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March 01, 2015

The Evolution of Unfinished Business Claims

Here is a guide to understanding the unfinished business rule, which has been applied to law firms for more than 60 years.

Andrew B. Ryan

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The mere mention of the unfinished business rule, or Jewel v. Boxer, draws an immediate and visceral reaction from most lawyers. Lawyers representing creditors and trustees of bankrupt law firms likely view the doctrine as good public policy because its application makes it possible for a bankrupt firm to repay some of the debt owed to creditors. On the other hand, law firms that scooped up or cherry-picked lawyers deserting the dissolving firm likely believe the rule is anathema to the practice of law because it limits mobility, restricts clients’ choices, and takes money from firms that earned it. No matter the reaction, the unfinished business rule has been applied to law firms for more than 60 years, and it is likely to be around for decades to come.

This article addresses four topics relating to the evolution of unfinished business claims. First, it outlines the history of unfinished business claims involving a law firm’s pending cases and uncompleted transactions, and how that history reveals a rule embedded in the partnership statutes and common law of many states. Second, the article discusses the application of the unfinished business rule to recent law firm bankruptcies, including public policy arguments for and against the rule. Third, it summarizes recent decisions that endorse or oppose the rule. Finally, the article identifies three key issues that will affect the development of the rule in ongoing and future litigation.

Origins of the Rule

There appears to be a misconception, both in the legal press and by some lawyers unfamiliar with partnership law, that the genesis of the unfinished business rule was a decision by a single appellate court in California that has been seized upon by trustees of bankrupt or dissolved law firms. The truth, however, is that the unfinished business rule is enshrined in the common law of partnerships and has been applied to law firms for more than 60 years. Long before uniform statutes codified the common law of partnerships, the U.S. Supreme Court held there is no reason to distinguish between “commercial partnerships” and “partnerships between lawyers.” Denver v. Roane, 99 U.S. 355, 358–59 (1878). When states adopted uniform partnership statutes, these statutes did not change the existing common law or its application to law partnerships. To the contrary, the Uniform Partnership Act of 1914 ( UPA) codified common law precedent applicable to partnerships. The UPA’s purpose—similar to the purpose of other uniform laws—was to provide an identical set of rules that would, across numerous states, allow for predictability and certainty regarding the obligations and rights of partners. By the 1970s, nearly every state had adopted the UPA.

As these UPA states applied the partnership law to dissolving law firms, they repeatedly and uniformly extended the UPA’s duty to account to a law firm’s pending client matters, regardless of whether the fee earned from the unfinished case was contingent or hourly. The best known of these decisions is Jewel v. Boxer, 156 Cal. App. 3d 171, 156 Cal. App. 3d 171 (Ct. App. 1984). In Jewel, the court addressed whether former partners of a dissolved law firm must account for income generated from the dissolved firm’s unfinished business and, if so, the amount that must be remitted to the dissolved law firm. Jewel held that

in the absence of a partnership agreement, the Uniform Partnership Act requires that attorneys’ fees received on cases in progress upon dissolution of a law partnership are to be shared by the former partners according to their right to fees in the former partnership, regardless of which former partner provides legal services in the case after the dissolution.

Id. at 174.

The facts in Jewel were relatively straightforward: a four-lawyer firm dissolved by mutual agreement, splitting into two firms. The dissolved firm had no agreement regarding allocation of profits and no written partnership agreement. On the date of dissolution, the firm had numerous active cases, which were completed by the firm’s former partners at their new law firms. One of the partners, Jewel, filed a suit for an accounting of cases active at dissolution. The trial court held a non-jury trial, ruled in the plaintiff’s favor, and awarded damages based on a sophisticated quantum meruit formula. The appellate court affirmed the liability finding but reversed the damages calculation, holding that the court’s quantum meruit theory contradicted the UPA. According to the appellate court, the UPA provides that a dissolved law partnership continues its unfinished business until the matters are wound up; the allocation of income from the unfinished matters is based on the former partners’ ownership share; and no former partner gets extra compensation for completing partnership work.

