On June 11, 2013, the New York State Court of Appeals reinstated a policyholder’s claim for coverage for a $160 million “disgorgement” payment to the SEC.  The decision, J.P. Morgan Securities v. Vigilant Insurance, No. 113 (June 11, 2013), is available here.

The dispute stemmed from the SEC’s investigation of Bear Stearns (which merged with J.P. Morgan in 2008) for facilitating late trading and market timing on behalf of its hedge fund clients.  In 2006, Bear Stearns entered into a settlement with the SEC; therein, “without admitting or denying the findings,” Bear Stearns agreed to pay $160 million as “disgorgement” and $90 million as a civil penalty.  The SEC order memorializing the settlement stated that Bear Stearns “knowingly or recklessly processed thousands of late trades;…took affirmative steps to hide from mutual funds the identity of customers that were known market timers by…assigning multiple account numbers to customers;…[and] willfully violated [the ’33 Act and the ’34 Act].”  Id. at *4.

After funding the $250 million settlement, Bear Stearns sought indemnification from its primary and excess insurers for the $160 million “disgorgement” portion.  The insurers denied coverage and a declaratory judgment action followed.  In its complaint, Bear Stearns alleged that $140 million of the disgorgement payment “represented illicit profits obtained by its hedge fund customers rather than gains enjoyed by Bear Stearns itself.”  The insurers moved to dismiss, arguing that public policy prohibited indemnification for any portion of the disgorgement payment.

After contrary decisions by the Supreme Court and the Appellate Division, the insurer’s motion to dismiss came before the Court of Appeals.  In a ruling certain to be welcomed by policyholders, the panel held that the SEC order “does not conclusively demonstrate that Bear Stearns…had the requisite intent to cause harm” necessary to preclude insurance coverage on public policy grounds.  Id. at *11. See also id. (“the public policy exception for intentionally harmful conduct is a narrow one, under which it must be established not only that the insured acted intentionally but, further, that it acted with the intent to harm or injure others.”).

The judges further opined on a secondary public policy argument – namely, the principle that “the risk of being ordered to return ill-gotten gains – disgorgement – is not insurable.”  Bear Stearns argued that this principle did not preclude coverage because “the bulk of the disgorgement payment — approximately $140 million — represented the improper profits acquired by third party hedge fund customers, not revenue that Bear Stearns itself pocketed.”  Id. at *11-12.  Again the Court ruled in favor of Bear Stearns: “The Insurers have not identified a single precedent…in which coverage was prohibited where…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.”

This decision is likely to create a dilemma for insurance carriers.  The statute that authorizes the SEC to bring enforcement actions allows the SEC to seek fines, penalties, and equitable relief.  See 15 U.S.C. §78u, et seq. (codifying §21 of the Securities Exchange Act of 1934).  As a general matter, courts have held that “equitable relief” includes injunctions and disgorgement, see, e.g., SEC v. Materia, 745 F.2d 197, 201 (2d Cir. 1984), but not “damages.”  See generally Press Release, Securities and Exchange Commission, SEC Enforcement Director’s Statement on Citigroup Case (Dec. 15, 2011); Memorandum from the New York City Bar Association on Securities Litigation, SEC v. Citigroup (July 2012).

But the SEC is intent on seeking settlements that represent “damages,” not just disgorgement, because the SEC wants to put the money recovered into a fund to compensate victims. See generally SEC v. DiBella, 409 F. Supp. 2d 122 (D. Conn. 2006); 15 U.S.C. § 7246.  Insureds are willing to go along with settlements that so provide because they are regulated by the SEC, and may see such a settlement as a credit against damages that might be awarded in private litigation.  The private plaintiffs’ bar, not surprisingly, tends to take a different view.

Thus, carriers that insure risks in New York will have two choices: either provide clearly in their policies that there is no coverage for settlements that arise out of regulatory proceedings, or bring actions for declaratory relief if and when the carrier and the insured cannot agree that there will be no coverage for a settlement following the commencement of an enforcement action.