Controversy in Mergers on Payments to Departing Partners

(Editor's Note: The case described in this article is interesting, in part due to an unusual aspect ' a major accounting system conversion ' and the motions filed in the case may themselves hold interest for litigators. But the main moral of the story is plainly this: If your partnership agreement's provisions on departing partners fail to accommodate the possibility of a mass defection, don't wait for an impending merger to update the agreement!)

New York's highest court has agreed to hear a case concerning law firms' ability to withhold capital contributions and compensation from departing partners.

The Court of Appeals granted leave at its Oct. 24 session to W. Edward Bailey, the former managing partner of intellectual property boutique Fish & Neave, and Kevin J. Culligan, a former management committee member. They are suing their old firm for allegedly trying to penalize them for defecting to another firm ahead of Fish & Neave's November 2004 merger with Boston's Ropes & Gray.

The case was unanimously thrown out by the Appellate Division, 1st Department, but the Court of Appeals has now agreed to hear the case. A decision by the Court of Appeals could have a major impact on law firm mergers. Most such mergers are attended by large numbers of departing partners, whose financial claims can total millions of dollars.

Under the original Fish & Neave partnership agreement, adopted in 1970, departing partners were entitled to receive unpaid shares of firm receivables as soon as the amounts could be ascertained. Capital contributions were to be returned within a year.

In May 2004, Fish & Neave partners approved by majority vote an amendment moving the firm from an accrual accounting system to a cash-based system. The amendment also permitted the firm to defer the payment of accrued income to departing partners until they reached age 65 and to spread out the return of capital over a 4-year period. (See the sidebar for details.)

Bailey, who was managing partner from 1994 to 2000, and Culligan claim the measure was enacted to punish them for leaving Fish & Neave in May and June of 2004 to join the New York office of Atlanta's King & Spalding. They claim they are owed $2.4 million in withheld compensation and unreturned capital.

Manhattan Supreme Court Justice Bernard Fried dismissed the case in May 2005, rejecting the plaintiffs' argument that the amendment was void because Fish & Neave lacked an amendment provision in its partnership agreement and therefore required unanimity for any changes. Justice Fried said the amendment amounted to a business decision and the firm partnership agreement clearly envisioned such a decision could be decided by a simple majority vote.

That decision was unanimously affirmed by the Appellate Division, 1st Department, earlier this year in a decision written by Justice Milton Williams.

In arguing for Court of Appeals review, Jeffrey A. Jannuzzo, the lawyer for Bailey and Culligan, said the Appellate Division's ruling produced an 'obnoxious' result ' permitting law firm partners to punish dissent by retroactively invalidating other partners' vested rights. He asked the court to determine whether partners' general right to amend their partnership agreement permitted them to 'take' other partners' vested earnings.

Jannuzzo also took aim at the 1st Department's reliance on language from the Uniform Partnership Act, which said decisions concerning 'the partnership business' could be made by simple majority rule. He argued that this language concerning 'business decisions' should not apply to amending the partnership agreement because it would permit a majority of partners to 'cram down' amendments on the rest.

'As the legal profession continues to change before our eyes, a holding that puts minority partners at the mercy of the majority is an especially bad idea,' Jannuzzo wrote. 'The holding below should not be the law in New York, but it will be unless the Court reviews this case.'

The firm has stressed in court papers that the amendment was a neutral business decision aimed purely at improving the firm's finances, not punishing departing or dissenting partners.

Jannuzzo said that he expected a decision in the case to have national impact because the recent mania for large law firm mergers meant 'partners' rights are under siege all over the country.'

Sidebar:

Partnership Agreement Change That Riled Departing Partners

Excerpt from the May 12, 2005 opinion of the Supreme Court, New York County. (Available at www.courts.state.ny.us/reporter/3dseries/2005/2005_50713.htm; affirmed April 6, 2006 by Appellate Division, 1st Department; accepted for review by Court of Appeals Oct. 24, 2006.)

