New York Court of Appeals Rules That $140 Million Disgorgement Payment to SEC Is Not an Uninsurable ‘Penalty’

On Nov. 23, the New York Court of Appeals held in a 6-1 ruling that an investment firm’s $140 million disgorgement payment to the Securities and Exchange Commission (SEC) was not a “penalt[y] imposed by law” under the firm’s wrongful act insurance policies, and thus was not necessarily excluded from coverage.^[1] In 2006, Bear, Stearns & Co. and Bear, Stearns Securities Corporation made a $160 million disgorgement payment to settle charges that they had facilitated late trading and market timing by their clients. In an opinion by Chief Judge DiFiore, the court found that $140 million of the $160 million total disgorgement payment reflected the losses of — and ultimately helped compensate — the investors allegedly harmed by the illegal trading practices. Concluding that a reasonable insured would expect such payments to be covered, the court reversed the Appellate Division and remanded for further proceedings. 

Although the Court of Appeals’ decision is not the final chapter in this long-running dispute — on remand, the insurers can make additional arguments about defenses to coverage — the court’s decision may affect the coverage considered available under wrongful act insurance policies with exclusions like those at issue here. 

Procedural Background

In 2000, Bear Stearns bought a primary insurance policy from Vigilant Insurance Company, and excess policies from a number of other carriers, that insured the “wrongful acts” of Bear Stearns and its subsidiaries. Each of the policies covered any “loss” that Bear Stearns sustained in connection with any governmental investigation into its wrongful acts. But the policies expressly excluded from coverage “fines or penalties imposed by law.”

In 2003, the SEC began investigating allegations that Bear Stearns entities had illegally facilitated late trading and market timing by their clients. Three years later, Bear Stearns settled the SEC’s proposed charges. Although it neither admitted nor denied liability, it agreed to make two separate payments into a “Fair Fund” to compensate allegedly harmed investors: (1) a $90 million “civil money penalt[y]” payment and (2) a $160 million “disgorgement” payment.

As part of the settlement order, the SEC imposed two specific conditions on the $90 million civil money penalty payment. First, the SEC prohibited Bear Stearns from using the payment to offset sums owed to private litigants suing over the same trading practices. And second, the SEC required Bear Stearns to treat the payment as a penalty for tax purposes. The SEC did not impose these same conditions on the $160 million disgorgement payment.

The Appellate Division Rules for the Carriers That the Disgorgement Payment Was Not Covered

After its insurers disclaimed coverage, Bear Stearns’ successor companies — the Bear Stearns Companies LLC, J.P. Morgan Securities Inc. and J.P. Morgan Clearing Corp. — sued the insurers, seeking a declaration of coverage for at least part of the disgorgement payment. The insurers moved to dismiss the complaint, arguing among other things that the disgorgement payment was not insurable as a matter of public policy.

The litigation bounced up and down New York state courts. The Supreme Court, New York’s trial court, denied the insurers’ motions to dismiss; the Appellate Division, First Department, reversed and dismissed the complaint; and then, on Bear Stearns’ first appeal to the New York Court of Appeals, the court reversed and reinstated the complaint. In the court’s view, the disgorgement payment was not clearly uninsurable as a matter of public policy.

As the litigation progressed, Bear Stearns moved for summary judgment, arguing that $140 million of the $160 million total disgorgement payment represented disgorgement not of Bear Stearns’ wrongful gains, but rather the wrongful gains of its clients, and therefore should not be considered an uninsurable penalty.

The trial court denied the insurers’ motions and granted summary judgment for Bear Stearns. But the Appellate Division reversed. Relying on the U.S. Supreme Court’s intervening decision in Kokesh v. SEC,^[2] the Appellate Division concluded that the $140 million disgorgement payment was in fact a “penalty” and thus was not an insurable loss.^[3]

Applying General Principles of Contract Interpretation, the Court of Appeals Holds That the $140M Disgorgement Payment Was Not an Uninsurable ‘Penalty’ 

With the case at the Court of Appeals now for a second time, the court ruled again for Bear Stearns, holding that the $140 million disgorgement payment was not a “penalty” under the insurance policies at issue, and thus was not clearly and unambiguously excluded from coverage. 

At the outset, the court explained that the case — a dispute over the meaning of an insurance contract — was governed by the general rules of contract interpretation. Under New York law, insurance contracts are “‘interpreted according to common speech and consistent with the reasonable expectation of the average insured’ at the time of contracting, with any ambiguities construed against the insurer and in favor of the insured.” Once the insured establishes the existence of coverage, “the insurer bears the burden of proving that an exclusion applies to defeat coverage.” 

The court then summarized the disputed language at the core of the appeal: 

• Under the policies, the insurers agreed to cover all “loss” that Bear Stearns sustained in connection with any governmental investigation into any wrongful act. 

• The policies expressly defined “loss” to include “costs, charges and expenses or other damages incurred in connection with any investigation by any governmental body.” 

• An exception in the definition of “loss” provided that “loss” did not include “fines or penalties imposed by law.”

The court then determined that the insurers had failed to prove that “a reasonable insured purchasing this wrongful act policy in 2000 would have understood the phrase ‘penalties imposed by law’ to preclude coverage for the $140 million SEC disgorgement payment.”

In so ruling, the court recognized a clear distinction in New York law between “penalties” on the one hand and compensatory remedies on the other. As the court explained, penalties are meant to punish a party for a public wrong and deter further wrongdoing; compensatory remedies, meanwhile, are meant to “compensate injured parties for their loss.” One of the key characteristics of a compensatory remedy, the court made clear, is that it is “measured through the harm caused by wrongdoing.”

