• New York Court of Appeals Holds that “Disgorgement” May be Indemnifiable
  • June 14, 2013 | Authors: David F. Cutter; Pamela L. Signorello
  • Law Firms: Troutman Sanders LLP - Chicago Office ; Troutman Sanders LLP - New York Office
  • In a decision issued today, the New York Court of Appeals reversed the dismissal of Bear Stearns’ coverage claim concerning a settlement with the SEC characterized by the SEC as “disgorgement.” See J.P. Morgan Securities Inc., et al. v. Vigilant Insurance Company, et al., No. 113 (N.Y. June 11, 2013). Because the insured alleged that the so-called disgorgement amount was calculated on profits earned by its customers - as opposed to moneys that Bear Stearns itself improperly earned - dismissal of the claim seeking indemnification of the “disgorgement” was deemed improper.

    In 2003, the SEC and other regulatory entities investigated Bear Stearns with respect to its alleged facilitation of late trading and deceptive market timing on behalf of certain customers. In March 2006, the SEC issued an order resolving the matter, under which Bear Stearns agreed to pay $160 million as “disgorgement” and a $90 million civil penalty. The SEC’s order found that Bear Stearns “willfully” violated the securities laws.

    Bear Stearns’ D&O insurers refused to indemnify the disgorgement amount as a matter of public policy. (The company did not seek coverage for the $90 million civil penalty.) Although the insurers apparently did not dispute that the payment technically satisfied the policy’s definition of “Loss,” they argued as a matter of public policy that indemnity should not be available because the company had enabled its customers to make millions of dollars through its unlawful trading tactics. The insurers also argued that public policy prohibits insurance coverage for intentionally caused harm.

    Bear Stearns acknowledged that an insured reasonably may be precluded from obtaining indemnity for the disgorgement of its own ill-gotten gains. However, it argued, a substantial portion ($140 million) of the SEC disgorgement payment represented illicit profits obtained by the company’s hedge fund customers - not gains enjoyed by Bear Stearns itself.

    The New York Supreme Court denied the insurers’ motions to dismiss, holding that it was unable to conclude that the disgorgement payment was “specifically linked” to Bear Stearns’ improperly acquired funds, as opposed to profits that flowed to its customers. The Appellate Division reversed and dismissed the insured’s coverage action as a matter of public policy.

    In its decision today, the New York Court of Appeals first rejected the insurers’ “intentional harm” public policy argument, stating: “[T]he public policy exception for intentionally harmful conduct is a narrow one, under which it must be established not only that the insured acted intentionally but, further, that it acted with the intent to harm or injure others.” The court concluded that, while the SEC order undoubtedly found willful violations of laws, it did not “conclusively demonstrate that Bear Stearns also had the requisite intent to cause harm.”

    With respect to the public policy argument against the indemnification of disgorgement, the court noted that, although it had not yet considered the issue, other courts have held that the risk of being ordered to return ill-gotten gains - i.e., disgorgement - is not insurable. While Bear Stearns purported to appreciate this principle, it also alleged that much of the payment - although labeled “disgorgement” by the SEC - represented the improper profits acquired by third-party hedge fund customers, “not revenue that Bear Stearns itself pocketed.” Reversing the dismissal, the court explained that, in the context of a dismissal motion, it must assume Bear Stearns’ allegations to be true unless conclusively refuted by the relevant documentary evidence (i.e., the SEC order). According to the court, “[c]ontrary 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.” The court distinguished the insurers’ cited case authorities on the basis that, in such cases, the disgorgement payments had been “conclusively linked” to improperly acquired funds in the hands of the insureds.