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Lawyers, liability and the firm

Cover Story
|Written By Philip Slayton
Lawyers, liability and the firm

Personal relationships and widely shared ideas about ethics and conduct once guarded the integrity of law firms. Not any more. Megafirms, competition and the LLP have changed all that. The question is, what is taking the place of the traditional law firm and the values it was built on?

strong>Personal relationships and widely shared ideas about ethics and conduct once guarded the integrity of law firms. Not any more. Megafirms, competition and the LLP have changed all that. The question is, what is taking the place of the traditional law firm and the values it was built on?

Harry Knutson has, as they say, been around the block a few times. Now about sixty, he’s an investment banker and entrepreneur, with a reputation for being tough and smart, who’s made — and lost — millions of dollars during a long and varied career. Harry’s no youngster, knows what it’s all about, and doesn’t expect to be coddled. Yet when I talked to him late last year about his ongoing litigation with Vancouver’s Davis & Company, he spoke with chagrin about his dealings with the law firm through his film financing company, Monarch Entertainment Corporation. For several years, Monarch had been one of Davis’s very biggest clients.

As any lawyer in Canada concerned about the growing issue of conflicts and professional liability knows by now, Monarch sued a former Davis tax partner named Robert Strother, and Davis itself, for tens of millions of dollars. The suit was launched in 1999, after what Knutson found to be a disturbing series of events. The trouble began with a meeting between Knutson and Strother in November 1997. Strother had bad news for his client: a crucial aspect of Monarch’s business, a tax shelter for investors that resulted in cheap financing for moviemakers, had recently been closed down by Revenue Canada. “There is no fix,” Strother is reported to have said.

Knutson took him at his word and closed down Monarch’s movie production financing business. A retainer agreement between Monarch and Davis & Company expired. But, shortly afterwards, Strother and a former Monarch employee named Paul Darc concluded that there was indeed a way through the closed tax loophole. With Strother’s legal help, Darc set up Sentinel Hill Entertainment Corporation (named after the part of Vancouver where Strother then lived) to exploit the opportunity, and in a few months received a favourable tax ruling from Revenue Canada. Strother left Davis and formally joined Darc in Sentinel Hill. The venture netted him spectacular gains — more than $30 million in about three years. When I went over this ground with Knutson late last year, it was clear that he felt betrayed, not only by Strother, but by Davis as well. Reflecting on his own emotions at the time he said: “My friends there — and I had a lot of them — betrayed me,” he said. “They were my lawyers. I trusted them, but they betrayed me.”

Well, one might say, too bad, that’s business. The retainer had expired, the new idea had been developed by Strother afterwards, the road was open. How many other times have such events occurred, apparently without attracting any sort of professional censure? But in January 2005, the B.C. Court of Appeal (unanimously reversing the trial judge) found that Strother was in breach of fiduciary duties owed to Monarch (referred to in the litigation as 3464920 Canada Inc.) and ordered Strother to disgorge to Monarch the $30 million or so he gained personally while in breach of those duties. In mid-December, the Supreme Court of Canada gave leave to appeal the decision; it is likely to hear the case in the fall of this year.

Strother, who had an outstanding reputation as an innovative and aggressive tax lawyer, clearly believed that he did nothing wrong. And many Canadian lawyers might agree with him. So what did he do? The nub of the matter, said the Court of Appeal, was a dual conflict within Strother’s legal practice. One conflict was between Monarch and Sentinel Hill. The second was between Monarch and Strother himself, for Strother had a significant personal financial interest in Sentinel Hill. The judgment emphasized a lawyer’s “duty not to place himself in a position of conflict and the duty to disclose any personal interest he may have that might affect his loyalty and dedication to the client’s cause.” It made clear that fiduciary obligations go beyond the scope of any contractual duties that might be found in a retainer letter and cannot be contractually limited or excluded.

Many lawyers were shocked by the Court of Appeal’s decision. Even if they had never been in Strother’s position, they could easily imagine how it could all happen. And, what was worse, other partners at Davis had been put at risk by a web of dealings over which they had had only limited control, and in some cases knew nothing about.

In the second part of its decision, given some months later, the court said that a law firm will only have full and direct liability for the unlawful gains of a partner if the firm gave him “knowing assistance,” or was There will only be vicarious liability if the rogue partner, when he made his unlawful gains, was acting in the ordinary course of the firm’s business. Neither, said the judgment, was the case when it came to Robert Strother’s breach of fiduciary duties owed to Monarch Entertainment. But, said the Court of Appeal, in the case of profits made by a law firm itself from the unlawful activity of a rogue partner, it doesn’t matter that the firm knew nothing about what was going on, or that the partner behaving badly was not acting in the ordinary course of the firm’s business. The firm is liable regardless. Accordingly, Davis & Company was told to disgorge its own profit from the files where Strother had a conflict. That profit may be as much as $9 million, although the precise means of calculation has yet to be established. This was like a punch to the legal profession: if upheld, the decision could mark a profound turning point in the way law is practised in this country, changing the very idea of what a law firm is.

