evanston insurance policy,
his embezzlement scheme,
the former clients' class action, and
Evanston's response to Donisthorpe's misconduct.

Desert State Life Management was a New Mexico trust corporation that acted as a trustee for disabled individuals. From 2008 to March 2017, Donisthorpe served as its CEO. In October 2016, Donisthorpe applied for an Evanston professional-liability insurance policy on Desert State's behalf. Donisthorpe's response to the following application question was a lie:  “Is the applicant [Desert State] or any principal, partner, owner, officer, director, employee, manager or managing member of the Applicant or any person(s) or organization(s) proposed for this insurance 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?"

WARRANTY

Donisthorpe, by the application warranted that he understood and accepted the notice and that the information contained in the application was true and that it "shall be the basis of the policy and deemed incorporated therein." Based on Donisthorpe's application responses, Evanston issued Desert State a professional-liability insurance policy.

Despite the notices, coverages, and exclusions, Donisthorpe completed Evanston's application while running an embezzlement scheme that exposed Desert State to liability. Donisthorpe intentionally misappropriated and commingled over $4.9 million of Desert State's client funds for his own use. Donisthorpe hid his scheme by presenting fraudulent reports to Desert State's board of directors and to New Mexico regulators.

In March, 2017 L. Helen Bennett, a Desert State director, told Evanston about Donisthorpe's misconduct. Evanston also began receiving claims from Desert State clients that confirmed Bennett's report. Evanston ultimately opted not to rescind the policy; instead, it notified Desert State that it wouldn't be renewing the policy. In August, Christopher Moya was appointed Desert State's receiver.

In November 2017, Donisthorpe pleaded guilty to a two-count federal felony information charging him with wire fraud and money laundering. He was sentenced to 144 months in prison and was ordered to pay $6.8 million in restitution and a $4.8 million money judgment. Donisthorpe's criminal case triggered demands for restitution among former Desert State clients.

By mid-December 2017, Evanston learned that Donisthorpe had pleaded guilty.Based on statements during his plea hearing, Evanston determined that Donisthorpe had made material misrepresentations when applying for insurance on Desert State's behalf. Evanston had no evidence that any Insured besides Donisthorpe had participated in the scheme, so Evanston assumed (correctly) that no Insured other than Donisthorpe had made material misrepresentations on the insurance application.

In June-six months after learning of Donisthorpe's guilty plea-Evanston sent Moya a letter offering to rescind the policy. The company cited Donisthorpe's misrepresentations on Desert State's application. Evanston also refunded Desert State for the premiums paid under the policy. But Desert State did not accept the offer to rescind.

DISCUSSION

Evanston argued that the district court erred by denying rescission and by concluding that the policy required Evanston to defend Moya and Bennett against the class-action claims.

RESCISSION MUST BE IMMEDIATE

Rescission is an equitable remedy that results in the cancellation of a contract. It is available where there has been a misrepresentation of a material fact, the misrepresentation was made to be relied on, and has in fact been relied on. But a party seeking to rescind "must promptly exercise it or [the] same will be waived."  [Putney v. Schmidt, 120 P. 720, 723 (N.M. 1911)]

The district court's factual findings belie any suggestion that Evanston acted promptly in seeking to rescind the policy. Evanston knew about this guilty plea by mid-December. Evanston was on notice of its right to rescind as early as March 2017, when Bennett first relayed Donisthorpe's misconduct to the insurer.  Circumstances outside a party's control can excuse a delayed rescission. Here, by contrast, Evanston faced few (if any) obstacles in rescinding, especially once it learned in December 2017 that Donisthorpe had pleaded guilty.

Because the undisputed facts establish that Evanston waited too long to rescind the policy, the Tenth Circuit held that the district court did not err in concluding that Putney effectively barred Evanston's rescission claim.

EXCLUSION P

Rescission was not the only remedy available to Evanston. In New Mexico, unambiguous contract provisions are applied, not interpreted. Although New Mexico courts generally interpret exclusionary language narrowly, they do not apply this principle to override the clear and unambiguous terms of an exclusion.

Because the unambiguous plain language controls, the Tenth Circuit applied Exclusion P as written. The class-action negligence claims arose out of Donisthorpe's commingling. In other words, the claims "originate from,  and therefore, the claims all flow from Donisthorpe's misconduct.

Evanston did not have a duty to defend Moya and Bennett under the policy. On rescission, the Tenth Circuit affirmed the district court. But, it reversed the district court's ruling on Exclusion P and remanded the case with instructions to enter judgment for Evanston and against Moya and Bennett. A concurring opinion argued that Evanston was fast enough in rescinding the policy but that fact was irrelevant because of the application of the exclusion. Therefore, Evanston owed nothing, was entitled to keep the premium it tried to return, and owed nothing to the defendants.

ZALMA OPINION

Although rescission was an obvious remedy - the policy was obtained by a lie told by a criminal trying to hide his crime - Evanston deprived itself of the right to rescind by its delay. Regardless, the exclusion was clear and unambiguous and, as a result, it owed neither defense nor indemnity to the insured and its bankruptcy trustee. Liars never prosper and insurers who sit on their rights will lose them. In this case, if the policy was rescinded Evanston needed to return the premium but since the claim was excluded it was entitled to retain the premium and seek refund of defense costs expended, although that would be difficult, since the insured had almost no assets.

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Barry Zalma, Esq., CFE, now limits his practice to service as an insurance consultant specializing in insurance coverage, insurance claims handling, insurance bad faith and insurance fraud almost equally for insurers and policyholders. He practiced law in California for more than 44 years as an insurance coverage and claims handling lawyer and more than 54 years in the insurance business. He is available at http://www.zalma.com and zalma@zalma.com

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