Why it matters

A New York Appellate Court unanimously held that a group of insurers could not invoke a Dishonest Acts Exclusion in a professional liability policy to avoid liability for $200 million that its insured paid regulators for market-timing allegations. Bear Stearns (acquired and now owned by J.P. Morgan) entered into settlements and consent orders with the SEC and the NYSE and turned to its insurers for coverage. The insurers denied coverage on several bases, including the application of a Dishonesty Exclusion, which barred coverage if a “judgment or other final adjudication thereof adverse to such Insured shall establish that such Insured was guilty of any deliberate, dishonest, fraudulent or criminal act or omission.” The court concluded that the insurers could not invoke the exclusion because Bear Stearns’ settlement resulted from negotiations and did not qualify as a “judgment or other final adjudication” of wrongdoing as required by the exclusion. The court further reasoned that the settlement could not be used to establish Bear Stearns’ guilt, when the document expressly provided that Bear Stearns did not admit guilt, and reserved the right to profess its innocence in unrelated proceedings. The court did, however, allow a public policy defense to coverage of losses caused by intentionally harmful conduct, based upon findings in such regulatory documents. This decision, the latest chapter in the coverage dispute surrounding Bear Stearns’ market-timing cases, demonstrates that despite the insured’s inclusion of “non-admission” language, the insurer may still be able to raise a public policy defense, providing an important lesson for policyholders to remain diligent when negotiating any findings with governmental agencies.

Detailed Discussion

In 2003, the SEC and the New York Stock Exchange (NYSE) began to investigate Bear Stearns for allegedly facilitating late trading and deceptive market timing by certain customers in connection with the buying and selling of shares in mutual funds.

After the SEC presented Bear Stearns with the evidence upon which it intended to base its civil enforcement proceedings, the company decided to settle the matter. The parties reached an agreement that was formalized into an “Order Instituting Administrative and Cease-and-Desist Proceedings, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order.”

The order stated: “Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission’s jurisdiction over them and the subject matter of these proceedings, which are admitted, [Bear Stearns] consent[s] to the entry of [the SEC Order].”

In addition, the order included 170 factual “findings” setting forth the actions the SEC had alleged against Bear Stearns, ranging from how the company operated its late trading and market-timing scheme in “direct disregard” of demands by mutual funds to the “affirmative steps” it took to help its client “evade the blocks and restrictions imposed by the mutual funds” and the efforts the company took to “ensure that [the clients’] rapid mutual fund trades would not be detected by the mutual funds.”

The SEC ordered Bear Stearns to pay $90 million in civil penalties and disgorge $160 million. The company entered into a similar arrangement with the NYSE. Bear Stearns also faced shareholder class actions that the company settled for $14 million.

Bear Stearns sought coverage for the settlements under its professional liability insurance policies. The insurers denied coverage on several bases, including the application of a Dishonesty Exclusion, which barred coverage if a “judgment or other final adjudication thereof adverse to such Insured shall establish that such Insured was guilty of any deliberate, dishonest, fraudulent or criminal act or omission.” The insurers argued that the administrative order contained a series of detailed “findings” that constitute a final adjudication of the insured’s wrongdoing, which triggers the exclusion.

Bear Stearns filed an action for declaratory relief, and the insurers responded with a motion to dismiss. The issues presented in that motion took the case up to New York’s highest court.

The insurers argued that, by consenting to the entry of the order that detailed “findings” and required Bear Stearns to make compensatory payments and pay penalties, Bear Stearns was adjudicated a wrongdoer. According to the insurers, the inclusion of the “findings” effectively transformed them from mere allegations to proven facts.

The Appellate Court disagreed with the insurers, ruling that the SEC order did not “establish” any wrongdoing by the insured because it expressly provided that the insured is not admitting or denying the “findings” set forth in the order.

The court stated that the insurers virtually ignored the part of the exclusion requiring that any adjudication “establish” that the insured was “guilty of any deliberate, dishonest, fraudulent or criminal act or omission.” A dictionary definition of “establish” is “to put beyond doubt.” In the court’s view, it could hardly be said that the SEC order and the NYSE stipulation put Bear Stearns’ guilt “beyond doubt,” as those very same documents expressly provided that Bear Stearns did not admit guilt and reserved the right to profess its innocence in unrelated proceedings. As such, the court held, the dishonesty exclusion was not triggered.

The insurers also asserted an affirmative defense that public policy prohibits insurance coverage for amounts paid by the insured as a result of intentional harm caused by the insured. The insured argued that the absence of an adjudication of wrongdoing bars the insurers from relying on the SEC order for purposes of their public policy defense. The court disagreed with the insured, holding that the court’s strong interest in enforcing public policy permits the use of the settlement orders to establish a public policy defense against insuring intentional wrongdoing, even though the order did not establish intentional misconduct sufficient to trigger the dishonesty exclusion.

To read the opinion in J.P. Morgan Securities, Inc. v. Vigilant Insurance Company, click here.