By: Stephen P. Pazan, Esquire
Originally published: June 27, 2003
The E-Commerce boom and subsequent shake-out left a lot of broken.com’s in its wake. Regardless, since "E-Commerce" is here to stay, coverage counsel will increasingly be called upon to resolve novel disputes under both traditional insurance policies and recently packaged insurance products, particularly in the area of software sales and service. Many of these products will be errors and omissions policies written on a claims-made basis. There are surprisingly few New Jersey cases dealing with professional liability policies. See, accord, Kenney and Lattal, New Jersey Insurance Law, §15-4 at 528 (2000). Observant coverage counsel may find value for clients in the debris of broken or unfulfilled contractual obligations. Success may depend on whether counsel can articulate a distinct error or omission in the context of software sales and computer services.
An example of the coverage provided in this area is found in Chubb’s Computer Software and Services Errors and Omissions Policy (Form 80-02-2013 (Ed.4:94). The insurance agreement provides that:
"Subject to the applicable limits of insurance, we will pay damages the insured becomes legally obligated to pay for any claim arising out of a negligent act, error or omission, to which this insurance applies, by or on behalf of the insured: in the performance of or failure to perform electronic data processing; in the performance of or failure to perform other computer services; or in the failure of software products to perform the function or serve the purpose intended."
CNA provides similar coverage in its "E-pack for Private Companies" program. The Professional Services Endorsement (G-128180-A2 (Ed. 10-00)), which is part of the Miscellaneous Professional Liability Coverage Part, defines covered "Technology Services" to include the following:
- Systems analysis, systems conversion and systems integration;
- Designing, developing, programming, distributing, installing, licensing, servicing, and maintaining computer hardware and software, including web-based applications, websites and online services;
- Education and training services in the use of computer hardware and/or software;
- Hosting and marketing of websites and online services;
- Services as an internet access provider, search engine or web browser;
- Development, design and maintenance of chat rooms, email services or bulletin board;
- Computer consulting;
- Management and operation of a third-party information services department;
- Data processing in connection with any of the above listed services."
The Chubb policy defines electronic data processing as "those activities usual to the processing of data or records of others." Chubb defines "other computer services" as "electronic data processing hardware and software consulting, analysis or design; computer hardware maintenance for others; and your distribution or sale of computer hardware." Software products are defined by Chubb as "computer software or programming which you or others trading under your name created, manufactured, sold, licensed, handled or distributed."
The primary question that will determine whether the claims are brought within the insuring agreement of these policies is whether the insured will be found to be doing anything "for others." Broadly construed, computer service companies are processing data or records. Narrowly construed, they are was not processing anything for anybody, but are merely selling a product.
The term, "wrongful act" and "loss" will be broadly construed. For example, in Central Dauphin School District v. American Casualty Ins. Co., 412 A.2d 892, 271 Pa. Super. 218, reversed on other grounds, 426 A.2d 94, 493 Pa. 254 (1979), a municipality illegally imposed a tax on teenagers. The school district, which was the offending organ of government, was compelled to repay the tax. It attempted to recover the repayment of the tax under its errors and omissions policy. Notwithstanding the insurance carrier’s argument that the illegally collected tax was not part of revenue, and therefore not actually a loss when paid back, the court decided that the definition of "wrongful act" and "loss" was so broad, that almost any act which resulted in a claim not otherwise excluded by the policy would be covered. The wrongful act was the passage and collection of the wrongful tax.
An insurer would argue that no lay person could read these policies and expect that the policies provide coverage for a simple contract dispute relating to a software product’s failure to perform. However, even where the claim is for simple breach of contract, courts should look closely at E&O policies in order to determine the true cause of the damages. See Bell Lavalin, Inc. v. Simcoe & Erie General Insurance Company, 61 F.3d 742 (9th Cir. 1955) (Alaska law). The applicability of E&O insurance depends on the nature of the act that caused the specific damages for which recovery is sought, not the label applied to the act by a claimant.
In Continental Casualty Company v. Board of Education in Charles County, 489 A.2d 536, 302 Md. 516 (1985), the insured school board terminated a contract for the building of a school and the contractor sued, presenting a complaint that sounded in breach of contract, and in tort. The school board settled the case and filed a successful declaratory judgment action against its E&O carriers. The contractor’s complaint stated that the Board had retarded and interfered with the performance of the contractor, and had prevented the contractor from completing the contract. Coverage was granted for that wrongful act.
