REVIEW Should Law Firms be Permitted to Incorporate? An Analysis of the Trade Practices Commission Recommendation

Ian M Ramsay Introduction In a wide ranging review of the Australian legal profession, the Trade Practices Commission has examined the rules that currently regulate the way in which law firms conduct their businesses.1 Although the Commission has made many recommendations in its report, the focus of this article is upon one recommendation. This recommendation would allow law firms to incorporate and thereby allow the partners (who would become equity holders) of the law firm to obtain the benefits of limited liability.2

Trade Practices Commission, Study of the Professions: Legal, Final Report, March 1994. The Commission notes in its Draft Report that solicitors are already permitted to incorporate their practices in four of the eight Australian jurisdictions. These jurisdictions are New South Wales, Victoria, South Australia and the Northern Territory. The Commission notes that where incorporated practices are allowed, approval by the relevant law society is conditional upon a number of matters including the sole object of the company being the practice of law; directors being actual persons holding practising certificates, all voting shares and the right to share in profits; and the company and its directors carrying unlimited liability. See Trade Practices Commission, Study of the Professions: Legal, Draft Report, October 1993.

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The precise recommendation of the Commission is that law firms would be able to incorporate and consequently limit the liability of the equity holders for malpractice to the extent to which each equity holder would not be jointly liable for the malpractice of the other equity holders in the firm. Individual equity holders would still have unlimited liability for their own malpractice. Compulsory professional indemnity insurance would have to be maintained by the law firm. The result is that clients who have suffered loss because of malpractice by an equity holder in an incorporated law firm would have potential redress up to the value of the compulsory insurance cover and the personal wealth of the relevant lawyer.3 The recommendation of the Commission is part of a broader debate concerning whether professionals should be able to limit the extent of their liability for malpractice. Much of this debate has focussed upon the liability of auditors given the significant increase in both the number and size of legal claims against auditors in recent years.4 Attention is now focussed upon lawyers limiting their liability for malpractice as a result of the Commission's report. The objective of this article is to evaluate critically the Commission's recommendation. A number of possible rationales for allowing the introduction of limited liability in the context of law firms are considered. Some of these are demonstrated to be unpersuasive. Two issues are given particular consideration. The first is the possible effects of limited liability on the standard of care employed by lawyers. Will limited liability reduce the standard of care? The second issue is the possible effects of limited liability on the degree to which lawyers in a firm will continue to monitor each other. Monitoring fulfils an important function as it ensures that the law firm is providing services of sufficient quality to clients. These two issues are related. Under a regime of unlimited liability, each lawyer, being fully liable for any malpractice which he or she performs, has a powerful incentive to ensure that appropriate care is taken in connection with the provision of legal services to clients. At the same time, because unlimited liability also means that all partners are jointly liable for the malpractice of other partners in the legal law firm, each partner also has an incentive to be monitoring the quality of the legal services provided by these other lawyers.

Trade Practices Commission, above, n 1 at 130. See, for example, Working Party of the Ministerial Council for Corporations, Professional

Liability in Relation to Corporations Law Matters, June 1993.

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Given the existence of these incentives to take appropriate care which are generated by unlimited liability, there must be strong reasons to allow law firms to incorporate and thereby obtain limited liability. The conclusion of the article is that these reasons do exist. In particular, it is demonstrated that unlimited liability does not always create the appropriate incentives to take care and, in addition, it can work against the interests of clients by imposing unjustified costs upon law firms which are passed on to clients. Limited Liability and Law Firms A number of rationales for allowing law firms to incorporate and obtain the benefits of limited liability are outlined in the report of the Commission. These rationales are quite different from those which have typically been advanced to explain why limited liability applies to public companies.5 The rationales in the context of public companies are that limited liability: *

* * *

decreases the need for shareholders to monitor the managers of companies in which they invest because the financial consequences of company failure are limited; assists the efficient operation of the securities markets; permits efficient diversification by shareholders; and facilitates optimal investment decisions by managers and provides incentives for managers to act efficiently and in the interests of shareholders.6

