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INSURANCE NOTES

Court Enforces Exclusionary Language For Claims "Arising Out Of" Breach Of Contract

11.21.2006
Medill v. Westport Insurance Corporation, 143 Cal.App.4th 819, 49 Cal.Rptr.3d 570 (2006), provides renewed support for the broad application of the terms "based upon, arising out of or in connection with" when used to expand the scope of exclusions.

In the case, Heritage Housing Development, Inc. issued bonds to acquire certain property. Heritage failed to pay on the bonds. A class action lawsuit was brought on behalf of bondholders alleging negligence and breach of fiduciary duties against Heritage's directors and officers and alleging violations of the Exchange Act of 1934 and similar state law. The indenture trustee also filed suit, asserting breach of fiduciary duties, negligence, fraudulent concealment of misfeasance and malfeasance.

Westport had issued a liability insurance policy to Heritage that provided coverage for "loss" because of "Wrongful Acts." "Wrongful Acts" was defined to include "any actual or alleged error or omission, negligent act, misleading statement or breach of duty." The policy included a "duty to defend" clause.

Westport agreed to defend the directors and officers subject to a reservation of rights and sought a judicial declaration as to its rights and duties. Westport brought a motion for summary judgment, and the trial court determined Westport had no duty to defend the directors and officers. The Court of Appeal affirmed the judgment for Westport.

The claims against the directors and officers involved allegations of "Wrongful Acts," including negligence and breach of fiduciary duty. Thus, at least at first blush, there appeared to be potential coverage under Westport's policy.

However, the Court held there was no coverage based on the definition of "loss" as well as certain exclusions. "Loss" was defined to exclude damages "arising out of breach of any contract." The policy further excluded claims "arising out of" Securities Act or Securities Exchange Act violations and for failure to pay on financial instruments. "Arising out of" was defined in the policy as "based upon, arising out of, or in connection with."

Before Medill, two cases discussed breach of contract exclusions under California law in the context of errors and omissions insurance. In one case, Southgate Recreation & Park Distr. v. California Assn. for Park & Recreation Ins., 106 Cal.App.4th 293, 130 Cal.Rptr.2d 728 (2003), subcontractors who had not been paid by a general contractor sued Southgate for negligence and breach of statutory duties in the administration of construction contract funds. The insuring documents excluded liability "arising out of" construction contracts. Southgate argued it had no contracts with the subcontractors and the exclusion thus was not applicable. The Court disagreed, reasoning that the "arising out of" language in the exclusion was broad enough to exclude the claims, whether or not Southgate was a contracting party.

The other case resulted in a different conclusion. In Church Mutual Ins. Co. v. U.S. Liability Ins. Co., 347 F.Supp.2d 880 (S.D.Cal. 2004), a contractor claimed that the insured made false representations about the quality of the work performed by the contractor, attempted to interfere with the contractor's work, and fraudulently induced the contractor to reduce its invoices for its work. The contractor asserted claims of fraud, breach of contract and emotional distress. The court first determined that the exclusion for any claim "arising out of . . . breach of contract" in the liability policy conflicted with the grant of coverage for "Wrongful Acts," defined as including "any actual or alleged act, error, omission, misstatement, misleading statement, neglect or breach of duties."

The Church Mutual court further concluded that the allegations that the insured fraudulently caused the contractor to reduce its invoices were independent of the breach of contract and were not excluded by the "breach of contract" exclusion.

The Medill Court discussed both Southgate Recreation and Church Mutual and concluded that the "breach of contract" exclusionary language in the Westport policy was not ambiguous. The Court determined that the negligence and breach of fiduciary duty claims against the directors and officers were not independent of the breach of contract. The Court rejected the argument that the asserted "noncontract" claims were concurrent independent causes of the loss, as those claims existed because of the failure to pay the bonds. The Medill Court observed that like in Southgate, there would be no potential director and officer liability without the underlying contracts.

As to the exclusion for claims arising out of violation of the Securities Act of 1933 or the Exchange Act of 1934 in the Westport policy, the directors and officers in Medill argued that the exclusion did not apply because the individual officers and directors did not issue the bonds. The Court rejected the argument, noting that the exclusion involved securities issued by "any" insured, which included Heritage. In other words, application as to one insured meant coverage was excluded as to all insureds.

The Medill Court also found that the exclusion for claims "arising out of" the failure to honor or pay financial instruments was broad enough to exclude coverage for the officers and directors, even though they had no personal obligation to pay the bonds. The insureds argued that coverage was illusory if "arising out of" was construed so broadly. The Court disagreed, noting the policy provided coverage for other activities of Heritage unrelated to the issuance or payment of bonds.

In sum, Medill provides support for the broad application of exclusions that use "based upon, arising out of, or in connection with," whether in restrictions on the coverage grant or in exclusions. Medill also provides very useful support for enforcing "breach of contract" exclusions, even where tort theories are asserted if the claims asserted are not factually independent of the underlying contract.

 

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