J.P. Morgan Securities Inc., et al., Appellants,v.Vigilant Insurance Company, et al., Respondents.BriefN.Y.May 1, 2013QCourt of ~peal~ STATE OF NEW YORK J.P. MORGAN SECURITIES INC., J.P. MORGAN CLEARING CORP., and THE BEAR STEARNS COMPANIES LLC, Plaintiffs-Appellants, vs. VIGILANT INSURANCE COMPANY, THE TRAVELERS INDEMNITY COMPANY, FEDERAL INSURANCE COMPANY, NATIONAL UNION FIRE INSURANCE COMPANY OF PITTSBURGH, PA., LIBERTY MUTUAL INSURANCE COMPANY, CERTAIN UNDERWRITERS AT LLOYD'S, LONDON, and AMERICAN ALTERNATIVE INSURANCE CORPORATION, Defendants-Respondents. New York County Clerk's Index Number: 600979/09 BRIEF OF AMICUS CURIAE AMERICAN INSURANCE ASSOCIATION IN SUPPORT OF DEFENDANTS-RESPONDENTS Daniel J. Standish Cara Tseng Duffield WILEY REIN LLP 1776 K Street, NW Washington, D.C. 20006 202.719.7000 202.719.7049 (fax) O/Counsel Dated: March 4,2013 S. Dwight Stephens MELITO & ADOLFSEN PC 233 Broadway New York, New York 10279 212.238.8900 212.238.8999 (fax) Attorneys for Amicus Curiae American Insurance Association CORPORATE DISCLOSURE STATEMENT The American Insurance Association ("AlA") is an incorporated entity that is not publicly traded and of which no publicly traded entity has an ownership interest. AlA does not have any corporate parent, subsidiaries or affiliates. TABLE OF CONTENTS TABLE OF CONTENTS ............................. ................ ............. ... ............................. i PRELIMINARY STATEMENT AND INTEREST OF AMICUS CURIAE ......... 1 STATEMENT OF FACTS ....................................................................................... 2 ARGUMENT .................................................................................................. ......... 6 I. THE PUBLIC POLICY PROHIBITION AGAINST INSURING DISGORGEMENT PAYMENTS IS CRITICAL TO THE SOUND FUNCTIONING OF THE INSURANCE MARKET ................................... 6 A. Established New York Law Proscribes Insuring Disgorgement. ........ 7 B. Allowing Coverage for Disgorgement Payments Would Undermine the Risk-Spreading Function of Insurance ..................... 11 C. Bear Stearns's Assertion That It Did Not Retain Any Ill-Gotten Gains Does Not Convert Its Disgorgement Payment Into Insurable Loss ....................................................................... ............. 14 II. ALLOWING INSUREDS TO RECAST THE TERMS OF REGULATORY SETTLEMENTS WOULD ALTER THE NATURE OF THE INSURED RISK AND OBSTRUCT THE CLAIMS HANDLING PROCESS ........................ .............................. ....... ............ ... .. 17 A. Allowing Policyholders to Recharacterize Sanctions Imposed by Their Regulators Would Alter the Nature of the Insured Risk .................................................................................................... 17 B. Established Law Allows Insurers to Gauge Coverage for Settlements Without Litigating the Merits of Underlying Actions ............................................................................................... 21 C. Allowing Insureds to Challenge the Nature of Their Regulatory Settlements Would Impede Efficient Claims Handling .................... 24 CONCLUSION ..... .......................................................... ....................................... 27 TABLE OF AUTHORITIES CASES Allstate Ins. Co. v. Mugavero, 79 N.Y.2d 153 (2002) .................................. 11 Bank of the West v. Superior Court, 833 P.2d 545, lOCal. Rptr. 2d 538 (Cal. 1992) .............................................................. 12 CNL Hotels & Resorts, Inc. v. Twin City Fire Ins. Co., 291 Fed. App'x 220 (lIth Cir. 2008) ...................................................... 23 Consolidated Edison Co. v. Allstate Ins. Co., 98 N.Y.2d 208 (2002) .......... 13 Continental Casualty Co. v. ACE Am. Ins. Co., No. 07 Civ. 958, 2009 WL 857594 (S.D.N.Y. Mar. 31, 2009) ..................................... 23, 24 Fair Housing Opportunities v. Am. Family Mut. Ins. Co., 684 F. Supp. 2d 964 (N.D. Ohio 2010) .......................................... ... 12,13 Glusband v. Fittin Cunningham & Lauzon, Inc., 892 F.2d 208 (2d Cir. 1989) ..................................................................... 14 Hartford Ace. & Indem. Co. v. Village of Hempstead, 48 N.Y.2d 218 (1979) ................. ............. ...... .... ......... ... ..... ... ............... ... 10 Home Ins. Co. v. Am. Home Products Corp., 75 N.Y.2d 196 (1990) .......... 10 Level 3 Communications, Inc. v. Federal Ins. Co., 272 F.3d 908 (7th Cir. 2001) ........................................ .............. .. ........ ... 23 Mat! v. St. Paul Fire & Marine Ins. Co., 31 Fed. App'x 838, 2002 WL 261437 (5th Cir. Jan. 31, 2002) ................................... ............ 13 Millennium Partners L.P. v. Select Ins. Co., 68 A.D. 3d 420 (lst Dep't 2009) ............................. .. ..................... .. 8, 9, 22 Mortenson v. Nat 'I Union Fire Ins. Co., 249 F.3d 667 (7th Cir. 2001) ....... 12 11 Public Servo Mut. Ins. CO. V. Goldfarb, 53 N.Y.2d 392 (1981) .................... 10 Reliance Group Holdings V. Nat 'I Union Fire Ins. Co., 188 A.D.2d 47 (1st Dep't 1993) ................................................................ 8 Ryerson, Inc. V. Federal Ins. Co., 676 F.3d 610 (7th Cir. 2012) .................. 23 s.E. C. V. Drexel Burnham Lambert, Inc., 956 F. Supp. 503 (S.D.N.Y. 1997) ............................................................ 8 s.E.c. v. Fischbach Corp., 133 F.3d 170 (2d Cir. 1997) ................................ 7 Scottsdale Indem. Co. v. Village of Crestwood, 673 F.3d 715 (7th Cir. 2012) ............................................................. 12,13 Soto V. State Farm Ins. Co., 83 N.Y.2d 718 (1994) ...................................... 