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Thursday, March 28, 2024 | Back issues
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Insurers May Have to Foot Bill for Bear Stearns

ALBANY, N.Y. (CN) - Bear Stearns can press its insurers to recover millions of dollars in costs associated with securities law violations, New York's highest court ruled.

The one-time broker-dealer, now part of J.P. Morgan, faced investigation by the U.S. Securities and Exchange Commission in 2003 for trading practices that favored certain customers - primarily large hedge funds - in buying and selling mutual fund shares. The practices, known as late trading and market timing, earned big profits for some clients at the expense of others.

When the SEC notified Bear Stearns that it would seek $720 million in sanctions for willful violations of securities law, the company objected, claiming no role in the mutual fund transactions - other than clearing them - and no share of the profits that resulted.

Bear Stearns then proposed its own settlement, without admitting or denying the agency's findings.

Under that settlement, which the SEC adopted in 2006, Bear Stearns agreed to pay $160 million as disgorgement - return of ill-gotten gains - and $90 million in civil penalties. The money created a $250 million fund to compensate mutual fund investors whom Bear Stearns allegedly harmed.

At the same time, Bear Stearns also spent $14 million settling a number of private class-action lawsuits brought by mutual funds.

It calculated the cost of defending those lawsuits and the SEC action at $40 million.

Bear Stearns then turned to its insurers to cover the disgorgement, private settlement and defense costs as losses.

When prime insurer Vigilant Insurance Co. and six excess carriers denied the claim, J.P. Morgan Securities - the name Bear Stearns took after its 2008 acquisition - sued for breach of contract in New York County Supreme Court.

Though a judge refused to dismiss the action against the insurers, the Appellate Division's First Judicial Department in Manhattan held that, as a matter of public policy, Bear Stearns could not seek to recoup the $160 million disgorgement.

But the Court of Appeals, New York's highest court, reinstated the Bear Stearns complaint Tuesday, saying the insurers were not entitled to a dismissal of the coverage claim.

"Although we certainly do not condone the late trading and market timing activities described in the SEC order, the insurers have not met their heavy burden of establishing, as a matter of law on their CPLR 3211 dismissal motions, that Bear Stearns is barred from pursuing insurance coverage under its policies," Judge Victoria Graffeo wrote for the mostly unanimous court.

The opinion notes that insurance contracts, like other agreements, "will ordinarily be enforced as written" without anyone passing judgment on their substance.

But insurance contracts have "public policy exceptions" that prohibit indemnification for punitive damage awards and for conduct intended to cause injury, according to the ruling.

The court rejected the claim that Bear Stearns triggered the latter exception by willfully violating securities laws, as the SEC had found.

"But 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," Graffeo wrote.

"The SEC order, while undoubtedly finding Bear Stearns' numerous securities laws violations to be willful, does not conclusively demonstrate that Bear Stearns also had the requisite intent to cause harm," she added.

The insurers also claimed on public policy grounds that Bear Stearns should not recover any portion of the $160 million disgorgement. The opinion notes that other courts have held that the return of ill-gotten gains does not constitute a "loss" or "damages" within the meaning of insurance policies.

"Bear Stearns does not disagree with these principles," Graffeo wrote, "but urges that they do not prohibit coverage here since the bulk of the disgorgement payment - approximately $140 million - represented the improper profits acquired by third party hedge fund customers, not revenue that Bear Stearns itself pocketed.

"Put differently, Bear Stearns alleges that much of the payment, although labeled disgorgement by the SEC, did not actually represent the disgorgement of its own profits," she added.

But "the SEC order does not establish that the $160 million disgorgement payment was predicated on moneys that Bear Stearns itself improperly earned as a result of its securities violations," according to the ruling.

"Consequently, at this early juncture, we conclude that the insurers are not entitled to dismissal of Bear Stearns' insurance claims related to the SEC disgorgement payment," Graffeo added.

Judges Susan Read, Robert Smith, Eugene Pigott and Jenny Rivera joined the lead opinion. Chief Judge Jonathan Lippman and Judge Sheila Abdus-Salaam took no part in the decision.

John Gross of Proskauer Rose in New York argued for J.P. Morgan Securities. Joseph G. Finnerty III of DLA Piper LLP (US) in New York represented Vigilant. Two of the excess carriers also had counsel: Michael Gioia of Landman Corsi Ballaine & Ford in New York for American Alternative Insurance Corp., and Edward Kirk of Clyde & Co. US in New York for Certain Underwriters at Lloyd's London.

The American Insurance Association submitted an amicus curiae brief.

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