The court also rejected any suggestion that compelling payment of post-dissolution income on unfinished business undercut the client’s right to counsel: “Even though the client had the right to the attorneys of its choice, that right was irrelevant to the rights and duties between former partners with regard to income from unfinished partnership business.” Id. at 177–78.

The court then held, consistent with the UPA, that the former partners were not entitled to any additional compensation for their work in completing the matter. Instead, Jewel held that the measure of damages is “net post dissolution income, not gross income that is to be allocated to former partners,” such that “the former partners will be entitled to reimbursement for reasonable overhead expenses (excluding partners’ salaries) attributable to the production of post dissolution partnership income.” Id. at 180.

Jewel is not unique—in fact, courts in California, Florida, Illinois, Indiana, Maryland, Massachusetts, Montana, Ohio, Oregon, Pennsylvania, and the District of Columbia have applied the unfinished business rule to a law firm’s client matters, whether contingent or hourly. Indeed, in the 30 years since Jewel, UPA states, with the exception of only Missouri and New York, have held that contingency fees are assets of a dissolved (or winding-up) law firm that are subject to distribution in accordance with the partnership statute.

Generally, the cases hold that the unfinished business rule is a subset of a partner’s fiduciary duty to account. Under the UPA, a partner has a duty to account to the partnership for any property, profit, or benefit that is earned from the winding up of partnership business or derived from the partner’s use of partnership property. And courts hold that pending cases are partnership business and that profits earned by the former partners during winding up must therefore be remitted to the partnership.

In recent law firm bankruptcies, defendants have countered this rationale by arguing that the duty to account extends only to partnership property and that client matters are not the law firm’s property because clients are free to hire and fire their attorneys at any time. The defendants’ argument stems from the various approaches that the UPA states have taken with respect to law firms bound by the unfinished business rule. Some UPA states have applied the unfinished business rule solely to contingency fee cases, some have applied the rule and not discussed the fee structure of the pending cases at all, and others have addressed the issue and applied the unfinished business rule to hourly matters only. As discussed below, the defendants’ distinction between hourly and contingency fee cases has sometimes prevailed. Law firm defendants have also tried with mixed success to limit the UPA’s duty to account to contingency fee cases.

In 1997, long after the first unfinished business cases and over a decade after Jewel, the Revised Uniform Partnership Act (RUPA) was adopted. Although the RUPA did not change the rules regarding a partner’s duty to account for unfinished business, it did add two significant provisions that have affected the landscape of unfinished business claims.

First, the RUPA added section 603(b)(3) regarding a party’s duty to account after dissociation (i.e., withdrawal or departure from the law firm). The official comment to this section states that “a withdrawing partner has a continuing duty after dissociation, but it is limited to matters that arose or events that occurred before the partner dissociated.” It then gives the example of a partner who leaves a brokerage firm, confirming that the withdrawing partner “must exercise care in completing on-going client transactions and must account to the firm for any fees received from the old clients on account of those transactions.”

Second, the RUPA allows partners who complete the winding up of partnership business to receive “reasonable compensation” for their work. Prior to 1997, courts following the UPA concluded that a partner winding up the business of a partnership cannot recover compensation for completing unfinished business, unless the partnership dissolved due to the death of a partner. Following this change in the RUPA, courts have permitted the partners to receive “reasonable compensation” in winding up the partnership affairs. The RUPA, however, did not define reasonable compensation, and the calculation of reasonable compensation remains mostly unsettled today.

Unfinished Business Rule

Even though the UPA and RUPA statutes (and cases interpreting them) have been around for decades, the unfinished business rule has received significant coverage in the legal press recently because of the large law firm bankruptcies that began with the economic collapse in 2008. This is because some law firms began adopting so-called Jewel waivers. Because the duty to account is a default rule, partnerships could, by agreement, decide to be bound by a different procedure. Jewel waivers were born from this realization. Law firms could surrender the firm’s rights to pursue former partners for the profits earned on their unfinished business. But instead of adopting Jewel waivers long before a law firm’s financial difficulties, Jewel waivers gained notoriety for their eleventh-hour introduction into a law firm’s partnership agreement as the firm neared collapse.