10 Vigilant Insurance Company V. The Bear Stearns Companies, Inc., 34 A.D.3d 300 (1st Dep't 2006) .............................................................. 18 Vigilant Ins. CO. V. Credit Suisse First Boston Corp., 10 A.D.3d 528 (1 st Dep't 2004) ...................................................... 8, 9, 21 Vigilant Ins. Co. v Credit Suisse First Boston Corp., 6 Misc. 3d 1020(A), 2003 WL 24009803 (Sup. Ct. N.Y. Co. 2003) .................... 8,21 STATUTES N.Y. Ins. Law § 1101 ..... ........ .......... ....... ..... ....................... .. .. ...... ...... ....... ... 13 15 U.S.C. § 77h-l ................................ ............................. ............................. 18 15 U.S.C. § 78u-2 ...... .... ..... .......................... ............... ............ ......... ............. 18 15 U.S.C. § 78u-3 ........................ ....... ...................... .... ................................. 18 OTHER 2 Allan Windt, Insurance Claims and Disputes § 6.31 (2012) .................... 24 111 PRELIMINARY STATEMENT AND INTEREST OF AMICUS CURlAE The American Insurance Association ("AlA") is a leading insurance trade organization. AlA represents approximately 300 insurers that write more than $100 billion in premiums each year. AlA member companies offer all types of property-casualty insurance, including professional liability insurance. On issues of importance to the insurance industry and marketplace, AlA advocates sound public policies on behalf of its members in federal and state legislative and regulatory fora. The association also files amici curiae briefs in significant cases before federal and state courts. AlA has a distinct interest in the issues in this case. First, the case raises important public policy questions regarding the types of monetary payments that are and should be insurable. Bear Stearns was required to disgorge $160 million in ill-gotten gains by the SEC as a result of willfully facilitating illegal late trading and market timing in mutual funds. Although Bear Steams seeks to shift this burden to its insurers and therefore other policyholders, disgorgement has long been held to be uninsurable at law in light of the moral hazard created by allowing policyholders to insure against the return of iII-gotten gains. Importantly, allowing insurance for disgorgement not only would increase undesirable underlying conduct; it also would increase claims and the cost of the insurance. 1 Second, the case concerns the information an insurer properly may examine in determining whether a policyholder has incurred a covered loss. Here, Bear Stearns seeks coverage for the disgorgement payment in the SEC Order while simultaneously asserting that its insurers cannot credit the SEC Order at the most basic level in order to determine whether coverage exists. In effect, Bear Stearns demands that its insurers must litigate the "truth" of underlying allegations or findings before assessing coverage for settlements. Not only is Bear Stearns's approach contrary to the SEC Order itself and settled law, but a ruling in Bear Stearns's favor would have negative systemic effects by delaying the claims adjudication process, raising the cost of claims investigation and handling, and unraveling the benefits of settlement by forcing parties to litigate in a coverage action what was settled in the underlying case. AlA respectfully submits that its perspective on these issues may aid the Court in its resolution of this appeal. STATEMENT OF FACTS The SEC and NYSE Orders. On March 13, 2006, the SEC issued an Order Instituting Administrative Cease-and-Desist Proceedings, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order (the "SEC Order") against Bear Stearns & Company ("BS&Co.") and Bear Stearns Securities Corporation ("BSSC") 2 (together, "Bear Steams"). R. 116. The SEC Order contains 170 paragraphs of detailed factual findings and concludes that, based on the findings of fact, Bear Steams willfully committed numerous violations of the securities laws. Bear Steams agreed to the entry of the order, including the findings of fact stated therein. R. 116-17. The SEC Order was the culmination of an investigation into the illegal mutual fund trading practices of late trading and market timing. Late trading is "the practice of placing orders to buy, redeem, or exchange mutual fund shares after the time as of which mutual funds calculate their net asset value (N .A. V.), typically 4 p.m., but receiving the price based on the prior N.A.V. already determined as of 4:00 p.m." R. 119. Rule 22c-l(a) of the Investment Company Act prohibits late trading. Id. Market timing is the "frequent buying and selling of shares of the same mutual fund" or "buying and selling mutual fund shares in order to exploit inefficiencies in mutual fund pricing." Market timing can "harm other mutual fund shareholders because it can dilute the value of their shares," disrupt mutual fund management "and cause the targeted mutual fund to incur considerable extra costs associated with excessive trading." R. 118. Market timing can be illegal when market timers use deception to induce funds to accept trades that are otherwise prohibited by the funds' own guidelines. R. 118-19. 