Liable for change: Progress and perils to limiting a firm’s liability

Feature

posted 26 Apr 2005 in Volume 7 Issue 10

Liable for change: Progress and perils to limiting a firm’s liability

The individual liability of members of a partnership can make the prospect of a successful claim against the firm a fearful prospect. Many firms have therefore wisely looked to strategies for limiting liability, including converting to LLPs. For many, the route will prove a sensible means to reducing risk but, as Peter Ashford, a partner at Cripps Harries Hall, argues, firms need to consider the options carefully before taking the plunge.

There are many risks that face a firm, ranging from ordinary trading risks to professional sanctions and even criminal liability. But it is the client claim that is most likely to be the catastrophic single event that can put the very existence of the firm in jeopardy.

In the event of a successful claim in excess of the firm’s indemnity cover, the partners will have to meet the cost from accumulated profits within the firm, borrowing or a cash call.

The potential for such liability must be considered when risk-management systems are put in place and reviewed, and when a particular matter is considered as a new instruction.

Contractual limitation of liability

It is against this background that many firms seek to limit their potential liability to their client by contract. In fact, doing so is now commonplace. A survey for the City of London Law Society in 1999 found just 20 per cent of firms limited their liability to the client. By 2004 in Legal Week’s ‘Big Question’, over 50 per cent of firms regularly or occasionally limited liability and 75 per cent did not think that they would damage the relationship with the client by doing so.

Against the announcement that the minimum level of indemnity cover will double from £1m to £2m (Gazette 27 January 2005) the issue takes on greater topicality. Smaller firms that relied solely on the primary layer will face considerable additional expense in taking the additional £1m. Firms that limit liability by contract will have to review the terms on which they do so.

Although it is clear that complete exclusion is both unprofessional¹, void for a contentious business agreement and is most unlikely to be reasonable under UCTA, it is quite permissible to limit liability to a specific figure (provided it is at least the minimum level of cover) and to exclude certain types of loss.

The place to limit liability by contract is within the documentation that forms the contract – for a solicitor this will typically be the retainer letter. It is better to have it in the letter than in general terms of business.

A typical limitation-of-liability clause² will limit liability to a specific sum, usually linked to a level, not necessarily the highest, of indemnity cover. It may also be sensible to consider seeking to exclude indirect or consequential losses (again subject to not producing a figure below the minimum level of cover)³. It is also important to distinguish between a limitation of liability and an exclusion of liability. The distinction may appear obvious but it is not always so⁴.

In drafting any limitation clause, regard must be had to principle 12.11 of the Guide to Professional Conduct⁵ and the requirements of the Unfair Contract Terms Act 1977 and/or The Unfair Contract Terms in Consumer Contracts Regulations 1999.

The Guide to Professional Conduct explains that liability for fraud or recklessness cannot be excluded, provisions limiting liability must be reasonable, any limitation must be brought to the attention of the client and the acceptance of such a provision should be evidenced or confirmed in writing.

Furthermore, it is vital to appreciate that the contractual limit will often be set having regard to insurance arrangements current at the time of the retainer. Insurance is invariably on a claims-made basis and if the level of cover reduces (perhaps due to the profile of work undertaken changing or the firm reducing in size), the cover at the date of the claim might be quite different to that at the time of the retainer. Still further, there may be an aggregation provision within the policy and the limit of indemnity may not be available on an each-and-every-claim basis.

Accordingly, it is sensible for a copy of all such letters limiting liability to be kept with the insurance-renewal papers for review at renewal.

With one exception, there is no distinction on limiting liability according to the nature of the work undertaken. Under s60(5) Solicitors Act 1974, there is, however, a specific provision relating to the exclusion of liability in contentious business agreements⁶.

It is important to appreciate that s60(5) only relates to a retainer under a contentious business agreement⁷. Importantly, it does not relate to all contentious work.

First, it relates solely to contentious matters as defined in the Act. This immediately restricts the provision to work undertaken in relation to actual proceedings before a court or arbitrator.

