NY High Court Rules Disgorgement Is Not a Penalty

The Facts of the Case

In 2003, the SEC began investigating Bear, Stearns & Co., Inc., and Bear, Stearns Securities Corporation (collectively, Bear Stearns) for allegedly facilitating late trading and deceptive market timing practices by its customers. Bear Stearns's insurers disclaimed coverage for the investigation.

Bear Stearns settled with the SEC in 2006, agreeing to, among other things, make a $160 million "disgorgement" payment as well as a $90 million payment for "civil money penalties." The two payments were deposited into a "Fair Fund" to compensate mutual fund investors allegedly harmed by Bear Stearns's activities. The settlement further provided that the $90 million payment—which it was required to treat as a penalty for tax purposes—could not be used as an offset to amounts owed by Bear Stearns to private litigants injured by Bear Stearns's activities. There was no such prohibition with respect to the $160 million disgorgement payment.

Of the $160 million, Bear Stearns only sought coverage for $140 million, which, according to Bears Stearns, reflected disgorgement of its clients' gains; the remaining $20 million represented Bear Stearns's own profits from the transactions. In an earlier decision in the case [21 N.Y.3d 324 (2013)], the New York Court of Appeals held that the disgorgement payment was not clearly uninsurable as a matter of public policy because it allegedly was "calculated in large measure on the profits of others." Id. at 336.

After that earlier decision, the case was remanded to the trial court, and Bear Stearns subsequently moved for summary judgment, seeking dismissal of the insurer's remaining coverage defenses with respect to the $140 million disgorgement payment. The insurers opposed the motion, arguing that the disgorgement payment did not represent client gains and, among other things, that the payment was a "penalty" and, therefore, not within the definition of "loss" in the policies. Specifically, the definition of "loss" in the policies excluded "fines or penalties imposed by law." The lower court granted Bear Stearns's motion, but the appellate division reversed, holding that disgorgement was a penalty and, therefore, excluded from the definition of covered "loss."

On appeal, the New York Court of Appeals found in favor of Bear Stearns, holding that the $140 million payment was not a penalty within the meaning of the policy. While the decision was an important one for policyholders seeking coverage for SEC disgorgement payments, the court's reasoning also has potential implications beyond just this narrow context.

The Court's Reasoning

The New York Court of Appeals began its analysis with the meaning of the word "penalty." Because the word was not defined in the policy, the court looked to the common understanding of the term as something that exceeds the injured party's actual damages, that is, something that is intended as a punishment, rather than compensation. According to the court, "a penalty is distinct from a compensatory remedy and a penalty is not measured by the losses caused by the wrongdoing." Id. at *4.

Further, the court recognized that, although the exclusion for "penalties" was found in the definition of "loss" and not the exclusion section of the policy, it nonetheless functioned as an exclusion and, therefore, must be construed narrowly. As a result, unless a payment is wholly punitive, with no compensatory element, "it should not be characterized as punitive in the context of interpreting insurance policies." Id. at *4. The court further opined that "a reasonable insured would likewise have understood the term 'penalty' to refer to noncompensatory, purely punitive monetary sanctions." Id. at *5. In that regard, the court noted that Bear Stearns's communications with the SEC indicated that the $140 million disgorgement payment reflected the valuation of Bear Stearns's "customers' gains and the corresponding injury suffered by investors as a consequence of the challenged trading practices." Id.

The court also noted that the $140 million was not required to be treated as a penalty for tax purposes and was to be placed into a fund to compensate injured parties; however, the court expressly stated that "neither the label assigned to the payment by the SEC and Bear Stearns, nor the mere fact that injured parties may ultimately receive the funds, is dispositive." Id. at *6. The court also rejected the dissent's argument that coverage should be precluded because the primary goal of SEC-ordered disgorgement was punishment and that compensation of injured victims was only a secondary goal.

In addition, the court rejected the argument that the US Supreme Court's ruling in Kokesh v. SEC, 137 S. Ct. 1635 (2020)—which held that the 5-year statute of limitations to enforce a "penalty" applied to SEC-ordered disgorgement—was relevant to whether disgorgement is a penalty for the purposes of insurance coverage. Id. at *7 ("The Supreme Court was not interpreting the term 'penalty' in an insurance contract (much less one governed by New York law) and, as we have cautioned, the meaning of that term may vary based on context.")

Accordingly, the court found that "the Insurers failed to establish that the $140 million 'disgorgement' payment—a component of the SEC settlement that serves compensatory purposes and was measured by the profits wrongfully obtained and losses caused by the alleged wrongdoing—clearly and unambiguously falls within the policy exclusion for 'penalties imposed by law.'" Id. at *7.

Implications

While the decision addresses the specific issue of SEC-ordered disgorgement, the New York Court of Appeals' reasoning potentially has broader implications. Exclusions for penalties are not limited to D&O policies, and there are any number of common law and statutory remedies that might be called a "penalty." Even punitive damages, which often are considered a penalty, may in some instances be calculated based on a measure of actual damages or otherwise have a compensatory component.

Based on the New York Court of Appeals' reasoning, coverage for a payment is not excluded simply because it is labeled a "penalty"; rather, a court should take into account the nature of the payment, including whether there is a compensatory purpose and whether the amount is based on a measure of actual damages, in deciding whether the payment is an excluded penalty. In addition, it is not enough that some portion of a payment is a penalty; to be excluded, the payment must be wholly a penalty.

Other courts outside of New York have adopted similar reasoning. For example, in Carey v. Employers Mut. Cas. Co., 189 F.3d 414 (3d Cir. 1999), the Third Circuit Court of Appeals held that a surcharge did not constitute an excluded "fine or penalty imposed by law" under an errors and omissions policy. The surcharge was imposed against three town supervisors due to alleged negligent overpayment on a municipal golf construction project. Like the New York Court of Appeals, the Third Circuit looked at the nature of the surcharge to determine whether it was a penalty. Specifically, the Third Circuit likened it to surcharges imposed on fiduciaries for negligent management of trust funds that, under Pennsylvania law, are imposed to "'compensate beneficiaries'" for the trustee's negligence. Id. at 420 (quoting In re Miller's Estate, 345 Pa. 91, 93 (1942)). Accordingly, the court concluded that "the surcharge is not punitive but remedial" and, thus, was not an excluded penalty. Id.

Likewise, in O'Connell v. Home Ins. Co., 1990 WL 137386 (D.C. Sept. 10, 1990), a federal district court found that a Rule 11 sanction imposed by a court was not excluded under a lawyer's professional liability policy. The policy defined "damages" as excluding "fines or statutory penalties whether imposed by law or otherwise." The court in the underlying claim sanctioned the policyholder attorney for filing a baseless claim by requiring the attorney to pay the other party's attorneys' fees and costs. The professional liability insurer denied coverage, arguing that the sanction was an uninsurable penalty. The court held that the sanction was "intended to compensate the defendant … for having to defend a 'baseless lawsuit'" and, therefore, was compensatory in nature and not a penalty. Id. at *5.

As these cases illustrate, determining what constitutes a "penalty" under an insurance policy requires looking merely beyond labels and examining the nature and purpose of the payment at issue.