Drafting Effective RWI Coverage Exclusions

Coverage exclusions are a key risk management tool for transactional liability insurers. But they can also be traps for the unwary. In the event of a claims dispute, the insurer will likely bear the burden of proving that an exclusion applies, and a judge or arbitrator may (depending on the circumstances) be tasked with interpreting the exclusion based solely on its terms, without external evidence of what the underwriter intended. Exclusions therefore must be carefully drafted with potential disputes over their meaning in mind.

This article provides guidance for transactional insurers drafting coverage exclusions based on our extensive practice advising on insured transactions and handling claims for our clients.

The Legal Landscape

While a full discussion of the law surrounding exclusions is beyond the scope of this article, we first highlight several legal issues that may arise in the context of a coverage dispute. Each of these issues informs the drafting of exclusions.

First, a well-established principle about the burden of proof: the insured generally bears the burden of “establish[ing] coverage in the first instance,” while the insurer has the burden of “proving that an exclusion applies.”^[1] Case law in the transactional liability context is limited, but in coverage disputes in this field, the insureds typically urge that the general principle should be applied.

A second issue is how exclusions will be interpreted. In our experience, insureds often cite case law that they argue imposes a strict standard on insurers seeking to invoke an exclusion. This includes cases that say, for example, that the exclusion must contain “clear and unmistakable language”; be “accorded a strict and narrow construction”; and be subject to “no other reasonable interpretation.”^[2]

In that regard, at least one case suggests that courts may be inclined to reflexively apply such rules from other contexts to representations and warranties insurance (RWI) policies. In WPP Group USA, Inc. v. RB/TDM Investors, LLC, the court denied an RWI insurer’s motion to dismiss that had invoked an exclusion that excluded the portion of loss relating to certain indemnities in the underlying purchase agreement. And the court observed, among other things, that “[a]mbiguities in exclusions must be strictly construed and are ordinarily resolved in favor of the insured,” citing to a New York Court of Appeals case involving a homeowner’s insurance policy.^[3]

Exclusions should be written with this case law in mind, but subject to the law governing any particular insurance policy, insurers have responses to arguments like the one in WPP. Insurers may argue that these interpretative rules emerged from a very different context — to address standard-form policies that were drafted by insurers, and were accepted by insureds with limited bargaining power — and should not apply to transactional liability insurance, which often involves bespoke policies negotiated by sophisticated parties, typically with the assistance of counsel.

Insurers may find support in case law addressing “sophisticated” policyholders.^[4] For example, in one recent case from outside of the RWI context, the insured was a sophisticated party that had negotiated the terms of the policy with the assistance of an outside law firm and a large and experienced insurance broker.^[5] When the insurer relied on an exclusion to deny coverage, the First Circuit (interpreting Puerto Rico law) declined to apply to the exclusion a rule requiring construction in favor of the insured. The court observed that the public policy rationale typically requiring construction in favor of the insured — “protect[ing] a weaker party when there is disparity at the bargaining table” — was not present in this case.^[6]

In addition, some courts have suggested that, regardless of context, these interpretative presumptions merely reflect a specific application of contra proferentem, the rule that an ambiguous provision should be interpreted against its drafter.^[7] On that view, such presumptions should not apply until after extrinsic evidence is considered, and only if the insurer, in fact, drafted the provision at issue. This view, however, is not always accepted.^[8]

Drafting RWI Coverage Exclusions That Work

Accordingly, insurers need to be prepared for courts or arbitrators to construe vague or ambiguous exclusions in favor of the insureds. Underwriters must draft exclusions as clearly as possible to minimize the risk that a judge or arbitrator will misinterpret the scope of the exclusion. To that end, insurers should consider the following:

• Choose Exclusions Tailored to the Underwriting Process: Given the compressed timeline of a typical underwriting, insurers should craft exclusions that are specific to the issues arising in the transaction being insured. In some instances, that means incorporating exclusions that address specific issues relating to the company (or its industry) that would otherwise be covered by the policy (e.g., excluding Medicare or Medicaid fraud claims for a health care provider). In other cases, it may mean adopting exclusions in areas where underwriters were not able to conduct sufficient diligence and need to minimize risk.
  
  
• Make Sure That the Executed Policy Matches the Underwriter’s Intent and Usual Best Practices: Because a third party such as a judge or arbitrator may be interpreting the exclusion after the fact, it is critical that insurers carefully draft the provision to ensure that the language matches the underwriter’s intent. Among other best practices, drafters should use clear, plain and unambiguous language; ensure that definitions are clearly defined and consistently used; and pay careful attention to the use of words that can potentially create ambiguity, such as “and,” “or,” “every,” “each” and “any.” For example, an exclusion that refers to “A or B” can be used in the “inclusive” sense, meaning “A or B, or both,” or in the exclusive sense, meaning “A or B, but not both,” depending on the context.^[9] To avoid any ambiguity, a drafter might instead state precisely which of these two potential interpretations is intended.
  
