Law Firm Bankruptcies

With globalization and the increasing number of mergers; with the opening of more branch offices by the national firms; and with record number of lawyers leaving law firms, competition in the legal profession has become more intense and cutthroat. As a result, are there more law firm bankruptcies on the horizon? If so, what are the ramifications? What procedures must be followed? The goal of this article is to provide an overview of the basic issues likely to surface in a law firm bankruptcy case.

Finley Kumble, Gaston & Snow, Altheimer & Gray, Arter & Hadden, Brobeck Phleger & Harrison, all prominent law firms in their prime that wound up in bankruptcy. See: In re Finley, Kumble, Wagner, Heine, Underberg, Manley, Myerson & Casey, 85 B.R.13 (Bankr. S.D. N.Y., filed March 2, 1988); In re Gaston & Snow, Case No. 91-B-14594 (Bankr. S.D. N.Y., filed Oct. 10, 1991); In re Altheimer & Gray, Case No. 03-B-43547 (Bankr. D. Ill. Oct. 24, 2003); In re Arter & Hadden, LLP, Case No. 03-23293 (Bankr. N.D. Ohio, filed Oct. 6, 2003); In re Brobeck Phleger & Harrison, LLP, Case No. 03-32715 (Bankr. N.D. Cal., filed Sept. 17, 2003).

The ability of a law firm partnership to operate as a going concern may be called into question for a variety of reasons. For example, overly-rapid expansions, over-leveraging, industry specific problems, the cyclical nature of our economy, mismanagement, and fraud have all had a catalytic effect on the need for companies to seek the protections afforded by the Bankruptcy Code (United States Code Title 11). Although historically less common than their corporate counterparts, partner attrition in the wake of the “dot-com” crash and in light of the growing merger trend among professional service firms have contributed to an increase in the incidence of law firm partnership bankruptcies.

Although state laws may provide a more attractive forum for dealing with the issues raised by failed or failing partnerships and an out of court dissolution and consensual resolution of these issues is usually the preferred course of action, the Bankruptcy Code may provide an attractive safe-haven for law firm partnerships in distress. Should client and counsel conclude that a bankruptcy filing is necessary, or should the law firm be forced into bankruptcy by its creditors, those entrusted with the task of handling such partnership bankruptcies must be intimately familiar with basically three sources of law:

1. Applicable state law (usually the Uni-form Partnership Act (UPA));
2. The Bankruptcy Code; and
3. Applicable case law under the UPA and the Bankruptcy Code.

In addition, familiarity with the law firm's partnership agreement is a given. Complicating this task, counsel may find itself in un-chartered waters as the Bankruptcy Code has recently been amended and the effects of such amendments are yet to be seen (On April 20, 2005, President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Unless specifically noted otherwise, the amendments to the Bankruptcy Code are effective as of Oct. 17, 2005.)

Further complicating this task is the fact that entities finding themselves in financial distress typically procrastinate retaining bankruptcy counsel.

Chapter 7 vs. Chapter 11

Partnership and non-partnership entities share many of the same concerns and considerations with respect to choosing between liquidation, on the one hand, and restructuring on the other. Entities that are contemplating liquidation are also faced with the dilemma of proceeding with a Chapter 7 liquidation, a process akin to a forced or “fire” sale, or an orderly liquidation pursuant to a Chapter 11 liquidating plan. Although more costly, entities without a prospect for reorganization ' as well as their creditors ' will likely prefer to proceed with an orderly liquidation pursuant to a Chapter 11 liquidating plan, assuming such a plan may be confirmed under Section 1129 of the Bankruptcy Code. Given that the ultimate distributions under a Chapter 11 liquidating plan must be at least as much as what creditors would receive in a Chapter 7 liquidation, and given the fact that, at least in theory, amounts realized in a forced sale should be less than what can be realized in an orderly disposition of assets, it is easy to understand why this is so. (See, 11 U.S.C. '1129(a)(7)(A)(ii) (a court shall confirm a plan only if, among other things, creditors receive or retain under the plan not less than the amount such creditors would receive in a Chapter 7 case)).

