You Wanna Do What? Attorneys Organizing as Limited Liability Partnerships and Companies: an Economic Analysis

Publication year1995

UNIVERSITY OF PUGET SOUND LAW REVIEWVolume 19, No. 2WINTER 1996

You Wanna Do What? Attorneys Organizing as Limited Liability Partnerships and Companies: An Economic Analysis

Mark Rosencrantz(fn*)

A law school graduate should expect to be sued at least three times in his career.(fn1) In 1989, I thought I understood what my professional responsibilities were. Now I don't have a clear understanding of what law is applicable.(fn2)

I. Introduction

It could happen to any law firm in America. Someone makes a drafting mistake, overlooks a filing date, or merely misinterprets a statute or case. The result can be enormous liability that taps not only into a firm's assets and malpractice insurance policy, but also into the pockets of individual partners; on the line could be a partner's house, car, investments, even the Matisse hanging on his wall. Just ask the partners at the white shoe Wall Street firm of Kaye, Scholer, Fierman, Hays and Handler (Kaye Scholer).

Their saga began in June 1986, when Peter M. Fishbein, the partner in charge of the Lincoln Savings and Loan Association (Lincoln) account and former chairman of the firm, was called in to help the thrift through a difficult examination by the Federal Home Loan Bank Board, the predecessor agency of the Office of Thrift Supervision (OTS).(fn3) After Lincoln failed, regulators claimed "that Kaye Scholer had concealed damning information about Lincoln from the government."(fn4) Regulators further claimed "that the firm had a responsibility to the public, not just its client."(fn5) In addition to requiring Kaye Scholer to pay a monetary fine, regulators insisted that Mr. Fishbein agree to lifetime banishment from practice involving thrifts.(fn6)

When Kaye Scholer decided to fight, the OTS answered by filing administrative charges, seeking $275 million from the firm and an order permanently barring Mr. Fishbein and three others from practice involving federally insured banks and thrifts.(fn7) The OTS then froze the partnership's assets.(fn8) Kaye Scholer was thus forced to capitulate to a $41 million settlement "and the humiliating ostracism of Mr. Fishbein from bank and thrift practice."(fn9) The first $25 million was covered by the firm's malpractice insurance, but the partners were left to pay the remaining $16 million out of their own pockets.(fn10) Other firms have also been forced to pay huge settlements over work done for thrifts, including Jones, Day, Reavis and Pogue (Jones Day), the nation's second-largest law firm,(fn11) Wall Street's Paul, Weiss, Rifkind, Wharton and Garrison;(fn12) and O'Melveny and Myers.(fn13)

The increase in liability that attorneys face today is by no means limited to the savings and loan (S and L) crisis, however. Changes in attorney malpractice law and the commercialization of the practice of law have also contributed to the phenomenon of increased liability. As a result of this increase, attorneys now take a long, hard look at the way their firms are organized, often opting for business forms that offer limited liability. As one commentator recently remarked, "Throughout the nation . . . [the use of limited liability forms for professionals] is a tide that is definitely rolling in."(fn14) Although many states have for years recognized the personal services corporation, or PC, two new forms are beginning to loom large on the legal landscape: the limited liability company (LLC) and the limited liability partnership (LLP).(fn15) Both forms seem to offer firms the characteristics they desire most-limited liability and pass-through taxation.(fn16)

Although many states have embraced the concept of limited liability for attorneys, approval is not universal. Rhode Island and California statutorily ban attorneys from practicing in such forms.(fn17) Further, even those states that have embraced the concept recognize concerns that, under a limited liability scheme, the quality of attorney work may suffer, and sufficient funds may not be available for potential plaintiffs.(fn18)

This Comment argues that attorneys should be allowed to limit their liability by using the LLP and LLC forms to provide relief from the upsurge of liability because traditional arguments against attorneys' use of such forms ignore the changes that have taken place in the practice of law and the dynamic of economic forces, both of which operate as a counterweight to liability limitation.(fn19)

