Illusory Coverage Leads to Potential Policy Reformation

By Don R. Sampen, published, Chicago Daily Law Bulletin November 5, 2019

The 7th U.S. Circuit Court of Appeals recently held that a contractual liability exclusion in an endorsement rendered illusory the professional liability coverage for a product designer, possibly requiring reformation of the policy.

The insurer in Crum & Forster Specialty Insurance Co. v. DVO Inc., 2019 U.S. App. Lexis 28714 (7th Cir., Sept. 23, 2019), was represented by Von Briesen & Roper S.C. of Milwaukee. The Weiss Law Office S.C. of Mequon, Wis., represented the insured, DVO.

DVO contracted with WTE-S&S AG Enterprises LLC in Sturgeon Bay, Wis., to design and build an anaerobic digester, which was to be used to generate electricity from cow manure. DVO breached the contract and WTE sued in state court and obtained a damage judgment.

Crum issued primary and excess policies to DVO, providing, among other coverage, commercial general liability and professional liability coverage, the latter being a part of the errors and omissions section of the policy.

Specifically, the errors and omissions coverage obligated Crum to pay damages for a “wrongful act,” which was defined to include the failure to render “professional services,” that term, in turn, defined as functions relating to DVO’s practice as a consultant, engineer or architect.

The policy, however, also contained an endorsement excluding coverage for damages “arising out of” a breach of contract.

Crum initially provided a defense to DVO for the lawsuit filed by WTE under a reservation, but later advised that it would no longer defend. Crum then brought this declaratory action seeking a determination that it had no duty to defend DVO. The U.S. District Court entered summary judgment in favor of Crum, and DVO filed this appeal.

Analysis

In an opinion by Judge Ilana Diamond Rovner, the 7th Circuit reversed. She characterized the “sole issue” in the appeal as “whether the language in that breach of contract exclusion renders the exclusion broader than the grant of coverage” for professional services. If so, she said the coverage would be rendered illusory, in which case reformation of the policy may be in order.

She noted, as an initial matter, that Wisconsin law, which applied to this litigation, rejected the argument that insurance liability was dependent on a theory of liability. Thus, claims of negligence in the failure to provide competent professional services could give rise to both tort and contract claims. As a result, even a claim that purported to be based in tort could be excluded under the breach of contract exclusion if it arose out of that contract.

Rovner further observed that the district court had rejected the argument that the coverage was illusory. It did so on the theory that third parties could still bring tort claims against DVO for negligent professional services and those claims would not fall within the contract exclusion.

She found that position unavailing, however. It was unavailing because the term “arising out of” is broadly construed under Wisconsin case law. Thus, it reaches any conduct that has at least some causal relationship between the injury and the event not covered. As a result, the exclusion would apply even as to claims of professional negligence by third parties, because they necessarily “arise out of” the contract under which DVO rendered the professional services.

Based on this reasoning, Rovner found that the breach of contract exclusion rendered the professional liability coverage in the errors and omissions policy illusory. Because it did so, the policy was potentially subject to being reformed. The benchmark for reforming as to the contract clause, however, was not necessarily — as the district court suggested — bringing third-party tort claims within the scope of the policy, which would not result in coverage for DVO.

Rather, Rovner said, the policy should be reformed so as to meet the reasonable expectations of DVO for liability arising out of negligence in the practice of the profession. Nonetheless, since DVO had not filed a cross-motion for summary judgment, the precise scope of the reformed policy should be left to the district court on remand.

The 7th Circuit, therefore, reversed and remanded for a determination by the district court on the terms of reformation.

Key points

• A contractual liability exclusion for claims “arising out of” breach of contract applies to tort claims growing out of contract performance.
• To reform an insurance policy based on a finding that the policy provides illusory coverage, the reformation should be based on the reasonable expectations of the insured.