Michigan Court Holds Contract Exclusion Applicable

In its recent decision in Certified Restoration Drycleaning Network v. Fed. Ins. Co., 2013 U.S. Dist. LEXIS 54457 (E.D. Mich. Apr. 16, 2013), the United States District Court for the Eastern District of Michigan had occasion to consider the application of a breach of contract exclusion to a dispute arising out of an alleged breach of a franchise agreement.

The insured, CRDN, franchised textile and dry cleaning systems throughout North America.  In 2007, it entered into an agreement with East Coast Garment Restoration, pursuant to which East Coast was required to pay a $11,000 franchise fee.  A year later, however, CRDN terminated the franchise relationship on the basis of information it learned from a background check of East Coast’s principal.  East Coast thereafter brought suit, and later an arbitration proceeding, against CRDN, alleging causes of action for breach of contract and breach of duty of good faith and fair dealing. 

Federal Insurance Company insured CRDN under a combined directors and officers, employment liability, fiduciary liability and insured organization coverage policy.  Federal’s policy obligated it to defend CRDN in connection with claims for wrongful acts.  The policy, however, contained an exclusion barring coverage for claims:

… based upon, or 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.

Federal denied coverage on the basis of this exclusion, contending that East Coast’s claim against CRDN arose solely out of the franchise agreement and CRDN’s alleged breach of this agreement.  CRDN, however, argued that notwithstanding the stated causes of action, certain assertions in the underlying proceeding could be interpreted as alleging misrepresentations made prior to the time that East Coast and CRDN entered into the franchise agreement.  CRDN also argued that there was no contractual relationship between it and East Coast.

While the court agreed that under Michigan law, it is not the “nomenclature” of the underlying claim, but instead the cause of injury that determines a duty to defend, the court agreed that East Coast’s claim arose wholly out of an alleged breach of franchise agreement.  Specifically, the underlying complaint alleged in detail CRDN’s efforts to induce East Coast to become a franchisee, the representations CRDN made concerning expected earnings, and CRDN’s decision to terminate the franchise agreement.  Further, the underlying complaint alleged that CRDN’s decision to terminate the franchise agreement was not on a ground permissible under the agreement.  Given these assertions, the court agreed that the exclusion applied, reasoning that the East Coast’s claim arose out of CRDN’s alleged breach of the franchise agreement, and that any references to “representations” were “a small part of the background story,” and did not change the nature of the underlying pleading.

In holding that the exclusion applied to bar coverage, the court considered and rejected CRDN’s argument that the exclusion did not apply because the underlying settlement agreement between CRDN and East Coast made reference to CRDN having made misrepresentations to East Coast.  CRDN argued that it was only upon drafting the settlement agreement that the parties determined that the “true nature” of East Coast’s claim was for misrepresentation rather than breach of contract.  The court found this argument “not realistic,” and that in any event, Federal’s duty to defend was determined based only on the allegations in the complaint rather than the language of the settlement agreement.