Seventh Circuit Holds “Breach of Contract” Exclusion in Professional Liability Policy Renders Coverage Illusory

Jason Taylor | Traub Lieberman Straus & Shrewsberry | October 2, 2019

Most professional liability policies include a “breach of contract” exclusion precluding coverage for claims or damages arising out of breach of contract. How to apply such broad exclusions to claims brought by clients of the insured (or others with whom the insured has contracted) can be difficult because most professional relationships necessarily involve an underlying contract. On the one hand, arguably every claim against an insured professional “arises out of” the contract where but for the contract there would be no relationship between the claimant and insured. That interpretation of the exclusion, however, is seemingly too broad. But, what about claims that could be brought in both contract and tort? Or, does the exclusion limit coverage only to claims brought by third parties with whom the insured has not contract? Just as “breach of contract” exclusions vary, courts are mixed.

In Crum & Forster Specialty Insurance Company v. DVO, Inc., 2019 WL 4594229 (7th Cir. Sept. 23, 2019), the Seventh Circuit addressed whether the E&O coverage of the primary and excess insurance policies issued to DVO cover a state court claim for contract violations in light of the policies’ broad “breach of contract” exclusion. In applying Wisconsin law, the Seventh Circuit found that the language in the “breach of contract” made the exclusion broader than the grant of coverage, and therefore, rendered coverage illusory.

In DVO, Inc., the underlying contract claim was brought by WTE pursuant to Standard Form Agreement under which DVO agreed to design and build an anaerobic digester for WTE to be used to generate electricity from cow manure which would then be sold to the electric power utility. WTE sued DVO for breach of contract alleging that DVO failed to fulfill its design duties, responsibilities, and obligations under the contract in that it did not properly design substantial portions of the structural, mechanical, and operational systems of the digester, resulting in substantial damages to WTE. WTE sought over $2 million in damages and fees.

Crum & Forster initially offered a defense under primary and excess policies providing a combination of commercial general liability, pollution liability, E&O and other coverages. The issue on appeal concerned the E&O coverage, and more specifically, whether the policies’ “breach of contract” exclusion barred coverage. The exclusion precluded coverage for damages and costs “based upon or arising out of: breach of contract, whether express or oral, nor any ‘claim’ for breach of an implied in law or an implied in fact contract[]….” DVO argued that the “breach of contract” exclusion was so broad as to render the E&O professional liability coverage illusory, and therefore, could not be enforced to preclude a duty to defend. The District Court held that the professional liability coverage was not illusory because it would still apply to third party claims, and even if it was, the remedy would be to reform the contract to allow coverage for third party claims against the insured, not to allow coverage for all professional liability claims. The Seventh Circuit reversed.

The Seventh Circuit began its analysis with familiar tenants of Wisconsin insurance law. First, a determination of whether the exclusion applies must focus on the incident that allegedly gave rise to the coverage, not the theory of liability. See e.g., 1325 North Van BurenLLC v. T-3 Group, Ltd. (noting that claims of negligence in the failure to provide competent professional services could raise both tort and contract claims). Therefore, according to the Court, even a claim that purports to be a tort claim can be excluded under the “breach of contract” exclusion if it arises out of that contract.

Second, the Seventh Circuit reiterated that the “arising out of” language, even in an exclusion, is broadly construed. The phrase is broad, general, and comprehensive, and it is ordinarily understood to mean “originating from, growing out of, or flowing from.” Therefore, under Wisconsin law, “the term ‘arising out of’ is interpreted broadly to reach any conduct that has at least some causal relationship between the injury and the event not covered, which sweeps in third-party claims as well when so related.” DVO, Inc., 2019 WL 4594229 at *8.

In DVO, Inc., the underlying state court complaint alleged that DVO was contracted to design and construct the anaerobic digester and, because of its faulty design, damages were incurred. As such, the complaint alleged a claim that arose out of the contract, and therefore, fell within the exclusion language. According to the Seventh Circuit, the “event not covered” in the policy was itself quite expansive, explicitly applying “breach of contract” to all contracts whether express or oral, and even including contracts implied in law or fact. The Seventh Circuit rejected the District Court’s attempt to distinguish between direct claims between contracting parties based on the contract, and third-party claims based on the insured’s failure to exercise reasonable professional care where the claimant has no contractual relationship with the insured. While the Seventh Circuit conceded that more tailored language may support the District Court’s reasoning, the “breach of contract” exclusion at issue was extremely broad: it included claims “based upon or arising out of” the contract, thus including a class of claims more expansive than those based solely upon the contract. Given that broad language, the exclusion would include even the claims of third parties. As to those third parties, the claims of professional negligence against DVO fell within the “breach of contract” exclusion because they necessarily “arose out of” the express, oral, or implied contract under which DVO rendered professional services on the project.