The first rationale advanced by the Commission for why law firms should be granted the benefits of limited liability is that limited liability will assist law firms obtain equity capital.7 It is not evident that law firms need equity

See I M Ramsay, "Holding Company Liability for the Debts of an Insolvent Subsidiary: A Law and Economics Perspective" (1994) 17 UNSWLJ 520 for discussion of limited liability and public companies. For discussion of these rationales in the context of limited partnerships, see I M Ramsay, "The Expansion of Limited Liability: A Comment on Limited Partnerships" (1993) 15 Sydney Law Review 537. These rationales are drawn from F H Easterbrook and D R Fischel, The Economic Structure of Corporate Law, Harvard University Press, Cambridge, 1991, pp 41-44. A major debate in corporate law is how to resolve the conflict between justifying limited liability on the basis that it encourages investment in productive but risky activities and companies engaging in overly risky or harmful activities because shareholders will not be liable personally for these activities. See D W Leebron, "Limited Liability, Tort Victims, and Creditors" (1991) 91 Columbia Law Review 1565 at 1565-1566. Trade Practices Commission, above, n 1 at 130. More detailed discussion of the rationales for limited liability is contained in the Draft Report of the Trade Practices Commission on the legal profession published in October 1993, above, n 2.

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capital. The fact that Australian law firms largely rely upon debt capital rather than equity capital has not prevented the formation of very large national law firms. For example, one law firm, the Australian Legal Group, has 217 partners, 547 employed solicitors and 1,011 support staff.8 The second largest national law firm, Mallesons Stephen Jaques, has 159 partners, 406 employed solicitors and 674 support staff.9 Australia has eight national law firms each of which has at least 100 partners and more than 250 employed solicitors.10 Therefore, a rationale that Australian law firms should be given limited liability because they require equity capital is unpersuasive. A second rationale advanced by the Commission draws upon the work of Carr and Mathewson.11 These two authors argue that unlimited liability causes law firms to be inefficiently small because it discourages investment in law firms. The authors support their argument with empirical evidence. A number of States in the United States now allow law firms to incorporate.12 The authors examined the size of law firms which changed their liability status from unlimited to limited. The evidence reveals that such a change in status increased the average law firm's size.13 The Carr and Mathewson study can be criticized on several grounds. First, it can be criticized on the same basis as the first rationale for limited liability advanced by the Commission. In other words, given the significant size of national law firms in Australia, each of which currently operates under a regime of unlimited liability, it is difficult to assert that these law firms are inefficiently small. Unlimited liability does not seem to have prevented the development of large law firms in Australia.

Australian Financial Review, 3 March 1994 at 28. Australian Financial Review, above, n 8 at 28. Australian Financial Review, above, n 8 at 28. J L Carr and G F Mathewson, "Unlimited Liability as a Barrier to Entry" (1989) 96 Journal of Political Economy 766. For discussion of these developments in the United States, see S E Kalish, "Lawyers Liability and Incorporation of the Law Firm: A Compromise Model Providing Lawyer-Owners With Limited Liability and Imposing Broad Vicarious Liability on Some Lawyer-Employees" (1987) 29 Arizona Law Review 563; K M Maycheck, ‘Shareholder Liability in Professional Legal Corporations: A Survey of the States' (1986) 47 University of Pittsburgh Law Review 817; D Paas, "Professional Corporations and Attorney-Shareholders: The Decline of Limited Liability" (1986) Journal of Corporation Law 371. Carr and Mathewson, above, n 11 at 781.

