NY Case Shows Insurance Possibility For SEC Disgorgements
By Stephen Weisbrod and Tamra Ferguson (December 16, 2021)
Directors and officers, or D&O, insurers almost invariably deny coverage for payments made pursuant to settlement agreements with the U.S. Securities and Exchange Commission when the settlements describe the payments as disgorgements.
But as shown in New York's highest court's recent decision in J.P. Morgan Securities Inc. v. Vigilant Insurance Co., or J.P. Morgan II, coverage for disgorgements may be available in some cases. In J.P. Morgan II, the New York Court of Appeals reversed the Appellate Division, First Department's grant of summary judgment in favor of insurers. The New York Court of Appeals held that insurers could be required to cover a policyholder's settlement payment to the SEC despite the fact that the settlement agreement described the payment as a disgorgement and despite the fact that, under the U.S. Supreme Court's decision in Kokesh v. SEC, SEC actions for disgorgement are treated as actions for penalties for purposes of calculating the applicable statute of limitations.
The J.P. Morgan coverage dispute has been litigated by one of the largest financial institutions in the world, but its impact will be felt by all kinds of organizations and individuals subject to SEC enforcement proceedings.
While J.P. Morgan could afford to settle with the SEC with or without coverage — and then litigate with insurers for years — many smaller policyholders and individuals desperately need D&O insurers to respond during settlement negotiations with the SEC. Without the ability to fund the kinds of payments to alleged victims that the SEC obtained from J.P. Morgan, small players may not be able to settle.
In a prior decision, J.P. Morgan Securities Inc. v. Vigilant Insurance Co., or J.P. Morgan I, the New York Court of Appeals ruled in favor of J.P. Morgan when it argued that its settlement payment could be covered because the facts showed that, despite the disgorgement label used in the settlement agreement, the payment was not actually a return of ill-gotten gains but rather "was attributable to the profits of its customers."
J.P. Morgan had argued, and the New York Court of Appeals agreed, that coverage could be available because the settlement payment at issue compensated alleged victims for amounts that allegedly constituted unfair profits earned by third parties, not amounts earned by J.P. Morgan itself. In so holding, the New York Court of Appeals reversed the Appellate Division, First Department that had ruled in favor of J.P. Morgan's insurers on a motion to dismiss.
Throughout the coverage litigation, J.P. Morgan had acknowledged that some settlement payments made to the SEC may be uninsurable returns of ill-gotten gains, but J.P. Morgan successfully emphasized that the particular settlement payment at issue far exceeded the payments that J.P. Morgan itself had received on the transactions that gave rise to the SEC's enforcement action.
J.P. Morgan thus was able to show that the settlement payment might not be an uninsurable disgorgement, regardless of the label that happened to be assigned to it.
While the New York Court of Appeals had accepted the argument that the nature of the disgorgement payment had to be determined based on the actual facts, the insurers argued on remand that coverage nevertheless was unavailable because, under the U.S. Supreme Court's decision in Kokesh, an SEC disgorgement is a type of penalty and the policy does not cover penalties. The same intermediate appellate court, the Appellate Division, First Department, that had ruled in the insurers' favor before ruled for them again.
In J.P. Morgan II, J.P. Morgan successfully argued in the New York Court of Appeals that the Appellate Division, First Department had made a mistake very similar to the one that the New York Court of Appeals had reversed in J.P. Morgan I. The settlement payment was not a penalty, J.P. Morgan argued, because the facts showed that the payment was compensatory.
Indeed, a separate payment under the settlement agreement had been labeled as a penalty, and J.P. Morgan did not seek coverage for the penalty payment that had been designated as such. J.P. Morgan argued that the fact that disgorgement payments may be treated like penalties for some purposes, such as calculating the statute of limitations, was not dispositive.
In J.P. Morgan II, the New York Court of Appeals reiterated that the "disgorgement" label is not dispositive and that actual facts matter, and concluded that the insurers had not met their burden of proof on the facts presented.
The New York Court of Appeals noted that J.P. Morgan had "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 [J.P. Morgan] was accused of facilitating," and contrasted that compensatory payment "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."
For policyholders dealing with the SEC, some lessons can be drawn from J.P. Morgan's successes.
First, policyholders should be prepared to argue for coverage based not only on the labels assigned to particular payments, but on the purposes of the payments and the purposes of the coverage. Most D&O insurance policies include coverage for damages or settlements, but exclude coverage for amounts wrongfully obtained and for fines and penalties. For example, some policies exclude from the definition of "covered loss" any amounts constituting remuneration, profit or other advantage to which the insured was not legally entitled, and any amounts constituting penalties imposed by law. In some states, even when the policy language does not contain an express exclusion, coverage for returns of ill-gotten gains or for fines and penalties may be precluded as a matter of public policy.
A policyholder will want to draft settlement agreements with the SEC to enable the policyholder to argue that the payment is in the nature of compensation for alleged losses rather than a return of ill-gotten gains or a penalty.
A policyholder should be prepared to point to facts beyond the SEC's standard terminology.
