Contract Liability Exclusion Precludes D&O Coverage for Tort Claims

By Kathryn A. Formeller, Esq. of Tressler LLP  
The contract liability exclusion precluded coverage for negligent misrepresentation and fraud in the inducement claims arising out of a written contract, according to the U.S. District Court for the Middle District of Pennsylvania. Federal Insurance Co. v. KDW Restructuring and Liquidation Services, LLC, No. 3:07-01357 (M.D. Pa. August 17, 2012).
In KDW Restructuring, Uni-Marts, LLC (“Uni-Marts”) sold a group of convenience stores in Pennsylvania. The buyers later contended that Uni-Marts had made misrepresentations and omissions about costs and expenses in running the convenience stores to induce prospective buyers and in violation of its contractual obligations. The buyers initiated a lawsuit in Pennsylvania state court against Uni-Marts. The underlying complaint contained five causes of action: (1) fraud in the inducement; (2) negligent misrepresentation; (3) breach of supply agreement; (4) breach of purchase agreement; and (5) breach of the right of first refusal agreement. The underlying action ultimately settled and Uni-Marts sought coverage under its D&O policy for its costs in defending the action as well as for the amounts it paid in settlement.
Uni-Marts’ D&O insurer denied coverage, relying on, among other things, the policy’s contractual liability exclusion, which provided that no coverage will be available “based upon, arising from, or in consequence of any actual or alleged liability of an Insured Organization under any written or oral contract or agreement, provided that this Exclusion … shall not apply to the extent that an Insured Organization would have been liable in the absence of the contract or agreement.”
The insurer filed an action in federal court seeking a declaration that coverage was precluded. The Court held that the insurer had no duty to defend or indemnify Uni-Marts in the underlying action as the causes of action in the underlying complaint were based on Uni-Marts’ alleged liability under a written contract and therefore were subject to the policy’s contractual liability exclusion.
There was no dispute that counts three through five of the underlying complaint were based on Uni-Marts’ alleged liability under a written contract. However, the parties disputed whether or not coverage was precluded by the contractual liability exclusion for the negligent misrepresentation and fraud in the inducement counts. Uni-Marts argued that the two tort claims arose out of pre-contractual conduct and were separate and apart from the contract claims. The court rejected Uni-Marts’ argument and held, “giving plain meaning to the unambiguous language of the contract exclusion,” that the fraudulent inducement and negligent misrepresentation claims “certainly are ‘based upon, arising out of, or in consequence of any actual or alleged liability’ under the contracts.” The court reasoned that the tort claims arose from the same essential facts and circumstances as those underlying the breach of contract claims.
The court also underwent a “but for” analysis with respect to the tort claims and determined that those claims would not exist in the absence of the contracts and their subsequent breaches. In further determining whether the contract exclusion applied, the court analyzed the allegations of the complaint under the “gist of the action” doctrine. Under this test, to be construed a tort action, the wrongful conduct must be the gist of the action with the contract being collateral. The court determined that the tort claims were barred since financial information that was the basis for the claims was intertwined in the obligations of one of the contracts itself and the contract claims.
Finally, the court held that requiring the insurer to cover Uni-Marts’ loss would greatly expand the coverage of the policy beyond its plain language. Accordingly, the court found that all counts of the underlying complaint were based upon, arose from, or were in consequence of Uni-Marts’ liability under the contracts and were therefore precluded from coverage under the contract liability exclusion.
In this case, the Court interpreted the contract liability exclusion broadly to preclude coverage for tort claims. The Middle District of Pennsylvania court distinguished a recent Western District of Pennsylvania decision in which the court, under very similar circumstances, found that misrepresentation claims were not precluded from coverage. The court’s determination in this case rested on the fact that all of the misrepresentations on which the plaintiffs relied had been incorporated into one of the written contracts at issue. Further, the court found that the "based upon" and "arising out of" phrases of the contract liability exclusion were broad and unambiguous and construed the exclusion according to its plain language.
Kathryn Formeller practices in the areas of insurance coverage analysis and litigation primarily focusing on directors and officers liability, EPL, professional liability and fiduciary liability matters. Kathryn participates in commercial litigation nationwide and counsels insurers with respect to coverage issues associated with D&O, E&O, EPL and professional liability claims. Contact info or 312.627.4009

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