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A second criticism of the Carr and Mathewson study has been made by Ronald Gilson.14 Gilson argues the authors have reversed the direction of causation. Rather than a change from unlimited to limited liability causing law firms to increase in size, Gilson argues it is more likely that law firms change their liability status because they in fact grow larger. Gilson argues that central to understanding law firm incorporation is that the choice depends upon income tax considerations primarily and not liability considerations. He demonstrates partners in large law firms earn more than partners in small firms and therefore, because their marginal tax rates are higher than those of partners in small firms, the tax value of incorporation is greater for the partners of large law firms. The result, according to Gilson, is that the increasing size of law firms leads to limited liability rather than, as Carr and Mathewson argue, limited liability leading to larger law firms.15 It can therefore be seen these two rationales advanced by the Commission are insufficient to justify the application of limited liability to law firms. As noted in the Introduction, there are more substantive issues that warrant consideration. These concern the relationship between limited liability and the standard of care employed by lawyers and the relationship between limited liability and the monitoring that lawyers in a firm undertake of each other to ensure that legal services of a sufficient quality are provided to clients. Limited Liability and the Standard of Care Legal rules can be evaluated according to two criteria.16 First, a legal rule must ensure that those subject to the rule take sufficient care in conducting their activities. Second, the legal rule must also ensure that activities which society considers necessary are undertaken to a sufficient degree.17 Law firms in Australia currently operate under a regime that combines unlimited liability for individual malpractice with joint liability for the malpractice of other partners. This creates financial incentives for lawyers to be taking appropriate care in the provision of legal services to clients. In

R J Gilson, "Unlimited Liability and Law Firm Organization: Tax Factors and the Direction of Causation" (1991) 99 Journal of Political Economy 420. Gilson, above, n 14 at 420. A M Polinsky, An Introduction to Law and Economics, Little, Brown and Company, Boston, 2nd ed, 1989, pp 130-132. Polinsky, above, n 16, pp 130-132.

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theory, this should result in less malpractice. Whether it does in fact have this effect is open to doubt. This is because lawyers are, to some degree, able to avoid these incentives. First, some lawyers are able to protect their assets in the event of malpractice by shifting ownership of these assets to relatives such as spouses. Any lawyer who is able to do this does not have the same financial incentives to take care as a lawyer whose personal assets are at risk because of malpractice. Of course this is not a complete analysis because it is not just financial incentives which have an effect on the standard of care. A lawyer concerned to protect his or her reputation also has an incentive to take care and minimize incidents of malpractice. The second way in which a lawyer is able to avoid the financial incentives to take care which are imposed by unlimited liability is by obtaining professional liability insurance which covers the full extent of the loss caused by malpractice. It is a particular feature of the compulsory liability insurance for lawyers in New South Wales that the premiums do not vary according to the claims history of each lawyer. The result is a lawyer with a history of substantial claims against him or her pays the same premium as a lawyer who has had no claim made against him or her for professional malpractice. Clearly, this does not provide appropriate incentives to take care.18 Because the premium paid by lawyers for compulsory liability insurance does not vary for lawyers within the same group or category,19 lawyers will only be under additional financial incentives to take care if the cost of the premiums for the insurance cannot be passed on to clients by way of an increase in legal fees. It is to be expected the cost of the insurance premiums is ultimately borne by the clients of law firms. One reason why clients may demonstrate little resistance to this is because, in the case of business clients of law firms, these clients may be able to either claim legal fees as a tax deduction or else can pass the cost of increased legal fees on to consumers of the business’s products or services by means of an increase in the price of

It is therefore not surprising the Trade Practices Commission has recommended compulsory liability insurance for lawyers should vary according to the claims history of each lawyer: Trade Practices Commission, above, n 1 at 129. In New South Wales in 1993, solicitors who were employed by government authorities or corporations were not required to contribute to the professional indemnity insurance fund administered by the New South Wales Law Society. Partners in law firms and sole practitioners whose income exceeded $35,000 paid an annual premium of approximately $5,000 to the professional indemnity insurance fund.

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these products or services.20 The result of this analysis is that, although in theory unlimited liability provides financial incentives for lawyers to take appropriate care, in reality, these financial incentives are to some extent eroded. It will be recalled that the second criteria by which to judge a legal rule is whether the rule ensures that necessary activities are undertaken to a sufficient degree. Lawyers undertake a number of valuable tasks. In a recent article, I have documented some of these tasks.21 They include: *

Efficient Resource Allocation. A task undertaken by some lawyers is to ensure resources are allocated to their most efficient users. For example, lawyers may be involved in ensuring the markets that allocate resources operate efficiently. Thus, lawyers associated with the enforcement of trade practices or competition laws are concerned with the elimination of anti-competitive conduct in the markets for goods and services. In addition, lawyers may be associated with the enforcement of specific legal rules or doctrines which promote efficient resource allocation. An example is legal rules which require producers of goods to internalize the costs of their production and thereby prevent these costs being shifted to others who are not compensated for bearing part of the costs of production. Aspects of tort law, environmental law and product liability law have this objective.

