No defense duty for criminal restitution claims

On April 15, the 9th U.S. Circuit Court of Appeals rendered its decision in Adir International, LLC v. Starr Indemnity & Liability Co., 2021 DJDAR 3524. Adir involves an unusual situation in which an insurer agreed to defend its insured under a reservation of rights in a lawsuit brought by the California attorney general, but stopped when the warned the insurer that it would be violating the California Insurance Code if it did so.

The insured had sought coverage under a policy obligating the insurer to defend and indemnify the insured and its executives from claims alleging wrongful acts. The attorney general's lawsuit alleged such wrongful acts, seeking restitution, civil penalties, and an injunction. Thus, it would seem that the insurer correctly acknowledged its duty to defend. Not so, according to the attorney general. The attorney general pointed to Insurance Code Section 533.5, which states, "No policy of insurance shall provide, or be construed to provide" "any coverage or indemnity" or "any duty to defend" as to "any claim for the payment of any fine, penalty, or restitution in any criminal action or proceeding or in any action or proceeding" brought pursuant to the Unfair Competition Law or False Advertising Law by the attorney general, notwithstanding whether the exclusion or exception regarding this coverage or indemnity or the duty to defend "is expressly stated in the policy."

When the insurer refused to keep paying for its defense, the insured sued. Among other points, the insured argued that Section 533.5 violated its due process right to retain and fund the counsel of its choice and that Section 533.5 did not apply because the attorney general's lawsuit included a claim for injunctive relief. The district court rejected the insured's statutory arguments, without reaching the due process argument.

On appeal, the 9th Circuit first addressed the due process claim. It noted that "California has stacked the deck against defendants facing these lawsuits filed by the state" because the attorney general, without yet proving any allegations, "has invoked the power of the state to deny insurance coverage that [the insured] has paid for to defend itself."

However, the court rejected the due process claim. It pointed out that "courts have construed the due process right to retain counsel very narrowly." It emphasized that "the due process right to retain counsel in civil cases appears to apply only in extreme scenarios where the government substantially interferes with a party's ability to communicate with his or her lawyer or actively prevents a party who is willing and able to obtain counsel form doing so." The court found that neither situation existed. As it explained, Section 533.5 "does not actively prevent [the insured] from obtaining counsel or communicating with its lawyers." As it observed, "At the end of the day, California's law only makes it harder, though not necessarily impossible, for a civil litigant to retain the counsel of their choice."

Next, the court addressed whether Section 533.5 did not apply because the attorney general sought not only monetary relief, but also an injunction. The insured argued that Section 533.5 applied only if monetary relief were the sole remedy sought. The court said that the insured's interpretation was a "strained reading" of Section 533.5. It held that Section 533.5's prohibition of a defense "is not limited to claims in which only monetary relief is sought" and that the insured's reading "goes against the plain text of the statute." The court also noted that "because indemnity for restitution and indemnity for an injunction are both equitable relief, there is no reason for this court to construe the statute differently for one type of equitable relief."

Adir's enforcement of Section 533.5 is consistent with California decisions in which courts have expressed reluctance to hold that insurers must defend and indemnify their insureds in criminal actions. See, e.g., Jaffe v. Cranford Ins. Co., 168 Cal. App. 3d 930, 934 (1985) ("neither imprisonment nor a fine constitutes 'damages' for insurance purposes"); State Farm Fire & Cas. Co. v. Superior Court, 191 Cal. App. 3d 74, 78 (1987) ("Restitution is ordered as punishment in a criminal case. No conceivable justification exists for allowing an individual to pass on such liability to an insurance carrier."); Foster-Gardner, Inc. v. Nat'l Union Fire Ins. Co., 18 Cal. 4th 857, 883 (1998) ("Nevertheless, a guilty verdict against the insured in the criminal proceeding may well affect the insured's ability to meaningfully defend any subsequent civil action. The fact that damaging, perhaps even irrefutable, findings will be made does not mean that a duty to defend arises in the criminal proceeding." (Citations omitted.)).

However, Adir does not narrow the scope of an insurer's duty to defend in a civil action. That duty exists whenever there is a potential for coverage, even if "noncovered acts predominate in the third party's action." Horace Mann Ins. Co. v. Barbara B., 4 Cal. 4th 1076, 1084 (1993). 