New York Court of Appeals Addresses the Meaning of “Penalty Imposed by Law” under Wrongful Act Professional Liability Policy

September 1, 2022 / Writing and Speaking

J.P. Morgan Securities Inc. v. Vigilant Insurance Co., 182 N.E.3d 443 (2021) involves a dispute between insured securities broker-dealers Bear Stearns and certain of its excess insurers (“Excess Insurers”) regarding the availability of coverage under a wrongful act professional liability policy for funds disgorged from the insured as part of a settlement with the Securities and Exchange Commission (“SEC”). In a reversal, the New York Court of Appeals held that the $140 million disgorgement for which Bear Stearns sought coverage was not excluded as a “penalty imposed by law” under the policies at issue. The Court of Appeals reasoned that at the time the parties contracted, a reasonable insured would have understood the term “penalty” to refer to non-compensatory, purely punitive monetary sanctions.

FACTUAL BACKGROUND

In 2000, Bear Stearns purchased a primary insurance policy and various excess insurance policies  providing coverage for “wrongful acts” of the company and its subsidiaries. In 2003, the SEC and other regulatory agencies began investigating Bear Stearns concerning allegations that, between 1999 and 2003, Bear Stearns had facilitated late trading and deceptive market timing practices by its customers in connection with the purchase and sale of shares of mutual funds. Bear Stearns settled with the SEC in early 2006. Pursuant to the settlement order, the SEC censured Bear Stearns and ordered it to cease and desist from any future securities law violations. Without admitting or denying the findings and solely for the purpose of the SEC proceedings, Bear Stearns agreed to a $160 million disgorgement payment ($140 million of estimates of client gain and investor harm plus $20 million of Bear Stearns’ own revenue) and a $90 million civil penalty. Both payments were to be deposited in a “Fair Fund” to compensate mutual fund investors allegedly harmed by the improper trading practices. Further, to preserve the deterrent effect of the civil penalty, the settlement order directed that the $90 million penalty payment—but not the disgorgement payment—was ineligible to offset any sums owed by Bear Stearns to private litigants injured by the trading practices. Bear Stearns was also required to treat the $90 million payment as a penalty for tax purposes. Following the settlement, Bear Stearns transferred the $160 million disgorgement and $90 million penalty payments to the SEC.

Bear Stearns’ successor companies subsequently sued the Excess Insurers alleging breach of the insurance contracts and seeking a declaration of coverage for the disgorgement payment.  Bear Stearns moved for summary judgment on the Excess Insurers’ various defenses to coverage, and it argued that $140 million of the disgorgement payment represented disgorgement of its clients’ gains, as compared with Bear Stearns’ own revenue, and thus was an insurable “loss” under the policies. The Excess Insurers opposed and cross-moved for summary judgment, arguing that the $140 million disgorgement payment did not represent client gains. The New York Supreme Court denied the Excess Insurers’ motions and granted summary judgment to Bear Stearns, concluding that the disgorgement of $140 million in client gains constituted an insurable loss. The Excess Insurers appealed. The Appellate Division, among other things, reversed and granted the Excess Insurers’ cross-motions for summary judgment, declaring that Bear Stearns was not entitled to coverage for the SEC disgorgement payment. The Appellate Division determined that the relevant portion of the disgorgement payment was a “penalty” and, as such, was not an insurable loss under the language of the policies.

On appeal to the Court of Appeals, Bear Stearns argued that the $140 million disgorgement was derived from estimates of client gains and investor harm and, therefore, the Excess Insurers failed to meet their burden of establishing that the payment was not a covered loss because it was a “penalty imposed by law.” The Court of Appeals agreed that the payment is not a “penalty” within the meaning of the policies.

ANALYSIS

The Court of Appeals found that whether the $140 million SEC-ordered disgorgement constituted a “penalty imposed by law” such that it is not recoverable as a “loss” under the relevant insurance policies is a question of contract interpretation. It is well-settled in New York that insurance contracts are subject to the general rules of contract interpretation and that, like other agreements, insurance contracts are typically enforced as written. As such, the Court of Appeals looked to the specific language in the policies, and applied rules of interpretation according to common speech and consistent with the reasonable expectation of the average insured at the time of contracting, with any ambiguities construed in favor of the insured. The Court of Appeals recognized that while an insured must establish coverage in the first instance, the insurer bears the burden of proving that an exclusion applies to defeat coverage. Additionally, before an insurer is permitted to avoid policy coverage, it must satisfy the burden of establishing that the exclusions or exemptions apply in the particular case, and that they are subject to no other reasonable interpretation. This standard may be implicated even when an insurer relies on “limiting language in the definition of coverage” instead of “language in the exclusions sections of the policy” because, in some circumstances, that limiting language functions as an exclusion.

