Editor’s Note: This is the second installment of a two-part series by the author. The first article was published in the December 2013 edition of the Business Reorganization Committee Newsletter.
The Bankruptcy Case: Determining Insolvency When Key Assets Are People
At the first-day hearing for the chapter 11 case of the law firm of Dewey & LeBoeuf LLP, debtor’s counsel, Albert Togut, explained that “the assets of a law firm go home every night…. The people are the assets and they went home every night until one night they went home and they didn’t come back. And that’s why we’re here today.”[1] Accordingly, the value of a law firm’s partners is commonly understood to be a firm’s most valuable assets. A law firm’s true financial status might therefore be difficult to determine from its balance sheet. While a law firm’s balance sheet reflects the firm’s physical assets, such as office space, computer systems and infrastructure, the value of these assets is contingent on profitable partners (and their loyal clients) remaining with the firm.[2] Unlike other industries where assets can be easily sold and valued, law firms face the risk of their most valuable asset simply leaving to practice elsewhere, usually bringing their clients with them.[3]
Once a law firm files for bankruptcy, a debtor in possession or trustee is given the power to avoid certain transfers or obligations that incurred two years prior to the bankruptcy, where the debtor (1) received less than a reasonably equivalent value in exchange for the transfer or obligation and the debtor was insolvent on the date the transaction occurred or became insolvent as a result of the transaction; (2) was engaged in a business for which remaining property represented an unreasonably small capital; or (3) intended to incur debts beyond the debtor’s ability to repay.[4] As a result, in law firm bankruptcy cases, the estate is tasked with determining the date at which the law firm became insolvent. When assets are people, determining the date of insolvency can be a formidable task, leading to lengthy litigation in the bankruptcy case with astounding professional costs.
In Heller Ehrman’s case,[5] the law firm claimed that the decision to file for bankruptcy was not prompted by running out of money, noting that the firm had great success in collecting outstanding receivables pre-petition and believed that it would continue to do so.[6] The firm’s creditors disagreed, alleging that the firm was insolvent as early as 2007, when the firm’s former chairman sent an email describing a $9.3 million payout to partners late in 2007 as an “overdistribution” while this payment was allegedly accounted for as a miscellaneous receivable.[7] Creditors alleged that firm managers were trying to prop up the firm’s profits-per-partner rankings to attract a merger partner.[8]
In response to avoidance actions seeking an aggregate of approximately $106 million, former Heller Ehrman partners rejected this contention, arguing the firm was profitable and well capitalized at the end of 2007, relying on evidence of audits and the continued willingness of their banks to lend them money.[9] The partners further argued that a “highly respected law firm consulting group” concluded that Heller’s financial condition was as good as other firms at the end of 2007, with less debt per equity partner and less debt as a percent of revenue than the top 20 percent of firms with less than 500 lawyers.[10] Partners claimed that two consulting firm reports found that the firm was much better capitalized than its potential merger partners, Baker Botts and Baker & McKenzie.[11] The partners blamed the firm’s ultimate failure on the economic downturn, the unforeseen departure of rainmakers responsible for $90 million worth of business in 2007, and the banks deciding to call the firm’s line of credit and seize the firm’s cash flow.[12] Although the case has been pending for approximately four and a half years, the court has not yet decided this issue.
Cleaning Up the Mess: The New Paradigm
While the number of law firm failures in recent years seems to have increased, the bankruptcy process appears to have at least drastically improved. Law firm bankruptcy cases have typically lasted for many years with staggering amounts spent on professional fees for estate representatives to pursue claims against former partners. In Dewey, the court’s approval of the estate’s settlement with former partners (the “PCP”) approximately five months after the case began set Dewey apart from previous law firm bankruptcy cases by achieving an “up-front” settlement with former partners, as opposed to years of embroiled litigation. This “time value” consideration affected the amount of contributions requested from each former partner. One estate representative explained that “[i]f it was going to take five or six years, as it has in other law firm cases, to resolve those cases, that was factored into our thinking on the value of those claims in a settlement, along with the obvious risk of litigation.”[13] While many former partners did not immediately embrace this novel approach, the parties and the court ultimately agreed that this approach was more effective than lengthy litigation.
