New York’s Highest Court’s Rejection of a Narrow View of Covered Damages Has Wide Application
In a highly anticipated decision, New York’s highest court held in a securities-related dispute that funds the insureds disgorged as part of a settlement with the SEC did not constitute a “penalty imposed by law” under the policies at issue. J.P Morgan Securities Inc., et al. v. Vigilant Ins. Co., et al. (N.Y. Ct. App. Nov. 23, 2021). Accordingly, the Court found that such payments were covered damages for purposes of insurance coverage. While the decision has important implications for insurance coverage in the securities context, it also is grounded in a number of propositions that have broad application and significance in other areas. Specifically, remedies such as disgorgement, restitution, unjust enrichment, abatement and other quasi-equitable or purported penalty-type forms of relief pervade current disputes arising out of climate change, baby food, plastics, opioids and other areas. Each of these remedies serves some compensatory goal connected to a loss, injury or damage. J.P. Morgan shows how they are covered.
The Court initiated its analysis with the principle that whether the SEC-ordered disgorgement at issue in J.P Morgan constituted “a penalty imposed by law” is a question of contract interpretation. This is because “insurance contracts are subject to the general rules of contract interpretation. Like other agreements, insurance contracts are typically ‘enforced as written’; absent a violation of public policy,‘ parties to an insurance arrangement may generally contract as they wish and the courts will enforce their agreements.’” Op. at 6. (citations omitted, emphasis added). Importantly, in a prior decision in the same case, the Court held that disgorgement “was not clearly uninsurable as a matter of public policy.” Op. at 4 (citation omitted, emphasis added).
As a factual predicate to support its holding, the Court noted that the insured argued “that the $140 million disgorgement for which it seeks coverage was derived from estimates of client gain and investor harm….” Op. at 6 (emphasis added). The development of a factual record was critical to the decision. Notably, the policyholder expressly put in evidence as to the nature of the payments; the carriers never refuted that evidence, relying instead on dubious technical legal arguments.
Although the Court’s analysis is built on the contrast between what constitutes a penalty or compensatory damages, the discussion of compensatory damages applies across-the-board. Thus, the Court noted that “a penalty is often characterized as monetary ‘recovery without reference or regard to the actual damage sustained’ that ‘is not designed to compensate anyone.’” Op. at 9 (citations omitted). As the Court explained, a penalty is not measured by the losses caused by the wrongdoing. This concept is the foundation in connecting any loss to covered damages and the ultimate measure of damages.
The Court found that, under New York law, “where a sanction has both compensatory and punitive components, it should not be characterized as punitive in the context of interpreting insurance policies.” Op. at 10 (citations omitted). In other words, unless a settlement or award is purely non-compensatory it may be covered. As such, the main evidentiary focus for purposes of determining coverage is whether a settlement or award “served a compensatory goal.” Id. at 13. In the context of J.P. Morgan, “neither the label assigned to the payment by the SEC and [J.P. Morgan/Bear Stearns], nor the mere fact that the injured parties may ultimately receive the payments is dispositive.” Id. at 13 (emphasis added, citations omitted). Rather, those factors are taken into account with “the fact that the payment effectively constituted a measure of the investors’ losses.” Id. (emphasis added). Thus, a key takeaway is that policyholders should build compensatory components or goals into any resolution, whether by settlement or otherwise.
The Court also clarified how non-insurance decisions affect the interpretation of an insurance policy. The carriers embraced a U.S. Supreme Court decision that, in the context of a statute of limitations for SEC actions seeking disgorgement, held that the five-year limitations period for actions to enforce a “penalty” encompassed “disgorgement” claims as a matter of statutory interpretation. Kokesh v. SEC, 137 S Ct 1635 (2017). In short, the J.P Morgan Court held that Kokesh did not control: “Initially the Supreme Court was not interpreting the term ‘penalty’ in and insurance contract (much less one governed by New York law) and, as we have cautioned, the meaning of that term may very based on context.” Op. at 16 (emphasis added). The significance of this aspect of the J.P Morgan decision is that the applicable insurance-related state law decisions should be analyzed in conjunction with the actual context of the exposure and/or dispute at issue. Correctly framed, the insurance industry should not be able to shut down coverage as a matter of law or by simply referencing allegations in pleadings.
Taking all of this together and applying the reasoning underlying the J.P Morgan decision, insurance policies “must be construed in a manner consistent with the expectations of a reasonable insured at the time of contracting….” Op. at 17 (emphasis added). Notably, the Court was “mindful” that the policyholder purchased insurance to cover liability arising from its business. Op. at 14. As such, policyholders should not lose sight of the fact that every problem has a story; the J.P Morgan decision provides an intuitive framework to set out a covered insurance narrative. Policyholders should ensure that any resolution of the underlying dispute is aligned with the principles set out in J.P. Morgan.