"Crawl before you walk" is a phrase that applies to many different scenarios in life. From a business perspective, many entities flourishing today evolved from operations that began as sole proprietorships or partnerships. For whatever reason, some of the entrepreneurs still operate in the organizational form in which they began despite the disadvantages of unlimited liability. Others have moved on to corporate or other structures for a variety of reasons, one of which could be the advantage of limited personal liability.
Once the decision is made to move from one business structure to another, e.g., (1) sole proprietor to partnership to corporation, (2) partnership to a limited liability company, (3) partnership to corporation, or (4) any combination thereof, the time during which individual owners first "crawled" through the difficult periods in developing successful businesses is largely forgotten.
In many instances, entrepreneurs do not want to reminisce about the old days and hard times. Instead, they want to focus their attention on the goals of the future. In fact, many individuals do not want to be reminded of and often forget about the past. For the most part, there is nothing wrong with this, except possibly with respect to certain forms of insurance.
There is an actual case where an individual purchased a CGL policy which indicated that his construction business was being operated as a sole proprietor. About five years after he built and sold the house in question, the ceiling collapsed and injured the owner-occupants and damaged some of their furnishings. When suit was filed against the named insured, it addressed him as a sole proprietor, which was his capacity at the time of the construction.
The insurer balked at providing coverage and defense, claiming that at the time of injury, the policy was written for a corporation and did not include the liability of the named insured as a sole proprietor.
It certainly might have been better had the sole proprietorship name been carried forward with subsequent policies written in the corporation's name. Realistically, however, insurance applications do not ask for past organizational structures and producers are under no obligation to inquire.
Underwriters who are "digging" for information about applicants may find out about these past business relationships but they, too, are under no obligation to advise or inform. Unfortunately, the individuals who find out about these discrepancies are generally those involved in insurance claims where it may be too late to do anything about it, except to "bite the bullet."
If it turns out that the contractor is currently operating as a closed corporation, i.e., he/she is the sole or majority shareholder, it still may be possible for the individual to obtain insurance coverage or at least defense from the insurer. What must be shown here is that there has been no real change in exposure from when the corporate owner operated as a sole proprietor. It may be more difficult to argue this point where the corporation has many shareholders or has even become publicly owned.
Perhaps this actual case is remote, but the exposure is not. Another exposure that is as prevalent (if not more so) as the one confronting the development of a sole proprietor to a corporation is the one involving partnerships and joint ventures. Cases involving these entities are legion.
Liability policies give advance warning to insureds of past partnerships, joint ventures, and limited liability companies. The standard ISO commercial general liability policy makes this clear with the last paragraph of the Who Is An Insured provision. It reads:
No person or organization is an insured with respect to the conduct of any current or past partnership, joint venture, or limited liability company that is not shown as a Named Insured in the Declarations.
A similar type provision, barring the additional reference to limited liability companies, was a part of standard policy provisions since 1966. Even so, it has taken some actual cases to drive home the point that insurers are serious when they say coverage does not apply to current and past partnerships or joint ventures that are not listed on the policy as named insureds.
So these past entities need to be maintained on current policies for as long as possible, because insurable interests from a liability standpoint continue indefinitely, and the statute of limitations for filing suits varies with the nature of the claim.
Unfortunately, standard liability policy provisions do not, and have never, contained a similar warning to insureds about past sole proprietorships. Why this is so is uncertain. However, the exposure of a sole proprietorship being transformed into a corporation is as common as a partnership getting involved in joint ventures, or transforming into limited liability companies.
Winding up the business
Those who are successful in building businesses (as well as those who buy existing ones) often have an additional challenge when they want to retire. When a business is closed or sold, a number of complex legal issues can arise. When a contractor, for example, completes a structure, or a manufacturer places a product in the stream of commerce, liability arising out of those activities does not cease merely because the business is sold or closed, or the product is discontinued. In fact, it is not unusual for such liability to arise long after the business no longer is in operation or the product's manufacture or sale has been discontinued.
If a corporation (particularly a closely held one) is sold, it is important to determine if the seller has transferred all of his/her interest, or whether the buyer has taken only the assets of the corporation. If the seller retains the corporate shell and any liability that attaches to the entity, one issue is whether the remaining shell can pay for any subsequent liability.
Members of partnerships, joint ventures, and sole proprietorships who sell, close, or discontinue their operations still may remain responsible for their liability arising out of products or services they have placed into the stream of commerce, or out of work or services they have performed for others.
These gaps can be closed through the purchase of discontinued operations coverage, which applies to both products liability and completed operations liability exposures. This type of coverage is not required by a going concern that decides to discontinue making one of its products. As long as the manufacturer continues to maintain products liability insurance, protection continues for claims or suits arising from the discontinued product line.
However, if the entity goes out of business or is acquired by another business that refuses to accept any liability stemming from injury or damage that could arise from products made or sold prior to liquidation or sale, the entity may wish to consider the purchase of this coverage.
Another possible situation where this coverage could be considered is when a manufacturer begins business as a sole proprietor or partnership and eventually changes its business structure to a corporation. The problems relating to these developments were already discussed in this article.
Suffice it to say, unless the insurer of the current liability policy is willing to provide continuous liability protection (including products) for the former business structures, discontinued operations (including products) coverage also may be necessary.
Insurers willing to write discontinued operations or products coverage commonly use a so-called "junk code," 44444, and determine the premium in the usual way, i.e., based on the rate of the operation (receipts) or product (sales) as it existed prior to termination of the business.
However, the premium is usually reduced, for example, by 25% the first year, 50% the second year, or on a percentage based on underwriting discretion, until the premium reaches the policy minimum. It also may be possible to obtain this type of coverage from the excess and surplus market.
Sometimes prospects of discontinued operations (including products) coverage do not feel they need the coverage and often do not want to spend the money for what they are told might be necessary. If a prospect says "show me," a case in point could be Pekin Insurance Company v. Janes & Addems Chevrolet, Inc., et al., 636 N.E.2d 34 (App.Ct. of Ill. 4th Dist. 1994).
The court in this case held that liability policies providing coverage for property damage occurring during the policy period did not provide coverage for damages arising from a fire which occurred after the policies expired, notwithstanding that the fire was allegedly caused by seepage of chemicals from the insured's property during the policy period.
Under some professional liability policies, specialty insurers are willing to provide unlimited "tail" coverage, so that whenever a claim is made against a retired professional (in good standing), he/she is protected. Other retiring professionals are not as fortunate and, depending on the policy, may be able to purchase only an extended reporting period for a shorter duration.
Whether the business is written on an occurrence or a claims-made basis, certain coverage needs to be continued for as long as possible, given the uncertainty of a future claim brought about by past conduct. What those coverage needs will be hinges on the nature of the exposure and the facts of each case. *
The author
Donald S. Malecki, CPCU, is chairman and CEO of Donald S. Malecki & Associates, Inc. He is a committee member of the International Insurance Section of the Society of CPCU, on the Examination Committee of the American Institute for CPCU, and an active member of the Society of Risk Management Consultants.
©COPYRIGHT: The Rough Notes Magazine, 2000