Professional liability policy “arising out of” breach of contract exclusion renders E & O coverage illusory

The Seventh Circuit (Judges Bauer, Rovner, and Hamilton), applying Wisconsin law, reversed the district court’s ruling that had held professional liability coverage in an Errors & Omissions (“E&O”) policy was not rendered illusory when read with breach of contract exclusion endorsement because the professional liability coverage would still apply to third party claims.  According to the Seventh Circuit, the policy language was illusory because the endorsement excluded coverage for claims “arising out of” breach of contract, which when broadly construed would exclude all claims for professional liability whether or not brought by third parties.

GHD Inc., n/k/a DVO Inc. (“DVO”) designs and builds anaerobic digesters, which use microorganisms to break down biodegradable materials to create biogas.   DVO and WTE-S&S AG Enterprise, LLC (“WTE”) entered into a contract under which DVO was to design and build an anaerobic digester for WTE.  The digester was 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 resulting it substantial damages.  WTE sought over $2 million in damages and fees.

DVO tendered the claim to its insurer, Crum & Forster Specialty Insurance Company (“Crum”).  Crum issued primary and excess policies to DVO for the relevant time period providing coverage for commercial general liability coverage, pollution liability coverage, E&O coverage, third party pollution coverage, and onsite cleanup liability coverage.  Crum initially provided a defense to DVO under a reservation of rights, but later advised DVO that it would no longer be defending.  Following a trial, the court found in favor of WTE and ordered DVO to pay over $65,000 in damages and $198,000 in attorney’s fees.

Crum sought a declaration that it did not have a duty to defend DVO against WTE’s claims.  The coverage dispute concerns two policy provisions.  The first is in the E&O professional liability coverage, under which Crum is required to pay “those sums the insured becomes legally obligated to pay as ‘damages’ or ‘cleanup costs’ because of a ‘wrongful act’ to which this insurance applies.”  “Wrongful act” is defined to include a failure to render professional services, and “professional services” is defined as “those functions performed for others by you or by others on your behalf that are related to your practice as a consultant, engineer, [or] architect … .”  The second relevant provision an endorsement which excludes coverage for claims “based upon or arising out of” breach of contract.  According to DVO, the breach of contract exclusion is so broad that it renders the E&O professional liability coverage illusory, and therefore cannot be enforced to preclude the duty to defend.  The District Court found in favor of Crum and held that the professional liability coverage was not illusory because it would still apply to third party claims.

The Seventh Circuit disagreed.  The issue on appeal was “whether the language in the breach of contract exclusion renders the exclusion broader than the grant of coverage, and therefore renders the coverage illusory.”  The Seventh Circuit found the exclusion language to be “extremely broad” because it includes claims “based upon or arising out of” the contract, and thus includes “a class of claims more expansive than those based upon the contract.”  Under Wisconsin law, the term “arising out of” is to be broadly construed and has been interpreted to reach any conduct that has at least some causal relationship between the injury and the event not covered, which includes third-party claims when so related:  “Given that broad language, the exclusion would include even the claims of third parties.  As to those third parties, the claims of professional negligence will fall within the contractual exclusion because they necessarily arise out of the express, oral or implied contract under which DVO rendered the professional services.”

Thus, the Seventh Circuit held that the breach of contract exclusion rendered the professional liability coverage illusory.  Under Wisconsin law, when a policy’s purported coverage is illusory, the policy may be reformed to meet an insured’s reasonable expectation of coverage.  However, the Seventh Circuit did not determine what reformation was appropriate because DVO did not file a cross motion of summary judgment.  “The district court on remand may consider DVO’s reasonable expectations in securing the coverage, and can reform the contract so as to give effect to that expectation.  The focus, however, must be on that reasonable expectation, which was upended by the breach of contract exclusion that rendered it illusory.”  Crum & Forster Specialty Ins. Co. v. DVO, Inc., formerly knowns as GHD, Inc. No. 18-2571 (7th Cir. Sept. 23, 2019).