COVERAGE FOR SEC-IMPOSED DISGORGEMENT BASED UPON IMPROPER "AFTER HOURS" TRADING

PART I: TOPICS

INSURERS' MOTION TO DISMISS BASED ON PUBLIC POLICY WHERE INSURED SEEKS INDEMNITY FOR INTENTIONAL WRONGFUL-ACTS

Michael Sean Quinn, Ph.D., J.D., Insurance Coverage Lawyer (Among Other Things)
Austin, Texas 78703

mquinn@msqlaw.com

 

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THIS IS ONE OF TWO BLOG POSTS REGARDING

TWO "HIGHEST COURT" OPINIONS IN THE SAME COMPLEX AND UNUSUAL CASE REGARDING DELIBERATE CONDUCT BY AN INSURED. 

THIS DECISION CONCERNED THE INSURERS’ MOTION TO DISMISS

(I Suggest You Read the Blog Regarding Substantive Matters First)

 

J.P. Morgan Securities, Inc. v. Vigilant Insurance Co., 
21 N.Y.3d 324 (2013)

Although substantive legal issues (and contract interpretation issues) underlie this opinion in the New York Court of Appeals, they do not surface explicitly, until a 2021 decision of the Court in this case.  In this opinion, issues of public policy and procedural matters are the most prominent issues. 

In this part of the case, the issue was whether the insurers could obtain early dismissal of the insured's lawsuit against them seeking indemnity. At the same time, this case contains–or carries with it–issues and law as to matters of insurance, such as insurability, and not just civil procedure.  It also involves how to think about principles of public policy and their proper role in judicial decision-making. All these dimensions make the court's decision and this opinion of nationwide–indeed, international–interest to insurance coverage geeks everywhere, especially if they are involved in complex, "upper level" business and financial insurance and/or issues involving directors and officers liability insurance. 

 

In any case, the New York Court of Appeals begins with the fact that the insurers' motion to dismiss (and get rid of the lawsuit early-on) was denied in the trial court but was granted in the intermediate court of appeals (or what New York law calls "the Appellate Division").  The issue as to whether the motion should be granted or denied came to this court–the highest in the state.  

The dismissal of the case below came to New York's highest court (the New York Court of Appeals) and the issue was whether the dismissal order was established conclusively. This question creates quite a different set of issues with which the 2013 opinion dealt and which the 2021 opinion took to have been established.  

Informally put, the 2013 opinion dealt with this "life-versus-death-of-the-case” procedural issue: Could the insured go forward with its case, or does it get thrown out early on–then-and-there, straight away–because public policy was so completely against it. Usually, these kinds of motions to dismiss are filed shortly after the plaintiff has served its complaint–what is known in Texas as its "Original Petition"–frequently before discovery has commenced. 

[MQ: I will have observations, questions, and comments. They should look like this entry–brackets, initials, italics: That appears to have been what happened in this case and that might well account for the long period of time between the 2013 filing of the Complaint and the 2021 Decision and Opinion.

In 2013, the Court of appeals said, "Go Forward." The 2021 opinion dealt with a substantive issue: Might the insured be entitled to indemnity for the $140M it paid as disgorgement? (The Court of Appeals answered "Yes, though there is more adjudicative work to do.") 

Here is an important point to keep in mind in order to grasp the framework within which the litigation took place: the insurance policies at issue in this case are variants of or quite similar to Directors and Officers (Professional) Liability policies. Some of the issues in this case closely resemble the kinds of issues that arise in D&O cases.] 

In this opinion, Bear Stearns (BS), which became part of the J.P. Morgan family of companies in 2008, (hence the way the plaintiff is named in the style of the case) engaged in "after-hours trading" of an improper sort. (Both opinions contain a description of this sort of activity.) Apparently, BS appeared to be functioning principally as “mere” brokers for several hedge fund companies, although it might have been somehow more intimately involved than that. From the descriptions found in both opinions of the court, the improper activity was using knowledge somehow acquired by the seller while the exchange was open but obtained in such a way is to impose huge losses on purchasing victims, in this case, investors in some mutual funds and make huge profits for itself. 