  
• Beware of “Illusory” Coverage Arguments: Insureds will sometimes argue that an exclusion should be ignored (or interpreted narrowly) because its application would cause the coverage granted by a policy to be “illusory.” For example, in denying the RWI insurer’s motion to dismiss, the WPP court observed that, even if the insurer’s interpretation of the exclusion was correct, “coverage might not be precluded as [the insurer’s] interpretation seemingly renders coverage [for certain breaches] illusory.”^[10]

Generally speaking, coverage is “illusory” only when it “eliminate[s] all or most of the coverage.”^[11] Nevertheless, underwriters should be mindful of the potential for such arguments, while still ensuring that the exclusion is sufficiently broad to address the intended risk.

• Do Not Assume Courts Will Consider Extracontractual Documents: In general, courts attempt to interpret insurance policies by focusing on the contract terms themselves (together with aids like established industry custom) and rely on evidence outside the four corners of the agreement (if at all) only when the policy provisions are ambiguous.^[12] Underwriters, therefore, should try to reflect their intent directly and plainly within the language of the exclusion itself and not assume that the court will consider other evidence (such as an email to a broker) as to its meaning.
  
  
• Stipulate That the Insured Participated in Drafting the Policy: Where applicable, parties should stipulate in the policy that the insured in fact participated in drafting the policy, or even a particular clause, and that the policy should not be construed against either party. While insurers still may bear the burden of proving that an exclusion applies, this may prevent ambiguities from being interpreted against them.
  
  
• Discuss With Outside Counsel and Claims Professionals: Internal claims professionals and outside counsel can also be a helpful resource, particularly since they may have dealt with similar issues in a prior dispute.
  
  
• Modify the Scope of Coverage: Exclusions are not the only way to limit the scope of coverage. Rather than draft an exclusion, an insurer can instead modify or narrow certain other provisions, such as the definition of a breach. As noted above, the insured typically has the burden of proving that a claim or loss falls within the scope of a policy’s insuring agreement. Note, however, that some courts have said that location and placement do not necessarily control, and so a court might place the burden of proof on an insurer even where a provision is not strictly labeled an exclusion.^[13]

^[1] _{See, e.g., J.P. Morgan Sec. Inc. v. Vigilant Ins. Co., 37 N.Y.3d 552, 562, 183 N.E.3d 443 (2021), reargument denied, 37 N.Y.3d 1228, 184 N.E.3d 886 (2022).}

^[2] _{See, e.g., Pioneer Tower Owners Ass’n v. State Farm Fire & Cas. Co., 12 N.Y.3d 302, 307, 908 N.E.2d 875, 877 (2009).}

^[3] _{See WPP Grp. USA, Inc. v. RB/TDM Invs., LLC, Index No. 656825/2019 (N.Y. Sup. Ct. Jan. 19, 2021), Doc. No. 67.}

^[4] _{See, e.g., Port Auth. of NY & NJ v. Affiliated FM Ins. Co., 311 F.3d 226, 235 (3d Cir. 2002) (“One of the frequently cited reasons for interpreting language in favor of the insured is that insurance policies are generally contracts of adhesion, which offer little choice to the purchaser. This justification, though, has little application in this case. As is often the situation with large, knowledgeable business firms, the contracts were manuscript policies negotiated and drafted by the insured.”).}

^[5] _{UBS Fin. Servs., Inc. of Puerto Rico v. XL Specialty Ins. Co., 929 F.3d 11, 24–25 (1st Cir. 2019).}

^[6] _Id.

^[7] _{See, e.g., Starr Indem. & Liab. Co. v. Brightstar Corp., 388 F. Supp. 3d 304, 356 n.21 (S.D.N.Y. 2019), aff’d, 828 F. App’x 84 (2d Cir. 2020).}

^[8] _{See, e.g., In re Adelphia Commc’ns Corp., 638 B.R. 506, 517 n.13 (Bankr. S.D.N.Y. 2022) (observing that New York Court of Appeals decisions state “in no uncertain terms, that under well-settled New York law, whenever an insurer wishes to exclude certain coverage from its policy obligations, it must do so in clear and unmistakable language” (internal quotation and alteration marks omitted)), reconsideration denied, 639 B.R. 657 (Bankr. S.D.N.Y. 2022).}

^[9] _{Hernandez v. Kijakazi, Civil Action No. 22-01556(FLW), 2022 WL 17751355, at *13 (D.N.J. Dec. 19, 2022).}

^[10] _{See WPP Grp. USA, Inc. v. RB/TDM Invs., LLC, Index No. 656825/2019 (N.Y. Sup. Ct. Jan. 19, 2021), Doc. No. 67.}

^[11] _{See, e.g., In re Generali COVID-19 Travel Ins. Litig., 576 F. Supp. 3d 36, 44 (S.D.N.Y. 2021), aff’d sub nom. Oglevee v. Generali U.S. Branch, No. 22-336-cv, 2022 WL 16631170 (2d Cir. 2022).}

^[12] _{Some jurisdictions provide exceptions to this rule in certain circumstances, such as in the case of the duty to defend.}

^[13] _{See, e.g., Borough of Moosic v. Darwin Nat’l Assurance Co., 556 F. App’x 92, 97–98 (3d Cir. 2014).}