August 31, 2013

The Belly of the Beast: Law Firm Insolvencies, Unfinished Business, and Jewel Waivers

The last decade has seen an unprecedented rise in bankruptcy filings by some of the nation’s largest law firms. Powerhouse firms such as Brobeck, Coudert Brothers, Heller Ehrmann, Thelen, Thacher Proffitt, Howrey, and Dewey & LeBoeuf have literally disappeared before our eyes and rumors of continuing problems at other big-law firms can be found in the legal blogs almost every day. Numerous theories abound as to the cause of these problems including: clients bringing more work in-house and trimming expensive outside counsel work, alternative fee arrangements, increased lateral movement by attorneys with large books of business, excessive compensation practices by firms to lure such attorneys, failed mergers and expansions across the globe, and increased debt load. Combined, these factors and others have created a snowball effect that essentially has obliterated the very law firm culture that bound partners to each other. 

The implications of these law firm failures are far reaching. Jobs are lost, receivables remain uncollected, and creditors are often left unpaid. One notable aspect of these cases, however, is the resulting litigation against former partners involving the dissolved law firm’s so-called unfinished business. Unfinished business claims, which seek to recover profits from lawyers and their new firms for work that the lawyers took with them following dissolution, have been particularly prevalent in the bankruptcy filings of Coudert Brothers and Thelen, where a split in the case-law is now pending before the Second Circuit Court of Appeals. The purpose of this article is to provide an overview of the unfinished business doctrine and, perhaps, some food for thought for attorneys who are rethinking their firms’ partnership agreements as a result of these issues. 

The Unfinished Business Rule

The unfinished business rule is rooted in very basic concepts of partnership law. Under the Uniform Partnership Act (UPA) and similar state statutes, a partnership is an association of two or more persons carrying on as co-owners of a business for profit. Joint ownership of the business and the sharing of profits and losses are key indicia of a partnership. Partners owe one another, and the partnership, fiduciary duties, including the duty to account for any benefit a partner derives from the use of partnership property. 

Upon the dissolution of a law firm, the partnership continues in existence until the “winding up” of its affairs is completed. Therefore, partners owe continuing fiduciary duties to each other, whether they stay at the firm or, whether they leave and finish the business elsewhere. This duty is codified in Section 404 of the UPA which provides that every partner has a duty to: 

account to the partnership and hold as trustee for it any property, profit, or benefit derived by the partner in the conduct and winding up of the partnership business or derived from a use by the partner of partnership property, including the appropriation of a partnership opportunity… 

Accordingly, a former partner of a law firm is free to practice elsewhere, and has the right to represent former clients of his or her former firm. That right, however, is subject to the former partner’s duty to account for the use of “partnership property” after dissolution. “Partnership property” arguably includes those client matters that he or she takes to the new firm. This concept has come to be known as the “unfinished business rule” and has been extended in the case law to a variety of other types of legal entities, including professional corporations and limited liability companies. 

The first opinion discussing the unfinished business rule in the context of a law firm was a 1984 opinion by the California Court of Appeals in the case of Jewel v. Boxer, 156 Cal. App. 3d 171 (1984). In that case, two partners of a dissolved four-partner litigation boutique brought an action for an accounting against their former partners with respect to fees received by such partners on a handful of large contingency fee matters after dissolution. The partnership had no written partnership agreement and, thus, the default rules of the UPA, as enacted in California, applied. 

The court held that, absent a provision in the partnership agreement to the contrary, former partners of a dissolved law firm have a duty to account to the dissolved firm, and each other, for profits earned (after payment of overhead expenses) from client matters that were completed after dissolution. It also found that a former partner completing unfinished business cannot avoid this result by simply entering into a “new” engagement letter with a client to complete the old business. 

The court reasoned that not only was this result consistent with applicable partnership law, but was supported by sound policy. Specifically, the rule prevents partners from: (1) competing with each other for the most profitable cases during the life of the partnership in anticipation that they might retain those cases should the partnership dissolve, and (2) scrambling to take physical possession of files and seeking personal gain by soliciting a firm’s existing clients upon dissolution. 

