New Jersey Supreme Court Holds That Capacity Exclusion Bars Coverage for Claims Involving Unfair Dealing Between Insured and Uninsured Entities Sharing Common Control

The New Jersey Supreme Court has affirmed the ruling of a state appellate court, upholding the right of an insurer to withdraw coverage pursuant to a capacity exclusion on which it had reserved rights.

The insurer issued a Directors and Officers insurance policy to Mist Pharmaceuticals (“Mist”) as the named insured. According to the terms of the policy, the chair of Mist’s board of directors (the “Chairman”) was an “insured person”. However, the policy contained a “capacity exclusion,” which barred coverage for claims involving a Wrongful Act committed by an Insured Person serving in their capacity as a director, officer, trustee, employee, member or governor of any other entity other than an Insured Entity.

A separate company—owned in part by the Chairman—brought direct and derivative actions against Mist, the Chairman, and several other entities the Chairman owned and/or controlled, alleging that the Chairman and his “paper companies” engaged in a scheme of self-dealing and improper transfers to deprive and divert profits away from the plaintiff entity in the underlying actions.

Mist and other companies owned by the Chairman retained defense counsel, and Mist tendered the claim to its insurer under the Directors and Officers policy. The insurer initially agreed to defend the claims under a reservation of rights, noting that only Mist and the Chairman are insureds under the policy, that none of the other defendant entities in the underlying actions are insured entities, and that, pursuant to the capacity exclusion, the policy would not cover the Chairman in connection with allegations arising out of his roles with any entity other than Mist.

Ultimately, the insurer withdrew coverage for the claims against Mist on the basis that the allegations against it were known to Mist prior to the start of the policy period. In connection with its withdrawal of coverage, the insurer advised Mist that it would not participate in mediation.

Mist then filed a coverage action against its insurer, alleging the insurer breached the policy, that it was estopped from withdrawing coverage, that its withdrawal constituted bad faith, and sought a declaration of coverage. The insurer raised the capacity exclusion as an affirmative defense and filed counterclaims seeking reimbursement of fees it had already paid to defend Mist in the underlying actions. During the pendency of the coverage action in the trial court, Mist requested that its insurer participate in a global settlement negotiation. Ultimately, a settlement was reached without the participation of the insurer. Eventually, the trial court found the insurer had a duty to defend and indemnify Mist in connection with the settlement. The insurer appealed, and the appellate division reversed, after which Mist petitioned for certification to the New Jersey Supreme Court, which granted certification and affirmed the reversal by the Appellate Division.

The insurer argued before the New Jersey Supreme Court that the capacity exclusion barred coverage for the claims because they primarily concerned the Chairman’s self-dealing as a director of the underlying plaintiff, rather than in his capacity as a director of Mist, the insured entity. In evaluating this contention, the New Jersey Supreme Court distinguished between, on one hand, exclusionary clauses that apply only where evidence supports a causal link between an excluded act and the alleged loss, and, on the other hand, clauses that do not require a causal relationship in order for the exclusion to apply. The court found the capacity exclusion at issue fell into the latter category, as it did not require that evidence establish the existence of any such causation.

Instead, the court held that the capacity exclusion barred coverage to the extent that the allegations in the underlying action in any way involve the wrongful act of an insured person acting in his capacity as an officer for another entity. Insofar as the underlying claims at issue focus on the acts and omissions of the Chairman in his capacity as the director of the underlying plaintiff entity—and not in his capacity as Mist’s director—the court held that the allegations fell within the scope of the exclusion and therefore barred coverage.

Notably, a dissenting opinion concluded that the exclusion bars coverage only for those wrongful actions that the insured person committed in an uninsured capacity, but not for actions he committed in his insured capacity as Mist’s director. The majority disagreed, holding that the exclusion barred coverage for any claim “in any way involving” a wrongful act committed by reason of an insured person’s status as a director or officer of another entity. Therefore, even if the claims partially involved actions committed in the Chairman’s role with Mist, the claims also involved alleged unfair dealings between Mist and a non-insured entity over which the Chairman had control. Because each underlying claim involving Mist also involved alleged wrongful acts by the Chairman in his capacity as an officer for an uninsured entity, the court found the capacity exclusion applied to bar coverage entirely.

Finally, the court held that the insurer did not act in bad faith by declining to participate in the global settlement, and that the insurer was not estopped from withdrawing coverage. The court found that, absent a covered claim, the insurer—having correctly determined that an exclusion barred coverage—had no obligation to contribute its policy limits towards the settlement. Moreover, the insurer reserved rights under the operative exclusion from the outset and relied on its reservation in ultimately denying coverage. The court therefore held that Mist could not have justifiably relied on any commitment by the insurer to cover the settled claims given that the settlement was reached after the insurer had already asserted the exclusion as an affirmative defense to the complaint in the coverage action.