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Posted: October 4, 2018

SEC Disgorgement Payment Not Covered Loss Under CGL Policy

On September 20, 2018, the First Department issued a decision in J.P. Morgan Sec., Inc. v. Vigilant Ins. Co., 2018 NY Slip Op 06146, holding that a disgorgement payment made as part of the settlement of an SEC enforcement action was a “penalty” and therefore did not qualify as a covered “loss” under a CGL policy.

At issue in J.P. Morgan v. Vigilant was a settlement the SEC reached with Bear Stearns, resulting from allegations that “Bear Stearns violated securities laws between 1999 and September 2003 by knowingly facilitating ‘late trading’and deceptive ‘market timing’ for certain hedge fund customers, and affirmatively assisting those customers in evading detection, thereby enabling them to earn hundreds of millions of dollars in profits at the expense of mutual fund shareholders.”  A component of the settlement was a disgorgement payment that included $140 million “allegedly representing the improper profits acquired by third-party hedge fund customers.”  Bear Stearns’ CGL policy excluded “penalties imposed by law” from the definition of a covered loss.  The insurer disclaimed coverage for the disgorgement payment on the ground that it was a “penalty.”  The First Department agreed, explaining:

In Kokesh [v. Securities & Exchange Commission __ U.S. __, 137 S. Ct. 1635 (2017),] . . . the United States Supreme Court held that SEC disgorgement constitutes a penalty, and is therefore subject to the five year statute of limitations of 28 USC § 2462. In so ruling, the Supreme Court reasoned that SEC disgorgement (i) is imposed as a consequence for a wrong committed against the public, rather than a wrong against particular individuals; (ii) is meant to punish the violator and deter others from similar violations; and (iii) in many cases, does not compensate the victims of securities violations; rather, the wrongdoer pays disgorged profits to the district court, which has discretion to determine how and to whom to distribute the money.

The Supreme Court’s rationale as to the nature of disgorgement in Kokesh applies with equal force to the issue of whether the disgorgement paid by Bear Stearns, even if representing third-party gains, was a “Loss” within the meaning of the policy and whether public policy bars insurance companies from indemnifying insureds paying SEC disgorgement. In both instances disgorgement is a punitive sanction intended to deter. To allow a wrongdoer to pass on its loss emanating from the disgorgement payment to the insurer, thereby shielding the wrongdoer from the consequences of its deliberate malfeasance, undermines this goal and violates the fundamental principle that no one should be permitted to take advantage of his own wrong. Thus, as SEC disgorgement is a penalty, it does not fall within the definition of “Loss” and there is no coverage.

(Citations omitted).

As a general matter, New York public policy does not permit indemnity coverage for intentional wrongdoing.  Importantly, however, defendants accused of deliberate misconduct can look to their liability carriers for defense coverage.

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