Surviving A Malpractice Fiasco: 10 Views

Part Two of Two

Editor's Introduction

Recently I asked members of A&FP's Editorial Board and several new contributors for their thoughts on how a law firm might best deal with the financial blow of an unusually large settlement or penalty assessed against the firm. Last month, in Part One, we got our roundtable discussants' views on how to keep a firm from crumbling immediately after a malpractice disaster. Concluding the discussion, here are their views on professional liability insurance.

Financial Planning for Future Claims

[Editor's note: Insurance broker Sam Harris informs me that coverages for Professional Liability, Errors & Omissions (E&O), and Attorney Malpractice are synonymous, with the first name being used most commonly.]

Douglas Thompson (Managing Director, Thompson Flanagan & Company, Chicago, [email protected]): The question of how much malpractice insurance to buy is one that vexes most large law and accounting firms. Large law firms cannot buy limits that fully cover their largest transactions, so they need to consider the firm's cash flow and revenues when purchasing limits of liability.

Law firms first need to buy enough so that a judge will consider the firm responsible. If a judge deems the limits too low, he or she will be less apt to work towards a settlement within the policy limits.

When purchasing insurance, the firm is among other things buying balance sheet protection: obviously that is where a claim payment would come from if the firm does not purchase insurance. Just how much of the firm's revenue or profits does the firm want to protect via insurance?

The firm needs to review the types of transactions it handles. Large-transaction firms cannot fully insure up to the value of their largest single transaction, but they can insure to an amount that could pay damages in the event there was a problem within the transaction. The same type of review should apply to litigation: how much insurance should the firm have in order to make the client whole (vs. to pay for the entire value of the litigation)?

The firm's risk philosophy is a factor. Highly risk-averse firms will purchase as much limits as the entire global marketplace will allow. This can be an expensive solution but provides ultimate balance sheet protection as well as “sleep insurance.” By contrast, some risk-taking firms hope never to be the deep pocket in a claim situation; that can be very dangerous. Somewhere in the middle of these positions exists a solution that is logical and appropriate in view of the firm's finances, types of services rendered and client makeup.

Ed Poll (President, LawBiz Management Co., Venice, CA, [email protected]): If the question is “How much E&O coverage to obtain?” the answer would be determined by a number of factors, some of which have already been mentioned:

• Attitude of the firm's controlling partners toward risk aversion generally and toward major disasters in particular. Some checks are just too big for the firm to write. Most lawyers believe that they should have as much insurance as they can afford, but risk-takers will favor higher deductibles.
• Regulation in the controlling jurisdiction concerning liability or exposure of non-negligent partners.
• Wealth of the firm and of individual partners ' and the possibility that some are judgment proof.
• Nature of the practice: small firms tend to work in commodity type or consumer type matters in which claims are smaller but more frequent; large firms tend to work in high risk areas such as tax shelters, M&A, etc., where the claims are fewer but larger.
• Whether firm leaders believe they can negotiate their way out of any challenge or claim. Firms with good client relationships often do settle client claims without involving their insurance carrier.

Samuel J. Harris (Insurance Broker, Barlocker Insurance Services, Laguna Hills, CA, [email protected]):

The remarks made above by Douglas Thompson are very accurate and practical. I would add that a firm could consider layering its E&O coverage, as the subsequent layers should be at a lesser rate than the initial policy.

In addition to the firm's regular E&O coverage, a firm (or partners of the firm) could also establish an investment fund to help offset potential successful claims. A self-insured E&O fund of this sort would be important for firms that take on high-risk work.

A firm may also want to explore other options to set aside funds that could be used, in the event of an award, for claims exceeding the limits of insurance.

Beyond that, a firm just has to be realistic in assessing its potential exposures and purchasing coverage accordingly. As we all know, firms are very fragile entities, and something like this can certainly be a damaging experience.

With 15 years of experience in the operation of large law firms and over 8 years experience as a commercial insurance broker, I can tell you that deciding when you have enough insurance protection is not the broker's role. It is the insured's role, and a good broker insists that the insured make that determination. The broker's role is to guide and give advice, but the insured knows best their exposures based upon their own client base and the nature of their practice.

[Ed. Note: Before entering the insurance business, Sam was a major law firm's executive director.]