Finally, the court suggested that there is a simple way around the unfinished business rule. Partners are free to include in a written partnership agreement provisions determining exactly how unfinished business will be treated. As a result of Jewel, many law firms have added so-called “Jewel waiver” provisions to their partnership or operating agreements. Such provisions expressly eliminate the partners’ continuing duty to account to the dissolved firm, and each other, for profits from unfinished business. 

Such waivers, however, may be meaningless depending on when they were incorporated into the firm’s governing documents. A number of courts have held that the inclusion of a Jewel waiver in a partnership or operating agreement on the eve of bankruptcy can be set aside as a constructively fraudulent transfer under state or federal law. See, e.g., In re Brobeck, Phleger & Harrison, LLP, 408 B.R. 318 (Bankr. N.D. Cal. 2009); In re Heller Ehrman, LLP, 2011 WL 1539796 (Bankr. N.D. Cal. Apr. 22, 2011). At the same time, however, courts have also acknowledged the value of a Jewel waiver where it is added outside the fraudulent transfer reach-back period or while the firm is still solvent. 

Differing Opinions in the S.D.N.Y. 

Two recent opinions out of the United States District Court for the Southern District of New York have dissected the unfinished business doctrine and, in doing so, reached differing results. First, in In re Coudert Brothers, 477 B.R. 318 (S.D.N.Y. 2012), the court held that unfinished business that followed the firm’s former partners to their new firms constituted an asset of the bankruptcy estate. Accordingly, the court ordered an accounting and required that the former partners of Coudert and/or their new firms turn over to the bankruptcy estate the profits earned on unfinished business. 

The court began its analysis with a review of the firm’s partnership agreement and New York partnership law, which is based on the UPA. Applying the statutory rules, the court found that a law firm’s business “belongs to the firm, and not to any individual partner,” irrespective of provisions in partnership agreements that allocate varying profit shares, bonuses, or guaranteed compensation to partners. Next, the court likened the taking by a partner of a client matter to carrying a Jackson Pollock painting from the wall of the dissolving law firm’s reception area without compensating the firm. Recognizing that this concept does not square nicely with the paradigm of modern, big-law practice, the court noted: 

The provisions of the Partnership Law just discussed may appear dated, or even downright quaint, to observers of the kind of sophisticated corporate law practice that was carried on at Coudert. In the context of the “mega-firm” model – divisions among classes of partners, client hoarding, and mercenary lateral hiring – one could argue that the law’s presumption that partners are mutual owners of all of a law firm’s business, and that all contribute to its success and so are entitled to share in the profits, no longer reflects the reality of practice. Many partners at such firms no longer view their “book of business” as an asset of the firm, but as a jealously guarded piece of personal property. Such a view undermines the conclusion that such client matters really are property of the firm, as well as the premises of the no compensation rule. But the Partnership Law says otherwise. 

The former partners and their new firms raised several arguments why the unfinished business rule should not apply to them. For instance, they argued that: (1) a distinction can be made between hourly fee matters and the primarily contingency-based matters at issue in Jewel, (2) the duty to account is contrary to public policy supporting a client’s right to choose its counsel, and (3) the bankruptcy estate was not damaged because there were, in fact, no profits from the unfinished business. The court rejected each of these arguments and specifically found that there is no distinction between hourly and contingent fee matters for purposes of the unfinished business rule and, moreover, that the duty to account does not interfere with a client’s unfettered right to choose its counsel. 

A few months later, in the bankruptcy case of Thelen, LLP, a different court in the Southern District of New York issued a memorandum opinion on the unfinished business rule that differs sharply from the Coudert opinion. In In re Thelen, 476 B.R. 732 (S.D.N.Y. 2012), the court held that unfinished hourly fee matters of a dissolved law firm (in contrast to contingency fee matters) do not remain the firm’s property under New York law when departing partners finish up that business at other firms. 

