LLP Q&A

LLCs, LLPs and S.C.s: The Rules for Lawyers Have Changed

By Clay R. Williams

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On March 18, 1997, the Wisconsin Supreme Court amended the Supreme Court Rules of Professional Conduct for Attorneys (the "Rules") to allow lawyers to avoid vicarious liability by practicing law in the form of limited liability companies (LLCs), limited liability partnerships (LLPs) and Service Corporations (S.C.s). In doing so, the court has made clear that effective July 1, 1997, there will be no ethical impediment to lawyers organizing and practicing law within a limited liability entity. (The court's order 96-02 creating the new Rule accompanies this article.)

The new Rules, SCR 20:5.4(d) and 20:5.7, in consonance with the legislation concerning LLCs, LLPs and S.C.s, do not address the liability either of the entity or of the lawyers actively engaged in representing a client within those organizations. They do allow, however, lawyers to avoid the vicarious liability previously risked by members or shareholders of such organizations for the acts or omissions of others. In approving the use of such organizations the court required:

1) Annual registration with and fee payment to the State Bar of Wisconsin;

2) Professional liability insurance for firms as follows:

• a) 1-3 lawyers, $100,000 per claim/$300,000 aggregate;
• b) 4-6 lawyers, $250,000/$750,000;
• c) 7-14 lawyers, $500,000/$1 million;
• d) 15-30 lawyers, $1 million/$2 million;
• e) 31-50 lawyers, $4 million/$4 million;
• f) 51 or more lawyers, $10 million/$10 million;

3) Inclusion of a written designation of the firm's limited liability structure as part of its name; and

4) The provision to clients and potential clients in writing of a plain-English summary of the limited liability features.

Wisconsin's Limited Liability Company Act, Chapter 183 of the Wisconsin Statutes, enacted in 1993, authorized the creation in Wisconsin of the then new form of business organization, the LLC. In 1995 Wisconsin continued to reflect the nationwide trend toward flexible business organizations by adopting 1995 Act 97, which provided for the creation of LLPs. Furthermore, as of July 1, 1996, S.C.s organized under Chapter 180 were allowed to limit the liability of shareholders in the same manner as members of LLCs and LLPs. ¹ All of these general business statutes - Chapter 183, Act 97 and section 180.1915 of the Wisconsin Statutes - are silent as to whether these vehicles can be used in practicing law. Under all three statutes, the organization's members are not personally liable, under ordinary circumstances, for the errors, omissions or contract claims of their comembers or coshareholders, beyond their investment in the organization. With the passage of this recent amendment to the Rules, attorneys practicing in Wisconsin know they can form limited liability vehicles without violating any ethical standards.

Background

In the past, Wisconsin allowed the practice of law individually, in a general partnership or in a corporation. A general partnership organized under Chapter 178 remains available for use by Wisconsin lawyers, unaffected by the LLC and LLP statutes. A corporation organized under subchapter 19 of Chapter 180, the Wisconsin Business Corporation Law, generally has been accorded tax treatment as a corporation, but the statute previously provided that service corporation shareholders had the same vicarious liability for the acts of other shareholders as did partners in a general partnership. No other state's corporation statute contained such a provision.

Effective July 1, 1996, the Legislature extended to service corporations the same limitation of vicarious liability contained in the LLP and LLC legislation. ² Following this legislative extension of protection, attorneys who operated as a service corporation found themselves in the same catch-22 as lawyers desiring to organize their firms as LLCs or LLPs. Although technically attorneys had the statutory authority to organize as a limited liability entity, there was no conclusive answer as to whether lawyers could do so ethically since the Rules did not address the question clearly.

National Trend

Wisconsin continued to be an anomaly as most of the states allowed some limitation of vicarious liability for lawyers. When the State Bar petitioned the Wisconsin Supreme Court in early 1996, there were only a few states remaining in which it was either forbidden or unclear whether attorneys could form a limited liability entity for the practice of law. ³ Yet even while Wisconsin was considering a change, this list was decreasing. On July 1, 1996, the Georgia Supreme Court reversed itself and specifically approved legislation allowing lawyers to practice in limited liability entities. ⁴ Several states have conditioned the ability to practice law in limited liability entities upon meeting certain financial responsibility requirements or upon providing certain amounts of liability insurance. Wisconsin has now joined this last group.

