Recently, in Crum & Forster Specialty Insurance Co. v. DVO, Inc., Slip Op., Case No. 18-2571 (7th Cir. Sept. 23, 2019) (“Slip Op.”), the Seventh Circuit held that, under Wisconsin insurance policy interpretation principles, an insurer may not avoid its coverage responsibilities by invoking an exclusion that is broad enough to fully encompass the scope of the coverage grant, thus rendering the policy illusory.
The dispute at issue originated from a state court action that WTE-S&S AG Enterprise, LLC (“WTE”) brought against DVO, Inc. (“DVO”), an anaerobic digester design and manufacturing company. WTE alleged that DVO breached a contractual agreement between the parties by failing to properly design and produce a digester. DVO provided notice of the claim to Crum & Forster Specialty Insurance Company (“Crum & Forster”), DVO’s primary and excess liability insurer, under its comprehensive insurance policy that included Errors & Omissions coverage to protect DVO from professional malpractice claims.
After initially providing a defense of the lawsuit under a reservation of rights, Crum & Forster subsequently disclaimed all of its coverage obligations based on language in the policy that excluded from coverage claims or damage “based upon or arising out of” breach of contract. This denial ultimately led to a coverage dispute between the parties, with DVO taking the position that the breach of contract exclusion was unenforceable because it effectively rendered the E&O coverage illusory by broadly encompassing all potential professional liability claims.
The district court rejected DVO’s position, concluding that the breach of contract exclusion would not apply to third-party claims asserted against DVO by entities to which DVO was not in direct contractual privity. Slip. Op. at 3. The district court further held that, even if it accepted DVO’s position that the exclusion as written rendered the coverage illusory, the proper remedy would be to narrow the exclusion to allow coverage for third-party claims, which would not help DVO under the circumstances given that DVO and WTE had a contractual relationship. Id.
On appeal, the Seventh Circuit took issue with both holdings. Regarding the scope of the exclusion, Judge Rovner noted that it expressly applies not only to direct breach of contract allegations, but also to any claim “based upon or arising out of” that contract. Thus, because Wisconsin courts have interpreted such language to broadly apply to any claim originating from, growing out of, or flowing from a contractual breach, including tort claims asserted by third parties (see Great Lakes Beverages, LLC v. Wochinski, 2017 WI App 13, ¶¶ 20-25, 373 Wis. 2d 649), the district court’s more narrow interpretation must be rejected. Slip Op. at 6-8. The court accordingly concluded that the scope of the breach of contract exclusion as written was more broad than the professional liability insuring agreement, thus rendering the E&O coverage illusory. Slip Op. at 10.
Moreover, the Seventh Circuit found that the district court improperly focused on hypothetical third-party claims in asserting that the exclusion simply should be narrowed to not exclude such claims. Rather, the court found that under Wisconsin law illusory insurance coverage must be reformed to meet the insured’s reasonable expectations, which requires a trial court to consider the intended role of the coverage and, under these particular circumstances, a determination regarding whether DVO expected its E&O coverage to apply to liability arising out of negligence, omissions, mistakes, and errors stemming from its professional services. Slip Op. at 11-12.
While the Seventh Circuit ultimately remanded the case to the district court to properly evaluate DVO’s reasonable expectations of coverage, it did note that the breach of contract exclusion was set forth in an endorsement that applied to all of the various coverages offered by the comprehensive liability policy (including CGL, pollution liability, and cleanup costs). The court suggested that a possible reformation would be to find that DVO did not reasonably expect the endorsement to apply specifically to its E&O coverage, as that is the only coverage in the policy that was rendered illusory by application of the exclusion. Slip Op. at 12.
This case is an important reminder that, under settled Wisconsin principles of insurance policy interpretation, insurance policies must (and should) be applied consistently with the insured’s purpose and intent in purchasing the coverage. Insureds should keep these equitable principles in mind when asserting their coverage rights, especially under circumstances where the policy at issue is written on standard coverage forms drafted unilaterally by the insurance industry.