Section II sets out the traditional arguments against allowing attorneys to limit their liability. It then provides a brief history of limited liability forms and describes the important characteristics of PCs, LLCs, and LLPs. Section III examines the forces driving firms towards limited liability. It looks at the increase in legal malpractice suits, the impact of the S and L crisis, and changes in the law of attorney malpractice, all of which have created an untenable situation. Further, this section examines changes that have occurred in the practice of law, including changes in how attorneys organize and view their practices, and the effects those changes have had on malpractice insurance. Finally, Section IV examines the current legal marketplace from a law and economics perspective, detailing the factors that drive actors to act as they do. It further applies that perspective to the behavior and motivations of attorneys in today's marketplace. This Comment ends by examining the massive externalizations taking place because of the current malpractice crisis.

II. An Overview of the Limited Liability Landscape

Traditionally, attorneys have not been permitted to limit their potential liability to clients. However, limitations on liability such as those afforded by PCs have recently come into play, and LLPs and LLCs have also emerged as new possibilities. Part A of this section sets out the traditional arguments against allowing attorneys to limit their liability. Part B provides a brief history of how and why attorneys have organized, and parts C, D, and E examine the PC, LLC, and LLP forms respectively.

A. The Three Traditional Arguments Against Allowing Limited Liability

Traditionally, three arguments have been advanced against allowing attorneys to limit their liability to clients.(fn20) First, courts and commentators assert that limited liability will thwart a client's legitimate expectation that the entire firm will be engaged on her behalf.(fn21) The Supreme Court of Georgia echoed this concern when it wrote:A lawyer's relationship to his client is a very special one. So also is the relationship between a lawyer and the other members of his or her firm. . . . When a client engages the services of a lawyer the client has the right to expect the fidelity of other members of the firm. It is inappropriate for the lawyer to be able to play hide-and-seek in the shadows and folds of the corporate veil and thus escape the responsibilities of professionalism.(fn22)

Second, courts and commentators assert that the practice of law is a professional service, not a commercial business,(fn23) and that limited liability might erode "traditionally rigorous notions of legal responsibility."(fn24) Courts require professionals to "exercise the learning and skill ordinarily possessed by members of their profession in the community."(fn25) Consistent with this requirement for professionals, courts have required attorneys to exercise "that degree of care, skill, diligence and knowledge commonly possessed and exercised by a reasonable, careful and prudent lawyer in the practice of law."(fn26) Toward that end, attorneys have been prohibited from engaging in certain types of conduct, such as contracting out of the duty of care.(fn27)

Finally, courts and commentators assert that limited liability may leave injured clients with inadequate remedies.(fn28) This assertion assumes that unless all of a firm's attorneys can be held personally liable, a deserving plaintiff may be unable to collect on his or her judgment.

B. A Brief History of Limited Liability Forms

Prior to the 1960s, law firms organized exclusively as partnerships.(fn29) Incorporation of professional organizations was so unusual that some states required approval by the state legislature,(fn30) and others denied it altogether.(fn31) The noncorporate status of the professional was considered necessary to preserve for clients "the benefits of a highly confidential relationship based upon personal confidence, ability, and integrity."(fn32) Unlike other businesspersons, attorneys were (and in some states are still) viewed primarily as public service providers.(fn33) Some states feared that professionals, if allowed to incorporate, would emphasize the business aspect of their professions rather than the service aspect, and clients would suffer as a result.(fn34)

The 1960s, however, saw the advent of "traditional" PC statutes. Interestingly, the adoptions of the first PC statutes were driven by professionals who wanted corporate tax status, not limited liability.(fn35) Because professionals were historically organized as partnerships, they were taxed as such; thus, they were unable to obtain any of the employee fringe benefits available only to corporations.(fn36) A few partnerships found relief in 1960 when the Internal Revenue Service (IRS) adopted the Kintner Regulations,(fn37) under which professional associations could be taxed as corporations if...

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