Unfinished Business Claims

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This two-part article describes recent developments with respect to unfinished business claims, including a thorough review of recent decisions in New York and California; discusses the implications that those cases may have on law firm partnerships; and provides some suggestions as to what law firms may do to avoid unfinished business claim litigation. We begin with a review of recent decisions.

Background

Litigation surrounding unfinished business claims has been actively pursued by bankruptcy trustees to recover the profits generated by the work of law firms hired by former clients of a dissolved law firm. The theory of recovery is predicated on an alleged fraudulent transfer made by a dissolving law firm by reason of its waiving any claims that it may have against departing partners for profits from future work performed on behalf of former clients of the firm.

This theory of recovery relies primarily on a decision by an intermediate California appellate court in Jewel v. Boxer , 156 Cal. App. 3d 171 (Cal Ct App. 1984) (Jewel), which held that absent an agreement to the contrary, profits derived from a law firm's unfinished business are owed to the former partners in proportion to their partnership interests. The doctrine rests on the legal principle that because departing partners owe a fiduciary duty to the dissolved firm and their former partners to account for benefits obtained from use of partnership property in winding up the partnership's business, they may not be separately compensated. This unfinished business doctrine has been applied by courts in various jurisdictions to both contingent and hourly matters.

While facially, Jewel seems to support a claim for unfinished business, several courts have recently held that unfinished business claims for hourly rate matters are clearly invalid. See Geron v. Seyfarth Shaw LLP (In re Thelen LLP (Thelen)) and Development Specialists Inc. v. K&L Gates LLP et al. (In re Coudert Brothers LLP (Coudert)), (NY Court of Appeals July 1, 2014); Heller Ehrman LLP v. Davis Wright, Tremaine, LLP (In re Heller Ehrman LLP ) (U.S. District Court for the Northern District of California June 11, 2014, appeal filed July 10, 2014). On the other hand, actions to recover unfinished business claims continue to be prosecuted. See In re Howery (U.S. District Court for the Northern District of California Order Re Motions to Withdraw the Bankruptcy Reference, dated July 15, 2104).

While the validity and enforceability of unfinished business claims has been finally determined by some courts, these claims continue to be prosecuted ' at least in California. This may be the case because the California Supreme Court, unlike the New York Court of Appeals, has yet to address the validity of such claims. An analysis of recent decisions, including a review of the positions of the parties should provide a better understanding of where we have been and where we stand today.

Analysis of Recent Decisions

A good starting point is the recent decisions in the Thelen and Coudert bankruptcy cases, where the New York Court of Appeals held that pending hourly fee matters are not partnership “property or unfinished business within the meaning of New York's Partnership Law” and that a law firm “does not own a client or an engagement, and it only entitled to be paid for services actually rendered.”

Thelen

On Oct. 28, 2008, the partners of Thelen LLP voted to dissolve the firm, which was insolvent. Thelen's partners adopted an amendment to their partnership agreement that was intended to expressly waive and opt out of, and be in lieu of, any rights that any partner might have to unfinished business as that term was defined in Jewel, or as otherwise might be provided under provisions of the California Uniform Partnership Act of 1994, as amended (the Jewel Waiver).

Following dissolution, 11 former Thelen partners joined Seyfarth Shaw, transferring unfinished matters to Seyfarth, which billed clients for these partners' future services. On Sept. 18, 2008, Thelen filed a voluntary petition for relief under Chapter 7 of the Bankruptcy Code. Subsequently, the Chapter 7 trustee commenced an adversary proceeding against Seyfarth, seeking under the Bankruptcy Code and California state law to avoid the Jewel Waiver as a constrictive fraudulent transfer, and to recover the profits realized by Seyfarth on the unfinished business for the benefit of the estate's creditors. The trustee assumed that the pending hourly matters were property of the estate that was transferred without consideration pursuant to the Jewel Waiver. Seyfarth moved for judgment on the pleadings, arguing that New York and not California law applied, and thus controlled whether it received any interest in property ' and that New York law did not recognize unfinished business claims for hourly rate matters.

The district court agreed with Seyfarth that New York law applied, and concluded that under New York law, the unfinished business doctrine does not apply to a dissolving law firm's pending hourly fee matters. Therefore, a partnership does not retain any property interest in such matters upon the firm's dissolution. The district court noted that to rule otherwise would conflict with New York's strong public policy in favor of client autonomy and attorney mobility ' which 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. The district court further observed that such an expansion of the unfinished business doctrine would violate New York's public policy against restrictions on the practice of law, and clash directly with New York's Rules of Professional Conduct.

By a decision dated Nov. 15, 2013, the U.S. Court of Appeals for the Second Circuit agreed with the district court that New York law applied. However, the circuit court recognized that the law in New York was unsettled, and thus certified two questions to the New York Court of Appeals, which in substance asked if unfinished business claims for hourly rate matters were valid under New York law.

