I have long believed and said that the typical professional liability and D&O liability insurance policy contractual exclusion written with the broad “based upon, arising out” preamble sweeps too broadly and precludes coverage for the very kind of claims for which policyholders buy the insurance. The Seventh Circuit has now said what I have long been saying; the appellate court found that the contractual liability exclusion in an E&O insurance policy renders coverage under the policy “illusory” and therefore the policy must be reformed to match the policyholder’s “reasonable expectations.” I hope everyone involved in the professional liability and D&O liability insurance industry will take the time to familiarize themselves with this recent decision. I also hope this decision means the end of contractual liability exclusions using the broad “based upon, arising out of” preamble.

The Seventh Circuit’s September 23, 2019 decision discussed below can be found here.

Background

DVO designs and builds anaerobic digesters that use microorganisms to break down biodegradable materials to create biogas. WTE entered a contract with DVO under which DVO was to design and build an anaerobic digester to be used to generate electricity from cow mature. WTE sued DVO for breach of contract, alleging that DVO failed to fulfill its design duties, responsibilities, and obligations, in that it allegedly did not properly design the various substantial operating systems within the anaerobic digester.

DVO submitted the WTE lawsuit to its E&O insurer. The insurer initially defended the claim under a reservation of rights, but several months later advised DVO that it would no longer provide a defense. The WTE litigation ultimately went to trial, resulting in a judgment in favor of WTE.

The insurer initiated an action seeking a judicial declaration that it does not have a duty to defend or indemnify DVO. The parties filed cross-motions for summary judgment. The insurer argued that coverage for the underlying claim was precluded by the policy’s contractual liability exclusion. DVO argued, among other things, that the contractual liability exclusion rendered coverage under the policy illusory and that the policy should be reformed.

The district court rejected the argument that coverage under the policy was illusory. The district court reasoned that though coverage for professional malpractice would always fall within the exclusion’s coverage preclusion, third parties (that is, non-clients) could still bring tort claims against DVO that would not be precluded by the exclusion. The policyholder appealed the court’s ruling.

The policy’s contractual liability exclusion, which was added to the policy by endorsement, provides in pertinent part that “This Policy does not apply to … any ‘claim’ or ‘suit’ … 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 contracts [sic].”

The September 23, 2019 Opinion

In a September 23, 2019 opinion written by Judge Ilana Rovner for a unanimous three-judge panel, the Seventh Circuit reversed the district court’s ruling and remanded the case for further proceedings.

In taking up the case, the appellate court noted that the parties agreed that the contract exclusion applies to preclude coverage; “the sole issue” in the case is whether the language in the breach of contract exclusion “renders the exclusion broader than the grant of coverage, and therefore renders the coverage illusory.”

In analyzing this issue, the appellate court rejected the district court’s conclusion that coverage is not illusory because the policy, even with the exclusion, still provides coverage for third-party claims. The problem with this conclusion is that “the language in the exclusion at issue here is extremely broad.” Wisconsin courts, the appellate court said, interpret exclusions with the “arising out of language” broadly. Indeed, the appellate court said, Wisconsin’s courts have interpreted this language broadly enough even to preclude coverage for third-party claims.

Wisconsin’s courts have interpreted the “arising out of” phrase broadly enough “to reach any conduct that has at least some causal connection between the injury and the event not covered.” And here, the “event not covered” is “itself quite expansive” as it extends to all contracts “whether express or oral, and even including contracts in law and in fact.” In any event, the court said, “the overlap between claims of professional malpractice and breach of contract is complete, because the professional malpractice necessarily involves the contractual relationship.” The broad “arising out of language” would “exclude all claims of professional liability whether or not brought by third-parties.”

Accordingly, the appellate court said, “we hold that the breach of contract exclusion in this case rendered the professional liability coverage in the E&O policy illusory.”

When a policy’s “purported coverage” is “illusory,” the policy “may be reformed to meet and insured’s reasonable expectation of coverage.” The focus should be “not on hypothetical third-party actions, but on the reasonable expectation of coverage of the insured in securing the policy.”

In that regard, the appellate court said, there is “no reason to believe” that in buying the E&O insurance DVO sought had “only a reasonable expectation that it was obtaining insurance only for claims of professional malpractice brought by third parties.” E&O insurance, the court said (quoting Wisconsin case authority) is designed to insure members of a particular professional group from liability arising out of the special risk such as negligence, [etc.] in inherent in the practice of the profession.”

Accordingly, the contract “should be reformed so as to meet the reasonable expectation of DVO as to the E&O policy’s coverage for liability arising out of negligence, omissions, mistakes and errors inherent in the practice of the profession.” The appellate court remanded the case to the district court for further proceedings so as to “give effect” to DVO’s “reasonable expectation.”

Discussion

It really shouldn’t require the lofty efforts of an august appellate court to declare that the whole point of an E&O insurance policy is to provide coverage for professional malpractice claims and that coverage under a policy that has an exclusion that operates to preclude coverage for a professional malpractice claim of the very type for which the insured purchased the insurance renders the coverage “illusory.”

