Reversing the New York Appellate Division, First Department, the New York Court of Appeals, in a 6–1 landmark decision, held that a $140 million disgorgement payment is an insured "loss," after a long history of insurance companies incorrectly characterizing such a payment as a "penalty" and, therefore, uninsurable as a matter of law. J.P. Morgan Sec. Inc. v. Vigilant Ins. Co., No. 61, 2021 WL 5492781 (N.Y., Nov. 23, 2021).
Amid allegations of "facilitat[ing] late trading and deceptive market timing practices," securities broker-dealer Bear Stearns entered into a settlement with the U.S. Securities and Exchange Commission ("SEC") in 2006, which included a $140 million disgorgement payment. Bear Stearns' successor companies sued their insurers after coverage for the disgorgement payment was denied under Bears Stearns' errors and omissions ("E&O") "wrongful act" liability insurance policies. The policies provided coverage for "loss," but not "penalties imposed by law."
In an earlier 2013 decision, the New York Court of Appeals agreed with the policyholder "that much of the payment, although labeled disgorgement by the SEC, did not actually represent the disgorgement of its own profits." The Court of Appeals thus held that the rule precluding coverage for the disgorgement of the policyholder's own illicit gains did not apply to that portion of the "disgorgement payment."
After remand, the insurers argued the disgorgement payment was a "penalty" and uninsurable as a matter of New York public policy. In a detailed opinion issued on November 23, 2021, the Court of Appeals found that the insurers had failed to meet their burden of proving the disgorgement payment constituted a "penalty" such that they could avoid coverage.
The Court of Appeals treated the dispute as one of insurance policy contract interpretation, explaining that specific language used in the insurance policies must be "consistent with the reasonable expectation of the average insured," at the time of contracting, with any ambiguities construed in favor of the policyholder. The term "penalty" was found to refer not to a compensatory award to injured parties, but rather to a punitive or deterrent monetary sanction: "A reasonable insured purchasing a wrongful act policy would expect an award or settlement payment that has compensatory purposes and is measured by an injured party's losses and third-party gains to fall within its coverage grant and, concomitantly, not be deemed a penalty."
According to the Court of Appeals, the $140 million dollar disgorgement payment could not be classified as a "penalty" because (i) it was determined by SEC-directed valuations of client gains and investor losses as a measure of harm caused by Bear Stearns' alleged wrongdoing; (ii) Bear Stearns was not required to treat the disgorgement payment as a penalty for tax purposes, and the payment was eligible to be used to offset private claims against the company; (iii) the E&O "wrongful acts" liability insurance policies expressly covered "settlements and other sums related to investigations by a governmental regulator;" and (iv) at the time of contracting, the SEC viewed disgorgement payments as "an equitable remedy and not a monetary penalty." In light of these considerations, the insurers' arguments categorizing the disgorgement payment as a "penalty" would thwart a policyholder's reasonable expectations of coverage.
The Court of Appeals further held that the United States Supreme Court decision in Kokesh v. SEC did not control as the term "penalty" in Kokesh was not interpreted in an insurance coverage context. Thus Kokesh, decided after the insurance policy was signed, could not have informed the parties' understanding of its meaning. Notwithstanding the arguments made in the Court of Appeals' lone dissent, the majority noted the United States Supreme Court has since clarified that "SEC-ordered disgorgement is not always properly characterized as a penalty insofar as the SEC may seek 'disgorgement' of a defendant's net gain for compensatory purposes as 'equitable relief in civil actions.'" The case has been remitted to the New York Appellate Division, First Department, to address outstanding issues. While policyholders can expect insurers to continue their efforts to avoid covering these types of losses, the New York Court of Appeals' decision provides a powerful rejection of insurers' attempts to convert covered "disgorgement" losses into uninsured "penalties" and ignore the reasonable expectations of their policyholders.
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