Applying a U.S. Supreme Court decision in the context of insurance coverage for a bank, a New York appellate court ruled that the amounts paid to the Securities and Exchange Commission (SEC) as disgorgement under a cease and desist order issued by the SEC were a “penalty” for which coverage was precluded.
The panel applied the reasoning of the U.S. Supreme Court’s 2017 decision in Kokesh v. SEC, where the justices ruled that a disgorgement payment to the agency represented a “penalty” as a matter of law.
In 2003, the SEC began an investigation to determine whether a national bank—now defunct—violated federal securities laws between 1999 and 2003 by knowingly facilitating “late trading” and deceptive “market timing” for certain hedge fund customers and affirmatively assisting those customers in evading detection.
Three years later, the SEC notified the bank that it intended to institute civil proceedings against it, seeking monetary sanctions of $720 million. The bank issued a formal offer of settlement, which resulted in a cease and desist order in which the bank neither admitted nor denied the findings, and agreed to pay disgorgement in the total amount of $160 million and civil money penalties in the amount of $90 million.
After making the payment, the bank turned to five of its insurers for indemnification of $140 million of the disgorgement payment, representing only that part of the monies ill-gotten by the bank’s hedge fund customers. When the insurers balked, the bank filed suit in New York state court, seeking a declaration that the defendant insurers had a duty to indemnify because the claim fell within the definition of a “Loss” under the implicated policies.
In a prior appeal, the appellate panel held that, as a matter of public policy, the bank could not seek recoupment of any portion of the disgorgement payment and dismissed the complaint. However, the state’s highest court reversed and reinstated the complaint, holding that the SEC order did not “conclusively demonstrate that [the bank] also had the requisite intent to cause harm.”
On remand, the trial court granted the bank’s motion for summary judgment. Based on the broad definition of “Loss,” the $140 million disgorgement payment constituted a covered Loss because it represented third-party gains (not the bank’s gain), the court said, adding an award of prejudgment interest to the bank.
The case then went back before the appellate panel, which reversed the trial court’s holdings.
Pursuant to the relevant policy, “Loss” was defined as follows: “(1) compensatory damages, multiplied damages, punitive damages where insurable by law, judgments, settlements, costs, charges and expenses or other sums [the bank] shall legally become obligated to pay as damages resulting from any Claim or Claim(s); (2) costs, charges and expenses or other damages incurred in connection with any investigation by any governmental body or self-regulatory organization (SRO), provided[,] however, Loss shall not include: (i) fines or penalties imposed by law; or … (v) matters which are uninsurable under the law pursuant to which this policy shall be construed.”
The insurers argued that the bank had no coverage, citing the U.S. Supreme Court’s opinion in Kokesh, which defined the nature of SEC disgorgement as a penalty. SEC disgorgement is meant to punish the violator and deter others from similar violations, the Court reasoned.
“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 [the bank], 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,” the New York appellate panel wrote.
“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 violate[s] 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.”
The plaintiffs attempted to rely upon the New York Court of Appeal’s prior opinion, but the appellate panel noted that decision was focused on the public policy issue and not the policy language. In addition, the U.S. Supreme Court has spoken in the interim (in Kokesh), providing a change of law establishing that disgorgement is a penalty, whether it is linked to the wrongdoer’s gains or to gains that went to others.
“Kokesh has significance beyond the narrow issue of the statute of limitations because the Supreme Court analyzed the fundamental nature and purpose of the SEC’s disgorgement remedy, which does not change into some different nature for purposes of insurance coverage,” the court said.
“Thus, as defendants argue, Kokesh and the longstanding legal principles on which it relied fatally undermine the motion court’s holding that the $140 million of the SEC disgorgement remedy that plaintiff seeks to recover is a covered loss under the policies. Indeed, if the $140 million portion of the disgorgement payment [the bank] seeks to recover reflects the gains of [the bank’s] customers rather than of [the bank] itself, it makes it more, not less, of a penalty.”
The panel reversed summary judgment in favor of the bank (as well as the award of prejudgment interest) and granted summary judgment in favor of the insurers.
To read the opinion, click here.
Why it matters
In the latest opinion in this long-running and closely watched insurance coverage litigation, a New York appellate panel relied heavily on the U.S. Supreme Court’s decision in Kokesh to hold that insurers had no duty to indemnify the bank for its disgorgement payment to the SEC. Although the justices were interpreting SEC disgorgement payments in the context of the statute of limitations, the New York court found the rationale behind the opinion applied with equal force to insurance coverage.
Note that, in our view, it is important to put this decision in the appropriate context. Insurers often seek, as they did in this case, to characterize different types of otherwise covered losses arising from civil or governmental proceedings as non-covered “penalties.” Under the particular facts of this case, the New York Appellate Division was sympathetic to the argument that disgorgement payments to the SEC were, in fact, penalties by virtue of the U.S. Supreme Court’s decision in Kokesh. In many other contexts in which insurers make similar arguments, however, the facts are not nearly as compelling, and their arguments may be wrong as a matter of law. Before accepting an insurer’s determination that a particular component of otherwise covered “Loss” is a non-covered “penalty,” policyholders would be well-advised to seek the advice of experienced policyholder-side insurance counsel.