Failure to Maintain Professional Liability Insurance is Not Grounds for Stripping Partners of Limited Liability Protection
The Supreme Court of New Jersey has held that a court may not strip a law firm’s partners of the protections of a limited liability partnership (LLP) because the firm did not maintain malpractice insurance to cover the period after the partnership had dissolved and was winding up its business. Mortgage Grader, Inc. v. Ward & Olivo, LLP, No. A-53-14, 2016 WL 3434529 (N.J. Jun. 23, 2016). The Court’s decision should give comfort to all professionals that practice in a limited liability entity that the liability protections they enjoy will not be forfeited just to provide a remedy to an injured plaintiff.
In Mortgage Grader, a former client sued the law firm and each of its partners after the firm dissolved and was in the process of winding up its affairs. The firm had maintained professional liability insurance during the time it was actively practicing law (when the alleged malpractice occurred) but it did not purchase “tail” coverage for claims arising after its dissolution. The trial court had held that the failure to maintain liability insurance violated Rule 1:21-1C(a)(3) (the “Rule”), which requires attorneys practicing within an LLP to maintain professional liability insurance to cover any damages resulting from any claim made against the LLP by its clients. Because the LLP did not have “tail” insurance, the trial court held that the individual partners were not shielded from personal liability, as they would have been as members of an LLP, and were vicariously liable for their partners’ negligence. The trial court thus stripped the partners of the protections of the LLP, converting the LLP into a general partnership. The Appellate Division reversed and held that neither the Rule nor the Uniform Partnership Act (UPA) authorized the trial court to remove the individual partners’ liability protections.
On appeal, the Supreme Court held that the Rule did not require a dissolved LLP to maintain professional liability insurance since it was no longer engaged in the practice of law but is simply collecting receivables and paying off the liabilities of the practice. Relying on the UPA and case law interpreting it, the Court held that the administrative activities conducted during the windup period did not amount to the transacting of business for which the LLP was created. Further, the law firm, in fact, had insurance at the time the alleged malpractice occurred. Even if the firm had failed to maintain insurance, nothing within the Uniform Partnership Act authorized the “conversion” of an LLP into a general partnership to rectify that omission. The Court noted that the UPA provisions governing revocation of LLP status manifested a strong intent to preserve the liability shield. Thus, the UPA requires at least 60 days’ notice before revocation, and affords the LLP an opportunity to cure any procedural deficiency prior to revocation. The UPA also allows for reinstatement of LLP status within two years of revocation as if there had been no interruption in status, for the specific purpose of preserving the limited liability protections.
Mortgage Grader shows that courts will be reluctant to order fundamental changes in the structure of freely chosen business entities, especially when imposing such changes would undermine the limited liability protections the members rely on and expect.