The PCP settled claims against former partners for fraudulent conveyances (claims relative to compensation that was paid to partners at a time the firm might have been or become as a result of such payments insolvent), avoidance claims for overdistributions, and fiduciary or mismanagement claims.[14] The initial PCP proposal called for 709 former Dewey partners to return a portion of the compensation that they had received in 2011 and 2012 when the firm was likely insolvent. This “rough justice” approach placed partners into tiers seeking payment of between $25,000 and $3 million per partner. After a series of meetings between Dewey’s counsel and partner constituencies, the PCP was revised to range from $3,000 to $3.37 million, with a premium of up to 20 percent charged to former members of Dewey’s executive committee, based on length of service.[15] Professionals also considered the likelihood of being able to actually collect on these claims as almost one-third of PCP participants were retirees, and the firm’s active partners were early in their careers and earning less than $500,000 or $600,000 annually, with mortgages and significant capital loans.[16] Further, certain former members of the firm’s management who were alleged wrongdoers were not permitted to participate in the PCP.[17]
The PCP was approved by the court on Oct. 9, 2012, and ultimately settled claims with approximately 400 of its former partners for a total of approximately $71 million.[18] In approving the PCP, the court held that the result of pursuing estate causes of action against partners was “likely to be protracted litigation” with uncertain recovery[19] and that there were likely to be practical difficulties in collecting judgments.[20] Instead, the PCPs would “avoid the costs of expensive and time-consuming litigation, conserve the Debtor’s resources to pursue claims against those most likely to have mismanaged the firm, and minimize the risk of expending the Debtor’s liability insurance policy on unnecessary defense costs.”[21]
In Dewey, a plan was confirmed in just nine months after the case commenced. The swift and novel approach taken in Dewey sharply contrasts with previous law firm bankruptcy cases that typically dragged on for years. As noted in the previous article, the Finley Kumble case lasted more than 20 years and more recent cases such as Coudert and Heller Ehrman took nearly two years just to confirm a liquidation plan with years of litigation thereafter.[22] In Howrey’s bankruptcy case, two years have passed and no plan has yet been confirmed.[23]
Conclusion
While law firms continue to be eager to conquer the international market and continue domestic expansion, the risk for law firm insolvency remains high. A recent survey of managing partners at nearly 800 large firms, conducted by Altman Weil, indicated that the risk for future partner defections remain high as many law firms are still reluctant to reform their business models or payment structures despite willingness to further expand. Some startling statistics include:
· more than half of firm leaders feel growth, in terms of lawyer headcount, is a requirement for their firms’ continued success;[24]
· less than half the firm’s surveyed had significantly changed their partnership admission or retention standards;[25]
· only 26 percent of firms surveyed reported a reduction in the number of equity partners in 2012, with more than 50 percent reporting a net increase.;[26]
· 62 percent of law firms surveyed would pursue the acquisition of practice groups in 2013 (increased from 55 percent in 2010);[27]
· 89 percent of firms surveyed would pursue hiring laterals (increased from 85 percent in 2010);[28] and
· only 2.2 percent of firm leaders felt that their fellow partners were highly receptive to change.[29]
While some recent mergers have effectively increased firm revenue (Polsinelli, DLA Piper, Hogan Lovells and Bradley Arant Boult Cummings, just to name a few), there have been 60 mergers involving Am Law 200 firms in each of the past two years, for most of which the success remains to be seen.[30] In consideration of the downfalls described herein, law firms should focus on keeping the business model liquid by regularly collecting outstanding receivables and maximizing hourly work. Law firms should analyze the profitability of various practice groups regularly to focus on the most lucrative business opportunities and maximize partner retention. Partner compensation should be reassessed periodically based on annual performance in order to keep target compensation numbers reasonable.
Having a transparent management and compensation structure will provide partners with the most comfort and help create a unified firm culture.[31] The Altman Weil survey concluded that “[s]electively acquiring laterals and groups who come with their own ready-made books of business is the preferred growth strategy post-recession.”[32] Accordingly, law firms should carefully evaluate the expected profit from any proposed expansion in addition to the potential effect on firm morale.
Law firms that maintain focus on profitability rather than expansion seem to be the most likely to succeed. Some experts predict that the nation’s strongest firms in today’s economy are instead elite New York-based firms that cover a wide spectrum of legal work,[33] which sharply contrasts to the model of rapid global expansion once pursued by Coudert, Heller Ehrman and Dewey. As described by Frederic R. Coudert, the great grandson of one of the firm’s founding brothers, his time at the firm was “young, idealistic and wonderful.” Coudert left the firm in 1997, almost 10 years before its demise. When asked about the firm’s failure, Coudert explained, “idealists have a hard time in this world.”[34]
[1] Transcript of Hearing on First Day Motions at 15:25–16:1, In re Dewey & LeBoeuf LLP, Ch. 11 Case No. 12-12321 (Bankr. S.D.N.Y. May 29, 2012) at 17:8-11.
[2] See State Bar of Cal., Insolvent Law Firms’ Issues and Options 8 (2012), available at http://html.documation.com/cds/SBC2012/Support/PDFs/011.pdf
[3] See “Dewey & LeBoeuf: With a Bang, Not a Whimper,” The Economist, April 26, 2012, available at www.economist.com/node/21553478.
[4] See 11 U.S.C. § 548(a)(2)(A) and (B) (2012).
[5] See In re Heller Ehrman LLP, Case No. 08-32514 (N.D. Cal.).
[6] See Disclosure Statement in Support of Joint Plan of Liquidation of Heller Ehrman LLP (May 14, 2010) at III.A.3, In re Heller Ehrman LLP, Ch. 11 Case No. 08-32514 (Bankr. N.D. Cal. May 25, 2010), ECF No. 1153.
