Putting the “limited' into law firm partnerships

The search for limited liability through changing a firm's structure may turn out to be the solicitor's Holy grail – forever unattainable, says Stephen Netherway. Stephen Netherway is a solicitor in the insurance and reinsurance group at Cameron Mckenna and co-author of Limited Liability for Professional Partnerships. Troubled by the extent of partnership liability, specifically potential unlimited personal liability? Worried about “doomsday” litigation leading to personal bankruptcy?

There are three ways a firm can respond: by limiting liability case by case in contractual agreement with clients; by changing the business structure of the firm; or by improving risk management.

The contractual route, increasingly used by other professionals, usually involves “capping” clauses which limits a firm's liability for economic loss arising from negligence.

Professionally, solicitors can seek to cap liability provided the cap is not below the compulsory minimum level of professional indemnity cover. But there are legal restrictions:

solicitors cannot contractually limit their liability to their clients in respect of contentious business (s60, Solicitors Act 1974); and otherwise permissible limitation clauses are valid only if they comply with the applicable provisions of the Unfair Contract Terms Act 1977 and the Unfair Terms in Consumer Contract Regulations 1994.

The biggest argument against using such capping clauses is that they may be commercially unacceptable to clients, who could take their instructions elsewhere.

So is changing your business structure the answer? Until recently solicitors had little option but to practise together in general partnership. Now they can incorporate their practices pursuant to the Solicitors' Incorporated Practice Rules 1988. But stringent conditions must be observed, such as securing Law Society approval and continuing to comply with the Solicitors' Indemnity Rules.

There may be other disincentives to incorporation:

The terms of the partnership agreement may mean that a “seamless” incorporation of a partnership business is possible only if all partners agree.

Double taxation. A discontinuance of the partnership will occur for income tax purposes and significant capital gains tax and stamp duty liabilities may also crystallise upon transfer of firm assets. While certain tax relief may be available to offset these liabilities, not all liability may be extinguished. A form of double taxation may also occur; those who become directors will be subject to the less favourable Schedule E income tax regime on personal income received and the new company will also be subject to corporation tax. Higher national insurance contributions will also be payable.

More information, such as accounting details, must be made publicly available after incorporation.

The process of incorporation will cost money, such as paying for independent professional advice, securing run-off insurance cover for on-going partnership liabilities and so on.

The incorporation route does not get rid of all personal liability. Directors can still be liable for actions for breaches of a number of Company Acts provisions and for acts taken by the company (Evans v Spritebrand [1985]), and they may still be found to assume personal duties of care in certain circumstances.

Conversion into a limited liability partnership (LLP) will soon be another option for solicitors to consider. LLPs have their origins in the US and permit a firm to possess a separate legal personality yet allow a partner to escape personal liability for the firm's negligent acts or omissions unless that partner caused the negligence in issue. LLP status is not yet recognised under English law but Jersey already has a LLP regime in place which is potentially available to UK professionals.

But Jersey LLP status appears not to be an option open to English law firms. The relevant Jersey law states that an LLP is not a “body corporate”. Therefore:

it is incapable of becoming a “recognised body” for the purposes of the Solicitors' Incorporated Practice Rules; and as it cannot qualify as a solicitor, it cannot be a “qualified person” for the purposes of the Solicitors Act 1974.

But practising as a UK LLP is likely to be a possibility in the near future. The Department of Trade and Industry (DTI) published a consultation paper on this topic on 20 February 1997 and legislation permitting LLP status for professional firms is now reportedly under serious consideration by the Labour Government. If the DTI paper proposals are broadly followed it may include the following:

A UK LLP will have a separate legal identity from its members and, provided the firm remains solvent, its members will be personally liable only if they themselves are personally negligent.

More detailed accounting and other firm information would have to be made public, and a system of registration for LLP firms would be created.

A financial bond will probably be required at the outset, as security for firm's general creditors in the event of its insolvency. The DTI paper has also proposed so-called “clawback” provisions in the event of insolvency, allowing partners' drawings to to be reclaimed if made within a specified period prior to the firm's insolvency.

It may well be that the start-up costs of quasi-incorporation will prohibit all but the largest firms from seeking UK LLP status. Retaining clients when moving to LLP status will be crucial commercially.

Even if all these hurdles are jumped, the limited liability protection offered by a UK LLP may prove illusory. The courts often construe that all partners in a firm participate in a negligent act or omission.

The third option, preventing litigation by implementing risk management, is open to firms of all sizes. Arguably this is the most effective means of limiting liability. Steps include:

building up good relationships with clients (goodwill may promote business solutions to problems);

ensuring that domestic assets are legally ring-fenced from potential liabilities arising from alliances with foreign firms or from foreign offices;

buying satisfactory levels of insurance cover from a reputable insurer; and implementing and maintaining quality control standards, including investing in training and employing high-calibre people.

Most firms will face litigation at some point and, although most cases settle within the limits of professional indemnity insurance, it only takes one catastrophic claim to cause partners many sleepless nights.

Pending any substantial change in the laws of partnership and/or joint and several liability, solicitors are wise to remain alive to the options available to protect their practices against the ultimate doomsday scenario.