All eyes are now on the Supreme Court. Robert Strother himself, of course, is appealing against the order that he disgorge $30 million or so. Davis & Company is arguing that it should not be required to give up the substantial profit it made from Strother’s activities. Monarch wants Davis & Company held jointly and severally liable with Strother for the full amount.

In its written reasons giving leave to appeal, the Supreme Court framed the case in a way that makes clear its fundamental importance to the future of the legal profession: “Circumstances in which solicitors and other professional fiduciaries are entitled to act for commercial competitors — Limits of duty of loyalty owed by a professional fiduciary — When disgorgement of profits through an accounting is justified as a remedy for breach of fiduciary duty — Whether no profit rule requires an order for disgorgement to one client, of profits or fees earned for services rendered to the other client — Whether disgorgement remedy can be ordered against a partnership on the basis of vicarious liability in the absence of any loss suffered as a result of a partner’s wrongful act.” Knutson is optimistic about his prospects in the Supreme Court, particularly when it comes to Davis & Company. (Strother and representatives of Davis & Company refused to discuss the case, on the traditional basis that it is still before the courts.) “My lawyers tell me that our arguments on the joint and several liability of Davis are very strong,” he told me. “When it’s all over, I expect to be sending the partners of Davis a very big bill, and it’ll be up to them to collect what they can from Robert Strother.” He added, with a slight smile: “The partners needn’t worry. I’ll work out a payment plan for each of them.”

It’s a mug’s game to predict the outcome of complex litigation, but the betting in the Canadian legal community seems to be that Strother will lose, and that Davis is vulnerable on the issue of joint and several liability. Of course, you could argue that Strother wins if Davis is held vicariously liable. If that happens, Davis may have to pay Monarch a huge amount, and try to collect later whatever it can from Robert Strother.

Meanwhile, the landscape for lawyers and their clients is shifting in other profound ways. Many Canadian law firms have lately changed from general partnerships to limited liability partnerships, as legislation and professional rules have been amended to make such a change possible. Typically, when this transmogrification takes place (by simple amendment to the existing general partnership agreement), a discreet advertisement is placed in the local newspaper’s business section and the firm quietly adds the letters “LLP” at the end of its name. (In many jurisdictions, such as Ontario, the formal requirement that clients be notified of the changed status is satisfied by advertising in a local newspaper.) Few clients, and certainly none but the most sophisticated, understand what has happened, and that what has happened is to their disadvantage.

And few partners seem to realize that the world has significantly changed for them as well. In a limited liability partnership, a partner has no responsibility for the liabilities of the partnership other than those which arise from his own negligent or wrongful act. (In some jurisdictions, a partner’s LLP liability also extends to persons under his supervision and control, and to liability for another partner or employee if he knew of that person’s negligence or malfeasance and did not take reasonable steps to prevent it.) Firms that convert to an LLP always disingenuously stress that, although the partners are no longer jointly and severally liable, clients should rest assured that the assets and insurance of the firm remain at risk. But most firms have little in the way of assets — they have leases of office space and computer systems that are more correctly seen as liabilities, a few pieces of art hanging in the reception area, that sort of thing — and have well-mined bank lines of credit that swamp the meagre assets they do possess. Recourse to firm assets will offer little comfort to a wronged client seeking recompense. Most firms — certainly the major ones — do carry significant insurance, although perhaps not enough to handle the very biggest of claims. It is the insurance policy, and particularly its fine print, that really matters.

People who use legal services, if you ask them the name of their lawyers, often give the name of a firm. Clients take comfort from the idea that an institution of history and reputation, one in which each member has responsibility for what the others do, is looking after their interests. But there is no such comfort if you are dealing with a limited liability partnership. The wise client will pick a particular lawyer, never a firm, for the concept of “picking a firm” now has little meaning. And, unless the lawyer you’re considering has great personal wealth, be sure to ask for those insurance policy details before signing up.

Even picking a particular lawyer may not work out the way you expect. Many years ago, I asked a very promising first-year lawyer at what is now McCarthy Tétrault LLP (today he is a senior and distinguished litigator) what kind of work he was doing. “Family law,” he said. I expressed surprise. How had that come about? “This is what happens,” he told me. “A senior businessman in Toronto is anxious to divorce his wife. He asks his friends: who is the best lawyer in Canada? They tell him, John J. Robinette. He comes to see Robinette. He gets me.” The same thing happens all the time today. A client meets a senior partner and acknowledged expert in the field at the first meeting. He may never see that senior partner again, but will have a lot to do with eager young associates.

The LLP structure, obliterating the traditional relationship between client and law firm, is also fundamentally changing the relationships between lawyers within a firm. The general partnership structure was based on trust. Only someone who was trusted was admitted to the partnership and kept there. Trust in your fellow partners, and in the quality of their work, was signalled to the world by agreeing to joint and several liability. Trust fostered a congenial work environment, and enhanced the quality of a legal practice. But the partners are no longer “all in it together.” Trust is no longer required: indeed, it is ill-advised. The savvy partner will be very careful what work he takes on, avoiding large, high-risk transactions that could destroy him financially if they go wrong (his “partners” will look on with sympathy while he is destroyed, but need not and will not put their hands in their own pockets).

