A recent decision from the Delaware Superior Court interpreting a so-called “capacity exclusion” in a director and officer (“D&O”) insurance policy should give private equity sponsors pause when reviewing and renewing both sponsor and portfolio company D&O policies. A “capacity exclusion” in a D&O policy refers to an exclusion of coverage for claims relating to an individual acting in some capacity other than as a director of the portfolio company. D&O lawsuits against directors designated by private equity sponsors almost always allege a breach of the duty of loyalty by such directors based on a director serving in multiple capacities for the sponsor and the portfolio company. Since sponsors typically count on director designees being insured through the portfolio company in addition to any insurance policies maintained by the sponsor, it is critical that D&O policies be reviewed for any capacity exclusions.

In Goggin v. National Union Fire Insurance Co., 2019 WL 97716, C.A. No. N17C-10-083 PRW CCLD (Del. Super. Nov. 30, 2018), the Delaware Superior Court denied coverage based on a “capacity exclusion” in a portfolio company’s D&O policy. The D&O policy excluded coverage for any claim alleging wrongdoing based on the director serving in any capacity other than as an officer or director of the portfolio company.

The court held that the capacity exclusion “clearly and unambiguously” excluded coverage under the policy for claims brought against members of the private equity sponsor who also served as portfolio company directors where the claims in question allegedly “arose out of” conduct performed by the director in their capacity as members/managers of two investment vehicles they set up as part of an effort to “reinvigorate [the portfolio company] through debt and other capital restructuring.” When the portfolio company’s creditors later forced the company into bankruptcy, the creditors committee sued the directors, claiming that they had engaged in conflicts of interest and had caused the portfolio company to enter into unfair contracts that benefitted the member/managers personally, to the detriment of the portfolio company.

The court denied coverage. The court held it did not matter whether the directors were being sued in their capacity as directors as long as the claims “arose from” actions taken by them in another capacity (here, as conflicted members/managers of the investment vehicles they set up). The court found that the D&O policy excluded coverage for any claims that would not have existed “but for” the actions taken by the directors in their capacity as members/managers (as opposed to as directors).

It remains to be seen whether other courts (including the Court of Chancery of Delaware) will adopt the same broad interpretation of the “capacity exclusion.” The decision has been criticized, mainly for failing to take into account that the directors in Goggin were only sued by the creditors committee for breaching their fiduciary duties in their capacity as directors, and D&O policies should typically cover any claims against individuals serving in that capacity. In other words, “but for” their status as directors, there would have been no lawsuit.

Key Takeaway

The main takeaway from the decision is that private equity sponsors and their insurance brokers ought to carefully review D&O policies of their portfolio companies to make sure they understand whether they contain a capacity exclusion and, if so, whether any improvements in policy language can be obtained to eliminate or minimize the risk created by the decision in Goggin. Private equity sponsors should also look at their own D&O policies to make sure they have adequate coverage available for claims against them and their designees serving on portfolio company boards, especially where, as in Goggin, policy exclusions exist that may limit or preclude coverage for actions taken by individuals serving in dual capacities.

This decision has been appealed to the Delaware Supreme Court. Appellants’ briefs are due February 11, 2019.