Jim Davidson (Consultant, former CFO of Holland & Hart, [email protected]): Small firms are generally capped by the insurance market as to how much they can buy. But more is not always better, even for big firms. More costs more, and provides a bigger honey pot for plaintiffs to go after.

Firms large and small in some practice areas have high exposure because of the nature of those practices, and should carry insurance commensurate with the risks. Insurance carriers can help with background data on the risks associated with given practice areas.

Organization structures can limit vicarious liability of partners or shareholders not involved personally in the malpractice. By contrast, those who are involved in malpractice cannot shield themselves personally via the firm's organization structure; only insurance stands in front of their personal assets ' which assets, of course, include the value of their interest in the law firm. Given these considerations, a firm should explicitly make the following decisions:

First, how far does the firm want to go to shield malpracticing partners? A firm's capital base is hard pressed to support judgments against the firm: there are already a lot of claims on firm capital, and partners are willing to put up only so much investment in the firm.

Second, how can the firm protect itself against charging orders or bankruptcies of partners, whether occasioned by malpractice or something else? Such protection should be implemented by appropriate provisions in the firm's partnership agreement or corporate bylaws. No firm needs a bankruptcy trustee or other stranger standing in as a substitute partner in a circumstance like this.

Regarding the setting aside of capital against malpractice lawsuits ' a query: is that inviting a plaintiff's lawyer to argue, “Of course they knew they were malpracticing, look at the capital they set aside to cover it!” Capital probably ought to cover the retention for one case ' maybe two, depending on the practice areas involved ' but in most firms not a lot beyond that.

Regarding ancillary businesses: I believe ancillary businesses that are not part of the practice of law should be separately incorporated and separately insured. At least some of the legal malpractice carriers flatly will not insure activities of the law firm that are not practicing law or directly supporting the practice of law. That's pretty broad, and any firm in an ancillary business needs to level with its carrier, to make sure both the carrier and the firm know what is being done and whether or not it is covered. Even separate incorporation may not be enough if the firm owns the corporation, since the firm with its perceived deep pockets will be dragged into any suit involving the ancillary business. The prospect of significant lucre ought to be very, very good before a firm takes on this kind of exposure.

Finally, every firm should sit down and think all of this through before an issue arises. Once an issue is out there, it is very difficult to agree on anything.

Part Two of Two

Editor's Introduction

Recently I asked members of A&FP's Editorial Board and several new contributors for their thoughts on how a law firm might best deal with the financial blow of an unusually large settlement or penalty assessed against the firm. Last month, in Part One, we got our roundtable discussants' views on how to keep a firm from crumbling immediately after a malpractice disaster. Concluding the discussion, here are their views on professional liability insurance.

Financial Planning for Future Claims

[Editor's note: Insurance broker Sam Harris informs me that coverages for Professional Liability, Errors & Omissions (E&O), and Attorney Malpractice are synonymous, with the first name being used most commonly.]

Douglas Thompson (Managing Director, Thompson Flanagan & Company, Chicago, [email protected]): The question of how much malpractice insurance to buy is one that vexes most large law and accounting firms. Large law firms cannot buy limits that fully cover their largest transactions, so they need to consider the firm's cash flow and revenues when purchasing limits of liability.

Law firms first need to buy enough so that a judge will consider the firm responsible. If a judge deems the limits too low, he or she will be less apt to work towards a settlement within the policy limits.

When purchasing insurance, the firm is among other things buying balance sheet protection: obviously that is where a claim payment would come from if the firm does not purchase insurance. Just how much of the firm's revenue or profits does the firm want to protect via insurance?

The firm needs to review the types of transactions it handles. Large-transaction firms cannot fully insure up to the value of their largest single transaction, but they can insure to an amount that could pay damages in the event there was a problem within the transaction. The same type of review should apply to litigation: how much insurance should the firm have in order to make the client whole (vs. to pay for the entire value of the litigation)?

The firm's risk philosophy is a factor. Highly risk-averse firms will purchase as much limits as the entire global marketplace will allow. This can be an expensive solution but provides ultimate balance sheet protection as well as “sleep insurance.” By contrast, some risk-taking firms hope never to be the deep pocket in a claim situation; that can be very dangerous. Somewhere in the middle of these positions exists a solution that is logical and appropriate in view of the firm's finances, types of services rendered and client makeup.

