NEW YORK APPELLATE COURT ADDRESSES COVERAGE FOR DISGORGEMENT

In J.P. Morgan Sec. Inc., et al. v. Vigilant Ins. Co., et al., the New York Appellate Division, First Department, held that a disgorgement payment by Bear Stearns to the SEC to settle charges regarding illegal market timing trading practices did not constitute insurable loss under Bear Stearns’ primary professional liability and follow-form excess insurance policies. 936 N.Y.S.2d 102, 2011 N.Y. App. Div. LEXIS 8829, *1 (Dec. 13, 2011). The decision may be viewed as a restatement of established law on the insurability of disgorgement of ill-gotten gains. However, the Appellate Division reversed the decision of the Supreme Court, New York County, which may have allowed coverage for disgorgement in this instance.

The settlement arose from the SEC’s 2005/2006 investigation of Bear Stearns for securities violations and illegal trading. After disputing the allegations, Bear Stearns made a formal settlement offer, which the SEC accepted. Thereafter, the SEC issued an Order terminating the proceedings and indicating that Bear Stearns, without admitting or denying the SEC’s findings, had agreed to pay “disgorgement in the total amount of $160,000,000” and “civil money penalties in the amount of $90,000,000.” Bear Stearns then sought coverage for the disgorgement payment under its professional liability tower arguing that the disgorgement payment constituted compensatory damages.

Bear Stearns’ insurance program provided coverage for “Loss which the insured shall become legally obligated to pay as a result of any Claim… for any Wrongful Act.” The term “Loss” was defined to include “compensatory damages,” but expressly excluded “fines or penalties imposed by law” and “matters which are uninsurable under the law.” The insurance program also excluded claims arising out of fraudulent acts or any profit or advantage to which Bear Stearns was not legally entitled.

The insurers argued that the disgorgement payment was not covered Loss. The Supreme Court, New York County disagreed, finding that the SEC’s Order did not “conclusively link” the disgorgement payment to funds improperly acquired by Bear Stearns. The Appellate Division reversed, and entered judgment for the insurers. While acknowledging that the SEC’s Order did not specifically state the funds were obtained improperly, and that Bear Stearns settled without admitting liability, the Appellate Division held that “read as a whole,” the settlement offer, SEC Order, and other documents related to the SEC investigation “[we]re not reasonably susceptible to any interpretation other than that Bear Stearns knowingly and intentionally facilitated illegal late trading… and that the relief provisions of the SEC Order required disgorgement of funds gained through that illegal activity.” The fact that the SEC did not itemize how it reached the agreed upon disgorgement figure “does not raise an issue as to whether the disgorgement payment was in fact compensatory,” according to the Appellate Division.

This decision reaffirms the generally accepted rule that disgorgement is not insurable. However, the case also demonstrates that courts may look beyond the disgorgement label in an agreed upon settlement, and look to the record as a whole in determining whether the amount disgorged is causally connected to the alleged violation, or instead may constitute compensatory damages as argued by Bear Stearns.