Rethinking the law firm organizational form and capitalization structure.

Author:Adams, Edward S.
 
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  1. INTRODUCTION

    The recent bankruptcy of large law firms has energized the debate over the viability of the traditional partnership model. Dewey & LeBeouf filed for bankruptcy in May 2012, becoming the largest law firm bankruptcy in U.S. history. (1) At its peak, Dewey employed 1,400 lawyers in several offices across the globe, causing some to ask whether Dewey's collapse was an isolated product of poor management or a symptom of greater systemic problems. (2) But Dewey's bankruptcy was not the first to result in the dissolution of a large firm. The financial downturn of 2008 deeply affected the legal profession, and several firms went under. (3)

    Many have already questioned the traditional business structure of the law firm in light of these bankruptcies and the manner in which they occurred. (4) Partner defections and limited capital place criticism squarely on the partnership model as a major factor in these bankruptcies. (5) Movements in Australia and the United Kingdom to liberalize law firm business structures and allow for both outside equity and multidisciplinary practices (MDPs) further fuel the criticism here in the United States. (6) The American Bar Association (ABA) Model Rules of Professional Conduct (Model Rules) have long prohibited public ownership and MDPs in law firms over concerns that such arrangements would encourage violations of the professional rules. (7)

    The goal of this Article is to examine the partnership model and advocate for a change in the Model Rules that would allow for public ownership of law firms, and to make disclosure of firm financials a mandatory requirement for all firms with over 100 lawyers. Part II explores the history and evolution of limited liability and law firm structures in the United States. Part III discusses incorporated law firms and MDPs and how they might benefit U.S. law firms. Part IV looks at the developments in the United Kingdom and Australia and the forces of globalization that have an effect on U.S. policy choices, concluding that global competition for legal services may force our hand. Part V advocates for similar changes in the U.S. public ownership because allowing public ownership in law firms will benefit both law firms and their clients and make firms more competitive globally. This Part concludes by advocating for mandatory disclosure requirements to benefit firms, prospective attorneys, and their clients.

  2. THE EVOLUTION OF LIMITED LIABILITY AND LAW FIRM STRUCTURES

    The formation and governance of business entities is regulated by state law. (8) Each state has a history of corporate and partnership regulation, and in recent decades new hybrid forms of business entities have evolved to fill the needs that corporate and partnership laws alone do not adequately address. (9) Law firms have been adopting the new business models made available by state statutes. (10) Most notably, law firms have begun taking advantage of limited liability. (11) While the evolution to limited liability within law firms has been a huge transformation, states have not yet enabled law firms to utilize other business forms that would allow them to have both limited liability and the ability to manage capital accounts and cash flow in a way that would leave firms less vulnerable to the exit of a partner or broader outside economic influences.

    1. The Evolution of State Partnership Laws and Their Effect on Law Firm Structures

      General Partnership (GP) law was originally codified in 1914 (12) and became the standard business form used by law firms. (13) The most attractive characteristic of the GP is the pass-through taxation of firm income, in which partnership profits are not subject to an entity-level tax but rather are taxed as personal income only when the partners receive a profit distribution. (14) More and more firms, however, have foregone the traditional GP form to instead partake in attractive limited liability entities such as limited liability companies (LLC) and limited liability partnerships (LLP). (15) Whereas in a GP each partner is exposed to "unlimited[] personal[] liability] for both the misconduct of his or her partners, as well as any debts of the partnership to the extent that either exceed the assets of the partnership," (16) in the LLC or LLP entities the respective member or partner (collectively "member") can at a minimum limit their personal liability to their own torts and thus remove any personal liability for the torts of other members. (17)

      The LLC entity was first introduced in Wyoming in 1977. (18) Florida was the only other state to enact an LLC statute until the Internal Revenue Service (IRS) explicitly acknowledged that LLCs would be recognized as partnerships. (19) After the IRS made this acknowledgement, many states quickly jumped on the limited liability bandwagon hoping to lure new business into the state to take advantage of corporate tax revenues, as well as investment capital. (20) By 1995, all but three states had enacted LLC statutes. (21) One of the primary disadvantages of LLCs is that the formation of an LLC, depending on the state, essentially requires the creation of a new business entity. (22) LLCs are at a disadvantage because this business form has not been fully tested in courts, meaning that potential complications that could arise under securities and tax laws have not been fully explored. (23)