Based on the above analysis, the Seventh Circuit reasoned that the “breach of contract” exclusion rendered the professional liability coverage in the E&O policy illusory. In the insurance context, “[i]llusory policy language defines coverage in a manner that coverage will never actually be triggered.” Id. *6. While the Seventh Circuit recognized that if the purported coverage in a policy proves to be illusory a court may reform the policy to meet the insured’s reasonable expectation of coverage, the Court disagreed with the District Court’s attempt to reform the contract. The District Court reasoned that even if the coverage was illusory, the remedy would be reform the contract to allow coverage for third party claims (and not those brought directly by parties with whom the insured contracted). The Seventh Circuit, however, held that the District Court’s focus on the hypothetical third-party action was misplaced. Rather, the focus should be on the “reasonable expectation” of coverage of the insured in securing the policy. Although the Seventh Circuit’s analysis of hypothetical third-party claims under the “breach of contract” exclusion might foreshadow the likely outcome in this case, ultimately the Seventh Circuit declined making a determination on the reasonable expectations of the insured and remanded the case back to the District Court to consider.

Breach of Contract Exclusion Precludes Coverage

Larry P. Schiffer | Squire Patton Boggs | August 14, 2019

Liability insurance policies are meant to cover claims brought against insureds by third-parties alleging a fortuitous event that causes damages. But most liability policies have exclusions that preclude coverage for certain events. For example, many policies exclude coverage for property damage to property owned by the insured. Another exclusion precludes coverage for damages resulting from the assumption of liability in a contract or agreement. And the one we will concentrate on in this post is the exclusion for breach of contract claims. The Sixth Circuit Court of Appeals recently addressed these exclusions.

In Maxum Indemnity Co. v. The Robbins Co., No. 18-3776 (6th Cir. Aug. 12, 2019) (Not Recommended for Publication), the policyholder leased a tunnel boring machine to a third-party for a construction project. The machine apparently failed. The lessee brought an arbitration under the lease against the policyholder for breach of contract. When the policyholder asked its insurance company to defend and indemnify, the insurance company brought a declaratory judgment action claiming that it owed neither a duty to defend nor a duty to indemnify. The district court granted the insurance company’s motion for judgment on the pleadings. The Sixth Circuit affirmed.

The policyholder’s main argument was that it was impossible to tell from the arbitration demand all the allegations and damages and that the court should have looked at additional evidence to determine if there was a duty to defend. In granting judgment on the pleadings to the insurer, the district court had focused on several exclusions, including the owned-property/work exclusion and the assumption of liability exclusion, but also found that the insurance policy specifically excluded contractual damages, which is what the lessee was seeking.

In affirming, the circuit court noted that the exclusions relied upon by the district court were not applicable, but that reliance was harmless error. First, the exclusion for damages as a result of an assumption of liability in a contract was irrelevant, said the court, because neither the lessee or the insurer argued that the policyholder assumed liability under the lease. Second, the exclusion for damages to property owned or rented was inapplicable according to the court, because even though the policyholder owned the tunnel boring machine, the lessee was not seeking damages for the machine, but was seeking damages for the policyholder’s failure to provide a working machine as promised in the lease.

The affirmance, instead, was based on the breach of contract exclusion. That exclusion specified that the insurance policy did not apply to any claim or suit for breach of contract, regardless of the nature of the damages. The exclusion also stated that no duty to defend arose for excluded claims for breach of contract. The circuit court rejected the policyholder’s argument that the difference between pleadings in arbitration and litigation required the district court to consider additional documents. The court was not persuaded that the differences between arbitration and litigation were as stark as the policyholder alleged. Nevertheless, the court reviewed the evidence provided by the policyholder and found that none of it described damages outside breach of contract damages.

Notably, the court declined to consider an itemized list of damages required by the arbitration panel because the policyholder had that list before the district court decided the insurance company’s motion and failed to provide that list to the court. While it is possible, said the court, that the district court might have found a duty to defend based on certain descriptions that could be seen as consequential property damage, the policyholder was the victim of its own delay. “[A]n appellate court does not exist to give litigants a second bite at the apple.”

Accordingly, the district court’s judgment was affirmed and no insurance coverage was available to the policyholder.

