Is the Relief Sought in Securities Fraud Lawsuits a Covered “Loss” under the Defendant’s D&O Policy?

August 2, 2013

Insurance LawThe Seventh Circuit’s decision in  Level 3 Communications, Inc. v. Federal Insurance Company, that the “standard damages relief in a securities-fraud case” is “restitutionary in character” and thus not a “loss” with the meaning of a D&O policy sent a tremor through the securities litigation community. Since the circuit court’s decision, authored by Judge Posner, insurers have attempted to characterize lawsuits seeking restoration of gain by the insured as “restitutionary in character” in order to avoid coverage.

Not All Securities Fraud Remedies Are Restitutionary

The Level 3 Communications court acknowledged that not all securities fraud-related liability is restitutionary in nature. If the insured did not, itself, obtain money to which the underlying plaintiff was entitled, the relief cannot be characterized as restitution. This usually means that if insured is not the issuer or seller of securities, the relief sought will qualify as a loss within the meaning of the policy. See, e.g., Bank of America Corporation v. SR International Business Insurance Company, (unreported) (bond offering’s underwriter’s liability qualified as a “loss” because plaintiffs “did  not seek to force the investment banks to return money which they had received and to which they were not entitled.”)

Complaint’s Characterization of Relief Not Determinative of Coverage

Just as a complaint’s characterization of the relief sought as something other than restitution is not determinative of whether the insured’s liability qualifies as a loss, a complaint’s characterization of the remedy as restitution or disgorgement also is not determinative. The Court of Appeals of New York’s recent decision in J.P. Morgan Securities, Inc. v. Vigilant Insurance Company, is illustrative. There, the SEC accused Bear Stearns of facilitating late trading and deceptive market timing on behalf of some of its large hedge fund customers. The SEC accepted Bear Stearns’s offer to settle for $250 million and memorialized the settlement in an “Order Instituting Administrative and Cease–and–Desist Proceedings, Making Findings, and Imposing Remedial Sanctions.” The Order characterized $160 million as “disgorgement” and $90 million as a “civil penalty.” Bear Stearns sought coverage for the $160 “disgorgement” payment from its E&O carrier.

Although, unlike the policy at issue in Level 3 Communications, Bear Stearns’s E&O policy defined “Loss” broadly to include “compensatory damages, multiplied damages, punitive damages where permissible by law,” intermediate appellate courts in New York have held that disgorgement of ill-gotten gain is uninsurable on public policy grounds.  See, e.g., Vigilant Insurance Co. v. Credit Suisse First Boston Corp. When its claim for coverage of the $160 million  payment reached the New York Court of Appeals, Bear Stearns chose not to challenge the public policy against insurance for disgorgement remedies, but instead argued that payment was not disgorgement and thus the state’s public policy prohibition did not apply. The New York high court agreed, finding that the bulk of the payment represented profits earned by the hedge fund customers, not revenue Bear Sterns itself pocketed.  Bears Stearns, the court reasoned, simply could not “disgorge” profits earned by third-parties, such as its clients, no matter what label the SEC placed on its remedy.  If Bear Stearns had acted illegally or fraudulently in helping its clients violate the law, then coverage might well be excluded on some other ground—just not on the basis that it constituted “disgorgement.”