When SEC enforcement actions are litigated to conclusion and result in payments from respondents, those payments are almost always described as either penalties or disgorgements. Unlike private civil lawsuits, SEC enforcement actions generally do not result in awards of damages.
This follows from the enabling Statute 15 of the U.S. Code, Section 78u-2, the civil remedies section of the Securities Exchange Act, which grants the authority to impose penalties and to enter an order requiring accounting and disgorgement. Thus, when a court or other tribunal actually orders a disgorgement as part of an adjudication, it is ordering the defendant to pay an amount that reflects ill-gotten gains.
As the U.S. Court of Appeals for the Second Circuit stated in Federal Trade Commission v. Bronson Partners LLC in 2011, "[l]like other equitable remedies such as the constructive trust and the equitable lien, disgorgement is 'a method of forcing a defendant to give up the amount by which he was unjustly enriched.'"
However, disgorgements are sometimes the product of negotiated settlements with the SEC and are not always ordered by courts or administrative law judges. Policyholders should be prepared to emphasize that the SEC often enters into settlement agreements that compensate alleged victims, describing as disgorgements many settlement payments that are neither returns of ill-gotten gains nor penalties, which SEC settlement agreements typically set forth separately from the disgorgement payments.
Usually the SEC's reasons for negotiating these kinds of nondisgorging disgorgements are good. The SEC wants to compensate injured investors despite the absence of express statutory authority enabling the SEC to seek restitution or damages on behalf of private parties. Policyholders must argue that insurers are invoking the SEC's unorthodox use of the word "disgorgement" to deny coverage for precisely the kinds of compensatory payments that are supposed to be covered by liability insurance.
Second, just as policyholders should attempt to show that the insurance analysis is not controlled by the SEC's disgorgement terminology, the insurance analysis cannot be controlled by the fact that SEC disgorgement actions are subject to the statute of limitations for actions seeking penalties.
As the New York Court of Appeals noted in J.P. Morgan II, the U.S. Supreme Court was not interpreting any insurance contract terms when the court decided Kokesh, and the Kokesh court specifically cautioned that "[t]he sole question presented in this case is
whether a disgorgement, as applied in SEC enforcement actions, is subject to [the statute's] limitations period."
The reasoning of the Kokesh court suggests that it probably did not think it was eliminating insurance coverage for compensatory settlement payments when the court ruled as it did.
The court held that disgorgements are penalties, and are not compensatory, because "[c]ourts have required disgorgement regardless of whether the disgorged funds will be paid to such investors as restitution."
Where a settlement agreement with the SEC mandates that disgorgements actually are amounts paid to injured investors to compensate them for injuries, that premise would seem inapplicable, at least in the context of a subsequent insurance dispute.
It remains to be seen whether other jurisdictions will follow J.P. Morgan II, but other courts have followed J.P. Morgan I. For attorneys who represent companies and individual insureds in SEC investigations and enforcement proceedings, these are important decisions that may be helpful in enabling clients to negotiate successfully with the SEC.
Stephen A. Weisbrod and Tamra B. Ferguson are attorneys at Weisbrod Matteis & Copley PLLC.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
 J.P. Morgan Securities Inc. v. Vigilant Insurance Co. , No. 61, 2021 WL 5492781 (N.Y. Nov. 23, 2021).
 Kokesh v. S.E.C. , 137 S.Ct. 1635 (2017).
 J.P. Morgan Sec. Inc. v. Vigilant Ins. Co. , 992 N.E.2d 1076 (N.Y. 2013).
 See J.P. Morgan I, 992 N.E.2d at 1082-83 (assuming as true the insureds' assertions that the majority of the amount of settlement labeled "disgorgement" represented the profits of third-parties, not of the insureds).
 See J.P. Morgan Sec., Inc. v. Vigilant Ins. Co. , 166 A.D.3d 1 (N.Y.A.D. 1st Dept. 2018).
 See J.P. Morgan II, 2021 WL 5492781, at *2-3.
 J.P. Morgan II, 2021 WL 5492781, at *5.
 FTC v. Bronson Partners, LLC , 654 F.3d 359, 372 (2d Cir. 2011) (quoting SEC v. Commonwealth Chem. Sec., Inc. , 574 F.2d 90, 102 (2d Cir. 1978)).
 2021 WL 5492781, at *7.
 137 S.Ct. at 1642 n.3.
 Id. at 1644 (internal quotation omitted).
 See, e.g., In re TIAA-CREF Ins. Appeals , 192 A.3d 554, 2018 WL 3620873 (Del. 2018) (applying New York law and finding that a settlement disgorgement is insurable when it is not "conclusively linked, in some fashion, to improperly acquired funds in the hands of the insured"); U.S. Bank Nat. Ass'n v. Indian Harbor Ins. Co. , 68 F. Supp. 3d 1044 (D. Minn. 2014), amended sub nom. U.S. Bank Nat'l Ass'n v. Indian Harbor Ins. Co., No. 12-CV-3175 (PAM/JSM), 2015 WL 12778848 (D. Minn. Mar. 19, 2015) (applying Delaware law and finding that a disgorgement payment made pursuant to a settlement regarding overdraft fees was insurable when there had not been a final adjudication of wrongdoing).