Moreover, within certain guidelines, insiders, including partners, may receive various indemnification and release of liability benefits under a Chapter 11 liquidating plan that cannot be obtained in a Chapter 7 case.

The preference for Chapter 11 over Chapter 7 is that much more pronounced in the context of law firm partnerships. That is, contrary to the typical “brick and mortar” debtor, the estates of law firm partnerships do not readily lend themselves to a forced liquidation that compromises the value of their assets and to the other strictures of Chapter 7. In this regard, law firm partnership bankruptcies typically either begin as Chapter 11 cases or as Chapter 7 cases that are later converted to Chapter 11. See, eg, In re Gaston & Snow, Case No. 91-B-14594 (Bankr. S.D.N.Y., filed Oct. 10, 1991); In re Heron, Burchette, Ruckert & Rothwell, Case No. 91-00697 (Bankr. D. D.C. July 1, 1991); In re Finley, Kumble, Wagner, Heine, Underberg, Manley, Myerson & Casey, Case No. 91-B-14594 (Bankr. S.D.N.Y., filed March 2, 1988).

The statutory aims of a Chapter 11 case include the following: a) preservation of the debtor's property as a “going concern” and the preservation of any “going concern” value of the debtor's business and property; b) avoidance of a forced and destructive liquidation of the debtor's assets; c) protection of the interests of creditors, both secured and unsecured; and d) restructuring of debts, finances, and/or ownership of the debtor as will enable it to retain those assets necessary to rehabilitate its finances and (at the same time) produce the greatest recovery for its creditors.

Venue of the Bankruptcy Case

As should become apparent from the discussions that follow, the benefits to be obtained from seeking relief under the Bankruptcy Code varies from district to district and from court to court. Accordingly, choosing a correct venue for filing the petition for relief is imperative to a successful case. A law partnership bankruptcy case may be commenced in the district in which the domicile or principal place of business of the law firm is located or where its principal assets are located for the 180 days immediately prior to filing or for a longer period of that 180-day period than any other district. See, 28 U.S.C. '1408(1). In addition, a law partnership bankruptcy case may be commenced in a district where there already is a pending bankruptcy case concerning a general partner. See, 28 U.S.C. '1408(2).

Getting Started:
Practical Considerations

After obtaining appropriate client release forms from its clients, the law firm partnership should begin the process of maintaining, transferring and disposing of client files. Two issues are likely to arise in this regard. First, should the law firm refuse to release a particular client's documents when such client has outstanding bills with the firm? Under the laws of many states, attorneys are entitled to assert a retaining lien on such documents and refuse to turn over a client's documents until all outstanding fees are paid. On the flip side, if the firm itself owes fees to the storage company holding its clients' documents and the record storage company refuses to release such documents until the outstanding bills are paid, the law firm partnership may have to make a motion before the bankruptcy court seeking an order requiring the turnover of all records held by such storage company. See, 11 U.S.C. '542(e).

At least until the bankruptcy court sets the deadline for creditors and potential creditors to assert any claims they may have against the law firm partnership, it is also essential for the law firm partnership to continue to maintain its malpractice insurance coverage. Allowing the policy to lapse prior to the court-imposed deadline to file claims potentially exposes the debtor to numerous malpractice claims. In this regard, it should be noted that malpractice insurance policies are

considered to be property of the debtor's estate and cannot be cancelled once a bankruptcy petition is filed absent relief from the automatic stay. See, eg, In re New England Marine Services, Inc., 174 B.R. 391, 396 (Bankr. E.D.N.Y. 1994); In re Minoco Group of Companies, Ltd., 799 F.2d 517, 519 (9th Cir. 1986); Moody v. Amoco Oil Co., 734 F.2d 1200, 1212-13 (7th Cir. 1984). Moreover, such professional liability policies may be considered executory contracts that may be assumed by the debtor at any time prior to confirmation of a plan in the context of a Chapter 11 case (11 U.S.C. '365(d)(2)), or, in the context of a Chapter 7 case, within 60 days from the filing of the petition (11 U.S.C. '365(d)(1)), upon the curing of defaults and providing adequate assurance of future performance (11 U.S.C. '365(b)).

