As seen on The D&O Diary:
By Kevin LaCroix on
A recurring D&O insurance question is whether or not a policy’s contract exclusion precludes coverage for claims that the insured induced the claimant into entering a contract through negligent or intentional misrepresentations. In a interesting December 22, 2014 opinion (here), District of Rhode Island Judge John J. McConnell, Jr., applying Rhode Island law, held that even a contract exclusion with the broad “based upon” or “arising out of” preamble language did not preclude coverage for a portion of a jury verdict holding that the insured’s intentional misrepresentations had induced the claimant to enter into the disputed contract. As discussed below, Judge McConnell’s opinion provides a useful and interesting perspective on this recurring question about the scope of the contract exclusion’s preclusive effect.
In 2004, TranSched Systems undertook negotiations to acquire certain software assets from Versys Transit Sollutions. During the course of these discussions, Versys was represented by Versys’ Vice President Sheryl Miller and its Vice President of Product Development and Chief Technology Officer, Lorin Miller. In February 2005, the two companies entered an Asset Purchase Agreement (APA) and related documents transferring ownership of the software assets from Versys to TranSched.
The software assets were not delivered as provided in the APA. TranSched initiated litigation in Delaware alleging that prior to the parties’ entry into the APA the two Versys representatives had made material misrepresentations about the software assets and also that Versys had breached the APA. After Versys received the complaint, it submitted the lawsuit as a claim under its D&O insurance policy.
The Delaware lawsuit went to trial and the jury found against Versys on three grounds: (1) intentional misrepresentation; (2) breach of contract regarding misrepresentations and warranties under the APA; and breach of the covenant of good faith and fair dealing. The jury awarded damages of $500,000. The trial judge awarded TranSched costs and prejudgment interest of over $170,000.
TranSched was unable to collect the judgment from Versys, which is no longer in business. TranSched attempted to collect the judgment from Versys’s D&O insurance carrier. The insurer denied coverage for the judgment and the TranSched filed an action in the District of Rhode Island seeking to establish that the insurer’s policy provided coverage for the amount of the judgment.
The insurer contended that coverage for the judgment was precluded from coverage by two policy exclusions, the Limited Contract Exclusion and the Fraud Exclusion.
The Limited Contract Exclusion provides that there is no coverage under the policy for any Claim “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 agreement.”
The Fraud Exclusion precludes coverage for Claims “based upon, arising from, or in consequence of any deliberately fraudulent act or omission or any willful violation of any statute or regulation by such Insured, if a final and non-appealable judgment or adjudication adverse to such Insured establishes such a deliberately fraudulent act or omission or willful violation.” The Severability of Exclusions clause provides further that with respect to the Fraud Exclusion, “only facts pertaining to and knowledge possessed by any past, present or future Chief Financial Officer, President, Chief Executive Officer or Chairperson of any Insured Organization shall be imputed to any Insured Organization to determine if coverage is available.”
The December 22 Opinion
In his December 22, 2014 memorandum opinion, District of Rhode Island Judge McConnell, applying Rhode Island law, held that while the breach of contract exclusion precluded coverage for the breach of contract and breach of the implied covenant of good faith portions of the jury’s verdict, neither of the two exclusions on which the insurer sought to rely precluded coverage for the intentional misrepresentation portion of the jury’s verdict.
In concluding that the Limited Contract Conclusion did not preclude coverage for the intentional misrepresentation portion of the jury’s verdict, Judge McConnell cited several prior decisions in which courts had concluded that intentional misrepresentations are not precluded from coverage under a contract exclusion “where the misrepresentations were made before the transaction and the transaction was generated by and was a consequence of a misrepresentation.” (Emphasis in original, citations omitted). Judge McConnell said he found “the reasoning in these cases to be persuasive and applicable to the facts of this coverage dispute.”
Judge McConnell went on to say that the contract exclusion is “limited to actual liability arising under the contract.” He added that the “evidence at trial sufficiently supports TranSched’s assertion that the intentional misrepresentation claim did not arise out of the contract, but concerned only pre-transaction conduct,” noting further that “the APA was not a cause of the intentional misrepresentation claim, it was the result of it, and any tortious conduct is not covered under the exclusion because it preceded the APA and was independent of the contract itself.”
With respect to the Fraud Exclusion, Judge McConnell rejected the insurer’s attempt to circumvent the Severability Exclusion by arguing that it was not attempting to impute any conduct to Versys but rather was focusing on the conduct of Versys itself. Judge McConnell said that to support this interpretation, he would have to “ignore the Severability of Exclusions clause” and would have to find that “any misleading statement representation or omission by any employee … would trigger the fraud exclusion.” He added that “the fraud exclusion, without the severability clause, could work an inequitable result when one considers how many employees a company has and the fact that the exclusion as written makes the company responsible for all of its employees’ misconduct without providing any coverage.”
