Whether there is insurance coverage for restitution or disgorgement of purported “ill-gotten gains” under Directors and Officers and other professional liability policies (collectively here, D&O policies) has become a pervasive issue in jurisdictions across the country. The increased filings in recent years of consumer and securities class actions, breach of fiduciary duty actions, SEC enforcement actions, and appraisal actions, has added renewed vigor to this judicial debate. Two recent decisions from the U.S. Supreme Court and the First Department in New York, both discussed below, add an important new dimension to this issue and D&O policyholders should not be caught unaware.

What Is the 'Disgorgement Defense'?

A standard D&O policy defines “Loss” as the total amount an insured becomes legally obligated to pay on account of a claim made against it for “Wrongful Acts,” including but not limited to damages, judgments, settlements, costs, and defense expenses. The definition of “Loss” typically goes on to state that “Loss” will not include: (1) fines or penalties imposed by law, or (2) matters uninsurable by law.

Insurers will often argue that, even though the scope of covered “Loss” is defined using broad, undefined terms such as “damages,” or “settlements,” public policy prevents the insurers from indemnifying any payment labeled as “disgorgement” or “restitution” because these payments are by nature, penalties, and uninsurable by law. In response, policyholders contend that the payment of damages and settlements was the precise reason for their purchase of liability insurance, and not only are they entitled to the policy benefits, but to so limit the policy would render the coverage itself, illusory.

Particularly since the Seventh Circuit's infamous decision on this issue in Level Three Communications v. Federal Insurance Co., 272 F.3d 908 (7th Cir. 2001), courts have grappled with how to resolve this question of coverage for disgorgement. A recent number of cases have chiseled away at the position that “disgorgement” or “restitution” is not, in any circumstance, covered by insurance. See, e.g., Burks v. XL Specialty Ins. Co., 2015 WL 6949610 (Tex. App. Nov. 10, 2015) (reasoning that the settlement of a claim seeking restitution was not necessarily uninsurable as a matter of law in the absence of an express finding that the settlement amount, in fact, represented the return of ill-gotten gain); U.S. Bank Nat'l Assoc. v. Indian Harbor Ins. Co., 68 F. Supp. 3d 1044, 1050 (D. Minn. 2014) (holding that under Delaware law restitution payments were not uninsurable); Cohen v. Lovitt & Touche, 308 P.3d 1196, 1200 (Ariz. Ct. App. 2013) (rejecting assertion that state public policy law prohibits insurance coverage for restitutionary payments); In re TIAA-CREF Insurance Appeals, 2018 WL 3620873 (Del. Sup. Ct. July 30, 2018) (applying New York law) (finding that there was no evidence that settlement payment labeled as disgorgement triggered any public policy concerns).

However, and as discussed in greater detail below, a potential set-back to policyholder's arguments occurred on Sept. 20, 2018, when a New York Appellate Court overruled J.P. Morgan Securities Inc. v. Vigilante Ins. Co., 57 Misc.3d 171, 177 (Sup. Ct. N.Y. Ctny. 2017), and held that SEC disgorgement is a “penalty,” which does not fall within the policies definition of “Loss” because it excludes “fines or penalties imposed by law.” J.P. Morgan Securities v. Vigilante Ins. Co., 2018 WL 4494692, *3 (1st Dep't Sept. 20, 2018).

The New York Supreme Court: 'J.P. Morgan Securities Inc. v. Vigilante Insurance Co.', 57 Misc.3d 171 (Sup. Ct. N.Y. Ctny. 2017)

In 2003, the SEC and NYSE conducted investigations against Bear Stearns for possible violations of federal securities laws regarding the alleged facilitation of late trading and market timing by certain customers. J.P. Morgan, 57 Misc.3d at 176. Following the investigations, the SEC told Bear Stearns that it intended to formally charge Bear Stearns with violations of federal securities laws. Id. Bear Stearns disputed the proposed charges but the parties settled the claims with no admissions of wrongdoing by Bear Stearns. Id. As part of the settlement, Bear Stearns agreed to pay $250 million, of which $160 million was labeled disgorgement and $90 million was labeled as a penalty. Id.

Bear Stearns' insurer refused to pay for its defense costs or any part of the settlement. Soon thereafter, in 2009 plaintiffs J.P. Morgan Securities and J.P. Morgan Clearing (formerly known as Bear Stearns entities), filed an insurance coverage lawsuit in New York state court seeking a declaration that pursuant to a primary professional liability policy, which sat below excess follow-form policies, plaintiffs' insurers were obligated to indemnify Bear Stearns for the non-penalty portion of the SEC settlement—namely, the disgorgement payment—defense costs and pre-judgment interests. Id. at 177. The insurers denied coverage on multiple grounds, including, that SEC disgorgement payments are an uninsurable penalty and not a “Loss” covered by the policy. Id.

The lengthy coverage battle, ended in the Supreme Court with the trial court's a pivotal decision on April 17, 2017. The trial court held that based on the policy's broad definition of “Loss,”, the settlement payment, labeled as disgorgement, was a covered “Loss” that represented the gains of third parties, not Bear Stearns. Id. at 179. The trial court also held that any public policy argument barring loss arising out of intentionally harmful conduct was not applicable because there was no evidence that Bear Stearns purposely intended to cause injury. Id. at 186.

The insurers appealed the trial court's April 17, 2017, decision. Shortly after the trial court's ruling, in June 2017, the U.S. Supreme Court issued its decision in Kokesh v. Securities and Exchange Commission, 137 U.S. S. Ct. 1635 (2017), which would pave the way for the insurer's arguments.

