J.P.Morgan Securities Inc. v. Vigilant Insurance Company et al,  New York Court of Appeals. Decision and Opinion Date November 23, 2021

[MQ:  The MQ italicized passages are my observations, comments, and opinions. As weird as the following may sound, portions of this case are of national significance, perhaps including Texas. Key portions of this case concern New York law about insurance policy interpretation, especially as regards exclusions, including language functioning as exclusions, though not called or identified as such. One can imagine these rules of interpretation applying anywhere, so it can be helpful in coverage litigation in other state jurisdictions. This observation may be especially true of Directors and Officers (D&O) Liability Insurance. Indeed, the policies, in this case, are variants of or very similar to D&O policies. One can even imagine it applying to the interpretation of contracts other than insurance policies. The very idea of this sort of non-fortuitous liability insurance raises “moral hazard problems.”]

**New York Judicial Organization—A Sketch Including Unusual Vocabulary**

[MQ:  Many lawyers, and others, find the way New York state names entities in its court system confusing, even mysterious. I am one of them. Leaving aside complexities here is how New York’s court system differs from everyone else’s.

In the federal system, for example,

(1) there are District Courts, i.e., trial-level courts. It has District Judges and Magistrates. (They are sort of deep, proxy helpers for their District Judges.)

(2) Then there are intermediate courts of appeals; they are arranged by different circuits, so there is the Second Circuit, where New York is located, the Fifth Circuit where Texas is located, the Eleventh Circuit which includes Florida, and so forth.

(3) Then there is the Supreme Court of the United States, the highest court in the land, it is said.

In summary, at the bottom there are district courts, then up the chain, there are intermediate-level appellate courts, i.e., circuit courts, and then at the top, there is the Supreme Court.

Most states name their courts at least something like this. New York does not. A trial court there is called a “Supreme Court.” There are first-level courts of appeals; each of them is called “Supreme Court–Appellate Division.” Up from that, there is the “New York Court of Appeals.” It is the highest court in the state. It is what many other states and the federal system call their “Supreme Court[s].”]

***** Now For the Case Itself*****

To repeat: it must be remembered that my comments are–or are supposed to be–bracketed, initialed, and italics, though not all italicized words are my comments. It will be easy to tell the difference.

Opinion of the Court

The opinion of the New York Court of Appeals, in this case, bears the signature of Chief Justice Janet DiFiore. The decision was 6-1. It reversed the Supreme Court–Appellate Division, pretty much as a whole, but not completely, and thereby more or less, affirmed the Supreme Court (i.e., the trial court), at least in major part. Here is how the court put it:

“[T]he judgment as appealed from and so much of the Appellate Division order brought for review should be reversed, with costs, and the case remitted to the Appellate Division for further proceedings in accordance with the opinion herein.”

[Often, the ending phrase just reported–”for further…herein”–refers to merely formal matters, e.g., the order “enter a judgment in conformity with what we just have said.” Not this time. It looks like there is other substantive work to be done. In the long run, the New York Court of Appeals may be making another decision and producing another opinion, although what it has not decided has been established and will not be reviewed.]

This very unusual case was decided by the New York Court of Appeals in November 2021 concerning an extraordinary–very unusual–insurance policy. One thing that makes the insurance policy unusual is that it was for dealing with Wall Street-related insurance markets and policies. Another thing that makes it unusual–indeed, strange–is that it covered losses including events that are not fortuitous but intended.

[MQ: Caution! I am working from the pre-publication, uncorrected version of the court’s opinion. Remember: Italicized passages are from me and not substantively inherent in the court’s decision and opinion.]

It must be kept in mind that the actual list of defendant insurers is lengthy. They are all functioning as excess carriers in this case, and they all follow the form of Vigilant’s* policy.  Several insurers needed to be involved since the sums involved were (and probably still are) in the nine figures. The SEC’s original complaint sought way over a half-billion dollars. The sums at issue here appear to have been within the collective policy limits, since the defendant appellees have not raised policy limits as an issue.  No doubt there was reinsurance involved.

(*Vigilant Insurance was the primary carrier. It is a smallish company that is part of the Chubb Group of Insurance Companies. See the earlier case amongst all the same carriers. J.P. Morgan Sec. Inc. v. Vigilant Ins. Co. N.Y. Slip. Op., 04272, 21 NY3d 330 (N.Y. 2013) [MQ: hereinafter referred to as the 2013 case.]

