Law Firms Must Pay Back Profits Earned on Dissolved Law Firm’s Hourly-Fee Cases

By Joan C. Rogers  

Unfinished client matters of a dissolved law firm remain its property when departing partners complete that business at other firms, even when the cases are billed by the hour rather than on a contingent fee basis, the U.S. District Court for the Southern District of New York held May 24 (Development Specialists Inc. v. Akin Gump Strauss Hauer & Feld LLP, S.D.N.Y., No. 11 civ. 5994 (CM), 5/24/12).

The case addresses a dispute between the administrator for the bankrupt law firm Coudert Brothers and 10 law firms to which former members of Coudert relocated and brought clients with them.

Applying New York partnership law, Judge Colleen McMahon decided that the hourly nature of the unfinished matters does not alter the basic principle that former partners of a dissolved law firm must account for their use of partnership property after dissolution. She also ruled that the dissolved firm's financial interest in the matters must be measured by the new firms' net profits, not the quantum meruit value of the work performed at Coudert.

McMahon rejected the argument that Coudert assets necessarily have no value because all of the profits from the unfinished matters are attributable to the former Coudert partners' post-dissolution efforts at their new firms.

The judge left the “thorny task” of determining how much the firms owe Coudert's bankruptcy estate to be resolved through an accounting.

McMahon signaled that she may be willing to certify her decision for immediate appeal under 28 U.S.C. §1292, which allows for quick review of “a controlling question of law,” the prompt resolution of which “may materially advance the ultimate termination of the litigation.” She asked the firms to submit briefs on that issue within 10 days.

The ruling is making waves in the legal profession, especially in light of the May 28 bankruptcy filing of another former powerhouse in the legal profession, Dewey & LeBoeuf LLP. See 28 Law. Man. Prof. Conduct 341.

'Erudite Opinion.'

“It's a wonderful, erudite opinion that serves as a nice refresher on partnership law principles that so many lawyers seem to have forgotten (or never learned),” professor Robert W. Hillman of UC Davis law school said in an email to BNA. He is the author of Hillman on Lawyer Mobility: The Law and Ethics of Partner Withdrawals and Law Firm Breakups.

According to Hillman, on the issue of whether unfinished business belongs to a dissolved firm there is no difference between the Uniform Partnership Act, which is the basis for New York partnership law, and the Revised Uniform Partnership Act, which a majority of states have enacted. Therefore, lawyers can expect the same result on this issue in other jurisdictions, he told BNA.

As for what the departed partners' new firms may keep for themselves out of the billings on the former Coudert matters, Hillman noted that RUPA allows “reasonable compensation” for a partner's efforts in winding up unfinished business, while the Uniform Partnership Act does not. But McMahon's opinion envisions that the new firms may keep something like quantum meruit for their work in completing the cases--which is roughly the same as RUPA, he explained.

'Policy Choice.'

Speaking to BNA, Douglas R. Richmond of Aon Risk Solutions, Chicago, said that the unfinished business rule McMahon applied reflects a “policy choice” that courts have made as a matter of partnership law.

Although it is an imperfect rule, he said, law firms have to live with it unless they amend their partnership agreements--which is easier said than done. Richmond is the author of Migratory Law Partners and the Glue of Unfinished Business, which is scheduled to appear in a forthcoming issue of the Northern Kentucky Law Review.

“A departing partner is not free to walk out of his firm's office carrying a Jackson Pollack painting he ripped off the wall of the reception area, simply because the firm has dissolved.”
Judge Colleen McMahon

Richmond pointed out that even though firms hiring partners of a dissolved firm don't get to keep profits from the former firm's unfinished matters, new matters from the clients the partners bring with them do not come within the unfinished business rule. For those matters firms can still benefit when partners of a failing firm bring along big clients that will send them additional business, he explained.

In addition, Richmond noted, partners who depart for greener pastures some time before a firm dissolves are not affected by the unfinished business rule.

Undermines Rule 5.6.

