Stein v. Axis Ins. Co.

• Decision Date: 08 March 2017
• Docket Number: B265069
• Citation: 10 Cal.App.5th 673,216 Cal.Rptr.3d 804
• Parties: Mitchell J. STEIN, Plaintiff and Appellant, v. AXIS INSURANCE COMPANY et al., Defendants and Respondents.
• Court: California Court of Appeals Court of Appeals

10 Cal.App.5th 673

216 Cal.Rptr.3d 804

Mitchell J. STEIN, Plaintiff and Appellant,

v.AXIS INSURANCE COMPANY et al., Defendants and Respondents.

B265069

Court of Appeal, Second District, Division 1, California.

Filed March 8, 2017

As Modified April 6, 2017

Certified for Partial Publication.^*

Law Offices of James N. Fiedler and James N. Fiedler for Plaintiff and Appellant.

Bowman and Brooke, Julian G. Senior and Marion V. Mauch ; BatesCarey, Ommid C. Farashahi, Michael T. Skoglund and Tiffany Saltzman–Jones for Defendants and Respondents AXIS Insurance Company and AXIS Capital Holdings Limited.

Drinker Biddle & Reath, William A. Hanssen ; Shipman & Goodwin and Joseph A. Bailey III for Defendants and Respondents HCC Global Financial Products, LLC, HCC Insurance Holdings, Inc., and Houston Casualty Company.

CHANEY, J.

In 2007, Heart Tronics, Inc., a medical device company, purchased directors and officers liability insurance policies from AXIS Insurance Company (AXIS) and Houston Casualty Company (HCC). The AXIS policy has been exhausted.

Under the HCC policy, HCC agreed to pay defense expenses incurred by Heart Tronics's officers and directors, and individuals serving in functionally equivalent capacities, in any criminal or civil proceedings, including appeals. An exclusion provided that upon final determination that an insured person committed willful misconduct, the insured would be obligated to repay the insurer any defense expenses paid on his or her behalf.

Mitchell J. Stein served Heart Tronics as a de facto officer, managing the company full-time without pay or formal position or title. In 2013, Stein was convicted of securities fraud in federal court. He tendered his appeal of that conviction to HCC, but HCC denied coverage, in part because it considered the conviction to be a "final determination" of Stein's willful misconduct for purposes of the policy exclusion, notwithstanding the policy's express coverage of defense expenses on appeal. Stein's conviction was affirmed on appeal, but a motion for rehearing is currently pending.

Stein sued HCC, alleging it defrauded him and breached the 2007 policy by failing to pay his litigation expenses on appeal. Stein also sued AXIS, alleging it conspired with HCC to defraud him. The superior court sustained the insurers' demurrers without leave to amend on several grounds and dismissed the case.

We conclude the AXIS demurrer was properly sustained because AXIS was a stranger to the HCC policy and owed no duties connected with it. The HCC demurrer was improperly sustained because when a policy expressly provides coverage for litigation expenses on appeal, an exclusion requiring repayment to the insurer upon a "final determination" of the insured's culpability applies only after the insured's direct appeals have been exhausted. Therefore, we reverse the trial court's judgment in part and affirm it in part.

BACKGROUND

We take the facts from the operative first amended complaint and from matters properly subject to judicial notice.

Heart Tronics, Inc., formerly Signalife Inc. (we will refer to them interchangeably), developed and manufactured an electrocardiograph

monitor called the Fidelity 100. Stein was a founder of Heart Tronics, and by 2007 functioned as its outside general counsel and also what he calls its "chief creative architect," managing the company on a full-time, daily basis without pay, formal position or title.

In November 2007, Stein and Lowell Harmison, CEO of Heart Tronics, purchased a $5 million directors and officers (D & O) liability insurance policy from HCC.