Second, it relates solely to work undertaken under a contentious business agreement (CBA). CBAs are defined by s59 of the Act. Although widely drafted, it is clear that the section is permissible – solicitors may enter into a CBA with the client. It is not that all retainers relating to contentious matters are CBAs. Indeed the contrary is more likely – most retainers will be under the flexibility acknowledged by CPR Part 48.8.

It is unlikely that a retainer will amount to a CBA “unless it is possible for the client...to calculate how much he is being asked to pay. An agreement as to the hourly rates to be charged will clearly be insufficient if the amount of time for which a charge will be made is not known at the time the agreement is entered into,” per Lord Denning in Chamberlain v Boodle & King [1982] (my emphasis). It follows that most retainers for contentious work are, in any event, not CBAs and, in consequence, the restrictions in s60(5) will not be relevant.

Third, even in the unlikely event that the retainer is on a CBA, the first limb of the sub-section prohibits complete exclusion of liability for negligence rather than a limitation of liability. The second limb is more perplexing. Logically, the draftsman must have intended a responsibility other than not to be negligent and there are of course many such duties in the Act. It is submitted that the section is directed at those responsibilities.

Sophisticated limitation clauses might also have a provision stipulating that claims must be made within a particular period. Such clauses will often have a provision for notification of claims within a first period and the commencement of claims within a further period. Such clauses are generally enforceable, if reasonable, although have not been tested in a professional rather than a commercial context⁸.

A still more sophisticated approach (found in particular in the context of the professional team in building projects) is to include a net-contribution clause. Such a clause short circuits the impact of potential contribution claims and leaves the professional with only that liability that it is fair for him to have, bearing in mind the blame attached to any other professional⁹.

LLPs as a risk-management strategy

Converting to a limited-liability partnership may not be the best risk-management solution, at least not without first evaluating the risk being addressed. Various strategies may be called on for different risks. If, for example, the risk is an immediate trading risk, conversion to LLP status may not assist at all in the immediate future (indeed the costs of conversion may exacerbate the problem) and, in the medium term, the success will depend on the willingness of the creditors to accept the covenant of the LLP.

Incorporation as an LLP will not, of course, dispense with all risk. The LLP will still expose the solicitor to the inevitable risks of being in business. The LLP will be subject to the same problems of gaining sufficient business, doing it profitably, getting paid and controlling costs.

Banks and other creditors may require debentures or even personal guarantees. In any event, it is vital to appreciate that if the LLP goes under, it will inevitably have a serious impact on the fortunes of the members who will lose their livelihood.

First and foremost, the cost of incorporation (aside from the fees and time spent on conversion) is classically said to be the requirement for financial disclosure. As the journals have increasingly accurate information on the top 100 (or more) firms, many feel that disclosure merely confirms published facts. There will remain a salacious interest in the accounts, and especially the detail hidden in the notes, but I suspect interest in the headline figures will be no more than is already common knowledge.

The second is the need for accounting adjustments. I understand that every firm that has converted has had to make some accounting change, incurring costs and making direct comparisons difficult. Third is the change in culture and the seatbelt mentality of risk taking. Having LLP protection may prompt some into taking greater risks, which may lessen the standing of the profession and generate more claims against the particular business. Finally, there was much concern that incorporation might destroy the ethos of the firm and the team spirit of the partnership. This concern is over-stressed. You remain in business with your former partners but as members. You retain the common interest of a successful business. In any event, some firms are already so large that they have a corporate feel.

The prize for incorporation is the limitation of liability. The mechanism by which it is achieved is not novel. The concept of a separate legal entity is well recognised in company law. It is because partnerships had no separate legal existence that the partners were personally liable. By having a trading entity that had its own identity the strictures visited by the Partnership Act are removed.

The other benefits of incorporation are said to be ease in recruitment and promotion. Assets are in a central ownership (and nominee partners owning a lease, for example, can be avoided), the structure is open, modern and refreshing, the conversion gives an ideal time to talk to clients, gain PR coverage and enhance the profile of the business and there is an enhanced regard for risk management within the firm, which may create efficiency gains.