The SEC's original case was absolutely enormous, but it and BS negotiated a settlement. There was an agreement that BS would pay disgorgement of $160M; $20M of this amount was for its own "sins"; the other $140M was apparently for the misconduct of BS's hedge-fund clients somehow conducted and perhaps sponsored by BS. BS sought indemnity from its insurers for only the $140M and not the $20M, or so, that it conceded was not recoverable from its insurer. 

Ultimately, the key substantive issue, in this case, was the meaning of the word "Loss" in the policy, for which there was coverage and the meaning of the word "penalty" for which there was not. Sums paid out by the insured as penalties were excluded from being covered Loss[es]. Thus, while their policy excluded coverage for penalties, it did not exclude other payments generated by the insured's performance of relevant acts, called "wrongful acts" in the policy, i.e., "any actual or alleged act, error, omission, misstatement, misleading statement, neglect or breach of duty by [BS]." 

[MQ: In other words, more or less, the insurance at issue covered payments the insured had to make as the result of the consequences of its wrongful acts, but this coverage did not include amounts paid as penalties, although the coverage was much broader than injuries and damages for which there might be compensation required by law. In other words, the insurance covered "way more" than consequential damages, i.e., what liability policies usually cover, but not harm caused by acts undertaken with the specific intent of causing harm. The intentionality of the wrongful act for which there was insurance is irrelevant to determining coverage. All that matters is whether the person performing the wrongful act intended to cause harm.]

The intricacies of the language of the policy were not really an issue in this part of the case.  Those ideas are treated much more clearly and conclusively in the 2021 opinion in this case, which is where they belong. Here–in the 2013 parts of the case–the focus was on public policy and some contracts of insurance. See Footnote 6 to this opinion.] 

Right from the start, the insurers sought to get the case dismissed on the grounds that the remedy BS wanted was against deep and important public policy. The insurers failed in the trial court. They tried again in the intermediate appellate court–the Appellate Division–arguing, at least in substantial part, that profoundly important public policy was categorically against deliberate wrongdoers receiving insurance compensation; punishment by such things as penalties are what appropriate, not rewards of some sort.  In this case, said the insurers, government-demanded and then negotiated-in-settlement disgorgement was what was involved, and those are penal in nature–at least, in part, because they were designed to punish, prevent, and/or deter similar acts in the future by both the actor and others. In the "Appellate Division," the insurers succeeded in obtaining an order of dismissal, and an appeal of that order which brought the matter to the Court of Appeals. 

[MQ: It must be kept in mind that the issue before the Court of Appeals was more procedural in nature, than substantive, since it was seeking dismissal (more or less) based on the pleadings, with the law and public policy providing the framework. The rules of civil procedure in New York state are what is really important, for example, because it specifies the requirement that must be met in order to obtain a dismissal, based upon a relevant motion. Those rules, which apply to all sorts of civil suits, determine insurers' burden of proof with respect to the following question, roughly speaking:  Does the plaintiff's case, as brought, have enough discernable, "just-maybe" level, merit to entitle it to go forward in adjudication, or should the case be tossed out forthwith, because it is completely–or almost completely–without any merit, even if all the statements of fact in the plaintiff's complaint are taken to be true. 

The insurers did not rely on statutes, the lack of statutes, precisely and directly relevant precedentially authoritative decisions from past courts. Instead, they relied on appeals to what the law and jurisprudence call "public policy." [MQ: It generally consists of  profound principles of our legal system and/or polity generally regarded as central to justice. These principles are not totally consistent. As one might imagine, it is very difficult to win cases based solely on "Public Policy Arguments," and this includes situations in which conflicting public policies are taken to clash.] The insurers propounded two very similar public policy arguments ("PPAs").

