California Appellate Court Holds D&O Insurer Must Pay Cost of Insured’s Appeal Despite Criminal Conviction

In Stein v. Axis Ins. Co., No. B265069, 2017 Cal. App. Unpub. LEXIS 1628 (Ct. App. Mar. 8, 2017), the Second District California Court of Appeal had occasion to consider whether a criminal conviction is a “final adjudication” such that it could bar coverage for appeal expenses under a willful misconduct exclusion.

In November 2007, Heart Tronics and its de facto officer, Mitchell Stein, purchased a $5 million director and officer (D&O) liability insurance policy from Houston Casualty Company (“HCC”). The original terms of the policy did not provide coverage for criminal acts. Nor did the original terms include coverage for “de facto” directors or officers. Because Mitchell Stein managed the company full-time without pay or a formal position or title, he was unsatisfied with the original HCC policy.

Stein and Heart Tronics obtained an amended policy from HCC that (1) changed the definition of “claim” to include criminal proceedings, up to and specifically including appeals; and (2) expanded the definition of “wrongful act” to include acts committed by those acting in their capacity as the “functional equivalent” of an officer or director. HCC allegedly represented to Stein and Heart Tronics that Stein would “absolutely” covered under the amended HCC policy.

On December 13, 2011, a federal grand jury indicted Stein on 14 counts of mail, wire, and securities fraud; money laundering; and obstruction of justice. The grand jury charged that Stein engaged, among other things, in an illegal “pump and dump” scheme. On May 20, 2013, a jury found Stein guilty on all counts. He was sentenced to 17 years in prison. Stein appealed the judgment to the Eleventh Circuit. In January 2017, the Circuit Court affirmed his conviction, but vacated the sentence and remanded the matter for resentencing. On February 7, 2017, Stein moved for an en banc rehearing before the Circuit Court.

Following his criminal conviction, Stein tendered his appeal to HCC. HCC denied coverage on the grounds that Stein was not the “functional equivalent” of a Heart Tronics officer.  HCC also invoked the willful misconduct exclusion of the policy, which stated that “Except for Defense expenses, the Insurer shall not pay loss in connection with any claim” occasioned by willful misconduct.  The exclusion made clear that it could be invoked “only if there has been a final adjudication adverse the Insured Person in the underlying action … establishing that the Insured Person” committed willful misconduct.

On June 25, 2014, Stein and Heart Tronics sued HCC in the California Superior Court of Los Angeles County alleging, among other things, fraud and breach of contract. HCC demurred to the complaint, contending that Stein was not an insured person under the policy and Stein’s defense expenses did not constitute covered losses under the policy. The trial court sustained the demurrer without leave to amend. Stein appealed.

On appeal, the appellate court rejected the trial court’s determination that Stein’s defense expenses on appeal were not covered losses. The appellate court held the trial court’s rationale that Stein’s criminal conviction was “final … until it is reversed” was erroneous because the HCC policy clearly and explicitly obligated HCC to cover an insured’s defense expenses as a result of an appeal from a criminal proceeding, even if a trial court determined the insured was guilty or liable for fraud.

The court distinguished the language in the willful misconduct exclusion in the HCC policy from that same provision in other policies that barred coverage for a “judgment or other final adjudication.”  As the exclusion in the HCC policy only applied to a “final adjudication,” the exclusion could not apply to preclude coverage.  The court’s ruling further explained that “a thing that is ‘final until reversed’ is not final.”  In other words, “[a]n appellate court can render an adjudication as well as a trial court can, with the added benefit [of] greater finality.”  The court concluded that the HCC’s policy “covers an insured’s litigation expenses incurred in directly appealing a conviction” because the policy specifically required HCC to pay defense costs.  The court therefore reversed the judgment against Stein.