Indemnification May Add to LLP Protection

Editor's note: The first part of this article focused on various LLP statutes, including sample language, and the basics of the concept of indemnification. We now turn to the potential consequences of indemnification and the future of LLPs.

There are situations when indemnification against the partnership assets may indirectly obligate partners to outside creditors. While many LLP statutes hold that partners are not liable “either directly or indirectly, by way of indemnification, contribution, assessment or otherwise” for the specific claims in which their liability is limited, under contribution laws, many partners still may remain liable for some of the firm's general obligations, including obligations incurred before the firm registered as an LLP. Since, often times, the firm's assets must be exhausted before contribution obligations arise, it may be difficult to allocate the sources of the remaining partnership debt, and as a result, individual partners may indirectly pay towards liabilities for which they are otherwise protected. Bromberg & Ribstein, '3.09(b). There is an emerging trend by which partnership statutes require depletion of partnership assets before plaintiffs can proceed against individual partners for their vicarious. Bromberg & Ribstein, '3.08(b). The marriage of LLP statutes with the exhaustion requirement provides another layer of protection for law firm partners in preventing creditors from accessing partners' assets.

Generally speaking, indemnification is not a perfect solution. On one hand, it forces partners to contribute towards claims for which they otherwise have no vicarious liability. On the other hand, limiting a partner's right to indemnification can essentially deny them relief. In LLPs where the risk of vicarious supervisory liability is spread among the partners through indemnification agreements, it is the supervisory partners, rather than the tort creditors, that are left with the risk that the assets of non-supervisory partners would be inadequate or unavailable to pay the claims. Symposium, “Limited Liability Companies for Unincorporated Firms,” 64 U.Cin. L. Rev. 319, 331 (1996). As a result, supervising partners may take certain precautions, such as contracting to increase their profit shares and reducing their involvement with supervisory positions.

Indemnification may also lead to intra-firm conflicts concerning the amount of malpractice insurance the firm should maintain (with the supervising partners demanding that the firm maintain a high level of insurance while the other partners are reluctant to pay a lot in premiums for what they may consider unnecessary coverage). Id. In fact, many states impose minimum insurance requirements to cover malpractice claims, including California, New Mexico, Massachusetts, Connecticut, Oklahoma, Rhode Island, Washington, South Carolina. Bromberg & Ribstein, '2.06(a). Indemnification agreements need to be very carefully constructed because, ultimately, if partnership funds prove insufficient, partners seeking indemnification may be forced to resort to litigation. Fortney, “Seeking Shelter,” at 741.

Another concern to be considered is that in states where the applicable LLP statute does not provide a full liability shield, but rather, holds individual partners liable for contract-type claims, indemnification of partners for their tort-type claims (for which the other partners have limited liability) may deplete partnership assets, leaving the individual partners responsible to cover the contract claims. Bromberg & Ribstein, '2.09(d).

Under traditional partnership law, partners must contribute towards the satisfaction of partnership liabilities, usually upon dissolution, by paying the debt in proportion to their obligations to contribute towards partnership losses. Bromberg & Ribstein, '2.09(d). While this provision has been modified to conform to LLP protections, individual partners are responsible for claims that arose before LLP registration and in some states, they are responsible for other liabilities, such as contract-type claims, as well as the additional contribution responsibilities that were agreed upon in the partnership agreement. Bromberg & Ribstein, '3.09(b). Indemnification of a partner may trigger the contribution obligations of the other partners when the firm's assets are insufficient to cover their liabilities. Bromberg & Ribstein, '3.09(c). When a partner in an LLP invokes his indemnification rights for a claim for which the other partners' liability is statutorily limited, and that indemnification depletes LLP funds, the question arises as to whether the other partners become liable for the deficit as a result of their contribution obligations. Id. The partners may become liable under the express terms of the partnership agreement or by virtue of state statute. For example, in states that hold partners liable for contract based claims, LLP partners may be responsible for the contact-based indemnification claims, even though they have limited liability for the underlying tort-type claim. Therefore, it is important to consider this particular issue when drafting an indemnification clause. This is especially important since partners' contribution obligations are usually triggered only when the partnership's liabilities exceed it's assets and partnership assets are usually depleted, making it futile for those partners to seek indemnification against the partnership for their contributions. Bromberg & Ribstein, '3.09(c).

It has only been about 10 years since LLPs were first introduced, and only time will tell whether or not they will be able to provide their partners with sufficient shelter from vicarious liability. In this age of Enron scandals and WorldCom debacles, some commentators are skeptical about giving lawyers the ability to shield themselves from liability to clients for negligent conduct by hiding behind a limited liability entity. Symposium, “Ethics and the Multi-jurisdictional Practice of Law,” 36 S. Tex. L. Rev. 967, 985 (1995). Others believe that the judiciary may reject legislative efforts to limit law firm liability, for example, through the imposition of joint and several liability via the rules of professional responsibility. Id. at 984 (1995); Fortney, “Professional Responsibility and Liability Issues related to Limited Liability Law Partnership,” 39 S. Tex. L. Rev. 399, 427 (1998) (explaining that courts can also reject the statutory limit on vicarious liability provided by LLP statutes by exercising their inherent authority to regulate the legal profession).

Yet, the past few years have proven that LLPs are an increasingly popular business entity, with over 50,000 LLP fillings between 1993-1999, and thousands since then. Bromberg & Ribstein, '1.01(e). While on the whole, LLPs offer partners in law firms more protection from vicarious liability then traditional general partnerships, certain LLP partners face exposure to new liabilities which, without inter-partner indemnification agreements, they may be forced to bear alone.