PPA#1, as applied, goes like this: BS is not entitled to relief from its liability insurance carriers because it "enabled its customers, the guilty hedge-funds, to make millions through BS's trading tactics, as well as their own." 

PPA#2, as applied, is similar; BS is not entitled to relief from its liability insurance companies because New York public policy "prohibits insurance coverage for intentionally caused harm."  

Naturally, BS rejected arguments, since it contended, among other reasons, that $140M of its $160M disgorgement was actually that of its hedge fund clients. 

It is worth noting in passing that, as the court observed, the Vigilant policy, and the policies of the excess carriers that followed Vigilant's form, were liability policies. However, as is often the case in such policies, e.g., directors and officers liability policies, the insurer had no duty to defend, as has already been mentioned, although an insured may have a right of indemnity from its liability insurer under some circumstances, one of which may be that the insured turns out to have a right to coverage, does not have a liability, and so forth.

Part of BS's argument that it should be able to proceed with its breach of contract case against the insurer was based on a claim that "as a clearing broker that processed transactions initiated by others, it did not knowingly violate any law; its management did not facilitate the late trading or market timing; and it did not share in the profits or benefits of the late trading, from which it received only $16.9 million in commissions."

The SEC had demanded disgorgement for a variety of reasons, including facilitating what happened, hiding what was going on from the mutual funds which were the victims, and various of BS's omissions, e.g., taking no steps to alter the process. In response to these and other demands, BS settled the case and agreed to other restrictions, e.g., in future private-law litigation arising out of this dark process.  Along the way, the SEC found that BS has "willfully" violated several laws regulating securities. The court did not take any of the SEC's ruling as requiring dismissal of the insured's lawsuit against its carriers.

In any case, the court was not sympathetic to the insurer's public policy arguments.

First and foremost, the most significant public policy in this area of jurisprudence “Freedom of Contract. As is true everywhere in every state, freedom of contract is itself deeply, deeply rooted in public policy. This doctrine is true as to insurance policies, except when controlled by government regulation, whether by statute or by rule. It is a public policy deeply involved in New York jurisprudence, and the court’s opinion stated it by citing some of its own cases. Thus, as was been explained as an earlier case, courts "'are reluctant to inhibit freedom of contract by finding insurance policy clauses violative of public policy.'" Slayko v. Security Mutual Insurance Company, 98 NY2d 309, 316-17 (2002).

At the same time, the court conceded that New York jurisprudence has two situations in which "countervailing public policy will override the freedom of contract, thereby precluding enforcement of an insurance agreement." (1) Insurance companies may not insure against an insured's losses due to punitive damage awards; policy provisions to the contrary are not enforceable. "The rationale underlying this public policy exception emphasizes that allowing [such] coverage 'would defeat the purpose of punitive damages, which is to punish and to deter others from acting similarly.'" (2) Insureds may not, as a matter of public policy, successfully "seek coverage when it engages in conduct 'with the intent to cause injury.'" (This citation is not from an insurance case.) Or to put it slightly differently (if at all really differently), "'Indemnification agreements are unenforceable as violative of public policy only to the extent that they purport to indemnify a party for damages from intentional causation of injury.'" (This citation by the court is from an insurance case.)

The court saw the following clearly: the requirement of the exception to public policy is not that the insured deliberately (and therefore intentionally) performs a wrongful act. The public policy exception applies only to situations in which the insured intended to and did cause injury. [MQ: As a  purely academic point, maybe, notice that the court does not say "injury to a human person."] It then concludes that it could not hold, as a matter of law, that this criterion was met. It would have to do this if it were to affirm the grant of the motion to dismiss under review. 

(MQ: In the remainder of its unanimous opinion, the court discusses several other matters which need not be reviewed here.] 

