E & O in the New Corporate Environment

The far-reaching import of the Sarbanes-Oxley Act for financial professionals is further illustrated in the Section 207 study of mandatory rotation of registered public accounting firms. Under this provision, the Comptroller General of the United States is required to conduct a study and review of the potential effects of requiring the mandatory rotation of registered public accounting firms – that is, establishing a limit on the period of years in which a particular registered public accounting firm may be the auditor of record for a particular issuer. Within one year of enactment of the Act, the Comptroller General must report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of the study and review required by this section.

Mandatory changes in outside auditing support could lead to an increase in restatements of financials, and a corresponding increase in securities litigation. For example, in Continental Casualty Co. v. Coregis Insurance Co., a small accounting firm performed audits for a computer company. After the company went public, however, it hired Pricewaterhouse to take over accounting responsibilities. Irregularities were discovered in the prior audits, and the financials were restated. A securities action was filed against the original auditor, and a coverage action followed. Continental Cas. Co. v. Coregis Ins. Co., 316 Ill. App. 3d 1052, 738 N.E.2d 509 (1st Dist. 2000). The scenario could become even more familiar depending on the results of the Section 207 study.

In the post-Enron business world, third-party professionals are under heightened scrutiny from regulatory agencies, plaintiffs' lawyers, and the public. In this new corporate environment, business professionals should consider whether they will be protected by current insurance coverage, in the event of financial problems. Knowing your E&O coverage is a necessity in today's corporate climate. This article provides a basic overview of E&O insurance.

Provisions of E&O Policies

There is no standard form for E&O policies and coverage varies by profession and insurer. A single insurer is likely to have different E&O policies depending on the type of professional covered. Although the terms and conditions of E&O coverage vary widely, there are some common features seen in most policies. Typically, E&O insurance includes an insuring agreement reading along the following lines:

“We will pay on behalf of an insured 'damages' for which 'claim' is first made during the 'policy period.' Such 'damages' must arise out of an error, omission, negligent act or 'personal injury' in the rendering or failure to render 'professional accounting services' for others by you or on your behalf. The error, omission, negligent act, or 'personal injury' must occur on or after the Retroactive Date Stated in the Declarations.”

Along with the insuring agreement, policies include exclusions, conditions, and definitions. E&O policies today are usually written as claims-made coverage, as opposed to occurrence policies, so coverage typically is triggered only when a claim is made and reported during the policy period.

Rendering Professional Service

Because E&O insurance is intended to be protection for professionals, a claim, to be covered, usually must arise out of an error or omission in rendering or failing to render professional services. Policies often exclude conduct that the policyholder undertakes in other capacities. An important consideration, therefore, becomes the scope of conduct considered “professional services” for the purposes of E&O coverage.

While there is no clear consensus on what constitutes “professional services,” courts generally use one of two methods to evaluate the policyholder's conduct. The majority view is based on the analysis in Marx v. Hartford Accident & Indemnity Company, 157 N.W.2d 870 (Neb. 1968), a case decided by the Nebraska Supreme Court. In Marx, a physician's employee mistakenly used benzine instead of water in a sterilization container, causing an explosion and resulting property damage. The physician was insured by a policy covering damages arising out of “'malpractice, error or mistake of the insured, or of a person for whose acts or omissions the insured is legally responsible … in rendering or failing to render professional services.'” Id. at 871. The court held that no coverage existed, defining “professional act or service” as “one arising out of a vocation, calling, occupation, or employment involving specialized knowledge, labor, or skill, and the labor or skill involved is predominantly mental or intellectual, rather than physical or manual.” Id. at 872. The focus of the Marx test is the nature of the act committed ' that is, whether the act itself was “professional” as distinguished from the act of a layperson.