3 The SEC Order states that "[b Jetween 1999 and 2003, Respondents facilitated a substantial amount of late trading and deceptive market timing." R. 117. According to the order, BS&Co. "facilitated illegal mutual fund trading by knowingly processing large numbers of late trades for certain market timing customers, predominantly large hedge funds, and by helping market timing hedge funds evade detection by mutual funds that did not want market timing business." Id. The order also states that BSSC "facilitated deceptive market timing by its prime brokerage customers and customers of its correspondents by providing them with deceptive devices, such as multiple account [J numbers and alternate branch codes, to avoid detection by mutual funds." Id. The order states that BSSC's mutual fund operations department had a "timing desk" that initially was established to monitor and block market timing. In practice, however, the timing desk employees "acted as troubleshooters" for customers engaged in market timing and late trading and "touted BSSC's abilities to assist timers." R. 118. According to the order, "Respondents' conduct benefitted their customers and customers of correspondent firms by enabling those customers to generate hundreds of millions of dollars in profits from these trading tactics at the expense of mutual fund shareholders." Id. The SEC Order concludes that, based on the factual findings in the order, BS&Co. and BSSC willfully violated numerous provisions of the securities laws. 4 R. 145-46. The SEC also imposed the following sanctions, to which BSSC and BS&Co. agreed: a censure; an order that BSSC and BS&Co. cease and desist from violating the above-noted securities laws; disgorgement of $160 million; and civil monetary penalties of $90 million. R. 154. The SEC Order also provides that Respondents must retain an Independent Distribution Consultant to develop a plan to distribute the entire $250 million in disgorgement and penalties pursuant to the SEC's Rules Regarding Disgorgement and Fair Fund Plans. R. 152-53. On March 10, 2006, a hearing panel of the New York Stock Exchange issued decisions sanctioning BS&Co. and BSSC for the same conduct at issue in the SEC Order (the "NYSE Decision"). Specifically, the panel imposed a censure and ordered payment in the amount of $250 million, comprised of $160 million as disgorgement and $90 million as a penalty, with payment of these amounts satisfied by payment pursuant to the SEC Order. R. 198. Bear Stearns's Claim for Coverage. Bear Steams brought suit against its insurers in the Supreme Court for New York County seeking, among other things, coverage for the $160 million disgorgement portion of the SEC Order. The insurers moved to dismiss Bear Steams's complaint, contending (among other things) that disgorgement is uninsurable as a matter of public policy. The Supreme Court denied the motion on the grounds that the SEC Order "does not contain an explicit finding that Bear 5 Steams directly obtained ill-gotten gains or profited by facilitating [illegal] trading practices. Consequently, the findings of the [SEC Order] alone do not establish as a matter of law that Bear Stearns seeks coverage for losses that include the disgorgement of improperly acquired funds." R.39. The insurers appealed. The Appellate Division, First Department, reversed. The court rejected Bear Steams's contention that the disgorgement payment was anything other than disgorgement: "[t]he fact that the SEC did not itemize how it reached the agreed upon disgorgement figure does not raise an issue as to whether the disgorgement payment was in fact compensatory." R. 1844. The court noted that the SEC needed only to establish that the "disgorged amount [was] causally connected to the violation" and held that the SEC Order demonstrated that connection. R. 1845. "Here, in addition to admittedly generating at least $16.9 million in revenues for itself, Bear Steams knowingly and affirmatively facilitated an illegal scheme which generated hundreds of millions of dollars for collaborating parties and agreed to disgorge $160,000,000 in its offer of settlement." R. 1846. ARGUMENT I. THE PUBLIC POLICY PROHIBITION AGAINST INSURING DISGORGEMENT PAYMENTS IS CRITICAL TO THE SOUND FUNCTIONING OF THE INSURANCE MARKET Bear Steams's request for insurance for its $160 million disgorgement payment should be denied. The SEC found that Bear Steams willfully violated the 6 securities laws and that its conduct was instrumental in generating hundreds of millions of dollars in ill-gotten gains. Allowing insurance for this payment not only would erase the deterrent effect of the sanction the SEC imposed on Bear Stearns; it would incentivize willful, wrongful conduct by other insureds at the expense of insurers and law-abiding policyholders. These moral hazard and underwriting concerns are reflected in well-established New York law prohibiting insurance for disgorgement payments. A. Established New York Law Proscribes Insuring Disgorgement. Established New York law forecloses Bear Stearns's request for insurance coverage for its $160 million disgorgement payment. In the SEC Order, Bear Stearns agreed to the entry of findings of fact that it willfully facilitated illegal late trading and market timing and to disgorge $160 million as a result of those practices. As the First Department correctly held, given the nature of both the sanctions levied and the conduct at issue, New York law prohibits insurance for Bear Stearns's disgorgement payment. As the First Department noted, the "primary purpose of disgorgement orders is to deter violations of the securities laws by depriving violators of their ill-gotten gains." R. 1840 (quoting SE.c. v. Fischbach Corp., 133 F.3d 170, 175 (2d Cir. 1997)). The primary goal of disgorgement is to make violating the law 7 unprofitable by depriving wrongdoers of their ill-gotten gains. s.E.c. v. Drexel Burnham Lambert, Inc., 956 F. Supp. 503,507 (S.D.N.Y. 1997). Disgorgement payments are not insurable under New York law. See Reliance Group Holdings v. Nat'l Union Fire Ins. Co., 188 A.D.2d 47 (1st Dep't 1993); Vigilant Ins. Co. v. Credit Suisse First Boston Corp., 10 