New Jersey Appellate Court enforces “capacity” exclusion in D&O policy as matter of first impression

As a matter of first impression, on July 9, 2024, the Superior Court of New Jersey Appellate Division issued a published decision upholding and enforcing a “capacity” exclusion contained in a Directors and Officers Liability (“D&O”) policy where the insured director/officer was acting in a dual role for both an insured business and an uninsured business. Mist Pharm., LLC v. Berkley Ins. Co., A-1286-22, 2024 WL 3333916 (N.J. Super. App. Div. July 9, 2024). The Court held that such an exclusion excluded coverage for the entire shareholder lawsuit, notwithstanding that the insured was allegedly liable in both an insured capacity and in an uninsured capacity. In this decision, the Appellate Division also found that the trial court erred when it failed to consider the applicability of the capacity exclusion in evaluating whether Berkley Insurance Company (“Berkley”) acted reasonably in withholding its consent to settle.

Berkley issued a D&O policy to Mist Pharmaceuticals, LLC (“Mist”). Mist and the chairman of its board, Krivulka, who was also a 90% owner of Mist, were sued along with other defendants in a Delaware action for an alleged self-dealing scheme. A shareholder of Akrimax Pharmaceuticals, LLC (“Akrimax”) sued Mist and Krivulka, who was also a director of Akrimax. The shareholder alleged that, in two of the transactions at issue, Mist acquired distribution rights for two drugs and then assigned those rights to Akrimax, as a result of which Akrimax bore all costs and expenses while Mist acted only as a “middleman.” The shareholder alleged that Krivulka improperly inserted Mist with no substantive business purpose because his personal interest in Mist was greater than his interest in Akrimax. 

After Mist reported the shareholder’s suit to Berkley, Berkley denied defense and indemnity coverage because the “claim,” as defined in the Berkley policy, arose prior to the inception of the policy period. Berkley also reserved the right to disclaim coverage based upon its “capacity” exclusion, pursuant to which coverage is excluded for “a claim made against any insured … based upon, arising out of, directly or indirectly resulting from or in consequence of, or in any way involving any Wrongful Act of an Insured Person serving in their capacity as director, officer … of any other entity other than an Insured Entity….” 

Mist commenced an action against Berkley seeking a declaratory judgment that Berkley was required to defend and indemnify Mist in the shareholder’s lawsuit. After discovery, the trial court found that no “claim,” as defined in the Berkley policy, arose prior to Berkley’s policy period, and that the shareholder lawsuit triggered Berkley’s duty to defend Mist. Thereafter, Mist sought Berkley’s consent to settle the shareholder lawsuit as well as indemnification for a global settlement that included Mist and other non-covered co-defendant businesses.   Berkely declined to consent or to indemnify Mist for the settlement. The trial court found that Berkely’s withholding of its consent to settle was unreasonable and refused to consider the applicability of the “capacity” exclusion because, under Fireman’s Fund Insurance Co. v. Security Insurance Co. of Hartford, 72 N.J. 63 (1976), “a recalcitrant insurer that breaches its policy can no longer look to contractual defenses to avoid coverage.” The trial court consequently entered judgment in favor of Mist and against Berkley.

The Appellate Division reversed. The Court noted that, under Fireman’s Fund, an insurer forfeits its coverage defenses only if it unreasonably delayed in investigating or dealing with a claim or unreasonably withholds consent to settle. The Court held that Berkeley’s refusal to provide consent to settle was reasonable in this case because “the global settlement represented the separate interests of multiple entities not insured under the policy, and Berkley reserved its rights under the capacity exclusion repeatedly from its earliest communications with Mist….” Therefore, it held that the trial court’s refusal to consider the capacity exclusion was in error.

As to the interpretation of the capacity exclusion, the Appellate Division noted that the critical phrase “arising out of” has been interpreted expansively under New Jersey law to mean conduct “originating from,” “growing out of” or having a “substantial nexus,” and such expansive interpretation applies both when the phrase appears in a coverage grant and in an exclusion. The Appellate Division further found persuasive decisions from Georgia, California, New York, Pennsylvania, and the Eleventh Circuit interpreting similar exclusions and concluded that because Akrimax’s alleged loss stemmed from Krivulka’s self-dealing in his capacity as both a director of Akrimax and a majority shareholder of Mist, under the “but for” analysis the Court adopts, Berkley’s “capacity” exclusion precluded coverage for the shareholder’s lawsuit. Further, the Court clarified that this analysis does not require the comparison of percentage of conduct by Krivulka as allocated between the covered and uncovered businesses. Rather, the exclusion applies to the entire lawsuit because the claimed loss arose from, and could not have occurred but for, Krivulka’s conduct in his uninsured capacity as a director of Akrimax. 

As a case of first impression in New Jersey, this precedential decision offers helpful guidance in evaluating similar capacity exclusions in D&O policies. Specifically, the court would interpret such an exclusion broadly to permit a disclaimer of coverage for the entire shareholder lawsuit, notwithstanding that the insured participated in the faulty underlying transaction in both an insured capacity and in an uninsured capacity. It also reinforces the importance of identifying potentially applicable exclusions early in a claim and communication of the insurer’s reservation of rights under potentially applicable exclusions. Moreover, it sets forth explicitly that an insurer may take into consideration coverage defenses in conducting a reasonable investigation and evaluation into whether to give its consent to settle.