Author: A.J. Webb, Articles Editor, University of Cincinnati Law Review
In recent years, numerous multinational law firms have declared bankruptcy amidst dwindling demand for legal services. Generally, the bankruptcy of a law firm is similar to that of any other debtor: a trustee must carefully scrutinize the debtor’s assets, ensuring their availability for distribution to outstanding creditors. These assets are essential in repaying the partnership’s previous debts.
The New York Court of Appeals, however, holds a different view of how a bankrupt law firm should be treated, at least with respect to legal fees generated after the law firm declares bankruptcy. In a decision this past July, the Court of Appeals held that the “unfinished business” rule of partnership law, which provides that any “profits arising from work begun by former partners of dissolved law firms are a partnership asset that must be finished for the benefit of the dissolved partnership,” is inapplicable to pending hourly fee matters.[1] Fees generated after the declaration of bankruptcy concerning pending matters prior to the firm’s bankruptcy belong to the attorney, not the bankruptcy estate.[2] This single decision by the Court of Appeals will have major ramifications in bankruptcy law. While rejecting the unfinished business rule increases attorney and client independence, it seriously harms a creditor’s chance of recovery from the firm in bankruptcy.
The Unfinished Business Rule
In 1984, California’s First District Court of Appeal decided in Jewel v. Boxer[3] that under the Uniform Partnership Act (UPA),[4] a partnership continues to exist until the winding up of all unfinished business is completed. Any income generated during the winding up of the business is to be allocated to the partnership.[5] Therefore, in the case of law firms, any income that a former partner receives from a case that is unfinished at the time of dissolution “is to be allocated on the basis of the partners’ respective interests in the dissolved partnership.”[6] The fees generated remain with the former partnership and do not travel with the attorney. In the case of bankrupt law firms, fees generated post-dissolution will return to the partnership’s bankruptcy estate for payment to creditors.[7]
Despite the court’s sweeping language in Jewel, the case has important limitations. First, the UPA is largely a series of “default rules” that control in the absence of an agreement to the contrary. Law firms are free to develop partnership agreements that reject the rule in Jewel and allow attorneys to retain any fees generated post-dissolution, even in bankruptcy.[8] Second, Jewel is most applicable in hourly fee matters where a court can easily quantify services rendered by an attorney to a firm’s former client post-dissolution.[9] Finally, if the dissolved partnership was involved on any contingency fee matters, the partnership is only entitled to the reasonable value of services rendered prior to dissolution, not the full contingency fee.[10]
In re Thelen LLP
Thelen LLP was a national law firm headquartered in San Francisco, California.[11] Experiencing a decline in revenues from the 2008 recession and the inability to merge with another firm, Thelen’s managing partners voted to dissolve and file for bankruptcy.[12] Prior to dissolution, the managing partners amended the partnership agreement to waive the unfinished business rule and expressly declared that the partnership had no right or entitlement to fees generated by partners after dissolution. Thelen’s bankruptcy trustee sought to avoid the unfinished business waiver, claiming that pending hourly matters were among the law firm’s assets.[13] The judge for the District Court for the Southern District of New York upheld the waiver and rejected the unfinished business rule, finding that the rule conflicts with New York’s “strong public policy in favor of client autonomy and attorney mobility.”[14] He simultaneously certified his order for interlocutory appeal.[15]
In upholding the district court’s rejection of the unfinished business rule, the New York Court of Appeals first held that the UPA does not define what constitutes property of the partnership. It only provides guidance as to how a partnership is to divide property upon dissolution.[16] Future hourly legal fees could not be considered property of the partnership because they were too contingent and speculative in nature. Furthermore, because a client has the absolute right to hire or fire an attorney, the legal matter belongs to the client, not the attorney or the partnership. The court noted that a partnership owns yet-unpaid legal services already provided prior to the dissolution, including the value of services rendered under a contingency fee arrangement.[17]
The court explained that upholding the unfinished business rule would have critical public policy implications. In particular, the court stated that allowing former partners to profit from future legal fees would create an unjust windfall for the partnership.[18] It would also create a “run-on-the-bank mentality” by encouraging partners to leave before the firm dissolves instead of remaining behind in an effort to boost chances of survival.[19]
Policy Considerations
The decision in Thelen LLP will likely have major ramifications for individual attorneys, law firms, and law firm bankruptcies. Many view the decision by the New York Court of Appeals as a victory for attorneys and firms because it promotes attorney mobility, but few have considered the practical application this ruling has for partnership creditors.
Despite the advantage of attorney mobility, rejecting the unfinished business rule inspires bad actors because partners are no longer held accountable for their actions in a partnership. If the partnership is forced to file bankruptcy, it is of no consequence to the departing partner. The partner-attorney can simply move to a new firm with his book of business and ignore the mistakes (and creditors) of the past. This result is alarming from both a public policy and bankruptcy perspective. Attorneys should be held accountable for their actions in a partnership, but the decision by the New York Court of Appeals promotes a mentality reminiscent of the Enron era: let the partnership continue to fail and then bail at the last possible minute with the partnership’s biggest asset—the book of business—in tow.
