The California Court of Appeals (2nd District) in Stein v. Axis Insurance Co., 10 Cal. App. 5th, 673, 216 Cal.Rptr.3d 804 (2nd Dist. 2017) held that a provision in a D&O policy requiring the insured to repay defense expenses unless there was a “final adjudication” determining that the insured committed willful misconduct did not eliminate coverage for defense expenses incurred during the insured’s appeal of the criminal fraud conviction.
At issue in this case was a wrongful misconduct exclusion which provided in relevant part that “except for defense expenses, the insurer shall not pay loss in connection with any claim” occasioned by willful misconduct. As is typical of this type of exclusion, the exclusion was triggered “only if there has been . . . a final adjudication adverse to [the] insured person in the underlying action . . . establishing that the insured person” committed the wrongful misconduct. The policy also contained a reimbursement provision that required the insured to repay the insurer’s defense expenses if it was ultimately determined that the exclusion applied, i.e., after a “final adjudication.”
The California trial court held that the policy’s willful misconduct exclusion precluded coverage because the criminal conviction was “final under federal law until it is reversed” and therefore the conviction, standing alone, constituted a “final adjudication” of the insured’s guilt within the meaning of the exclusion. The California Court of Appeals (2nd Dist.), disagreed. The Court of Appeals found three fatal flaws in the trial court’s analysis for why the exclusion applied. First, there was nothing in the policy that indicated the parties intended that the phrase “final adjudication” carried the same meaning in the exclusion as it carried under federal law. The fact that the conviction was in federal court was irrelevant to the application of the exclusion. Second, addressing the issue of whether the adjudication was final until reversed, the court pointed out that such an adjudication was not final for all purposes. Although the judgment may have res judicata effect, it could still be appealed and an appellate ruling was as much an adjudication as the trial court’s judgment, albeit the Court of Appeals adjudication would have the benefit of greater finality. Finally, the exclusion, by its terms, did not apply to defense expenses. The reimbursement provision only permitted the insured to seek the reimbursement of defense costs that had been paid once a final adjudication established that the exclusion applied.