In an email to BNA, Roy Simon, professor emeritus at Hofstra law school, said the court's holding undermines Rule 5.6(a), which in many jurisdictions prohibits agreements requiring a departing lawyer to remit a percentage of future fees from pending matters that the lawyer takes to a new firm.

Courts have always said, he explained, that clients don't “belong” to lawyers and that imposing what he called a financial “tax” on lawyers whose clients follow them to new firms discourages lawyers from accepting those clients, thus chilling a client's right to choice of counsel.

Yet Simon saw a positive side to the holding. “If partnership law effectively taxes lawyers 100% of their hourly billings when they take matters from a bankrupt firm to a solvent firm, then why not likewise allow solvent firms to impose a hefty tax on lawyers who take matters with them to competing firms? Why prohibit solvent firms from doing what the law mandates for insolvent firms? We should attack the root of the problem and allow non-compete clauses in law firm partnership agreements (as California already does),” he said.

Changing Rule 5.6(a) to allow noncompete covenants in law firm partnership agreements would make law firms much more stable, Simon contended. Star lawyers would have less incentive to leave their current firms, and competing firms would have less incentive to lure away star lawyers, making law firm bankruptcies less likely in the first place, he said.

'Accident in Slow Motion.'

Some observers were highly critical of McMahon's decision and, more broadly, oppose application of the unfinished business doctrine to law firms.

Seeing the unfinished business rule applied to modern law practice is “like watching an accident in slow motion,” Ronald C. Minkoff told BNA. He is with Frankfurt Kurnit Klein & Selz, New York.

Minkoff said that as a matter of policy the rule should not apply to law firms, at least in unfinished hourly matters. Law firms are treated differently from other types of partnerships for purposes of noncompetition agreements and they should also be treated differently for purposes of the unfinished business doctrine, he contended.

In an article titled Why Jewel Is Wrong, Minkoff and co-author Caren Lerner, an associate at Frankfurt Kurnit, contend that the common law went seriously off track when the unfinished business doctrine was applied to law firms in Jewel v. Boxer, 203 Cal. Rptr. 13 (Cal. Ct. App. 1984).

Jewel did not have to turn out that way and should not be followed, they contend. The article asserts that

the result in Jewel is unfair to almost everyone: to clients, to the lawyers who work on the cases, to the successor firms who complete them. The only ones who benefit are the former partners of the failed business who do not do the work, and the former firm's creditors (who get a windfall). Yet as wrong-headed as Jewel is, it continues to be cited and even expanded, covering not just contingency fee matters but hourly matters as well.  

Hourly Matters Completed Elsewhere.

McMahon's rulings came on dueling motions for summary judgment in actions that Development Specialists Inc., the administrator of Coudert's bankruptcy estate, filed against 10 law firms that hired former Coudert partners after it dissolved: Akin Gump Strauss Hauer & Feld, Arent Fox, Dechert, DLA Piper, Dorsey & Whitney, Duane Morris, Jones Day, K&L Gates, Morrison & Foerster, and Sheppard Mullin Richter & Hampton.

Coudert clients with unfinished matters retained the firms to conclude the matters. The defendant firms completed nearly all of the matters on an hourly basis.

Under New York partnership law, McMahon said, unfinished business is presumed to be partnership property on the date of dissolution. Coudert's partnership agreement could have provided otherwise but did not, and there was no evidence that Coudert partners intended to exclude pending but uncompleted representations from the firm's assets, she said.

On the contrary, McMahon found, Coudert's partnership agreement specifically stated that the property of the firm belongs to the firm, not the individual partners. A special authorization that the partners passed to allow the firm's executive board to wind up the firm plainly contemplated that client matters were firm business and should be handled so as to maximize their value, she said.

Duty to Account for Profits.

McMahon said that because of the fiduciary duty that partners owe to each other, all partners of a dissolved firm have an obligation to account for their use of partnership property after dissolution.

This obligation qualifies the oft-stated rule that former partners of a dissolved law firm have the right to accept retainers from those who had been clients of the firm, she said.

This qualification is implicit in the nature of a partnership, McMahon stated. “A departing partner is not free to walk out of his firm's office carrying a Jackson Pollack painting he ripped off the wall of the reception area, simply because the firm has dissolved,” she wrote.