Perhaps foremost in importance in getting the bankruptcy case started and keeping it on track to successful completion are the efforts of the law firm in marshalling its assets and liabilities, especially its collection efforts in respect of accounts receivable and work-in-progress. In this regard, the law firm's partnership agreement should be analyzed and a determination made as to how work-in-progress that has not yet been billed should be treated and partners working on such matters should be advised as to how to proceed.

Finally, communication with both partners and creditors is a necessary ingredient for a successful bankruptcy. With respect to current partners, the formation of a liquidation committee may be the only practical method of dealing with the decisions that inevitably will need to be made in all but the smallest law firm partnership cases. Moreover, both applicable state law, as well as the Bankruptcy Rules, require certain partnership disclosures to partners upon demand. See, UPA ”19 & 20; Bankruptcy Rule 2004. In this regard, the liquidation committee should be sensitive to the amount of detail provided. Former partners will undoubtedly have many questions as well. In addition, as partners may be called upon to dedicate time and effort to the case and possibly to contribute personal funds towards a plan of liquidation, the partnership's success in establishing a dialogue with partners may ultimately decide the fate of the case. Similarly, the law firm partnership debtor may choose to inform current and former clients and creditors of its liquidation to prevent itself from being bound by actions taken by partners outside the scope of its liquidation. (See, UPA '35(b) (firm may incur liability for acts of partners outside scope of dissolution to extent creditor has no knowledge of dissolution. Knowledge presumed where notice of dissolution published in newspaper)). Clients should also be given the opportunity to direct where their respective files should be sent, thereby minimizing the risk of additional malpractice claims.

With globalization and the increasing number of mergers; with the opening of more branch offices by the national firms; and with record number of lawyers leaving law firms, competition in the legal profession has become more intense and cutthroat. As a result, are there more law firm bankruptcies on the horizon? If so, what are the ramifications? What procedures must be followed? The goal of this article is to provide an overview of the basic issues likely to surface in a law firm bankruptcy case.

Finley Kumble, Gaston & Snow, Altheimer & Gray, Arter & Hadden, Brobeck Phleger & Harrison, all prominent law firms in their prime that wound up in bankruptcy. See: In re Finley, Kumble, Wagner, Heine, Underberg, Manley, Myerson & Casey, 85 B.R.13 (Bankr. S.D. N.Y., filed March 2, 1988); In re Gaston & Snow, Case No. 91-B-14594 (Bankr. S.D. N.Y., filed Oct. 10, 1991); In re Altheimer & Gray, Case No. 03-B-43547 (Bankr. D. Ill. Oct. 24, 2003); In re Arter & Hadden, LLP, Case No. 03-23293 (Bankr. N.D. Ohio, filed Oct. 6, 2003); In re Brobeck Phleger & Harrison, LLP, Case No. 03-32715 (Bankr. N.D. Cal., filed Sept. 17, 2003).

The ability of a law firm partnership to operate as a going concern may be called into question for a variety of reasons. For example, overly-rapid expansions, over-leveraging, industry specific problems, the cyclical nature of our economy, mismanagement, and fraud have all had a catalytic effect on the need for companies to seek the protections afforded by the Bankruptcy Code (United States Code Title 11). Although historically less common than their corporate counterparts, partner attrition in the wake of the “dot-com” crash and in light of the growing merger trend among professional service firms have contributed to an increase in the incidence of law firm partnership bankruptcies.