The U.S. Supreme Court: 'Kokesh v. SEC,' 137 S.Ct. 1635 (2017)

In 2009, the SEC brought an enforcement action against Charles Kokesh, alleging that he violated various securities laws by concealing the misappropriation of $34.9 million from various development companies. Id. at 1638. The SEC sought monetary civil penalties, disgorgement, and an injunction barring Kokesh from future securities violations. Id. After a jury found Kokesh guilty of the misappropriation, the District Court of New Mexico imposed the penalties sought by the SEC and determined that because disgorgement was not a “penalty” within the meaning of 28 U.S.C. §2462, the applicable five-year statute of limitations did not apply and disgorgement actions “in the securities-enforcement context” must be commenced within five years of the date the claim accrues. Id. at 1641. The U.S. Court of Appeals for the Tenth Circuit affirmed the district court's opinion, confirmed that SEC disgorgement is not a penalty, and further found that disgorgement is not a forfeiture. Id. The SEC appealed the Tenth Circuit's ruling to the U.S. Supreme Court.

On June 5, 2017, the Supreme Court reversed the Tenth Circuit's decision and held that, “[d]isgorgement, as it is applied in SEC enforcement proceedings, operates as a penalty under §2462,” and “any claim for disgorgement in an SEC enforcement action must be commenced within the five years of the date the claim accrued.” Id. at 1645. In its analysis, the Supreme Court considered and determined: (1) SEC disgorgement is imposed by the courts as a consequence for violating a wrong to the public, rather than an individual; (2) SEC disgorgement is imposed for punitive purposes, not remedial; and (3) often, SEC disgorgement is not compensatory and operates to deter, not compensate—the hallmarks of a penalty. Id. at 1644.

The First Department: 'J.P. Morgan Securities v. Vigilante Insurance Co.', 2018 WL 4494692, *3 (1st Dep't Sept. 20, 2018).

On Sept. 20, 2018, the First Department became one of, if not the first, court to hold that Kokesh's finding that SEC disgorgement is a penalty, “applies with equal force” to insurance coverage actions. J.P. Morgan, 2018 WL 4494692 at *3 (finding that Kokesh's holding applies with “equal force to the issue of whether the disgorgement paid by Bear Stearns, 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.”).

In the appeal of the trial court's April 17, 2017 decision, the First Department considered whether “SEC disgorgement is an uninsurable penalty and not a “Loss” covered by the policy.” J.P. Morgan, 2018 WL 4494692, at *3. In a unanimous opinion, the First Department found that the Kokesh decision “provided the missing precedent, establishing that disgorgement is a penalty, whether it is linked to the wrongdoer's gains or gains that went to others.” Id. at *5. The First Department reasoned that the trial court's opinion granting coverage could not stand because SEC disgorgement is a “penalty,” and does not fall within the policies definition of “Loss” which excludes “fines or penalties imposed by law.” Id. In reaching this conclusion, Associate Justice Richard Andrias 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 “and violate[s] the fundamental principle that no one should be permitted to take advantage of his own wrong.”

Id. at *3 (internal quotation marks omitted).

Policyholder Considerations

The First Department's ruling in J.P. Morgan establishes New York precedent for the insurability of SEC disgorgement payments while Kokesh raises the broader question regarding the scope of insurability for any disgorgement payments in the future. However, in the face of these decisions, policyholders should also take the following into consideration:

First, it is currently unknown whether other courts and jurisdictions will agree with J.P. Morgan and find that Kokesh's holding applies “with equal force” to insurance coverage actions. Indeed, Justice Sotomayor cautioned courts that nothing in the Kokesh decision should be interpreted as an opinion on “whether courts have properly applied disgorgement principles in this context. The sole question presented in this case [Kokesh] is whether disgorgement, as applied in SEC enforcement actions, is subject to §2462's limitation period.” Kokesh, 137 S.Ct. 1635, at n.3. Thus, it remains to be seen if the First Department's application of Kokesh is merely an outlier, or the ringleader. In addition, J.P. Morgan is still subject to an application for appeal and could be overturned by the Court of Appeals.

Second, Kokesh held that SEC disgorgement is a “penalty,” imposed as a sanction for violating public laws and is imposed for punitive reasons. Kokesh, 137 S.Ct., at 1638. Applying Kokesh, J.P. Morgan did not hold that all forms of disgorgement are uninsurable but rather, only that “SEC disgorgement,” which has been determined as a matter of law to be a penalty, is uninsurable. Therefore, J.P. Morgan holds, at most, that this specific type of disgorgement is uninsurable.

Third, since J.P. Morgan is limited to an analysis of the insurability of “SEC disgorgement,” and not the insurability of all payments that happen to be labeled as “disgorgement,” D&O policyholders should pay close attention to both the nature of the claims (i.e., fiduciary duty claims, class actions, securities enforcement actions) and the specific type of damages sought. In illustration, the Delaware Supreme Court, applying New York law, recently distinguished the trial court's decision in J.P. Morgan and similar cases that “involve regulatory proceedings which resulted in settlements ordering the insured to pay disgorgement damages.” In re TIAA-CREF Insurance Appeals, 2018 WL 3620873, at * 2 (Del. Sup. Ct. July 30, 2018). In TIAA-CREF, settlement payments labeled as disgorgement were made in connection with civil ERISA class actions where defendant TIAA consistently denied liability, defended the civil class actions, there was no finding of wrongdoing by the court, and the ill-gotten gains were not necessarily in the hands of the policyholder. Id. at *2. Therefore, the court's review of the nature of these settlement payments, even though they were labeled as such, did not represent disgorgement. Id.

Mikaela Whitman is an attorney at Pasich in New York.