Limited Liability of Professional Firms after Enron

Article excerpt

ABSTRACT

Some commentators suggest that mandatory personal liability of professionals for liabilities of their firms is appropriate in light of professionals' role in Enron and other recent frauds. This liability can, indeed, help ensure that professional firms deliver on their obligations to monitor their members and clients. However, such liability is ineffective and costly. Holding professionals vicariously liable for their colleagues' defaults is unlikely to significantly increase firm monitoring. At the same time, imposing this risk on professional firm members is likely to perversely affect both professionals' incentives and the structure of their firms. Professional firms accordingly are better constrained by the market for professional services, which demands that professional firms develop significant reputations to, in effect, bond their promises to monitor. Moreover, professional services firms someday may be able to rely more on conventional financial capital to bond their monitoring promises. These alternatives to vicarious liability are constrained by legal restrictions on the size and shape of professional firms, particularly including restrictions on non-competition agreements and on ownership by non-professionals.

Just as professionals managed to clear away the last vestiges of mandatory personal liability for the debts of their firms, the stock market crash and scandals of 2002 are now threatening this equilibrium. Lawyers and accountants are taking some blame for the monitoring failures that led to Enron. In particular, claims against several large law firms and Arthur Andersen arising out of the Enron collapse have survived a motion to dismiss and are pending resolution.1 Commentators ask whether professionals' lapses can be attributed to their limited liability.2 For example, Deborah L. Rhode and Paul D. Paton conclude:

In essence, LLPs privilege professional over public interests. Moreover, the benefits of this system flow disproportionately to the largest law firms, which could most readily prevent and spread the costs of misconduct. Reducing this insulation from accountability could give lawyers greater incentives to address collegial misconduct and to establish the internal oversight structures that can check abuses.3

This Article questions this conclusion. To be sure, vicarious liability of professionals for the debts of their firms would increase professionals' accountability for their firms' failures to monitor their members and clients, thereby reducing the risks faced by clients and others in relying on professional firms. But mandating vicarious liability for professionals is a relatively ineffective way to cause professional firms to perform their duties to clients and others. Among other things, this liability is based on an attenuated notion of responsibility and unrealistic assumptions about firm members' ability to monitor. More importantly, exposing professionals to the risk of personal liability for their colleagues' mistakes may increase certain types of agency costs between professionals and their clients, perversely affect professional firm size, structure and scope, and even reduce desirable liability of the firm.

In evaluating vicarious liability's appropriate role, it is important to recognize that, even without such liability, professional firms have strong incentives to build and maintain valuable reputations by monitoring both members and clients. Since monitoring lapses automatically devalue firms' reputations, this mechanism theoretically can operate wholly without liability rules. Alternatively, reputational sanctions might be triggered by a relatively low-cost liability regime in which the liability acts primarily as a signaling mechanism rather than as a way to assess damages.

A potential problem with this analysis is that, even if it is in the firm's interest to maintain its reputation, individual members may have incentives to cater to clients' shortterm interests in minimizing compliance with disclosure and other regulations. …