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How to Increase the Prospects of Coverage of SEC Settlements


Most directors and officers' insurance policies and similar professional liability policies have "in fact" dishonesty and personal profit taking exclusions which generally bar indemnity coverage for payments of claims based on violation of securities and similar laws.  These policies also exclude indemnity coverage for disgorgement or civil penalties.  What happens when the insured settles such a claim for amounts, which it contends are not solely attributable to disgorgement or civil penalty?

Of course, defense of such claims brought by the SEC (or raised in shareholder derivative suits or related litigation) is generally covered by insurers.  This is because courts have found that "intentional acts" exclusions, in these kinds of policies, usually contain "in fact" language, which does not bar coverage until there is a final "in fact" adjudication, as the language of the exclusions actually provides. That is, to bar coverage based on these exclusions, there must be a final adjudication finding in fact that the insured did the intentional dishonest acts.

Where a policy limits the dishonesty exclusion to an "in fact" finding of dishonesty, the insurer is generally compelled to provide a full defense coverage until there is a final judgment establishing dishonesty by the insured officer(s) and director(s).  Atlantic Permanent Fed'l Sav. & Loan Ass'n v. American Casualty Co. of Reading Pa (4th Cir. 1988) 839 F 2d 212, 217.

Indeed, one court held these kind of exclusions and the "personal profits" exclusion cannot be applied to securities fraud claims at all, as to do so would "directly conflict with the coverage grant of the policy," which included security fraud claims.  How could there be coverage for such claims, asked the court, if on proof of such claims the exclusion necessarily swallowed the coverage grant?  Astin v. St. Paul Mercury Ins. Co. (DC DE 2002) 179 F. Supp. 2d 376, 396, based on Delaware and Illinois law.  However, Astin aside, this long standing doctrine, requiring a final adjudication to enforce "in fact" exclusions has now come into question as insurers more boldly seek to avoid paying such claims whether there is a final adjudication or not.

In a recent decision from the New York Supreme Court, Appellate Division, First Department, JP Morgan Securities v. Vigilant Insurance Co. 2011 NY Slip Op 08995, the appellate court reversed a trial court and held that JP Morgan's Bear Stearns could not force its insurers to pay any part of a $250 million settlement with the SEC that grew out of an investigation into "late trading," a well known device whereby mutual funds are allowed to trade after the market has closed for the day, contrary to well established prohibitions, even though the settlement agreement had standard boilerplate language whereby Bear Stearns recited it was entering this settlement "without admitting or denying the findings" by the SEC.

Unfortunately for Bear Stearns' insurance prospects, the findings included that JP Morgan subsidiary, Bear Stearns used to permit its clients to profit wrongfully at the expense of mutual fund shareholders, and thus Bear Sterns agreed to pay $160 million in profit disgorgement and $90 million in civil penalties, while not admitting these claims of disgorgement or civil penalty.  As is usual in such policies, the Bear Stearns' policies only covered compensatory damages and excluded claims "based upon or arising out of the Insured gaining in fact any personal profit or advantage to which the Insured was not legally entitled."  A related exclusion barred coverage for claims "based upon or arising out of any deliberate, dishonest, fraudulent or criminal act or omission" provided there has been an adverse final adjudication to that effect.

The SEC findings coupled with a settlement in which Bear Stearns neither admitted nor denied the findings was enough for the New York Appellate Court to apply the exclusion to bar coverage.  The Appellate court reversed the trial court and ordered the trial court to grant the insurer's motion to dismiss the coverage suit holding that the Bear Stearns' settlement amount did not constitute an "insurable loss' because the conduct in question was an intentional violation of law. The precise holding was:

"Read as a whole, the offer of settlement, the SEC Order, the NYSE order and related documents are not reasonably susceptible to any interpretation other than that Bear Stearns knowingly and intentionally facilitated illegal late trading for preferred customers, and the relief provisions of the SEC Order required disgorgement of funds gained through that illegal activity." (emphasis added)

This was a rather lop-sided reading of the results of the SEC investigation and the ensuing settlement wherein Bear Stearns neither admitted nor denied these same findings.  Yet the Appellate court recited the SEC findings as the only reasonable interpretation of the facts, in effect adjudicating them in favor of the SEC and against the insured.  The Appellate court actually considered an SEC press release to emphasize that the purpose of the SEC administrative order was to not only to "deprive Bear Stearns of the gains it reaped by its conduct" but also to force the company into reforming internal procedures to deter such misconduct.  Most importantly, the New York court did not even mention the regular rule that the dishonest conduct exclusion will not apply in the absence of a judicial finding of dishonesty which has become final.  It is hard to believe that Bear Stearns would not have presented that argument. Maybe the court found it so unpalatable that it simply closed its eyes to this policy requirement.

Of course had Bear Stearns not settled, is it possible Bear Stearns may have prevailed against the accusations?  If so, would not its costs of defense be covered?

This decision should serve as a warning to insureds entering into such settlements.  At the very least, insureds should be encouraged to use stronger language in settlement agreements, more than simply neither admitting nor denying the findings.  Perhaps had Bear Sterns flatly contested the findings, it may have at least have raised triable issues of fact.  It would have advanced the cause of coverage if the agreement also recited those facts favoring Bear Stearns' view that it did nothing wrong. Of course that always supposes such facts did exist.

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