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Law Firm's Organizational Form, Insolvency Affect Extent of Members' Personal Liability

Wednesday, March 14, 2012

By Joan C. Rogers  

CHICAGO—Law firms' switch to limited liability entities can give lawyers a false sense of security about their vicarious liability for claims arising from colleagues' conduct, according to a panel discussion March 2 at the 11th Annual Legal Malpractice & Risk Management Conference.

In launching the panel on “How Limited Is Your Liability?” moderator Allison D. Rhodes joked darkly that the real topic was “how we get your house.” The speakers focused on a question of keen interest to lawyers everywhere: Under what circumstances can members of a law firm be forced to write checks from their personal accounts to cover liabilities grounded on the activities of others in the firm?

Although lawyers are always liable for their own malpractice, it matters greatly how their firm is organized when it comes to personal liability, Rhodes said, noting that lawyers whose firms are healthy tend not to think about the liability shield and instead see the sad stories as limited to other firms.

Rhodes is a partner in the Portland, Ore., office of Hinshaw & Culbertson, the principal sponsor of the conference.

Fellow panelist Samuel L. Bufford pointed out that a law firm's structure matters if the firm goes bankrupt. For a firm that is a general partnership, he explained, the rule of thumb is that all partners go into bankruptcy too, unless they can pay all of the liabilities of the current firm—which can be a huge check. Bufford, a former bankruptcy judge, is now a professor at Penn State law school.

The other panel member, Robert W. Hillman, added that lawyers have reasons other than bankruptcy to care about the liability shield. When a firm takes on a partner with a book of business, “you take on all the baggage of that book,” he said. Hillman is a professor at the University of California, Davis, and the co-author of Hillman on Lawyer Mobility (2d ed. 2011) and The Revised Uniform Partnership Act (2011-2012 ed.).

History Lesson

Hillman explained that back in the old days—the 1960s—lawyers had no organizational choices other than partnerships with attendant joint and several personal liability. Chiefly for tax reasons, however, lawyers persuaded state legislatures to allow them to form professional corporations.

Although PCs were not originally created for purposes of limiting liability, that increasingly became an unintended benefit, Hillman explained. Although PCs still offer the advantage of limited liability in many jurisdictions, that is not the case in some jurisdictions, and in a fair number of states the liability shield provided by PCs is unclear, he said.

Limited liability partnerships, Hillman continued, emerged in Texas 21 years ago in reaction to the federal government's efforts to hold lawyers personally responsible for savings and loan losses that the government covered.

Originally the LLP statutes offered only a partial liability shield, but the statutes in many states now provide full protection, he noted.

Rhodes made the point that contractual liability is different from tort liability. I'm not aware of any statutes, she said, that put a lawyer in a limited liability entity personally on the hook for the firm's lease.

According to Bufford, lessors were well aware of this lack of personal liability and wanted a personal guarantee from lawyers. For a time landlords stopped demanding a personal guarantee, but they've started requiring it again, he said.

‘Deemed Guarantee.'

Rhodes said that because of regulators' sense that lawyers shouldn't have unlimited protection from liability, some states have adopted the concept of a “deemed guarantee,” in which the liability shield depends on carrying qualifying insurance. This “deemed guarantee” varies quite a bit among states, she said.

In California, Rhodes noted, LLPs are subject to a deemed guarantee, and lawyers in a PC are even required to sign a personal guarantee. When a law firm opening a California office finds out that its 300 partners must sign a personal guarantee, “that's a nonstarter,” she said, explaining that firms end up becoming LLPs to avoid the need to get that paper signed.

Elaborating on the concept of a deemed guarantee, Rhodes noted that the guarantee applies only if the lawyer does not carry malpractice insurance of a specified amount. But questions can arise if a claim exceeds the policy limits, she said, commenting that the California LLP statute is unclear on this point.

How Firms Are Organized

Rhodes said that a recent national survey of law firm listings in the Martindale-Hubbell directory found that:

  • 52 percent were professional corporations;
  • 23 percent were limited liability companies;
  • 11 percent were limited liability partnerships; and
  • 14 percent were general partnerships.

Hillman related that in his own survey a decade ago, 48 percent of firms were PCs; 7 percent were LLCs; 9 percent were LLPs; 26 percent were general partnerships; and 10 percent were sole proprietorships. See Hillman, Organizational Choices of Professional Service Firms: An Empirical Study, 58 Bus. Law. 1387 (2003).

As firm size increased, Hillman noted, the likelihood that a firm was organized as an LLP grew substantially; half of firms with 50 or more lawyers were LLPs.

While the percentage of firms that are general partnerships has dropped substantially over the years, the percentage that are PCs has remained steady at roughly half of all firms, Hillman pointed out. “I think that's very surprising,” he said.

Bufford speculated that part of the explanation could be inertia, in that PCs might be smaller firms that were incorporated years ago and just haven't changed their structure.

Rhodes noted that PCs are popular for small groups, especially for tax purposes. But “once a PC, always a PC,” because converting is a huge tax hit, she said, adding that “I'm constantly urging startups to form as an LLP.”