Although state laws may provide a more attractive forum for dealing with the issues raised by failed or failing partnerships and an out of court dissolution and consensual resolution of these issues is usually the preferred course of action, the Bankruptcy Code may provide an attractive safe-haven for law firm partnerships in distress. Should client and counsel conclude that a bankruptcy filing is necessary, or should the law firm be forced into bankruptcy by its creditors, those entrusted with the task of handling such partnership bankruptcies must be intimately familiar with basically three sources of law:

1. Applicable state law (usually the Uni-form Partnership Act (UPA));
2. The Bankruptcy Code; and
3. Applicable case law under the UPA and the Bankruptcy Code.

In addition, familiarity with the law firm's partnership agreement is a given. Complicating this task, counsel may find itself in un-chartered waters as the Bankruptcy Code has recently been amended and the effects of such amendments are yet to be seen (On April 20, 2005, President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Unless specifically noted otherwise, the amendments to the Bankruptcy Code are effective as of Oct. 17, 2005.)

Further complicating this task is the fact that entities finding themselves in financial distress typically procrastinate retaining bankruptcy counsel.

Chapter 7 vs. Chapter 11

Partnership and non-partnership entities share many of the same concerns and considerations with respect to choosing between liquidation, on the one hand, and restructuring on the other. Entities that are contemplating liquidation are also faced with the dilemma of proceeding with a Chapter 7 liquidation, a process akin to a forced or “fire” sale, or an orderly liquidation pursuant to a Chapter 11 liquidating plan. Although more costly, entities without a prospect for reorganization ' as well as their creditors ' will likely prefer to proceed with an orderly liquidation pursuant to a Chapter 11 liquidating plan, assuming such a plan may be confirmed under Section 1129 of the Bankruptcy Code. Given that the ultimate distributions under a Chapter 11 liquidating plan must be at least as much as what creditors would receive in a Chapter 7 liquidation, and given the fact that, at least in theory, amounts realized in a forced sale should be less than what can be realized in an orderly disposition of assets, it is easy to understand why this is so. (See, 11 U.S.C. '1129(a)(7)(A)(ii) (a court shall confirm a plan only if, among other things, creditors receive or retain under the plan not less than the amount such creditors would receive in a Chapter 7 case)).

Moreover, within certain guidelines, insiders, including partners, may receive various indemnification and release of liability benefits under a Chapter 11 liquidating plan that cannot be obtained in a Chapter 7 case.

The preference for Chapter 11 over Chapter 7 is that much more pronounced in the context of law firm partnerships. That is, contrary to the typical “brick and mortar” debtor, the estates of law firm partnerships do not readily lend themselves to a forced liquidation that compromises the value of their assets and to the other strictures of Chapter 7. In this regard, law firm partnership bankruptcies typically either begin as Chapter 11 cases or as Chapter 7 cases that are later converted to Chapter 11. See, eg, In re Gaston & Snow, Case No. 91-B-14594 (Bankr. S.D.N.Y., filed Oct. 10, 1991); In re Heron, Burchette, Ruckert & Rothwell, Case No. 91-00697 (Bankr. D. D.C. July 1, 1991); In re Finley, Kumble, Wagner, Heine, Underberg, Manley, Myerson & Casey, Case No. 91-B-14594 (Bankr. S.D.N.Y., filed March 2, 1988).

The statutory aims of a Chapter 11 case include the following: a) preservation of the debtor's property as a “going concern” and the preservation of any “going concern” value of the debtor's business and property; b) avoidance of a forced and destructive liquidation of the debtor's assets; c) protection of the interests of creditors, both secured and unsecured; and d) restructuring of debts, finances, and/or ownership of the debtor as will enable it to retain those assets necessary to rehabilitate its finances and (at the same time) produce the greatest recovery for its creditors.