A.D.3d 528 (1 st Dep't 2004); Millennium Partners L.P. v. Select Ins. Co., 68 A.D.3d 420 (1st Dep't 2009). Both Credit Suisse and Millennium Partners address insurance coverage with respect to disgorgement payments ordered in SEC proceedings and are directly relevant here. In Credit Suisse, the SEC filed a civil action against Credit Suisse alleging that "[i]n exchange for shares in 'hot' IPQs, CSFB wrongfully extracted from certain customers a large portion of the profits those customers made by flipping their IPQ stock." Vigilant Ins. Co. v Credit Suisse First Boston Corp., 6 Misc. 3d 1020(A), 2003 WL 24009803, at *2 (Sup. Ct. N.Y. Co. 2003). A consent judgment was entered shortly thereafter that ordered Credit Suisse to pay $70 million in disgorgement. Credit Suisse then sought insurance coverage for the payment. The Supreme Court rejected Credit Suisse's claim for coverage, noting that the "deterrent effect of [an SEC] enforcement action would be greatly undermined if securities law violators were not required to disgorge illicit profits" and holding that allowing Credit Suisse to obtain insurance coverage and shift the 8 loss to its insurers would "defeat the purpose of the disgorgement provision" in the consent judgment. Id. at *3-4. The court's decision was affirmed on appeal. 10 A.D.3d 528 (1 st Dep't 2004). Similarly, in Millennium Partners, the SEC entered a cease-and-desist order against Millennium containing findings of fact that Millennium had engaged in market timing. The order required Millennium to disgorge $148 million. Millennium sought its defense costs from its insurer. In holding that Millennium was not entitled to coverage for defense costs, the court stated that "one may not insure against the risk of being ordered to return money or property that has been wrongfully acquired" and reasoned that, because Millennium's disgorgement payment was uninsurable, its defense costs for the same matter likewise were not covered. Millennium Partners L.P. v. Select Ins. Co., 24 Misc. 3d 212,216 (Sup. Ct. N.Y. Co. 2009), afJ'd 68 A.D.3d 420 (1st Dep't 2009). Here, the First Department determined that Bear Steams's conduct described in the SEC Order is the type of conduct that should be deterred, not insured. The First Department rejected Bear Steams's argument that the SEC had merely charged it with inadequate supervision and therefore insurance should be permitted. As the First Department described, the "SEC Order illustrates how the Bear Steams timing desk actively collaborated with Bear Steams's clients to execute illegal mutual fund trading." R. 1842. Bear Steams "processed [ ] late 9 trades and then falsified internal order tickets to misrepresent that it had received late trading orders prior to the 4 p.m. deadline." Id. The "SEC Order details how Bear Stearns operated its late trading and market timing scheme in direct disregard of demands by mutual funds that Bear Stearns stop allowing timing in their funds." Id. By focusing on the need to deter such conduct, the First Department's decision is consonant with New York law's prohibition on insurance for punitive damages. Coverage for disgorgement is prohibited just as coverage for punitive damages is prohibited. Although punitive damages also are intended to punish the wrongdoer, both punitive damages and disgorgement are intended to deter willful wrongdoing. The deterrent effect of both sanctions is erased by allowing insurance coverage for such payments. Soto v. State Farm Ins. Co., 83 N.Y.2d 718,724 (1994) (the "only real purpose" of punitive damages is to punish and deter the wrongdoer; goals would not be permitted if wrongdoer were able to "divert the economic punishment to an insurer"); Home Ins. Co. v. Am. Home Products Corp., 75 N.Y.2d 196, 203 (1990) ("punitive damages are intended to act as a deterrent to the offender"); Public Servo Mut. Ins. CO. V. Goldfarb, 53 N.Y.2d 392,400 (1981) ("to allow insurance coverage for such damages is totally to defeat the purpose of punitive damages"); Hartford Ace. & Indem. CO. V. Village of Hempstead, 48 N.Y.2d 218,228 (1979) (same). A public policy prohibition on insurance for 10 disgorgement awards, particularly in the context of the findings of the SEC Order, serves the same deterrence goals. B. Allowing Coverage for Disgorgement Payments Would Undermine the Risk-Spreading Function of Insurance. Beyond deterrence, the prohibition on insuring disgorgement payments advances other public policies as well- namely, the healthy operation of insurance's risk-allocation function. Insurers play an important economic and social role, accepting risk for premium and thereby spreading risk of loss across a pool of policyholders. Allowing insurance for disgorgement payments would have negative systemic consequences for insurers and policyholders alike. Given the risk-spreading function of insurance, Bear Steams's request for coverage from its insurers necessarily comes at the expense of other policyholders. As this Court has noted, it is fundamentally unfair to ask other policyholders in the risk pool to subsidize the cost of one insured's willful wrongdoing. CI, Allstate Ins. Co. v. Mugavero, 79 N.Y.2d 153, 161 (2002) ("the ordinary person would be startled, to say the least, by the notion that Mugavero should receive insurance protection for sexually molesting these children, and thus, in effect, be permitted to transfer the responsibility for his deeds onto the shoulders of other homeowners in the form of higher premiums"). Insurance for disgorgement payments would create acute moral hazard problems. Moral hazard refers to the effect of insurance on a policyholder's 11 incentive to prevent loss. See Mortenson v. Nat 'I Union