A second test sometimes used to determine coverage under an E&O policy focuses on the policyholder's course of conduct. The determinative question is whether the conduct giving rise to the claim was part of the insured's regular or expected professional activities. For example, in Albert J. Schiff Associates Inc.v. J. Flack, 417 N.E.2d 84, 85 (N.Y. 1980), a life insurance company sought coverage from its E&O carrier after being sued by a competitor for willful usurpation of a “trade secret” novel insurance program for its own use. Under the terms of the policy, the insurer was obligated to cover all sums the policyholder became legally obligated to pay as a result of any error, omission, or negligent act committed by the insured in “the performance of services in the professional capacity of the Assured.” Id. at 85. The policyholder argued that the policy covered the claim because the policyholder's liability resulted from acts related to professional insurance activities. The court disagreed, explaining that services that are merely “incidental” to the policyholder's business are risks that normally would be covered by a general liability policy, not an E&O policy. The court noted that “an errors and omissions policy is intended to insure a member of a designated calling against liability arising out of the mistakes inherent in the practice of that particular profession or business.” Activities which may “set the stage for the performance of business or professional services” are not the professional activities contemplated by E&O coverage.” Id. at 88.

The perils of an unclear “professional services” requirement can be seen in Morgan Stanley Group, Inc. v. New England Insurance Company, 225 F.3d 270 (2d Cir. 2000). In Morgan Stanley, the company's E&O policy covered Morgan Stanley for wrongful acts committed in its “duties as investment counselor.” When presenting the policy, the insurance broker told Morgan Stanley that the term investment counselor was used to allow the policy “to be as flexible as possible especially when one considers the wide array of different advisory services that a firm as large as Morgan Stanley can provide.” Id. at 282. Subsequently, on behalf of a client, Morgan Stanley sold to lenders participations in a loan for a financial venture that later failed, and two of the purchasers sued Morgan Stanley for negligence and fraud. In the coverage case, the court held that Morgan Stanley's connection with the purchasers was not as an investment counselor and thus no coverage existed. While the court agreed that the term “investment counselors” could be considered vague within certain parameters, nevertheless it held that no reasonable interpretation of the term as used in the policy would encompass Morgan Stanley's conduct, which amounted to pitching to a potential buyer as agent of the seller. Id. at 277.

Similarly, in George Muhlstock & Co. v. American Home Assurance Co., 502 N.Y.S.2d 174 (N.Y. App. Div. 1986), after providing advice on an investment, the policyholder accounting firm was asked to pitch investments to its clients. Subsequently, the SEC investigated offerings and civil suits were filed. The accountants were denied coverage for the amounts they paid in settlement of the class action suits because the court held that, in brokering investments, the accountants were not performing professional services as accountants. Id. At 125-126. Despite the fact that a policyholder's conduct may be of a “professional” nature, if the activity is not encompassed by the policyholder's actual professional enterprise, as described in the policy, coverage is not guaranteed.

The manner in which courts interpret “professional services” is a marked contrast between CGL policies and E&O coverage. CGL policies usually include an exclusion of coverage for acts a policyholder undertakes in a professional capacity. A general liability policy affords a broader sphere of coverage than E&O insurance, and correspondingly, a professional services exclusion within a general liability policy is usually read to exclude a broader range of conduct than what is encompassed within an E&O policy. In Aetna Casualty & Surety Co. v. Dannenfeldt, 778 F. Supp. 484 (D. Ariz. 1991), the court held that a professional services exclusion in a CGL policy barred coverage for claims relating to the sale of sophisticated financial instruments by the policyholder savings and loan. The court noted that:

“To determine whether a risk falls within the basic coverage of a professional malpractice policy, the inquiry centers on the particular profession for which the policy provides coverage. To determine whether a risk is within a professional services exclusion, and therefore taken out of the basic coverage of a general liability policy, a generic definition of 'professional services' is applied to a far broader range of activities, producing understandably disparate interpretations in the case law.”

In Dannenfeldt, the court held that the policyholders, bond sales representatives, were performing “professional services” within the ambit of the professional services exclusions in their excess general liability policies, regardless of the fact that they were ill-trained or untrained, because they played an integral part in marketing sophisticated investment instruments in the savings and loan industry.

Professional services exclusions are not solely the province of CGL policies. D&O policies often contain the exclusion as well and there the exclusions may carry a similarly broad interpretation. See Piper Jaffray Cos. v. National Union Fire Ins. Co., 38 F. Supp. 2d 771 (D. Minn. 1999).

Dishonest, Fraudulent, Criminal or Malicious Acts Exclusion

Perhaps the most common restriction on coverage in an E&O policy is the exclusion for intentionally fraudulent or dishonest behavior. A typical deliberate fraud exclusion reads: “This insurance does not apply to any claim: Arising out of any dishonest, fraudulent, criminal or malicious act or omission of any insured or employee of any insured.”

