Corporate scandals are hammering the errors and omissions market.
You may think it wasn't your fault, but don't expect a jury to believe you. With 95 million Americans fearful of the future of their mutual funds, often their only liquid asset, and the demise of Italian food company Parmalat convincing Europeans that international corporate scandals are also made outside the US, it's not a good time to be a professional adviser to a company in trouble. In their separate ways, the US courts and the European Commission are enabling shareholders to take action against any company's professional advisers.
"Any deep pocket involved in a scandal, whether individual or not, should be worried," said Adam Barker, partner and insurance expert at the London offices of law firm Sedgwick, Detert, Moran & Arnold. The depth of that deep pocket is open to interpretation, he added.
Just how far this net could spread to any organisation's employees will be demonstrated by the outcome of an action by accountancy firm Deloitte Touche Tohmatsu against the Bank of England for "misfeasance in public office" in its handling of the collapse of the Bank of Credit & Commerce International (BCCI) in 1991. The operations of Luxembourg-registered BCCI, which laundered money for Middle Eastern terrorist groups and Colombian drug cartels, were largely unsupervised in the UK. The Bank of England as a regulator is immune from negligence claims, but Deloitte's case is attempting to show that a number of the Bank's employees, albeit senior ones, were negligent.
Adam Barker thinks that this case will be one of a kind and will not trigger similar litigation against a regulator in the US, where such an action remains unthinkable at present. But it will reinforce the need for companies to maintain high standards of corporate governance and professional judgment. Meanwhile, the ongoing scandals are making errors and omissions (E&O) insurance "virtually unobtainable", he said.
The cost of E&O insurance for professionals such as lawyers, accountants and those with fiduciary responsibility, such as benefits administrators, has skyrocketed on both sides of the Atlantic. In the US, a survey conducted by the Risk & Insurance Management Society (RIMS),
which compiled information from more than 750 companies, indicated that liability insurance costs are up by 150% compared with a year earlier, while policyholder retentions have increased by as much as 250% to 500% over the past year. The rise has been greater in the Canadian market, which is influenced by the fall-out from US corporate scandals but which also has fewer insurance carriers. Five years ago in the UK market it was possible for lawyers to get significant liability limits from their insurers. A large law firm could obtain limits of £100m, said Mr Barker, though the limits available in the US market were always much lower.
On the primary level over the past year, insurance carriers have changed their approach to risk selection, observed Sabrena Sally, vice president and underwriting manager at GE Commercial Insurance in Chicago. Carriers are focusing on making a true underwriting profit to compensate for the investment income which has been lost as a result of the stock market collapse. Losses had also piled up from medical malpractice claims as well as shareholder class actions after the dot.com bust in 2000.
But despite rate increases in specialised sectors, it is also possible to see an overall rate flattening in the E&O market, said Clint Johnson, New York-based senior vice president of ACE USA. The rate increases are focused on those sectors which have generated or could generate significant losses either because of litigation or because of changes in legislation.
In addition to lawyers, accountants and financial institutions generally, these include companies with large public audit exposures or firms specialising in selling tax shelters. "The IRS (Internal Revenue Service) has made several public statements on clamping down on individuals who abuse tax shelters," said Mr Johnson.
And now that questionable 1990s innovation, the multi-year policy, is a thing of the past. "There is a recognition on the part of insurers and reinsurers that whether for a financial institution or a law firm, these policies are so complex and the environment changes so rapidly, that it's difficult to get around them," said Susan Drake, global professional liability leader at GE ERC Group in Hartford, Connecticut. Such multi-year, multi-sector policies managed to coalesce E&O with directors and officers (D&O) insurance into a broad package. These sectors are now separating again.
Exclusions for market abuse and deliberate corporate acts are increasing, as are scandal specific clauses such as the 'Enron exclusion'. This is a wording which excludes claims related to the Enron case. "If a scandal is big enough, it gets its own exclusion," said Mr Barker.
The E&O market itself is pretty fragmented and can be anything an individual insurance carrier wants it to be, covering lawyers, accountants, financial institutions, small businesses, medical practitioners, architects, surveyors and the like. The potential market has expanded with the development of more service-based economies in which companies outsource activities to independent contractors, which in turn require E&O cover. Writing business in each sector requires a large body of knowledge. "So the E&O market doesn't lend itself to people jumping into it," observed Stephen Sills, President and CEO of Darwin Professional Underwriters in Farmington, Connecticut.
But people can and are jumping out of the market, scared at the potential losses which could be triggered by the ongoing scandals. There could be worse to come if the former US Securities and Exchange Commission (SEC) Chairman Arthur Levitt's description of corruption in US mutual funds as "the biggest financial scandal ever" comes true. The SEC and New York Attorney General Eliot Spitzer have taken legal action against a number of mutual fund companies for allowing larger clients such as hedge funds to profit from short-term trades, known as 'market timing', at the expense of long term investors. As investors join the authorities in taking action against fund administrators and financial advisers, the potential for claims rises to the tens of hundreds of millions of dollars, thinks Stephen Sills.