[7] See Eric Young, “Heller Creditors Eye $150M From Partners,” San Francisco Bus. Times, Oct. 29, 2009, available at www.bizjournals.com/sanfrancisco/stories/2009/10/26/daily126.html; Amanda Royal, “Heller Creditors Seek $150 Million, Detail Firm’s Failings,” The Recorder (Oct. 29, 2009), available at www.law.com/jsp/article.jsp?id=1202435020542&Heller_Creditors_Seek_150_….
[8] See Eric Young, Heller Creditors Eye $150M From Partners, San Francisco Bus. Times, Oct. 29, 2009, http://www.bizjournals.com/sanfrancisco/stories/2009/10/26/daily126.html;
[9] See Royal, supra n.7.
[10] See id.
[11] See id.
[12] See Drew Combs, “Former Heller Partners Dispute Creditors Claims,” Am Law Daily (Oct. 7, 2009), http://amlawdaily.typepad.com/amlawdaily/2009/10/heller.html; Royal, supra n. 7.
[13] Transcript of Hearing Held Sept. 21, 2012, at 28:9-12, In re Dewey & LeBoeuf LLP, 478 B.R. 627 (Bankr. S.D.N.Y. 2012) (Ch. 11 Case No. 12-12321), ECF No. 507 [hereinafter, the “Dewey Mitchell Examination”].
[14] See id. at 27:10-18.
[15] See Motion for Entry of an Order Pursuant to Bankruptcy Code Sections 105(A), 362 and 363 and Bankruptcy Rule 9019 Approving the Settlement Agreement Between the Dewey & LeBoeuf Liquidation Trust, Xl Specialty Insurance Company and Steven H. Davis ¶ 11, In re Dewey & LeBoeuf LLP, Ch. 11 Case No. 12-12321 (Bankr. S.D.N.Y. Apr. 22, 2013), ECF No. 1372 [hereinafter, the “Davis Settlement”].
[16] See Dewey Mitchell Examination, supra n.13, at 33:7-24.
[17] See id. at 30:5-20. Steven Davis recently settled with the estate agreeing to make a payment of $511,145 in exchange for protection against future mismanagement claims. He agreed to pay the estate 8 percent of his annual earnings for the next six years, beginning in March 2014. Any outstanding balance will accrue interest at a rate of 9 percent annually. See Davis Settlement, supra n.15.
[18] See In re Dewey & LeBoeuf LLP, 478 B.R. 627, 634 (Bankr. S.D.N.Y. 2012); see also Disclosure Statement Relating to the Second Amended Chapter 11 Plan of Liquidation of Dewey & LeBoeuf LLP, Dated Jan. 7, 2013 at 33, In re Dewey & LeBoeuf LLP, Ch. 11 Case No. 12-12321 (Bankr. S.D.N.Y. Jan. 7, 2013), ECF No. 808.
[19] See In re Dewey & LeBoeuf LLP, 478 B.R. 627, 642-43 (Bankr. S.D.N.Y. 2012).
[20] See id.
[21] Id. at 643.
[22] See In re Finley, Kumble, Wagner, Heine, Underberg, Manley, Myerson & Casey, Ch. 11 Case No. 88-10377 (Bankr. S.D.N.Y.); In re Coudert Bros. LLP, Ch. 11 Case No. 06-12226 (Bankr. S.D.N.Y.); In re Heller Ehrman LLP, Case No. 08-32514 (N.D. Cal.).
[23] See In re Howrey LLP, Ch. 11 Case No. 11-31376 (Bankr. N.D. Cal.).
[24] See Thomas S. Clay, Altman Weil Inc., Law Firms in Transition, at v (2013).
[25] See id. at iii.
[26] See id. at 30-31.
[27] See id. at 30.
[28] See id. at 30-31.
[29] See id. at ii.
[30] See Chris Johnson, The Am Law 200’s Haves and Have-Nots, The Am. Lawyer (June 10, 2013), http://www.americanlawyer.com/PubArticleTAL.jsp?id=1202600856100&The_Am… (citing Altman Weil’s MergerLine, which tracks publicly reported mergers among U.S. law firms).
[31] See “Don’t Let A Partner Defection Damage Your Law Firm,” Feeley & Driscoll, P.C. (last visited June 4, 2013), available at www.fdcpa.com/PSF/0313LawNews-when-a-partner-leaves-your-law-firm.htm.
[32] Thomas S. Clay, Altman Weil Inc., Law Firms in Transition, at vi (2013).
[33] See “A Less Gilded Future,” The Economist, May 5, 2011, available at www.economist.com/node/18651114.
[34] Jonathan D. Glater, Law Firm That Opened Up Borders Is Closing Up Shop, N.Y. Times, Aug. 30, 2005, http://www.nytimes.com/2005/08/30/business/30law.html?pagewanted=all.