Reversing a prior dismissal, the New York Court of Appeals (New York’s highest court) held that J.P. Morgan Securities (JPM) may seek recovery from its insurers of a settlement amount paid to the SEC constituting disgorgement of ill-gotten gains received by JPM’s customers, not by JPM. The case stemmed from SEC allegations that JPM’s predecessor, Bear Stearns, violated SEC regulations by engaging in “late trading” and “market timing” with respect to mutual funds. Without admitting or denying these allegations, Bear Stearns entered into a settlement with the SEC, under which Bear Stearns agreed to pay $160 million as “disgorgement” and $90 million as a civil penalty. All settlement funds were deposited in a fund to compensate any mutual fund investors harmed by Bear Sterns’ alleged conduct. Bear Stearns then sought to recover the $160 million “disgorgement” payment (less a $10 million self-insured retention) from its insurers.
The relevant policies excluded from the definition of “Loss” any “fines or penalties imposed by law” and “matters which are uninsurable under the law.” The policies also included a so-called “personal profit exclusion,” disclaiming coverage for claims “arising out of [Bear Stearns’] gaining in fact any personal profit or advantage to which [Bear Stearns] was not legally entitled,” and a “prior acts exclusion,” negating coverage for any wrongful acts occurring prior to March 21, 2000.
Bear Stearns argued that its “disgorgement” payment was not excluded under either the definition of “Loss” or the exclusions because a substantial portion of the payment – $140 million – represented illegal profits obtained by its hedge fund customers, not Bear Stearns itself. Bear Stearns’ insurers argued that public policy considerations barred coverage for Bear Stearns’ willful violations of law and “disgorgement,” in addition to the operation of the exclusions. The issues surrounding insurance coverage for amounts designated as “disgorgement” of ill-gotten gains have been the subject of vigorous dispute between insureds and insurers for over a decade.
The lower court dismissed the case, holding that Bear Stearns could not be indemnified for any portion of the SEC disgorgement payment as a matter of public policy. Reversing, the Court of Appeals held that the order issued by the SEC in connection with the settlement did not conclusively demonstrate that Bear Stearns had the requisite intent to cause harm necessary to bar coverage under New York public policy, notwithstanding the SEC order’s finding of “willful” violations by Bear Stearns. Moreover, the Court held that the public policy rationale for precluding indemnity for disgorgement properly applies only where the ill-gotten gains were received by the insured, but not where the gains went to third parties: “The Insurers have not identified a single precedent, from New York or otherwise, in which coverage was prohibited where, as Bear Stearns claims, the disgorgement payment was (at least in large part) linked to gains that went to others. Consequently, at this early juncture, we conclude that the Insurers are not entitled to dismissal of Bear Stearns' insurance claims related to the SEC disgorgement payment.” The Court of Appeals also rejected application of the “personal profit” exclusion on the same grounds, noting that the “SEC order does not conclusively refute  that [Bear Stearns’] misconduct profited others, not itself.” As to the “prior acts” exclusion, the Court determined that “numerous disputed factual assertions remain” concerning Bear Stearns’ knowledge of any wrongful acts and preclude that exclusion’s application at the motion to dismiss stage of litigation.
Insurers frequently argue that disgorgement is not a covered loss given public policy considerations, as well as the holdings in certain, pre-existing case law. This decision serves as an important victory to policyholders by narrowing the ability of insurers to rely on such public policy rationales, particularly in the context of SEC settlements.