Giving advice to colleagues on difficult problems arising in large transactions is something to avoid: a ten-minute chat in your office about the issues in an important legal opinion could wipe you out financially. One of the best features of traditional law firm life — the give and take on legal problems, the exchange of wisdom and experience — is severely discouraged by the LLP structure. And only someone very comfortable with personal risk would occupy a management position in an LLP — head of a practice group, for example, or member of an opinion committee — because such a position carries with it possible liability for everybody and everything.

A limited liability partnership shifts risk, away from the law firm, to clients and insurers. Even worse, it takes away a powerful incentive to adopt systems that prevent negligence and malfeasance. Many scholars have argued that the corporate debacle beginning with the collapse of Enron was in part made possible by the limited liability structure of professional firms, such as Arthur Andersen, that gave poor (and sometimes unlawful) advice to corporations that later imploded.

In the limited liability partnership, the rogue partner problem virtually disappears: the straight-dealing partner doesn’t have to be overly concerned about those who stray. One reason why Arthur Andersen collapsed so dramatically, suggest some commentators, is that there was no reason for partners to stay around and sort out the mess: after all, it was an LLP, and they weren’t on the hook.

All of which brings us back to Robert Strother and Davis & Company. It only became possible for a British Columbia law firm to become an LLP in 2005 (through amendments to the B.C. Partnership Act, the Legal Profession Act and the Law Society Rules). Davis & Company, along with many other B.C. law firms, seized the opportunity as soon as it was presented. It is, of course, irrelevant to Strother’s personal liability that Davis was not an LLP when there was all that trouble with Monarch Entertainment. But had the firm been a limited liability partnership at that time — as it is now — other Davis partners could have looked on the Strother proceedings with sang froid. Their personal economic welfare would not be at stake, although, of course, firm assets, such as they may be, would have been in jeopardy, and there is the question of the insurance policy.

Oh yes, the insurance policy. As I described in the March 2005 issue of Canadian Lawyer, there’s a problem with the insurance in Strother. The B.C. Law Society’s professional liability insurance policy excludes from coverage a claim in connection with any organization in which a lawyer had greater than a 10 percent ownership interest at the time of the error (Strother had such an interest in Sentinel Hill). Coverage is excluded for both the lawyer and for any lawyers vicariously liable for the responsible lawyer’s acts, including his partners. This exclusion is also a common provision in excess insurance policies designed to supplement insurance provided by law societies. (Since 2002, the B.C. Lawyers Insurance Fund has provided optional “innocent insured coverage” for lawyers who may face claims that are uninsured because of the business interests of another lawyer at the firm.)

And so, had Davis & Company been an LLP in the 1990s, any possible recourse by Monarch Entertainment to the firm and its partners would not amount to much. The partners who were not involved would not be liable; the firm assets undoubtedly would not even remotely satisfy the size of any judgment against Davis in favour of Monarch; and insurance coverage is dubious.

But that doesn’t help Robert Strother very much. He wouldn’t talk to me because, he said, his case is before the courts, but that didn’t stop him, once the Supreme Court had given leave to appeal, from issuing a press release (through a public relations firm), and giving an interview to Vancouver journalist David Baines.

The December 15 press release says in part: “This case has occupied my life for almost half a decade, and it is my hope that the Supreme Court will restore the Trial Judge’s findings and conclusions…. Obviously the court has seen the important elements of the case and has moved to address them.” The press release referred to the B.C. Court of Appeal decision as “surprising and controversial.” David Baines, reporting on his Strother interview in the Vancouver Sun last December, describes Strother as striking “a philosophical pose” when asked about the Court of Appeal ruling, and saying — of the forthcoming Supreme Court decision — “whatever the decision I will live with it.”

Argument before the Supreme Court in Strother will likely take place in the autumn of 2006, with judgment sometime in 2007. We wait for the Supreme Court to tell us: What is the duty of a lawyer to his client? What is the duty of a lawyer to his law firm? And what is the duty of a law firm to the client of a law firm member? The answers to these questions will go far to tell us what a law firm is.

Philip Slayton received law degrees in 1968 and 1969 from Oxford University in England, which he attended as a Canadian Rhodes Scholar. He clerked for a judge of the Supreme Court of Canada, and then was a law professor, and later dean of a law faculty. After leaving the academic world in 1983, he practised commercial and corporate law for almost twenty years as a partner of a major Canadian law firm. His book on errant lawyers, Lawyers Gone Bad: Money, Sex and Madness in Canada’s Legal Profession, will be published by Penguin Canada later this year. He writes a regular column for the magazine and is currently Visiting Professor of Law at the University of Cape Town in South Africa.