[MQ: It is interesting that Judge Rivera participated in the unanimous 2013 decision, but she was the lone dissented from the 2021 opinion of the court.  Chief Judge DiFiori was not on the court yet in 2013; she was appointed in 2015. Interestingly, both  Chief Judge DiFiori (R) and Judge Rivera (D) were appointed by the same then governor (D). There had been no controversy about the appointment of the Chief Judge DiFiori (R); in contrast, there had been an uproar about the appointment of Judge Rivera (D).

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.

Read Part II: Topics & Themes / Liability Insurance For Deliberate Conduct Causing Non-Fortuitous Consequences / Liability Insurance For Wrongful Acts And The Problems Of “Moral Hazard” / Liability Insurance For Disgorgements Interpreting The Language Of Policy Exclusions Under New York Law

 

'Wrongful Act' Insurance Coverage for Broker-Dealers in the Securities Markets

Part II: TOPICS & THEMES

                LIABILITY INSURANCE FOR DELIBERATE CONDUCT CAUSING NON-FORTUITOUS CONSEQUENCES

LIABILITY INSURANCE FOR WRONGFUL ACTS AND THE PROBLEMS OF “MORAL HAZARD”

 

LIABILITY INSURANCE FOR DISGORGEMENTS INTERPRETING THE LANGUAGE OF POLICY EXCLUSIONS UNDER NEW YORK LAW

Michael Sean Quinn, Ph.D., J.D. Coverage Lawyer Geek, Among Other Things

Austin, Texas 78703

mquinn@msqlaw.comm 

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

**Preface**

 

[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.

AMBIGUITY IN INSURANCE POLICIES: "EARTHQUAKES," "POLLUTION," AND "WASTEWATER," PLUS SOME SURPLUS LINES MATTERS

 AMBIGUITY IN INSURANCE POLICIES: "EARTHQUAKES," "POLLUTION," AND "WASTEWATER," PLUS SOME "ODDBALL"   SURPLUS LINES MATTERS

National American Insurance Co. v. New Dominion, 2021 OK 62, _ P.3d _ (2021).

                                                           Michael Sean Quinn, Ph.D., J.D., 
                                          Austin, Texas Insurance Coverage Lawyer, Among Other Things*

This case concerns unusual exclusions in a series of modified Comprehensive General Liability insurance policies--some of them renewals--designed to serve productive business entities in the oil and gas industry in Oklahoma. The court's opinion was not unanimous.

The Oklahoma Supreme Court decided the appeals on November  23, 2021.  The insured was accused by several plaintiffs in several different lawsuits of causing the earth to quake (and thereby causing earthquakes*) resulting from its operations.   

(*The term "earthquake" is not defined in the case (or--for that matter--in the policy), but the parties do not dispute that earthquakes are causative and/or caused events that were or were not covered.) 

Three of the four policies involved appear to have been renewal policies. In any case, these lawsuits are called "the Earthquake Lawsuits." There was an additional policy but it is largely irrelevant to the key issues in the case.

Property damages were the principal foundation of alleged liability. (One plaintiff alleged personal injury, but her injury was alleged to occur before any NAIC policy took effect and so was not an issue in the insurance dispute.)

It was New Dominion's discharge of wastewater that was alleged to be the cause of property damage. NAIC brought a declaratory judgment action against its insured, and the insured counterclaimed. 

As indicated this case involved separate policies over four different periods (2012-16). That matter shall not be considered here, except for one point. The main focuses of this post are ambiguity issues to be found in two different exclusions. The Court held that the exclusion entitled "Total Pollution Exclusions" (TPE) was ambiguous and so did not preclude coverage but that the "Subsidence and Earth Movement Exclusions" (SE) were not ambiguous and so precluded coverage. 

[I have underlined the "s's" in the court used names of the two exclusions at issue, because the court treats them as concatenations or groups of separate, though topically related, exclusions--rather like packages or bundles. There is certainly nothing wrong with pluralizing title language in this context. It looks like the insurer itself had done this. In my experience, this grammar is a little odd in insurance policies. Perhaps this semantics results from the fact that the policy is not a standard CGL policy but one specially designed--probably by of at the direction of the insurer--for a sector of the oil and gas industry. I shall say a little more about this at the end of the post. See the paragraph near the end of this post.]

