Multi-State Firms Take Advantage of Illinois' Limited Liability

Rule 721(d) has now been amended to permit partners to avoid joint and several liability if their firm voluntarily maintains adequate professional responsibility ('malpractice') insurance or proof of financial responsibility in accordance with new Rule 722. Illinois joins just eleven other states in imposing an insurance/financial responsibility requirement as a condition of limited liability. The vast majority of firms who will take advantage of Rule 722 likely will do so by compliance with the minimum malpractice insurance requirement.

By maintaining the requisite malpractice insurance, partners generally can limit their liability for malpractice claims to that provided in the enabling acts of the limited liability entities. Thus, for law firms which organize under Illinois' LLP Act (as favorably amended last year to be a so-called 'full shield' statute against partnership obligations arising in contract, tort or otherwise), the LLP's partners will not be liable for negligent or wrongful acts of others unless the wrongdoers are under the partners' direct supervision and control. See 805 ILCS 205/15. For law firms organized as Illinois LLCs, their members or managers are generally not liable for the company's debts, obligations or liabilities solely by virtue of being or acting as members or managers. 805 ILCS 180/10-10. Also see Rule 722(c): 'nothing in this rule or any law under which a limited liability entity is organized shall relieve any lawyer from personal liability for claims arising out of acts, errors, or omissions in the performance of professional services by the lawyer or any person under the lawyer's direct supervision and control.'

In addition, Rule 722 expressly continues to impose personal liability on partners for 1) their own negligent or wrongful acts or omissions, and 2) the amount of any deductible in the applicable malpractice insurance policy, unless the law firm provides 'proof of financial responsibility' (as defined in the new Rule) in the amount of the deductible. As a result, law firms carrying insurance policies with substantial deductibles will need to provide proof of financial responsibility in the amount of the deductible if their partners are to receive meaningful limited liability protection.

How much malpractice insurance must a law firm carry to meet the 'adequate insurance' requirement of Rule 722? The Rule requires minimum coverage of $100,000 per claim and $250,000 annual aggregate, each multiplied by the number of lawyers in the firm at the beginning of the annual policy period, provided that the firm's insurance need not exceed $5 million per claim and $10 million per aggregate. (For an in-depth analysis of the minimum insurance and proof of financial responsibility requirements, see Sheldon I. Banoff and Steven F. Pflaum, 'Limited Liability Legal Practice: New Opportunities and Responsibilities for Illinois Lawyers,' 17 CBA Record 37 (May 2003.))

The change in Illinois' Rule 721(a) to permit law firms to practice in Illinois as an LLP (even if the firm's principal office is located elsewhere) breaks a logjam for law firms having both Illinois and California offices. Previously, Illinois permitted practice in LLC form but not in LLP; California permits law practice in LLP form but not in LLC. Moreover, since PCs didn't provide vicarious liability protection for malpractice in Illinois under Rule 721(d), most law firms with Illinois and California offices remained general partnerships. With the change in Illinois Rule 721 and 722, such Illinois/California law firms can operate as an LLP. Alternatively, they could form a general partnership consisting of a California PC and an Illinois PC, with the practitioners being the shareholders of the corporation in the state in which they practice; the Illinois PC can now take advantage of Illinois Rule 722 to limit or eliminate vicarious liability, which was not previously permissible.

The change in the Illinois rules, which arose in response to a petition jointly filed by the Chicago Bar Association and the Illinois State Bar Association, does not affect lawyers' ethical responsibilities. Rule 721(e)(5) and (f) leave unchanged the requirement that the original or renewal application for a limited liability entity's certificate of registration must certify that each shareholder or member of the entity is a member of the bar of each jurisdiction in which such person practices law and that no disciplinary action is pending against any of them.

The Illinois rule contains several provisions which may serve as models for other states to reexamine their rules permitting limited liability legal practice. First, amended Rule 721 facilitates registration and renewal of limited liability entities by permitting a single authorized member of such law firm to execute the application for registration or renewal. Previously, in Illinois all of the equity owners of the limited liability entities were required to sign registration and renewal forms.

Secondly, Illinois has facilitated 'two-tier' limited liability entities. Before it was amended, Illinois Rule 721(c) required all equity owners in limited liability entities to be licensed to practice law. Across the nation, however, there is an increasing number of law firms organized as limited liability entities with partners that are themselves limited liability entities. The new Illinois rules permit law firms with Illinois offices to organize in this fashion so long as the natural persons who are partners are licensed to practice law and at least one of them is licensed in Illinois.

In jurisdictions other than Illinois, the most common form of two-tier limited liability entity consists of LLPs with partners that include some one-lawyer PCs. (Federal tax law previously encouraged the creation of such PCs for retirement planning purposes; tax considerations now discourage their dissolution even though they no longer enjoy tax-advantaged status.) However, Rule 721(c) previously prevented Illinois law firms in which such one-lawyer PCs practice from being limited liability entities, and impeded such lawyers' ability to join law firms already organized as limited liability entities, because PCs (as opposed to the lawyers who owned them) are not licensed to practice law. (Limited liability entities are registered, rather than licensed, to practice law in Illinois.) The new rules remove this obstacle, and permit two-tier limited liability entities, but simply requiring that all natural persons who are partners in limited liability entities meet the requirements of Rule 721(c).