In this case, the Court of Appeals attempted to interpret the various components of Bear Stearns’ insurance coverage, particularly the definition of “loss”. The policies stated that Excess Insurers agreed to pay all “loss” which Bear Stearns became legally obligated to pay as the result of any claim for any wrongful act by Bear Stearns while providing services as a securities broker and dealer. The policies defined “loss” to include compensatory damages, punitive damages where insurable by law, multiplied damages, judgments, settlements, costs, and expenses resulting from any claim. However, an exception in the definition of “loss” provided that “loss” shall not include fines or penalties imposed by law.

The Court of Appeals explained that although the policy limitation on the definition of “loss” as exempting “penalties imposed by law” is contained in the coverage section, the carve out excepting certain “penalties” from coverage amounts to an exclusion because, absent that language, the definition of “loss” would otherwise encompass such payments. Thus, the question shifts to whether the Excess Insurers demonstrated that a reasonable insured purchasing this wrongful act policy in 2000 would have understood the phrase “penalties imposed by law” to preclude coverage for the $140 million disgorgement payment. The Court of Appeals held that the Excess Insurers did not meet this burden, reasoning that, while the phrase “penalties imposed by law” was not defined in the insurance policies, the term “penalty” has been commonly understood to reference a monetary sanction designed to address a public wrong that is sought for purposes of deterrence and punishment rather than to compensate injured parties for their loss. In the context of statutory penalties, the word “penalty” does not apply to actual damages but, rather, exacts sums from a wrongdoer that exceed the injured party’s actual damages. The Court of Appeals stated that this view is consistent with dictionary definitions in effect around the time the policies were issued, and the modern understanding that recovery without reference or regard to the actual damage sustained is not designed to compensate anyone. Simply stated — a “penalty” is distinct from a compensatory remedy and a “penalty” is not measured by the losses caused by the wrongdoing.

The Court of Appeals ultimately held that the disgorgement payment clearly did not fall within the policy exclusion for penalties imposed by law, stating:

Bear Stearns demonstrated the absence of any material question of fact as to what the $140 million payment represented. Bear Stearns submitted evidence regarding its communications with the SEC throughout the negotiation process indicating that, at the direction of the SEC, Bear Stearns undertook various valuation of its customers’ and the corresponding injury suffered by investors as a consequence of the challenged trading practices. In particular, the correspondence—taken together with other collaborating testimonial and documentary evidence, supported its contention that, after negotiations regarding the appropriate valuation method, Bear Stearns estimated third-party gains to be approximately $140 million and Bear Stearns ultimately agreed with the SEC to incorporate that amount into the settlement as representative of client gains and the concomitant investor losses.Thus, Bear Stearns 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 alleged wrongdoing that BearStearns was accused of facilitating. This can be contrasted with the $90 million payment denominated a “penalty,” which was not derived from any estimate of harm or gain flowing from the improper trading practices.

Because the Excess Insurers did not submit any evidence rebutting this proof, the Court of Appeals concluded that the Excess Insurers failed to establish that the disgorgement payment falls within the policies’ exclusion for “penalty imposed by law” and that the Appellate Division erred in granting summary judgment to the Excess Insurers on that basis.

LEARNING POINT

The Court of Appeals affirmed that penalties have consistently been distinguished from compensatory remedies, damages, and payments otherwise measured through the harm caused by wrongdoing. Accordingly, at the time the parties contracted, a reasonable insured would have understood the term “penalty” to refer to non-compensatory, purely punitive monetary sanctions. In this case, the Court of Appeals shifted the burden of proof to the Excess Insurers, and the lack of contrary evidence from the Excess Insurers provided the Court of Appeals with an avenue to find in favor of coverage.

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