*

Enforcement of Property Rights. Many lawyers are associated with the creation and enforcement of property rights. If a society does not sufficiently recognize or enforce property rights then this will reduce the incentive to engage in research and development. For example, the function of intellectual property laws is to provide incentives to undertake research and development given that successful innovations will receive protection from those who would otherwise be able to appropriate the innovations.

The degree to which costs incurred by a law firm can be passed on to clients will partially depend upon whether the market for legal services is competitive. See S Domberger and A Sherr, "The Impact of Competition on Pricing and Quality of Legal Services" (1989) 9 International Review of Law and Economics 41. The authors undertake an economic analysis of the conveyancing monopoly which lawyers had until recently in England and Wales. I M Ramsay, "What Do Lawyers Do? Reflections on the Market for Lawyers" (1993) 21

International Journal of the Sociology of Law 355.

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*

Lawyers as Relationship Orderers. Lawyers are specialists in normative ordering in that they "create, find, interpret, adapt, apply, and enforce rules and principles that structure human relationships and interactions".22

One argument that has sometimes been employed to support the limitation of liability for professionals is that professionals will no longer provide particular services and talented individuals will be deterred from becoming professionals in particular fields if the risk of personal liability in these professions is excessive. There is no evidence lawyers are leaving the practice of law because of what they regard as an excessive risk of liability resulting from malpractice. In fact, record numbers of students are entering law schools.23 This undermines any argument that the potential risk of malpractice liability is deterring individuals from becoming lawyers. The forgoing analysis has resulted in different conclusions when the two criteria for evaluating legal rules are applied to the effects of limited liability on the standard of care. First, it was noted the existing regime of unlimited liability for lawyers does not appear to be resulting in the provision of fewer legal services. Second, it was stated unlimited liability should, in theory, result in less malpractice because it creates financial incentives for lawyers to be undertaking work to an appropriate standard when they provide legal services to clients. Yet these incentives are eroded when lawyers are able to ensure their personal assets will not be liable in the event of a successful malpractice claim or when professional liability insurance is obtained which covers the full extent of the loss created by the malpractice and the premiums charged for the insurance do not reflect the claims history of the lawyer. Demonstrating that incentives to take care can, in some circumstances, be eroded, does not of itself justify a move to a regime of limited liability. Unlimited liability may still provide incentives for lawyers to take appropriate care in a broad range of situations.

R Clark, "Why So Many Lawyers? Are They Good or Bad?" (1992) 61 Fordham Law Review 275 at 281. Clark identifies six distinct arenas of normative ordering: legislation, administrative rule-making, private deal-making, counselling and planning, non-judicial dispute resolution and litigation. See D Weisbrot, "Recent Statistical Trends in Australian Legal Education" (1990-91) 2 Legal Education Review 219; Centre for Legal Education, Newsletter, Vol 2 No 2, July 1993, p 3, noting that in 1993 these were 21,374 law students in Australia compared to 29, 165 practising lawyers.