Fire Ins. Co., 249 F.3d 667,671 (7th Cir. 2001) ("For obvious reasons, insurance companies try to avoid insuring people against risks that having insurance makes far more likely to occur"); see also Scottsdale Indem. Co. v. Village o/Crestwood, 673 F.3d 715,718 (7th Cir. 2012); Fair Housing Opportunities v. Am. Family Mut. Ins. Co., 684 F. Supp. 2d 964, 970 (N.D. Ohio 2010). If Bear Steams were allowed to willfully facilitate an illegal trading scheme that generated illegal profits for its customers and then, when it was held responsible for disgorging those profits, was able to transfer the cost of that responsibility to its insurers, it would have no incentive to avoid such behavior. To the contrary, allowing insurance for ill-gotten gains resulting from such a scheme increases the likelihood that such undesirable behavior will recur. See, e.g., Bank o/the West v. Superior Court, 833 P.2d 545, 555, lOCal. Rptr. 2d 538, 548 (Cal. 1992) ("[ w ]hen the law requires a wrongdoer to disgorge money or property acquired through a violation of the law, to permit the wrongdoer to transfer the cost of disgorgement to an insurer would eliminate the incentive for obeying the law"). Writ large, allowing insurance for ill-gotten gains not only would have the undesirable effect of incentivizing bad conduct by insureds; it also would distort the risk pool through the increased filing of claims. When a policyholder has a financial incentive to engage in behavior that will trigger an insurance recovery, 12 the resulting increase in claims "can have a significant distorting effect on rates and cause huge losses to the insurer." Fair Housing Opportunities, 684 F. Supp. 2d at 970. Increased moral hazard "increase[ s] the probability of losses and so drive[s] up premiums." Village o/Crestwood, 673 F.3d at 718. Finally, insurance fundamentally is intended to protect against accidents. "Insurance policies generally require 'fortuity' and thus implicitly exclude coverage for intended or expected harms." Consolidated Edison Co. v. Allstate Ins. Co., 98 N.Y.2d 208,220 (2002); see also N.Y. Ins. Law § 1101(a)(2) ("Fortuitous event" means "any occurrence or failure to occur which is, or is assumed by the parties to be, to a substantial extent beyond the control of either party"). Insurance does not cover non-fortuitous losses, i. e., losses caused by events entirely within the insured's control. In those circumstances, no risk is being transferred; the insured can trigger an insurance payout through its own intentional conduct. Insurance is not intended to cover the types of intentional acts that give rise to disgorgement payments like the willful acts catalogued in the SEC Order. See MatI v. St. Paul Fire & Marine Ins. Co., 31 Fed. App'x 838, 2002 WL 261437, at *3 (5th Cir. Jan. 31,2002) (recognizing difficulty of underwriting insured's "deliberate decision to break the law"). All of these policy reasons support New York law's prohibition on insuring disgorgement payments. The Court should uphold New York's settled law on this 13 point and the insurance community's concomitant expectations that disgorgement payments are not insurable. Glusband v. Fittin Cunningham & Lauzon, Inc., 892 F.2d 208, 212 (2d Cir. 1989) ("we cannot ignore the fact that insurance systems rely upon predictability of risk and that predictability will be seriously diminished or destroyed if courts refuse to abide by limitations on insurance policies"). C. Bear Stearns's Assertion That It Did Not Reta.in Any III-Gotten Gains Does Not Convert Its Disgorgement Payment Into Insurable Loss. Bear Steams concedes that under New York law disgorgement of ill-gotten gains is uninsurable. Nevertheless, Bear Steams contends that it is entitled to insurance because, while its customers reaped profits from its illegal conduct, Bear Steams itself did not retain any ill-gotten gains. In its opening brief, Bear Steams contends that the "SEC claimed the power to force Bear Steams to pay amounts allegedly received by its customers .... It was the assertion of that power, not the power to force Bear Steams to return funds that it had received, that accounted for the payment agreed to here." Bear Steams Br. at 30. Bear Steams's arguments ignore the scope of the SEC's authority to order disgorgement payments. The insurers' response brief amply demonstrates that the SEC may order disgorgement of all ill-gotten gains generated by an illegal scheme from anyone collaborator. See Insurers Br., Section LA. Absent this rule, wrongdoers would be able to circumvent the securities laws simply by contending 14 that they personally did not retain ill-gotten gains even if their conduct allowed others to reap such gains. Id. Bear Steams's argument that it should be entitled to insurance because it was required by the SEC to pay more than its "fair share" as a result of wrongdoing contravenes the scope of the SEC's authority to seek disgorgement. If accepted by the Court, Bear Steams's position also would create a coverage loophole for wrongdoers who are able to cover the trail of benefits they receive from their illegal conduct or divest themselves of their ill-gotten gains. Notably, not even the SEC faces this burden of proof in making its disgorgement calculations. As the First Department noted in its opinion, "the fact that the SEC did not itemize how it reached the agreed upon disgorgement figure does not raise an issue of fact as to whether the disgorgement payment was in fact compensatory." R. 1844. The SEC "is not required to trace every dollar of proceed[s] or to identify misappropriated monies which have been commingled." R. 1845 (internal citations and quotations omitted). There is no basis to place a