Background
In J.P. Morgan Securities Inc. v. Vigilant Insurance Co., the New York Court of Appeals was asked to determine whether a $140 million “disgorgement” payment paid by J.P. Morgan’s predecessor in interest, Bear Stearns, to the SEC over alleged illegal trading practices was a “penalty imposed by law,” and thus excluded from coverage under the insurance policy at issue. By way of background, in 2000, Bear Stearns purchased a primary insurance policy from Vigilant Insurance. The policy provided coverage for the “wrongful acts” of the company but excluded “fines and penalties imposed by law” from the definition of covered “loss.” Starting in 2003, the SEC began investigating Bear Stearns for late trading and deceptive market timing practices. Bear Stearns ultimately settled with the SEC in 2006, agreeing to pay a $160 million “disgorgement” payment and a $90 million payment for “civil money penalties.” $140 million of the disgorgement payment purportedly reflected an estimate of the profits gained by Bear Stearns’ clients as a result of the illegal activity. Following its settlement with the SEC, Bear Stearns sought coverage from Vigilant for the $140 million portion of the payment. Litigation ensued.
Court’s analysis
In concluding that the $140 million “disgorgement” payment was not a “penalty imposed by law,” the Court of Appeals began its analysis by laying out the general principles of New York insurance law. The court noted that the issue presented was “a question of contract interpretation” and that under New York law, insurance contracts “must be interpreted according to common speech and consistent with the reasonable expectation of the average insured at the time of contract.” The court’s focus on the reasonable expectations of the insured would animate the remainder of its opinion.
With those background principles in mind, the court turned to interpreting the term “loss” in the policy, and specifically, how the parties would have understood the exclusion for “penalties imposed by law” when they entered into the insurance contract. Noting that “penalties imposed by law” was not defined in the policy, the court looked to that term’s “commonly understood” meaning as well as its prior case law for guidance. Based on those sources, the court concluded that “a penalty is distinct from a compensatory remedy and a penalty is not measured by the losses caused by the wrongdoing.”
Next, the court addressed the issue of settlement payments that have both compensatory and punitive components. Looking to its 1994 decision in Zurich Insurance Co. v. Shearson Lehman Hutton, the court explained that “where a sanction has both compensatory and punitive components, it should not be characterized as punitive in the context of interpreting insurance policies.” Given that Zurich preceded the insurance policy at issue by six years, the court reasoned that a reasonable insured at the time of contracting would have understood “penalty” in the policy to refer specifically to non-compensatory, purely punitive monetary sanctions.
Having defined the scope of “penalty” under New York insurance law, the court then examined whether Bear Stearns’ $140 million payment to the SEC met that standard. Analyzing Bear Stearns’ communications with the SEC during the settlement negotiations, as well as testimonial and documentary evidence, the court concluded that Bear Stearns conclusively demonstrated that the $140 million disgorgement payment “was calculated based on wrongfully obtained profits as a measure of the harm or damages caused by the wrongdoing that Bear Stearns was accused of facilitating.” The insurers did not submit any evidence to rebut this proof.
The court also found that the $140 million payment “served a compensatory goal.” Under the terms of the settlement agreement, only the $90 million civil money penalty could be considered a penalty for tax purposes. Additionally, the disgorgement payment, unlike the civil money penalty, could be used to offset private claims against Bear Stearns. Moreover, as the court explained, while “neither the label assigned to the payment by the SEC and Bear Stearns nor the mere fact that injured parties may ultimately receive the funds, is dispositive,” these factors must be considered together with the fact that the payment at issue constituted a measure of investors’ losses. As such, the court concluded that the $140 million payment was intended, at least in part, to compensate those injured by Bear Stearns’ alleged wrongdoing. Therefore, under Zurich, the payment “could not fairly have been understood as a ‘penalty’” under the policy.
Finally, the court rejected the intermediate appellate court’s reasoning that Kokesh controlled and required that a “disgorgement” payment be considered a “penalty.” According to the Court of Appeals, in Kokesh, the U.S. Supreme Court “was not interpreting the term ‘penalty’ in an insurance contract.” Moreover, given that Kokesh was decided nearly two decades after Bear Stearns and Vigilant entered into the insurance agreement, the Supreme Court’s decision “could not have informed the parties’ understanding of the meaning of the term ‘penalty.’” Therefore, according to the Court of Appeals, Kokesh did not require the $140 million payment to be considered a “penalty imposed by law.”
Takeaways
This decision is noteworthy for policyholders for several reasons. First, for policyholders in New York, it offers an avenue for coverage for settlement payments associated with major regulatory risks. Second, similar to the Northern District of Illinois’ recent decision in Astellas v. Starr Indemnity et al., No. 17-cv-8220 (N.D. Ill. Oct. 8, 2021), J.P. Morgan Securities encourages courts to look beyond the labels attached to settlement payments when construing coverage. And finally, for policyholders outside of New York, the Court of Appeals’ decision offers several arguments to distinguish Kokesh should insurers raise that case as a defense to coverage. In short, J.P. Morgan Securities adds yet another arrow to policyholders’ quiver and will help guide future courts to the proper result.
Client Alert 2021-324
