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CHICAGO--Dissolution is only the beginning of the end for a law firm. Although a dissolved firm's former partners may already have begun work for new firms, they still must wind up the old firm's business and, absent an effective agreement absolving them, account to each other for the resulting income.
Even nonequity partners may have to disgorge not only the receipts from that unfinished business but also the sums they received under their firm contracts as “clawbacks” to satisfy the firm's creditors.
And if the firm enters bankruptcy, an unfriendly trustee may look for even more causes of action against the firm's partners, particularly if it appears that mismanagement led to the firm's destruction.
Using the recent demise of a number of prominent and venerable law firms as a springboard, a panel of lawyers considered these and other issues at the ABA's Fall 2012 National Legal Malpractice Conference. Douglas R. Richmond, managing director in the Professional Services Group of Aon Risk Solutions in Chicago, moderated the Sept. 6 discussion, “Liability Lessons From Law Firm Dissolutions.”
Panelist H. Bruce Bernstein asked “If a dissolved firm has the responsibility to complete its unfinished business, how is it going to do that when there are no lawyers left in the firm?” Bernstein is a senior counsel in the Chicago office of Sidley Austin and chairs his firm's new-business committee.
Panelist Robert W. Hillman explained that the dissolution of a law firm is not synonymous with its termination. Hillman, a professor at the University of California Davis School of Law and an authority on lawyer mobility, said that law firm partnerships have three stages of existence: the partnership as a normal business operation, the partnership in the process of dissolving, and the partnership after dissolution.
“When a partnership dissolves, whether it's a law firm or any other, it doesn't end,” he said. “It simply begins the winding-up phase of its existence. It doesn't matter whether its partners scatter to new firms--it's still winding up. All of its open matters need to be brought to a conclusion.”
A law firm's final winding-up stage can last for years, Hillman said. “What do we do” with the firm's unfinished business? Hillman asked. “Who owns it?”
Until recently, he said, the law was settled that the dissolved partnership owned any business uncompleted at the time of dissolution. This principle, known as the “unfinished business doctrine,” was established by Jewel v. Boxer, 203 Cal. Rptr. 13 (Cal. Ct. App. 1984), in which the court held that, absent a partnership agreement to the contrary (known as a “Jewel waiver”), net income from work on matters in progress at the time of a law firm's dissolution belongs to the former partners according to their respective shares in the firm, no matter which former partner provided those services after the firm's dissolution.
While reasonable overhead expenses attributable to producing that income may be subtracted from the gross income received on matters in progress, the court said, lawyers winding up their former firm's matters may not receive compensation beyond their interests in the dissolved partnership.
“Lots of law firms are structured as PCs,” Richmond interjected. “Does that have any effect on how the law looks at the obligations of partners, post-dissolution?”
No, Hillman responded. “Arguably PCs and LLCs should be distinct, but a small but growing number of opinions say it makes no difference whether you're a PC or LLC”--the rule established by Jewel still applies to a firm's unfinished business.
The California court decided Jewel under the Uniform Partnership Act, a version of which most states at that time had adopted, the panelists noted. Since then, a majority of states have moved on to the Revised Uniform Partnership Act (RUPA), which changes the law as to the entitlement to income from post-dissolution work on matters pending at the time of dissolution.
In contrast to UPA, RUPA provides that partners of a dissolved law firm are entitled to “reasonable compensation” for their work on winding up the dissolved law firm's business, Hillman said. But “RUPA provides no standards for defining 'reasonable compensation,’” and case law has only slowly begun to define those standards, he observed.
Because a number of jurisdictions have not yet adopted RUPA, Jewel remains authoritative for those that retain versions of UPA, although some larger law firms are resisting its application, Hillman said.
Among the jurisdictions that still have a version of UPA is New York, where members of some recently dissolved large law firms are litigating the rights to fees from unfinished business, the panel noted. See Dev. Specialists Inc. v. Akin Gump Strauss Hauer & Feld LLP, 2012 BL 140364, 28 Law. Man. Prof. Conduct 327 (S.D.N.Y. May 24, 2012), in which the court held that under New York law all client matters pending on the date of a law firm's dissolution are assets of the law partnership for which the former partners who concluded them have a duty to account; and Geron v. Robinson & Cole LLP, No. 11 Civ. 8967, 28 Law. Man. Prof. Conduct 557 (S.D.N.Y. Sept. 4, 2012), in which the court held that a dissolved law firm's pending hourly-fee matters are not partnership assets. Panel members said they expect the Second Circuit Court of Appeals to weigh in on both cases.
