Errors and Omissions Insurance – Necessary Protection of Officers and Directors

Nov 212008

Dr. Earl R. Smith II
Managing Partner, The Federal Circle
DrSmith@Dr-Smith.com
Dr-Smith.com

One area of my work that has gotten a lot more attention since 2002 is the question of exposure of directors to liabilities arising from their board service. Most serving directors realize that managing this liability is only partially under their control. Certainly, they can be sued for neglecting their responsibilities to the shareholders – and minority shareholders are much more aggressive these days. However, they also incur risks for the actions – or lack of actions – of the management they are supposed to be overseeing. Some of these risks – but not all – can be mitigated with the proper insurance.

In today’s litigious society Errors and Omissions Insurance (E & O) is a necessity. Everyone will eventually make an error or omit an important clause in a contract leaving open the possibility of a lawsuit. Sarbanes-Oxley (SOX) holds Directors personally liable in certain instances for actions or for the failure to act on the part of the board of directors. Errors and Omissions insurance is concerned with performance failures and negligence on the part of a company’s products or services.

Errors and Omissions Insurance covers acts, actual or alleged, errors or omissions, misstatements, misleading statements, or breach of fiduciary duty or other duty while holding authority and responsibility for professional governance of an organization. It will often cover issues when an officer or director knew or should have known an act was happening and the officer or director failed to act to correct the issue. With breath and width of director responsibilities growing daily, corporate governance becomes more complex and directors must work through others and on the recommendation of others to execute business transactions. The CEO exercises powers to act on behalf of the board in many circumstances. A board member is liable for the CEO’s malfeasance if the governance model shows the director or directors should have exercised greater oversight of the CEO.

Companies engaged as advisers offering advice on corporate finance are liable if there assessment is not thorough enough to catch corporate finance irregularities. Errors and Omissions Insurance coverage would cover the company if the advice proved to be inaccurate or illegal and the adviser knew or should have known the advice was an error. The same is true if the advisor failed or omitted key information regarding corporate finance that created a problem for their client. Professional services usually extend to supervisory services, computer and internet services, administrative services, and even publications prepared for the company especially if corporate financial documents are involved.

External auditors generally carry Errors and Omissions Insurance. Auditors review and offer opinions of the accounting policies used by a company to produce corporate finance statements. Auditors also offer opinions regarding the accuracy with which the financial statements reflect the financial condition of the company. Auditors that failed to investigate thoroughly the accounting practices of a company engaged in non-G.A.A.P. accounting practices are accountable for not disclosing this fact in their report.

Banks and other lending institutions typically require Errors and Omissions Insurance when companies request a new line of credit, or an adjustment to an existing line of credit. Banks understand the devastating impact a lawsuit can have on corporate operations and therefore often insist on insurance as a rider in the loan contract. Errors and Omissions Insurance will generally cover legal defense costs no matter how baseless the allegation and will cover the company for any resulting judgments, including court costs, up to the coverage limits on the policy.

Some companies make a serious mistake. General liability insurance does not cover errors, contract performance disputes or any other professional liability issues. Errors and Omission insurance covers mistakes on the part of the company, the company’s officers, employees and even independent contractors working on behalf of the company.

Boards of directors are responsible for enhancing the value of the shareholders of the company over time. Part of that responsibility is protecting the company from events that could disrupt the company’s ability to operate. A lawsuit arising from company malfeasance could potentially destroy corporate finances and put a company into bankruptcy.

One final point – Errors and Omissions Insurance is useful only if the directors take a professional and responsible approach to their service on the board. Insurance companies review each claim with an eye to finding reasons not to protect the individual directors or board from the results of actions that are not professional, best practices – they look for negligence and malfeasance – they will not protect a director who has violated their fiduciary responsibility to the shareholders. In short, they will normally look to the other provisions of Sarbanes-Oxley and other regulations guidelines for director performance. Errors and Omissions Insurance protects the responsible and professional directors who have made mistakes – but not the mistakes that have become directors.

If you are serving on a board – or are considering such service – and want to discuss the potential exposure – send me an e-mail and we will arrange a time to talk.

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