Courts Routinely Failing to Accept Reasonable Constructions of Exclusions

By David A. Gauntlett*

Introduction

It is widely known that courts are obligated to give an insured the benefit of the doubt when interpreting policy provisions. This rule is particularly forceful in determining the proper construction of an exclusion or other limitation on coverage. Contrary to what most policyholders might assume (and contrary to many recent rulings improperly applying coverage law principles), the court’s duty is not to evaluate the constructions offered by each party and determine which is most reasonable. Instead, the court must adopt any reasonable construction preferred by the policyholder without even evaluating the alternative construction from the insurer.

Any Reasonable Construction Proposed by the Insured Must Be Accepted

As noted above, thoughtful coverage cases from across the country have concluded that a court must accept any reasonable construction from the policyholder.[1] This standard was properly applied in the recent Fifth Circuit decision SXSW, L.L.C. v. Fed. Ins. Co., No. 22-50933, 2024 U.S. App. LEXIS 6771, at *9 (5th Cir. (Tex.) Mar. 21, 2024). There, the court evaluated SXSW’s interpretation of the relevant exclusion, explained why it was reasonable, and concluded no further analysis was required.[2] Unfortunately, several decisions post-dating SXSW have failed to adhere to this standard by focusing on what the court deems the best construction of an exclusion without explaining why the insured’s interpretation is unreasonable.

Allied World Nat’l Assurance Co. v. NHC, Inc.

In Allied World Nat'l Assurance Co. v. NHC, Inc., No. 22-00469 MWJS-WRP, 2025 U.S. Dist. LEXIS 127281 (D. Haw. July 3, 2025), now on appeal before the Ninth Circuit, the District Court determined the initial coverage requirements of offense “f” for “use of another’s advertising idea in your ‘advertisement’” were satisfied. The “Failure to Conform” exclusion, however, was then determined to negate that coverage. The opinion is problematic in that it acknowledged the potential for coverage under offense “g” for “infringing upon another’s . . . trade dress . . . in your ‘advertisement’,” but failed to explain why the “Failure to Conform” exclusion would apply to that coverage theory.

This is a common failure of courts analyzing exclusions. In their haste to quickly resolve a case by finding an applicable exclusion, they overlook that coverage law requires them to first articulate the coverage theory to which the exclusion would apply. This was most famously stated in Waller v. Truck Ins. Exchange, Inc., 11 Cal. 4th 1, 16 (1995): “Before ‘even considering exclusions, a court must examine the coverage provisions to determine whether a claim falls within [the policy terms].’” Though no Hawai’i court has explicitly addressed whether the same principle applies under Hawai’i law, those courts routinely adopt coverage principles from California law. For example, the NHC court readily accepted the “all possible worlds” standard for exclusions first articulated in Atlantic Mut. Ins. Co. v. J. Lamb, Inc., 100 Cal. App. 4th 1017, 1039 (2002).

The NHC court’s failure to address the potential trade dress coverage is problematic as that form of coverage is inherently incompatible with the “Failure to Conform” exclusion. The exclusion is aimed at the failure of goods to possess “quality” in the sense of general excellence, not “a quality” in the sense of a particular feature.[3] Trade dress, by contrast, is explicitly defined as a non-functional part of the product that could not possibly affect performance in the manner required by the “Failure to Conform” exclusion.[4]

 Aram Logistics v. United States Liab. Ins. Co.

In Aram Logistics v. United States Liab. Ins. Co., No. 24-1046, 2025 WL 470888 (9th Cir. (Cal.) Feb. 12, 2025), the panel accepted the validity of extrinsic evidence ignored by the district court, but it concluded potential coverage was precluded by the “Knowing Violation” exclusion. The exclusion applies to claims “caused by or at the direction of the insured with the knowledge that the act would violate the rights of another and would inflict ‘personal and advertising injury.’” The panel provided only one conclusory sentence to explain the exclusion’s applicability:

The only extrinsic evidence upon which Aram relies to establish a duty to defend on the part of USLI also indicates that Aram must have knowingly copied Diakon’s advertising materials because the infringing officer at Aram was once at Diakon and was certainly familiar with its advertising information.[5]

The panel failed to address the fact that Aram’s “knowledge” was a contested issue of fact in the underlying litigation. By accepting it as true, the panel ignored the wealth of case law establishing that an insurer cannot rely on contested assertions of scienter to justify application of a “Knowing Violation” exclusion. In KM Strategic Mgmt., LLC v. Am. Cas. Co. of Reading PA, the court rejected its application based on an allegation that the policyholder “engaged in knowingly false and intentional conduct in an effort to prevent Prime Partners from contracting with other IPAs.”[6] This is analogous to the unproven allegations against Aram that it “intentionally attempted to disrupt many of Diakon’s customer relationships by . . . unlawfully using Diakon’s proprietary . . . information.”