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Given these conclusions, it cannot be said the Commission’s recommendation to continue unlimited personal liability in the case of equity holders of incorporated law firms who have committed malpractice is incorrect. The more significant issue then becomes the recommendation of the Commission that joint liability not apply to equity holders in incorporated law firms. This issue requires an analysis of the relationship between liability and monitoring in law firms. Joint Liability and Monitoring We have seen an important rationale for joint liability in the context of law firms is that, because the personal wealth of every partner is at risk because of the malpractice of any of the other partners, each partner has incentives to be monitoring the quality of the work provided by the other partners. In addition to this monitoring of the quality of work, there is also a second type of monitoring which a regime of joint liability provides incentives for partners to undertake. This is monitoring by partners of the wealth of their other partners. This type of monitoring will be undertaken because, if a malpractice claim is brought against the firm and its partners, and one or more of the partners has divested themselves of their assets, then more of the remaining partners' assets will be at risk should the malpractice claim succeed.24 Any costs incurred by partners of a law firm in monitoring their other partners can be expected to increase legal costs. These cost will generally be borne by clients of the firm. Yet it is not evident that all of this monitoring created by joint liability is desirable. First, it has not been established that the benefits of monitoring by partners of the wealth of their other partners exceed the costs. Indeed, in the absence of any desirable effect on the behaviour of the partners, such wealth monitoring does not result in any social gains.25 Leebron argues such monitoring may not occur among shareholders of companies because "monitoring other shareholders could only

Another type of monitoring which will be undertaken in a law firm is monitoring to ensure that lawyers are working sufficiently hard. In other words, that they are not shirking. Shirking can be reduced by establishing performance goals for lawyers within the firm. Typically, these goals take the form of a minimum number of hours that must be billed to clients over a specified period of time. Another way in which law firms reduce shirking is to maintain a ratio of partners to employed solicitors which means that it is difficult to become a partner. To maintain such a ratio encourages performance on the part of the employed solicitors. As Table 1 [see p 261] demonstrates, the ratio of partners to employed solicitors in the largest Australian law firms is usually less than 1:2. Leebron, above, n 6 at 1582.

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be for informational purposes since there is little one can do about the wealth of one’s fellow shareholders, except to sell one’s own shares".26 In the case of law firm partnerships, there are greater incentives to undertake wealth monitoring. This is because there are significantly fewer partners in a law firm than shareholders in a public company. Consequently, the potential for any one partner to have increased personal liability when other partners have divested themselves of assets is greater. It is unlikely that discovering other partners have divested themselves of assets will produce desirable effects. Should a partner make this discovery, the most likely effect is for the partner to also divest herself of assets.27 The second point is that, turning from wealth monitoring to monitoring of the quality of legal services, in some circumstances, this type of monitoring will be better undertaken by clients rather than partners. This will apply where the client is knowledgable and informed in relation to legal services. An example is where the client of the law firm is an "in-house" corporate lawyer who regularly utilizes legal services provided by private law firms.28 Third, compulsory professional indemnity insurance (as recommended by the Trade Practices Commission) would mean monitoring is undertaken by insurance companies as part of their process of adjusting premiums for each law firm.29 Fourth, monitoring by partners in a large national law firm of their other partners may not only be costly but may also be impractical. In such a firm, where lawyers will have significantly different expertise and qualifications, it can be very difficult to provide adequate monitoring of the quality of legal services provided to clients.30 This problem of monitoring is compounded

Leebron, above, n 6 at 1607. Leebron notes that, in the case of shareholders in a company, they might consider imposing a requirement that each shareholder possess some minimum net wealth. However, this would involve both monitoring and enforcement costs: Leebron, above, n 6 at 1607. Of course, in a range of circumstances, the client will be unable to assess the value and quality of the legal services being provided to him or her. Insurance must be compulsory in a regime of limited liability because otherwise limited liability creates incentives not to insure or else to under-insure. For discussion of this issue in the context of shareholders and companies, see H Hansmann and R Kraakman, "Toward Unlimited Shareholder Liability for Corporate Torts" (1991) 100 Yale Law Journal 1879 at 1888-1890. Law firms monitor the quantity of legal work undertaken within the firm to a considerable degree. Law firms establish billable hour goals for lawyers who in turn keep detailed timesheets of the time spent on particular client matters. See generally, F S McChesney,

