Daniel Gerber and Sarah Delaney on the Directors and Officers Policies and the Breach of Contract Exclusion: Broad Application Could Swallow Coverage

There are no standard industry-wide directors and officers’ coverage forms, nonetheless the contractual liability exclusion is a common exclusion in directors and officers coverage. Recently, courts have broadly construed the exclusion, and applied it to any claim remotely relating to a contract. This presents a problem for the insured because most of the transactions taking by directors and officers involve a contractual responsibility of some sort. Thus, in practical terms, the exclusion could swallow the coverage, and the insured and practitioner should be aware of the potential implications.
 
August Entertainment, Inc. v. Philadelphia Indemn. Ins. Co., 146 Cal.App.4th 565 (Cal. Ct. App. January 7, 2007), provides a tidy discussion of the exclusion and its application to both officers and corporations. It involves a contract relating to distribution rights for certain films owned by August Entertainment. The insured, InternetStudios, had entered the contract via one of its officers, a Robert Maclean. Following the execution of the contract, InternetStudios attempted to escape the deal because “it became clear that InternetStudios was unable to actually acquire all of August’s distribution rights,” as originally believed when the agreement was entered into. It asserted that there was no agreement. Naturally, August took the opposite tact, and insisted that a binding agreement existed. 
 
August and InternetStudios later agreed that Mr. Maclean was acting as on officer of InternetStudios, and on behalf of InternetStudios, but retained separate liability because he failed to advise August he was signing in that capacity, and the letterhead he used did not indicate that InternetStudios was a corporation. It was then agreed that judgment would be entered against Maclean, and his rights under the D&O policy would be assigned to August.
 
InternetStudios maintained a Directors and Officers’ policy with Philadelphia Indemnity Insurance Company. As with nearly all D&O policies, the Philadelphia policy provided coverage for the individual directors and officers’ liability, as well as for the company itself. With regard to coverage for Maclean’s liability, August asserted that Maclean was liable as an individual because, by signing the agreement on behalf of InternetStudios without the proper formalities, he became individually, but not personally, liable.
 
Although there is no contractual liability exclusion in Side A coverage (applying to the directors and officers’ personal liability), there is apparently still no coverage for breach of contract claims under that coverage according to August. The court held that there was no coverage for Maclean because: (1) an officer acting in an official capacity cannot be liable for a breach of corporate contract; and (2) an officer who is liable is excluded from coverage because he or she was not acting as an official. Thus, an officer could never breach a contract within the meaning of D&O coverage.   
 
With regard to coverage for the company itself, the court held that a contract “loss” was not a loss created by a wrongful act; rather to allow such coverage would make the insurer an “unwitting investor in the deal,” noting that some courts hold that breaches of contract are not covered, even in the absence of an exclusion.    Just because the contract may have been entered into negligently, it did not create coverage for obligations that were not actual losses. But the court did not go so far as to hold that breaches of contract were uninsurable per se. Rather, “We do not suggest that officers who make seemingly minor scrivener errors must face financial ruin…Broader coverage may be available.”
 
In the short time since August Entertainment was decided a number of other courts have addressed the issue. In S.J. Amoroso Construction Co., Inc. v. Executive Risk Indemnity, Inc., (N.D.Ca October 30, 2007) (unpublished), the president of the insured, Amoroso, made representations regarding an assignment of liability relating to a construction contract. Amoroso was not actually a party to the contract in question. Amoroso eventually denied that the president was authorized to make the representations in question.
 
Ultimately, a lawsuit was brought alleging defects in the construction, and the insured sought coverage under their D&O policy. The D&O carrier disclaimed, and the insured sued asserting that the breach of contract exclusion only applies if the insured is a party to the contract. As an initial note the court, citing August, supra, found that there was no coverage for the named insured because it had disavowed the acts of its officer. In other words, because the insured disclaimed responsibility for the actionable statements, the statements were not made by an insured, and therefore no coverage was available to the insured. The insured apparently disavowed its way out of coverage in that regard.
 
With regard to the contract exclusion, the insured’s negligence could not be independent from the contract because, even though the insured was not a signatory to the contract, it would have not had the opportunity to be negligent in its absence, citing Spirtas Company v. Federal Ins. Co., 481 F.Supp.2d 993 (E.D. Mo. March 7, 2007). The court also cited the public policy concern that allowing coverage for breach of contract claims would encourage insureds to breach contracts with impunity. In Spirtas¸ the claims against the insured and its officers were for conversion and unjust enrichment, clearly not contractual duties. The relationship to the party making those claims was contractual, however, and therefore it did not matter that the causes of action would exist unless the insured had entered into a contract. 
 
In Verticalnet, Inc. v. U.S. Specialty Ins. Co., 492 F.Supp.2d 452 (E.D. Pa. May 21, 2007), the insured corporation agreed to merge with another. Following the merger, the corporation was to issue new share certificates, and change the file registration statement with the state. It failed to do either, and a lawsuit resulted. The court held that although the failures were part of standard corporate duties, they arose due to the merger documents, and therefore were contractual. Although the policy did not contact a contractual exclusion, and therefore were not excluded, if such exclusion had existed, the court would have found it to apply. Thus, the formation and reconstitution of a corporation is “contractual,” and any missteps along the way do not result in “loss” per se, even if there is a palpable devaluation of the corporation. The existence and broad application of the contractual exclusion is tricky from both the perspective of the insured and the perspective of the insurer.   Most corporations do most of their business through contracts. See GE HFS Holdings, Inc. v. National Union Fire Ins. Co. of Pittsburgh, PA, 520 F. Supp. 2d 213 (D. Mass. September 5, 2007). 
 
As demonstrated by the above cases, contractual relations come in many forms, and result in many variant claims. Therefore, the contractual liability exclusion, applied broadly, could eliminate coverage in many, if not all instances, which lends itself to the argument that directors and officers coverage is illusory for companies that deal mostly with contracts. But that is apparently not the case: the GE HFS, supra, court held that “arising out of” was to be read expansively, and that if a policy still provided coverage for some acts, an exclusion was not void simply because of a potentially wide exclusion.
 
Directors and Officers Coverage is most often procured to protect both directors and officers, as well as the corporation, from the missteps and potentially wrongful actions of the officers.   The lesson to be learned from these cases is that coverage is often more restricted than anticipated, and coverage for many of a corporation’s activities is excluded. Yet, despite the apparent breadth of the exclusion, amount of resulting litigations is relatively small.
 
In-house counsel and insureds should be aware of the potential limitations of the exclusions, and the emerging number of instances where the insurer seeks to apply it. Indeed, as there are no standard D&O policy forms, it would be ideal if a corporation could negotiate a policy without the exclusion. In practical terms, arguably the insurer would still not be liable for the amounts directly related to a standard breach of contract because it would not be strictly a “loss.” See August, supra.
 
 
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