Policy exclusions with the broad “based upon or arising out of” sometimes may be applied very broadly to sweep beyond the claims that the exclusion aimed to exclude. In a recent coverage dispute, a professional liability insurer sought to apply an exclusion with the broad preamble language and precluding coverage for ERISA and securities law claims in order to preclude coverage even the common law and bankruptcy law claims alleged against the insured. In a February 7, 2020 opinion (here), Eastern District of Michigan Judge Laurie J. Michelson, applying Michigan law, concluded that the exclusion’s preclusive effect did not apply to the common law claims, because the insurer failed to establish the exclusion’s required causal connection between the alleged statutory violations, on the one hand,  and the common law and bankruptcy law claims, on the other hand.  Judge Michelson’s opinion provides an interesting perspective on exclusions with the broad “based upon and arising out of” preamble language.



Stout Risius Ross is a financial advisory firm that was retained by the Trustees of the Appvion Retirement Savings and Employee Stock Ownership Plan (Appvion ESOP) to provide an annual independent valuation, as required by ERISA,  of the of the stock of Paperweight Development Corp. Appvion later went bankrupt and the Appvion ESOP suffered financial losses.


Stout was named as a defendant in two separate lawsuits relating to the Appvion collapse. First the Appvion ESOP sued Stout, alleging that Stout negligently or fraudulently appraised and overstated the value of the ESOP’s stock, which contributed to Appvion’s bankruptcy and to the ESOP’s corresponding losses. The Appvion ESOP’s lawsuit contains five counts: (1) knowing participation in breaches of fiduciary duty, pursuant to ERISA; (2) fraud; (3) negligent misrepresentation; (4) Wisconsin securities fraud; (5) federal securities fraud.


Stout was also sued by the co-trustees of the Appvion Liquidating Trust, who alleged that Stout’s flawed valuation of Paperweight stock contributed to the plaintiffs’ financial losses and that Stout received greater payments than it was entitled to. The Appvion Trust action has three counts against Stout: (1) aiding and abetting breaches of the fiduciary duties of care and loyalty; (2) avoidable preference; and (3) avoidable transfer.


Stout sought coverage for the actions from its professional liability insurer. The insurer agreed to defend Stout subject to a reservation of rights, and separately filed an action seeking a judicial declaration that it does not have a duty to defend or indemnify Stout. Stout filed a motion for partial summary judgment, arguing that Exclusion F of the policy precluded coverage for both of the underlying lawsuits.


The Relevant Exclusion and the Parties’ Arguments Regarding the Exclusion

Exclusion F provides in relevant part as follows:

This Policy does not apply to any Claim … based on or arising out of actual or alleged violation of … (1) The Employee Retirement Income Security Act of 1974; (2) The Securities Act of 1933; (3) The Securities Act of 1934; (4) Any state Blue Sky or Securities law; … or any rules, regulations or amendments inssue in relation to such acts, or any similar state or federal statutes or regulations, including any Claim based on common law principles of liability.


In arguing that Exclusion F precluded coverage for every count of the two underlying claims, the insurer basically made two arguments, both of which support its contention that each claim alleged is “based on or arising out of” either an ERISA violation or a securities law violation: all of the claims relate to Stout’s provision to the ESOP of valuations that are required under ERISA; all of the claims, including even the common law claims, arise out of the same facts as the claims alleging violations of ERISA and of the securities laws.


Stout argued that the exclusion was ambiguous, and that in any event the various common law claims did not arise out of “violations” of ERISA or of the securities laws.


The February 7, 2020 Opinion

In her February 7, 2020 opinion, Judge Laurie Michelson, applying Michigan law, denied the insurer’s motion for partial summary judgment, holding that the insurer had failed to meet its burden of establishing as a matter of law that it has not duty to defend the underlying actions.


In reaching this conclusion, Judge Michelson addressed Stout’s argument that Exclusion F is ambiguous. Judge Michelson said that “although the precise definition of ‘based upon or arising out of’ could be articulated in different ways, the phrase is not ambiguous such that it is susceptible to more than one meaning.”  The “essence of the phrase” is that there must be a “cause-and-effect relationship.” So that “for a claim to be based on or arising out of a legal violation, the legal violation must cause the claim to occur.”