Nothing will be said here about the issues of estoppel and reformation which were involved in the court's opinion, after having been raised by the insurer, nor will anything be said about the involvement of the insurance agent. It is interesting that the agent told the insured that the insurer probably had a duty to defend and that it was unlikely that New Dominion would have liability if the insured defended the policy, since--as the agent put this assertion more-or-less--the stance of the insurance industry was to avoid setting any precedent that might encourage or support plaintiffs' bring more cases against operators. (This unequivocal assertion is a little odd since many cases settle subject to confidentiality agreements.)

The TPE bars coverage for both bodily and property damage "'which would not have occurred in whole or in part but for the actual,  alleged or threatened discharge, dispersal, seepage, migration, release or escape of 'pollutants' at any time.' Pollutants are defined within the policies as 'any solid, liquid, gaseous or thermal irritant or contaminant, including smoke, vapor, soot, fumes, acids, alkalis, chemicals and waste.' Waste refers to 'materials to be recycled, reconditioned, or reclaimed.'"  

[One may wonder why alleged and threatened discharges are included in the list of "un-covered" substances. After all, if an alleged discharge is pleaded without the actual discharge occurring, it cannot (or very, very likely will not) cause any sort of injury or damages, whether bodily or property. Probably, it seems to me, the language is included to avoid having the duty to defend cases where the excluded physical event does not occur but there is an allegation that it has.]

The Subsidence and Earth Movement Exclusions (SE), with one exception, reads this way: "'This insurance does not apply to 'property damage', whether direct or indirect, any loss, injury, or damage arising out of, caused by, resulting from, contributed to, or aggravated by the subsistence, settling, expansion, sinking, slipping, falling away, tilting, caving in, shifting, eroding, mud[-]flow, rising,  or any other movement of land or earth, whether or not any of the foregoing emanate or arise from or are related to the operations of the insured or any other person for whose acts the insured is legally liable.'" (Court-created emphasis removed.)

[Notice that the words "alleged" and "threatened" are not included. Notice also that all occurrences involving earth movement are excluded. If taken literally, this exclusion would include accidental dumping of material including earth, for example, placed on the front lawn of an arbitrary individual. Chances are, this court would find the exclusion ambiguous. It should be remembered that ambiguities which are irrelevant to a case before a court are ignored; this linguist rule is sensible, of course.]

(The exception to the uniformity of the renewal is the policy that contains the word "earthquake" immediately after the word "rising." Without difficulty, the court observed (or found) that the presence or absence of the word "earthquake" in this sentence makes no difference to how the sentence fits with reality and so does not create ambiguity. [I guess that the court believes that an earthquake is an "'other movement of land or earth.'" Now, this last one is a phrase that's likely to be found ambiguous.)

The pollution exclusion, TPE is different, given its wording and given Oklahoma law on how to deal with ambiguities in contracts. The relevant analyses are two-step processes. First, a judge must find that the terminology is actually ambiguous, and contract language is ambiguous "if it is reasonably susceptible to more than one interpretation." Simple disagreement as to meaning is not by itself ambiguity. Second, if the wording is found ambiguous by a judge, then it must be found that "the insured could have reasonably expected coverage under its terms. Ambiguous clauses will not be permitted to defeat coverage that was reasonably expected by the insured. Ambiguities are construed against the insurer and in favor of the insured." 

[Interesting, different jurisdictions have different criteria for ambiguity. In Texas, for example, Step One in the process is the same as that in Oklahoma. The second step is quite different. The ambiguous term or phrase will be interpreted in favor of the insured if it is a reasonable interpretation, even if the interpretation proposed by the insured is more reasonable. There is no reference in the Texas rule as to what the insured reasonably expects. My theory is that Texas is avoiding the fact question as to what was in the insured's mind, since that is a question of fact and would consequently  be removed from the judge's domain which is confined to the meaning of language and does not include fact findings.] 