The Illinois rules also uniquely deal with law firms in bankruptcy. At that time, such firms may lose the ability to control their financial destiny and maintain the requisite malpractice insurance. It is precisely at this time that professional liability claims may surface, and it is then that partners of the law firm innocent of wrongdoing most need the protection of Rule 722. With this in mind, Rule 722(d)(4) provides that if a limited liability entity maintains minimum insurance or proof of financial responsibility when a bankruptcy case regarding the firm has begun, it shall be deemed to do so with respect to such claims asserted after the commencement of the case.

In light of the aforementioned changes, Illinois will no longer be the 'lowest common denominator' that thwarts the efforts of multi-state firms (whether based inside or outside Illinois) to provide attorneys with the same liability shields that accountants, doctors and other professionals enjoy. However, Illinois' relatively high minimum insurance requirements may cause some firms with under 50 attorneys to materially increase their malpractice insurance coverage ' and premiums ' in order to eliminate vicious liability for its innocent partners.

Sheldon I. Banoff, P.C. is a partner in the Chicago office of Katten Muchin Zavis Rosenman and a member of the Board of Editors of Law Firm Partnership & Benefits Report. His expertise includes general tax and partnership matters and counseling professional firms.

Effective July 1, 2003, pursuant to rules recently adopted by the Illinois Supreme Court, law firms with Illinois offices will be able to practice as limited liability partnerships (LLPs). In addition, co-owners of law firms organized as limited liability legal entities (ie, as members of LLPs or limited liability companies (LLCs), or as shareholders of professional corporations (PCs)) will be able to avoid exposure to vicarious liability for malpractice committed by other lawyers in their firms, if their firms meet and maintain specified minimum amounts of malpractice insurance or other proof of financial responsibility.

Many Illinois-based firms, including those with multi-state offices, are expected to take advantage of the vicarious liability protection procedure. A number of large law firms based outside Illinois having Illinois offices are also expected to take advantage of the new rules. The rule change also will permit several 'national' firms to abandon their cumbersome multiple entity legal structures previously adopted to deal with the absence of a rule permitting firms to practice in Illinois as LLPs. The Supreme Court's action is particularly timely because the Illinois Uniform Partnership Act was amended last year to broaden the limited liability protection afforded partners of LLPs formed in Illinois. See Sheldon I. Banoff, 'Illinois Developments Are Good News for Multistate Law Firms Across the Country,' 8 LFPBR 5 (November 2002).

Prior to the rule change, Illinois was the only state that explicitly held all members of law firms (regardless of legal form) to be liable for the wrongdoings of their co-owners. Illinois Supreme Court Rule 721(d) stated that the articles of incorporation or other organizational document of a PC, PA or LLC shall provide, and in any case the owners of such limited liability entities (partners) shall be deemed to agree, that the partners are jointly and severally liable for the acts, errors or omissions in the performance of professional services committed by any firm lawyers or employees. By its terms all partners, not just those practicing in Illinois, potentially were subject to vicarious liability. Thus, Illinois operated as the lowest common denominator for multi-state law firms.

Rule 721(d) has now been amended to permit partners to avoid joint and several liability if their firm voluntarily maintains adequate professional responsibility ('malpractice') insurance or proof of financial responsibility in accordance with new Rule 722. Illinois joins just eleven other states in imposing an insurance/financial responsibility requirement as a condition of limited liability. The vast majority of firms who will take advantage of Rule 722 likely will do so by compliance with the minimum malpractice insurance requirement.

By maintaining the requisite malpractice insurance, partners generally can limit their liability for malpractice claims to that provided in the enabling acts of the limited liability entities. Thus, for law firms which organize under Illinois' LLP Act (as favorably amended last year to be a so-called 'full shield' statute against partnership obligations arising in contract, tort or otherwise), the LLP's partners will not be liable for negligent or wrongful acts of others unless the wrongdoers are under the partners' direct supervision and control. See 805 ILCS 205/15. For law firms organized as Illinois LLCs, their members or managers are generally not liable for the company's debts, obligations or liabilities solely by virtue of being or acting as members or managers. 805 ILCS 180/10-10. Also see Rule 722(c): 'nothing in this rule or any law under which a limited liability entity is organized shall relieve any lawyer from personal liability for claims arising out of acts, errors, or omissions in the performance of professional services by the lawyer or any person under the lawyer's direct supervision and control.'

