Directors and officers (D&O) and errors and omissions (E&O) policies often contain “capacity” limitations, which restrict coverage to claims against the insured alleging acts undertaken by the insured in his or her insured capacity. These insured capacity limitations can take on different forms. For example, the policy may limit the definition of an “insured person” to someone acting in his or her capacity as an officer or director of the insured company. Or the definition of a covered “wrongful act” can be limited to acts undertaken solely in the insured’s capacity as an officer or director of the insured company. In Associated Industries Insurance Co. v. Kleinhendler, the Second Circuit Court of Appeals addressed a third type of insured capacity limitation in the context of an exclusion.

In Kleinhendler, Associated Industries Insurance Co. (AIIC) filed suit against Howard Kleinhendler and his former law firm, Wachtel Missry LLP, seeking a declaration that AIIC need not provide insurance coverage under an E&O policy for either Kleinhendler or the firm in connection with a legal malpractice suit filed by Allan Applestein and Diatomite Corporation of America. According to the plaintiffs in the legal malpractice action, Applestein engaged Kleinhendler and the firm to represent him in connection with the sale of land. Applestein alleged that Kleinhendler took advantage of Applestein’s declining health and convinced him to rezone the land so that it could be developed as a mixed-use project. Applestein further alleged that, instead of selling the land to another buyer, Kleinhendler convinced Applestein to sell the land to Kleinhendler so that he could develop it without advising Applestein of the conflicts of interest inherent in the transaction. Thereafter, Kleinhendler created Virginia True Corp. to purchase the land, all while continuing his legal representation of Applestein. Based on acts allegedly undertaken by Kleinhendler in connection with the transaction, Applestein filed suit and asserted claims for legal malpractice, breach of fiduciary duty, elder abuse, and fraud.

Subject to its terms and conditions, the E&O policy issued by AIIC to the firm provided insurance for “Damages and Claim Expenses … that the Insured shall become legally obligated to pay as a result of a Claim made against the Insured for a Wrongful Act.” The term “insured” included the firm as well as any partner of the firm, “but solely while acting within the scope of their duties as such on behalf of the [firm] in rendering Professional Services.” The policy defined “professional services” to mean services provided by any Insured to others as a lawyer; in essence, one form of capacity limitation.

The policy contained another capacity limitation in the form of an exclusion, which barred coverage for “any Claim … based upon or arising out of any actual or alleged activities of an Insured as, or an Insured acting in, the capacity as … an officer, director, partner, trustee or employee of a pension, welfare, profit sharing, mutual or investment trust or fund, charitable organization, corporation or business enterprise, other than the Named Insured” (referred to as the “business enterprise exclusion”).

The Second Circuit held that the business enterprise exclusion applied to bar coverage for the legal malpractice action because liability for all of the claims arose out of Kleinhendler’s position at Virginia True. Kleinhendler argued that the business enterprise exclusion did not bar coverage because the complaint in the legal malpractice action alleged acts undertaken by him prior to and unrelated to the formation of Virginia True. The Second Circuit rejected that argument, reasoning that although the Applestein complaint alleged acts predating the formation of Virginia True, all of the claims arose out of Kleinhendler’s position at Virginia True. In that regard, the court noted that the claims rested on the conflict of interest created by Kleinhendler’s position at Virginia True, and his alleged acts were done for the purpose of inducing Applestein to sell the land to Virginia True. Because all of Kleinhendler’s potential liability stemmed from his position at Virginia True, the Second Circuit affirmed the district court order that the business enterprise exclusion applied to bar coverage for the suit in its entirety.