In its recent decision in J.P. Morgan Securities, Inc. v. Vigilant Ins. Co., 2013 N.Y. LEXIS 1465 (NY June 11, 2013), New York’s Court of Appeals – New York’s highest court – had occasion to consider whether an insured can seek recovery against its insurers for amounts described as “disgorgement” by the Securities and Exchange Commission.

The J.P. Morgan decision relates to coverage under a professional liability insurance program for a payment made pursuant to a settlement with the SEC.  The insureds, various Bear Stearns entities, had been the subject of an SEC investigation in connection with its alleged practices of facilitating late trading and engaging in deceptive market timing for certain favored customers.  While Bear Stearns did not admit to liability, it ultimately settled with the SEC by agreeing to a payment in the amount of $160 million and a separate civil penalty payment in the amount of $90 million. The SEC order described the $160 million payment in an order as one for disgorgement. New York’s Appellate Division for the First Department held as a matter of public policy that both the disgorgement payment was uninsurable, and that as such (and because the $90 million penalty was not covered), the underlying declaratory judgment action brought by J.P. Morgan on behalf of Bear Stearns could not survive a motion to dismiss.

On appeal, the Court of Appeals agreed that New York has recognized that public policy will prohibit insurance coverage when the underlying damages result from the insured’s conduct intended to cause harm.  The Court of Appeals nevertheless held that at the pleadings stage, it could not be determined that Bear Stearns willfully violated federal securities laws, and in particular, the SEC order was not determinative of this issue.  As such, it was premature to conclude as a matter of law that Bear Stearns could not, as a matter of public policy, be indemnified for the payment to the SEC.  The insurers also argued that as a matter of public policy, a party cannot be insured for disgorgement of ill-gotten gains.  Bear Stearns agreed that as a matter of principle, such amounts are uninsurable, but contended that the majority of its payment to the SEC should not be characterized as a disgorgement, notwithstanding the SEC’s label to the contrary.  Rather, Bear Stearns contended that at least $140 million of its payment “represented the improper profits acquired by third party hedge fund customers, not revenue that Bear Stearns’ itself pocketed.”  The court found validity in this argument, noting:

Contrary to the Insurers' position, the SEC order does not establish that the $160 million disgorgement payment was predicated on moneys that Bear Stearns itself improperly earned as a result of its securities violations. Rather, the SEC order recites that Bear Stearns' misconduct enabled its "customers to generate hundreds of millions of dollars in profits." Hence, at this CPLR 3211 [New York’s civil procedure rule for motions to dismiss] stage, the documentary evidence does not decisively repudiate Bear Stearns' allegation that the SEC disgorgement payment amount was calculated in large measure on the profits of others.

The court further reasoned that the facts involved were notably different than in other New York cases where courts that insureds as a matter of law were not entitled to coverage for disgorgement of ill-gotten gains, such as the decisions in Millennium Partners, L.P. v Select Ins. Co., 889 N.Y.S.2d 575 (1st Dep’t 2009) and Vigilant Ins. Co. v. Credit Suisse First Boston Corp., 782 N.Y.S.2d 19 (1st Dep’t 2004):

Bear Stearns alleges that it is not pursuing recoupment for the turnover of its own improperly acquired profits and, therefore, it would not be unjustly enriched by securing indemnity. 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.

As such, the Court of Appeals held that the declaratory judgment action should be reinstated, allowing Bear Stearns to pursue its insurance recovery action.  In doing so, the court noted that its decision was based solely on whether the allegations in the underlying complaint could survive a motion to dismiss.  As the court explained, “although we certainly do not condone the late trading and market timing activities described in the SEC order, the Insurers have not met their heavy burden of establishing, as a matter of law on their CPLR 3211 dismissal motions, that Bear Stearns is barred from pursuing insurance coverage under its policies.”