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New York’s Highest Court Rules That Disgorgement Payment is Not A Penalty For Purposes of Insurance Coverage

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  • Posted on: Dec 1 2021

By: Jeffrey M. Haber

On June 5, 2017, the U.S. Supreme Court held that claims for disgorgement imposed as a sanction for violation of the federal securities laws must be commenced within five years of the date the claim accrues.1 In doing so, the Court concluded that disgorgement “in the securities enforcement context is a ‘penalty’ within the meaning of Section 2462” of the U.S. Code. 

In concluding that disgorgement is a penalty, the Supreme Court looked at two factors. First, whether the payment had been imposed to redress a wrong to the public, or a wrong to an individual. The Court noted that a penalty is imposed to redress the former, not the latter. “This is because penal laws, strictly and properly, are those imposing punishment for an offense committed against the State.”  (Internal quotations omitted.) The Court also noted that disgorgement is more like a penalty because, as applied by the courts, it does not necessarily compensate the victims; disgorged profits are paid to the courts, and it is “within the court’s discretion to determine how and to whom the money will be distributed.” (Citation and internal quotation marks omitted.) Second, whether the payment was imposed to deter future wrongdoing by depriving violators of their ill-gotten gains.

Apply those factors, the Supreme Court concluded that “[b]ecause disgorgement orders go beyond compensation, are intended to punish, and label defendants wrongdoers as a consequence of violating public laws, they represent a penalty .…” (Internal quotation marks and citation omitted.)

[Ed. Note: this Blog wrote about Kokesh here.]

In J.P. Morgan Sec. Inc. v. Vigilant Ins. Co., the New York Court of Appeals held that Kokesh did not apply to the dispute before it because the disgorgement was not punitive but compensatory and, therefore, was not a penalty.2 J.P. Morgan involved a dispute between insured broker-dealers and certain excess insurers concerning the availability of coverage under a “wrongful act” liability policy for funds the insureds “disgorged’ as part of a settlement with the Securities and Exchange Commission (“SEC”). In concluding that the settlement payment in question was not excluded from insurance coverage as a “penalt[y] imposed by law” under the policies at issue, the Court reversed the decision of the Appellate Division, First Department, which ruled to the contrary in reliance on Kokesh.3 

Factual Background

As noted, the dispute concerned insurance which J.P. Morgan’s predecessor, The Bear Stearns Companies (the “Companies”), purchased from defendant Vigilant Insurance Company. The policy provided coverage for “wrongful acts” of the Companies and its subsidiaries. The Companies also purchased various excess insurance policies that followed the policy issued by Vigilant. The excess policies provided coverage for “loss” that the Companies became liable to pay in connection with any civil proceeding or governmental investigation into violations of laws or regulations. They defined “loss” as including various types of damages – including compensatory and punitive damages (“where insurable by law”) – but not “fines or penalties imposed by law.”

In 2003, the SEC and other regulatory agencies began investigating Bear, Stearns & Co. Inc. and Bear, Stearns Securities Corporation – broker-dealers that processed and cleared trades for clients (collectively, “Bear Stearns”). The investigation concerned allegations that, between 1999 and 2003, Bear Stearns had facilitated “late trading” and deceptive “market timing” practices by its customers in connection with the purchase and sale of shares of mutual funds.4 Bear Stearns notified its insurance carriers (the “Insurers”) of the pending investigation, but the Insurers effectively disclaimed coverage. Eventually, the SEC informed Bear Stearns that it intended to commence a civil action or administrative proceeding charging violations of the federal securities laws and that it would seek, among other things, $720 million in monetary sanctions. Although Bear Stearns disputed the proposed charges, in early 2006 it settled with the SEC.

Pursuant to the settlement order, the SEC censured Bear Stearns and ordered it to cease and desist from any future securities law violations. Without admitting or denying the SEC’s findings, Bear Stearns agreed to disgorge $160 million and pay civil penalties of $90 million. Both payments were to be deposited into a Fair Fund5 to compensate mutual fund investors allegedly harmed by the improper trading practices. 

Further, “[t]o preserve the deterrent effect of the civil penalty,” the settlement order directed that the $90 million payment – but not the disgorgement payment – was ineligible to offset any sums owed by Bear Stearns to private litigants injured by the trading practices. Bear Stearns was also required to treat the $90 million payment as a penalty for tax purposes. 