In an E&O policy, this exclusion generally does not require an adjudication of fraud in an underlying case or collateral proceeding, unlike similar provisions in some D&O policies. A professional liability insurer may be relieved of its duty to defend and indemnify when only allegations of fraud are present in the complaint against the policyholder. But see Conner v. Transamerica Ins. Co., 496 P.2d 770 (Okla. 1972) (insurers had duty to defend conspiracy claim against policyholder in absence of adjudication of dishonesty). For example, in Huey T. Littleton Claims, Inc. v. Employers Reinsurance Corp. 933 F.2d 337 (5th Cir. 1991), the policyholder sued its E&O insurer seeking a declaration that losses arising out of employee embezzlement were covered by the policy. The insurer defended “on the ground that the company's losses were attributable to [its employee's] 'dishonest,' 'criminal' act” and were therefore barred under the policy's deliberate fraud exclusion. Id. at 339. The policyholder argued that the exclusion should be construed “as providing coverage for its 'negligent acts or omissions which may have resulted in [its employee's criminal conduct] ' that is to say, for [its] independent negligence (if any).” The court disagreed, holding that the exclusion: “preclude[d] coverage when the [policyholder's] liability for the loss is based upon the excluded conduct of its employee. Irrespective of the legal theory through which [the policyholder's] clients proceed against it ' whether vicarious tort liability, independent tort liability, or even contractual liability ' [the employee's] perfidy remains an essential if not the legal proximate cause of the client's damage. Alternatively stated, regardless of why [the policyholder] is held liable, any claim it files with [the insurer] will in the end stem from [the employee's] “dishonest,” “criminal” act ' expressly excluded under [the terms of the policy]. Id. at 339. See also, Battisti v. Continental Casualty Co., 406 F.2d 1318 (5th Cir. 1969).

In many instances, underlying claims against professionals ' particularly accountants ' may initially appear to fall within the “dishonest acts” exclusion. While case law varies, courts have generally held that malpractice claims are not precluded under the exclusion unless they necessarily involve an element of scienter on the part of the policyholder. See eg, St. Paul Fire & Marine Ins. Co. v. Weiner, 606 F.2d 864 (9th Cir. 1979).

Severability

Decisions holding all policyholders liable for the fraud of a single actor emphasize the importance of severability provisions in professional liability coverage. A standard severability provisions provides that the deliberate fraud exclusion: “does not apply to an insured who did not personally commit or personally participate in committing any of the acts, errors, omissions, or 'personal injury' if:

• Such insured had neither notice nor knowledge of such acts … and
• Such insured, upon receipt of notice or knowledge of such acts … immediately notified us.”

A severability provision saved coverage in SEC v. Credit Bancorp, Ltd., 147 F. Supp. 2d 238 (S.D.N.Y. 2001), where a bank and its officers were accused of defrauding customers. In this case, the court held that the policy's non-imputation exception to fraud exclusion applied to non-fraudulent officers' negligent failure to uncover or prevent fraud. Absent a severability provision, innocent policyholders likely would have been without coverage.

Rescission

Related to the problems policyholders encounter when fighting a fraudulent acts exclusion are the issues raised when there are misrepresentations in the application for insurance. If misrepresentations are discovered, the insurer may seek to rescind coverage on the grounds that the insurance contract is void ab initio. Misrepresentations in the E&O context can include a policyholder's failure to disclose the existence of pending or potential claims by third parties at the time of the application. For example, in INA Underwriters v. D.H. Forde & Co., 630 F. Supp. 76 (W.D.N.Y. 1985), a CEO's false representation on the application for insurance voided the policy as a whole, barring coverage even to those who had not signed the application.

Timing of the 'Claim'

The most litigated issue in E&O coverage disputes is whether a claim was made and reported to the insurer in a timely matter. Virtually all professional liability insurance policies issued today are claims-made policies. Often, to obtain coverage, the claim must take place and the policyholder must report the claim during the policy period. Coverage is not dependent on when the wrongful act occurred, but rather on when the claim took place and was reported. See generally, Chas. T. Main, Inc. v. Fireman's Fund Ins. Co., 551 N.E.2d 28, 29 (1990). A policyholder, however, may be able to obtain coverage for a claim made after the policy period if the policyholder notified the insurer of circumstances that may give rise to potential claims during the policy period. In this situation, subsequent claims related to the noticed circumstances are deemed to have been made during the policy period, even if the actual claims are asserted after the policy period. Note, however, that some policies require this type of notice to be given during the policy period as opposed to the extended reporting period.

