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April 9, 1996

Albert F. Esoldi & Diana Esoldi, Plaintiffs,
David Esoldi, et al., Defendants.

The opinion of the court was delivered by: BASSLER


 This litigation involves claims arising out of an alleged partnership agreement between two brothers. The plaintiff and his wife, Chuck and Diana Esoldi, allege that Chuck's brother, David Esoldi, in conjunction with the other defendants, misappropriated funds and business opportunities of partnerships in which Chuck Esoldi had an interest. Two of the defendants are a law firm, Hartmann, Brooks, Van Dam & Sinisi ("Hartmann Brooks") and one of its partners, David Van Dam. This opinion resolves a counterclaim by Hartmann Brooks' insurer for reformation of Hartmann Brooks' professional liability insurance policy based on misrepresentations by David Van Dam in the insurance application. *fn1"

 National Union Fire Insurance Company ("National Union") was the professional liability insurer for Hartmann Brooks. *fn2" National Union alleges that David Van Dam made a material misrepresentation on the firm's insurance application for the policy that became effective March 28, 1990. In response to a question on the renewal application David Van Dam indicated that he was not aware of any circumstances that could lead to a claim against the firm or any one of the partners. National Union contends that David Van Dam was aware of circumstances that could give rise to a claim on November 8, 1989 and during the period before the policy became effective.

 Plaintiffs object to both the legal remedy of reformation and the factual basis for it. Plaintiffs contend that David Van Dam answered the question honestly, and thus, his answer is not a basis to reform the contract. They argue that rescission, not reformation, is the appropriate remedy and that the defendants have waived their right to either remedy. Even if the remedy is available, the plaintiffs argue that coverage can not be reformed as to the other partners of the firm because they are "innocent insureds." Finally, plaintiffs contend that this action is barred by the entire controversy doctrine.

 This court has jurisdiction over this portion of the trial pursuant to 28 U.S.C. § 1367.

 The matter came before the court for trial without a jury. The court heard testimony on April 3rd and 4th, 1996 and held closing arguments on April 8, 1996.

 The court concludes that National Union is entitled to reformation of the insurance contract to its prior coverage limits of $ 2 million per claim and $ 3 million aggregate.


 A. Hartmann Brooks' Insurance Policy

 National Union Fire Insurance Company of Pittsburgh, Pa. ("National Union") is an insurance company whose business includes the issuance of policies of professional liability insurance.

 At all times relevant hereto, defendant Hartmann, Brooks, Van Dam & Sinisi, formerly Hartmann, Brooks & Van Dam ("Hartmann Brooks"), was a New Jersey law firm of which Robert K. Hartmann and defendant David Van Dam were partners.

 National Union insured Hartmann Brooks for several years prior to 1990 with the policy year commencing on March 28th of each year under professional liability policy number LPL-1674018. Prior to March 28, 1990, the limits of the Hartmann Brooks policy were $ 2,000,000 per claim and $ 3,000,000 annual aggregate.

 Hartmann Brooks applied for a renewal of the policy for the year starting March 28, 1990 by way of an application signed by David Van Dam and dated November 8, 1989. Def. Exh. 1. Question 14 of the Renewal Application read as follows:

Is the firm aware of any circumstances, or any allegations or contentions as to any incident which may result in any claim being made against the firm or any of its past or present Owners, Partners, Shareholders, Corporate Officers or Employees or its predecessors in business?

 David Van Dam answered that question in the negative. The application included the following statement:

I/we hereby declare that the above statements and particulars are true and I/we have not suppressed or misstated any material facts, and I/we agree that this application shall be the basis of the contract with the Company.

 In December of 1989, Hartmann Brooks added five new attorneys to the firm. As a result of the merger, Hartmann Brooks' bookkeeper, Carol Sue Campbell, requested that National Union increase the firm's policy limits from $ 2 million per claim and $ 3 million aggregate. Def. Exh. 6. The policy was renewed by National Union with increased policy limits of $ 5 million per claim and $ 5 million annual aggregate. Endorsement No. 2 to the policy, dated February 12, 1990, reflects the increased limits of $ 5 million/ $ 5 million.