Following the settlement, Bear Stearns transferred the $160 million disgorgement and $90 million penalty payments to the SEC. Bear Stearns also eventually settled a series of class actions brought on behalf of injured private investors based on similar late trading and market timing allegations.

Plaintiffs, Bear Stearns’ successor companies, subsequently commenced the action alleging that the Insurers breached the insurance contracts and seeking a declaration of coverage for the disgorgement payment, private settlement, and various other defense costs and expenses. The Insurers moved to dismiss the complaint arguing, among other things, that the disgorgement component of the SEC settlement was not insurable as a matter of public policy. The motion court denied the motions to dismiss, but the First Department reversed and granted the motions.6 Bear Stearns appealed. The Court of Appeals reinstated the complaint, concluding that the Insurers were not entitled to dismissal because the disgorgement payment, allegedly “calculated in large measure on the profits of others,” was not clearly uninsurable as a matter of public policy.7 

Following additional motion practice, Bear Stearns moved for summary judgment, seeking dismissal of the Insurers’ various defenses to coverage and arguing that $140 million of the disgorgement payment represented disgorgement of its clients’ gains, as compared with Bear Stearns’ own revenue, and was an insurable “loss” under the policies. The Insurers opposed and cross-moved for summary judgment, arguing that the $140 million did not represent client gains and relying on various policy exclusions and public policy-based arguments against indemnification. The motion court denied the Insurers’ motions and granted summary judgment to Bear Stearns, concluding that the disgorgement of $140 million in client gains constituted an insurable loss.8 The Insurers appealed.

The First Department, among other things, reversed, denied Bear Stearns’ motion for summary judgment, and granted the Insurers’ motions for summary judgment, stating that Bear Stearns was not entitled to coverage for the SEC disgorgement payment.9 Relying on Kokesh, the First Department determined that the relevant portion of the disgorgement payment was a “penalty” and, as such, was not an insurable loss under the language of the policies.10 On remand, the motion court dismissed the complaint as to certain excess insurers and severed the remaining claims as to other insurers. The Court of Appeals granted leave to appeal as against four of the excess insurers.

On appeal, Bear Stearns argued that the $140 million disgorgement for which it sought coverage was derived from estimates of client gain and investor harm and, therefore, the Insurers failed to meet their burden of establishing that the payment was not a covered loss because it was a “penalty imposed by law.” In a 6-1 decision written by Chief Judge DiFiore, the majority agreed, holding that the payment was not a penalty within the meaning of the policies.

The Court’s Decision

As an initial matter, the Court examined the insurance contracts as it would any other contract.11 Thus, the Court looked to the specific language used in the policies,12 and “interpreted [them] according to common speech and consistent with the reasonable expectation of the average insured” at the time of contracting (i.e., in 2000), and construed any ambiguities against the Insurers and in favor of the insured.13 

Against the foregoing principles, the Court turned its attention to the policies at issue, noting that resolution of the dispute turned on the definition of “loss” thereunder.14 The Court observed that under the policies, the Insurers agreed to pay the “loss” that Bear Stearns became legally obligated to pay as the result of any claim (defined as including any civil proceeding or governmental investigation) for any wrongful act, which encompassed any actual or alleged act, error, omission, misstatement, neglect, or breach of duty by Bear Stearns and its employees while providing services as a securities broker and dealer.15 The Court noted that the policies defined “loss” to include compensatory damages, punitive damages where insurable by law, multiplied damages, judgments, settlements, costs, and expenses resulting from any claim.”16 Further, said the Court, the term “loss” expressly encompassed “costs, charges and expenses or other damages incurred in connection with any investigation by any governmental body”, though “fines or penalties imposed by law” were excluded from the definition of “loss”.17 

The Court concluded that the Insurers had not met their burden of proving that in 2000, when the policies were purchased, the Companies understood the phrase “penalties imposed by law” to preclude coverage for the $140 million SEC disgorgement payment.18 

The Court examined the meaning of “penalty” and concluded that a “penalty” “is distinct from a compensatory remedy” – “a penalty is not measured by the losses caused by the wrongdoing.”19 However, noted the Court, “where a sanction has both compensatory and punitive components, it should not be characterized as punitive in the context of interpreting insurance policies.”20 Thus, said the Court, “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.”21

The Court explained that “Bear Stearns demonstrated that the $140 million disgorgement payment was calculated based on wrongfully obtained profits as a measure of the harm or damages caused by the alleged wrongdoing that Bear Stearns was accused of facilitating.”22 In contrast, noted the Court, the $90 million payment was denominated a “penalty” and “was not derived from any estimate of harm or gain flowing from the improper trading practices.”23

