Seventh Circuit Court of Appeals Holds Breach of Contract Exclusion in E&O Policy Unenforceable

In a recent opinion in Crum & Forster Specialty Insurance Co. v. DVO, Inc.,[1] the United States Court of Appeals for the Seventh Circuit considered whether a breach of contract exclusion in an errors and omissions insurance (“E&O”) policy eliminated coverage for a breach of contract claim related to an improper design.  The Seventh Circuit held the breach of contract exclusion rendered coverage under the policy illusory and therefore the exclusion was not enforceable.

The insurance coverage dispute arose from an underlying case in which an engineering firm was sued for breach of contract for failing to properly design an anaerobic digester.  The engineer had a liability insurance policy which included E&O coverage among other types of coverage, and the engineer tendered the claim to that insurer.  The insurer refused to defend the engineer, and the claims against the engineer proceeded to trial where the engineer was found liable.  The insurer filed a declaratory judgment action as to whether the claim was covered under the E&O policy.  After the lower court entered summary judgment in favor of the insurer, the Seventh Circuit reversed the judgment on appeal.

The engineer and insurer agreed that the conduct giving rise to the breach of contract claim in the underlying suit came within the professional malpractice coverage of the E&O policy.  The parties also agreed that a breach of contract exclusion in the policy eliminated coverage for the breach of contract claim in the underlying suit.  The breach of contract exclusion provided that the policy did not cover any claim “based upon or arising out of breach of contract.”  The parties’ sole disagreement was whether that breach of contract exclusion rendered the E&O coverage illusory and therefore whether the exclusion was enforceable.

Looking to Wisconsin insurance law, the Seventh Circuit stated that illusory insurance policy language is language that defines the policy’s coverage in such a way that the coverage can never actually be triggered.  Where policy language is illusory, a court can reform the language to conform with the insured’s reasonable expectations of coverage.

Below, the lower court had found the language was not illusory because the policy would still provide coverage for claims by third-parties who had no contractual relationship with the insured.  The Seventh Circuit disagreed, finding the exclusion’s use of the “arising out of” language rendered the exclusion so broad as to cover claims by third-parties and thereby eliminate all E&O coverage.  The Court reasoned that any work by an engineer will be pursuant to a contract and therefore, given the broad effect of the “arising out of” language, any claim against the engineer would be barred by the exclusion and coverage would be illusory.

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[1] Crum & Forster Specialty Ins. Co. v. DVO, Inc., 939 F.3d 852 (7th Cir. 2019).