heightened burden on insurers. Here, the SEC Order finds that Bear Steams facilitated late trading and market timing that earned hundreds of millions of dollars for its clients. Bear Steams now asserts it earned only $16.9 million in revenues and no profits whatsoever from this activity. It is facially dubious that Bear Steams would 15 engage in clear and systemic violations of the law and risk its dealer agreements with mutual funds for zero upside. The SEC obviously took a different view than Bear Steams. It found that Bear Steams's illegal conduct generated "hundreds of millions" of dollars and it required Bear Stearns to disgorge $160 million of those gains. This is a classic disgorgement calculation. The fact that Bear Steams contends that it did not retain all of those gains does not change its direct responsibility for creating the ill-gotten gains or its liability to disgorge them. Even assuming that Bear Steams did not reap the profits of its actions, the acts by Bear Stearns that the SEC Order identifies are still precisely the type of conduct that creates moral hazard concerns and should be deterred. The SEC found that Bear Steams willfully engaged in bad acts by providing its customers with deceptive devices (e.g., multiple account numbers and alternate branch codes) and falsifying order tickets in order to facilitate late trading and illegal market timing. The SEC also found that the ill-gotten gains could not have been generated without Bear Steams's participation. Bear Steams has not raised any argument that this conduct is legitimate or that barring insurance for the SEC Order would chill productive activity. 16 II. ALLOWING INSUREDS TO RECAST THE TERMS OF REGULATORY SETTLEMENTS WOULD ALTER THE NATURE OF THE INSURED RISK AND OBSTRUCT THE CLAIMS HANDLING PROCESS Bear Steams essentially argues that the findings of fact and determinations in the SEC Order are irrelevant to this coverage litigation. In settling with the SEC, Bear Steams agreed to the entry of detailed findings of fact and to pay $160 million in disgorgement. In suing its insurers, however, it now contends that it has the right to re-litigate the findings of fact that formed the basis for the SEC's $160 million disgorgement order and that the payment is not really disgorgement. This avenue is foreclosed by settled law. Moreover, following Bear Steams's path and deviating from this established law would lead to undesirable consequences for insurers and policyholders alike, including delays in coverage determinations and a proliferation of coverage litigation. A. Allowing Policyholders to Recharacterize Sanctions Imposed by Their RegulatOios Would Alter the Nature of the Insured Risk. While the detailed description of Bear Steams's willful conduct and the magnitude of the monetary sanctions imposed on Bear Steams make the SEC Order particularly noteworthy, the issues raised by this case-a policyholder's settlement with its regulator and attempt to obtain coverage for the same-are not unique. The AlA's members issue insurance policies to numerous policyholders that are subject to regulation by state and federal authorities. Allowing an insured 17 to recast the sanctions imposed by its regulator would fundamentally change the nature of the risk insured in a great many cases. Bear Steams appears to agree with the proposition that disgorgement is not insurable under New York law, but it contends that its $160 million disgorgement payment is not actually "disgorgement." This argument overlooks the fact that, in cease-and-desist proceedings, the only monetary sanctions the SEC is able to impose are disgorgement and penalties. See 15 U.S.C. § 77h-l(e), (g); 15 U.S.C. § 78u-2(a), (e); 15 U.S.C. § 78u-3(e). The SEC does not have statutory authority to order payment of damages. Indeed, in an earlier case, the SEC criticized Bear Steams's "disgorgement is not really disgorgement" argument. In Vigilant Insurance Company v. The Bear Stearns Companies, Inc., 34 A.D.3d 300 (1st Dep't 2006) ("Bear Stearns f'), Bear Steams sought insurance coverage for amounts it was ordered to disgorge in settling charges relating to research analyst conflicts of interest. Bear Steams argued that the $25 million disgorgement payment assessed by the SEC was simply compensatory damages masquerading as disgorgement. After the Appellate Division denied the insurers' summary judgment motion, finding a fact issue as to whether the $25 million disgorgement payment in fact represented the disgorgement of ill-gotten gains, the insurers sought leave to appeal. The SEC filed an amicus brief in support of the insurers' motion for leave to appeal. In 18 response to Bear Steams's argument, the SEC stated that it "sought and obtained disgorgement," not compensatory damages, "which are an impermissible form of relief in Commission actions under the federal securities laws." R. 1408. The SEC rejected Bear Steams's argument that the Commission "was seeking ... anything other than ill-gotten gains from the alleged misconduct." R. 1410. Here, as in Bear Stearns I, Bear Steams's argument for coverage depends on the proposition that the SEC exceeded its authority and extracted an ultra vires payment. This argument fails. Bear Stearns agreed to the SEC Order and to make the required disgorgement payment, and thus its belated challenge to the SEC's authority falls flat. The cases Bear Steams cites for the proposition that the "label" given to a payment does not control for coverage purposes therefore are distinguishable. See Bear Steams Br. at 27-28. Each case (Genzyme, Unified Western Grocers, Pereira, Pan Pacific, Ryerson, Wojtunik, CNL Hotels, and Bank of America) addresses the characterization of amounts