The dispute was (and may still be) between an insured securities broker-dealer company and a list of insurers regarding whether there was coverage for the conduct of the broker-dealers under a “wrongful act” liability insurance policy for funds the insured “disgorged” as part of a settlement with the Securities and Exchange Commission. More concretely put, the issue was whether the disgorgement at issue was covered under the policy, or whether it was really a “penalty,” for a wrongful act, something excluded by the policy language.

[MQ: Nothing is said about the fact that it was Bear Stearns that proposed the settlement numbers. Interestingly, it is not uncommon for settlements to be subject to notice to and consultation with the carrier. One wonders if that happened here.]

More precisely, the policies provided coverage for “loss” that the insured became liable to pay in connection with any civil proceeding or government’s successful investigation into violations of laws or regulations, defining “loss” as including various types of damages–including compensatory and punitive damages (“where insurable by law”)–but not “fines or penalties imposed by law[,]” whether or not they were somehow covered, legally speaking. The question, in this case, was how to treat disgorgements.

J.P. Morgan Securities, Inc., the named plaintiff, was not the doer of the wrongful acts that provided the stage for this drama, that was at least two Bear Stearns companies. They were both purchased by J.P. Morgan long after the wrongful acts were performed. (See n. 2 of the Opinion of the Court.) It was Bear Sterns that was/were the insured(s). The court treated the Bear Stearns entities as one entity. It appears that the individuals involved were not seeking recovery from the insurers.

Vigilant was the primary carrier that played a role in this case and in the 2013 case. One would think that there might be other primary carriers, if there were/are any. It is not mentioned in the court’s opinion what had happened with to the other primary carriers with respect to which the defendant carriers were excess carriers, assuming that there were any other primary carriers. [MQ: Maybe Vigilant was the only one, so that this is why there were a sizable number of excess carriers.]

The wrongful acts were part of a scheme that occurred between 1999 and 2003. The scheme alleged was one involving (1) so-called “late trading”–deliberate acts not illegal in and of themselves–and (2) deceptive market timing practices, which is illegal. The court described the scheme as follows in its footnote #1: “‘Late trading is the practice of placing orders to buy, redeem or exchange mutual fund shares after the 4:00 p.m. close of trading, ‘ but receiving the price based on the net asset value set at the close of trading,” which practice ‘allows traders to obtain improper profits by using information obtained after the close of trading. ‘ (J.P. Morgan Sec. Inc. v. Vigilant Ins, Co., 21 NY3d 324, 330 n. 1 [2013]) “Market timing is the ‘practice of frequent buying and selling of shares of the same mutual fund or the buying or selling of mutual fund shares to exploit inefficiencies in mutual fund pricing’; although this [practice] is ‘not per se improper, it can be deceptive if it induces a mutual fund to accept trades it otherwise would not accept under its own market timing policies.” (Id.).

Thus, what is involved in this case is a professional malpractice policy for Wall Street traders which has the unusual provision that wrongful conduct is covered. [MQ: One might conjecture that the relevant underwriters for Vigilant, the policy of which was the form for all the insurers’ policies, thought that its policy insured nothing more than negligently performed wrongful acts. If so, then the underwriter failed to know about or understand how “Wall Street Broker/Adviser Professional Malpractice Policies” had to work, given the nature and extent of SEC regulation, and given the temptations traders might face. Of course, if this speculation is correct, all the insurers made the same underwriting mistake. [MQ: There are enough differences between the duties of directors and officers and those of Wall Street operators to know that using the same policy form is ill-advised.]

It is not necessary to sketch details about the SEC’s investigation. Eventually, Bear Stearns settled the SEC’s $720M lawsuit. The settlement included $90M in civil penalties and $160M as disgorgement. “Both payments were to be deposited in a ‘Fair Fund’ to compensate mutual fund investors allegedly harmed by improper trading practices.” (42 USC s. 7246). As part of the settlement, Bear Sterns was required to treat the $90M penalty as a penalty for tax purposes. The same did not apply to the $140M disgorgement. [MQ: Elsewhere it is said that the final settlement number was proposed by Bear Stearns.]