Nevertheless, the appellate court has said it. And what the appellate court has said here could be said in all contexts and for all professional liability policies – including in particular D&O insurance policies – that have contractual liability exclusions with the broad “based upon, arising out of” exclusions. These exclusions simply sweep too broadly, precluding coverage for the very types of claims for which the policyholders purchase the coverage.

It is particularly important here to note that the appellate court’s conclusion that the exclusion rendered the coverage “illusory” was not based on the exclusion as it was applied – to the contrary, it was based on the exclusion as it was written. That is, the exclusion ON ITS FACE renders coverage illusory.

Some background on this issue in the D&O context seems appropriate here.

There was a time long ago when D&O insurance policies did not have contractual liability exclusions. In those days, the insurers took the position (and may still take the position when working with policies that do not have contractual liability exclusions) that a liability insurance policy does not cover liabilities under taken by contract. D&O policies, the insurers contend, only provide coverage for liabilities imposed “by law,” but not for liabilities that are voluntarily undertaken in a contract.

In the mid 90’s, when D&O policies were rebuilt to include entity liability coverage in addition to the standard individual liability protection, contractual liability exclusions soon became a standard policy feature, in order to make it clear that the policy’s entity coverage did not extend to liabilities undertaken by contract. (The exclusions typically are found only in private company and non-profit organization D&O policies; because public company D&O insurance policies provide entity coverage only for securities claim, there is no need for a contractual liability exclusion because contractual liability claims simply do not fall within the policy’s entity coverage insuring agreement).

The insurers’ original sin is that when they added the contractual liability exclusion they did not draft the exclusion simply to reflect existing law that liability policies do not provide coverage for claims for voluntarily undertaken liability. Instead, the insurers tried to extend the preclusive effect of existing law not only to claims “for” contractual liability, but drafted it overly broadly to reach also to claims “based upon or arising out of” a contract. The effect of this broad wording is, as the appellate court said here, that the exclusion sweeps extremely broadly. Indeed, as the appellate court concluded, the exclusion sweep so broadly that it renders coverage “illusory.”

And the reality is, as so many of us have seen time and time again over the years, that the insurers rely on the contractual liability exclusion to try to deny coverage even for the very kind of claims for which policyholders buy the coverage in the first place.

The point of this digression, and really the point of the appellate court’s decision, is that the contract exclusion in professional liability insurance policies — including D&O liability insurance policies — should be written with a “for” preamble, rather than a “based upon or arising out of” preamble,” in order to ensure that the exclusion does not sweep too broadly and does not render coverage under the policy “illusory.”

I can anticipate the kinds of objections that insurer side advocates will raise to this analysis.

First, they will point out that this exclusion at issue in this case was written even more broadly than the standard contractual liability exclusion, precluding coverage as it does for breaches of contracts “whether express or oral” and whether “implied in law” or “implied in fact.” Yes, yes, this language is unusual and it is broad. But the appellate court did not base its decision on this unusual language; to the contrary, the appellate court’s conclusion that the exclusion is “extremely broad” was not based on the exclusion’s unusual language; rather, the conclusion was based on the exclusion’s all too common “based upon, arising out of” preamble language. Any attempt to try to evade the obvious implications of this decision by trying to rely on the unusual extraneous phrases in the exclusion would be a total red herring – not to mention a complete misreading of the court’s analysis.

I can also anticipate insurers trying to evade the clear impact of this decision by saying that, well, it was under Wisconsin law, and <<shrug>> what does Wisconsin have to do with anything in the real world? To which I say, be kind to Wisconsin, for better or worse, its citizens helped determine the outcome of the last Presidential election. In addition, although Wisconsin’s principles of insurance contract exclusion are perhaps of a greater clarity that the principles under some other jurisdictions’ laws, there is nothing so unusual about Wisconsin law that would render this decision relevant only to disputes to which Wisconsin’s law applies. Anyway, the fact is, the decision was rendered not by some court in the backwoods of Wisconsin. This was a decision by the Seventh Circuit, an important and respected court in the federal judiciary.

So, my friends, here is where we are: It is time to put an end to the contractual liability exclusions with the “based upon, arising out of” language. There is no reason for exclusions with this language to be in a professional liability policy or in a D&O insurance policy except to give insurers a way to try to dodge coverage for claims that they ought to be covering – indeed, to deny coverage for claims that are the very kinds of claims for which their customers buy their insurance product.

I hope policyholder-side advocate out there will join me in saying that from this point forward we will do everything we can to ensure that professional liability insurance coverage – including D&O liability insurance coverage—will not be written on policies with contractual liability exclusions with the broad “based upon, arising out of” wording.

“Aux armes, citoyens/ Formez vos bataillons!”

Are you with me, friends? Then, good, time to man the barricades. From now on, as much as possible, contractual liability exclusions only with the “for” wording.

“Marchons, marchons!”

And once we fix the contractual liability exclusion, we can then move on the professional services exclusion, which has exactly the same fundamental problem as the contractual liability exclusion.

“Le jour de gloire est arrivé!”