In addition, Rule 722 expressly continues to impose personal liability on partners for 1) their own negligent or wrongful acts or omissions, and 2) the amount of any deductible in the applicable malpractice insurance policy, unless the law firm provides 'proof of financial responsibility' (as defined in the new Rule) in the amount of the deductible. As a result, law firms carrying insurance policies with substantial deductibles will need to provide proof of financial responsibility in the amount of the deductible if their partners are to receive meaningful limited liability protection.

How much malpractice insurance must a law firm carry to meet the 'adequate insurance' requirement of Rule 722? The Rule requires minimum coverage of $100,000 per claim and $250,000 annual aggregate, each multiplied by the number of lawyers in the firm at the beginning of the annual policy period, provided that the firm's insurance need not exceed $5 million per claim and $10 million per aggregate. (For an in-depth analysis of the minimum insurance and proof of financial responsibility requirements, see Sheldon I. Banoff and Steven F. Pflaum, 'Limited Liability Legal Practice: New Opportunities and Responsibilities for Illinois Lawyers,' 17 CBA Record 37 (May 2003.))

The change in Illinois' Rule 721(a) to permit law firms to practice in Illinois as an LLP (even if the firm's principal office is located elsewhere) breaks a logjam for law firms having both Illinois and California offices. Previously, Illinois permitted practice in LLC form but not in LLP; California permits law practice in LLP form but not in LLC. Moreover, since PCs didn't provide vicarious liability protection for malpractice in Illinois under Rule 721(d), most law firms with Illinois and California offices remained general partnerships. With the change in Illinois Rule 721 and 722, such Illinois/California law firms can operate as an LLP. Alternatively, they could form a general partnership consisting of a California PC and an Illinois PC, with the practitioners being the shareholders of the corporation in the state in which they practice; the Illinois PC can now take advantage of Illinois Rule 722 to limit or eliminate vicarious liability, which was not previously permissible.

The change in the Illinois rules, which arose in response to a petition jointly filed by the Chicago Bar Association and the Illinois State Bar Association, does not affect lawyers' ethical responsibilities. Rule 721(e)(5) and (f) leave unchanged the requirement that the original or renewal application for a limited liability entity's certificate of registration must certify that each shareholder or member of the entity is a member of the bar of each jurisdiction in which such person practices law and that no disciplinary action is pending against any of them.

The Illinois rule contains several provisions which may serve as models for other states to reexamine their rules permitting limited liability legal practice. First, amended Rule 721 facilitates registration and renewal of limited liability entities by permitting a single authorized member of such law firm to execute the application for registration or renewal. Previously, in Illinois all of the equity owners of the limited liability entities were required to sign registration and renewal forms.

Secondly, Illinois has facilitated 'two-tier' limited liability entities. Before it was amended, Illinois Rule 721(c) required all equity owners in limited liability entities to be licensed to practice law. Across the nation, however, there is an increasing number of law firms organized as limited liability entities with partners that are themselves limited liability entities. The new Illinois rules permit law firms with Illinois offices to organize in this fashion so long as the natural persons who are partners are licensed to practice law and at least one of them is licensed in Illinois.

In jurisdictions other than Illinois, the most common form of two-tier limited liability entity consists of LLPs with partners that include some one-lawyer PCs. (Federal tax law previously encouraged the creation of such PCs for retirement planning purposes; tax considerations now discourage their dissolution even though they no longer enjoy tax-advantaged status.) However, Rule 721(c) previously prevented Illinois law firms in which such one-lawyer PCs practice from being limited liability entities, and impeded such lawyers' ability to join law firms already organized as limited liability entities, because PCs (as opposed to the lawyers who owned them) are not licensed to practice law. (Limited liability entities are registered, rather than licensed, to practice law in Illinois.) The new rules remove this obstacle, and permit two-tier limited liability entities, but simply requiring that all natural persons who are partners in limited liability entities meet the requirements of Rule 721(c).

The Illinois rules also uniquely deal with law firms in bankruptcy. At that time, such firms may lose the ability to control their financial destiny and maintain the requisite malpractice insurance. It is precisely at this time that professional liability claims may surface, and it is then that partners of the law firm innocent of wrongdoing most need the protection of Rule 722. With this in mind, Rule 722(d)(4) provides that if a limited liability entity maintains minimum insurance or proof of financial responsibility when a bankruptcy case regarding the firm has begun, it shall be deemed to do so with respect to such claims asserted after the commencement of the case.

In light of the aforementioned changes, Illinois will no longer be the 'lowest common denominator' that thwarts the efforts of multi-state firms (whether based inside or outside Illinois) to provide attorneys with the same liability shields that accountants, doctors and other professionals enjoy. However, Illinois' relatively high minimum insurance requirements may cause some firms with under 50 attorneys to materially increase their malpractice insurance coverage ' and premiums ' in order to eliminate vicious liability for its innocent partners.

Sheldon I. Banoff, P.C. is a partner in the Chicago office of Katten Muchin Zavis Rosenman and a member of the Board of Editors of Law Firm Partnership & Benefits Report. His expertise includes general tax and partnership matters and counseling professional firms.