Crackdown on the Gatekeepers

There are two major cases in Canada regarding liability of the “gatekeepers”. Here, is Castor Holdings, and here is Hercules. Hercules is one of the most cited cases in Canadian law, and it significantly reduced the professional liability risk faced by the gatekeepers. Castor is a new Quebec court decision, but if it stands up to appeal it will mean significant new risk for the gatekeepers.

But perhaps the Castor case has already changed the tides on liability risk. As written here in this Ottawa Citizen article, the OSC is pursuing Ernst & Young LLP as auditors of SinoForest for “failing to perform sufficient work to verify the existence and ownership of Sino’s most significant assets.” This article also mentions E&Y’s agreement to pay $117 million to settle one of Sino’s securities class action lawsuits, which is “more than double the size of any other reached in Canada with an auditing firm.”

The allegations against E&O have not been proven in court and the settlement agreement does not include any admission of liability. But the court will not decide on approval of the settlement plan until January 15, 2013.

Further evidence of new exposure to the gatekeepers is the recent Court of Appeal for Ontario decision, here, which denied the appeal of the gatekeepers and upheld the lower court’s interpretation of the new amendment to the CCAA that indemnity claims by the gatekeepers against their client for legal costs or damages they face as a result of their work for the client will take the status of an “equity claim” and therefore be subordinate to the secured and unsecured creditors. In most large professional services negligence claims the client is bankrupt and the equity interests are worth nothing.

The insurance spin: 

There are three major types of insurance coverage, which if purchased and properly negotiated and maintained, could be tapped.

The Directors’ and Officers’ Liability policy (D&O) for Sino; it will not likely be triggered by the allegations of negligence against the auditors, underwriters or other gate-keepers, but the ‘allocation’ provisions could broaden that coverage to a degree not contemplated by the insurance underwriters (I believe there is $90 million limit as per previous information circulars) and potentially respond to loss of the ‘gate keepers’. Depending on the wording of the D&O policy there is a very good chance the entire limits of that program will be fully exhausted, and unfortunately,  for some of the individual directors and officers, that limit exhaustion could easily come before all losses are settled, and while they still face litigation and personal statutory liability obligations like taxes, wages, etc. There are many other provisions of that policy that will determine its success/failure, like ‘severability’, ‘conduct exclusions’, ‘final adjudication in the underlying action’, and, don’t forget, the insurance application and insurance submission materials form part of the policy contract.

E&Y’s D&O policy, if one is purchased, might have a component of coverage but there are a few areas of insurance risk which might come into play. First, many large professional firms will comingle their D&O coverage with their E&O coverage under one aggregate limit of liability; so, the E&O claim could severely erode the limits otherwise available to the individual directors and officers. Second, the ‘professional liability exclusion’ will be tested. Third, investigation costs might not be a feature of this coverage, or the nature of the investigation might not be contemplated by the contract.

The E&O insurance policy (E&O) for E&Y could be severely eroded by this matter, but auditors E&O insurance is not widely competitive thanks to the ‘programs’ within this industry, which has meant that the many independent insurance companies who could accept this risk on individual auditing firms have not seen these opportunities. When other industry-based insurance programs have failed (and they have), individual companies (and their partners/professional) have found it very difficult to find coverage. When this happens, many people will suggest that insurance companies are “gouging” them or even “extorting” them for exorbitant insurance premiums. But only few are willing to admit that by supporting a non-diversified, industry-based program, they have left the independent insurance companies with no underwriting history, no lost or claims history, no “money in the bank” from previously successful underwriting periods, and concerns about the ‘moral hazard’ risk within that industry. When industry-based insurance programs implode (meaning their capital and support shrinks to the point of disappearing) all of the underlying insureds (good and bad, together) ‘hit the street’ at the same time and independent insurance underwriters are limited in resources to respond and they will have the legitimate fear that the new client submissions they are receiving might be the ‘bad actors’ who caused the demise of the industry-based insurance program.

Investigation Costs Coverage – probably not in play as this is relatively new coverage and not a common purchase for most regulated firms. There may be some coverage in the E&Y D&O policy, or perhaps even in the Sino D&O policy, but this is typically sublimited to between $50,000 and $1 million. The Investigation Costs Coverage is best purchased on a standalone basis with dedicated limits of liability because it can be seen as a form of ‘entity coverage’ and if it is built into the D&O coverage it will contribute to the early erosion of the limits of liability otherwise available to the individual directors and officers. But if this coverage was purchased by E&Y or Sino, it would have been a great use of funds.

Greg Shields is a D&O, Professional Liability, Employment Practices Liability, Fiduciary Liability and Crime insurance specialist and a Partner at the University and Dundas (Toronto) branch of Mitchell Sandham Insurance Services. He can be reached at gshields@mitchellsandham.com, 416-862-5626, or Skype at risk.first.

CAUTION: This article does not constitute a legal opinion or insurance advice and must not be construed as such. It is important to always consult a registered and truly independent insurance broker and a lawyer who is a member of the Bar or Law Society of the relevant jurisdiction with regard to this material before making any insurance or legal decisions. All material is copyrighted by Mitchell Sandham Inc. and may not be reproduced in any form for commercial purposes without the express written consent of Mitchell Sandham Inc. Anyone seeking to link this document from any external website must receive the consent of Mitchell Sandham Inc. by sending an e-mail to gshields@mitchellsandham.com.