Numerous bar associations also have drafted and generated ethics opinions allowing attorneys to practice with limited vicarious liability. ⁵ For example, the American Bar Association issued an ethics opinion as early as 1961 in which it indicated that where appropriate safeguards are used, attorneys were entitled to practice as professional corporations. ⁶ More recently, in ABA Formal Opinion 96-401 of Aug. 2, 1996, the ABA Standing Committee on Ethics and Professional Responsibility opined that lawyers are permitted by the ABA Model Rules to practice in LLPs or similarly limited entities. Indeed, several states also have applied the principle found in ABA Model Code of Professional Responsibility EC6-6 to limited liability companies and limited liability partnerships. ⁷

Why the Change

Originally, ethics rules and partnership rules evolved separately but contemporaneously, and it was not the ethics rules that dictated the vicarious liability of attorneys but rather partnership law that imposed joint and several liability. ⁸ Thus, imposing vicarious liability on attorneys practicing in the form of general partnerships historically has not been required by ethics rules but rather by the partnership law that arose from the late 1700s.

Several factors reflect changes in the current practices of law firms and are the bases for limiting vicarious liability of attorneys. These factors include the changes in the legal profession that tend to prevent close lawyer monitoring: that is, the rapid growth in the number of lawyers in the past 25 years; the rapid growth in the number of mid-sized and large law firms; the establishment and operation of branch offices for larger law firms; the increasing specialization and departmentalization of law firms; and the changing definition of legal malpractice in which courts have more frequently entertained new legal malpractice theories for imposing liability upon attorneys. ⁹ Imposing vicarious liability may result in inequitable treatment of certain attorneys in a law firm. In response to this inequitable treatment, attorneys have sought to use limited liability entities. These practical considerations explain why vicarious liability no longer works as an effective tool to promote lawyer monitoring.

In addition, attorneys have become increasingly vulnerable to multi-million dollar lawsuits - lawsuits founded both on malpractice and other tort-like claims and contract claims, often including punitive damages. ¹⁰ Thus, not only are law firms increasing in size but the settlements and judgments for actions against law firms are increasing in size and frequency. These trends place more attorneys who achieve their goals of becoming a successful member of a reputable law firm more at risk for the actions of other partners over which they have no control. The wholesale bankruptcy of every member of a law firm adversely affects the legal matters of all clients of the firm.

Quality Assurance

It has been argued that permitting the use of limited liability entities by attorneys may result in lower-quality legal service for clients. But there is little question that it is the desire of all attorneys in a law firm, to the extent they are able, to protect the firm's reputation, goodwill and assets.¹¹ Those assets include the firm's accounts receivable, work-in-process and other assets, all of which remain exposed to claims. Thus, a law firm's partners and shareholders still have the necessary incentives for generating quality legal work without the added burden of imposing vicarious liability among the members.

Mandatory Malpractice Insurance

By conditioning a lawyer's ability to limit vicarious liability on maintaining a current annual registration and mandatory liability insurance with prescribed minimum coverages, the Rules recognize that many law firms are not well capitalized and that eliminating vicarious liability may, in some cases, limit a client's recourse for malpractice. The insurance requirement is an alternative to capitalization that is more easily attainable while providing a recourse for clients that, unlike conventional capitalization, is not subject to fluctuations because of liabilities or financial stresses not related to malpractice claims. This Rule should help decrease the number of uninsured Wisconsin lawyers.

The Rule's minimum limits are not so high, however, as to place the Rule's benefits beyond the practical reach of lawyers in smaller practices. Wisconsin lawyers are not presently required to maintain malpractice insurance, minimum levels of capitalization or to demonstrate financial responsibility in any manner as a prerequisite to licensure and authorized practice. Indeed, some data suggests that many lawyers have no malpractice insurance at all.¹² As a condition to limiting vicarious liability, the Rule requires minimum insurance coverage on a variable scale depending upon the number of lawyers in the firm.

