Hunton Insurance Recovery Blog

A panel of the California Court of Appeals, in an unpublished opinion (Stein v. Axis Ins. Co., (Cal. Ct. App., Mar. 8, 2017, No. B265069) 2017 WL 914623), issued March 8, 2017, held that a policy exclusion requiring "final adjudication" did not support a refusal to pay the policyholder's defense costs by Houston Casualty Company (HCC) following a trial court's entry of judgment where the policyholder still could pursue appeal.

Michael Stein, a founder of Heart Tronics, was indicted in federal court on criminal charges including securities fraud.  In 2013, a jury convicted Stein on all charges and he was sentenced to a lengthy prison term.  Following his conviction, Stein tendered his criminal appeal to HCC, Heart Tronics' second-layer D&O insurer after coverage issued by Heart Tronics' primary insurer, Axis Insurance Company, had been exhausted. HCC denied coverage contending, in part, that coverage was barred by the policy's Willful Misconduct Exclusion.  Stein sued HCC (as well as Axis on the theory that it has conspired with HCC to defraud him), and the trial court sustained the insurers' demurrers, dismissing Stein's claims with prejudice.

The California Court of Appeals reversed as to HCC, rejecting HCC's argument regarding the Willful Misconduct Exclusion.  The Willful Misconduct Exclusion provided that "Except for Defense Expenses, the Insurer shall not pay Loss in connection with any Claim occasioned by willful misconduct," but only "if there has been . . . a final adjudication adverse to [the] Insured Person in the underlying action."  Significantly, while the Exclusion expressly carved out "Defense Expenses," the Exclusion further provided that "[i]f it is finally determined that [the exclusion] applies," the policyholder would be required to repay any defense expenses paid by HCC on the policyholder's behalf.  HCC contended that Stein's conviction in the trial court was a "final adjudication" sufficient to trigger the exclusion because it was "final under federal law until reversed."  HCC reasoned, therefore, that not only did the exclusion bar coverage for Stein's trial-level defense, but it also obviated any obligation to pay Stein's defense expenses on appeal given the exclusion's repayment language.

The Court forcefully rejected HCC's argument that "final adjudication" in the policy means "final under federal law until it is reversed."  The Court explained that the policy made no mention of federal law, nor any distinction between federal and state proceedings.  Further, the Court commented that "a thing that is 'final until reversed' is not final," and that "[a]n appellate court can render an adjudication as well as a trial court can, with the added benefit of greater finality."  The Court also distinguished cases HCC relied on, which interpreted different policy language requiring only a "judgment or other final adjudication."  The Court's analysis suggested that the word "judgment," without the adjective "final" before it, could include an appealable judgment, but the policy's use of the term "final adjudication," instead of simply a "judgment," implied that a trial court judgment alone would not trigger the exclusion.

The Stein case teaches valuable lessons for policyholders.  In selecting D&O coverage, policyholders should pay careful attention to the proposed wording of the policy's Willful Misconduct Exclusion, which typically is intended to apply to intentional business torts such as fraud.  Policyholders should examine what events trigger the exclusion, as well as the existence and scope of any carve-outs (such as defense expenses) or repayment obligations.  Key considerations include:

• Is the exclusion triggered by a "final adjudication," a "final judgment" or a "judgment after the exhaustion of all appeals," or can it be triggered merely by a "judgment?"
• Are defense expenses carved out from the exclusion? Many policy forms carve out such expenses.
• Is there an obligation to repay defense expenses if the willful misconduct judgment is affirmed on appeal and, if so, after what level of appeal? Many policy forms do not impose a repayment obligation at all.

Consulting coverage counsel when selecting a D&O policy is an important step in making sure your directors and officers are not left funding their own appeals.