In the first of these last-minute Jewel waiver cases, from the Brobeck firm bankruptcy, the Northern District of California Bankruptcy Court held that although a Jewel waiver was valid under the partnership law, it could be invalidated as a fraudulent transfer:

[A]ttorneys in a failing firm can patch up their differences with an agreement that is valid and proper under applicable law and decide to go their separate ways. . . . But because they did not guard against such failure until the firm succumbed to insolvency, the Trustee’s . . . attack under the fraudulent transfer laws must succeed . . . .

In re Brobeck, Phleger & Harrison LLP, 408 B.R. 318, 325–26 (Bankr. N.D. Cal. 2009).

The use of fraudulent transfer claims to rescind Jewel waivers and recover unfinished business profits is a relatively new phenomenon, beginning in Brobeck and continuing through Heller, Thelen, and Howrey. As the cases have evolved, the former partners’ new firms have become direct targets, which raises at least three issues of fraudulent transfer law: (1) whether the partners are necessary parties to any suit against their successor law firm; (2) identifying the initial and subsequent transferees of the Jewel waiver; and (3) evaluating whether the law firms, if found to be subsequent transferees, have defenses to the liquidator’s claims under 11 U.S.C. § 550(b). These issues, which are beyond the scope of this article, will be crucial questions as unfinished business claims continue to be litigated in ongoing law firm bankruptcies.

With respect to public policy, however, the central question is whether the unfinished business rule so restricts attorney mobility that it hampers a client’s right to select the counsel of his or her choosing. Opponents of the unfinished business rule claim that it limits lawyer mobility by imposing a cost on the departing lawyer: Either the lawyer or the lawyer’s new firm may have to remit the profits from those pending matters to the dissolved firm, resulting in the lawyer having worked for free. According to opponents of unfinished business claims, this makes lawyers from dissolved firms less attractive to new firms, and this perceived restriction could be so great that lawyers will essentially tell their clients to find other counsel, which will undermine the client’s right to choose his or her own lawyer.

Until recently, the vast majority of courts throughout the country rejected this argument. Their reasoning varies, but the general point is that the lawyer from the dissolved firm is required to remit only some or all of the profits from pending matters while still taking all of the profits from any new, subsequent engagements from the client. As a result, some commentators conclude that the economic cost to lawyers is slight—like a tax or headhunter’s fee that attaches to their move to a new law firm.

Of course, trustees of dissolved law firms argue the facts of each particular bankruptcy: There would be no unfinished business claims against third-party law firms if the lawyer had not already found a suitable home for his or her clients and their matters. And lawyers never claim they fired their clients to find a new home at another firm. After all, clients are the lifeblood of this profession, and few (if any) lawyers would fire a good client just to avoid paying out some of the profits from a current engagement to their former partners. Indeed, one bankruptcy court described the lawyer mobility argument many years ago as a “sky is falling” exaggeration by noting the law firm was “unable to point to any disasters which have developed in any of the many jurisdictions” that recognize that the unfinished business doctrine applies to hourly fee cases. In re Labrum & Doak, LLP, 227 B.R. 391, 409 (Bankr. E.D. Pa. 1998).

Recent Cases

Recent decisions on both sides of the unfinished business doctrine have focused on its history, its support (or lack thereof) in partnership law, and the public policy arguments for and against the rule. In May 2013, the Eleventh Circuit held that Florida’s RUPA “clearly supports” the rule that “dissociated partners must account to the partnership for any fees from ongoing client transactions that are received after dissociation.” See Buckley Towers Condo., Inc. v. Katzman Garfinkel Rosenbaum, LLP, 519 F. App’x 657, 662 (11th Cir. 2013). Buckley Towers involved three firms’ representation of a client in an insurance recovery matter governed by contingency fee contracts. The client received a final judgment in its favor of just over $12 million, terminated the firm, and placed part of the final judgment in the court’s registry to cover the three prior firms’ competing claims to the contingent fee.