This finding, reasoned the Court, was underscored by the SEC’s requirement that Bear Stearns treat the $90 million payment, but not the disgorgement, as a penalty for tax purposes. In addition, noted the Court, although the $90 million civil penalty funds were ineligible to be used to offset a private claim against Bear Stearns, the same was not true of the disgorgement payment. These factors, explained the Court, “must be taken together with the fact that the payment effectively constituted a measure of the investors’ losses.”24

Notably, the Court held that Kokesh did not control the outcome in the case. The Court distinguished Kokesh on the ground that “the Supreme Court was not interpreting the term ‘penalty’ in an insurance contract (much less one governed by New York law).”25 The Court noted that “the 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.”26 “Moreover,” reasoned the Court, “Kokesh – decided nearly two decades after the parties executed the relevant insurance contracts – could not have informed the parties’ understanding of the meaning of the term ‘penalty.’”27 “Thus,” concluded the Court, “Kokesh [did] not mandate that the $140 million disgorgement payment be considered a ‘penalty imposed by law’ under the insurance policies at issue here.”28 

Accordingly, the Court held that the First Department erred in granting summary judgment to the Insurers.

Judge Rivera dissented, arguing that “the majority’s conclusion that the disgorged funds [were] recoverable from the insurers [was] contrary to the insurance policy language and undermine[d] both federal regulation of illegal conduct in the securities market and the SEC’s efforts to discourage future violations.”29


Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP.

This article is for informational purposes and is not intended to be and should not be taken as legal advice.

Footnotes

  1. Kokesh v. SEC, 581 US ___, 137 S.Ct. 1635 (2017).
  2. J.P. Morgan Sec. Inc. v. Vigilant Ins. Co., 2021 N.Y. Slip Op. 06528 (Nov. 23, 2021) (here).
  3. J.P. Morgan Sec. Inc. v. Vigilant Ins. Co., 166 A.D.3d 1 (1st Dept. 2018) (here).
  4. “Late trading is the practice of placing orders to buy, redeem or exchange mutual fund shares after the 4:00 p.m. close of trading, but receiving the price based on the net asset value set at the close of trading,” which practice “allows traders to obtain improper profits by using information obtained after the close of trading.” J.P. Morgan Sec. Inc. v. Vigilant Ins. Co., 21 N.Y.3d 324, 330 n.1 (2013). Market timing is the “practice of frequent buying and selling of shares of the same mutual fund or the buying or selling of mutual fund shares to exploit inefficiencies in mutual fund pricing”; although this is “not per se improper, it can be deceptive if it induces a mutual fund to accept trades it otherwise would not accept under its own market timing policies.” Id.
  5. A Fair Fund is a fund established by the SEC to distribute disgorgements and penalties to defrauded investors. Congress created Fair Funds in the Sarbanes-Oxley Act of 2002.
  6. 91 A.D.3d 226 (1st Dept. 2011).
  7. 21 N.Y.3d 324, 336 (2013).
  8. 57 Misc. 3d 171, 179-183 (Sup. Ct., N.Y. County 2017).
  9. 166 A.D.3d 1 (1st Dept. 2018).
  10. Id. at 8.
  11. Slip Op. at *3 (“As we have often stated, insurance contracts are subject to the general rules of contract interpretation.”).
  12. Id. (citing Jin Ming Chen v. Insurance Co. of the State of Pa., 36 N.Y.3d 133, 138 (2020); Roman Catholic Diocese of Brooklyn v. National Union Fire Ins. Co. of Pittsburgh, Pa., 21 N.Y.3d 139, 148 (2013).
  13. Id. (citing (Dean v. Tower Ins. Co. of N.Y., 19 N.Y.3d 704, 708 (2012) (internal quotation marks and citation omitted).
  14. Id.
  15. Id.
  16. Id. at *3-*4.
  17. Id. at *4.
  18. Id.
  19. Id.
  20. Id. (citing Zurich Ins. Co. v. Shearson Lehman Hutton, 84 N.Y.2d 309, 312-313 (1994)).
  21. Id. at *4-*5.
  22. Id. at *6.
  23. Id.
  24. Id.
  25. Id.
  26. Id. at *7 (citing Liu v. SEC, ___ U.S. ___, 140 S. Ct. 1936, 1940 (2020) (footnote omitted).
  27. Id.
  28. Id.
  29. Id.
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