Following the settlement, Bear Stearns handed both the $90M and the $160M over to the SEC. It also settled a series of class actions that injured investors had brought.  Bear Stearns did not collapse and disappear as a result of what it did in this case. [MQ: Its demise occurred in 2008 as the result of its involvement with mortgage-back securities. The mortgages backing the securities were very weak, and huge parts of U.S. financial markets were adversely affected leading to the “Great Recession.”]

It is not necessary to review the procedural history of this case. Other interesting facts are summarized in the 2013 case. The crucial question was simple: Was their coverage for the required disgorgement, or was it a “penalty imposed by law,” for which there was no coverage. By the time it came to the Court of Appeals the trial court had ruled in favor of Bear Stearns, while an intermediary-level court of appeals–the Appellate Division–had sided with the insurers.

Under applicable New York law, contract language is to be interpreted in the ordinary sense of words–how they are used in common discourse–absent specific definitions. Insureds bear the burden of proving coverage “in the first instance,” while “the insurer bears the burden of proving that an exclusion applies to defeat coverage. . ..”Indeed, before an insurance company 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.” [Citations omitted.] 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.'” (Emphasis added.)

Based on this reasoning and law, the court observed that the case turns on “the proper interpretation of various components of the coverage provision [of the policy], particularly the definition of ‘loss.’ Under the relevant policies, the insurers agreed to pay ‘all’ loss which Bear Stearns became legally obligated to pay as the result of any claim–defined as including any civil proceeding or governmental investigation–for any wrongful act, which encompasses any actual or alleged act, error, omission, misstatement, neglect, or breach of duty by Bear Stearns and its employees while providing services as securities broker and dealer. The policy defines ‘loss’ to include compensatory damages, punitive damages where insurable by law, multiple damages, judgments, settlements, costs, and expenses resulting from any claim or other damages incurred in connection with any investigation by any governmental body. ‘However, an exception in the definition of ‘loss’ provided that ‘loss’ shall not include ‘fines or penalties imposed by law.’” This language is the core of this appeal.”

In effect, the court is saying that the defendant insurers must demonstrate that the term “penalty” includes “disgorgement.” Here is the way the court puts it: “Thus, the question is whether the [i]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 SEC disgorgement payment.” At that point, in mid-opinion, the court says “The [i]insurers have not met this burden.” [MQ: QED, as the saying goes.]

[MQ: It must be kept in mind that the 2013 case was the insurers’ attempt to get the Bear Stearn’s case against the insurers–both primary and excess–dismissed. In other words, the insurance companies had filed a motion to dismiss–never something easy to get in a case like this one. That case is discussed in a different Post adjacent to this one. In the 2013 decision, the portrait of the situation was that Bear Stearn’s total disgorgement was much less, while that of the other participants of the scheme was the remainder of the $140 million. Bear Stearns self-portrait was that it was the mere broker-donkey while those it served were the far worse culprits. None of those portraits or arguments appear to play a role in the court’s reasoning in this case. One must wonder if there were “side-deals between Bear Stearns and its conspiratorial compatriots.]

The Court’s Opinion under discussion does not stop with the semantics of the insurance policy, however. It goes on to argue about the meaning of the word “penalty” in New York law and in SEC contexts when the insurance was purchased. “Our analysis nonetheless indicates that a reasonable insured purchasing a wrongful act policy [at the time these were purchased, 2000] would expect an award or settlement payment that has compensatory purposes and is measured by an injured party’s losses and third-party gains to fall within its coverage grant and concomitantly, not be deemed a penalty.”

[MQ: The framework the court sets up for this argument is ingenious. Here is my view as to why. First, it does not require that compensation be the only purpose of the disgorgement in order for it not to be a penalty. If compensation is a secondary or subordinate component, that is good enough to avoid classifying the disgorgement as a penalty. The dissenting judge, Jenny Rivera, appears to hold the opposite view. To repeat, the majority opinion does not require that compensation be the “first” or most important purpose of the disgorgement. Second, it is not required that the compensatory nature of the disgorgement be explicitly tied to and restricted to persons or entities directly injured by the insured’s wrongful act. Third, if some of the disgorgement is designed to compensate other parties who are themselves indirectly injured the same or similarly situated as Bear Stearns directly injured victims, there is no reason this fact should defeat the disgorgement as having some compensatory purpose. If my view is correct, it is easy to see why a formalistically thinking lawyer, judge, or legal analyst might be uncomfortable with the court’s jurisprudence here. The ancient and orthodox view is that a judgment is compensatory if it awards monetary recovery to the exact person or entity that the defendant injured directly or indirectly. The Opinion does not think of recovery simply like that. For a formalist in legal analysis and decision-making, the court’s reasoning will strike him/her as unnecessarily fuzzy, or downright sloppy.