On or about May 21, 2004, by a majority vote, the partners of the Firm passed the permanent amendment (the Amendment), which transited the Firm from an accrual-based accounting system to a cash-based accounting system, and eliminated the 'pipeline,' or the right of each partner to receive his or her accrued income upon withdrawal. The Amendment provided, in part, that:

Notwithstanding Sections 4 and 11 of the Partnership Agreement, all accounts receivable and work in process shall be assets of the Firm, and no Partner shall have any specific interest in or claim to them or the proceeds that result from their conversion into cash or possess any claim resulting from the elimination of the Firm's accounting system in effect prior to January 1, 2004.

Exhibit 1 to Glasgow Aff., Section II of Attachment I to Amendment. Under the Amendment, partners withdrawing from the Firm, instead of receiving their share of accrued income, would receive a 'Special Distribution' in an amount specified in a 'Schedule A' attached to the Amendment (Id.). The Amendment states that this 'Special Distribution' was to be paid out to withdrawing partners over a 60-month period when they reach the age of 65 (Id., Section II.4, at 3). Plaintiff Bailey's 'Special Distribution' is $340,690, and plaintiff Culligan's 'Special Distribution' is $431,929 (Id., Schedule A).

The Amendment further provided that the withdrawing partners would be repaid their capital 'in accordance with the procedures set forth in the 1997 memorandum approved by the Partners relating to the return of capital' (Id., Section III.1, at 4). This 1997 memorandum outlined a capital restructuring plan for the Firm (Exhibit 4 to Glasgow Aff.). It required that partners who withdraw from the Firm maintain his or her capital in the Firm for a one- to four-year period (Id. at 3).

Plaintiffs claim that prior to the purported amendment of the Partnership Agreement, and for 34 years, withdrawing partners were entitled to their share of the accounts receivable and work in process (work done but not yet paid for), based on the partner's percentage interest in the Firm. They were also entitled to receive a portion of the contingent fees collected by the Firm after departure. Finally, they were entitled to the return of their capital by the end of the fiscal year in which they departed. Plaintiffs assert that they had an established right to these payments, and, then, the majority voted for the monies to 'go into their own pockets.'

(Editor's Note: The case described in this article is interesting, in part due to an unusual aspect ' a major accounting system conversion ' and the motions filed in the case may themselves hold interest for litigators. But the main moral of the story is plainly this: If your partnership agreement's provisions on departing partners fail to accommodate the possibility of a mass defection, don't wait for an impending merger to update the agreement!)

New York's highest court has agreed to hear a case concerning law firms' ability to withhold capital contributions and compensation from departing partners.

The Court of Appeals granted leave at its Oct. 24 session to W. Edward Bailey, the former managing partner of intellectual property boutique Fish & Neave, and Kevin J. Culligan, a former management committee member. They are suing their old firm for allegedly trying to penalize them for defecting to another firm ahead of Fish & Neave's November 2004 merger with Boston's Ropes & Gray.

The case was unanimously thrown out by the Appellate Division, 1st Department, but the Court of Appeals has now agreed to hear the case. A decision by the Court of Appeals could have a major impact on law firm mergers. Most such mergers are attended by large numbers of departing partners, whose financial claims can total millions of dollars.

Under the original Fish & Neave partnership agreement, adopted in 1970, departing partners were entitled to receive unpaid shares of firm receivables as soon as the amounts could be ascertained. Capital contributions were to be returned within a year.

In May 2004, Fish & Neave partners approved by majority vote an amendment moving the firm from an accrual accounting system to a cash-based system. The amendment also permitted the firm to defer the payment of accrued income to departing partners until they reached age 65 and to spread out the return of capital over a 4-year period. (See the sidebar for details.)

Bailey, who was managing partner from 1994 to 2000, and Culligan claim the measure was enacted to punish them for leaving Fish & Neave in May and June of 2004 to join the New York office of Atlanta's King & Spalding. They claim they are owed $2.4 million in withheld compensation and unreturned capital.