The Eleventh Circuit described the issue as “the unique situation of the client choosing to follow an attorney that twice exited the firm representing the client in the midst of litigation.” Id. at 661. Although none of the firms had dissolved, the Eleventh Circuit focused on the unfinished business doctrine and affirmed that pending contingency fee cases were a law firm asset. Under section 603, “the partner’s duties of loyalty and care continue only with regard to matters arising and events occurring before the partner’s dissociation.” Id. at 662. The court particularly cited this official comment to section 603:

The commentary goes on to provide an example of a partner leaving a brokerage firm, confirming that the withdrawing partner “may immediately compete with the firm for new clients, but must exercise care in completing on-going client transactions and must account to the firm for any fees received from the old clients on account of those transactions.

Id. at 662 n.6.

The Eleventh Circuit ultimately concluded that section 603(b)(3) extends the unfinished business rule to partners who leave a law firm regardless of whether the firm dissolves.

In addition to Buckley Towers, two recent decisions in the Howrey bankruptcy applied the unfinished business rule to a law firm’s hourly matters, including matters completed by partners who left the firm before its dissolution. In a February 2014 decision on the law firms’ motions to dismiss, the court focused on two questions: (1) whether District of Columbia law supported applying the unfinished business rule to a law firm’s hourly matters, and (2) if so, whether section 603(b)(3) of the RUPA extends the unfinished business rule to partners who dissociate from a firm before it dissolves. The court answered both questions in favor of the trustee and against the law firm defendants. Then, in a September 2014 decision, the court determined which claims could be brought against law firm defendants who hired partners who dissociated from Howrey prior to its dissolution. In re Howrey LLP, 515 B.R. 624, 625 (Bankr. N.D. Cal. 2014).

The Howrey court agreed with the interpretation of section 603(b)(3) in Buckley Towers and held that the District of Columbia would apply the unfinished business rule to partners who left Howrey before its implosion. However, the court granted the law firm defendants’ motions to dismiss fraudulent transfer and accounting claims related to the duty to account. And after a second round of motions to dismiss, the court held that only a claim for unjust enrichment would lie against law firms that hired pre-dissolution departing partners. Id. at 630–33.

On the other side of the ledger, two decisions issued within weeks of one another rejected the unfinished business rule’s application to a law firm’s hourly fee matters. In California, a federal district judge reversed a bankruptcy court’s decisions applying the unfinished business rule to the hourly matters of Heller Ehrman that were completed at other law firms. After citing five differences from Jewel, the court concluded that California’s highest court would not hold that a law firm has a property interest in its hourly cases. The opening two sentences of this decision encapsulate the criticisms of the unfinished business rule: “A law firm—and its attorneys—do not own the matters on which they perform their legal services. Their clients do.” Heller Ehrman LLP v. Davis, Wright, Tremaine, LLP, 2014 U.S. Dist. LEXIS 81087, at *1 (N.D. Cal. June 11, 2014).

The district court’s reasoning in Heller began with two questions: (1) whether hourly fee matters pending when a law firm dissolves are firm property, and (2) whether the firms that completed Heller’s pending matters can be sued to recover the profits from that property. Believing that the California Supreme Court had not ruled on these issues—and that Jewel v. Boxer, an intermediate appellate court decision, was inapposite—the district court in Heller turned to the equities and public policy behind the unfinished business rule and held that both support the defendants. According to the court, Heller’s pending hourly matters ceased being the firm’s business when the clients transferred their matters to new law firms, who then worked the files and deserved to be paid the full fee for their services. Concluding otherwise, the Heller court claimed, would discourage law firms from accepting partners from dissolving firms, hindering lawyer mobility and client choice. Id. at *7.

As in Heller, the New York Court of Appeals focused on the public policy issues and equities in holding that New York would not recognize a firm’s property interest in hourly matters pending at the time of the law firm’s dissolution. Using phrasing similar to the Heller decision, the court decided that “[a] law firm does not own a client or an engagement, and is only entitled to be paid for services actually rendered.” In re Thelen LLP, 24 N.Y.3d 16, 2014 N.Y. LEXIS 1577, at *1 (N.Y. July 1, 2014). Although New York had adopted a partnership law identical to the UPA, the New York Court of Appeals ruled that pending hourly matters were not partnership property because the client had an unfettered right to hire and fire its counsel, leaving the law firm with only an expectancy interest in future business. Moreover, the New York court held that the unfinished business rule would create an “unjust windfall” for dissolved law firms and a “run-on-the-bank mentality” that would make unstable firms even more so, as well as undermining lawyer mobility and client choice. Id. at *7.