Coudert

On Aug. 16, 2005, the law firm of Coudert Brothers LLP dissolved. That same day, the equity partners adopted a Special Authorization in which they authorized the Executive Board to grant waivers and to do other things necessary to wind down the business. Former Coudert partners subsequently joined other law firms and took with them various client relationships to their new firms, where the clients retained the new firm as their counsel. In September 2006, Coudert filed Chapter 11. Developmental Specialists, Inc. (DSI) was appointed to administer the estate. DSI commenced adversary proceedings against the law firms that hired former Coudert partners, seeking to recover the profits realized by such firms in connection with unfinished business. The district court granted DSI's motion for summary judgment, finding that under New York Partnership Law, the new client representations were Coudert's assets. On appeal to the Second Circuit, the Circuit Court certified the same questions to the New York Court of Appeals; namely, whether upon dissolution of a law firm, New York recognized unfinished business claims for hourly rate matters.

Thelen and Coudert: The Court of Appeals Decision

The New York Court of Appeals rejected the arguments of the Thelen trustee and DSI, dispelling the notion that bankruptcy estate has a property interest in unfinished business. This exposed the fundamental weakness of the plaintiffs' arguments by clarifying that New York Partnership Law does not create property rights. The court stated that the Partnership Law does not define property; rather, it supplies default rules for how a partnership upon dissolution divides property as elsewhere defined in state law. As a result, the Partnership Law itself has nothing to say about whether a law firm's client matters are partnership property.

The court, when discussing what constitutes property, stated, “we have explained that the expectation of any continued or future business is too contingent in nature and speculative. Although property is often described as a 'bundle of rights,' or 'sticks,' with relational aspects ' the ability to terminate the relationship at any time without penalty [] cannot support a finding that a transferrable property right existed,” citing V erizon New England, Inc. v Transcom Enhanced Servcs. Inc., 21 NY3d 66, 72 (2013).

Further, the court concluded that no law firm has a property interest in future hourly legal fees because these fees are too contingent in nature and speculative to create a present or future property interest, given the client's unfettered right to hire and fire counsel. Indeed, the court found that the purpose of the Uniform Partnership Act is to harmonize partners' duties regarding partnership property, not to delineate the scope of such property. New York courts have never suggested that a law firm owns anything with respect to a client matter other than yet-unpaid compensation for legal services already provided.

Decisions dealing with unfinished business claims in the context of contingency fee arrangements uniformly conclude that the dissolved partnership is entitled only to the value of its services. And notably, these cases have involved disputes between a dissolved partnership and a departing partner, not outside third parties. In this context, statements that contingency fee cases are assets of the partnership subject to distribution simply means that, as between the departing partner and the partnership, the partnership is entitled to an accounting for the value of the cases as of the date of the dissolution.

Hourly rate cases differ from contingency cases because in an hourly case, the value of the work performed by the law firm is periodically billed and collected, whereas the value of the work performed on contingency cases is dependent on the outcome of the case. What differentiates the hourly rate and contingency cases is that the value of work in hourly rate cases can be determined quite easily. It is either work in progress, or an account receivable. On the other hand, the value of work performed on a contingency case during the partnership and after a firm dissolves is not as easily calculated, and certainly any fee is incapable of being paid until the matter is successfully completed.

Therefore, it is not surprising that the value of work performed in connection with a contingency case during the partnership may constitute a viable unfinished business claim. It is compensable because the capital and resources of the partnership before dissolution were used to provide value for which no payment has been made. Equally true is the proposition that the value of the work and effort performed by an attorney after dissolution should be reasonably compensated.

However, the same analysis does not apply to hourly rate matters. Indeed, the court noted that treating a dissolved firm's pending hourly fee matters as partnership property would have numerous perverse effects, and conflicts with basic principles that govern the attorney-client relationship under New York law and the Rules of Professional Conduct. Allowing former partners of a dissolved firm to profit from work they do not perform, all at the expense of a former partner and his or her new law firm, creates an unjust windfall. This also conflicts with New York's strong public policy encouraging client choice and, concomitantly, attorney mobility.

In this regard, the New York Court of Appeals reiterated its view that clients are not merchandise. Lawyers are not tradesmen. They have nothing to sell but personal service. An attempt, therefore, to barter in clients, would appear to be inconsistent with the best concepts of our professional status.

(At press time, the Second Circuit Court of Appeals, relying on the New York Court of Appeals ruling that unfinished business claims for hourly rate matters are not recognized under New York law, affirmed the district court ruling in Thelen.)

Heller Ehrman and Howery: the California Decisions

Two judges sitting in the District Court in the Northern District of California recently issued decisions with respect to unfinished business claims. Judge Charles R. Breyer's decision came in the Heller Ehrman bankruptcy case (Heller) and Judge Saundra Brown Armstrong's decision came in the Howery bankruptcy case (Howery).