Ed Poll (President, LawBiz Management Co., Venice, CA, [email protected]): If the question is “How much E&O coverage to obtain?” the answer would be determined by a number of factors, some of which have already been mentioned:

• Attitude of the firm's controlling partners toward risk aversion generally and toward major disasters in particular. Some checks are just too big for the firm to write. Most lawyers believe that they should have as much insurance as they can afford, but risk-takers will favor higher deductibles.
• Regulation in the controlling jurisdiction concerning liability or exposure of non-negligent partners.
• Wealth of the firm and of individual partners ' and the possibility that some are judgment proof.
• Nature of the practice: small firms tend to work in commodity type or consumer type matters in which claims are smaller but more frequent; large firms tend to work in high risk areas such as tax shelters, M&A, etc., where the claims are fewer but larger.
• Whether firm leaders believe they can negotiate their way out of any challenge or claim. Firms with good client relationships often do settle client claims without involving their insurance carrier.

Samuel J. Harris (Insurance Broker, Barlocker Insurance Services, Laguna Hills, CA, [email protected]):

The remarks made above by Douglas Thompson are very accurate and practical. I would add that a firm could consider layering its E&O coverage, as the subsequent layers should be at a lesser rate than the initial policy.

In addition to the firm's regular E&O coverage, a firm (or partners of the firm) could also establish an investment fund to help offset potential successful claims. A self-insured E&O fund of this sort would be important for firms that take on high-risk work.

A firm may also want to explore other options to set aside funds that could be used, in the event of an award, for claims exceeding the limits of insurance.

Beyond that, a firm just has to be realistic in assessing its potential exposures and purchasing coverage accordingly. As we all know, firms are very fragile entities, and something like this can certainly be a damaging experience.

With 15 years of experience in the operation of large law firms and over 8 years experience as a commercial insurance broker, I can tell you that deciding when you have enough insurance protection is not the broker's role. It is the insured's role, and a good broker insists that the insured make that determination. The broker's role is to guide and give advice, but the insured knows best their exposures based upon their own client base and the nature of their practice.

[Ed. Note: Before entering the insurance business, Sam was a major law firm's executive director.]

Jim Davidson (Consultant, former CFO of Holland & Hart, [email protected]): Small firms are generally capped by the insurance market as to how much they can buy. But more is not always better, even for big firms. More costs more, and provides a bigger honey pot for plaintiffs to go after.

Firms large and small in some practice areas have high exposure because of the nature of those practices, and should carry insurance commensurate with the risks. Insurance carriers can help with background data on the risks associated with given practice areas.

Organization structures can limit vicarious liability of partners or shareholders not involved personally in the malpractice. By contrast, those who are involved in malpractice cannot shield themselves personally via the firm's organization structure; only insurance stands in front of their personal assets ' which assets, of course, include the value of their interest in the law firm. Given these considerations, a firm should explicitly make the following decisions:

First, how far does the firm want to go to shield malpracticing partners? A firm's capital base is hard pressed to support judgments against the firm: there are already a lot of claims on firm capital, and partners are willing to put up only so much investment in the firm.

Second, how can the firm protect itself against charging orders or bankruptcies of partners, whether occasioned by malpractice or something else? Such protection should be implemented by appropriate provisions in the firm's partnership agreement or corporate bylaws. No firm needs a bankruptcy trustee or other stranger standing in as a substitute partner in a circumstance like this.

Regarding the setting aside of capital against malpractice lawsuits ' a query: is that inviting a plaintiff's lawyer to argue, “Of course they knew they were malpracticing, look at the capital they set aside to cover it!” Capital probably ought to cover the retention for one case ' maybe two, depending on the practice areas involved ' but in most firms not a lot beyond that.

Regarding ancillary businesses: I believe ancillary businesses that are not part of the practice of law should be separately incorporated and separately insured. At least some of the legal malpractice carriers flatly will not insure activities of the law firm that are not practicing law or directly supporting the practice of law. That's pretty broad, and any firm in an ancillary business needs to level with its carrier, to make sure both the carrier and the firm know what is being done and whether or not it is covered. Even separate incorporation may not be enough if the firm owns the corporation, since the firm with its perceived deep pockets will be dragged into any suit involving the ancillary business. The prospect of significant lucre ought to be very, very good before a firm takes on this kind of exposure.

Finally, every firm should sit down and think all of this through before an issue arises. Once an issue is out there, it is very difficult to agree on anything.