Breach of contract exclusions in commercial general liability (CGL) policies typically eliminate coverage for “‘personal and advertising injury’ arising out of a breach of contract,” with exceptions for “misappropriation of advertising ideas under an implied contract” (in the 1986 Insurance Services Office (ISO) policy) or “an implied contract to use another’s advertising idea in your ‘advertisement’” (in the 2017 ISO policy).
In a directors’ and officers’ (D&O) or errors and omissions (E&O) policy, the language can vary. For example, one such policy states that the insurer “shall not be liable for Loss on account of any Claim against an Organization . . . based upon, arising from or in consequence of any liability in connection with any oral or written contract or agreement,” with an express exception allowing coverage if the policyholder “would have been liable in the absence of such contract or agreement.”
The existence of a contract does not place a claim within a contract exclusion. Courts generally conclude that the mere existence of a contractual relationship between the parties in litigation is insufficient to bar coverage under any “breach of contract” exclusion, no matter how broadly they define the “arising out of” provision at issue. This is especially the case where the policy provides an exception to any breach of contract claims, as courts are particularly generous to policyholders when interpreting exclusions that could have been drafted more carefully to limit qualifying claims.
“Arising out of” provisions in exclusions require narrow construction. In many jurisdictions, a conflict of principles exists when “arising out of” is used in an exclusion. While courts must interpret exclusionary language as narrowly as possible to provide the greatest possible coverage to the policyholder, the phrase “arising out of” is typically given a broad construction.
A recent Ninth Circuit decision, My Choice Software, LLC v. Travelers Casualty Insurance Company of America, acknowledged the conflict and resolved it in favor of the policyholder. The Ninth cited favorably a California federal court decision, Tower Insurance Co. of New York v. Capurro Enterprises, Inc., as support for rejecting the proposition that “‘arising out of’ is always construed broadly, even in exclusionary clauses, and noting that the ‘broad coverage-narrow exclusion principle is well illustrated with respect to the phrase “arising out of.”’”
Capurro distinguished prior Ninth Circuit precedent applying the breach of contract exclusion where the injury was part and parcel of the breach of contract claim. In Capurro, on the other hand, the tort-based claims at issue for infringement of intellectual property rights did not depend on the existence of any contract. The “arising out of” provision was not satisfied because the claims did not have even an incidental relationship to liability for a contract breach. Other jurisdictions, however, have yet to factor into their analysis the narrow exclusion language principle when applied to broad language used in the exclusion, leading to inconsistent decisions.
Exclusions must apply in “all possible worlds.” “[A]n insurer that wishes to rely on an exclusion has the burden of proving, through conclusive evidence, that the exclusion applies in all possible worlds.”
Equivalent formulations of this doctrine support equivalent results. For instance, applying New York law, the Second Circuit acknowledged that “breach of contract” exclusions in CGL policies apply “‘only if the advertising injury suffered . . . would not exist but for the breach of contract . . . . [O]nly then would [the insurer] not be obligated to indemnify [the insured].’” This result is reinforced by a narrow interpretation of “arising out of” in the exclusion required by New York precedent and also articulated by the Ninth Circuit in My Choice Software.
The exclusion is limited to contract enforcement claims. Courts generally agree that, if contract liability arises from conduct not tied to enforcement of contract provisions, the breach of contract provision should not apply. As the Texas Supreme Court recently reaffirmed, “when a covered event and an excluded event ‘each independently cause’ the loss, ‘separate and independent causation’ exists, ‘and the insurer must provide coverage despite the exclusion.’”
A Fifth Circuit case applying Texas law held that a contract exclusion was inapplicable because the “entire [underlying] suit was based on copyright infringement” and “[a]ll the damages in the prior judgment arose under copyright law, not breach of contract law.” The Second Circuit held that the exclusion barred coverage for breach of contract claims but not an unjust enrichment count because “this is a case where ‘several claims arise from the same set of facts,’ and where at least one ‘of the claims [is] covered’ by the Policies, the Insurers have a duty to defend the entire action brought under any of the Policies, including the uncovered claims.”
Finally, the Third Circuit clarified in an analogous case that “[a]lthough the relationship between [the claimant] and the Insureds is contractual, the actions of the Insureds were independently tortious. The contractual relationship was not endemic to the Insureds infringing of [the claimant’s] trademarks.”
Constructions rendering policy terms superfluous evidence illusory coverage. Arguments that make coverage meaningless when a contract happens to exist between the accuser and the object of the wrongful conduct run contrary to the insured’s reasonable expectations, which is the lens through which courts must view a situation to determine the applicability of an exclusion. For example, in Rockhill Insurance Co. v. Hoffman-Madison Waterfront, LLC, a District of Columbia court held that an insurer’s breach of contract exclusion would be illusory when applied to bar coverage for “personal and advertising liability that arose indirectly from a contract” because such a broad interpretation of the breach of contract exclusion “would render . . . [that] coverage for personal and advertising injury to be meaningless.”