Enron I & II rulings
Recent rulings by a fifth Circuit Court in Texas, known as Enron I and Enron II, have broadened the standards of and grounds for liability. Lawyers, accountants and other advisers may be found liable in any given case if they "created a misrepresentation". This comes from a January 2003 opinion by Judge Melinda Harmon who is presiding over the consolidated Enron shareholder federal securities action lawsuit. The opinion expands the reach of Section 10(b) of the 1934 Securities Exchange Act (the Exchange Act) and means that plaintiffs can proceed against law firms, accountancy firms and banks even if these firms did not sign a document which contains the misrepresentation in question. The Enron II decision expanded the breadth of liability through its interpretation of the "control person liability" standards of the Exchange Act. This permits plaintiffs to proceed against individuals in accountancy firm Arthur Andersen who were "upper echelon partners" or who were "involved in the Enron engagement" or who had the "power to control" Arthur Andersen policies regarding Enron. Plaintiffs need only demonstrate that an individual had the "power to control" any aspect of corporate policy. According to Carol Zacharias, senior vice president for ACE USA in New York, if you have the power to control and the responsibility, you can be sued.
The fallout from the Enron and now Parmalat scandals are forcing a different behaviour on professional advisers. PricewaterhouseCoopers has stated publicly that auditors must accept more responsibility for finding fraud.
Previously, auditors did not assume that the management of the company they audited could be crooks. Questions are being asked about the role of the banks which handled Parmalat bonds for the past five years, and both the SEC and the Italian regulators are investigating whether such banks have been "reckless or negligent".
Pension plan administrators are also reeling from the Enron rulings as fiduciary claims against Enron executives go to trial. Judge Harmon stated that Enron officers who also acted as pension plan fiduciaries can only wear one hat at a time. Arguments by the Enron defendants that they could not disclose non-public information to plan participants without violating securities laws were rejected. These laws do not shield fiduciaries from their duty of disclosure, the court ruled.
However, Susan Drake is not panicking yet. The issue is the extent of any adviser's involvement in any scandal and the nature of their responsibility.
At the moment, shareholders and pension plan participants are pursuing their claims along whatever avenues are available, she said.
Corporate scandals and fraud judgments have stirred up what was always a deep popular antipathy in the US towards large corporations. Some companies are settling disputes confidentially rather than risking the large damages US juries award. But even these settlements have risen by over 50% compared with one year ago. According to a Bloomberg survey, US juries awarded damages of $13.8bn in 2003 against companies sued for fraud, compared with $1.46bn in 2002. These fraud verdicts surpassed personal injury awards, as measured by Bloomberg in the 25 largest cases. In 2003, personal injury awards amounted to $945.8m compared with $31.1bn in 2002. In 2002, the largest personal injury award was $28bn (since reduced to $28m on 19/12/02) to a smoker with lung cancer against cigarette manufacturer Philip Morris Cos.
Executives from many corporations have called such legal action "extortion".
This has often been applied in the case of human rights and environmentalist advocacy groups suing US multinationals in US courts under the Alien Tort Claims Act (ATCA) for their operations in third countries. The actions under ATCA have either been thrown out by US judges on jurisdictional grounds or are still ongoing. But there is no appetite on a popular level for tort reform to limit so-called "frivolous litigation", and no politician could dare suggest it. "Everyone is asking, how do we sue those people?" said Carol Zacharias. Claimants have been targeting those jurisdictions where juries will give the biggest award. The American Tort Reform Association (ATRA) named Madison County, Illinois as the country's worst "Judicial Hellhole" for 2003.
This will move to Europe, if the European Commission (EC) has its way.
During the 2002 passage of the Sarbanes-Oxley Act in the US, which stipulated new rules on corporate governance, European governments were happy to claim that "an Enron could never happen in Europe". In reality, shareholders and policyholders had regularly been defrauded by financial and corporate scandals in western Europe ever since the merger and acquisitions boom of the 1980s in preparation for the single European market. Over most of this period there were inadequate rules about disclosure, minority shareholder rights barely existed, and governments ensured that the taxpayer would always bail out any bankruptcy. Then European shareholders wisened up and began class actions in the US against European companies which had used the US capital markets to raise finance. "They try to get damages they wouldn't get in Europe," said Mr Barker.
But US regulators' demands that foreign companies conducting business in the US must conform with the Sarbanes-Oxley Act sped the EC's Action Plan for "Modernising Company Law and Enhancing Corporate Governance in the EU". Its main initiatives include the enhancement of shareholder rights, the promotion of non-executive or supervisory directors, and the collective responsibility of board members for both financial statements and key non-financial statements. But this has to be contained within a broad EU framework allowing for member state flexibility. The Parmalat scandal has persuaded the EC to take another look at the kinds of regulatory reform which will be needed in the EU marketplace as a result.
So if Europeans become as litigious as Americans, how can E&O carriers recognise trouble before it happens? Clint Johnson said reinsurers will ask clients about things such as their mutual fund exposures, the nature of the business they conduct, and will request copies of relevant agreements.
If the information is not forthcoming, then neither is the cover. Susan Drake can use the ERC Group's vast databank on E&O business to identify market trends. One of the things data analysis could indicate is any diversification in an insured's business, for example, if a company moves from being a service provider mainly to the public sector to providing services mostly for the private sector, and so changes its risk profile. At the moment, she thinks, there does not seem to be a real shortage of reinsurance capacity for E&O. But after another year of court rulings and legislation, it could be a different world.