To best ensure coverage, a policyholder should be certain to provide notice of circumstances that may give rise to claims in a “notice” letter. The information should not just be made in a renewal application and if possible should target a specific occurrence and provide as many details as possible, including whether litigation is anticipated soon. See eg, Sigma Fin. Corp. v. American Int'l Specialty Lines, 200 F. Supp. 2d 710 (E.D. Mich. 2002). There is a tendency for policyholders to provide the insurer with a “laundry list” of all potential claims just before the policy period expires. Generally, however, the effectiveness of such laundry lists relates directly to the amount of detail provided.

The Importance of Notice

Courts typically enforce notice requirements under E&O policies strictly. In most cases, insurers are not required to show prejudice to deny coverage based on late notice. See eg, Pacific Employers Ins. Co. v. Superior Court of L.A. County, 221 Cal. App. 3d 1348, 270 Cal. Rptr. 779 (1990) (finding that California's “notice prejudice rule” does not apply to claims made E&O policies). For example, in Pope v. Leuty & Heath, PLLC, 2002 WL 1015932 (Tenn. Ct. App. May 21, 2002) the policyholder, accountants, were sued for auditing malpractice two years after the policy period expired. The insurer knew of the potential for a claim during policy period, but the accountants did not report a potential claim. The court held that regardless of the insurer's knowledge, there was no coverage under policy due to the policyholders' failure to provide formal notice during the policy period.

Prior Knowledge/Prior Acts

Although the timing of the notice is a key consideration of a claims-made E&O policy, the timing of the act giving rise to the claim and the policyholder's knowledge and disclosure of the risk can be equally important. Because the trigger of coverage for an E&O policy is the report of a claim during the policy period, claims relating to prior conduct that are anticipated by the policyholder when the policy period begins could be covered. Insurers have long been aware of the risk that policyholders applying for claims-made professional liability policies will withhold knowledge that specific claims are likely to be made based on prior conduct. To combat this perceived problem, insurers sometimes include a “prior acts” exclusion, reading, for example:

“This policy does not apply to any claim arising out of any act, error or omission occurring prior to the effective date of this policy if any insured at the effective date knew or could have reasonably foreseen that such act, error or omission might be expected to be the basis of a claim or suit.”

This exclusion has been held to bar coverage for conduct occurring prior to the referenced date, even if the claim is made during the policy term. See e.g., General Ins. Co. of America v. Robert B. McManus, Inc., 272 Ill. App. 3d 510, 650 N.E.2d 1080 (1st Dist. 1995) (prior acts exclusion barred coverage for claims arising out of an insurance broker's placement of his client's business with an unlicensed insurer over two years before the inception date of the policy). Instead of this exclusion, some policies include a “retroactive date” ' essentially a referenced date for which, if a claim arises from conduct prior to that date, coverage will not be available. A policyholder is well served by having the retroactive date be as long as possible before the inception of the policy period.

Conclusion

In the wake of Enron, professionals, especially those involved in corporate decision-making, need to consider whether they will be protected in the event of financial crisis. The first step in this process should be a careful review of the professional's E&O coverage.

Errors and Omissions (E&O) coverage protects policyholders in various professional occupations ' such as the legal, medical, architectural, engineering, insurance, and accounting fields ' against professional liability claims. This form of insurance, sometimes referred to as professional liability or malpractice insurance, covers economic damages resulting from an error, omission, or negligent act related to the rendering of professional services.

The importance of E&O coverage has never been more evident than in today's business environment. In the much-watched case of Newby v. Enron, 2002 WL 31854963 (S.D. Tex. Dec. 19, 2002), plaintiffs leveled claims against not only Enron's directors and officers, but also targeted lawyers, auditors, and even investment banks for their respective roles in Enron's collapse. Newby paved the way for other disappointed shareholders to expand their litigation targets beyond the directors and officers.

