New York Court Allows Disgorgement Coverage Action to Proceed

In its recent decision in J.P. Morgan Securities, Inc. v. Vigilant Ins. Co., 2013 N.Y. LEXIS 1465 (NY June 11, 2013), New York’s Court of Appeals – New York’s highest court – had occasion to consider whether an insured can seek recovery against its insurers for amounts described as “disgorgement” by the Securities and Exchange Commission.

The J.P. Morgan decision relates to coverage under a professional liability insurance program for a payment made pursuant to a settlement with the SEC.  The insureds, various Bear Stearns entities, had been the subject of an SEC investigation in connection with its alleged practices of facilitating late trading and engaging in deceptive market timing for certain favored customers.  While Bear Stearns did not admit to liability, it ultimately settled with the SEC by agreeing to a payment in the amount of $160 million and a separate civil penalty payment in the amount of $90 million. The SEC order described the $160 million payment in an order as one for disgorgement. New York’s Appellate Division for the First Department held as a matter of public policy that both the disgorgement payment was uninsurable, and that as such (and because the $90 million penalty was not covered), the underlying declaratory judgment action brought by J.P. Morgan on behalf of Bear Stearns could not survive a motion to dismiss.

On appeal, the Court of Appeals agreed that New York has recognized that public policy will prohibit insurance coverage when the underlying damages result from the insured’s conduct intended to cause harm.  The Court of Appeals nevertheless held that at the pleadings stage, it could not be determined that Bear Stearns willfully violated federal securities laws, and in particular, the SEC order was not determinative of this issue.  As such, it was premature to conclude as a matter of law that Bear Stearns could not, as a matter of public policy, be indemnified for the payment to the SEC.  The insurers also argued that as a matter of public policy, a party cannot be insured for disgorgement of ill-gotten gains.  Bear Stearns agreed that as a matter of principle, such amounts are uninsurable, but contended that the majority of its payment to the SEC should not be characterized as a disgorgement, notwithstanding the SEC’s label to the contrary.  Rather, Bear Stearns contended that at least $140 million of its payment “represented the improper profits acquired by third party hedge fund customers, not revenue that Bear Stearns’ itself pocketed.”  The court found validity in this argument, noting:

Contrary to the Insurers' position, the SEC order does not establish that the $160 million disgorgement payment was predicated on moneys that Bear Stearns itself improperly earned as a result of its securities violations. Rather, the SEC order recites that Bear Stearns' misconduct enabled its "customers to generate hundreds of millions of dollars in profits." Hence, at this CPLR 3211 [New York’s civil procedure rule for motions to dismiss] stage, the documentary evidence does not decisively repudiate Bear Stearns' allegation that the SEC disgorgement payment amount was calculated in large measure on the profits of others.

The court further reasoned that the facts involved were notably different than in other New York cases where courts that insureds as a matter of law were not entitled to coverage for disgorgement of ill-gotten gains, such as the decisions in Millennium Partners, L.P. v Select Ins. Co., 889 N.Y.S.2d 575 (1^stDep’t 2009) and Vigilant Ins. Co. v. Credit Suisse First Boston Corp., 782 N.Y.S.2d 19 (1^st Dep’t 2004):

Bear Stearns alleges that it is not pursuing recoupment for the turnover of its own improperly acquired profits and, therefore, it would not be unjustly enriched by securing indemnity. The Insurers have not identified a single precedent, from New York or otherwise, in which coverage was prohibited where, as Bear Stearns claims, the disgorgement payment was (at least in large part) linked to gains that went to others. Consequently, at this early juncture, we conclude that the Insurers are not entitled to dismissal of Bear Stearns' insurance claims related to the SEC disgorgement payment.

As such, the Court of Appeals held that the declaratory judgment action should be reinstated, allowing Bear Stearns to pursue its insurance recovery action.  In doing so, the court noted that its decision was based solely on whether the allegations in the underlying complaint could survive a motion to dismiss.  As the court explained, “although we certainly do not condone the late trading and market timing activities described in the SEC order, the Insurers have not met their heavy burden of establishing, as a matter of law on their CPLR 3211 dismissal motions, that Bear Stearns is barred from pursuing insurance coverage under its policies.”

New York Court Holds Disgorgement Payment Not Covered Under Professional Liability Policies

In its recent decision in J.P. Morgan Securities, Inc. v. Vigilant Ins. Co., 2011 N.Y. App. Div. 8829 (N.Y. 1^st Dep’t Dec. 13, 2011), the New York Appellate Division for the First Judicial Department considered whether a disgorgement payment made pursuant to a settlement with the SEC qualified for coverage as compensatory damages under the insureds’ professional liability coverage program.

The insureds, various Bear Stearns entities, had been the subject of an SEC investigation in connection with its alleged practices of facilitating late trading and engaging in deceptive market timing for certain favored customers.  While Bear Stearns did not admit to liability, it ultimately settled with the SEC by agreeing to a disgorgement payment in the amount of $160 million and a civil penalty payment in the amount of $90 million.   

Bear Stearns sought indemnification for the settlement amount under its primary and excess layer professional liability policies that provided coverage for “Loss which the insured shall become legally obligated to pay as a result of any Claim … for any Wrongful Act on its part.”  “Loss” was defined by the policies as including compensatory damages and costs associated with defending an governmental investigation, but expressly carved out “(i) fines or penalties imposed by law; or … (v) matters which are uninsurable under the law pursuant to which this policy shall be construed.”  The policies also excluded coverage for claims “based upon or arising out of any deliberate, dishonest, fraudulent or criminal act or omission.”  Bear Stearns insurers disclaimed coverage for the disgorgement payment on the basis that it did not fall within the definition of “Loss” and that it was otherwise excluded. 

Bear Stearns subsequently commenced coverage litigation against its insurers, and the trial court denied the insurers’ motion to dismiss.  Bear Stearns argued that while the $160 million payment to the SEC was labeled a “disgorgement payment,” it nevertheless should be considered compensatory damages for the purpose of the policies’ definition of Loss.  The court held that a question of fact existed as to whether the disgorgement payment was exclusively linked to improperly acquired funds.  Specifically, the lower court found that there was nothing in the SEC Order or the related documents from which to conclude that Bear Stearns directly profited from the alleged violations, or that it earned $160 million as a result of its conduct. 

On appeal, the Appellate Division reversed, concluding that the facts established that Bear Stearns’ offer of settlement, the corresponding SEC Order, and various other documents, established that Bear Stearns “knowingly and intentionally facilitated illegal late trading for preferred customers, and that the relief provisions of the SEC Order required disgorgement of funds gained through that illegal activity.”   Among other things, the SEC Order demonstrated Bear Stearns’ falsification of order tickets and its use of dummy account and trader numbers to conceal late trades.  The Order also determined that Bear Stearns “willfully violated, willfully aided and abetted and caused” numerous securities violations.  As such, the Appellate Division concluded that it “cannot be seriously argued that Bear Stearns was merely found guilty of inadequate supervision and a failure to place adequate controls on its electronic entry system.”

The Appellate Division also rejected Bear Stearns contention that an issue of fact was raised as to whether the entirety of the $160 million disgorgement payment related to ill-gotten gains.  While the SEC Order did not specifically itemize how the $160 million disgorgement figure was determined, explained the court, it also did not raise a possibility that the amount, or at least a portion of it, was compensatory in nature. A disgorgement payment need not be specifically calculated, noted the court, but need only be a “reasonable approximation of profits casually connected to the violation.”