Remaining Questions

These decisions, both for and against the unfinished business rule, do not however, resolve the matter for the profession. Instead, as unfinished business claims continue to evolve in the courts, lawyers should be attuned to three key issues that will affect the application of the doctrine: (1) whether the duty to account for unfinished business extends to partners who dissociate from a firm prior to its dissolution, (2) the proper measure of damages for an unfinished business claim, and (3) the amount of reasonable compensation a partner should be paid for winding up his or her law firm’s unfinished business.

The question of whether section 603(b)(3) imposes a duty to account on partners who leave before their firm’s dissolution has recently been litigated, first in the Buckley Towers case and then in the Howrey bankruptcy. This question is central to the operation of all law firms that are governed by a RUPA state that has adopted section 603(b)(3), as it would impose unfinished business liability on partners who leave one healthy firm for another. Whether this is good or bad for the profession, however, remains to be seen. After all, most healthy law firms would not enforce section 603(b)(3) against departing partners and their successor firms, and the financially distressed firms would benefit from its application (perhaps even saving the firm from dissolution). This will no doubt be one of the largest issues in the Howrey bankruptcy case and a critical issue if any additional law firms fail, as partners who leave a firm at the first sign of trouble may not be able to escape unfinished business liability.

And while determining whether the successor firm has liability for unfinished business matters is only half of the calculus, the proper measure of damages for unfinished business claims has not yet been litigated to conclusion in a published opinion. As a result, plaintiffs and defendants alike are left to argue over how to measure damages with little case law to guide them. Nevertheless, there are some basic concepts that appear to govern damages. The rationale for measuring profits from the perspective of the dissolved firm is to avoid a windfall to its trustee. Thus, if the dissolved law firm would have made a 20 percent profit from completing the unfinished business, its trustee or plan administrator should not be permitted to recover a 35 percent profit simply because the successor firm is more profitable. This does create, however, an incentive for the successor firm to show that its profit margin on the unfinished business is less than that of the dissolved law firm, which invites another area of dispute by requiring analysis of what overhead is attributable to completing unfinished business.

Another damages issue concerns the measurement of reasonable compensation to be paid to partners who complete a law firm’s unfinished business. This too is unsettled. Neither the statute nor case law defines what compensation is reasonable. Instead, one of the few decisions to date that has addressed the issue—a summary judgment ruling in the Heller bankruptcy—rejected certain proxies for reasonable compensation as inapplicable, leaving the proper measure open for future cases. In Heller, the law firm defendants argued that reasonable compensation under the RUPA should be measured under one of two metrics—either the hourly rate paid by the client or the amount the law firm defendant paid the partner. In re Heller Ehrman LLP, 2014 U.S. Dist. LEXIS 81087, at *4–5 (Bankr. N.D. Cal. Jan. 28, 2014). The Heller court rejected both as incompatible with the unfinished business doctrine. Providing partners with a dollar-for-dollar offset in reasonable compensation for every hour billed would leave minimal, if any, profits remaining for the dissolved law firm, and using the defendant firm’s compensation model would divorce reasonable compensation under the RUPA from the cost of completing the unfinished business. Determining the measure of reasonable compensation is critical: After all, the public policy arguments against the unfinished business doctrine depend on the lawyer not receiving any financial benefit from completing the work. But this issue remains unresolved and will no doubt be the subject of hotly contested litigation.

In sum, there’s a lot to come. Many of the most pressing and controverted issues have yet to be addressed by any court. Others have been addressed but not definitively. As lawyers, we have a special interest in these cases, so stay tuned.

Andrew B. Ryan

The author is a commercial trial lawyer in Dallas.