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by the problem of geography. It may be impossible for a partner in the Sydney office of a national law firm to monitor adequately the legal services provided to clients in the Perth office of the law firm. None of this is meant to discount the value of all monitoring. Rather, what is suggested is some types of monitoring are not beneficial and all monitoring involves costs and these costs have to be weighed against the benefits of monitoring. Joint liability creates incentives for partners of law firms to be undertaking wealth monitoring of other partners. Yet we have seen that this type of monitoring is unlikely to result in any social gains. Joint liability also creates incentives for partners of law firms to be monitoring the quality of legal services provided by other partners. Yet even here we have seen that in some circumstances, such monitoring cannot be done or else involves excessive costs. Moreover, monitoring is not only undertaken by partners of the law firm. It can also be undertaken by clients and insurance companies. Finally, it should be stated that it is appropriate to allocate costs (including the costs of professional negligence) to those who produce these costs. In the case of law firms, this is the individual partners involved in the negligence. It is inefficient to allocate costs to those who do not produce the costs. Yet this is the effect of joint liability. It might be possible to justify joint liability if this would provide compensation to those who would otherwise remain uncompensated as a result of negligence. This is not a relevant consideration under the proposal of the Trade Practices Commission because compulsory professional indemnity insurance must be maintained by law firms which operate under a regime of limited liability. These arguments support the recommendation of the Trade Practices Commission to eliminate joint liability as part of allowing law firms to incorporate. This leads to discussion of the types of law firms that might

"Team Production, Monitoring, and Profit Sharing in Law Firms: An Alternative Hypothesis" (1982) 11 Journal of Legal Studies 379. However, it is much more difficult to monitor the quality of legal services provided to clients. The difficulty of monitoring quality is increased where lawyers within the one firm have different qualifications and expertise, ie, where lawyers are heterogeneous rather than homogenous. There is no doubt that some law firms are very homogenous. This leads Hansmann to advance the thesis that employee ownership (an example of which is law firms) works best where the costs of governing the firm are low because of the homogeneity of the owners. See H Hansmann, "When Does Worker Ownership Work? ESOPs, Law Firms, Codetermination and Economic Democracy" (1990) 99 Yale Law Journal 1749. However, this homogeneity in law firms is now breaking down as has been documented in several studies of US law firms. See, for example, R L Nelson, "The Changing Structure of Opportunity: Recruitment and Careers in Large Law Firms" (1983) 1 American Bar Foundation Research Journal 109.

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incorporate. As the following section demonstrates, the recommendation offers most benefits for large law firms. Liability, Monitoring and the Size of Law Firms Joint liability creates incentives to limit the number of partners in law firms so that sufficient monitoring of sufficient quality by partners of other partners can be undertaken.31 Indeed, there is empirical evidence that partners are effective monitors in law firms which have up to five partners.32 Monitoring is also important where the law firm operates in an unstable environment. This may occur where law firm clients are readily prepared to move from one law firm to another. This can be yet an additional incentive to limit the number of partners in law firms.33 Lawyers working either as sole proprietors or in small law firms do not always obtain the benefits that accrue to lawyers working in larger firms. These benefits include:34

This has been suggested as a motivation for the establishment of small boutique law firms in Australia: "There are other advantages which flow from a boutique law firm as opposed to a large legal practice ... Each member has responsibility for fewer partners, for example, and this is particularly relevant with the unlimited liability nature of law firms and the experience that Allens has had with the Adrian Powles matter over the past twelve months" Sydney Morning Herald, 22 December 1993 at 33. This article is written about the establishment of the small law firm, Atanaskovic and Hartnell, headed by two well-known commercial lawyers who broke away from the national law firm, Allen Allen & Hemsley. 1 Leibowitz and R Tollison, "Free Riding, Shirking and Team Production in Legal Partnerships" (1980) 18 Economic Inquiry 380. There have been studies of the way in which the environment in which companies operate influences the ownership structure of these companies. In particular, where companies operate in an unstable environment, monitoring of management becomes more important and this can creative incentives for concentrated ownership structures, ie, fewer shareholders who each hold a significant percentage of the shares. For further discussion, see D Leech and J Leahy, "Ownership Structure, Control Type Classifications and the Performance of Large British Companies" (1991) 101 Economic Journal 1418; H Demsetz and K Lehn, "The Structure of Corporate Ownership: Causes and Consequences" (1985) 93 Journal of Political Economy 1155. For discussion of this issue in the context of the ownership concentration of Australian companies, see I M Ramsay and M Blair, "Ownership Concentration, Institutional Investment and Corporate Governance: An Empirical Investigation of One Hundred Australian Companies" (1993) 19 Melbourne University Law Review 153. This list of benefits is extracted from S S Samuelson, "The Organizational Structure of Law Firms: Lessons from Management Theory" (1990) 51 Ohio State Law Journal 646 at 647-648. More detailed discussion of these benefits is contained in RJ Gilson and R H Mnookin, "Sharing Among the Human Capitalists: An Economic Inquiry Into the Corporate Law Firm and How Partners Split Profits" (1985) 37 Stanford Law Review 313 and R J Daniels, "The Law Firm As An Efficient Community" (1992) 37 McGill Law Journal 801.