In any case, here is the court's  application of the Oklahoma rule" "New Dominion contends that it did not contemplate that the exclusion would apply in instances where an irritating or contaminating  substance[--]in this case[--]wastewater, caused bodily injury or property damage that was not the result of the wastewater's irritating or contaminating nature." In other words, even if its wastewater caused the earthquake, it was not its "'irritating or contaminating nature" that caused it. With respect to the ambiguity of the TPE, the court reversed the district court's judgment and sent the case back.

[ND's reasoning was not that the phrase "irritant contaminate," in the context of the policy's definition, restricted the term "pollution" to the types of entities and/or conditions that explicitly found in the definition. Perhaps, it could have contended that the composition of its wastewater is not on the list. Or it could have argued, maybe, that given the way the  term "waste" is defined in the policy--"material to be recycled, reconditioned or reclaimed"--its wastewater does not meet that definition of "waste." I suspect that its argument as to the term "waste" is both more elegant and more persuasive than the two I just sketched, so its choice was well chosen.]

Turning to the SEs, the court held that the applicable parts of the  SEs were not ambiguous. "We find that the Subsidence Exclusions[...] clearly and unambiguously preclude coverage for the events that form the basis for the Earthquake Lawsuits.[*] While the term 'earthquake' is omitted from the list of events for which coverage would be denied in one of the policies, the list comprises nearly every event that is commonly associated with an earthquake. Thus, it would be absurd to find that the Subsidence Lawsuits do not contemplate earthquakes as well." [At this point, the court discusses relevant Oklahoma cases on Oklahoma jurisprudence regarding exclusions and ambiguity, and it goes on as follows:] "[W]e need only to decide whether the inclusion of this term--the term "earthquake"--injects any ambiguity into an otherwise unambiguous exclusion. Obviously it does not. The inclusion of the term 'earthquake' only serves to more explicitly preclude coverage for incidents like those which form the basis of the Earthquake Lawsuits."

**********

Although the following has little to do with the case under discussion, it is worth observing that NAIC is a company about which public information is fragmentary. NAIC is apparently one of the major subsidiaries of what appears to be a very small holding Oklahoma company, the name of which is  "Chandler USA Inc," "Chandler (u.s.a.) Inc, "Chandler (USA) Inc," or something like that. NAIC is said to be part of the "Chandler Group of Companies." The group is said online that a large number of companies; 1240 is the number given, for those involved in the Group. 

[Not all of these companies have their home office in Chandler, Oklahoma, but at least some of them do and at the same or close-by address. NAIC is one of them.  NAIC goes to considerable trouble to distinguish itself from other entities and/or carriers.]

One of the Chandler companies is Chandler Insurance Managers, Inc. (CIMI) It describes itself as being very close to NAIC. It also states that it is an underwriting manager, a "wholesaler,"* and a "managing general agent." (MGA) These terms are characteristic of the surplus lines component of the insurance industry. At the same time, online entries regarding NAIC do not explicitly indicate one way or another whether it is a surplus lines insurer. 

[*The term "wholesaler" and the term "wholesale broker," together with closely related terms, refer to a special kind of insurance broker that connects surplus lines carriers to "retail agents," the types of insurance agents and brokers with whom the general population has some familiarity. There is no indication in the court's opinion whether the agent with whom someone at NAIC conferred was a "wholesaler." However, in general, surplus lines carriers are not permitted to deal directly with so-called "retail agents." (For more on the relationship between "wholesalers" and "retail agents, see Amy K. O'Connor, "Wholesale Brokers Look to Continue Offering Value While Addressing Talent Gap," INSURANCE JOURNAL (December 7, 2021). See also the Conning Analysis (2016) commissioned by the Wholesale and Speciality Insurance Association. The latter is a financial comparison regarding cost structures and ratios between wholesale and retail intermediaries.]

