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Can Bankrupt Law Firms Claw Back 'Unfinished Biz' Profits?

Lauren Friend McKelvey and Dylan G. Trache
May 30, 2014 | Law360

On June 4, 2014, the New York Court of Appeals will hear arguments arising from the bankruptcies of two law firms—Thelen LLP and Coudert Brothers LLP—as to whether the former partners of the bankrupt law firms must turn over profits earned after the bankrupt firms’ dissolution on billable-hour client matters they brought to their new firms.

The battle lines have been drawn, with the American Bar Association and 12 prominent New York law firms filing amici curiae briefs arguing that the so-called “unfinished business” profits are not property of the bankrupt law firms.  On the other side, the trustees and plan administrator for the bankrupt law firms of Dewey & LeBoeuf LLP, Howrey LLP and Heller Ehrman LLP, filed an amici curiae brief urging the court to rule that the former partners have a fiduciary duty to account for profits earned from the completion of ongoing client matters for the benefit of the dissolved partnership and its creditors.

After two judges of the United States District Court for the Southern District of New York issued conflicting opinions on whether a client matter that is billed on an hourly basis is property of the bankrupt law firm where the matter originated, the Second Circuit certified two questions to New York’s highest court:


Under New York law, is a client matter that is billed on an hourly basis the property of a law firm, such that, upon dissolution and in related bankruptcy proceedings, the law firm is entitled to the profit earned on such matters as the “unfinished business” of the firm?

If so, how does New York law define a “client matter” for purposes of the unfinished business doctrine and what proportion of the profit derived from an ongoing hourly matter may the new law firm retain?

In re Thelen LLP, 736 F.3d 213, 225 (2d Cir. 2013), certified question accepted by Thelen LLP v. Seyfarth Shaw LLP, 22 N.Y.3d 1017, 981 N.Y.S.2d 349, 4 N.E.2d 359 (2013).

Clawback Actions Against Former Partners of Bankrupt Laws Firms

Supporters of the unfinished business doctrine cite to Jewel v. Boxer, a decision of the California Court of Appeals holding that, absent a contrary provision in a partnership agreement, a former law firm partner had a duty to account to a dissolved partnership for any profits generated through winding up unfinished partnership business.  Jewel v. Boxer, 156 Cal. App. 3d 171, 203 Cal. Rptr. 13, 15-17 (1984).

Trustees and administrators of bankrupt law firms—including those for Thelen, Coudert, Brobeck Phleger & Harrison, Heller Ehrman and Howrey—have initiated lawsuits against former partners and their new firms to recover profits from client matters moved by partners from the bankrupt firm to the new firm.  Bankruptcy courts have generally sided with the bankruptcy trustees, holding that former partners and their new firms must account to the bankrupt firm for profits earned on the transferred client matters, regardless of whether the client matter is billed on a contingent, flat fee or hourly basis.

In states where the Uniform Partnership Act (UPA) applies, such as New York, bankruptcy trustees have argued that partners are entitled to no compensation for winding up unfinished partnership business.  In states adopting the Revised Uniform Partnership Act (RUPA), however, partners are allowed reasonable compensation for completing their obligations to wind up partnership businesses.  Courts have not settled on how to calculate “profits” to be turned over to the bankrupt law firm in UPA jurisdictions or what constitutes “reasonable compensation” to be retained by departing partners in RUPA jurisdictions.

Some of the bankrupt law firms, such as Thelen and Brobeck, included a “Jewel waiver” in their partnership agreement, wherein the partnership waived any rights to clients, cases or matters ongoing at the time of the partnership’s dissolution other than for work performed prior to a partner’s departure from the firm.  The Jewel waiver, however, may be avoidable as a fraudulent transfer under section 548 of the Bankruptcy Code or applicable state law if adopted in conjunction with dissolution of the firm while it is insolvent.  See Greenspan v. Orrick Herrington & Sutcliffe LLP (In re Brobeck Phleger & Harrison LLP), 408 B.R. 318, 340-46 (Bankr. N.D. Cal. 2009).

