Insurance company’s duty to defend and indemnify contractor against owner’s breach of contract claim. Crum & Forster Specialty Insurance Co. v. GHD Inc. United States Court of Appeals for the Seventh Circuit (2019), by Hugh Anderson

Summary: DVO Inc. (formerly GHD) is in the business of designing and constructing anaerobic digesters, which use microorganisms to break down materials in the absence of oxygen. This creates biogas, which can be used to generate electricity. DVO entered into a contract with a private owner, WTE, to design and build such a digester in Door County, Wisconsin, for use in processing cow manure. WTE subsequently brought a lawsuit against DVO, based on breach of contract. After WTE went bankrupt, its successors in interest continued to pursue the claim, and after a trial WTE’s successors were awarded $65,000 in damages and $198,000 in attorneys’ fees.

The contract was an unspecified EJCDC standard contract—perhaps a design-build contract, or a modified construction contract or professional services agreement. The contract contained insurance requirements, which DVO met. One requirement was to carry professional liability insurance, referred to in the case as E & O coverage. The E & O policy issued by Crum & Forster protected DVO against claims arising from the rendering of professional services. However, the policy also excluded coverage of claims arising from breach of contract.

Crum & Forster filed a complaint in the United States District Court, Eastern District of Wisconsin, seeking a declaration that it did not have a duty to defend or indemnify DVO, because the claim was based on breach of contract. DVO’s primary defense was that the contract exclusion, if applied literally, would swallow the rule—all of its services were being rendered under contracts. If there was no coverage for contract errors, the policy was “illusory” in that no benefits were gained by the purchase of the policy.
The federal district court agreed with the insurance company. Based on the plain words of the exclusion, the district court declared that the insurance company had no duty to defend or indemnify DVO against the owner’s breach of contract claim.

The court concluded that if the claim was by a third party, such as a neighbor injured by an explosion, the exclusion would not apply, and DVO would have coverage; thus the policy was not illusory. The district court explained:

The manifest intent of the breach of contract exclusion is to avoid making Crum & Forster a guarantor of DVO’s contractual obligations. Crum & Forster agreed to insure DVO against liability it incurred to third parties for its negligent error or omissions; it chose not to insure DVO for liability it incurred to its own customers for failing to meet its contractual obligations. DVO appealed the adverse ruling to the United States Court of Appeals, Seventh Circuit.

Decision: The Seventh Circuit reversed the district court’s ruling. The appellate court defined the “sole issue” as:
…whether the language in that breach of contract exclusion renders the exclusion broader than the grant of coverage, and therefore renders the coverage illusory. “[I]llusory policy language defines coverage in a manner that coverage will never actually be triggered.”

The district court had concluded that the E & O coverage was not illusory because third-party claims would be covered. The Seventh Circuit disputed that conclusion, holding that the contract exclusion was extremely broad and would have barred any coverage for third-party claims, because even they would have “arisen from” the insured’s contractual services. Thus, the exclusion was indeed broader than the E & O coverage—the coverage was therefore illusory.

The Seventh Circuit then explained that when an insurance policy’s coverage is held to be illusory, the next step is to reform the policy to meet the insured’s reasonable expectation of coverage. The case was remanded to the district court for a determination of what DVO’s reasonable expectations had been, but in doing so the Seventh Circuit steered the lower court to find that the coverage was intended to apply to client claims as well as third-party claims:

There is, after all, no reason to believe that DVO in purchasing Errors and Omissions coverage to provide insurance against professional malpractice claims had a reasonable expectation that it was obtaining insurance only for claims of professional malpractice brought by third parties.

Comment: Most professional liability policies for design professionals will cover breach of contract claims by the A/E’s clients—as the Seventh Circuit noted, this is a basic expectation of the design professional when it purchases such coverage. It is also the expectation of the client that requires professional liability coverage, and of the insurance companies that regularly serve the design professions.

Although it is common for professional liability policies to exclude claims based on express warranties, or claims arising from certain contractual commitments that exceed common law obligations, these exclusions are narrow in focus and can be avoided when entering into the owner-A/E contract—for example, by including a professional standard of care that disclaims any elevated warranties. The EJCDC professional services agreements feature such standards of care.