Venue of the Bankruptcy Case

As should become apparent from the discussions that follow, the benefits to be obtained from seeking relief under the Bankruptcy Code varies from district to district and from court to court. Accordingly, choosing a correct venue for filing the petition for relief is imperative to a successful case. A law partnership bankruptcy case may be commenced in the district in which the domicile or principal place of business of the law firm is located or where its principal assets are located for the 180 days immediately prior to filing or for a longer period of that 180-day period than any other district. See, 28 U.S.C. '1408(1). In addition, a law partnership bankruptcy case may be commenced in a district where there already is a pending bankruptcy case concerning a general partner. See, 28 U.S.C. '1408(2).

Getting Started:
Practical Considerations

After obtaining appropriate client release forms from its clients, the law firm partnership should begin the process of maintaining, transferring and disposing of client files. Two issues are likely to arise in this regard. First, should the law firm refuse to release a particular client's documents when such client has outstanding bills with the firm? Under the laws of many states, attorneys are entitled to assert a retaining lien on such documents and refuse to turn over a client's documents until all outstanding fees are paid. On the flip side, if the firm itself owes fees to the storage company holding its clients' documents and the record storage company refuses to release such documents until the outstanding bills are paid, the law firm partnership may have to make a motion before the bankruptcy court seeking an order requiring the turnover of all records held by such storage company. See, 11 U.S.C. '542(e).

At least until the bankruptcy court sets the deadline for creditors and potential creditors to assert any claims they may have against the law firm partnership, it is also essential for the law firm partnership to continue to maintain its malpractice insurance coverage. Allowing the policy to lapse prior to the court-imposed deadline to file claims potentially exposes the debtor to numerous malpractice claims. In this regard, it should be noted that malpractice insurance policies are

considered to be property of the debtor's estate and cannot be cancelled once a bankruptcy petition is filed absent relief from the automatic stay. See, eg, In re New England Marine Services, Inc., 174 B.R. 391, 396 (Bankr. E.D.N.Y. 1994); In re Minoco Group of Companies, Ltd., 799 F.2d 517, 519 (9th Cir. 1986); Moody v. Amoco Oil Co. , 734 F.2d 1200, 1212-13 (7th Cir. 1984). Moreover, such professional liability policies may be considered executory contracts that may be assumed by the debtor at any time prior to confirmation of a plan in the context of a Chapter 11 case (11 U.S.C. '365(d)(2)), or, in the context of a Chapter 7 case, within 60 days from the filing of the petition (11 U.S.C. '365(d)(1)), upon the curing of defaults and providing adequate assurance of future performance (11 U.S.C. '365(b)).

Perhaps foremost in importance in getting the bankruptcy case started and keeping it on track to successful completion are the efforts of the law firm in marshalling its assets and liabilities, especially its collection efforts in respect of accounts receivable and work-in-progress. In this regard, the law firm's partnership agreement should be analyzed and a determination made as to how work-in-progress that has not yet been billed should be treated and partners working on such matters should be advised as to how to proceed.

Finally, communication with both partners and creditors is a necessary ingredient for a successful bankruptcy. With respect to current partners, the formation of a liquidation committee may be the only practical method of dealing with the decisions that inevitably will need to be made in all but the smallest law firm partnership cases. Moreover, both applicable state law, as well as the Bankruptcy Rules, require certain partnership disclosures to partners upon demand. See, UPA ”19 & 20; Bankruptcy Rule 2004. In this regard, the liquidation committee should be sensitive to the amount of detail provided. Former partners will undoubtedly have many questions as well. In addition, as partners may be called upon to dedicate time and effort to the case and possibly to contribute personal funds towards a plan of liquidation, the partnership's success in establishing a dialogue with partners may ultimately decide the fate of the case. Similarly, the law firm partnership debtor may choose to inform current and former clients and creditors of its liquidation to prevent itself from being bound by actions taken by partners outside the scope of its liquidation. (See, UPA '35(b) (firm may incur liability for acts of partners outside scope of dissolution to extent creditor has no knowledge of dissolution. Knowledge presumed where notice of dissolution published in newspaper)). Clients should also be given the opportunity to direct where their respective files should be sent, thereby minimizing the risk of additional malpractice claims.