McMahon predicted that “the New York Court of Appeals would, if confronted with the issue, conclude that all client matters pending on the date of dissolution are assets of the firm--regardless of how the firm was to be compensated for the work.”

“It's a wonderful, erudite opinion that serves as a nice refresher on partnership law principles.”
Professor Robert W. Hillman
University of California Davis

En route to this conclusion, McMahon pointed out that as a general rule the unfinished business of a professional partnership is an asset of the partnership unless a contrary intention appears. This rule has been applied, in New York and elsewhere, to law firms that handled cases on a contingent fee basis, she found.

Along with other decisions, McMahon cited Jewel and Santalucia v. Sebright Transp. Inc., 232 F.3d 293, 16 Law. Man. Prof. Conduct 632 (2d Cir. 2002).

Every case in a UPA jurisdiction that has considered the precise question posed here has concluded that billable hour matters are partnership assets in the absence of any expressed intention that they should be treated otherwise, she said.

Mini-Contract Theory Rejected.

McMahon disagreed with the defendant firms' argument that legal business billed by the hour is distinguishable from legal business paid on contingency for purposes of applying the unfinished business doctrine.

Although acknowledging that contingent fee and billable hour matters are different in important respects, McMahon rejected the idea that hourly matters give rise to a series of mini-contracts, each one corresponding to a new billing period, rather than a single contract.

That theory, she said, conflates a law firm's rights against its clients, which may differ according to how matters are billed, with the rights of former partners among themselves, which include the right to demand an accounting from any partner who derives a benefit from exploiting a partnership asset.

McMahon also disputed the basic premise underlying the mini-contract theory. The fact that clients are billed and pay periodically simply reflects the parties' arrangement about when and how compensation would be received, she said.

Public Policy Argument.

According to McMahon, the firms' strongest argument was that the imposition of a duty to account on former partners who finish hourly client matters would create a financial disincentive for departing partners to continue representing the dissolved firm's clients and thus would deprive clients of their counsel of choice, in violation of strong New York public policy.

Delving into cases applying the ethics rule against restrictive covenants now embodied in Rule 5.6, McMahon acknowledged that in Cohen v. Lord, Day & Lord, 551 N.Y.S.2d 157 (N.Y. 1989), New York's high court held that a monetary penalty exacted from a competing ex-partner was void and unenforceable as an impermissible restriction on the practice of law, and that in Denburg v. Parker Chapin Flattau & Klimpl, 604 N.Y.S.2d 900 (N.Y. 1993), the court struck down a provision requiring departing partners to turn over 12.5 percent of fees from ex-clients of a firm for two years.

The financial disincentive found repugnant to public policy in those cases is similar to the practical effect of the unfinished business doctrine in these cases, McMahon acknowledged. She emphasized, however, that Cohen and Denburg involved ex-partners competing with their former firm and that those cases had nothing to do with the unfinished business doctrine.

Seeing the unfinished business rule applied to the modern law practice is “like watching an accident in slow motion.”
Ronald C. Minkoff
Frankfurt Kurnit Klein & Selz

McMahon noted that if the rationale underlying those cases precluded application of the unfinished doctrine to hourly cases, the same rationale also would prevent the doctrine from being applied to contingent fee cases. Such a result, she said, would be contrary to Santalucia, which adopted the New York appellate courts' rule that contingent fee cases pending on the date of dissolution are partnership assets subject to distribution in the absence of a contrary agreement.

There is no logical reason, McMahon said, why as a public policy matter the rule ought not be the same for any pending legal representation that remains unfinished when a law firm handling it dissolves--regardless of how it is billed.

No-Compensation Rule.

McMahon also spurned the firms' fallback position that even if the unfinished client matters are Coudert assets those assets have no value because all of the profits to which Coudert might otherwise be entitled are attributable to the former partners' efforts, skill, and diligence in completing the matters.