Judge Michelson then turned to the specific claims alleged in the two lawsuits, starting first with the claims alleged in the Appvion ESOP action, noting that the plaintiff in that action alleged claims of common law fraud and negligent misrepresentation, as well as alleged violations of ERISA and of the securities laws. The insurer argued that Exclusion F’s broad “based upon or arising out of” preamble was broad enough to preclude all claims that arise out of the same set of facts.


Judge Michelson rejected this argument, noting that “under a commonsense reading of the language of Exclusion F, for a claim to be excluded it must be based on or arise out of a violation of ERISA or securities law.”(Italics in the original.)  In other words, “a violation of ERISA must have caused Stout to commit negligence and/or fraud.” Though, with reference to ERISA’s annual valuation requirement, the insurer was able establish how the common law claims arise out of ERISA, “it does nothing to explain how the counts arise out of an ERISA violation.” (Italics in the original.)


Nor is it sufficient, Judge Michelson said, to establish the applicability of the exclusion that the common law and the Securities law violation arise out of the same underlying factual scenario, as the insurer has not alleged that Stout’s alleged common law fraud or negligent misrepresentation arose from a securities violation; it is instead, she said, “more likely that the alleged securities violation arose from the fraud or negligent misrepresentation.”


Finally, with respect to the Appvion Trust action, Judge Michelson said that the insurer’s argument that Exclusion F precludes all of the claims alleged is “subject to the same flaw.” Two of the Appvion Trust claims alleged bankruptcy specific causes of action for avoidable preference and avoidable transfer, having to do with Stout’s alleged payment of excessive fees for the valuation services in the run-up to bankruptcy. The “only connection” between these counts and ERISA is that Stout was hired to do valuations required by ERISA. Judge Michelson said “any connection between these bankruptcy counts and an alleged ERISA violation by Stout or any of the plan fiduciaries is too remove to establish that the claims are based on or arising out of an ERISA violation.”



Regular readers know that I have a problem with exclusions built on the broad “based upon or arising out of” formulation, as all too often these exclusions are applied far too broadly to preclude coverage even for claims that are of the very type for which the policy was procured in the first place.


Here, the equivalent exclusion built with the “for” wording rather than the broad preamble would have accomplished the insurer’s intended purpose of assuring that its professional liability policy does not pick up coverage for ERISA and securities law claims. But with the exclusion’s broad preamble wording, the insurer tried to apply the exclusion even to preclude coverage for claims that were not based on those statutes and that indeed could have been asserted in complaints without any reference to ERISA or the securities laws.


Judge Michelson broke down the language in the exclusion in a way that avoided this overbroad application of the exclusion. First she determined that the exclusion’s broad “based upon or arising out of” preamble establishes a causal connection between the claim sought to be excluded and claims based on ERISA or the securities laws. Next, she determined that the causal connection must be based on a violation of ERISA or of the securities laws; the claim sought to be excluded must be based on a violation of ERISA or the securities laws. The fact that the annual valuation was performed pursuant to an ERISA requirement did not establish that the common law claims arose form a violation of ERISA.


Anyone temporarily puzzled about how a separate claim would be based on or arise from a violation of ERISA or the securities laws would do well to contemplate Judge Michelson’s observation about the relationship between the common law claims and the securities law claims. She said that the alleged fraud and negligent misrepresentation claims did not arise from the alleged securities violations; instead, she said, it is likelier that the securities law violations arose from fraud or negligent misrepresentation – which, when you stop and think about it for a minute, makes sense, and shows how there could be causal connections between alleged legal violations.


Where so many carriers get carried away in claims denials is to try to extend an exclusion’s preclusive effect to sweep beyond clearly excluded claims to try to reach claims that are not clearly excluded. Carriers seem particularly inclined to try to do this when the relevant exclusion has the broad “based upon, arising out of” preamble, which is yet another reason to prefer exclusions with the “for” wording rather than the broader wording. But even with respect to exclusions with the broader wording, Judge Michelson’s “commonsense” reading of the exclusion, requiring as it does a causal connection between alleged legal violations, appropriately limits the preclusive effect even of broadly worded exclusions only to the matters the exclusion sought to preclude in the first place.