Applying this penalty-compensation distinction, the court held that at the time the insurance policies were executed, the $140 million disgorgement payment “could not fairly have been understood as a ‘penalty.’” First, the court found that Bear Stearns had submitted sufficient evidence to prove that the $140 million disgorgement payment reflected the wrongful gains of Bear Stearns’ clients — and corresponding investor losses — rather than the wrongful gains of Bear Stearns itself. In other words, the $140 million disgorgement payment had one of the key characteristics of a compensatory remedy: It “measure[d] ... the harm or damages caused by the alleged wrongdoing [i.e., late trading and market timing] that Bear Stearns was accused of facilitating.” Second, the court found that the $140 million disgorgement payment was deposited into a fund for those same investors, and thus “was intended — at least in part — to compensate those injured by the wrongdoing.”[4]

The court also noted that when Bear Stearns bought the insurance policies at issue, disgorgement was one of the SEC’s primary enforcement remedies. What is more, the SEC “believed it had the power — as an equitable remedy — to require an entity that facilitated wrongdoing to ‘disgorge’ profits wrongfully obtained by third parties.”[5] Given that the insurance policies at issue “expressly covered settlements and other sums related to investigations by a governmental regulator,” the court reasoned that were it to adopt the insurers’ position, “indemnity for loss arising from otherwise covered governmental investigations would be substantially curtailed in a manner arguably inconsistent with an average insured’s reasonable expectations.”

Kokesh Does Not Control

The court also rejected the argument that based on the U.S. Supreme Court’s intervening decision in Kokesh v. SEC, the $140 million disgorgement payment should be considered a “penalty.” In Kokesh, the U.S. Supreme Court “held, as a matter of statutory interpretation, that the five-year limitations period for [SEC] actions to enforce a ‘penalty’ encompassed ‘disgorgement’ claims.”[6] The Supreme Court found that “SEC-ordered disgorgement is a ‘penalty’ because it is imposed to vindicate a public, rather than a private, wrong and is used to deter future wrongdoing even though it may have compensatory purposes.”[7] Yet Kokesh was distinguishable, the Court of Appeals explained, because the U.S. Supreme Court was not interpreting the term “penalty” as used in an insurance contract governed by New York law. Moreover, given that Kokesh was decided nearly two decades after the insurance policies here were executed, the case had no bearing on the most critical issue on appeal: “the parties’ understanding,” when they executed the policies, “of the meaning of the term ‘penalty.’”

The Dissent

In dissent, Judge Rivera argued that the $140 million disgorgement payment was in fact “a nonrecoverable penalty.” According to Judge Rivera, “SEC disgorgement is a penalty within the meaning of the insurance policy language because it deters violations of public law ... rather than compensating violations against a particular aggrieved individual.” Judge Rivera found that although Bear Stearns did deposit the $140 million disgorgement payment in a fund for allegedly injured investors, that fact did “not change the essentially punitive character of disgorgement as a tool of deterrence.” And even if the majority were correct that disgorgement can at times serve a compensatory purpose, Judge Rivera added, Bear Stearns was still not entitled to summary judgment because its evidence “failed to establish that there was no material factual issue regarding whether the $140 million reflected anything other than Bear Stearns’s own ill-gotten gains.”

Remand to the Appellate Division to Consider Other Arguments 

While the Court of Appeals concluded that the insurers had failed to establish that the $140 million disgorgement payment “clearly and unambiguously f[ell] within the policy exclusion for ‘penalties imposed by law,’” and that the Appellate Division had erred in granting judgment to the insurers on that basis, the case continues. Recognizing that the insurers had raised other arguments that the Appellate Division had not yet reached — including other defenses to coverage — the court remanded the case to the Appellate Division to address those arguments in the first instance.

_{[1] J.P. Morgan Sec. Inc. v. Vigilant Ins. Co., No. 61 (N.Y. Nov. 23, 2021), https://www.nycourts.gov/ctapps/Decisions/2021/Nov21/61opn21-Decision.pdf.}

^[2] _{137 S. Ct. 1635 (2017).}

^[3] _{The Court of Appeals subsequently granted Bear Stearns’ motion for leave to appeal as against certain of the excess insurers as to which final dismissal orders had been entered. The court accepted briefing from all the other insurers.}

^[4] _{The court acknowledged that Bear Stearns had deposited the $90 million civil money penalty payment into the very same compensation fund. But the court distinguished the $90 million civil money penalty payment from the $140 million disgorgement payment on two grounds. First, “Bear Stearns was required to treat the $90 million penalty, but not the disgorgement, as a penalty for tax purposes.” Second, “although the $90 million civil penalty funds were ineligible to be used to offset a private claim against Bear Stearns, the same was not true of the disgorgement payment.”}

^[5] _{The Court of Appeals acknowledged that in Liu v. SEC, 140 S. Ct. 1936 (2020), while upholding the SEC’s general disgorgement powers, the U.S. Supreme Court “suggest[ed], but d[id] not definitively hold, that SEC ‘disgorgement’ that exceeds a party’s net profits and is not distributed to injured investors may transform the ‘disgorgement’ into a punitive sanction beyond the SEC’s then-existing equity powers.” J.P. Morgan Sec. Inc., No. 61 at 16 n.10.}

^[6] _{Id. at 15.}

^[7] _{Id. at 15-16.}