Consequential Damages can be Recovered Against Insurer in Breach of Contract

David Adelstein | Florida Construction Legal Updates | June 1, 2019

In a favorable case for insureds, the Fifth District Court of Appeal maintained that “when an insurer breaches an insurance contract, the insured is entitled to recover more than the pecuniary loss involved in the balance of the payments due under the policy in consequential damages, provided the damages were in contemplation of the parties at the inception of the [insurance] contract.”  Manor House, LLC v. Citizens Property Insurance Corp., 44 Fla. L. Weekly D1403b (Fla. 5thDCA 2019) (internal citations and quotation omitted).   Thus, consequential damages can be recovered against an insurer in a breach of contract action (e.g., breach of the insurance policy) if the damages can be proven and were in contemplation of the parties at the inception of the insurance contract.

In Manor House, the trial court entered summary judgment against the insured holding the insured could not seek lost rental income in its breach of contract action against Citizens Property Insurance because the property insurance policy did not provide coverage for lost rent.  However, the Fifth District reversed this ruling because the trial court denied the insured the opportunity to prove whether the parties contemplated that the insured, an apartment complex owner, would suffer lost rental income (consequential damages) if the insurer breached its contractual duties.

This ruling is valuable to insureds because Citizens Property Insurance, a creature of statute, cannot be sued for first-party bad faith.  However, the Fifth District found that the consequential damages in the form of lost rental income did not require the insured to prove the insurer acted in bad faith, but merely, breached the terms of the policy.   This holding can be extended to other breach of contract actions against an insurer when the insured suffered and can prove consequential-type damages caused by the breach. 

Insurance Policy’s Promise to Advance Claims Expense for Covered Claims Does Not Create a Duty to Defend

Christopher Kendrick and Valerie Moore | Haight Brown & Bonesteel | May 7, 2019

In United Farm Workers of America v. Hudson Insurance Company, (E.D. Cal.) 2019 WL 1517568, the United Farm Workers of America union (UFW) sued Hudson Insurance Company for breach of contract and bad faith arising out of a former employee’s wrongful termination and wage and hour lawsuit.

Hudson provided UFW with Labor Professional Liability Insurance that included employment practices liability coverage. Hudson reserved its rights and agreed to pay an allocated share of the defense costs, citing the terms of its policy. UFW and Hudson agreed to a 50-50 allocation and, defending itself, UFW moved to compel arbitration of the employee lawsuit pursuant to its collective bargaining agreement. However, the trial court found that the only claim subject to arbitration was the employee’s wrongful termination claim, which Hudson contended eliminated the sole covered cause of action.

The employee’s complaint was amended to include class action allegations for the statutory wage and hour claims and the case proceeded to trial, resulting in an adverse judgment of $1.2 million. Hudson paid UFW for the allocated share of the defense costs incurred through the dismissal of the sole covered claim, and disclaimed any obligation for the wage and hour award.

Hudson retained Haight, Brown & Bonesteel to defend the company against the subsequent bad faith lawsuit brought by the UFW, which alleged that Hudson wrongfully failed to defend or indemnify the union for the employees’ lawsuit. Besides the $1.2 million wage and hour award, UFW claimed in excess of $800,000 incurred defending itself as damages.

UFW and Hudson brought cross-motions for summary judgment, with UFW seeking summary adjudication on the duty to defend. UFW argued that Hudson had a duty to defend the entirety of the employee lawsuit based on the mere potential for coverage, which was not extinguished by the partial grant of UFW’s motion to compel arbitration. (Citing Gray v. Zurich Ins. Co. (1966) 65 Cal.2d 263; Montrose Chem. Corp. v. Super. Ct. (1993) 6 Cal. 4th 287; and Buss v. Super. Ct. (1997) 16 Cal.4th 35.) UFW argued that Hudson’s failure to do so amounted to a bad faith breach of contract, exposing Hudson to the full amount of the defense costs, the resulting judgment, UFW’s own attorney’s fees for suing Hudson under Brandt v. Super. Ct. (1985) 37 Cal.3d 813, and other damages.

Hudson’s cross-motion for summary judgment asserted that there was no duty to defend under the terms of its policy, which expressly stated that UFW had the duty to defend. Under the policy, Hudson was only obligated to advance defense expenses for covered claims, subject to an allocation based on the respective liabilities and further subject to reimbursement in the event of an uncovered result, none of which translated into a duty to defend. (Citing Jeff Tracy, Inc. v. United States Spec. Ins. Co. (C.D. Cal. 2009) 636 F.Supp.2d. 995; and Petersen v. Columbia Casualty Company (C.D. Cal.) 2012 WL 5316352.) Further, although the employee’s original claim for wrongful termination was a covered claim under the Hudson policy’s definition of Wrongful Employment Practices, Hudson argued that none of the statutory wage and hour claims that remained after wrongful termination was ordered to arbitration came within the policy’s Wrongful Acts, Wrongful Offenses or Wrongful Employment Practices coverages. (Citing California Dairies v. RSUI Indem. Co. (E.D. Cal. 2009) 617 F.Supp.2d 1023.)