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Economies of Scale. The average cost of producing legal services can decline as the volume of production rises. This is because a larger number of lawyers can more efficiently utilize support services such as libraries, para-legals and administrative support staff. Economies of Scope. Because clients of law firms frequently need the services of different legal specialists, a law firm which is able to offer a range of different legal services may be able to do so at less cost than a smaller firm or a sole practitioner. It can be expected a law firm that has provided previous services to a client and has thereby become familiar with the operations of the client will be able to provide other legal services more cheaply and efficiently than another law firm which is unfamiliar with the client. Specialization. The law is increasingly complex. The result is that lawyers have tended to become specialists. A law firm of sufficient size can afford to develop areas of specialization. For example, a firm of sufficient size will have its lawyers divided into sections such as corporate, banking and finance, real estate, and litigation. Other sections may include intellectual property, environmental law and media law. Because this specialization is a result of the increasing complexity of the law, specialization may result in higher quality legal services being provided by a large law firm. This is because a smaller firm or sole practitioner may endeavour to cover a range of different fields of law yet lawyers in a small firm cannot devote the same time to mastering each of these fields that a specialist in a larger law firm is able to do.35 Minimum Scale. A small law firm or sole practitioner may not have the resources necessary to staff a major corporate transaction or a major litigation case. Diversification. The typical lawyer has a significant investment in his or her human capital. By joining a law firm of sufficient size where partners share profits, a lawyer is able to diversify his or her human capital by sharing market risks with other lawyers who have different areas of specialization. For example, lawyers who have expertise in arranging capital raising by companies may be able to

A small firm that elects not to provide a diverse range of legal services could of course obtain the benefits of specialization.

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survive a market downturn if the insolvency practice of the law firm of which they are members is generating significant profits.36 The discussion has demonstrated that both large and small law firms have advantages. Therefore, one should expect to see the existence of both types of firms. Statistics for New South Wales solicitors bear this out. Table 2 [see p 261] examines the number of law firms in New South Wales according to the number of solicitors for the period 1984-1991. In July 1991, 50.1 percent of all New South Wales law firms were sole practitioners. A further 40.7 percent of all law firms had only two to five solicitors in the firm. Yet this Table also reveals that it is the largest category of law firms (twenty-one or more solicitors) which increased the most in the period 1984-1991. This category of law firms increased by 123.5 percent. A more precise indication of the structure of law firms in New South Wales can be gained by examining the numbers of lawyers associated with firms of particular size. In July 1984, there were 1, 398 New South Wales solicitors who were sole practitioners. By July 1991, this had increased to 1,689 solicitors, an increase of 20.8 percent.37 It is the largest law firms which employ the most solicitors even though there are far fewer of these law firms. According to Table 2 in July 1991 there were thirty-eight New South Wales law firms which had twenty-one or more solicitors. Although this category of law firm constituted only 1.5 percent of all law firms in New South Wales in 1991, in fact, these law firms had an average of 77.29 lawyers each.38 This means that these law firms had 2,937 lawyers compared to 1,689 sole practitioners.39

