The potential for personal liability can be scary to a partner, especially when the liability is the result of something the partner did not do and knew nothing about. However, by taking effective, affirmative steps, partners can limit their potential exposure.

One recent state Supreme Court case illustrates the risk partners face. In Illinois State Bar Ass'n Mut. Ins. Co. v. Law Office of Tuzzolino & Terpinas, 27 N.E.3d 67 (Ill. 2015), a client accused his attorney, Tuzzolino, of committing malpractice by failing to inform the client that his suit had been dismissed, among other things. Less than three months later, Tuzzolino completed an insurance application on which he denied knowledge of "any circumstance, act, error or omission that could result in a claim."

After the insurance policy incepted, Tuzzolino's law partner, Terpinas, received a lien letter from the attorney representing Tuzzolino's client. Terpinas immediately reported the claim to their insurer. The insurer then brought suit seeking the rescission of the policy on the basis that it relied on Tuzzolino's material misrepresentation in issuing the policy.

Terpinas argued that it would be "unfair and against public policy to rescind insurance coverage [for him], an innocent insured who had no knowledge of Tuzzolino's misdeeds and the alleged misrepresentation."

Although the appellate court agreed with Terpinas based on its application of the innocent insured doctrine, the Illinois Supreme Court reversed, holding that the policy was rescinded as to all insureds, including Terpinas. The court noted that, while certain policy exclusions may only apply to the insured that committed the acts at issue (such as an intentional acts exclusion), a misrepresentation in the application affects the validity of the policy as a whole. The court further held that the policy's severability clause was of no help to Terpinas, as although it created a separate contract with each insured, each insured was still bound by the statements on the application.

In reaching this conclusion, the court rejected the public policy concerns raised by Terpinas. However, those concerns were embraced by a dissenting justice, who stated that he was "troubled by the scope of the consequences resulting from the majority's holding on other law firms and especially midsize and large firms." The implications for innocent partners are obvious in situations where the policy does not otherwise protect them. Every partner in the law firm can pay for the misdeeds of any one partner. Terpinas lost insurance coverage even though he had no knowledge of the threat of a claim against his law partner, did not complete the policy application, and in fact reported the claim immediately upon receiving the letter from the claimant's attorney.

Worse yet, if the law firm has not formally organized (as a professional corporation, limited liability company, or limited liability partnership), then each partner of the wrongdoer could be personally and individually liable.

These are not risks that law firms or partners should take—especially when they can take the following steps to avoid them.

1. Become a professional corporation, limited liability company or limited liability partnership

The first advice any attorney typically gives a client starting a new business is to incorporate or otherwise formally organize the business. Professional corporations, limited liability companies and limited liability partnerships offer protections to the individual and personal assets of partners that general partnerships do not.

Once a law firm is organized, the exposure of innocent partners is substantially reduced. Any recovery against the law firm would be limited to the assets of the law firm and not to the personal or individual assets of any innocent partner. Importantly, for the attorney whose conduct is at issue, the risks remain the same.

2. Purchase insurance that protects innocent partners

Legal malpractice insurance can provide either broad or narrow coverage and, accordingly, may or may not provide protection for partners who were not involved in any alleged wrongdoing. While the organizational structure of the firm can protect innocent, noninvolved partners, legal malpractice insurance protects the assets of the law practice, and correspondingly, the partners' interests in those assets.

Many options exist to maximize the protection for innocent partners. One of the simplest is an innocent insured clause, which makes clear that the conduct or knowledge of any one partner will not impair or impact the coverage of any other partner. This includes both the application (where, as in Tuzzolino, the knowledge of one partner can vitiate coverage for the entire firm) and the operation of the policy.

In the alternative, some policies include a severability of insurance clause, which means that every insured's coverage is viewed separate and apart from the coverage of every other insured. This may protect innocent insureds from the application of certain exclusions but, again as in Tuzzolino, it may not prevent the rescission of a policy as to all insureds.

Moreover, to further limit the risk of rescission, some policies narrowly define the individuals who have notice obligations. As a result, the insurer may not be able to rescind coverage simply because any attorney or employee at the firm had knowledge of information that was not later disclosed on the application, assuming that the individual tasked with providing the information to the insured had no knowledge of the issue. This can be especially helpful to mitigate the risk at larger firms.

3. Impose accountability by contract

The final step for law firms is to make sure that guilty partners remain accountable for their misconduct. The most effective approach is a clawback provision in the organizing agreement that permits innocent partners to claw back payments to guilty partners.

The level of conduct triggering the right to claw back can differ. Some firms limit such relief to claims involving intentional, criminal, dishonest or fraudulent acts or omissions—tracking the same boundaries as the typical legal malpractice policy exclusion. Other firms can recover for the partner's knowing violations of the law or reckless misconduct.

Partners following the rules and contributing to the success of the law practice deserve to be protected. These three steps help limit the risk.

As published by The Daily Report