Cover Note Catastrophe

In following the company's internal procedures, K jointly signed with another director a cover note for issue to a client. The note incorrectly stated the package credit granted by underwriters to the insured as 5%; in fact it was 7.5%. Although the error amounted to a difference of two characters in two documents (slip and cover note) of over 20,000 characters each, as a result of the difference, the company fraudulently retained a hidden commission amounting to 2.5% of the gross premium for that policy year. This fraud, perpetrated by another director, had been ongoing for about 10 years and the commissions involved amounted to a considerable sum of money. It was not alleged, nor was there any evidence, that K was aware of or involved in the fraud. However, his error in failing to spot the inaccuracy in the cover note he signed became a disciplinary matter.

The Tribunal determined two issues:

• whether K should have checked the percentage figure allowed for the package credit; and
• whether his failure to do so was sufficiently serious to amount to misconduct.

Having reviewed the facts, the Tribunal referred to paragraph 6.1 of the Code of Practice for Lloyd's brokers which states:

The Tribunal also referred to the Memorandum of Loss Control circulated to all Lloyd's brokers in 1992 which stated:

The Tribunal concluded that the percentage allowed for the package credit was a significant term of the policy and that accordingly it was one which K should have specifically checked. On the second issue, Leading Counsel for K submitted that such a mistake was no more than human fallibility. The Tribunal disagreed. It went on to conclude that K's error amounted to serious negligence, finding him guilty of misconduct, namely failure to take reasonable steps to avoid harm to Lloyd's policyholders, the Society, its members or those doing business at Lloyd's.

On appeal, the Lloyd's Appeal Tribunal concluded that the Tribunal had in this regard merely found the individual guilty of "failing to take reasonable steps" and "in adding the adjective "serious" it was doing no more than making it clear that the failure in question went well beyond any mere technicality". The Appeal Tribunal upheld the decision..

It is difficult to justify a finding of serious negligence on the facts of this case. However, if it is accepted that the cover note is a condensation of the terms and conditions of cover (as the 1992 Memorandum of Loss Control suggests), it must follow that the cover note should contain all the significant terms of cover. It is therefore arguable that, following this decision, any mistake, typographical or otherwise, in a cover note signed by a broker can amount to misconduct. If the cover note contains an error, regardless of the result, misconduct has occurred. There is, to all intents and purposes, strict liability.

The harshness of this decision is illustrated by the facts of K's particular case. He had a long unblemished career, and it was accepted that his normal practice was to check cover notes thoroughly. His company had stringent internal procedures; a cover note (which was an electronic replication of the slip) would only be presented for signature by a director after being checked by at least one account technician. He was not involved in the placing of the particular risk. It was accepted that K was wholly unaware of the fraud being perpetrated. His error was comparatively small. Yet despite all this, K was penalised.

Although one may question the intention of such a harsh decision, irrespective of the issues of fairness and proportionality it raises, the decision does give a useful opportunity to consider the effect of paragraph 6.1 of the Code of Practice for Lloyd's brokers. There are a wide range of possible interpretations. Perhaps the narrowest is that, to comply with the Code, a broker need simply check that the cover note mirrors the slip. A broader interpretation is that a broker, before signing a cover note, is required to review the placing file completely to ensure, not only that the cover note reflects the slip, but also that the slip reflects the instructions received from the client and that the insurance meets the client's requirements - "the placing has been properly effected". Where there is no documentary evidence of the client's instructions, such an interpretation might require the broker to interview the account technician to establish the client's instructions before signing that cover note.

The decision involving K is consistent with the latter broader interpretation. Clearly, even the most well organised of brokers, with the most stringent of internal procedures, risk falling foul of paragraph 6.1 if its terms are interpreted that strictly.

The rigorous standards imposed could have dramatic results. Consider an E&O claim against a broker where it is alleged that the insurances arranged are not as instructed. A large number, if not the majority, of E&O cases arise from just such an allegation. If each E&O claim gave rise to subsidiary regulatory proceedings, not only could the cost to brokers and individuals be crippling, particularly where such costs are irrecoverable from E&O or D&O insurers, but the regulatory process might find itself overrun.

Although brokers undoubtedly accept that an effective system of regulation is required, some may feel relief that as from 3rd July 2000 they will no longer be regulated by Lloyd's. However, the story will not end there. Lloyd's has indicated on various occasions in the past that when it has finished with brokers, it intends to turn its attention to Managing Agents. If such a harsh regime is redirected to Managing Agents, there may be more surprises to follow.