The court’s opinion contains arguments from several points of view, including analyses of cases, evidence as to how the SEC and the insureds were negotiated, how the disgorgement component of the settlement supported “the fact that the payment effectively constituted a measure of the investors’ losses.”

What is most important to the majority opinion is not the substance of substantive New York case law. What matters is how the term “penalty” was arguably understood by reasonable insureds at the time the policy was purchased.  Precedential authority from New York on the law of remedies, torts, and contracts is not decisive. Virtually no case resolutions should be taken to be really influential as to the actual question at issue. What the applicable law was after 2000 is, strictly speaking, irrelevant, and this proposition is especially true since there is much debate and confusion on this topic to be found in various cases.

To the extent that legal matters other than the characteristics of relevant type purchasing persons and institutions in the insurance marketplace, it will be New York law concerning the governing the proper interpreting of exclusions, in insurance policies. And here it is. Exclusions must be “given a ‘strict and narrow construction.’ Seaboard Sur. Co. 64 NY2d at 311.” The insurers, hold the court, did not meet their burden of proof under this criterion. [MQ: New York has the same as in many other states: when it comes to the interpretation, scope, and effects of exclusions, the insurers bear the burden of proof.]

[MQ: The Opinion of the Court does not explicitly mention the role ambiguity plays in interpreting terms in insurance policy language, not to mention that of other types of contracts. Instead, it refers to what a reasonable person might believe about the meaning of a term at the time the person purchased the policy. It seems to me that this is a hidden use of the well-established doctrine of interpreting ambiguous language, except for one unrecognized thing: “what-all” a reasonable person believes about relevant words in an insurance contract are factual matters and/or will depend on empirical facts, albeit subjective ones, such as the social and political contexts in which the policy was issued and the presence of clarity or established meanings to be found in disputed language. If my view is true, then what was believed by an insured about policy language becomes a jury issue, since it is an issue of fact, e.g., What did X believe? and Was his/her/its belief reasonable under the circumstances? Obviously, my view is inconsistent with established contract law? Or so it would seem.]

[MQ: The court’s actions reflected in this opinion are not a comprehensive final judgment. Here is what the Opinion says: “The Appellate Division erred in granting summary judgment to the Insurer [on the basis it did] . . . . The parties raise additional arguments that were not reached by the Appellate Division due to its resolution of the penalty issue, including additional defenses to coverage proffered by the Insurers as additional grounds for affirmance. Under the circumstances presented here, “‘the preferable, more prudent corrective action is ‘remittal’ to permit the Appellate Division to address those issues in the first instance. [Citations omitted.] Accordingly, the judgment as far as appealed from and so much of the Appellate Division order brought up for review should be reversed, with costs, and the case remitted to the Appellate Division for further proceedings in accordance with the opinion herein.” The long quote included in this “MQ Comment Section” is a quote from the opinion of the court.]

[MQ: As already indicated, this case has a way to go. Each of the sides has spent millions in legal fees and other expenses. That burden will not get any lighter hereafter. One can imagine that a judge might find this form of “punishment” appropriate under the circumstances.]

Dissenting Opinion of Judge Jenny Rivera

The dissenting opinion was a detailed opinion, longer than the opinion of the court. It covered more than a few cases and a fair amount of recent legal history when it comes to understanding the nature of disgorgements and the nature of penalties.

Some people accuse her of being professorial in framing her opinion, so I shall mention only her central points. Her disquisition on, the details of New York law is for New York coverage lawyers. Here are more nationally interesting features of her opinion.

Disgorgements, which are not a form of compensatory damages, are principally for deterring future wrongful conduct. They penalize wrongful conduct. This is true even when a disgorgement order (or settlement) contains some compensation as a secondary purpose.  Thus, disgorgement is not a species of restitution and calling it an equitable remedy does not make it such. Judge Rivera argues that this is an established view. She also emphasizes that the SEC does not have the authority to award compensatory damages and reasons that a disgorgement is demands or orders cannot be compensatory or have compensatory nature. [MQ: This is a most un-professorial argument.]