CIMI's self-description on the internet is as follows (or close to it): "CIMI is an underwriting manager and wholesaler to support our agency force by developing a wholesale platform that would offer an ease of doing business with the placement of risks outside of the NAICO's appetite. CIMI has extended underwriting knowledge in multiple industry segments and a carrier appetite to support multiple market opportunities for risk."  [Assuming that CIMI has extended underwriting knowledge, as it says it does, one can hope that it understands statistics and probability calculus better than it grasps the essentials of clear business prose composition.] In any case, it is obvious that NAIC and CIMI are closely related.

Of course, there is nothing intrinsically or inherently problematic about surplus lines insurance entities or surplus lines markets; many sophisticated high dollar individuals and industries use such carriers. At the same, it must be kept in mind that such companies are not as subject to state regulations as "admitted" carriers are, and they or their MGA-types commonly draft portions of their insurance policies rather than depending on state forms or forms approved by states, e.g., fixed ISO forms. That last point may have a connection with the difficulties and awkwardnesses to be found in the two exclusions that were the central topics of the coverage litigation under discussion here. It should be kept in mind that in insurance vocabulary, the fact that a carrier is "licensed" to do business in a given state, does not mean that it is "admitted" in that state. Surplus lines carriers may not be admitted in a given state, but "they" may be "licensed" there. The licenses are obviously smaller in scope than what "admitted" carriers have. In some states at least, a surplus lines carrier that has not been licensed in a given state cannot conduct any business at all in that state.  Texas is like that.

There is some evidence, maybe, suggesting that NAIC is not itself a surplus lines insurer, although it is almost certainly surrounded by some. In a case styled Chandler (U.S.A.), Inc v. Tyree, 2004 OK 16, 87 P.3d 598 (2004). Chandler appears to have stated that NAICO was the largest "writer" of worker compensation insurance in Oklahoma, except for a state fund. It is extremely unlikely that a surplus lines carrier would be issuing worker comp policies, since those are heavily regulated and protected by state law. Worker Comp carriers at least tend to be admitted carriers. Interestingly, NAICO was a plaintiff along with Chandler. I find the Tyree case and the court's opinion both confusing and mysterious. (Terry J. Tyree was the Commissioner of Oklahoma Insurance Fund at this case was brought and decided, and the substantive issues, in that case, pertained to whether the Oklahoma Insurance Fund would be required to issue worker compensation insurance to Chandler.) 

It may be important to note that in surplus lines markets, where insurers are in groups of some sort and are close in some way or other, one company can "write" or "underwrite" policies while another entity actually issues them. What was said about NAIC might fit that pattern. At the same time, I am not suggesting that this configuration is correct; I have not found data to support or refute any proposition about this. In addition, I am unclear how often this distinction--underwriting versus issuing--is utilized in connection with worker compensation insurance. Curiously, some statements in the Tyree case suggest that NAICO and Chandler USA were thought to be insurance competitors.

It is interesting to note that some online literature seems to be saying that Chandler USA Inc., NAIC's parent company, also has a parent company. Its name seems to be Chandler Insurance Co. Ltd, and it too appears to be located in Chandler Oklahoma. In one place it is said that Chandler employs 500 people in Chandler,  although Chandler USA is a holding company with very few employees. (Perhaps various of the other Chandler companies have more employees. NAIC seems to go out of its way to state that it is not to be confused with American National Insurance Company. It is sensible to make this point explicitly, I guess, since it appears that both companies are subsidiaries of Chandler USA. 

One practical point: When insurers are defendants in coverage disputes, they try very strenuously to avoid testifying about or producing documents regarding how given carriers, MGAs, wholesale brokers, and so forth are hooked up. Often the carriers succeed in this effort. Sometimes they prevail in this kind of avoidance, and sometimes they are right. Sometimes they succeed because counsel for the policyholder doesn't know what there is to be maybe had in such discovery. Sometimes the case isn't large enough to make such a pursuit economically sensible.