The collateral benefits of mandatory insurance should not be overlooked. Careful scrutiny by underwriters may well improve the internal controls and systems of lawyers and law firms that previously have not had to participate in that process.¹³ Those lawyers and law firms unable to secure minimum levels of coverage because of their claims experience or the want of suitable internal controls arguably should not qualify for limited liability in any event. The insurance requirement increases both a client's protection after malpractice and the client's chances that such malpractice will not even occur.

Liability and Obligations

The change in the Supreme Court Rule of Professional Conduct is for the most part purely a statement of ethics by the Wisconsin Supreme Court. Section 20:5.7(a)(2) of the Rules limits the operation of the Rule to situations of vicarious liability. A lawyer's personal liability arising out of his or her own acts, errors and omissions remains unaffected. This is a feature of the law in virtually every other state that has allowed limitation of vicarious liability of lawyers.

In large measure a lawyer's ethical responsibilities under the Rules operate independently of the lawyer's civil liability for professional negligence. Subsection (c) continues that separateness. Even a lawyer satisfying all of the Rule's requirements for limiting vicarious liability still is subject to discipline for failing to maintain client confidences (SCR 20:1.6); failing to enforce compliance with the Rules generally (SCR 20:5.1); and failing to supervise subordinate attorneys and nonattorneys (SCR 20:5.2 and 20:5.3). ¹⁴ To allay any concerns that lawyers with limited vicarious liability may become less attentive to these ethical responsibilities, the Rule reminds lawyers that these duties remain undiminished.

Public Notice and Registration

The Rule makes specific provision for public notice and notice to clients. Most states do not require such extensive notice, although a few have imposed various disclosure requirements as a precondition to eligibility for limited liability.¹⁵

The Wisconsin Supreme Court has required three basis forms of notices as part of the Rules: 1) registration with the State Bar; 2) inclusion of a written designation of the limited liability structure as part of the name; and 3) provision of a plain-English written summary of both the features of the operative organizational statute and SCR Chapter 20.

Registration with the State Bar must be annual, on a form to be provided by the Bar, accompanied by a fee yet to be announced. The registration must include the information called for by SCR 20:5.7(b), including a certificate of insurance reflecting the required limits. (Note: The State Bar will mail this form to all Wisconsin law firms in May or download the form here.*) (* Requires Acrobat Reader. Go to the WisBar Toolbox and download it NOW! Need an Acrobat tutorial? Go to the WisBar Toolbox)

The second form of notice, inclusion of a written designation of the limited liability structure as part of the firm name, is more problematic. The organizational statutes for LLCs, LLPs and S.C.s all specifically provide for some abbreviation to reflect the nature of the organization. ¹⁶ Not only does SCR 20:5.7(e)(1) not provide for an abbreviation as a form of notice, such language was specifically requested by the State Bar and not included.¹⁷

The third type of notice, set forth in SCR 20:5.7(e)(2), requires that clients and potential clients be advised in writing in a plain-English summary of both the features of the limited liability law used by the firm and of the applicable provision of SCR 20.

The Rule at subsection 20:5.7(d) also provides that law firms organized under other states' limited liability laws must register with the Wisconsin Supreme Court if it has at least one lawyer licensed to practice law in Wisconsin. This Rule clarifies the status of those lawyers practicing in Wisconsin but whose law firms are organized in other states. As long as the law firm is organized as a limited liability entity under another state's laws and registers as provided in the Rule (which includes providing a certificate of insurance in compliance with 20:5.7(bm)), its lawyers will have complied with the Rules for their actions in Wisconsin. The public disclosure aspect of the registration requirement may be even more valuable in the case of a non-Wisconsin law firm, because the information required by the registration may be more difficult to obtain by the Wisconsin public from other sources.

Liability for Noncompliance

The draft of the proposed Rules submitted to the supreme court by the State Bar as part of its revised petition specifically provided, in then section 20:5.7(e), that the provision of the organizing statutes protecting against vicarious liability would be of no effect during any period the firm was not in compliance with the new Rules.¹⁸ That provision was not enacted by the supreme court. While no reason was given for the deletion, one assumes it reflected the court's desire to avoid being seen as usurping the legislative prerogative.