The panel’s decision even deviates from prior Ninth Circuit cases holding that scienter-based exclusions should not be applied where the allegations of intent are contested:

Killer Music's actions were not proven to be “willful” as a matter of law. While Zurich characterizes Killer Music's infringement as “knowing,” Killer Music's president Hicklin, by sworn affidavit, indicated that he did not know that any of Pfeifer's work was being used in the music library and that he “never intended to engage in any unauthorized use of any work owned in whole or in part by Pfeifer.”[7]

This practice also fails to account for the logic of Dobrin v. Allstate Ins. Co., 897 F. Supp. 442, 444 (C.D. Cal. 1995), which recognized that a party might strategically plead “specifically so that there [will] be no coverage” to deny their opponent an insurer-funded defense.[8]  

Conclusion

As shown by the NHC and Aram decisions, judges are easily misled by insurers pushing for the “most reasonable” construction of a provision. As understandable as that mistake may be, it is nevertheless still a mistake. As in MacKinnon and several equivalent cases, state supreme courts have clearly articulated the standard for evaluating exclusions, and it does not involve a quest for the “most reasonable” construction. Policyholder counsel must make every effort to emphasize the proper rule for judges who often are unfamiliar with coverage law and have instincts that make them prone to flawed arguments of insurers.

*David A. Gauntlett is a principal of Gauntlett & Associates and represents policyholders in insurance coverage disputes regarding intellectual property, antitrust, and business tort claims, as well as in the underlying actions. Mr. Gauntlett can be reached at (949) 514-5662 or dag@gauntlettlaw.com. For more information, visit Gauntlett & Associates at www.gauntlettlaw.com.

[1] MacKinnon v. Truck Ins. Exch., 31 Cal. 4th 635, 655 (2003) (“[E]ven if [the insurer’s] interpretation is considered reasonable, it would still . . . have to establish that its interpretation is the only reasonable one.  ‘[W]e are not required, in deciding the case at bar, to select one “correct” interpretation from the variety of suggested readings.’ ”) (citation omitted).

[2] SXSW, 2024 U.S. App. LEXIS 6771 at *9 (“We need not consider Federal's understanding of the exclusion because SXSW's reading of it is plainly reasonable.”)

[3] Pennfield Oil Co. v. Am. Feed Indus. Ins. Co. Risk Retention Grp., Inc., No. 8:05CV315, 2007 U.S. Dist. LEXIS 21456, at *25 (D. Neb. Mar. 12, 2007) (“[T]he injuries excluded by the clause are limited to those caused by a claim that the company's product did not conform with its advertised quality or performance.”); DecisionOne Corp. v. ITT Hartford Ins. Group, 942 F. Supp. 1038, 1043 (E.D. Pa. 1996) (“[T]he exclusion for the failure of goods, products or services to conform with advertised quality or performance, is not applicable. STK was not claiming that Bell Atlantic's quality did not rise to the level advertised.”)

[4] Star Mkts., Ltd. v. Texaco, Inc., Civil NO. 95-01018 BMK, 1996 U.S. Dist. LEXIS 22443, at *9–10 (D. Haw. Dec. 11, 1996) (“To prevail on a claim of trade dress infringement, Plaintiff must establish that its trade dress (1) is nonfunctional . . . .”)

[5] Aram Logistics, 2025 WL 470888 at *1.

[6] See, e.g., KM Strategic Mgmt., LLC v. Am. Cas. Co. of Reading PA, 156 F. Supp. 3d 1154, 1170 (C.D. Cal. 2015) (“An insurer does not meet its burden of establishing an exclusion's application by pointing to unproven and disputed allegations in the very complaint it is called upon to defend.”); Arch Specialty Ins. Co. v. Beacon Healthcare Servs., Inc., No. 822CV00305MCSDFM, 2023 WL 2347396, at *4–5 (C.D. Cal. Jan. 18, 2023) (dispute over consensual nature of sexual relationship precluded use of “Abuse or Molestation” exclusion).

[7] Zurich Ins. Co. (U.S. Branch) v. Killer Music, Inc., 998 F.2d 674, 678 (9th Cir. (Cal.) 1993).

[8] See also Hudson Ins. Co. v. Colony Ins. Co., 624 F.3d 1264, 1296 (9th Cir. (Cal.) 2010) (recognizing plaintiffs may omit valid negligence counts “for strategic adversarial reasons”).