Problems with LLP structure and personal liability for members10

One of the most obvious ways to manage the risk of the catastrophic client claim is to incorporate as an LLP¹¹. The perceived Holy Grail of incorporation as an LLP is to remove personal liability. The theory goes that the liabilities all rest with the LLP and if the claim exceeds the limit of indemnity, the LLP can be sacrificed leaving the personal wealth of the members untouched.

In many instances, the liability will rest with the LLP and the member will remain inviolate (subject only to losing his wealth in the LLP, his livelihood and the possibility of claw back). Nevertheless, cases such as Williams v. Natural Life Health Foods¹² and Merrett v. Babb¹³ have left serious doubts as to whether and, if so, in what circumstances, the desired protection will be effective.

The nightmare scenario is that LLP protection for members will be tested not by a large corporation but by a little old lady from Nuneaton who entrusted her affairs to an adviser who stressed that he would personally oversee matters.

There have been suggestions that to address the ethos argument, members’ agreements should replicate much of what was in the previous partnership agreement, including such things as good faith between members. Any step in this direction runs the risk of fundamentally undermining the concept of limitation of liability. A member sued under the Williams v Natural Health/Merrett v Babb principles may seek a contribution from his fellow members if there is an express duty of good faith, the breach of which has exposed him to the claim.

Still more undesirable is any concept of an indemnity between members as this may result in more partners becoming insolvent.

Similarly, discussions prior to conversion to the effect of “we’ll each make sure the other keeps a roof over their heads” notwithstanding the conversion, may give rise to misrepresentation or collateral contract claims. Remember that in the nightmare scenario the wrongdoing member may become bankrupt and his trustee in bankruptcy may be pursuing the claims rather than the member himself.

Furthermore, a management board that presides over working practices that give rise to claims (for example, insufficient secretarial resource resulting in delays) might itself be vulnerable to a claim for failing in a duty to a particular member to properly manage the business. Furthermore, the right of any liquidator to pursue claims in the name of the LLP against members for breach of their duties to the LLP is likely to be a key area of future jurisprudence.

Entire agreement clauses and clauses determining how and in what manner variations to a member’s agreement can be made are likely to be vital in such circumstances¹⁴.

The starting point for any personal responsibility, in contrast to LLP liability, is, as ever, that the client contracts with the LLP and it is the LLP against whom they have a claim. It is only if the unusual circumstances of an assumption of personal responsibility arise that the member will have a joint liability with the LLP.

That assumption of personal responsibility must, it appears, derive from “exchanges between the [parties]. The enquiry must be whether the [member] conveyed directly or indirectly to the [client] that the member assumed personal responsibility towards the [client]¹⁵”. If such assumption were established the client must prove reliance but: “The test is not simply reliance in fact. The test is whether the [client] could reasonably rely on an assumption of personal responsibility¹⁶.”

It is clear that a serious personal risk remains for the solicitor, even within an LLP, whose relationship with a client is very personal, whose client-care letter stresses his personal involvement and who personally gives reassurance that the work of junior members of staff is correct. It is for these reasons that the little old lady from Nuneaton may be a more formidable foe than the large corporation. How the law will develop in this area will no doubt be keenly awaited.

Claims do not have to come merely from clients. The claim from the non-client is a particular concern especially as the potential to limit liability is removed due to the absence of a contract within which to limit liability. Accountants have been particularly alert to the potential for claims arising from audit reports in accounts. A Scottish decision¹⁷ caused considerable concern to the profession and resulted in audit reports being amended to expressly exclude any liability to anyone other than the company and its members¹⁸. No doubt, with suitable amendments, the use of this sort of clause will become more prevalent with solicitors.

There are finally a group of miscellaneous liabilities that either cannot be moved to the LLP or are not known about. These may include retired-partner annuities, historic-lease liabilities and claims for work undertaken for which releases cannot be sought or obtained. Firms with strong balance sheets have been able to get releases from banks and landlords in return for new covenants from the LLP.