If that assumption is accurate, it may predict the answer to questions sure to arise: Will a lawyer avoid vicarious liability for her colleague's malpractice during the period after passage of the enabling legislation for LLCs, LLPs and S.C.s, but before the new Rule's effective date (7/1/97), or during a period following July 1, 1997, when a limited liability organization fails to comply with SCR 20:5.7? The deletion of the submitted subparagraph (e) by the supreme court suggests that it may well conclude, as have others, ¹⁹ that it is the Legislature's province to legislate liability and the supreme court's province to prescribe the ethical standards of lawyers.

Conclusion

At a time when malpractice judgments against lawyers are increasingly being borne by innocent partners and shareholders, with tragic and potentially catastrophic results both to lawyers and other clients, Wisconsin now has joined the vast majority of states permitting lawyers to use limited liability entities to avoid vicarious liabilities. These changes are designed to assist lawyers in preserving their practices. In addition to the obvious insurance requirements, the rigors of complying with modern day insurance underwriting and administrative practices will improve many of the firms that subscribe. Stronger and better new law firms will improve the quality of service and the viability of firms for all clients, not just that rare client who seeks to hold his or her lawyer financially responsible.

Endnotes

¹ See Wis. Stat. 180.1915 (Professional Relationships and Liability).

² Id.

³ Jennifer L. Johnson, Limited Liability for Lawyers: General Partners Need Not Apply, 51 Bus. Law. (Nov. 1995), at 85-145.

⁴ Henderson v. HSI Fin. Serv. Inc., Case No. 595G 1746 (1996 WL 36154 (Ga.)). In addition, both Florida and Georgia adopted new ethical standards.

⁵ Johnson, supra.

⁶ ABA Formal Ethics Op. 303 (11/27/61).

⁷ LLCs permitted: Alabama, Connecticut, Kansas, Maryland, Michigan, Mississippi, New York, Texas; LLPs permitted: Washington, D.C., Kansas, Ohio.

⁸ Michael J. Lawrence, The Fortified Law Firm: Limited Liability Business and the Propriety of Lawyer Incorporation, 9 Geo. J. Legal Ethics 207, 207-09 (1995).

⁹ Id. at 211.

¹⁰ See Some Law Firms Were Hit by Massive Suits, Nat'l L.J., Dec. 26, 1994, at C11. See also Lisa Isom-Rodriguez, Limiting the Perils of Partnership, Am. Law, July 1992, at 30.

¹¹ Lawrence, supra at 224.

¹² In July 1995, Wisconsin Lawyers Mutual Insurance Co. estimated that 15 to 30 percent of private practitioners have no malpractice insurance.

¹³ The new rules do not specify any particular levels or amounts of deductible allowed, other than requiring it be disclosed in the registration process. SCR 20:5.7(bm). It appears that the supreme court has left that determination to the insurer's sound underwriting judgment.

¹⁴ It is possible that conduct constituting a lawyer's failure under SCR 20:5.1, 20:5.2 and 20:5.3 may also subject the lawyer to direct (as opposed to vicarious) civil liability under several tort theories. See, e.g., Johnson v. Misericordia Community Hosp., 99 Wis. 2d 708, 734-35, 301 N.W.2d 156 (1981).

¹⁵ Johnson, supra at 120-21 and accompanying footnotes. This may be due to the fact that existing laws already provide notice of an entity's limited liabilty. Existing business organization statutes already require the business name to contain some reference to the type of entity. Moreover, neither existing law nor the rules require notice to clients of other aspects of a lawyer's or law firm's financial condition - that it is insolvent, poorly capitalized, in default on important obligations or subject to malpractice judgments - or the existence (or lack) of insurance coverage or applicable coverage limits.

¹⁶ See Wis. Stat. 180.1977 (S.C.); 183.0103 (LLC); 178.42 (LLP).

¹⁷ Letter of Feb. 27, 1997, to the supreme court clerk, requesting inclusion in section 20:5.7(e)(1) of the language "or an appropriate abbreviation thereof." In some states it has become the practice to incorporate both an abbreviation and a descriptive phrase in the name, for example, Huey, Dewey & Louie, L.L.P., a Limited Liability Partnership.

¹⁸ See, revised Petition filed March 27, 1996 SCR 20:5.7(e).

¹⁹ Lawrence, supra; Henderson v. HSI Fin. Serv. Inc., supra.

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