1. Original HCC Policy Draft

As originally offered, the HCC policy provided that HCC agreed to "pay, on behalf of the Insured Persons, Loss from Claims first made during the Policy Period," November 13, 2007, to November 13, 2008.¹

a. Original Definitions

"Loss" was defined as "any amount, including Defense Expenses, which an Insured Person is obligated to pay as a result of a Claim ...."

"Defense expenses" included "reasonable legal fees ... incurred ... in defense of a Claim."

"Insured person" meant "any past, present or future director or officer of" Signalife.

"Claim" meant "written notice received by an Insured Person or the Company that any person or entity intends to hold an Insured Person responsible for a Wrongful Act, including ... a legal, injunctive or administrative proceeding ...."

"Wrongful act" meant "any actual or alleged act ... or breach of duty by an Insured Person in his or her capacity as" a "director or officer" of Signalife.

b. Original Exclusions III(A)(3) and (III)(B)

HCC Policy Exclusion III(A)(3) (the Willful Misconduct Exclusion) excluded payment for loss in connection with any claim arising from "any dishonest or fraudulent ... or ... criminal act ... or any willful violation of any statute ... by an Insured Person," but did not exclude payment for defense expenses, provided that a final determination that the insured person committed the wrongful act would obligate him or her to repay the defense expenses.

Exclusion III(B) (the Bodily Injury Exclusion) excluded payment for defense expenses altogether if the claim involved bodily injury.²

2. Amended HCC Policy

Stein and Harmison were dissatisfied with the offered HCC policy because it failed to cover criminal matters or individuals such as Stein, who had no formal title but was extensively involved in Signalife operations. On December 18, 2007, they met with HCC agents Paul Chambers and Lindsay McLeroy, who offered an amended policy that extended coverage to defense costs for criminal matters—from the initial filing of charges to final appeal—and to any individual serving Signalife as the "functional equivalent" of an officer or director. Chambers and McLeroy represented to Stein and Harmison that the amended policy "absolutely" covered Stein as a de facto officer of Signalife.

a. Amended Definitions

In the amended policy, the definition of "claim" was expanded to include any civil or criminal proceeding "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."

"Wrongful act" was redefined to include an act committed not only by an insured person in his or her capacity as a director or officer of Signalife, 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.

b. Amended Exclusion III(A)(3)

The Willful Misconduct Exclusion 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.³

3. Criminal Proceedings

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, whose wife nominally owned a limited liability company that owned 85 percent of Signalife, misappropriated Signalife's assets, testified falsely to the United States Securities and Exchange Commission (SEC) to conceal his conduct, and engaged in a "pump and dump" scheme wherein he artificially inflated the company's stock and concealed his ownership and trading of the shares. 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 Eleventh Circuit affirmed his conviction but vacated the sentence and remanded the matter for resentencing. (United States v. Stein (11th Cir.2017) 846 F.3d 1135, *1155-1156.) On February 7, 2017, Stein moved for panel or en banc rehearing before the Eleventh Circuit.

4. SEC Action

On December 20, 2011, the SEC filed a civil action against Stein and Heart Tronics, alleging securities fraud and falsification of records. The SEC 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 $5,378,581.61 in illegally-gained profits.

5. Tender to HCC

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.

6. Complaint and HCC Demurrer

On June 25, 2014, Stein and Heart Tronics sued HCC Insurance Holdings, Inc., and in the first amended complaint named as additional defendants HCC, HCC Insurance Holdings Group, and HCC Global Financial Products, LLC.⁴ Plaintiffs asserted in the first amended complaint causes of action for fraud, breach of contract, breach of the covenant of good faith and fair dealing, and unfair competition, alleging Stein was the functional equivalent of a Signalife officer or director, and HCC breached the HCC policy by refusing to pay his defense expenses in the SEC and criminal matters. Plaintiffs alleged Chambers and McLeroy were given express authority by HCC to represent it in negotiations, and they represented to Stein and Harmison that Stein was "absolutely" covered under the HCC policy, knowing at the time that the representation was false. Pla...