In bankruptcy, trustees are tasked with maximizing the debtor’s available assets to ensure their distribution to creditors. When a partner-attorney takes clients to a new firm, there are few, if any, remaining assets to maximize for creditor distribution. The Thelen LLP decision comes astonishingly close to promoting creditor fraud. After the decision there is little stopping a partner from willfully accumulating massive debt and then fleeing with the only source of income the trustee has to pay creditors. While the trustee can attempt to pursue a fraudulent transfer action,[20] nothing is gained unless there is an actual source of money from which the trustee can pay creditors, and New York has definitively placed the partnership’s largest asset beyond a creditor’s reach.
A Compromising Solution?
Thelen LLP’s trustee advanced a straightforward and convincing argument regarding the unfinished business rule: the rule is only a default rule, and partnerships are free to specifically exclude its application through proper drafting in an operating agreement. The court stated that such a theory “simply does not comport with our profession’s traditions and the commercial realities of the practice of law today.”[21] This is unpersuasive.
Despite the court’s objection, the approach advocated by the trustee creates an effective balance among the goals of the bankruptcy process, partnership creditors, and attorneys. If a partnership agreement does not exclude application of the unfinished business rule, partners must bear full responsibility. In that event, future profits generated from clients of the defunct partnership will be placed back into the bankruptcy estate to recompense creditors. If a partnership agreement is drafted to specifically exclude the unfinished business rule, former partners and their new, respective firms are entitled to keep future profits.
Creditors should bear the risk of lending to partnerships in both of these situations. A creditor is free to request a copy of the partnership agreement prior to authorizing a loan. If the agreement waives the unfinished business rule, then the creditor can choose whether to lend to money to the partnership, with the knowledge that the debtor’s bankruptcy estate will likely be unable to repay the loan. Any later amendment to the partnership agreement waiving the unfinished business rule would be inapplicable to preexisting creditors. This is the most effective approach without unduly harming the interests of the bankruptcy process and creditors. At the least, it is more suitable than the all-or-nothing approach reached by the court in Thelen LLP.
The Proper Place of the Unfinished Business Rule
The existence of an attorney-client relationship does not entitle partners in a law firm partnership to preferred treatment in bankruptcy. Assets of the law firm partnership must be maximized for distribution to creditors, including all hourly fees generated from unfinished business. To hold otherwise seriously undermines the bankruptcy process and enables law firm partners to defraud creditors. Courts in Uniform Partnership Act jurisdictions should continue to apply the unfinished business rule. Partnership agreements are the proper place to reject the unfinished business rule, not the courts.
[1] In re Thelen LLP, 2014 WL 2931526, at *1, *4 (N.Y. Ct. of App. July 1, 2014).
[2] Id. at *1.
[3] 156 Cal.App.3d 171 (Ct. App. 1984).
[4] The Uniform Partnership Act is a uniform act governing business partnerships formed and operated in the United States.
[5] Jewel, 156 Cal.App.3d at 176.
[6] Id. at 177.
[7] In re Thelen LLP, 2014 WL 2931526, at *2.
[8] Jewel, 156 Cal.App.3d at 176.
[9] See In Re Thelen LLP, 2014 WL 2931526, at *3-6 (discussing hourly and contingent fee matters).
[10] Id. at *5.
[11] Thelen Fires 26 Associates as Firm Layoffs Spread West, Wall St. J. (Mar. 20, 2008, 9:47 AM), http://blogs.wsj.com/law/2008/03/20/thelen-fires-26-associates-as-firm-layoffs-spread-west/.
[12] Andrew Ross, Confirmed: Thelen Falls, SF Gate (Oct. 28, 2008 2:41 PM), http://blog.sfgate.com/bottomline/2008/10/28/confirmed-thelen-falls/; In re Thelen LLP, 2014 WL 2931526, at *2.
[13] Id. at *2.
[14] Id.
[15] On appeal, the Second Circuit Court of Appeals certified the question of whether New York Recognizes the unfinished business rule to the New York Court of Appeals. Id. at *2-*3.
[16] Id. at *4-*5.
[17] Id. at *5.
[18] Id. at *7.
[19] Id. While the New York Court of Appeals rejected the unfinished business rule, not all courts are in agreement. See In re Howrey LLP, 2014 WL 4435982 (Bankr. N.D. Cal. Sept. 9, 2014) (holding that the District of Columbia still recognizes the unfinished business rule).
[20] See 11 U.S.C. § 548 (fraudulent transfers and obligations).
[21] In re Thelen LLP, 2014 WL 2931526, at *9.