Consequently, Hudson contended that its payment after the entry of judgment, limited to an allocated share of the defense expense, and its disclaimer of coverage for the wage and hour award, were entirely proper and not in breach of the contract. In addition, Hudson uncovered the existence of misrepresentations in UFW’s application for the insurance during discovery, which Hudson argued voided the policy. (Citing Imperial Cas. Co. v. Sogomonian (1988) 198 Cal.App.3d 169; and Thompson v. Occidental Life (1973) 9 Cal.3d 904.) Without coverage or a breach of contract, Hudson argued that there could be no bad faith.

The district court agreed with Hudson, denying UFW’s motion for summary adjudication on the duty to defend and granting Hudson’s cross-motion for summary judgment. The court found that there was no duty to defend under the terms of the policy, which imposed the duty to defend on the insured and not the insurer. The court agreed that Hudson’s obligation was limited to payment for the cost of defending claims actually covered by the policy, and the award for wage and hour violations did not come within any of the policy’s coverages. Additionally, the court found that UFW made material misrepresentations in its application for insurance, holding that the contract was void. Because there was no coverage there was no breach of contract, and the cause of action for breach of the implied covenant of good faith and fair dealing had to fail as well, entitling Hudson to summary judgment.

This document is intended to provide you with information about insurance law related developments.The contents of this document are not intended to provide specific legal advice. If you have questions about the contents of this alert, please contact the authors. This communication may be considered advertising in some jurisdictions.

Federal Court Rules Contractor Is Not Intended Third-Party Beneficiary under Owner-Engineer Agreement

Amandeep Kahlon | Buildsmart | April 23, 2019

In March, a Massachusetts federal court addressed whether a design-builder contractor could recover for breach of contract under an intended third-party beneficiary theory against a design firm hired by the project owner to complete 30% designs. In Arco Ingenieros, S.A. DE C.V. v. CDM International Inc., a Salvadoran contractor entered into a design-build agreement with the U.S. government to build eight schools and a health clinic in El Salvador as part of a hurricane relief effort.

The design-build agreement included 30% designs, which were to form the design criteria for the project. The agency had contracted separately with a U.S. engineering firm via a task order to complete the 30% designs. After construction started, the contractor alleged the designs provided by the agency were defective and did not actually constitute 30% designs. Ultimately, the contractor filed suit against the agency and the engineer. As one theory of liability, the contractor claimed to be a third-party beneficiary under the task order between the agency and the engineer. The engineer moved to dismiss the contractor’s complaint arguing that the contractor was not an intended third-party beneficiary under the task order.

The federal court agreed and entered an order dismissing the contractor’s breach-of-contract claim against the engineer. The court reasoned that nothing in the task order evidenced an intent that the engineer’s design work was to benefit the contractor. While the contractor may have been an incidental beneficiary of the task order, the task order language provided that the engineer’s express purpose under the agreement was to provide design services to the government agency only. The statements in the separate design-build agreement that the contractor could rely on the 30% designs produced under the task order did not alter the task order’s intent. The court found this approach consistent with other federal decisions holding that general contractors are generally not intended beneficiaries of owner-architect agreements.

While not surprising, the federal court’s decision in this matter demonstrates the complexity of commercial contract disputes in the construction industry. With owners, engineers, contractors, and subcontractors all entering into different interrelated agreements, there is always potential that a particular contract or subcontract will be detrimentally impacted by another party’s failure to perform under a different agreement on the project. For owners, they can manage these risks by making all downstream parties insert language into their contracts that shows the owner is an intended third-party beneficiary.

For contractors, engineers, and other parties that are more parallel in the contracting hierarchy, it may be more difficult to contract around these risks. A contractor can mitigate this risk by seeking indemnification or other protection from the owner or other direct contractual party for interference, negligence, or delays by non-parties. Additionally, the design-builder contractor here could have considered the 30% designs more closely, rather than relying on the owner’s representations, and the contractor could have requested an opportunity to review the design task order to evaluate the risks of relying on potentially defective design criteria.