Heller

First let's turn to Heller. Heller was a global law firm with approximately 700 lawyers until its dissolution in 2008. The firm had a revolving line of credit from Bank of America to finance its operations. In September 2008, Bank of America declared Heller to be in default, and seized control of the firm's bank accounts. Unable to continue its business, Heller voted to dissolve the firm in accordance with a dissolution plan. The plan included a so-called Jewel Waiver. Heller notified its clients that it would no longer be able to provide legal services, and filed Chapter 11 in December 2008. Subsequently, adversary proceedings were commenced against a number of law firms where former Heller partners had relocated to recover alleged constructive fraudulent transfers because of the Jewel Waiver.

The district court was asked to address questions of first impression: namely, whether hourly fee matters pending when a law firm dissolves are the property of that firm, and whether Heller's bankruptcy trustee has a claim against third-party law firms that hired former Heller lawyers, representing former Heller clients in hourly fee matters. The court answered both questions with a “no.” The Heller court, like the Court of Appeals in Thelen and Coudert , held that neither law, equity, nor policy recognizes a law firm's property interest in hourly fee matters.

The Law

The Heller court found that Jewel was not controlling under the facts, and that no California Supreme Court decision supports such a result, concluding that the trustee does not have a property interest in profits defendants earned post-dissolution working on hourly fee matters that Heller had once handled. The court noted that: 1) although Jewel has been cited in dozens of cases from California and beyond, courts have cited it reflexively and uncritically, that is, without much analysis or consideration of the changes in law firm practice or law; and 2) the California Supreme Court has not ruled on the issue before the court, nor did any published California cases decided under the Revised Uniform Partnership Act (the RUPA) cite Jewel for its unfinished business rule.

Next, the court concluded that the equities clearly favored the defendants (third-party law firms that earned the compensation paid to them) over Heller (which received full payment for its services). And finally, considering the policies favoring the primacy of the rights of clients over those of lawyers, the court determined that it was essential to provide a market for legal services that is unencumbered by quarrelsome claims of disgruntled attorneys and their creditors. The court was also of the opinion that the California Supreme Court would likely hold that hourly fee matters are not partnership property and therefore are not unfinished business subject to any duty to account ' exactly what the Court of Appeals determined in Thelen and Coudert when asked to determine that issue under New York law. Interestingly, the court concluded that Jewel was inapplicable to Heller for five key, related reasons.

First, the dissolution of the firm at issue in Jewel was voluntary, while Heller's dissolution was forced when Bank of America withdrew the firm's line of credit. This is significant because the partners in Jewel could have finished representing their clients on behalf of the old firm, but chose not to. On the other hand, Heller simply lacked the financial ability to continue providing legal services to its clients, leaving those with ongoing matters no choice but to seek new counsel ' and Heller attorneys no choice but to seek new employment.

Second, in Jewel, the new firms represented the clients under fee agreements entered into between the client and the old firm. In Heller, the clients signed new retainer agreements with the new firms.

Third, in Jewel, the new firms consisted entirely of partners from the old firms: One firm with four partners had become two firms with two partners each. In Heller, the defendants were pre-existing third-party firms that provided substantively new representation, requiring significant resources, personnel, capital, and services well beyond the capacity of either Heller or its individual shareholders. Where in Jewel, the departed partners continued to have fiduciary duties to each other and the old firm, in Heller, the third-party firms never owed any duty, fiduciary or otherwise, to the dissolved firm.

Fourth, Jewel treated hourly fee matters and contingency fee matters as indistinguishable. In Heller, there were no contingency fee cases at issue.

Finally, Jewel was decided in 1984 and thus applied the Uniform Partnership Act, which was superseded by the materially different Revised Uniform Partnership Act. The RUPA, which applies after 1999 to all California partnerships, allows partners to obtain reasonable compensation for helping to wind up partnership business, and thus undermines the legal foundation on which Jewel rests.

The court found that the RUPA's impact on Jewel was significant, noting that section 404(b)(3) of the RUPA provides that a partner must “refrain from competing with the partnership in the conduct of the partnership business before the dissolution of the partnership.” Quoting from the drafters of the RUPA, the court noted that this language means that the duty not to compete does not extend to winding up the business, as do the other loyalty rules. Thus, a partner is free to compete immediately upon an event of dissolution.

Therefore, unlike in Jewel, if a former Heller partner signed a new retainer agreement with a former Heller client, this would not violate the fiduciary duty not to take any action with respect to unfinished partnership business for personal gain. Consequently there is no provision of the RUPA that gives the dissolved firm the right to demand an accounting for profits earned by its former partner under a new retainer agreement with a client. Moreover, in Heller, the new retainer agreements were not even signed between former Heller clients and former Heller partners, but rather between the clients and new, third-party firms.

Next Month

This article concludes next month with a look at the equities and more, and discusses the implications that those cases may have on law firm partnerships.

Robert W. Dremluk is a Partner in the New York office of Culhane Meadows PLLC. Reach him at [email protected].