      Although they are more recent additions in the land of hybrid business forms, LLPs have quickly grown in popularity, becoming more attractive to law firms than the LLC form. (24) LLPs first emerged as a new business form in Texas in 1991 and initially limited a partner's vicarious liability only to malpractice claims resulting from actions (or omissions) of other partners. (25) The LLP structure appeals to professional partnerships, such as law firms, for a variety of reasons: (1) the firms can continue to function as they did before with the added benefit of limited liability as to both tort and contract claims; (2) unlike LLCs, the LLP form does not require partnerships to create an entirely new type of business entity; and (3) the LLP form allows for the continued tradition of professionals holding themselves out as "partners" (rather than as "members"). (26) Within a year of the emergence of the LLP structure, the IRS issued an important ruling confirming that LLPs would continue to be taxed as partnerships, allowing the continued use of pass-through taxation. (27) Within six years, LLP legislation exploded across the United States and many states expanded limited liability to "full shield" protection, providing for limited personal liability for both tort and contract claims. (28) This type of full shield protection is necessary in large firms where not every partner can ensure the accountability of everyone else. (29) This race among states to attract more revenue was to the benefit of business and professional firms, not necessarily the clients whose ability to pursue individual partners or lawyers for malpractice or malfeasance was thereby diminished. (30)

      LLP formation is simple. Most states have a filing requirement to put the public and the state on notice that the firm desires to conduct business under the shield of limited liability. (31) The extent of protection from liabilities varies greatly between jurisdictions. (32) In general, an LLP partner has partially limited liability for the negligence, wrongful acts, and other misconduct of other partners. (33) In an increasing number of jurisdictions, partners have no personal liability for any partnership debt (unless sophisticated creditors contract around it, of course). (34)

      Since LLPs are an extension of GPs, they are still based upon the classic structure wherein the partners are co-owners of the firm, sharing in the firm's profits, losses and risks. (35) Additionally, LLP partners may participate in management while maintaining their limited-liability shield. (36) LLPs are also financed through capital contributions from the partners, just like in the traditional GP. (37) These contributions are put into capital accounts and historically have made up a large percentage of a firm's assets. (38) Despite the fact that individual partners' liability is limited, the LLP is still fully liable for any claims against the entity; as a result, all the partnership assets--such as the funds within the capital account--remain at risk in connection with any such liability. (39)

    2. Law Firm Capital Accounts and the Struggle for Viability Through a Partnership

      Law firm capital accounts hold the firm's working capital. (40) An increasing number of firms have attempted to maximize earnings per partner (the frequently-used metric for law firm profitability) by limiting the number of equity partners in the firm. (41) This has created a two-tiered system of "partner" titles in the firm: the first-tier "rainmakers," who are the highly-coveted equity partners who bring in and maintain clients, (42) and the second-tier non-equity partners. If, or when, the rainmakers leave, they can take their clients with them, and--even more perilous to the company--withdraw their capital contributions. (43) Such an exodus of capital and the partner's associated cash flow, as well as the related problem of the firm sometimes replacing that missing capital by excessive leveraging, has resulted in an astounding number of law firms collapsing. (44)

    3. LLP Statutes Have Provided Law Firms with the Most Beneficial Structure Yet, but Are Not Without Limitations and Problems

      Three main issues limit the attractiveness of LLPs: (1) the uncertainty of vicarious liability, (45) (2) the lack of incentive for firms to invest in their associates for fear that they will gain knowledge and then leave for a "better" job, (46) and (3) the ethics mandate preventing non-lawyer ownership. (47)

      Over the last forty years, firms have created a myriad of hybrid structures in an effort to balance the...

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