Complicating that partnership issue is “the overlay of bankruptcy law” which intersects with partnership law on unfinished business in surprising ways, Hillman said.
Richmond noted that some dissolved law firms have gone to great efforts to wind up their affairs without seeking bankruptcy protection. He asked the panelists to address why the management of a law firm that is going to dissolve or has dissolved might wish to avoid bankruptcy.
“To avoid the appointment of a trustee,” answered panelist Margaret M. Anderson of Chicago. Anderson is a partner at Fox, Hefter, Swibel, Levin & Carroll, practicing in the area of creditors' rights and bankruptcy.
Anderson explained that the interests of a dissolved law firm's former partners may be in conflict. Sometimes--particularly if there is a feeling that former management mishandled the firm's business--one or more of the former partners may want an independent trustee appointed to administer the dissolved firm's affairs. “They don't want the fox controlling the henhouse,” she said.
Bankruptcy may make things worse, Bernstein explained. “An examiner may spend an awful lot of the firm's money in exploring what actions could be brought against the former partners. The administrative expenses of a bankruptcy are a tremendous drain on the limited assets that the [dissolved] partnership has.”
While a firm trustee may pursue “clawback actions” seeking the return of income paid to former partners before the firm's dissolution, once counsel for the creditors' committee, lawyers for the debtors, and a committee of advisers to the dissolved firm all weigh in, Bernstein said, typically “not all that much money” remains.
Nevertheless, “given the complexity of these cases,” he said, it can be “very difficult” for a dissolved law firm to avoid bankruptcy.
In addition, the panelists warned, there is always a possibility that the bankruptcy trustee may void a partnership's “Jewel waiver” as a fraudulent transfer.
“From the bankruptcy court's point of view,” Anderson said, “one of the most important assets is the revenue from work completed after the firm has dissolved.” Under bankruptcy law, a transfer of property belonging to the debtor's estate may be deemed fraudulent if the property is transferred for less than reasonable value when the debtor is in financial distress, she said. “So if you enter into a Jewel waiver [when the law firm is in trouble], you're giving up a very valuable firm asset and getting nothing in return.”
To be assured that a Jewel waiver will be effective, Bernstein said, a law firm must have adopted it well in advance of bankruptcy.
While federal law generally imposes a two-year statute of limitations for avoidance of fraudulent transfers, Bernstein remarked, state law may extend that period. For example, he said, a “strong-arm” statute in New York extends the period to six years before bankruptcy. Additionally, the bankruptcy trustee may avoid certain transfers made to creditors (who may include members of the dissolved law firm) within 90 days of the bankruptcy filing. For firm insiders, the reachback period is one year.
In Anderson's view, even nonequity partners risk satisfying the definitions of insiders and creditors for reachback purposes. “Everything you are paid is subject to return” as an over-distribution, Anderson warned, and capital partners who had not completed their contributions at the time of the firm dissolution may also be required to continue to pay their capital contributions “even though you will never see any of it back.”
“That's why you are seeing partners [of dissolved law firms] write checks,” Bernstein said. “It's the only way out of litigation you would be facing as an individual for the next 10 years.”
“Say I have a large book of business,” Richmond posited. “Can I pick a good time to run, from a bankruptcy perspective? Can I pick the time when I can flee [my firm] and feel safe that I can elude the clutches of a bankruptcy trustee?”
Because of the limitation periods, Anderson said, “It's guessing when the firm will become insolvent. That encourages lawyers to get while the getting is good rather than hanging on, because the longer they hang on the more likely they are to have to pay back [fees].” That's bad policy, she said.
Richmond speculated that many existing partnership agreements do not contemplate the partnership's dissolution. “I'm not sure that amending partnership agreements” --i.e., inserting a Jewel waiver--“is as easy from a practical standpoint as some courts have suggested,” he stated.
Bernstein agreed. “The fact is that if somebody proposes putting a Jewel waiver in[to the partnership agreement], everyone is going to say 'What is going on?’ It isn't that easy.”