Insurance and members agreements: Managing the risk

If a member is the subject of a catastrophic claim and is personally insolvent, an indemnity between members is undesirable. There may be no alternative other than to allow that member to become bankrupt.

There are two main alternatives to bankruptcy beyond normal commercial negotiation:

The trust approach. A trust is established and set aside for the dependants of an insolvent member. The workings of the trust are a matter for the individual LLP. The dependants of members of the LLP could be members of the class of beneficiaries and money advanced or loaned to them to purchase the insolvent member’s interest in, say, the family home and/or provide some ongoing income. Again, it will be a matter for each LLP to determine the extent to which the trust needs to be fully funded or whether the members are happy with a promise of future income payments from the other members;
The possibility of insurance. St Paul Travelers has its product ‘Lifeboat’, which is designed to pay out to protect the family assets. The insurance has the advantage that a cash reserve does not need to be built up to establish the trust fund. I understand that the policy can have a limit of up to £10m and is available to all UK-based LLPs subject to normal underwriting considerations.

References:

Guide to Professional Conduct – Principle 12.11
Typical basic wording might be: “The firm’s aggregate liability, if any, to you under this retainer or otherwise relating to it (including costs) and whether for breach of contract, negligence, misrepresentation or otherwise is limited to the lower of (a) £X and (b) any loss caused directly by us (thereby excluding all indirect or consequential loss) subject always to our liability not being below [the minimum level of cover]”
But note the distinction between direct and indirect losses: Hotel Services Limited v. Hilton Hotels International (UK) Limited [2001] 1 All ER (Comm) 750
See the discussion in Watford v. Sanderson [2001] 1 All ER (Comm) 696 paras 49 – 58 per Chadwick LJ where the distinction is drawn between excluding a type of loss (indirect or consequential loss on the facts of the case) and restricting liability
This provides: “Although it is not acceptable for solicitors to attempt to exclude by contract all liability to their clients, there is no objection as a matter of conduct to solicitors seeking to limit their liability provided that such limitation is not below the minimum level of cover required by the Solicitors’ Indemnity Rules”
The sub-section provides: “A provision in a contentious business agreement that the solicitor shall not be liable for negligence, or that he shall be relieved from any responsibility to which he would otherwise be subject as a solicitor, shall be void”
See s59 of the Act.
See generally Senate Electrical v. Alcatel Submarine [1999] 2 Lloyds Rep 243
A typical clause might provide: “The firm’s liability under this retainer or otherwise relating to it shall be limited to that proportion of your losses that it would be just and equitable to require the firm to pay having regard to the extent of the firm’s responsibility for the same on the basis that all other professional advisors involved in matters relating to this retainer shall be deemed to have provided an undertaking in terms no less onerous than this clause.”
For more on this subject see the article by the author and Peter Garry in The Lawyer, 8 November 2004
A typical clause might provide: “Your agreement is solely with the limited-liability partnership and no member of it assumes or will assume personal liability for the conduct of the work you instruct us to carry out. To the extent permitted by law, no member of the limited-liability partnership shall have any personal liability for any matter arising out of this instruction whether arising in contract, tort, negligence, breach of statutory duty or otherwise and you waive any such claim as may arise.”
[1998] 1 WLR 830
[2001] QB 1174
Although see Lowe v. Lombank [1960] 1WLR 196
per Lord Steyn in Williams @ p 835H
Ditto @ p 837
The Royal Bank of Scotland v. Bannerman Johnstone Maclay [2003] SLT 181
The suggested text for auditors in the ICAEW publication Audit 1/03 is: “This report is made solely to the company’s members, as a body, in accordance with section 235 Companies Act 1985. Our audit work has been undertaken so that we might state to the company’s members those matters we are required to state to them in an auditor’s report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the company and the company’s members as a body, for our audit work, for this report, or for the opinions we have formed.”

Peter Ashford is a partner in the commercial-disputes team at Cripps Harries Hall. He can be contacted at pra@crippslaw.co