United States: Stein v. Axis Insurance Company

In Stein v. Axis Insurance Company, 10 Cal.App.5th 673 (March 8, 2017), the California Court of Appeal reversed the trial court's entry of judgment after issuing an order sustaining defendant Houston Casualty Company's ("HCC") demurrer to a complaint for declaratory relief and bad faith filed by Michael Stein in connection with HCC's refusal to pay for defense expenses incurred in connection with the appeal of a criminal conviction under a directors and officers liability insurance policy issued to Heart Tronics, Inc. ("Heart Tronics"). The parties' dispute arose out of a grand jury charge indicting Stein with 14 counts of mail, wire, and securities fraud; money laundering and obstruction of justice. On May 20, 2013, a jury found Stein guilty on all counts and he was sentenced to 17 years in prison and ordered to forfeit over $5 Million. Stein appealed the judgment, and in January 2017, the 11th Circuit confirmed his conviction, but vacated the sentence and remanded the matter for resentencing. Thereafter, Stein moved for panel or en banc rehearing from the 11th Circuit. The FCC also filed a civil action on December 20, 2011 against Stein and Heart Tronics alleging securities fraud and falsification of records. The FCC alleged Stein "was a de facto officer" of Heart Tronics, in that he performed policy-making functions for Heart Tronics akin to an officer. On February 18, 2015, the district court granted summary judgment to the SEC, finding no triable issue existed as to Stein's securities fraud, and ordered Stein to disgorge $5.3 Million in illegally gained profits.

After his criminal conviction, Stein tendered his appeal to HCC. HCC denied coverage on the ground that Stein was not the functional equivalent of a Heart Tronics officer. In addition, HCC took the position that the judgment entered against him in connection with the criminal proceedings constituted a final adjudication adverse to Stein eliminating its obligation to pay for the appeal of the criminal judgment. In response, Stein filed a complaint for fraud, breach of contract and bad faith against HCC. Stein argued that the definition of "claim" in the HCC policy was expanded in an amended policy issued by HCC after meeting with Stein's broker to include civil or criminal proceedings commenced by the service of a complaint or similar document, the filing of a notice of charges or formal investigative order, or the return of an indictment or information, including an appeal from any such proceeding.

In addition, the definition of "wrongful act" in the HCC policy was re-defined to include an act committed not only by an insured person in his or her capacity as a director or officer of Signal Life (i.e., Heart Tronics), but also an insured person acting in his or her capacity as the "functional equivalent" of an officer or director. As redefined, "wrongful act" meant "any actual or alleged act . . . or breach of duty by an insured person," and "insured person" was expanded to include not only officers and directors, but any person "serving in a position functionally equivalent" to an officer or director.

Lastly, the willful misconduct exclusion in the HCC policy was amended to provide, in pertinent part, that "except for defense expenses, the insurer shall not pay Loss in connection with any claim" occasioned by willful misconduct. The exclusion would be invoked "only if there has been a final adjudication adverse to the insured person in the underlying action establishing that the insured person committed willful misconduct." If it is finally determined that the exclusion applies, "the insured would be obligated to repay the insurer any defense expenses paid on his or her behalf."

In reversing the trial court's order sustaining HCC's demurrer to Stein's complaint, the Court of Appeal held as follows:

The HCC policy provided coverage for "loss," which the policy defined as "any amount," including defense expenses, the insured would be obligated to pay as the result of a claim. "Claim" included any civil or criminal proceeding, and expressly included "an appeal from any such proceeding." Although the Willful Misconduct Exclusion removed coverage for losses brought about by fraud or criminal acts, the exclusion did not apply to defense expenses: "Except for Defense Expenses, the Insurer shall not pay Loss in connection with any Claim [brought about by fraud]." (Italics added.) The policy language therefore clearly and explicitly obligated HCC to cover an insured's defense expenses incurred as a result of an appeal from a civil or criminal proceeding even if a trial court determined the insured was guilty of or liable for fraud.

This coverage is further supported by the fact that when the parties wished to exclude defense expenses from coverage, they did so explicitly. Exclusion III(B) excludes payment for defense expenses if a claim involves bodily injury, as follows: "The Insurer will not pay Loss, including Defense Expenses, in connection with any Claim ... for bodily injury, sickness, disease or death of any person, or for damage to or destruction of any tangible property ... ." That Exclusion (III)(A) did not explicitly exclude defense expenses on appeal implies the parties did not wish it to do so.

HCC argues the Willful Misconduct Exclusion, which becomes operative once there has been a "final adjudication" of fraud, precludes coverage here because a federal trial court judgment such as Stein's criminal conviction is a final adjudication for policy purposes. This is so, HCC argues, because under federal law, a trial court judgment is deemed to be a final adjudication until reversed on appeal. The argument suffers many fatal flaws.

First, nothing in the policy indicates the parties intended that the phrase "final adjudication" carry the same meaning in the exclusion as it carries in federal law. Policy language is construed in the context of the policy as a whole and the circumstances of the case, not by reference to abstract concepts cherry picked from outside factors. (Powerine Oil Co. v. Superior Court, supra, 37 Cal.4th at p. 391.) The policy made no mention of federal law and no distinction between federal and state court proceedings. That Stein's conviction happened to be in federal court was irrelevant to the policy.

Second, even under federal law, an adjudication that is "final until reversed" is not final for all purposes. (See Martin v. Martin (1970) 2 Cal.3d 752, 761 [87 Cal. Rptr. 526, 470 P.2d 662] [under federal law, a trial court judgment is final for purposes of res judicata but may still be appealed].) An appellate ruling is as much an "adjudication" as a trial court judgment, with greater finality.

Third, even if HCC were correct that the Willful Misconduct Exclusion comes into play when a final adjudication determines culpability, the point is irrelevant because the exclusion by its terms does not apply to defense expenses.

HCC represents that "[c]ourts have repeatedly held that the exhaustion of all appeals is unnecessary to satisfy exclusions that require a 'final adjudication.'" HCC cites two trial court cases for this "repeated" holding, Unencumbered Assets v. Great American Ins. Co. (S.D. Ohio 2011) 817 F.Supp.2d 1014 (Unencumbered Assets) and Chubb Custom Ins. Co. v. Triumph Capital Group, Inc. (Super. Ct. 2007) 22 Mass.L.Rep. 192 (Triumph), but each undermines rather than supports HCC's point. In each case, the policy at issue provided that a "'judgment or other final adjudication'" would trigger a dishonesty exclusion. (Unencumbered Assets, supra, at p. 1033, italics added; Triumph, supra, at p. 193, italics added.) Each court treated this phrase as disjunctive, and held that the occurrence of either disjunct—for example, a judgment—would alone suffice to trigger the dishonesty exclusion. (Unencumbered Assets, supra, at p. 1032; Triumph, supra, at p. 194 ["the phrase 'judgment or other final adjudication' is disjunctive, so a judgment of conviction would still be sufficient by itself to bar coverage even if it were not a final adjudication"].) The HCC policy is not disjunctive—there is only one trigger for the Willful Misconduct Exclusion: final adjudication. If anything, this implies a judgment alone would not trigger the exclusion.

We conclude the HCC policy covers an insured's litigation expenses incurred in directly appealing a conviction. (See Mid-Century Ins. Co. v. Superior Court (2006) 138 Cal.App.4th 769, 775 [41 Cal. Rptr. 3d 833] [an action is deemed to be pending until HCC's final determination upon direct appeal].) Plaintiffs alleged HCC breached the policy by denying coverage for these expenses. Therefore, HCC's demurrer on the ground that Stein's criminal conviction precluded coverage should have been overruled.

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