Unusual Figures

Highlighting some unusual figures about law firm organization, Rhodes noted that California has 39 firms organized as a limited liability company even though LLCs are prohibited by regulatory requirements there. The state also has 1,000 more PCs than LLPs despite the personal guarantee requirement for PCs in that state, she said.

And in 13 jurisdictions, she noted, general partnerships make up 25 percent or more of all law firms, despite the associated personal liability.

Hillman said that although the tax hurdle for PCs to convert to LLPs may explain their persistence, “I can't explain why a general partnership wouldn't convert to an LLP.”

After the collapse of Enron taught everyone about the potential for liability, firms no longer worry that converting to an LLP will be perceived as a negative signal, Hillman said, noting that in 2003 Cravath, Swain & Moore was the last major firm to switch to LLP status.

Regulatory Headaches

States have different requirements for organizing as particular kind of entities, Rhodes pointed out.

It's not uncommon at all, she said, to find that law firms have not complied with all regulatory filing requirements. Fifteen states require regulatory filings in addition to typical secretary of state authorizations, she said.

The penalty for failure to comply with regulatory requirements is that the lawyers no longer have the limited liability shield—the firm becomes a general partnership, she warned.

Variations in regulatory requirements among states mean that limited liability protection may not be available for some firms that expand across state lines, according to the panel materials.

Law Firms Belly Up

The panel also discussed another major influence on personal liability: law firm bankruptcy.

Firm bankruptcies are on the rise, and when a firm enters bankruptcy, all the rules governing personal liability change, according to the panel. When a firm goes bankrupt, not only are former partners potentially on the hook to repay profits from unfinished business. Healthy firms acquiring assets, lawyers, and clients from a bankrupt firm may face claims too.

When a law firm goes into bankruptcy, Bufford said, typically its leases are its biggest obligations. Firms can get a huge reduction in liability on a commercial lease by going into bankruptcy, and “this is the driver for most of the law firm bankruptcies,” he said.

Prominent bankruptcy cases involving three defunct firms—Heller Ehrman, Brobeck, Phleger & Harrison, and Coudert Brothers—have riveted attention on the potential liability associated with the transfer of unfinished business when law firm partners move from a bankrupt firm to other law firms.

As background for understanding the potential liability, Hillman explained that the income from unfinished business when a partnership dissolves is income of the firm to be shared according to partners' income ratios. This basic principle of partnership law was applied in the seminal California case Jewel v. Boxer, 203 Cal. Rptr. 13 (Cal. Ct. App. 1984), which held that former partners in a firm were entitled to their partnership share of income generated by the work of other former partners on cases that were active upon the firm's dissolution.

Although a lot of people mistakenly dismiss Jewel as merely a California case, Hillman said, it's been followed in a number of jurisdictions and rejected in very few. Furthermore, Jewel has been applied to LLCs and other forms of associations, and it has been applied to all work in progress, including hourly cases, he noted.

Rhodes pointed out that Jewel affects healthy firms that hire laterals because of the incoming lawyers' book of business. If the laterals left their practice because their firm went out of business or dissolved, “the assumption that you get to keep all those fees is an incorrect assumption because of Jewel,” she said.

Jewel recognized, Hillman noted, that this result can be changed by including a term in the partnership agreement that the firm shall have no continued interest in future fees of any client matters that departing partners take to subsequent law practice. Such an “anti-Jewel agreement” or “Jewel waiver” is a common provision in partnership agreements and is effective in most circumstances, he said.

Jewel in Bankruptcy Context

In the context of bankruptcy, Jewel means that profits from cases pending at the time of a law firm's bankruptcy filing belong to the bankruptcy estate, according to the panel materials.

In Brobeck's case, Bufford said, the bankruptcy judge found that when partners took business to their new firm without the former partnership getting reasonably equivalent value, that amounted to a fraudulent transfer. In other words, the former Brobeck partners lost, he said. Although the firm had a Jewel waiver, a contract can't waive federal law about fraudulent transfers, he noted.

Bufford said that although bankruptcy law has a two-year statute of limitations on claims for fraudulent transfers, many states have longer limitation periods. In California, he said, the limitation period for fraud is seven years.

For opinions discussing Jewel in the context of bankruptcy, see Coudert Bros. LLP v. Akin Gump Strauss Hauer & Feld LLP (In re Coudert Bros. LLP), 447 B.R. 706 (S.D.N.Y. 2011); Heller Ehrman LLP v. Arnold & Porter LLP (In re Heller Ehrman LLP), Bankr. Case No. 08-32514DM, Adversary Proceeding No. 10-3203DM (Bankr. N.D. Cal., April 22, 2011); and Greenspan v. Orrick, Harrington & Sutcliffe (In re Brobeck Phleger & Harrison LLP), 408 B.R. 318 (Bankr. N.D. Cal. 2009).

See also 27 Law. Man. Prof. Conduct 501 regarding unfinished-business claims in the Heller bankruptcy proceeding, and 21 Law. Man. Prof. Conduct 186 regarding the multimillion-dollar settlement of claims against former Brobeck partners.

The ABA/BNA Lawyers’ Manual on Professional Conduct is a joint publication of the American Bar Association Center for Professional Responsibility and Bloomberg BNA.

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