As a general matter, McMahon said, a partner making his accounting may deduct expenses from gross fees and remit the net fees--that is, profits--to his former partners for division. But under the “no compensation” rule of the common law, codified in the Uniform Partnership Act, partners are not entitled to be paid for post-dissolution efforts in winding up partnership business. Thus, “expenses” that may be deducted from gross fees are not supposed to include compensation for a partner's post-dissolution efforts. Section 40(6) of the New York Partnership Law allows reasonable compensation only to a surviving partner who winds up partnership affairs, she noted.

McMahon pointed out, however, that in an apparent attempt to soften the harshness of the no-compensation rule, New York cases applying the unfinished business doctrine have calculated expenses in a manner different from how courts in other UPA jurisdictions have done.

Decisions such as Kirsch v. Leventhal, 586 N.Y.S.2d 330 (N.Y. App. Div. 1992), have not allowed the former firm to share in any “value” the case yields as a result of a former partner's “efforts, skill, and diligence,” McMahon observed. This rule in effect treats the value of the former partner's services as an expense, not as compensation to the partner, she explained.

Saying that the result in Kirsch and similar cases eviscerates the no-compensation rule, McMahon expressed doubt that New York's high court would follow that approach. The great weight of authority in UPA jurisdictions is against Kirsch, she added, citing Jewel and several other opinions.

“Lest there be any doubt: this Court cannot blithely assume that the profits attributable to the Former Coudert Partners' post-dissolution “efforts, skill and diligence” are equal to the profits realized by the Firms for completing the Client Matters. One only need to look to Santalucia itself to reach this conclusion,” McMahon wrote.

Number Crunching.

McMahon emphasized that at this point she was unable to make findings about the value of the client matters on the date of dissolution, the amount of post-dissolution profits attributable to the former Coudert partners' “use” of the client matters, or the amount of the post-dissolution profits that can be attributed to the former partners' post-dissolution efforts, skill, and diligence.

The “thorny task” of resolving these issues, she said, raises new questions that go beyond the present opinion:

• Is a former partner's share of the new firm's profit measured by his share of the new firm's profit on the matter, or by the entire profit realized on the matter?

• What constitutes a deductible expense or overhead at the new firm, and what portion of the new firm's realized fee is profit and what is expenses?

• How does one value the former partner's contribution of effort, skill, and diligence?

Firms on the Hook.

McMahon granted DSI's summary judgment motion for a declaration that, as a matter of law, the client matters in question were Coudert's property on the date of that firm's dissolution.

As for the defendant law firms' summary judgment motion, McMahon dismissed DSI's claims for unjust enrichment, conversion, and turnover, but she allowed DSI's claims for an accounting.

McMahon also ruled that the firms are jointly liable for an accounting, but that there is no need to join the former Coudert partners individually. The former partners' duty to account to Coudert arose as they completed the client matters and earned fees in the matters, and these actions were within the scope of the business of the firms they joined, she explained.

David J. Adler, McCarter & English, New York, represented Development Specialists Inc.

Attorneys representing the defendant law firms included:

Erik M. Kay and Susheel Kirpalani of Quinn Emmanuel Urquhart Oliver & Hedges, New York, for Akin Gump.

Allen G. Reiter of SNR Denton US, New York, along with George P. Angelich and Matthew S. Trokenheim of Arent Fox, New York, for Arent Fox.

Claire L. Huene of Miller & Wrubel, New York, for Dechert.

Howard S. Davis and Jeffrey Schreiber of Meister Seelig & Fein, New York, and James P. Ulwick and Jean E. Lewis of Kramon & Graham, Baltimore, for DLA Piper.

Jessica D. Mikhailevich of Dorsey & Whitney, New York, for Dorsey & Whitney.

Lawrence J. Kotler, Duane Morris, Philadelphia, for Duane Morris.

Geoffrey S. Stewart and Steven C. Bennett of Jones Day, New York, for Jones Day.

Jeffrey N. Rich of K&L Gates, New York, for K&L Gates.

Brett H. Miller of Morrison & Foerster, New York, for Morrison & Foerster.

Daniel L. Brown and Malani J. Sternstein of Sheppard Mullin Richter & Hampton, New York, for Sheppard Mullin.

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