Split Within SDNY Over the Bankrupt Firm’s Ownership of Client Matters

The appeals in the Thelen and Coudert cases before the N.Y. Court of Appeals on June 4 both arise from lawsuits brought by the bankruptcy trustee or plan administrator of the bankrupt firms to recover unfinished business profits from former partners and their new law firms.  Months apart, two S.D.N.Y. judges considering the unfinished business lawsuits reached opposite conclusions regarding the bankrupt firm’s ownership rights in hourly client matters, with the judge in the Coudert case finding that pending hourly matters are law firm assets and the judge in the Thelen case holding that they are not.

In declining to follow the district court’s decision in the Coudert case, the district court in Thelen reasoned that a finding that hourly client matters are property of dissolved law firms is inconsistent with a client’s right to choose its attorneys, clashes directly with New York’s Rules of Professional Conduct prohibiting fee sharing and “would result in an unjust windfall for the Thelen estate, as compensating a former partner out of that fee would reduce the compensation of the attorneys performing the work.” Geron v. Robinson & Cole LLP (In re Thelen LLP), 476 B.R. 732, 740-41 (S.D.N.Y. 2012) (quotation and citation omitted).  The district court in Thelen also identified the “bizarre consequences” of the bankrupt firm having such property interests—including, potentially, the power of a debtor law firm to sell its hourly fee matters to the highest bidder under section 363 of the Bankruptcy Code and the inability of a client to transfer its case to a new firm without violating the automatic stay under section 362 of the Bankruptcy Code.  Id.

Trustees of Bankrupt Law Firms, the American Bar Association and NY Law Firms Weigh In

The trustees and plan administrator for the bankrupt law firms of Dewey & LeBoeuf, Howrey and Heller Ehrman submitted an amici curiae brief arguing that bankrupt law firms have property rights in hourly matters, entitling bankruptcy trustees to recover unfinished business profits for the benefit of the bankrupt firm’s creditors.  They noted the significance of the ruling in Thelen:


Until Judge Pauley’s decision in the Thelen LLP bankruptcy, three federal judges had ruled that New York would apply the Unfinished Business Rule to a law firm’s hourly matters and every court in every major urban or financial center — from California to Washington D.C. to Illinois and Pennsylvania — had applied the Unfinished Business Rule to law firms, regardless of whether ongoing client matters were billed on a contingent or hourly basis. ... In the fall of 2012, Judge Pauley’s decision brought chaos where there was once order by finding that New York, the epicenter of the U.S. legal market, would not abide by the uniform application of the Unfinished Business Rule.

Also filing an amici curiae brief, a group of 12 prominent firms with offices in New York argued that the application of the unfinished business rule to hourly fee matters infringes on clients’ unfettered right to choose their counsel and “would impose a monetary penalty on firms agreeing to represent clients who, through no fault of their own, happened to be represented at one time by attorneys whose former law firm failed.”  The 12 firms have agreed to represent clients whose former firm has dissolved after hiring the dissolved firm’s former partners.

The American Bar Association also weighed in, “in support of neither party, but rather in support of the client’s right to choose its counsel.”  The ABA, with nearly 400,000 members including over 36,000 lawyers in New York, asserted “that the contention that an unfinished hourly rate client matter of a dissolved firm is property of the dissolved firm conflicts directly with the long-standing principle that the client has the right to control its relationship with its attorney, and to select and retain or change counsel at any time.”

Conclusion

The N.Y. Court of Appeals’ ruling in the Coudert and Thelen cases will likely have a significant impact on the ability of bankruptcy trustees in recent and future law firm bankruptcy cases to claw back unfinished business profits from law firms who absorbed partners from the bankrupt firms.

The issue of whether dissolved law firms have a property interest in client matters has reached only a handful of appellate-level courts.  Although the N.Y. Court of Appeals’ decision will only be binding precedent in New York, where Dewey & LeBoeuf was headquartered, it will likely be cited by the prevailing side as persuasive authority in other jurisdictions.  Moreover, the N.Y. Court of Appeals decision may be important to bankruptcy fraudulent transfer actions against N.Y. partners of dissolved firms regardless of whether the firms were headquartered in New York or other jurisdictions.

For more information, please contact Lauren Friend McKelvey at 703.905.2838 or lmckelvey@wileyrein.com and Dylan G. Trache at 703.905.2829 or dtrache@wileyrein.com.


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