A Web site/e-business platform developer was contracted to develop a company's Web site. Time passed, and the customer became frustrated with the vendor's failure to meet project milestones.
In addition, the customer alleged that the vendor misrepresented its capabilities and supplied personnel not capable of completing the project. The case went to trial, and although the vendor argued that the customer failed to identify specific work required and repeatedly altered the project's specifications, the jury awarded the plaintiff $608,402 in damages. The case is on appeal, and the legal expenses to date exceed $1.5 million.
This is just one example of a small technology firm being held responsible for substantial damages when its software services or products fail to function in a proper manner.
While every technology firm is at risk for this type and magnitude of liability, surprisingly few purchase any or adequate Errors & Omissions (E&O) liability limits to protect themselves from claims.
Sure, the chances of a loss may be small, but in some instances, the cost of the loss can be high and may even affect the firm's solvency.
The first step toward determining fair and responsible payout limits for an E&O policy lies in understanding the nature of the coverage. Errors and Omissions policies have two provisions or payout "buckets." These consist of payment for the legal defense expenses in defending a covered loss and the indemnity payment resulting from a settlement or court order.
In contrast to automobile and general liability coverage, both the legal defense costs and the final indemnity payments erode the E&O liability limit in most states. Defense costs can eat up a large portion of the liability limits leaving companies to pay all or a portion of the indemnity out-of-pocket when limits are not adequate.
More than 700,000 technology firms exist in the United States and a vast majority of them have fewer than 25 employees. A large percentage of these firms don't purchase E&O liability limits, or only purchase the minimum limits they are required to carry to obtain a contract. They are focused on developing and delivering their products and services and are not necessarily thinking about insurance and risk management. Owners of these companies often assume that because they are small, they will not be sued or will not be sued for large sums of money. They may rely heavily on protections written into contracts and overlook the legal cost that may be involved to defend their contract in a claim. They are confident in the technology they develop, believing they can quickly fix any problem that arises.
Also, many companies believe they are developing technology that is incorporated into the software or hardware of others thereby eliminating the risk of a claim being filed against them.
These companies would do well to realize that today small firms are being held accountable and liable for product or work failure just as much as large firms. A shift in the vendor/customer relationship in recent years has made small firms vulnerable in this regard. With revenues on the line, customers, end users, or operating equipment manufacturers are far less tolerant of bugs, flaws in the system, incompatibility, or expectations not being met and they have no qualms about suing to recoup losses suffered because of these issues.
By the same token, the business relationship between technology vendor and customer has eroded, resulting in the customers' reduced tolerance for errors or omissions in products or services obtained from the vendor.
With so many alternatives available to the customer, they are quick to try new, different or better products.
SIZE ALWAYS A FACTOR
Several factors, other than the size of the firm, govern the wise purchase of E&O liability limits. The size of the contract the firm enters into is a good indicator of the minimum limits a firm should obtain. A firm should determine the largest contract it has or may enter into prior to determining the limits it will purchase.
It also needs to consider the size of the customers with which it is contracting or doing business. The larger the firm, the higher the limits it should purchase. In deciding upon the amount of limits to purchase, a firm should consider both the complexity of its product or service, as well as the complexity of any hardware or software it is providing. A good rule of thumb is the more complex the product, the higher the needed limits.
When working as a subcontractor for a larger company, technology companies may assume that they will not be held liable for malfunctioning software because the insurance coverage carried by the larger contracting company will protect them.
Unfortunately, in many instances, that is not the case. In fact, subcontractors may be bound by their contracts with larger companies to purchase adequate E&O coverage as a condition of doing business. The size and type of customer involved will provide some parameters for setting limits.
Large companies with vast financial resources and in-house legal counsel tend to be aggressive in protecting their capital and may not hesitate to take action against a smaller subcontractor in order to protect both their invested financial resources and recoup losses from a potential business interruption incident.
At the outset of any project, technology companies should examine the size and importance of the project from the client's point of view and ask themselves, "How much do they have to lose if the software fails?"
The answer will, in part, dictate the breadth and depth of the E&O coverage that should be put in place.
While many software start-up entrepreneurs tend to be optimists who don't think in a "worst-case scenario" mindset, it would behoove them to do so when contemplating their E&O coverage. Reviewing all possible negative scenarios and working to prevent and mitigate them is the essence of any exercise in effective risk control.
Finally, the complexity of the project and relative probability of failure must be taken into account.
Again, no software developer likes to anticipate failure or a problem that can't be easily fixed.
However, it's important to accept the fact that the bigger the project, the bigger the chance something will go wrong which could result in a claim. This is not pessimism. It is smart risk management.
With these guidelines in mind, technology companies can begin to approach the important decision of setting their E&O liability limits with confidence and answer the question: "How low is too low?"
is senior vice president of strategic development for the Global Technology Underwriting business unit of Travelers.
November 1, 2006
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