A liability insurance policy is not intended to provide policyholders a means to shift to the insurer their separate, voluntarily undertaken contractual obligations. Private company D&O insurance policies generally embody this principle in a separate exclusionary provision. However, the wording of the exclusionary clause can substantially affect the scope of coverage otherwise available under the policy. In particular, the expansive reading given certain exclusionary language in recent cases suggests that a more narrowly constructed exclusion would more appropriately address the concern that the provision was originally intended to address.
Long standing case law establishes that liability insurance policies do not cover breach of contract claims, because a contractual duty is not a liability imposed by law but is rather a voluntarily undertaken obligation. By way of illustration, a debtor ought not to be able to borrow funds, neglect to repay the debt, and then shift the repayment obligation to an insurer.
While these case law principles are well-established, some years ago private company D&O insurers nevertheless began to insert express contract exclusions in their policies. In part the insertion of the contract exclusion was intended to address the recurring policyholder objection that the policy does not say that it will not cover contractual liability. The insurers also wanted policy language to try to address recurring problems presented by claims against insured companies that sound both in contract and in tort (e.g., a complaint that asserts both a breach of contract claim and a claim for tortious breach of contract).
In addressing these issues, some carriers have adopted broadly worded exclusionary language. For example, one leading carrier’s private company D&O insurance policy contract exclusion precludes coverage for claims "based upon, arising from, or in consequence of any actual or alleged liability of an Insured Organization under any written or oral contract or agreement provided that this exclusion… shall not apply to the extent that an Insured Organization would have been liable in the absence of the contract or agreement."
As an important aside, most public company D&O insurance policies typically have no contract exclusion, for the simple reason that the company (or "entity") coverage provided in most public company D&O insurance policies is limited exclusively to Securities Claims. Because contract claims are not within the scope of entity coverage provided in the typical public company policy, there is no need to exclude contract claims. The contract exclusion (in some form) is, however, a relatively standard part of most private company D&O insurance policies because the entity coverage afforded under the private company policy is more expansive and is not restricted merely to a single category of claims.
While most private company D&O insurance policies have some form of contract exclusion, not all policies have adopted the more expansive exclusionary language of the type illustrated in the example quoted above. The scope of language in the exclusion can substantially affect the extent of coverage available under the policy; in particular, courts have applied a broadly preclusive interpretation to the expansive exclusionary language of the type quoted above.
Recent Case Examples
Spirtas: In an April 2008 opinion (here), the Eighth Circuit affirmed an Eastern District of Missouri opinion granting summary judgment on behalf of a D&O insurer on the basis of the applicable policy’s contract exclusion.
The insured, Spirtas Company, had entered a contract to perform construction contract demolition work. The project manager later sued Spirtas claiming that it had not performed the demolition work properly and had failed to use funds the project manager had supplied Spirtas to pay subcontractors and suppliers. The complaint alleged breach of contract, breach of express or implied trust, conversion and unjust enrichment. Spirtas sought coverage for the claims under its D&O insurance policy.
The D&O insurer denied coverage in reliance on a policy exclusion that, in pertinent part, precluded coverage "based upon, arising from or in consequence of any actual or alleged liability of an Insured Organization under any written or oral contract or agreement." In the ensuing coverage litigation, the district court granted the insurer’s motion for summary judgment holding that the underlying cause of action, including the tort claims, arose from Spirtas’s obligations under the demolition contract.
The Eighth Circuit affirmed, holding that the contract exclusion "applies to claims sounding in tort as long as they flowed from or had their origins in the breach of contract." The Eighth Circuit made it clear that its conclusion was reinforced by the broad scope of the exclusion’s "arising from" language.
GE HFS: The difficulty with the breadth of scope given the "arising from" language in this context is that it potentially lacks a logical stopping point. A 2007 opinion in the GE HFS case in the District of Massachusetts illustrates the how broadly this expansive reading just might extend. (The magistrate’s report and recommendation, which was subsequently adopted by the district court, can be found here; this post refers to the magistrate’s report and recommendation.)
In the GE HFS case, a home health care company had a line of credit in which the company was obliged to provide the lender certain status reports, upon which the lender relied in advancing additional credit. After receiving reports and advancing funds, the lender claimed the company had overstated its assets, as a result of which it had overextended the credit. The company went bankrupt. The lender sued certain of the company’s directors and officers.
The lender’s complaint, by its own terms, sought damages from the individual defendants for "negligent misrepresentations…with respect to collateral available to satisfy loans." The complaint also sued certain of the individual defendants for breach of contract on a personal guaranty. (There was no contention that the claims based on the personal guarantees were covered under the policy.) According to the magistrate in the coverage action, the "crux" of the lender’s complaint is its allegation that the individual defendants in the underlying action "failed to exercise reasonable care and competence in the preparation and communication" to the lender, as a result of which the receivables collateral were overstated and the lender advanced more money than it would have if the reports had been accurate.