 David Van Dam was aware of acts that could lead to a claim against the firm in November of 1989 when he submitted the insurance application. David Van Dam also became aware of other circumstances that could lead to claims against the firm prior to the effective date of the new policy.

 1. Pre-Application Acts

 At the time he signed the insurance application, David Van Dam was aware of at least two circumstances that could expose the firm to liability. First, David Van Dam knew that he had made a misrepresentation to Polifly Savings & Loan ("PS&L") regarding his partner Robert Hartmann's interest in one of the entities to which PS&L loaned money.

 Hartmann Brooks acted as associate counsel to PS&L from July 1984 until March 6, 1990. Robert Hartmann served as a director of Polifly Savings and Loan ("PS&L") from 1973 until March 6, 1990. Because Hartmann was a director of PS&L, PS&L was barred by federal banking regulations from loaning more than $ 100,000 to any entity in which Hartmann or a member of Hartmann's family had an interest. David Van Dam was aware of this prohibition.

 Nevertheless, Hartmann possessed an interest in Changebridge East, Inc., a company that PS&L loaned $ 26,000,000. Changebridge East was a New Jersey corporation that owned real estate in Montville, New Jersey which it intended to develop into townhouses and single family homes.

 In October, 1986 PS&L asked Changebridge for a list of its shareholders. At the time, David Van Dam represented Changebridge. He responded to PS&L's request in an October 30, 1986 letter in which he falsely indicated that the only shareholders in Changebridge were himself and two other individuals. David Van Dam intentionally did not list Hartmann or Hartmann's wife as shareholders, even though Hartmann owned 24 shares that he had placed in his wife's maiden name. On May 23, 1993, David Van Dam pled guilty to making a false statement to a federally insured financial institution and obstruction of justice based on this misrepresentation.

 At the time David Van Dam signed the insurance application, he was aware of this misrepresentation. He knew that he had a legal and ethical obligation to disclose Hartmann's interest and was aware that if PS&L knew about Hartmann's interest it could not make the loan to Changebridge. 4-3-96 Tr. at 154-55. David Van Dam also knew that Changebridge was a problem loan, and knew that he could be subject to liability for his misrepresentation.

 In addition to misrepresenting Hartmann's interest in Changebridge, David Van Dam was also aware that he had engaged in a "questionable" transaction regarding David Esoldi's purchase of a unit located at the Northgate condominium complex ("Unit 39"). The Northgate complex was owned by Northgate Associates, a limited partnership in which the limited partner was Chalder Investment Corp., a wholly owned subsidiary of PS&L, and the general partner was North Hedge Builders, Inc., a corporation in which Chuck Esoldi was a shareholder, director and the corporate secretary.

 Chuck Esoldi told David Van Dam that he refused to sign a deed from Northgate Associates to David Esoldi for Northgate Unit 39 before there was an accounting. David Van Dam had his legal secretary sign the deed in April, 1989, as assistant secretary of North Hedge Builders. After the secretary executed the deed David Van Dam delayed recording the deed in order to satisfy Chuck Esoldi's desire to have an accounting before the deed was executed. 4-3-96 Tr. at 75.

 David Esoldi secured a loan from PS&L for the purchase of Unit 39 prior to the execution of the deed by David Van Dam's secretary. David Van Dam gave PS&L a mortgage signed by David Esoldi, certified that PS&L had a first lien on the property, and recorded the mortgage before his secretary signed the deed. At the time, he knew that recording the mortgage before recording the deed was "questionable." 4-3-96 Tr. at 161.

 David Van Dam admits that "in retrospect, there's no question" that he was aware of circumstances that could result in a claim being made against him or the firm when he signed ...

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