sought in litigation with civil plaintiffs where the nature of the settlement payment was unclear. None of the cases concerns coverage for disgorgement payments where the plaintiff s remedy was statutorily circumscribed to disgorgement as in the SEC Order. As Bear Steams itself emphasizes, the SEC is one of its primary regulators, and the potential of an SEC investigation or proceeding is a principal risk. From an underwriting perspective, the nature of that risk would be vastly different if the 19 SEC had statutory authority to seek compensatory damages rather than disgorgement, penalties and injunctive relief. Bear Steams's attempt to argue that non-covered disgorgement assessed by the SEC is really covered compensatory damages is simply a risk that its insurers did not contract to bear. Bear Steams offers no reason why it should be permitted to consummate a settlement with the SEC by making a disgorgement payment and then, in seeking coverage for the settlement, deny the very nature of the payment it made. Allowing an insured to divorce coverage determinations from the underlying settlement, like Bear Steams seeks to do here, would simply open the door to meritless, manufactured claims for coverage after the insured has agreed to settle the matter. Indeed, if as Bear Steams now suggests, its agreement to pay $160 million in disgorgement in fact had nothing to do with disgorging ill-gotten gains generated by its own willful and intentional misconduct, it would appear difficult if not impossible to establish that its decision to settle was even reasonable-and on that basis, too, the settlement would fall outside coverage. The fact that Bear Steams's settlement with the SEC is rendered unreasonable ifit is detached from the SEC's order delineating Bear Steams's wrongful conduct and ordering it to disgorge $160 million as a result of that conduct emphasizes the impropriety of Bear Steams's 20 efforts to obtain coverage for a settlement the very nature of which it simultaneously seeks to sidestep. B. Established Law Allows Insurers to Gauge Coverage for Settlements Without Litigating the Merits of Underlying Actions. Bear Steams argues that, because it agreed to the entry of findings in the SEC Order on a "neither admit nor deny" basis, there is no grounds on which to assess the insurability of the $160 million disgorgement payment. Bear Steams's argument contravenes established New York law. The courts in both Credit Suisse and Millennium rejected the very argument Bear Steams raises here. Credit Suisse sought insurance coverage for the disgorgement payment it was ordered to pay by the SEC, arguing that "there was no final adjudication of wrongdoing on its part, and, therefore, permitting coverage would not result in [its] retaining a benefit that it may have obtained wrongfully." 2003 WL 24009803, at *3. The Supreme Court disagreed: "CSFB correctly states that the Final Judgment is not the same as a final adjudication of the facts after a trial. However, the effect of the Final Judgment, under the particular facts of this case, is essentially the same because the Final Judgment states that CSFB is disgorging money that it obtained improperly." Id. at *4. The Appellate Division affirmed. Credit Suisse, 10 A.D.3d at 529 (final judgment ordered disgorgement based on allegations in complaint, and Credit Suisse agreed not to contest allegations in complaint). 21 In Millennium, which concerned an SEC cease-and-desist order like the SEC Order here, Millennium also argued that the findings in the order did not conclusively establish that it was being forced to disgorge ill-gotten gains. The court disagreed: "the findings recited in the SEC's cease-and-desist order to which plaintiff consented ... conclusively link the disgorgement to improperly acquired funds, notwithstanding that plaintiff consented and agreed to these orders without admitting or denying the findings therein. The fact that no judgments resulted from the negotiated settlements in which these findings were made does not affect the validity of the findings." 68 A.D.3d at 420 (internal citations and quotations omitted). Bear Steams attempts to distinguish the holdings in Credit Suisse and Millennium by arguing that the insureds in those cases did not dispute that they had obtained ill-gotten gains. The distinction is unavailing. In both Credit Suisse and Millennium, the insureds argued, as Bear Steams does here, that coverage was not available because the amounts at issue were paid pursuant to settlements or consent judgments, not after a final adjudication of wrongdoing. Both courts squarely rejected that argument, holding that insureds are bound by findings in settlements for insurance coverage purposes when they submit those settlements to their insurers. Neither court's ruling on this point concerned the insured's retention of ill-gotten gains. 