On Tuesday, in deciding J.P. Morgan Securities, Inc., et al. v. Vigilant Insurance Company, et al., the New York Court of Appeals handed down a victory for policyholders seeking insurance coverage for liabilities arising from Securities & Exchange Commission (SEC) claims, particularly broker-dealers and clearing firms. Frequently, the SEC resolves such claims by way of a consent order (e.g., an “Order Instituting Administrative and Cease-and-Desist Proceedings, Making Findings, and Imposing Remedial Sanctions”), which requires a policyholder to pay certain amounts as “disgorgement.” Insurers typically refuse to cover disgorgement remedies, contending that public policy prohibits insurance recovery for the return of so-called “ill-gotten gains.”
But not all “disgorgement” is created equal. In J.P. Morgan, the Court of Appeals clarified that mere labels used in an SEC conse
nt order will not determine a policyholder’s rights under an insurance policy. Using the court’s analysis, the insurer must examine the nature of the disgorgement payment to determine whether it represents revenue that the policyholder pocketed or improper profits acquired by third parties. If the disgorged monies are not the policyholder’s own revenue, then the company will not be unjustly enriched by recouping insurance proceeds and may obtain coverage for its loss. This is particularly good news for financial companies with potential liability to the SEC for allegedly ill-gotten profits that ultimately end up in third parties’ pockets, such as hedge fund customers.
- Bear Stearns Settles an SEC Claim
In J.P. Morgan, Bear Stearns sought coverage for the amounts it paid to settle SEC claims that it allegedly facilitated illegal late trading and market timing practices with mutual fund trades that enabled certain hedge fund clients to earn hundreds of millions of dollars in profits. Bear Stearns countered that it received only $16.9 million in commissions on the trades and did not share in any benefits or profits of the alleged late trading. Nevertheless, Bear Stearns settled with the SEC, agreeing that it would pay $160 million as disgorgement damages and another $90 million as a civil penalty. (Bear Stearns did not seek insurance coverage for the $90 million.)
- Disgorgement Damages May Be Covered
Bear Stearns’ insurers denied coverage for its disgorgement payment based upon so-called New York public policy, and, after Bear Stearns brought suit, the insurers sought to dismiss the action on this same basis. The Court of Appeals held that the insurers were not entitled to dismiss Bear Stearns’ complaint because Bear Stearns was “not pursuing recoupment for the turnover of its own improperly acquired profits….” According to the court, because the so-called disgorgement was linked to gains that went to others and “not revenue that Bear Stearns itself pocketed,” Bear Stearns would not have been unjustly enriched if it recovered the loss from its insurers. The Court noted legal authority supporting the proposition that the SEC could “hold one party liable in disgorgement for the improper profits of another.” The Court also distinguished prior New York appellate level case law that found disgorgement remedies uninsurable because in each of those cases the disgorgement payment was directly linked to funds that were improperly acquired and “in the hands of the insured.”
- Companies Facing Potential “Disgorgement” Liabilities Need to Analyze Available Coverage
The J.P. Morgan decision is an important precedent for policyholders that face potential liability to the SEC arising out of activities as a conduit in the trading of securities and to similarly situated federal or state agencies seeking to recover allegedly ill-gotten gains. Companies operating in financial markets face a wide range of potential liabilities arising out of their activities, even when the profit from those activities inures to a third party’s benefit. The J.P. Morgan decision is a clarion call indicating that New York’s highest courts will evaluate the substance of a policyholder’s claim and will not deny coverage merely because a loss is labeled “disgorgement.” Many insurers include New York choice of law clauses in their professional lines insurance policies likely because of perceived advantages under New York law, such as the now debunked prohibition on coverage for “disgorgement” remedies. Companies that facilitate securities trading should evaluate the scope of their available coverage with this in mind and should not accept disclaimers from insurers based upon purported New York public policy without first insisting on a rigorous analysis of the subject loss.