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.”

4th Circuit Holds No Duty to Defend Insurance Broker In Bodily Injury Suit

In its recent decision in Houston Cas. Co. v. St. Paul Fire & Marine Ins. Co., 2011 U.S. App. LEXIS 24157 (4^th Cir. Dec. 6, 2011), the United States Court of Appeals for the Fourth Circuit, applying South Carolina law, considered whether a general liability insurer had a duty to defend its insured, an insurance broker, in connection with an underlying construction site injury lawsuit.

The insured, McGriff, Seibels & Williams, Inc. (“McGriff”), was the broker of record for an owner-controlled insurance program (“OCIP”) issued to provide coverage for claims arising out of dam construction project.  As part of its services, McGriff distributed a document called “Manual of Insurance Procedures” to the various contractors covered under the OCIP policy.  The Manual expressly stated that McGriff, in conjunction with the project’s general contractor, would have various safety-related responsibilities in connection with the project. 

McGriff was named as a defendant in a suit brought by an individual who suffered catastrophic injuries while working on the project.  Plaintiff alleged causes of action for negligence and breach of contract against McGriff on the basis that it had assumed responsibiliy for performing inspections at the work site to ensure that it was reasonably safe, but failed to perform these inspections.  McGriff’s professional liability carrier, Houston Casualty Company, undertook McGriff’s defense.  St. Paul, however, which was McGriff’s general liability carrier denied coverage on the basis of an “Insurance and Related Work” endorsement, stating:

We won't cover injury or damage or medical expenses for which the protected person may be held liable because of:

• any obligation assumed by any protected person in connection with an insurance contract or treaty; [or]

• any failure to carry out, or improper carrying out of, any contractual or other duty or obligation in connection with an insurance contract or treaty.

Houston brought a contribution action against St. Paul, alleging that St. Paul had a duty to defend and McGriff in the underlying suit.  The trial court granted summary judgment in St. Paul’s favor, agreeing that the exclusion applied because McGriff was sued “in connection with an insurance contract.”  On appeal, Houston argued that McGriff’s safety-related duties in connection with the project existed independent of the insurance contract, and thus did not fall within the scope of the exclusion.  More specifically, Houston argued that plaintiff’s negligence claim against McGriff was based upon a common law duty arising from a voluntary undertaking of various safety-related duties, and that plaintiff’s breach of contract claim did not allege breach of an insurance contract.

The court rejected Houston’s broad reading of the complaint, pointing out that the exclusion applied to any failure to carry out any contractual or other duty in connection with an insurance contract.  As such, the court explained, the exclusion would apply to a breach of any contract claim, even one other than the insurance policy itself, so long as the additional contractual obligation arose “in connection with” an insurance contract.  The court further explained that as long as McGriff’s common law obligations would fall within the exclusion as long as those obligations arose “in connection with” an insurance contract.

Looking to the complaint, as well as the Manual, the court concluded that McGriff’s contractual and common law obligations were related to and stemmed from its efforts to issue the OCIP.  While McGriff assumed various obligations outside of the OCIP, it did so as part of its efforts to broker the program, and thus arose “in connection with” the policy.  As such, the Fourth Circuit affirmed the grant of summary judgment, finding persuasive the lower court’s statement that “there is no allegation or suggestion in the complaint that McGriff assumed any safety-related duties except in this role [i.e., as the broker of record].” 

Pennsylvania Federal Court Addresses Insolvency Exclusion

In its recent decision ACE Capital Ltd. v. Morgan Waldon Ins. Mgmt., LLC, 2011 U.S. Dist. LEXIS 135902 (W.D. Pa. Nov. 28, 2011), the United States District Court for the Western District of Pennsylvania had occasion to consider the scope of an insolvency exclusion in a professional liability policy.

ACE provided errors and omissions coverage to Morgan Waldon Insurance Management, LLC (“MWIN”), an insurance agency that created and administered employee health benefit plans.  MWIN was named as a defendant in two lawsuits brought by union clients alleging that MWIN had wrongfully created their health care benefit plans as self-insured plans funded by trusts established and controlled by MWIN.  The unions alleged that they did not know that their employers were paying health care benefits into the trust rather than directly to a health care insurer.  The unions claimed that MWIN negligently failed to calculate the monthly contributions necessary to fund the benefits offered, and as a result, the trusts were grossly underfunded and many health care claims subsequently went unpaid. 

Although ACE defended MWIN in the suits, subject to a reservation of rights, it subsequently sought a declaratory judgment on several grounds, including the application of its policy’s insolvency exclusion, which stated that:

We will not defend any Claim or pay any Damages or Claim Expenses based upon, arising out of, directly or indirectly relating to or in any way involving:

*          *          *

3.         Insolvency, bankruptcy, liquidation, receivership, rehabilitation or financial inability of the following, including but not limited to the failure, inability or unwillingness to pay Claims, losses or benefits due to the insolvency, liquidation or bankruptcy of:

    a. Any insurance company; or

    b. Any reinsurer; or

    c. Employee benefit plan; or

    d. Any self-insured program; or

    e. Any trust; or

    f. Any risk retention group; or

                g. Any risk purchasing group.

ACE argued that the exclusion applied because the underlying suits were premised on the theory that the self-insured plans were insufficiently funded, i.e., the plans were insolvent.  MWIN argued that the exclusion was ambiguous as applied, and that its application would defeat MWIN’s reasonable expectations of coverage and would otherwise render coverage under the policy illusory.

The MWIN court acknowledged that in the context of an insurance broker’s professional liability policy, an insolvency exclusion is most often applied in situations in which the broker places a client’s coverage with a carrier that subsequently becomes insolvent.  The court did find, however, a line of cases extending the exclusion to situations in which investment advisors place their clients’ funds in investments that subsequently become insolvent. MWIN argued that these cases were inapplicable since they concerned situations in which third parties became insolvent whereas the underlying suits alleged that MWIN’s own negligence resulted in the insolvency of the plans.  The court held that this was a distinction without a difference, explaining:

… the Policy exclusion is broadly worded: it precludes coverage for any claim "based upon, arising out of, directly or indirectly relating to or in any way involving" the insolvency, bankruptcy, liquidation, receivership, rehabilitation or financial inability of" a number of entities, including an "employee benefit plan," a "self-insured program" or a "trust." … Defendants cannot and do not dispute that the [the underlying suits] allege that the self-insured programs and/or employee benefit plans set up by MWIM to pay the plan members' benefit claims, which were funded through trusts … were unable to satisfy those claims because the plans were insufficiently funded by MWIM. Even if the claims cannot be said to "arise from" the plans' insolvencies, it cannot be argued that the claims do not "relate to" these insolvencies, irrespective of the fact that the mistakes made by MWIM occurred prior to the insolvencies.    

The court further rejected MWIN’s arguments concerning reasonable expectations and illusory coverage.  The court held that as a sophisticated, commercial enterprise, MWIN could not rely on the reasonable expectations doctrine to defeat an otherwise clear and unambiguous exclusion.  Moreover, because the exclusion would only apply to a limited category of claims, the court concluded that the exclusion did not render coverage under the policy illusory.