In Thelen, the Chapter 7 trustee commenced actions against certain former partners to recover profits earned for work performed after they joined their new firm. The trustee argued that the Jewel waiver contained in Thelen’s partnership agreement, which was added shortly before the filing, constituted a fraudulent transfer because Thelen was insolvent at that time. Because there was no dispute that the dissolved firm did not receive any value in exchange for the Jewel waiver, the court focused on whether the firm, by granting such waiver, was giving up an asset of value or, in other words, whether the unfinished business had any value. 

The court recognized the movement towards the extension of Jewel to all matters, including hourly fee matters, by courts in other jurisdictions. Nevertheless, the court stressed that the critical issue was whether New York law, not the law of California or any other state, extended the “unfinished business doctrine” to a dissolved law firm’s pending hourly fee matters. Although New York’s highest state court had not addressed the issue, the court gave substantial weight to a trial court opinion, in the case of Sheresky v. Sheresky, where the court expressly declined to characterize hourly fee matters as an asset of a dissolved partnership. In adopting the holding of Sheresky, the court found that the application of the unfinished business rule to hourly fee matters “would result in an unjust windfall for the Thelen estate” because the attorneys performing the work would receive reduced compensation for the services they performed in order to compensate the former law firm, which did nothing. 

The court also focused on the nature of unfinished business in the legal services context and recognized that if a dissolved law firm had a property interest in pending hourly fee matters, the splitting of such fees would be contrary to New York’s rules of professional conduct. Further, the court found that client matters are not just an ordinary article of commerce that can sold to the highest bidder in a Section 363 bankruptcy sale: “Contrary to [Coudert], an hourly fee matter is not akin to ‘a Jackson Pollock painting’ that a departing attorney ‘rip[s] off the wall of the reception area[.]’” Instead, the court found, contracts for legal services are unique and clients, not attorneys or their former law firms, decide when to move a matter to a new firm. The court concluded that if client matters were treated as assets of a bankrupt and dissolved firm, it would lead to “unworkable results” such as a client potentially violating the automatic stay by transferring his case to a new firm. Such a result, the court concluded, is a strong indicator that the unfinished business doctrine should not be extended to hourly fee matters. 

Based on New York's “strong public policy in favor of client autonomy and attorney mobility,” the court held that the out-of-state case law expanding the unfinished business doctrine to hourly fee matters was “irreconcilable” with New York law. Therefore, after concluding that “under New York law, a dissolved law firm's pending hourly fee matters are not partnership assets,” the court dismissed the trustee’s lawsuit. 

Recognizing the importance of this issue in the wake of the multiple, recent large law firm bankruptcies, both the Coudert and Thelen courts certified their orders for interlocutory appeal to the United States Court of Appeals for the Second Circuit. As of the writing of this article, briefing is ongoing in the appeal. 

Jewel Waivers: Good or Bad? 

Attorneys are often surprised when they first learn of the unfinished business doctrine. As noted by the court in Coudert, we think of our book of business as our own, something that we can freely take with us if we switch firms. Nevertheless, the current majority view seems to be that those attorney-client relationships are an asset of the firm and, upon the commencement of a bankruptcy case, property of the firm’s bankruptcy estate. 

The courts in Jewel, Coudert, and Thelen all noted that a simple solution is available for those who seek to avoid the consequences of the unfinished business doctrine. As we learned years ago in law school, the partnership statutes are merely default rules, and partners are generally free to modify such rules. As the Coudert court explained: 

If law firms like Coudert need an alternative set of assumptions to survive in a new marketplace, they are free to provide for one in their partnership agreements. Given their resources and sophistication, it is far more equitable to ask them to draft any special rules they want to follow than it is to add a gloss to the statute applicable to the far more numerous, and undoubtedly less sophisticated, partnerships the affairs of which are governed by the Partnership Law. In the absence of special rules, the Couderts of this world are bound by the “quaint” practices of yore. 