Gilson and Mnookin observe that the benefit of diversification carries with it a cost. The cost is that lawyers whose specialization is in demand have an incentive to either leave the law' firm or demand a higher share of the profits because the income that these lawyers are generating for the firm subsidises the income of the other lawyers whose specializations are in less demand: Gilson and Mnookin, above, n 34. The authors state the solution is to develop "firmspecific capital". Where a law firm can develop capital which is associated with the firm rather than with individual lawyers, incentives for lawyers to leave the firm or to insist on a higher income are reduced. The two major types of firm-specific capital are clients who belong to the law firm rather than to individual lawyers and the reputation of the law firm itself for performing high quality legal work. These statistics are obtained from Law Society of New South Wales, Trends in the Profession (1992), p 9. Law Society of New South Wales, above, n 37 at 23. For discussion of the history of the rise of large law firms in Australia, see D Weisbrot,

Australian Lawyers, Longman Cheshire, Melbourne, 1990, pp 257-266; O Mendelsohn and M Lippmann, "The Emergence of the Corporate Law Firm in Australia" (1979) 3 University of New South Wales Law Journal 78.

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The issue then becomes whether the size of law firms impacts upon the decision whether to incorporate and obtain the benefits of limited liability. We have seen larger law firms are able to obtain benefits that cannot fully be obtained by sole practitioners such as economies of scale and diversification of human capital. At the same time, monitoring becomes more difficult as a law firm increases in size. Consequently, it can be expected that the introduction of limited liability will benefit larger law firms. For sole practitioners, the recommendation of the Trade Practices Commission is irrelevant because individual lawyers would still have unlimited liability for their own malpractice. The recommendation would only limit the liability of the equity holders in a law firm for malpractice to the extent to which each equity holder would not be jointly liable for the malpractice of the other equity holders in the firm. Monitoring of the quality of legal services is more readily undertaken in small law firms than in larger law firms and therefore the costs of monitoring are less for small firms. Consequently, while the introduction of limited liability will have advantages for small law firms, these advantages will not be as significant as those available to larger law firms where monitoring is difficult. What this may mean is that if limited liability for law firms is introduced then, other factors remaining the same,40 it may be the larger law firms which elect to incorporate and thereby obtain the benefits of limited liability rather than small law firms. This is because the benefits of limited liability, in terms of reduced monitoring costs, are greatest for these firms. Conclusion The Trade Practices Commission has recommended that law firms should be able to incorporate and thereby limit the liability of equity holders for malpractice to the extent to which each equity holder would not be jointly liable for the malpractice of the other equity holders in the firm. Although, in theory, joint liability creates financial incentives to provide legal services of required quality, the discussion has demonstrated that sufficient reasons exist to support the recommendation of the Commission. In particular, joint liability creates incentives to undertake some unnecessary and excessively costly monitoring. Moreover, it violates, without sufficient justification, the

Another factor which will influence the decision to incorporate is taxation: see Gilson, above, n 14.

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principle that the costs of professional negligence should be allocated to those who commit such negligence.

Table 1 Australian National Law Firms 1994 Statistics

Law Firm

Partners

Employed Solicitors

Ratio of Partners to Employed Solicitors

Australian Legal 217 547 1:2.5 Group Mallesons Stephen 159 406 1:2.6 Jaques Minter Ellison 158 1:2.2 349 152 Freehill 278 1:1.8 Hollingdale & Page Clayton Ltz 145 1:2.5 371 124 282 Phillips Fox 1:2.3 123 1:3.2 Blake Dawson 397 Waldron 111 Corrs Chambers 1:2.3 257 Westgarth Source: AAustralian Financial Review, 3 March 1994 at 28.

Table 2 Number of Firms According to the Number of Solicitors 1984-1991 No of Solicitors

1 2-5 6-10 11-20 21 & more

September 1984 Number Percent % (a) 44.2 999

Number (b) 1,281

July 1991 Percent % 50.1

nuns

3775

T7531

3077

121 40 17

5.4 1.8 0.8

148 50 38

5.8 2.0 1.5

% Increase (b-a) 100/a 22.2 -3.9 22.3 25.0 123.5

100.0 13.1 TOTAL 2,260 100.0 2,558 Profession Trends in the The Law Society of New South Wales, Source: (1992), p 21

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