It is critical to distinguish professional services from other ministerial activities. For example, in Medical Records Association v. American Empire Surplus Insurance Company, 42 F.3d 512 (1st Cir. 1998), the First Circuit, under Massachusetts law, analyzed a dispute between a medical records service and lawyers who were trying to recover excessive costs imposed on them by the service. The service unsuccessfully sought recovery under its E&O policy for any excess charges it was required to return to the lawyers. The improper billing practices were characterized by the Court as ministerial, because they did not require special training or learning. This case demonstrates how an insured’s chances of obtaining coverage increase if it can articulate a "professional act" that contributed to the breach of contract.
E&O coverage may also depend on whether the insured breached a duty created by law, or a duty created by contract. For example, the duty to process installments on a contract would not be covered by an E&O policy, because such a duty is purely ministerial, and exists solely because of the existence of the contract. Failure to process a payment does not involve professional activities that might implicate a separate duty or standard of care. See Cincinnati Insurance Company v. Metropolitan Properties, 806 F.2d 1541 (11th Cir. 1986) (Alabama law). Obviously, this analysis is complicated in cases where a professional’s duty exists solely because of a contract (doctors, lawyers, etc). Regardless, it has been resolved that performance under a contract and the performance of professional services are not mutually exclusive, so the focus is not on whether the insured was performing because of a contract, but on whether the insured’s actions as a professional caused the damages. See Continental Casualty Company v. Cole, 809 F.2d 891 (D.C. Cir. 1987) (D.C. law).
There appear to be few cases discussing these concepts in the computer software and services and data processing contexts. One is Touchette Corporation v. Merchants Mutual Insurance Company, 429 N.Y. S.2d 952, 76 A.D.2d 7 (4th Dept. 1980). In Touchette, Merchants Mutual issued coverage insuring against "any negligent act, error or omission of the insured arising out of the performance of data processing services for others." Touchette violated a contract with the Civil Service Employees Association (CSEA). It failed to provide CSEA with services, including an accurate list of subscribers, and a satisfactory system for notifying employers of employees’ dues deductions. Touchette also failed to design and implement a data processing system. The Fourth Department found that it was not the form of the pleading that determined coverage, but rather, the insured’s conduct. A finding of negligence was not necessary for coverage under the E&O policy. The court stated:
"It can not be decided solely upon a finding that Touchette’s duty arises from contract rather than from general tort principles. Insurance was purchased by Touchette to protect it from its own failures, and if it does not provide coverage under the circumstances alleged in the complaint, it is difficult to imagine what risk the policy does cover."
429 N.Y. S.2d at 954-55.
In USM Corporation v. Arthur D. Little Systems, Inc., 546 N.E. 2d 888, 28 Mass. App. Ct. 108 (1989), USM wanted to purchase a computer system for use in the business of manufacturing and selling shoe-making equipment. USM and the Arthur D. Little Systems ("ADLS") contracted for the system based on the needs of USM. The primary purpose of the system was to provide accounts receivable, billing data, inventory control and other record keeping functions. Furthermore, the functions were warranted to satisfy certain specifications. It became clear that there were major problems with the system. USM unilaterally terminated the contract, and resisted suggestions made by ADLS to improve performance of the system. USM alleged breach of contract and deceit (similar to constructive fraud) against ADLS. The factual findings of the court included that ADLS was unduly optimistic regarding the speed at which the system was capable of performing, and that the term "free of defects and design" can be broadly construed to mean that ADLS was warranting that the system would meet the specifications designated in the contract.
At the conclusion of the contract litigation, USM sued ADLS’s carrier for the coverage the carrier provided to ADLS. In USM Corporation v. First State Insurance Company, 652 N.E. 2d 613, 420 Mass. 865 (1995), the Supreme Judicial Court rejected the proposition that the E&O policy did not cover losses arising from "special contractual commitments, such as express warranties, that exceed the normal obligations of a professional consultant to her client." 652 N.E. 2d at 614. Notwithstanding that the Supreme Judicial Court never found negligence, coverage was found under the policy because the loss was incurred by the insured "in the conduct of its business as consultants, and in the rendering of professional services incidental thereto." Id. The error that was committed was deemed inherent in the rendering of professional advice. The advice was wrong, although the error was non-negligent. Id. at 615.
These cases suggest that in each and every case where there has been a failure to perform that leads to a breach, coverage counsel should examine the transaction in order to determine whether a professional may have exercised professional judgment at some point. Since most of these computer functions are performed by specialists of one kind or another, what appears to be a garden variety breach of contract may well have been the result of a miscalculation by a software engineer or consultant committed during the scope of his or her professional duties. For example, if a consultant assures a client that a piece of software can be installed to perform as desired, and it does not, the breach of contract may arise out of a covered error or omission committed by the consultant in the evaluation of the software. At the very least, coverage counsel may be able to use the possibility that such an error occurred in order to negotiate a defense agreement, and quite possibly obtain a contribution toward indemnity in order to aid in the pretrial settlement of claims.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.