As long as a Jewel waiver is added outside the fraudulent transfer reach-back period, or while the firm is still clearly solvent, it should avoid the consequences of the unfinished business doctrine. Sample Jewel waiver language, which was approved in dicta by the bankruptcy court in the Brobeck, Phleger & Harrison bankruptcy case, is as follows: 

Except as specifically set forth below, neither the Partners nor the Partnership shall have any claim or entitlement to clients, cases or matters ongoing at the time of the dissolution of the Partnership other than the entitlement for collections of amounts due for work performed by the Partners and other Partnership personnel on behalf of the Partnership prior to their departure from the Partnership. The provisions of this Section 9(e) are intended to expressly waive, opt out of and be in lieu of any right any Partner or the Partnership may have to ‘unfinished business’ of the Partnership, as that term is defined in Jewel v. Boxer, or as otherwise might be provided in the absence of this provision through interpretation or application of the California Revised Uniform Partnership Act. 

When incorporated into a partnership or operating agreement, this language should trump the default rules in the statute and avoid unfinished business litigation entirely. Accordingly, a number of firms have sought to modify their governing documents to incorporate Jewel waivers. If a firm does go down the road of a Jewel waiver, then it seems the best practice is to get the document approved as soon as possible. Moreover, any firm accepting a lateral hire with a book of business should inquire as to whether the attorney’s former firm has a Jewel waiver in its governing documents. 

All that said, in light of the catastrophic consequences of the failure of a large and prestigious law firm such as Dewey & LeBoeuf, where jobs were lost, firm receivables were not collected in full and creditors were forced to take substantial haircuts, perhaps it is appropriate to reconsider the significance of the unfinished business doctrine and the impact of a Jewel waiver on a firm. 

Those who have followed the Dewey & LeBoeuf collapse know that there are a number of reasons that the firm spiraled into bankruptcy. It is well known, however, that the departure of several rainmakers within one or two important practice groups at Dewey helped seal the firm’s fate by triggering a mass exodus of partners. If partners or important practice groups are permitted to jump ship to greener pastures at the first sign of trouble and free from consequences, it is likely that there will be many more Dewey-like collapses down the road. 

Instead of thinking about incorporating Jewel waivers into partnership and operating agreements, perhaps firms should be thinking about incorporating contractual language which discourages partners from leaving a troubled firm – language which strengthens the ties which bind partners together. It is, of course, not legally possible to prohibit a partner from withdrawing from a firm. Nevertheless, there is nothing in the partnership law that prohibits certain withdrawals from a partnership being deemed “wrongful,” thereby resulting in a damages claim for the firm (which arguably might impede, or at least delay, the train from going off the tracks). For example, partnership agreements could include provisions that: (1) expressly reinforce the unfinished business doctrine, (2) require a period of advance notice before a partner can withdraw from the firm, and/or (3) prohibit attorney withdrawal and/or removal of files from the firm until outstanding receivables and partner contributions are paid in full. Admittedly, such provisions would have to be carefully drafted by practitioners who are more knowledgeable in partnership law than the authors of this article in order to ensure that they don’t run afoul of the applicable laws in a particular jurisdiction, including the rules of professional conduct. Nevertheless, the concept that should be considered here is that, as counter-intuitive and, frankly, offensive as the unfinished business doctrine is to some attorneys, perhaps it is a good thing that can and should be enhanced (not waived) to help keep firms together, thereby avoiding more law firm collapses in the future. 

Conclusion 

A law firm bankruptcy does not occur in a vacuum. Such cases are not merely about collection and distribution of assets. Rather, similar to a divorce, a law firm bankruptcy can result in a stream of litigation and tense emotions. While there are a number of lessons that can be learned from the recent string of filings, there are also a number of unanswered and lingering questions. 

Regarding unfinished business, as long as a Jewel waiver is adopted outside the fraudulent transfer reach-back period, such language can effectively avoid the consequences of the unfinished business doctrine for a firm and its partners. Nevertheless, in the wake of the prominent law firm bankruptcies of the last decade, firm management should think long and hard about whether it wants to adopt a Jewel waiver or, alternatively, whether it should add to its governing documents contractual language which discourages partners from departing the firm in times of trouble.