Friday, December 16, 2011

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. 1st 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.”

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