Providing coverage for disgorgements would interfere with their deterrence function since it brings the wrongdoer back to where he started. “In summary SEC disgorgement is a penalty within the meaning of the insurance policy language because it deters violations of public law… rather than compensating violations against a particular aggrieved individual. That some portion of a particular disgorgement may be distributed to an unidentified injured party does not change the essentially punitive character of disgorgement as a tool of deterrence.” Having said this, Judge Rivera goes on to state that the opinion of the court “is not a correct reading of the insurance policy language.” [MQ: The judge should have written, “cannot be a correct reading. . .] She then goes on to say that “the SEC and Congress could not have intended the possible anti-deterrent outcome that if appellants eventually succeed on remittal[,] the insurers will indemnify Bear Stearns for $140 million disgorgement sanction that was imposed to prevent their alleged wrongdoing in the securities market.”

[MQ: The trouble with Judge Rivera’s opinion is that it has almost nothing to do with insurance and interpreting insurance contract language.  As the majority opinion indicates, it does not matter what the SEC and the Congress intended; what matters is what the insured reasonably believed when the policy was purchased, keeping in mind how strict and stringent language is interpreted when it comes to understanding exclusions.]

[MQ: I am sympathetic to Judge Rivera’s position. After all, we would not permit insurance to be sold indemnifying bank robbers if they are caught and must disgorge the stolen money.  “Don’t let the crooks win or, at least–do not them not loose! Do not let them escape justice!”] But this is a public policy and legislative outlook, not an outlook when it comes to interpreting insurance policies.  [Is there any chance there is an Elizabeth Warren-type political bias shining through?]

[MQ: In reality, Judge Rivera’s position is also a contemporary version of the classic “moral hazard” argument which has been deployed as to many kinds of insurance of all sorts way back into the 19th Century, for sure, and centuries earlier for maritime and fire insurance. Auto liability insurance faced this objection in the early 20th Century. Liability insurances face it still. See, for example Christopher Parsons, “Moral Hazard in Liability Insurance,” 28 The GenevaPapers on Risk and Insurance, 448-471 (2003). The thing is, Judge Rivera may be right that the moral hazard problem should be determinative in this sort of case as to whether “wrongful act” insurance should be issued at all. After all, it is the non-fortuitous, deliberate, evil acts of the insured that are being insured. But the insurance policy could easily have been thought through and written more carefully to prevent the disputed issues in this case.

A special, unique, non-fortuity policy for the “sins” of Wall Streeters might be a good idea.  At a more subtle level, there is a fair chance that the SEC and the insurers, as well as counsel for the broker-dealers, knew all this and decided to write, sell, buy, and proceed using the policy–-defects and all–just as they did, anyway. Should the insurers be permitted to get away with this by refusing to indemnify on the grounds of an abstract public policy not easily applicable to Wall Street transactions? The insurers almost certainly knew what they were doing and the risk they were taking. What about the well-established policy that parties to contracts are free to determine the terms of their contracts, a public policy that does not work well between giant insurance carriers and Mom-and-Pop candy stores, but which may work fine for hyper-sophisticated Wall Street type traders.]

A Current Probably Quite Irrelevant Curiosity

[MQ: Finally, there are some interesting historical questions about the careers of the two judges that are probably not at all relevant to the opinions they signed. Judge Rivera was part of the majority in the 2013 decision. The most recent, most gossipy, and perhaps the most irrelevant one is this one: Why did the ultra-liberal Judge Rivera refuse to get herself vaccinated against COVID-19, as required by the applicable NY mandate, and thereby get her “un-vaxed” body locked out of the courthouse, including her chambers, as this case went forward? (Of course, she was “remotely” (or “virtually”) present for hearings, etc.; still. . ..) ‘Any chance of some sort of ethnic solidarity in the background here?’ asked some of those who opposed her appointment to the bench of the Court of Appeals.]

Read Part I: Insurers’ Motion To Dismiss Based On Public Policy Where Insured Seeks Indemnity For Intentional Wrongful-Acts.

The content of this article, essay, post, or document should not be taken as legal advice to anyone, whether client, customer, or otherwise. Nor may it be taken to be anything a lawyer might perform for a client. In so far as it is other than accurate reporting. The observations are mine and not intended to be foundation of client or client-like decision-making.