Based on his review of the evidentiary material presented Judge McConnell said that “it is clear that the case mainly focused on the vice presidents’ roles in driving the transaction,” and that because “their conduct does not bind Versys on the terms of the exclusion, the fraud exclusion does not apply in this case.”
As a result of the Judge McConnell’s conclusion that the jury verdict was awarded on both covered and uncovered claims, he determined that there would have to be an allocation. He ordered the parties to submit the allocation to mediation using either the services of the Magistrate Judge assigned to the case or of a mediator of their own choosing.
This case represents the relatively unusual circumstance that the insurance coverage questions are being considered after the entry of a jury verdict in the underlying claim. It is much more frequently the case that these kinds of issues are being disputed after the underlying case has been settled. Though the jury verdict does make this case distinct from many other situations in which these kinds of questions arise, Judge McConnell’s ruling may nevertheless be useful and even instructive in other cases in which the extent of the preclusive effect of the policy’s contract exclusion is in dispute.
In that regard, it is important to note that though there were breach of contract allegations, and though all of the allegations in the underlying lawsuit related to the transaction in connection with which the relevant contract had been entered, Judge McConnell did not simply conclude that the broad preamble of the exclusion meant that the exclusion’s preclusive effect applied to all of the transaction-related allegations.
As I have noted in prior posts (for example, here), I have been concerned by a number of recent court decisions in which courts have interpreted D&O insurance policy contract exclusions with a broad preamble to sweep so broadly as to preclude coverage not only for breach of contract claims but also for misrepresentation claims relating to the same transaction in which the contract arose.
Here, even though the contract in question followed the alleged misrepresentations, and even though the contract in question arose from and was induced by the alleged misrepresentations, Judge McConnell concluded that the contract exclusion did not preclude coverage for the misrepresentation claims. As he put it, the misrepresentations “did not arise out of the contract, but concerned only pre-transaction conduct,” adding that the APA contract “was not a cause of the intentional misrepresentation claim, it was the result of it, and any tortious conduct is not covered under the exclusion because it preceded the APA and was not independent of the terms of the contract itself.”
Judge McConnell’s conclusion in this regard (and the conclusions of the courts on whose opinions he relied) stands in contrast to the cases in which courts have interpreted contract exclusions with a broad preamble so broadly as to preclude coverage even for claims alleging that the contract resulted from pre-contract inducements.
While circumstances will vary and while there may be factual issues that affect the analysis in specific situations, there is an element of convincing logic to Judge McConnell’s analysis that the contract exclusion – even an exclusion with a broad “based upon” or “arising out of” preamble – does not apply to preclude coverage for claims involving conduct that preceded the entry of the contract. This logic applies even if the allegation is that the pre-contract conduct was an inducement for the parties to enter the contract. As Judge McConnell said, liability for these types of inducement claims does not arise out of the contract, it is the other way around; the contract arose out of the inducements.
As I have noted in prior posts, the prior cases in which courts have applied contract exclusions to preclude coverage even for negligent or fraudulent inducement claims arguably are applying the contract exclusions so broadly as to preclude coverage for the very types of claims for which the policy’s coverage was intended.
I have long thought that the cure for this overly broad application of the contract exclusion would be to amend the exclusion’s preamble to provide that the exclusion’s preclusive affect applies only to claims “for” breach of contract.
However, Judge McConnell’s opinion makes clear that even if a contract exclusion uses the broader “based upon or arising out of” language, the policy exclusion does not apply to all claims asserted merely because there is a transaction involved. His conclusion that the exclusion does not apply to pre-transaction conduct provides an important distinction on which policyholders can seek to rely in contending that even a contract exclusion with a broad preamble does not preclude coverage merely because a transaction is involved.
On a final note, it is worth observing that Judge McConnell concluded that the policy’s fraud exclusion did not preclude coverage even though this case involved the rather unusual situation in which there had actually been a final adjudication of an intentional misrepresentation. His ruling in that regards was reliance on the severability clause that limited the persons whose conduct could be imputed to the company. Judge McConnell’s ruling on the fraud exclusion not only underscores the critical importance of the inclusion of these types of severability provisions, but the analysis in his opinion highlights the unfairness that would be involved if the policy did not include a severability provision of this type. His analysis also highlights how important it is to limit the number of persons whose knowledge or conduct will be imputed to the entity for purposes of determining the applicability of the conduct exclusions.
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