“Law firms are low-trust environments and surprisingly fragile organizations,” Richmond observed. “Whether [there are] bad internal dynamics or competitive pressures or other things, they're pretty vulnerable to erosion. Pretty soon it becomes a flow you can't stop.”
Richmond asked about additional theories of exposure for the former management of a dissolved law firm.
“One thing that strikes me,” he said, “is that on the path to dissolution, something's happening. There are arguably unwanted business decisions being made, outrageous partner compensation, a bad business plan, and the failure to cut expenses as the firm doesn't perform.”
Do the managers of a law firm bear a fiduciary duty to their fellow partners to manage the law firm responsibly, and in the event of mismanagement, “Is there any traction to making breach of fiduciary duty claims?” he asked.
Hillman said that such claims would be “problematic” under partnership law. “Under UPA, there was no fiduciary duty to exercise care in the management of the partnership” as there is under corporate law, he said. “RUPA creates a limited duty of care” in referring to “gross negligence as a standard of fiduciary responsibility,” he said. However, he continued, the statute “makes it clear that ordinary negligence may not be the basis of a claim by one partner against another.”
Hillman also observed that “the line between conflict of interest and poor business judgment can become quite blurry.”
Additionally, Anderson noted, some lawyers are suing their dissolved firm's managers “on the basis that 'you breached your fiduciary duty to me when you snookered me into joining the firm.’”
Though Hillman pointed out “That is not a 'duty of care’ claim, that is a 'you tricked me’ claim,” Anderson noted that settlement agreements may buy those partners “peace for mismanagement claims.”
Referring to media reports of possible “last-ditch mergers” as large law firms spiral toward dissolution, Richmond commented “I would have some concern as the destination firm that if I acquire that firm, maybe I'm something more than just a destination.” He asked the panel to address what successor liability issues might arise in the course of such mergers.
“Successor liability is easy to allege but difficult to prove,” said Bernstein. Nevertheless, “you're going to have successor liability issues if you hire a substantial number of lawyers from the old firm or if the management of the old firm continues on and becomes management of the new firm.”
He warned that destination firms face potential claims for “aiding and abetting, breaches of fiduciary duty, and tortious interference with contractual relations--anything you can think of where someone is trying to get some money.” Destination firms, he suggested, doubtless take these risks into account in making their offers to lawyers fleeing dissolving firms.
“If one partner is a huge rainmaker and his departure destabilizes the firm, is that enough to give rise to a cause of action?” Richmond asked.
“That's a great theoretical argument,” Hillman responded. A few state supreme courts, he said, “have suggested that if a partnership is about to engage in some significant transaction, such as taking on additional office space, on the assumption that the partnership is stable, and at the same time a group of partners is planning to leave, they may have a fiduciary duty to inform management before it enters into the transaction.” Because those suggestions have been mere dicta, he said, “there's not much there.”
Hillman likewise discounted the artful crafting of partnership agreements to build in responsibilities that would by definition be breached by departure, as Bernstein observed some California firms have done. “In most jurisdictions” with the notable exception of California, “a financial penalty” for a partner's departure, “including the delayed return of capital, would not be enforceable,” Hillman stated.
Hillman also rejected Richmond's suggestion of requiring a departing partner to provide the firm with, say, 90 days' notice “so that [other] partners can cement relationships with other lawyers who might want to join the departing partner, and also tell the clients that you aren't as great as they think you are.”
Hillman explained that “It's affecting the rights of clients to secure the representation of their choice if you are trying to prohibit the lawyer from going anywhere else for 90 days.” And, in any event, he noted, “Lots of firms say that if you are leaving, we don't want you to stick around, we want you out now.”
On the other hand, Hillman suggested that a provision that a partner who has gone far enough in discussions with another firm so that the other firm is about to perform a conflicts check must inform firm management might be enforceable.
Hillman noted that a recent proposal to amend the Model Rules of Professional Conduct to include similar provisions with respect to clients was unsuccessful. See 28 Law. Man. Prof. Conduct 509.
Commenting “It really has been stunning how many of these major liquidations [of well-established law firms] have occurred in recent years,” Bernstein remarked that lawyers “want to be someplace that offers them a platform to succeed and grow, and they will get there however they get there.”
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