In addition, regulatory changes sparked by Enron-type abuses are increasing the types of claims facing corporate decision-makers. The Sarbanes-Oxley Act (the Act) includes rules governing the standard of conduct for third parties such as auditors and lawyers who routinely assist corporations with their financial compliance. For example, Section 204 of the Act now requires outside auditors to report specified information to auditing committees, including “critical accounting policies and practices” and “alternative accounting treatments.” The critical accounting practices would include an assessment of management's disclosures and any proposed modifications by the accountants that are not included in the disclosures. Section 802 of the Act, likely inspired by Arthur Anderson's conduct, now requires accounting firms to retain audit work papers and other documents that form the basis for the audit for seven years. Section 307 of the Act establishes minimum standards of professional conduct for attorneys who appear or practice before the SEC, including requirements that attorneys report evidence of any “material violations” up the corporate chain.

The far-reaching import of the Sarbanes-Oxley Act for financial professionals is further illustrated in the Section 207 study of mandatory rotation of registered public accounting firms. Under this provision, the Comptroller General of the United States is required to conduct a study and review of the potential effects of requiring the mandatory rotation of registered public accounting firms – that is, establishing a limit on the period of years in which a particular registered public accounting firm may be the auditor of record for a particular issuer. Within one year of enactment of the Act, the Comptroller General must report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of the study and review required by this section.

Mandatory changes in outside auditing support could lead to an increase in restatements of financials, and a corresponding increase in securities litigation. For example, in Continental Casualty Co. v. Coregis Insurance Co., a small accounting firm performed audits for a computer company. After the company went public, however, it hired Pricewaterhouse to take over accounting responsibilities. Irregularities were discovered in the prior audits, and the financials were restated. A securities action was filed against the original auditor, and a coverage action followed. Continental Cas. Co. v. Coregis Ins. Co. , 316 Ill. App. 3d 1052, 738 N.E.2d 509 (1st Dist. 2000). The scenario could become even more familiar depending on the results of the Section 207 study.

In the post-Enron business world, third-party professionals are under heightened scrutiny from regulatory agencies, plaintiffs' lawyers, and the public. In this new corporate environment, business professionals should consider whether they will be protected by current insurance coverage, in the event of financial problems. Knowing your E&O coverage is a necessity in today's corporate climate. This article provides a basic overview of E&O insurance.

Provisions of E&O Policies

There is no standard form for E&O policies and coverage varies by profession and insurer. A single insurer is likely to have different E&O policies depending on the type of professional covered. Although the terms and conditions of E&O coverage vary widely, there are some common features seen in most policies. Typically, E&O insurance includes an insuring agreement reading along the following lines:

“We will pay on behalf of an insured 'damages' for which 'claim' is first made during the 'policy period.' Such 'damages' must arise out of an error, omission, negligent act or 'personal injury' in the rendering or failure to render 'professional accounting services' for others by you or on your behalf. The error, omission, negligent act, or 'personal injury' must occur on or after the Retroactive Date Stated in the Declarations.”

Along with the insuring agreement, policies include exclusions, conditions, and definitions. E&O policies today are usually written as claims-made coverage, as opposed to occurrence policies, so coverage typically is triggered only when a claim is made and reported during the policy period.

Rendering Professional Service

Because E&O insurance is intended to be protection for professionals, a claim, to be covered, usually must arise out of an error or omission in rendering or failing to render professional services. Policies often exclude conduct that the policyholder undertakes in other capacities. An important consideration, therefore, becomes the scope of conduct considered “professional services” for the purposes of E&O coverage.

While there is no clear consensus on what constitutes “professional services,” courts generally use one of two methods to evaluate the policyholder's conduct. The majority view is based on the analysis in Marx v. Hartford Accident & Indemnity Company , 157 N.W.2d 870 (Neb. 1968), a case decided by the Nebraska Supreme Court. In Marx, a physician's employee mistakenly used benzine instead of water in a sterilization container, causing an explosion and resulting property damage. The physician was insured by a policy covering damages arising out of “'malpractice, error or mistake of the insured, or of a person for whose acts or omissions the insured is legally responsible … in rendering or failing to render professional services.'” Id. at 871. The court held that no coverage existed, defining “professional act or service” as “one arising out of a vocation, calling, occupation, or employment involving specialized knowledge, labor, or skill, and the labor or skill involved is predominantly mental or intellectual, rather than physical or manual.” Id. at 872. The focus of the Marx test is the nature of the act committed ' that is, whether the act itself was “professional” as distinguished from the act of a layperson.