Editor's note: The first part of this article focused on various LLP statutes, including sample language, and the basics of the concept of indemnification. We now turn to the potential consequences of indemnification and the future of LLPs.

There are situations when indemnification against the partnership assets may indirectly obligate partners to outside creditors. While many LLP statutes hold that partners are not liable “either directly or indirectly, by way of indemnification, contribution, assessment or otherwise” for the specific claims in which their liability is limited, under contribution laws, many partners still may remain liable for some of the firm's general obligations, including obligations incurred before the firm registered as an LLP. Since, often times, the firm's assets must be exhausted before contribution obligations arise, it may be difficult to allocate the sources of the remaining partnership debt, and as a result, individual partners may indirectly pay towards liabilities for which they are otherwise protected. Bromberg & Ribstein, '3.09(b). There is an emerging trend by which partnership statutes require depletion of partnership assets before plaintiffs can proceed against individual partners for their vicarious. Bromberg & Ribstein, '3.08(b). The marriage of LLP statutes with the exhaustion requirement provides another layer of protection for law firm partners in preventing creditors from accessing partners' assets.

Generally speaking, indemnification is not a perfect solution. On one hand, it forces partners to contribute towards claims for which they otherwise have no vicarious liability. On the other hand, limiting a partner's right to indemnification can essentially deny them relief. In LLPs where the risk of vicarious supervisory liability is spread among the partners through indemnification agreements, it is the supervisory partners, rather than the tort creditors, that are left with the risk that the assets of non-supervisory partners would be inadequate or unavailable to pay the claims. Symposium, “Limited Liability Companies for Unincorporated Firms,” 64 U.Cin. L. Rev. 319, 331 (1996). As a result, supervising partners may take certain precautions, such as contracting to increase their profit shares and reducing their involvement with supervisory positions.

Indemnification may also lead to intra-firm conflicts concerning the amount of malpractice insurance the firm should maintain (with the supervising partners demanding that the firm maintain a high level of insurance while the other partners are reluctant to pay a lot in premiums for what they may consider unnecessary coverage). Id. In fact, many states impose minimum insurance requirements to cover malpractice claims, including California, New Mexico, Massachusetts, Connecticut, Oklahoma, Rhode Island, Washington, South Carolina. Bromberg & Ribstein, '2.06(a). Indemnification agreements need to be very carefully constructed because, ultimately, if partnership funds prove insufficient, partners seeking indemnification may be forced to resort to litigation. Fortney, “Seeking Shelter,” at 741.

Another concern to be considered is that in states where the applicable LLP statute does not provide a full liability shield, but rather, holds individual partners liable for contract-type claims, indemnification of partners for their tort-type claims (for which the other partners have limited liability) may deplete partnership assets, leaving the individual partners responsible to cover the contract claims. Bromberg & Ribstein, '2.09(d).

Under traditional partnership law, partners must contribute towards the satisfaction of partnership liabilities, usually upon dissolution, by paying the debt in proportion to their obligations to contribute towards partnership losses. Bromberg & Ribstein, '2.09(d). While this provision has been modified to conform to LLP protections, individual partners are responsible for claims that arose before LLP registration and in some states, they are responsible for other liabilities, such as contract-type claims, as well as the additional contribution responsibilities that were agreed upon in the partnership agreement. Bromberg & Ribstein, '3.09(b). Indemnification of a partner may trigger the contribution obligations of the other partners when the firm's assets are insufficient to cover their liabilities. Bromberg & Ribstein, '3.09(c). When a partner in an LLP invokes his indemnification rights for a claim for which the other partners' liability is statutorily limited, and that indemnification depletes LLP funds, the question arises as to whether the other partners become liable for the deficit as a result of their contribution obligations. Id. The partners may become liable under the express terms of the partnership agreement or by virtue of state statute. For example, in states that hold partners liable for contract based claims, LLP partners may be responsible for the contact-based indemnification claims, even though they have limited liability for the underlying tort-type claim. Therefore, it is important to consider this particular issue when drafting an indemnification clause. This is especially important since partners' contribution obligations are usually triggered only when the partnership's liabilities exceed it's assets and partnership assets are usually depleted, making it futile for those partners to seek indemnification against the partnership for their contributions. Bromberg & Ribstein, '3.09(c).

It has only been about 10 years since LLPs were first introduced, and only time will tell whether or not they will be able to provide their partners with sufficient shelter from vicarious liability. In this age of Enron scandals and WorldCom debacles, some commentators are skeptical about giving lawyers the ability to shield themselves from liability to clients for negligent conduct by hiding behind a limited liability entity. Symposium, “Ethics and the Multi-jurisdictional Practice of Law,” 36 S. Tex. L. Rev. 967, 985 (1995). Others believe that the judiciary may reject legislative efforts to limit law firm liability, for example, through the imposition of joint and several liability via the rules of professional responsibility. Id. at 984 (1995); Fortney, “Professional Responsibility and Liability Issues related to Limited Liability Law Partnership,” 39 S. Tex. L. Rev. 399, 427 (1998) (explaining that courts can also reject the statutory limit on vicarious liability provided by LLP statutes by exercising their inherent authority to regulate the legal profession).

Yet, the past few years have proven that LLPs are an increasingly popular business entity, with over 50,000 LLP fillings between 1993-1999, and thousands since then. Bromberg & Ribstein, '1.01(e). While on the whole, LLPs offer partners in law firms more protection from vicarious liability then traditional general partnerships, certain LLP partners face exposure to new liabilities which, without inter-partner indemnification agreements, they may be forced to bear alone.