Claims outside contract-based liability are covered. Generally, to enforce a breach of contract exclusion, insurers must establish that a claim either “arose from” or “arise[s] . . . out of any liability in connection with any oral or written contract or agreement.” Courts interpret this language as requiring a causal nexus between a “claim” and “liability in connection with any . . . contract.” The precise nature of the causal nexus remains subject to debate, with some states interpreting “arising out of” as requiring “but for” causation while others find an “incidental relationship” between a contract and the covered conduct sufficient. Under either standard, a claim for relief must have arisen out of a breach of contract that does not emanate from a source other than contract law.
Cases applying Colorado, Kansas, and North Carolina law reveal the proper application of this doctrine. Gustafson v. American Family Mutual Insurance Co. held the “breach of contract” exclusion inapplicable because the false advertising claim that triggered coverage “[under offense (f)] in the underlying action is not based on Mr. Gustafson’s breach of the insurance contract.” In the underlying case at issue, the insured “falsely advertised and solicited to American Family customers to switch their policies from American Family to his Advantage Insurance” and “directed insureds to come into his office, and then he solicited their business and redirected them to the correct American Family office.” No aspect of the court’s conclusion that “use of another’s advertising idea in [the insured’s] ‘advertisement’” implicating potential coverage under offense (f) was tied to a breach of contract claim, so the exclusion for breach of contract had no application.
A federal court in Kansas provided similar analysis on analogous facts:
Vita Craft counters that TSI’s allegations about Vita Craft spreading false rumors would exist regardless of the license agreements between Vita Craft, Imura and TSI. Further, the unfair competition and false rumor allegations did not mention the license agreements between TSI and Vita Craft. Narrowly construing the exclusion, as it must, the Court finds that the disparagement allegations did not arise out of breach of contract.
A recent case in federal court in North Carolina applied the broader view of “arising out of” policy language despite its inclusion in an exclusion, describing it as the “ordinary meaning.” Even so, it held that “if claims for injury rely upon a legal source other than contract law, they do not arise out of a breach of contract and are not subject to the breach of contract exclusion.” As the court explained,
[i]t is well settled, however, that the same acts or omissions may constitute breaches of general duties as well as contractual duties and may give rise to both actions in tort and actions in contract. . . . Likewise, the same acts or omissions that violate contractual duties may also violate statutory law. The facts supporting plaintiff’s alternative claims need not be distinct from those supporting a breach of contract, but rather the claims themselves must arise from an alleged violation other than violation of a duty imposed by contract.
Independent claims of causation fall outside the exclusion. As one court noted, the mere fact that claims address contracts between the same parties concurrently claiming tort liability is not determinative in evaluating the breach of contract exclusion because “acts committed by the same actor are [not] necessarily concurrent and excluded from coverage. . . . ‘But when a covered event and an excluded event “each independently cause” the loss, “separate and independent causation” exists, “and the insurer must provide coverage despite the exclusion.’”” Courts have also acknowledged the need to limit the breadth of “arising out of” based on “the narrowness of other terms” in the policy.
Tort claims not dependent on contract breach are covered.
Unjust enrichment or conversion. Because of the causal nexus required to satisfy the “arising out of” component of the exclusion, claims necessarily fall outside the scope of the exclusion if there are grounds for liability that do not depend on, relate to, or arise from contract breach. Even when a contract exclusion does not include an exception for “liability in the absence of the contract,” the exclusion does not remove coverage for non-contract claims. If an underlying complaint asserts claims for unjust enrichment or conversion, those claims do not bear even an “incidental relationship” to any asserted breach of contract claims because, in many jurisdictions, “‘[w]here there is an express contract, there can be no recovery based upon an unjust enrichment theory.’” This is further confirmed when a claim seeks only the return of amounts paid, not the benefit of the bargain. Indeed, claims of breach of contract and unjust enrichment are mutually exclusive.
Like unjust enrichment, conversion does not “aris[e] out of a breach of contract.” Thus, courts usually hold that a claim for conversion is equally incapable of supporting the minimally required “incidental relationship” for the breach of contract exclusion to bar a defense.