A second test sometimes used to determine coverage under an E&O policy focuses on the policyholder's course of conduct. The determinative question is whether the conduct giving rise to the claim was part of the insured's regular or expected professional activities. For example, in Albert J. Schiff Associates Inc.v. J. Flack, 417 N.E.2d 84, 85 (N.Y. 1980), a life insurance company sought coverage from its E&O carrier after being sued by a competitor for willful usurpation of a “trade secret” novel insurance program for its own use. Under the terms of the policy, the insurer was obligated to cover all sums the policyholder became legally obligated to pay as a result of any error, omission, or negligent act committed by the insured in “the performance of services in the professional capacity of the Assured.” Id. at 85. The policyholder argued that the policy covered the claim because the policyholder's liability resulted from acts related to professional insurance activities. The court disagreed, explaining that services that are merely “incidental” to the policyholder's business are risks that normally would be covered by a general liability policy, not an E&O policy. The court noted that “an errors and omissions policy is intended to insure a member of a designated calling against liability arising out of the mistakes inherent in the practice of that particular profession or business.” Activities which may “set the stage for the performance of business or professional services” are not the professional activities contemplated by E&O coverage.” Id. at 88.

The perils of an unclear “professional services” requirement can be seen in Morgan Stanley Group, Inc. v. New England Insurance Company , 225 F.3d 270 (2d Cir. 2000). In Morgan Stanley, the company's E&O policy covered Morgan Stanley for wrongful acts committed in its “duties as investment counselor.” When presenting the policy, the insurance broker told Morgan Stanley that the term investment counselor was used to allow the policy “to be as flexible as possible especially when one considers the wide array of different advisory services that a firm as large as Morgan Stanley can provide.” Id. at 282. Subsequently, on behalf of a client, Morgan Stanley sold to lenders participations in a loan for a financial venture that later failed, and two of the purchasers sued Morgan Stanley for negligence and fraud. In the coverage case, the court held that Morgan Stanley's connection with the purchasers was not as an investment counselor and thus no coverage existed. While the court agreed that the term “investment counselors” could be considered vague within certain parameters, nevertheless it held that no reasonable interpretation of the term as used in the policy would encompass Morgan Stanley's conduct, which amounted to pitching to a potential buyer as agent of the seller. Id. at 277.

Similarly, in George Muhlstock & Co. v. American Home Assurance Co., 502 N.Y.S.2d 174 (N.Y. App. Div. 1986), after providing advice on an investment, the policyholder accounting firm was asked to pitch investments to its clients. Subsequently, the SEC investigated offerings and civil suits were filed. The accountants were denied coverage for the amounts they paid in settlement of the class action suits because the court held that, in brokering investments, the accountants were not performing professional services as accountants. Id. At 125-126. Despite the fact that a policyholder's conduct may be of a “professional” nature, if the activity is not encompassed by the policyholder's actual professional enterprise, as described in the policy, coverage is not guaranteed.

The manner in which courts interpret “professional services” is a marked contrast between CGL policies and E&O coverage. CGL policies usually include an exclusion of coverage for acts a policyholder undertakes in a professional capacity. A general liability policy affords a broader sphere of coverage than E&O insurance, and correspondingly, a professional services exclusion within a general liability policy is usually read to exclude a broader range of conduct than what is encompassed within an E&O policy. In Aetna Casualty & Surety Co. v. Dannenfeldt , 778 F. Supp. 484 (D. Ariz. 1991), the court held that a professional services exclusion in a CGL policy barred coverage for claims relating to the sale of sophisticated financial instruments by the policyholder savings and loan. The court noted that:

“To determine whether a risk falls within the basic coverage of a professional malpractice policy, the inquiry centers on the particular profession for which the policy provides coverage. To determine whether a risk is within a professional services exclusion, and therefore taken out of the basic coverage of a general liability policy, a generic definition of 'professional services' is applied to a far broader range of activities, producing understandably disparate interpretations in the case law.”

