Risk Management – Hazard Controls

By Dennis Duitch & Marcia W. Wasserman
Los Angeles Daily Journal California Law Business July 10, 2000

The practice of law has changed over the last decade and will continue to change as a result of the technological revolution and its impact on how firms practice. Law firms today need to operate more as businesses than ever before, including being proactive about risk management and the type of insurance coverage carried.

According to Karl Bemesderfer, vice president and general counsel of Seraph Insurance Services, “Three trends have transformed and are transforming the private practice of law from a common profession into an individualized business. [They are] the movements from general partnerships to limited liability structure, from status-based compensation to performance-based compensation, and from growth based on internal promotion to growth based on lateral hiring.”

Bemesderfer feels that the conversion to a limited liability partnership removes some of the protections against a major personal loss because partners tend to minimally capitalize such firms. In limited liability law firms, all but negligent partners are shielded from risk, “Instead of being one of three barriers to personal financial ruin, insurance has become the only barrier.” (Asset and income protection insurance is available to provide coverage to individual partners beyond traditional errors-and-omissions insurance coverage.)

Additionally, he notes that “moving from status-based compensation to performance-based compensation and from promotion to lateral entry as a means of growth discourages risk management since risk management is a product of collaboration. As firms are transformed from risk-and-reward sharing common enterprises into ‘every man for himself’ collections of individual lawyers, the risk of serious malpractice rises.”

Another trend that could give rise to liability is attorneys taking an equity interest in clients. Elliott Rothman, vice president of Professional Practice Insurance Brokers, Inc. notes that “most errors-and-omissions policies have an exclusion for outside interests, and that if the firm has an ownership interest, controls or manages a client, it may not be covered for legal work performed for the client.”

Rothman encourages firms to carefully read their professional liability-insurance policies. “Some policies define what they mean by ‘control’ and others do not. Some policies use benchmarks between publicly and privately held companies.” He suggests that “firms keep their positions in clients small, and invest in not more than 3 [percent] to five percent of the stock of the client as a risk management benchmark”.

Rothman also says “the biggest threat probably comes from the risk of third party claims by shareholders, which could result in punitive damages that would not be covered by errors-and-omissions insurance.”

Bruce Friedman, chair of the litigation department at Alschuler Grossman Stein & Kahan LLP, who specializes in lawyers’ professional-liability defense, adds that errors-and-omissions policies also have exclusions that “preclude lawyers from serving as directors of companies for whom they perform legal services. Lawyers that serve on client boards should obtain consent and coverage from their errors-and-omissions insurer and also insist that the company have directors and officers coverage for their exposure as directors. It is very difficult for a lawyer/director to avoid liability as a lawyer when he sits on a client board as the corporation can point the finger at the lawyer in his capacity as a lawyer even if he is offering his advice and counsel solely in his director capacity.”

With respect to firms owning an interest in clients, Friedman finds that lawyers “fail to comply with Rules of Professional Responsibility, and most particularly Rule 3-300, which prohibits a lawyer from entering into a business transaction with a client” unless certain conditions are met. “Failure to comply with this rule,” says Friedman, “places the lawyer in jeopardy of a breach of fiduciary duty claim and a burden to prove that the transaction was fair and reasonable.”

In addition to the impact of the aforementioned trends, there is a need for heightened awareness of some of the more “routine” areas that could give rise to a malpractice claim. In order to minimize the firm’s exposure to malpractice, the following questions should be considered:

  • Does the firm screen potential new clients before accepting new business? As difficult as it may be to turn down new business, it is important that potential new clients be “screened” before their matters are accepted by considering such issues as whether the new client previously changed attorneys. If so, the attorney needs to explore why the prior firm was terminated. If the explanation seems inadequate, or the client has already been represented by several law firms, is this the kind of business and risk the firm really wants?
  • Is the matter within the area of the individual lawyer’s specialty or the firm’s area of expertise? Is it safer to refer any matter which is not to another firm that has such expertise?
  • Is the client’s matter larger than the matters usually handled by the firm? If so, does the firm really have the required resources to handle it with full professionalism? Is the client having serious financial problems? If the financial viability of the client depends upon a favorable outcome, and a favorable outcome cannot be assured, might the client look to the firm if the results do not meet its expectations?
  • If, after “screening” the matter, the firm declines to represent a client, is a declination letter immediately sent to the client by certified mail as a proactive method of risk management?
  • Does the firm have, and does it regularly use, a computerized docket/calendar/conflict-of-interest program? In today’s automated world, there is no reason to keep this information manually. The conflict portion of the database should contain potential clients that have been declined, names of parties added during the pendency of an action, and officers, directors, owners, relatives and parent and subsidiary companies. The master calendar should be maintained on the firm’s network, printed and distributed at least weekly and be accessible online to all attorneys, paralegals, law clerks and legal secretaries in the office.
  • Does the firm have a segregated client trust account that complies with the rules and regulations promulgated by the State Bar of California? Is that account reconciled monthly to ensure that all client trust-account funds have been properly accounted? Are client trust funds kept separate and never comingled with moneys in the firm’s general account?

    Further, the only signatories on client trust accounts should be attorneys, and preferably partners. As an ethical and internal control, bookkeepers, administrators and office managers should never have check signing authority on client trust accounts. Mishandling of client trust funds frequently gives rise to malpractice claims and can result in lawyers losing their license to practice.

  • Does the firm have a procedure for screening new lawyers, paralegals and legal secretaries before they are hired for potential conflicts of interest, and for new lawyers, prior malpractice claims and prior malpractice coverage? This is a question that is frequently asked on lawyers professional liability insurance application forms. Too often the right questions are not asked before someone is hired, which could result in the firm being disqualified or sued for malpractice due to conflict of interest. In addition, lateral attorney hires’ prior malpractice claims could negatively impact the firm’s professional-liability insurance rates and coverage availability.
  • Does the firm sue clients for unpaid legal fees? Insurance carriers ask this question on application forms because, in almost every instance, a lawsuit against a client for unpaid legal fees will result in a counterclaim for malpractice. Even if the lawsuit is without merit, insurance carriers would rather not be forced to defend such lawsuits.

Beyond malpractice exposure, increased reliance on the Internet and use of computers for communicating with clients has created risk of another kind. E-business exposures may not be covered under traditional commercial insurance or professional-liability insurance. These policies may limit or exclude cyber-risk coverage or specifically exclude coverage due to breaches in security. According to Stephen Kempsey, vice president and Practice Leader for financial and professional insurance products at Marsh, Inc., “a new type of insurance is available that addresses significant e-business exposures including loss or theft of electronic information assets, including intellectual property; loss of income due to network and web-site disruptions or interruptions; theft of credit card information; third-party financial losses associated with computerized business links and interdependencies; breach of privacy and unauthorized release of personal information; multimedia or content injury, such as web-related defamation, copyright infringement and false advertising.”

Law firms should weigh the cost of such coverage against the risk of a potential business loss or claim due to e-business exposure.

Finally, beyond being adequately insured, firms need to maximize their awareness by creating in-house risk-management programs. Risk management should be part of the firm’s continuing legal-education programs. These programs should include updates on professional standards and current legal developments with respect to malpractice. Internal risk-management policies and procedures need to be implemented, disseminated and monitored to minimize the firm’s risk.