It is an unwelcome experience for any policyholder to receive a claim denial letter in which the insurer contends that the language of the policy excludes the claim in question. Even more frustrating for the policyholder, however, is when the insurer contends that even if the policy language does cover the claim in question, “public policy” nevertheless allows the insurer to avoid providing the coverage it promised in the policy. A claim denial based on public policy is especially frustrating to a policyholder because, in essence, the insurer is contending that it sold the policyholder coverage that it was not legally permitted to provide. Recognizing the inequity in allowing insurers to avoid their express contractual promises, New York’s highest court recently provided a reminder to insurers that they will only be able to escape from their coverage obligations on public policy grounds in rare and narrow circumstances.
The J.P. Morgan Argument
New York’s Court of Appeals addressed the limitations of public policy exclusions to coverage under New York law in J.P. Morgan Securities, Inc. v. Vigilant Insurance Co., No. 113 (N.Y. June 11, 2013). In that decision, in which Proskauer represented the policyholder, the Court of Appeals reversed a lower court decision that had dismissed, on public policy grounds, a coverage action brought by Bear Stearns (now part of J.P. Morgan Chase). Bear Stearns, a broker-dealer, had sought coverage for settlement of claims brought by the SEC and the New York Stock Exchange, which had charged it with facilitating late trading and market-timing in mutual funds by its customers, in violation of the securities laws. In settlement of these claims, without admitting or denying the facts recited by the SEC pursuant to an Administrative Order entered on consent, Bear Stearns agreed to make two payments: $160 million denominated as “disgorgement,” for which Bear Stearns sought insurance coverage; and an additional $90 million penalty for which it did not.
Bear Stearns argued that the SEC had not precluded it from seeking coverage for the “disgorgement payment.” Moreover, they argued that the amount of the payment had not been calculated on the basis of gains that Bear Stearns itself received (meaning, the payment did not actually represent profits being “disgorged” from Bear Stearns). Instead, the “disgorgement payment” was based almost entirely on the trading gains allegedly achieved directly by Bear Stearns’ customers and clients as a result of their own misconduct. Thus, Bear Stearns argued, although certain courts had rejected coverage for disgorgement payments where the insured had returned its own improper gain — some on public policy grounds (to prevent the insured’s unjust enrichment) and others on the ground that the return of ill-gotten gains is not a loss — neither rationale was applicable to the situation at hand. They urged the court to be very wary of extending public policy prohibitions to insurance coverage expressly provided by the policy — which included coverage for regulatory claims by the SEC and other governmental and self-regulatory bodies — by endorsing the Appellate Division’s rationale that insurance should be disallowed in order to preserve the deterrent effect of an SEC disgorgement remedy.
The Court’s Decision
The Court of Appeals accepted Bear Stearns’s arguments. Noting the complete absence of precedent from any other court prohibiting coverage for disgorgement where the insured was not required to return gains that it had actually received, the court declined to adopt a public policy-based prohibition of insurance coverage for the payment made by Bear Stearns. Instead, the court found that public policy mandated enforcement of insurance contracts freely entered into by the parties according to their terms.
The Court explained that it previously had recognized countervailing exceptions to the public policy of enforcing insurance contracts as written in only two narrowly defined circumstances: for punitive damages, where the purpose of the remedy is to punish as well as deter wrongdoing, and where the insured had engaged in conduct specifically intended to harm third parties. On the record before it, which included the SEC’s Administrative Order and findings, the court found that neither exception applied: Bear Stearns was not seeking coverage for punitive damages and had not been found to have engaged in intentionally harmful conduct. The court emphasized that the public policy exception for intentionally harmful conduct is a narrow one, under which it must be established not only that the insured acted intentionally but, further, that it acted with the intent to harm or injure others. The SEC’s findings that Bear Stearns willfully committed securities law violations did not establish that it acted with the requisite intent to cause harm.
The Court of Appeal’s strong endorsement of enforcement of the express terms of freely negotiated insurance contracts in the J.P. Morgan decision – with very limited public policy exclusions to coverage – is welcome news for policyholders. Along with providing possible coverage for SEC disgorgement payments, the decision will make it harder for insurance companies to rely on public policy arguments as a basis to avoid their coverage obligations.