In Dannenfeldt, the court held that the policyholders, bond sales representatives, were performing “professional services” within the ambit of the professional services exclusions in their excess general liability policies, regardless of the fact that they were ill-trained or untrained, because they played an integral part in marketing sophisticated investment instruments in the savings and loan industry.

Professional services exclusions are not solely the province of CGL policies. D&O policies often contain the exclusion as well and there the exclusions may carry a similarly broad interpretation. See Piper Jaffray Cos. v. National Union Fire Ins. Co., 38 F. Supp. 2d 771 (D. Minn. 1999).

Dishonest, Fraudulent, Criminal or Malicious Acts Exclusion

Perhaps the most common restriction on coverage in an E&O policy is the exclusion for intentionally fraudulent or dishonest behavior. A typical deliberate fraud exclusion reads: “This insurance does not apply to any claim: Arising out of any dishonest, fraudulent, criminal or malicious act or omission of any insured or employee of any insured.”

In an E&O policy, this exclusion generally does not require an adjudication of fraud in an underlying case or collateral proceeding, unlike similar provisions in some D&O policies. A professional liability insurer may be relieved of its duty to defend and indemnify when only allegations of fraud are present in the complaint against the policyholder. But see Conner v. Transamerica Ins. Co., 496 P.2d 770 (Okla. 1972) (insurers had duty to defend conspiracy claim against policyholder in absence of adjudication of dishonesty). For example, in Huey T. Littleton Claims, Inc. v. Employers Reinsurance Corp. 933 F.2d 337 (5th Cir. 1991), the policyholder sued its E&O insurer seeking a declaration that losses arising out of employee embezzlement were covered by the policy. The insurer defended “on the ground that the company's losses were attributable to [its employee's] 'dishonest,' 'criminal' act” and were therefore barred under the policy's deliberate fraud exclusion. Id. at 339. The policyholder argued that the exclusion should be construed “as providing coverage for its 'negligent acts or omissions which may have resulted in [its employee's criminal conduct] ' that is to say, for [its] independent negligence (if any).” The court disagreed, holding that the exclusion: “preclude[d] coverage when the [policyholder's] liability for the loss is based upon the excluded conduct of its employee. Irrespective of the legal theory through which [the policyholder's] clients proceed against it ' whether vicarious tort liability, independent tort liability, or even contractual liability ' [the employee's] perfidy remains an essential if not the legal proximate cause of the client's damage. Alternatively stated, regardless of why [the policyholder] is held liable, any claim it files with [the insurer] will in the end stem from [the employee's] “dishonest,” “criminal” act ' expressly excluded under [the terms of the policy]. Id. at 339. See also, Battisti v. Continental Casualty Co., 406 F.2d 1318 (5th Cir. 1969).

In many instances, underlying claims against professionals ' particularly accountants ' may initially appear to fall within the “dishonest acts” exclusion. While case law varies, courts have generally held that malpractice claims are not precluded under the exclusion unless they necessarily involve an element of scienter on the part of the policyholder. See eg, St. Paul Fire & Marine Ins. Co. v. Weiner , 606 F.2d 864 (9th Cir. 1979).

Severability

Decisions holding all policyholders liable for the fraud of a single actor emphasize the importance of severability provisions in professional liability coverage. A standard severability provisions provides that the deliberate fraud exclusion: “does not apply to an insured who did not personally commit or personally participate in committing any of the acts, errors, omissions, or 'personal injury' if:

• Such insured had neither notice nor knowledge of such acts … and
• Such insured, upon receipt of notice or knowledge of such acts … immediately notified us.”

A severability provision saved coverage in SEC v. Credit Bancorp, Ltd., 147 F. Supp. 2d 238 (S.D.N.Y. 2001), where a bank and its officers were accused of defrauding customers. In this case, the court held that the policy's non-imputation exception to fraud exclusion applied to non-fraudulent officers' negligent failure to uncover or prevent fraud. Absent a severability provision, innocent policyholders likely would have been without coverage.

Rescission

Related to the problems policyholders encounter when fighting a fraudulent acts exclusion are the issues raised when there are misrepresentations in the application for insurance. If misrepresentations are discovered, the insurer may seek to rescind coverage on the grounds that the insurance contract is void ab initio. Misrepresentations in the E&O context can include a policyholder's failure to disclose the existence of pending or potential claims by third parties at the time of the application. For example, in INA Underwriters v. D.H. Forde & Co., 630 F. Supp. 76 (W.D.N.Y. 1985), a CEO's false representation on the application for insurance voided the policy as a whole, barring coverage even to those who had not signed the application.

