A recent California appellate court decision, Mt. Hawley Insur. Co. v. Lopez, addresses an important topic regarding the advancement of defense costs when a director or officer is facing criminal prosecution.  The decision was sent to us by our friends Fran Goins and Jim Wing, who are respectively chairs of the Developments and D&O Insurance Subcommittees of the ABA Business Section’s Director and Officer Liability Committee.

The case arose from an insurer’s denial of coverage for defense costs incurred in a federal criminal case based on a California statute, Cal. Insur. Code 533.5(b), prohibiting insurers from advancing defense costs.  The statute provides:

No policy of insurance shall provide, or be construed to provide, any duty to defend…any claim in any criminal action or proceeding or in any action or proceeding brought pursuant to California’s unfair competition law under Business and Professions Code Sections 17200 and 17500 in which the recovery of a fine, penalty, or restitution is sought by the Attorney General, any district attorney, any city prosecutor, or any county counsel, notwithstanding whether the exclusion or exception regarding the duty to defend this type of claim is expressly stated in the policy.

Lopez, the insured, was charged by federal prosecutors with criminal violations of federal statutes.  Lopez claimed that he was entitled to advancement of his defense costs because the statute applied only to civil and criminal claims seeking recovery of a fine, penalty, or restitution under the enumerated California statutes addressed to unfair competition and unfair advertising and brought by one of four specific enforcement counsel.  The insurer argued, and the trial court held, that Sec. 533.5(b) was not so limited, and that it in fact barred insurers from covering defense costs in any criminal action.

The Court of Appeals for the Second Appellate District in California reversed the trial court. It held that the statute bars defense cost advancement only in respect of claims or charges brought by the named enforcement counsel under the specifically identified state statutes, and did not bar the advancement of defense costs in a criminal proceeding brought by a federal prosecutor.  The Court of Appeals based its ruling not only on the legislative history of Sec. 533.5(b), but also on  other California statutes which authorize insurance that “provides a defense to individual defendants in various kinds of proceedings, including criminal proceedings.”  As a result, the insurer in this case, which had agreed to provide its insureds with a defense in “a criminal proceeding . . . commenced by the return of an indictment” “even if the allegations are groundless, false or fraudulent,” could not avoid its contractual duty to defend an insured against federal criminal charges by relying on the above statute.

Importantly, the Court of Appeals also drew support from the more general policy of corporation law favoring director and officer protection. It held  that California  “Corporations Code Section 317 applies to criminal proceedings against the agent as long as that person acted in good faith and in a manner the person reasonably believed to be in the best interests of the corporation and, in a criminal case, where the person had no reasonable cause to believe the conduct of the person was unlawful.”  See, e.g., Cal. Corp. Code 317(b) and (c).  The Court  noted that “[a]llowing insurers to provide for defense costs in criminal cases against corporate agents enhances the ability of for-profit and non-profit organizations to attract directors [and officers] who otherwise might hesitate or decline to serve because of fear of lawsuits and criminal prosecutions.”  It further held that advancement was “consistent with the principle that insureds charged with crimes begin with a presumption of innocence.” The Court differentiated between indemnification and defense and noted that “there is no public policy in California against insurers contracting to provide a defense to insureds facing criminal charges, as opposed to indemnification for those convicted of criminal charges.”

This opinion stresses that advancement fulfills a major objective of corporate policy.  It does not, however, consider the issue of whether advancement can be required when the person seeking advancement from either the corporation or an insurer asserts the Fifth Amendment privilege (or the insured’s counsel, the work product privilege) in response to inquiries by either the corporation or the insurer. The latter issue is a major focus of the ABA committee’s current work, given that the vast bulk of existing case law and corporate statutes do not expressly provide that these policies are sufficient to override an assertion of an executive’s privilege against self-incrimination.

This decision has direct implications for Delaware practitioners.  According to Jim Wing, some states (and California is one of them) apply the law of that state to advancement and indemnity rights of directors and officers of (generally, non-public) Delaware corporations that have a certain nexus to the state.  The California statute facially forbids any contract that attempts to reverse that point.  

This area of the law, formerly thought to be settled, continues to evolve.