Manhattan Supreme Court Justice Bernard Fried dismissed the case in May 2005, rejecting the plaintiffs' argument that the amendment was void because Fish & Neave lacked an amendment provision in its partnership agreement and therefore required unanimity for any changes. Justice Fried said the amendment amounted to a business decision and the firm partnership agreement clearly envisioned such a decision could be decided by a simple majority vote.

That decision was unanimously affirmed by the Appellate Division, 1st Department, earlier this year in a decision written by Justice Milton Williams.

In arguing for Court of Appeals review, Jeffrey A. Jannuzzo, the lawyer for Bailey and Culligan, said the Appellate Division's ruling produced an 'obnoxious' result ' permitting law firm partners to punish dissent by retroactively invalidating other partners' vested rights. He asked the court to determine whether partners' general right to amend their partnership agreement permitted them to 'take' other partners' vested earnings.

Jannuzzo also took aim at the 1st Department's reliance on language from the Uniform Partnership Act, which said decisions concerning 'the partnership business' could be made by simple majority rule. He argued that this language concerning 'business decisions' should not apply to amending the partnership agreement because it would permit a majority of partners to 'cram down' amendments on the rest.

'As the legal profession continues to change before our eyes, a holding that puts minority partners at the mercy of the majority is an especially bad idea,' Jannuzzo wrote. 'The holding below should not be the law in New York, but it will be unless the Court reviews this case.'

The firm has stressed in court papers that the amendment was a neutral business decision aimed purely at improving the firm's finances, not punishing departing or dissenting partners.

Jannuzzo said that he expected a decision in the case to have national impact because the recent mania for large law firm mergers meant 'partners' rights are under siege all over the country.'

Sidebar:

Partnership Agreement Change That Riled Departing Partners

Excerpt from the May 12, 2005 opinion of the Supreme Court, New York County. (Available at www.courts.state.ny.us/reporter/3dseries/2005/2005_50713.htm; affirmed April 6, 2006 by Appellate Division, 1st Department; accepted for review by Court of Appeals Oct. 24, 2006.)

On or about May 21, 2004, by a majority vote, the partners of the Firm passed the permanent amendment (the Amendment), which transited the Firm from an accrual-based accounting system to a cash-based accounting system, and eliminated the 'pipeline,' or the right of each partner to receive his or her accrued income upon withdrawal. The Amendment provided, in part, that:

Notwithstanding Sections 4 and 11 of the Partnership Agreement, all accounts receivable and work in process shall be assets of the Firm, and no Partner shall have any specific interest in or claim to them or the proceeds that result from their conversion into cash or possess any claim resulting from the elimination of the Firm's accounting system in effect prior to January 1, 2004.

Exhibit 1 to Glasgow Aff., Section II of Attachment I to Amendment. Under the Amendment, partners withdrawing from the Firm, instead of receiving their share of accrued income, would receive a 'Special Distribution' in an amount specified in a 'Schedule A' attached to the Amendment (Id.). The Amendment states that this 'Special Distribution' was to be paid out to withdrawing partners over a 60-month period when they reach the age of 65 (Id., Section II.4, at 3). Plaintiff Bailey's 'Special Distribution' is $340,690, and plaintiff Culligan's 'Special Distribution' is $431,929 (Id., Schedule A).

The Amendment further provided that the withdrawing partners would be repaid their capital 'in accordance with the procedures set forth in the 1997 memorandum approved by the Partners relating to the return of capital' (Id., Section III.1, at 4). This 1997 memorandum outlined a capital restructuring plan for the Firm (Exhibit 4 to Glasgow Aff.). It required that partners who withdraw from the Firm maintain his or her capital in the Firm for a one- to four-year period (Id. at 3).

Plaintiffs claim that prior to the purported amendment of the Partnership Agreement, and for 34 years, withdrawing partners were entitled to their share of the accounts receivable and work in process (work done but not yet paid for), based on the partner's percentage interest in the Firm. They were also entitled to receive a portion of the contingent fees collected by the Firm after departure. Finally, they were entitled to the return of their capital by the end of the fiscal year in which they departed. Plaintiffs assert that they had an established right to these payments, and, then, the majority voted for the monies to 'go into their own pockets.'