22 Courts in other jurisdictions also have held that disgorgement payments are not covered even when they are made as part of a settlement, rather than after adjudication at trial. See Level 3 Communications, Inc. v. Federal Ins. Co., 272 F.3d 908, 911 (7th Cir. 2001) (rejecting insured's contention that "[a]s long as the case is settled before entry of judgment, the insured is covered regardless of the nature of the claim against it"); Ryerson, Inc. v. Federal Ins. Co., 676 F.3d 610 (7th Cir. 2012) (settlement payment constituted non-insurable loss); CNL Hotels & Resorts, Inc. v. Twin City Fire Ins. Co., 291 Fed. App'x 220 (lIth Cir. 2008) (same). More generally, it is well-established that when an insured submits a settlement for coverage, the existence of coverage depends on the nature of the claimant's allegations at the time of settlement. The insurer is entitled to base its coverage determination on the same allegations that the insured settled. For instance, in Continental Casualty Co. v. ACE Am. Ins. Co., No. 07 Civ. 958, 2009 WL 857594 (S.D.N.Y. Mar. 31, 2009), the insured reached a settlement with the claimant. The insurer denied coverage because the insured had failed to obtain its consent to the settlement and because the covered portion of the settlement did not exceed the self-insured retention. Even though the underlying suit was settled and therefore no actual penalties or punitive damages were assessed, the court agreed that a significant portion of the settlement should be allocated to non-covered 23 penalties and punitive damages and therefore the covered portion of the settlement would not exceed the retention. Id. at * 5. See also 2 Allan Windt, Insurance Claims and Disputes § 6.31 (2012) ("Following a settlement as to which the insurer denies coverage, the existence of coverage should depend on what claims were settled; that is, it should depend on why the money was paid. The actual merit of each of the plaintiff s claims against the insured is not directly relevant. . . . Neither the insurer nor the insured should be allowed to try the plaintiffs claim in the coverage suit"). C. Allowing Insureds to Challenge the Nature of Their Regulatory Settlements Would Impede Efficient Claims Handling. Under the approach taken by New York courts, coverage for settlements is determined by the nature of the allegations being settled. Under Bear Steams's methodology, coverage for settlements cannot be determined until the insurer and insured have litigated the truth or falsity of the allegations settled. This approach is conceptually flawed and unreasonable under the circumstances presented here for several reasons. Bear Steams's approach would undermine the well-established judicial policy favoring settlements. In Bear Steams's world, policyholders and insurers would be forced to litigate the merits of underlying cases, converting settled cases back into litigated ones. The benefits of settlement, finality and litigation cost savings, would quickly be undone by coverage litigation. Moreover, it would be 24 illogical to force insureds to litigate the merits of underlying claims they already had elected to settle and unfair to force insurers to litigate by proxy plaintiffs' allegations against their insureds in order simply to determine whether coverage exists and to enforce the boundaries of coverage in their insurance policies. In addition, Bear Stearns's methodology would delay coverage determinations and raise the cost of claim handling enormously. If an insurer were forced to litigate each underlying matter to judgment in order to determine coverage, coverage litigation would become the norm, coverage determinations would be delayed, and insurance costs would rise for insurers and policyholders alike. Indeed, if insurers ultimately had to prove their insureds' liability in the underlying matter to resolve coverage issues, they would have less incentive to consent to settlements. Here, protracted coverage litigation is particularly unnecessary because the SEC and Bear Steams already agreed to the precise conduct that forms the predicate for the $160 million disgorgement payment. The SEC Order was the product of an extensive investigation, including production of "200,000 pages of documents, large volumes of e-mail transmissions and electronic trading data, [ ] audiotapes of [Bear Steams's] employees' conversations with its customers," depositions, and interviews of 35 Bear Stearns employees. R. 74. Bear Steams essentially argues that, before the insurers can make a coverage determination, they 25 must not only review that underlying material but also litigate with Bear Stearns the factual and legal issues set forth in the SEC Order. While some coverage disputes conceivably could require the parties to litigate the basis for the underlying settlement, this is not such a case. Given the detailed findings of fact in the SEC Order and Bear Stearns's agreement to the entry of those facts here, there is no justification for imposing on the insurers this enormous cost. The First Department therefore correctly rejected Bear Stearns's argument that it could selectively disavow portions of the very SEC Order that formed the basis of its claim for coverage. Bear Stearns asserts that it "agreed only to make a payment that the SEC demanded," see Bear Stearns Br. at 31, as if the findings of fact, securities laws and regulations cited, and nature of the monetary payments required in the SEC Order were mere surplusage. To the contrary, there can be no doubt that the $160 million disgorgement payment, following extensive findings of fact and law, and levied in the same document, is "conclusively linked" to the conduct highlighted in the findings of fact. That conduct unquestionably formed the basis for the $160 million disgorgement payment, and, given the nature of the payment, the insurers were fully within their rights under the policies and applicable law in denying coverage for the SEC investigation. 26 CONCLUSION For the foregoing reasons, amicus curiae the American Insurance Association respectfully requests that the Court affirm the First Department's decision granting the insurers' motion to dismiss. 27 Respectfully submitted, dlP S. Dwigh{ Stephens MELITO & ADOLFSEN PC 233 Broadway New York, NY 10279 212.238.8900 212.238.8999 (facsimile) Attorneys for Amicus Curiae American Insurance Association Of Counsel: Daniel J. Standish Cara Tseng Duffield WILEY REIN, LLP 1776 K Street, NW Washington, DC 20006 202.719.7407 (telephone) 202.719.7049 (facsimile)