Tortious interference. Similarly, courts have determined that where claims based on violation of offense (d) are generated by distinct tortious interference elements, they do not depend on any breach of contract. Such claims are distinct from allegations of “breach of contract.” A broad construction of the breach of contract exclusion that would capture such claims would be inconsistent with coverage law nationwide. In addressing an analogous exclusion, one court explained the applicable reasoning as follows:
Under their reading of the policy, all that is necessary for an additional insured to be covered is that the insured’s conduct be a causal link to the injury. This is an incorrect interpretation of the policy language, which, by its terms, describes proximate causation and legal liability based on the insured’s negligence or other actionable deed. . . . [T]he majority’s analysis ignoring what at “worst” (from the prospective of the putative additional insureds) is an ambiguity in that language overlooks our teachings that, when there is doubt with respect to the meaning of an insurance policy, an insurer should revise the policy so as to leave no doubt as to the meaning of that contract.
Unfair competition. A North Carolina federal court used this same reasoning to conclude that a “breach of contract” exclusion could not preclude coverage for several claims—including trademark infringement, false designation of origin, and unfair competition—made in addition to breach of contract. As the court explained,
an injury arises out of a breach of contract when it “spring[s] up from” or “originate[s]” in the contract. . . . It follows from that definition that an injury does not arise out of a contract when the underlying actions are alleged to be unlawful independent of any contractual relationship between the parties. Thus, if claims for injury rely upon a legal source other than contract law, they do not arise out of a breach of contract and are not subject to the breach of contract exclusion under the policies.
D&O policies have distinct features affecting exclusions. In D&O policies, “Loss” is typically defined as “any amount which Insureds are legally obligated to pay for a claim made against them for ‘Wrongful Acts’, and shall include but not be limited to damages, judgments, settlements and costs . . . .” As such, many courts have broadly defined the term “Loss” to encompass “Damages” applying to restitutionary recovery as long as the moneys secured at the time were not wrongfully obtained and made claimants whole.
Distinct liability claims may arise against officers versus directors. Domokos v. Scottsdale Insurance Co. gave “arising out of” a broad interpretation, missing the course correction of My Choice Software in following month. The court distilled the issue to “whether the allegations in the Underlying Action in this case would stand absent the contract between Shocking and Mahamedi.” Determining that the “fraud-related claims do not rely on the existence of a contract,” the insurer was required to provide coverage benefits.
Domokos also found significance in some features unique to D&O policies. First, the court concluded that reading the breach of contract exclusion to preclude coverage of all the underlying tort claims “would appear to defeat the very D&O coverage that Shocking secured” as a “Wrongful Act” included “actual or alleged error, omission, misleading statement, misstatement, neglect, breach of duty or act.”
Second, D&O policies often distinguish between parties suffering loss, with some exclusions applying to loss of the organization and others applying to loss attributable to individuals. While the underlying complaint’s allegations were against the directors and officers, the “breach of contract” exclusion applied only to “Loss of the Company.”
Similarly, a federal court addressing Texas law determined that so long as any potentially covered claim falls outside the breach of contract exclusion, a defense arises. Because no causal relationship between the covered negligent misrepresentations that evidenced “wrongful acts” and any “breach of contract” exclusion arose, the exclusion did not bar a defense.
The D&O exclusion exception cannot be read out of the contract. A federal district court in Austin, Texas, held the contract breach exclusion applicable where the claimants in the underlying action sought refunds following the cancellation of the South by Southwest (SXSW) music festival due to COVID-19. But the refund and revocation policy clearly articulated that purchasers were not entitled to cash refunds. The claimants asserted that the policy should be “severed from the contract” because it was “unenforceable,” thus “allowing [Claimants] and the Class to pursue the relief to which they are entitled: a refund of all monies paid to SXSW for Credentials for the 2020 festival.” This contract provision was not cited as a source of SXSW’s liability. But by referencing the contract’s no-refund clause, Count I (breach of contract) alleged facts showing the absence of contractually assumed liability. Count II (unjust enrichment) made no reference to the SXSW terms and did not claim that SXSW breached any agreement or contract term.
As described above, breach of contract exclusions require the excluded claim to have either an “incidental relationship” or “but for” causal connection (depending on the jurisdiction) to breaching a contract to satisfy the “arising out of” requirement. Thus, factual scenarios like that in SXSW are about the necessary connection between the injury and breach of a valid contract. Coverage analysis like that followed by this court, which selectively referenced facts from the complaint, is inconsistent with the views of the Texas Supreme Court on interpreting similar policy language.
As shown above, “breach of contract” exclusions can be problematic, whether embedded in a CGL policy or, like many other exclusions, in a D&O policy especially. Overbroad construction of this exclusion to “remove from coverage every claim against the company for every error or omission that occurred in the course of its business” is impermissible and can render coverage illusory. To avoid this problem, more clarity in drafting and attention the interplay between the exclusion and its exceptions are required.