Timing of the 'Claim'

The most litigated issue in E&O coverage disputes is whether a claim was made and reported to the insurer in a timely matter. Virtually all professional liability insurance policies issued today are claims-made policies. Often, to obtain coverage, the claim must take place and the policyholder must report the claim during the policy period. Coverage is not dependent on when the wrongful act occurred, but rather on when the claim took place and was reported. See generally, Chas. T. Main, Inc. v. Fireman's Fund Ins. Co., 551 N.E.2d 28, 29 (1990). A policyholder, however, may be able to obtain coverage for a claim made after the policy period if the policyholder notified the insurer of circumstances that may give rise to potential claims during the policy period. In this situation, subsequent claims related to the noticed circumstances are deemed to have been made during the policy period, even if the actual claims are asserted after the policy period. Note, however, that some policies require this type of notice to be given during the policy period as opposed to the extended reporting period.

To best ensure coverage, a policyholder should be certain to provide notice of circumstances that may give rise to claims in a “notice” letter. The information should not just be made in a renewal application and if possible should target a specific occurrence and provide as many details as possible, including whether litigation is anticipated soon. See eg, Sigma Fin. Corp. v. American Int'l Specialty Lines , 200 F. Supp. 2d 710 (E.D. Mich. 2002). There is a tendency for policyholders to provide the insurer with a “laundry list” of all potential claims just before the policy period expires. Generally, however, the effectiveness of such laundry lists relates directly to the amount of detail provided.

The Importance of Notice

Courts typically enforce notice requirements under E&O policies strictly. In most cases, insurers are not required to show prejudice to deny coverage based on late notice. See eg, Pacific Employers Ins. Co. v. Superior Court of L.A. County , 221 Cal. App. 3d 1348, 270 Cal. Rptr. 779 (1990) (finding that California's “notice prejudice rule” does not apply to claims made E&O policies). For example, in Pope v. Leuty & Heath, PLLC, 2002 WL 1015932 (Tenn. Ct. App. May 21, 2002) the policyholder, accountants, were sued for auditing malpractice two years after the policy period expired. The insurer knew of the potential for a claim during policy period, but the accountants did not report a potential claim. The court held that regardless of the insurer's knowledge, there was no coverage under policy due to the policyholders' failure to provide formal notice during the policy period.

Prior Knowledge/Prior Acts

Although the timing of the notice is a key consideration of a claims-made E&O policy, the timing of the act giving rise to the claim and the policyholder's knowledge and disclosure of the risk can be equally important. Because the trigger of coverage for an E&O policy is the report of a claim during the policy period, claims relating to prior conduct that are anticipated by the policyholder when the policy period begins could be covered. Insurers have long been aware of the risk that policyholders applying for claims-made professional liability policies will withhold knowledge that specific claims are likely to be made based on prior conduct. To combat this perceived problem, insurers sometimes include a “prior acts” exclusion, reading, for example:

“This policy does not apply to any claim arising out of any act, error or omission occurring prior to the effective date of this policy if any insured at the effective date knew or could have reasonably foreseen that such act, error or omission might be expected to be the basis of a claim or suit.”

This exclusion has been held to bar coverage for conduct occurring prior to the referenced date, even if the claim is made during the policy term. See e.g., General Ins. Co. of America v. Robert B. McManus, Inc., 272 Ill. App. 3d 510, 650 N.E.2d 1080 (1st Dist. 1995) (prior acts exclusion barred coverage for claims arising out of an insurance broker's placement of his client's business with an unlicensed insurer over two years before the inception date of the policy). Instead of this exclusion, some policies include a “retroactive date” ' essentially a referenced date for which, if a claim arises from conduct prior to that date, coverage will not be available. A policyholder is well served by having the retroactive date be as long as possible before the inception of the policy period.

Conclusion

In the wake of Enron, professionals, especially those involved in corporate decision-making, need to consider whether they will be protected in the event of financial crisis. The first step in this process should be a careful review of the professional's E&O coverage.