The coverage case involved one of the individual defendants, Ingoldsby, who asserted among other things that the underlying complaint did not allege that he had prepared or compiled the disputed reports, and therefore that the claim against him was in effect a claim for negligent supervision or mismanagement, rather than misrepresentation. Indeed, the magistrate assumed for purposes of its opinion that the claim against him was for "negligent supervision."
The D&O insurer nevertheless denied coverage for Ingoldsby’s defense expenses on the basis of the applicable policy’s contract exclusion. The exclusion precluded coverage for claims "alleging, arising out of, based upon or attributable to any actual or alleged contractual liability of the Company or any other Insured under any express contract or agreement."
The magistrate found that the "arising out of" language "must be read expansively," holding that because the "allegedly wrongful conduct" was "dependent upon and in furtherance of" the loan, the loan "provided more than context: the entire claim was based upon the performance under the contract." Because the "allegedly wrongful conduct was part and parcel of performance under the contract," the contract exclusion applied.
The court also rejected the Ingoldsby’s argument that "the exclusion is void as it excludes virtually all types of coverage." The magistrate found that "misrepresentations may occur in a business setting yet not be related to a contractual duty."
The outcome in the GE HFS case may be entirely appropriate give the facts and the contractual language involved, but the practical consequences of the case should not be overlooked. The court denied coverage for an individual director and officer for a negligent supervision claim, because of the relation of the claim to the underlying contract and because of the breadth of the contract exclusion.
The troublesome thing about the breadth of the preclusionary effect applied in these cases is that some type of transaction is at the heart of many claims under a private company D&O insurance policy. The danger is that insured individuals could find themselves facing claims of a kind that might well have assumed would be covered (say, for example, a negligent supervision claim), because of the involvement in the claim of an underlying transaction and because of the expansiveness of the D&O insurance policy’s contract exclusion.
Which brings me to the ultimate point– that is, the real problem here may be the expansiveness of the preamble to the exclusion. Clearly, the use of the broad "based upon" and "arising out of" language was instrumental in the two cases discussed above.
The court in the GE HFS case more or less recognized this when it acknowledged that "the coverage provided by the policy at issue… may be more limited than other available D&O policies." The inverse of this statement is, of course, that coverage provided by other policies is less limited. While that does not necessarily mean that a differently worded policy would have covered the claims at issue in the GE HFS case, the differently worded policy would not be as "limited."
My own observation is that carriers whose policies have the broad preamble language in the contract exclusion of the type discussed above perceive that coverage under their policies is indeed limited, demonstrating that as a practical matter there may be no logical stopping point in interpreting the coverage restrictions created by an expansive exclusionary provision.
By significant contrast, certain carriers’ private company D&O insurance policies have contract exclusions that do not use the broad omnibus "based upon" or "arising out of" preamble language. Rather, these carriers’ policies use the more restricted "for" wording.
Given the extent of the preclusive effect that courts have found in interpreting policies with the broad omnibus wording, policy forms using the narrower "for" wording are, in this respect at least, clearly superior from the policyholder’s perspective, particularly if carriers whose policies have the broader wording choose (as some are now doing) to try to apply the exclusion to preclude a wide swath of otherwise covered claims, including not just contract claims against entities but tort claims against individuals.
Indeed, I would argue that the "for" wording is much closer to the original purposes for the inclusion of the contract exclusion in private company D&O insurance policies – that is, an exclusion with the "for" wording makes it clear that insurers do not intend to pick up the insured company’s contractual liability, without extending the potential preclusive effect, for example, to tort claims against individuals.
Many prospective insurance buyers would be surprised indeed to learn that their prospective insurer intended to take the position that their policy would not cover even defense expense for, say, a negligent supervision claim if the claim also involves an underlying business transaction. Indeed, I suspect that many D&O underwriters would be surprised to learn that the claims handling counterparts would take such a position.
The use of the "for" wording in the contract exclusion provides at least some assurance that these reasonable expectations will not later be defeated by a reading of the contract exclusion that is so broad that is arguable defeats coverage for claims that might reasonably be presumed to be covered.
One final note. I want to acknowledge that my thoughts on this topic were triggered by the excellent November 2008 PLUS Journal article by Joseph A. Bailey III of the Drinker Biddle law firm entitled "Trio of Recent Cases Affirms Broad Scope of Contract Exclusion" (here). I hasten to add that the views expressed in this post are exclusively my own.