NYS Appellate Division Holds That SEC Disgorgement of Over $140 Million is an Uninsurable Penalty Under Professional Liability Policy

The Securities and Exchange Commission (SEC) regularly seeks disgorgement, which is "a form of restitution measured by the defendant's wrongful gain," in enforcement proceedings as a sanction for violating a federal securities law. Recently the US Supreme Court held that disgorgement claims in SEC proceedings constitute "penalties" and thus are subject to a five-year limitations period under federal law. Kokesh v. SEC, 137 S. Ct. 1635 (2017). The Supreme Court reasoned that SEC disgorgement constitutes a penalty because it is imposed for punitive purposes "to deter violations of the securities laws by depriving violators of their ill-gotten gains." In many cases, disgorgement is not compensatory as the money is paid to the court.

In September 2018, the Appellate Division, First Department applied the court's reasoning in Kokesh in the context of an insurance coverage dispute arising from the insured's monetary settlement of an SEC proceeding and related private litigation regarding the insured's violation of federal securities laws. J.P. Morgan Sec., Inc. v. Vigilant Ins. Co., 2018 NY Slip Op 06146, A.D.3d (September 20, 2018). The case involved an agreement by Bear Stearns to pay disgorgement in the amount of $160 million, $140 million of which represented improper profits acquired by third-party hedge fund customers. Bear Stearns's liability insurers refused to indemnify J.P. Morgan Securities, Inc. (Bear Stearns's successor), which thereafter sued the insurers for indemnification on the basis that all of the claims were covered under the relevant professional liability policy, which provided that the insurers were to "pay on behalf of [Bear Stearns] all Loss which [Bear Stearns] shall become legally obligated to pay as a result of any Claim"¦for any Wrongful Act of [Bear Stearns]." The definition of "loss" in the policy did not include "fines or penalties imposed by law."

The trial court awarded judgment to the plaintiffs, finding, among other things, that pursuant to the broad terms of the policy, the $140 million disgorgement payment at issue constituted a covered loss because it represented third-party gains. On appeal, the insurer argued that "there was no coverage because the United States Supreme Court in Kokesh . . . conclusively defined the nature of the SEC disgorgement remedy as a penalty, not a loss." The First Department in a unanimous decision agreed, stating "[t]he 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." Thus, the court held, the SEC disgorgement did not fall within the definition of "loss," thereby negating coverage under the policy.

The Vigilant decision could be significant for insurers and policyholders dealing in securities transactions because it calls into question the availability of coverage for SEC-mandated disgorgement payments. Practitioners should continue to monitor whether the decision is appealed further to the NYS Court of Appeals and whether other courts weigh in on this issue.