The dissolution of a law firm can be a financial catastrophe for its partners. In a typical law firm dissolution, the partners lose any bonuses, end-of-year draws, and thousands or hundreds of thousands of dollars in capital. Adding insult to injury, if the firm’s creditors force it into bankruptcy, which often happens following law firm dissolutions, the partners can expect to be the targets of litigation.
In the major law firm bankruptcies, there are two types of claims usually alleged. The first are “clawback” lawsuits. These lawsuits assert that the former partners must return all or a substantial portion of their draws and other compensation because, allegedly, the bankrupt law firm was insolvent or inadequately capitalized when it paid the distributions to the partners. The second type of claims are called “Jewel lawsuits.” These are lawsuits against the former partners’ new law firms, which seek to collect any profits that the new firms earned from the dissolved firm’s former engagements. Jewel lawsuits are based on the duty of partners of a dissolved partnership to account back to the partnership in dissolution for any profits they received from finishing firm business.[1] Bankruptcy estate representatives usually assert that this duty to account for profits from unfinished business of the dissolved partnership (“Jewel duty”) exists for both hourly fee cases and for contingency matters.
Two recent decisions, one from the New York Court of Appeals and one from the District Court for the Northern District of California, have changed the landscape for law firm bankruptcies by rejecting the applicability of Jewel v. Boxer to major law firm bankruptcies. On June 11, 2014, Judge Charles R. Breyer of the U.S. District Court for the Northern District of California issued a ruling in several consolidated lawsuits arising out of the Heller bankruptcy.[2] Prior to its bankruptcy and as part of its dissolution, Heller notified its clients that it would no longer be able to provide legal services and agreed on a plan of dissolution that contained a “Jewel waiver” purporting to waive any Jewel duty. After Heller filed for bankruptcy, Heller (controlled by a trustee) sued law firms that hired its former partners, alleging that the Jewel waiver was avoidable as a fraudulent transfer and that the Heller estate had property rights in the unfinished hourly matters pending at the time the former Heller lawyers joined the other law firms.
Judge Breyer rejected the application of Jewel v. Boxer in this case, holding:
A law firm — and its attorneys — do not own the matters on which they perform their legal services. Their clients do. A client, for whatever reason, may summarily discharge counsel and hire someone else. At that point, the client owes fees only for services performed to the date of discharge, and his former lawyer must, even if fees are in dispute, cease working on the matter and immediately cooperate in the transfer of files to new counsel.[3]
Judge Breyer’s decision in Heller was soon followed by a decision from the New York Court of Appeals. On July 1, 2014, in response to questions arising out of the Thelen and Coudert bankruptcies, the New York Court of Appeals unanimously held, in the case of In re Thelen LLP, that, as a matter of New York partnership law, there was no Jewel duty because “pending hourly fee matters are not [a dissolved law firm’s] ‘property’ or ‘unfinished business’” under New York’s partnership law.[4] In that consolidated appeal, the bankruptcy trustees of Thelen and Coudert argued that, under Stem v. Warren[5] (a 1920 New York Court of Appeals case involving an architecture partnership) and several more recent New York contingency fee cases,[6] New York followed the rule in Jewel v. Boxer. However, the court rejected the application of Jewel v. Boxer to dissolved law firms. In a portion of the opinion that echoed Judge Breyer’s decision, the Court held that “[a] law firm does not own a client or an engagement, and is only entitled to be paid for services actually rendered.”[7]
The Thelen court’s rejection of Jewel v. Boxer was premised on two principles: First, under New York law (California law is similar), clients have an “unqualified right to terminate the attorney-client relationship and can terminate an attorney at any time.”[8] Second, because the client can terminate a law firm at any time, the “expectation of any continued or future business is too contingent in nature and speculative to create a present or future property interest.”[9] Thus, although New York’s partnership act imposed an obligation to liquidate the firm’s property and to account for any property and unfinished business, the client matters that Thelen and Coudert were working on before they dissolved could not constitute property or unfinished business.
It is likely that the decisions by the New York Court of Appeals and the Northern District of California will have significant impact on law firm bankruptcies. Because the New York Court of Appeal is authoritative on New York law, it is binding for the bankruptcy of any New York law partnership. Future bankruptcies of New York firms are unlikely to see demands or lawsuits against firms that hire the attorneys from the partnership in bankruptcy. It remains to be seen whether the New York Court of Appeals decision will have any application to non-legal partnerships formed in New York. In California, Judge Breyer’s decision is not controlling authority. However, the decision will carry significant persuasive authority, particularly in combination with the New York Court of Appeals decision.
[1] In particular, Section 21(1) of the UPA provides that “[e]very partner must account to the partnership for any benefit, and hold as trustee for it any profits derived by him without the consent of the other partners from any transaction connected with the formation, conduct, or liquidation of the partnership or from any use by him of its property.” Cal. Corp. Code § 16404(b)(1). Section 18(f) of the UPA provides that “[n]o partner is entitled to remuneration for acting in the partnership business, except that a surviving partner is entitled to reasonable compensation for his services in winding up the partnership affairs.”
[2] Heller Ehrman LLP v. Davis, Wright, Tremaine, LLP, C 14-01236 CRB, __ B.R.__, 2014 WL 2609743 (N.D. Cal. June 11, 2014).
[3] Id. at *2.
[4] In re Thelen LLP, 24 N.Y.3d 16, 995 N.Y.S.2d 534, 20 N.E.3d 264 (2014).
[5] 222 N.Y. 538 (N.Y. 1920).
[6] Grant v. Heit, 263 A.D.2d 388, 389 (N.Y. App. Div. 1999); Shandell v. Katz, 217 A.D.2d 472, 473 (N.Y. App. Div. 1995); DelCasino v. Koeppel, 207 A.D.2d 374, 374 (N.Y. App. Div. 1994); Dwyer v. Nicholson, 193 A.D.2d 70, 73 (N.Y. App. Div. 1993); Kirsch v. Leventhal, 181 A.D.2d 222, 223 (N.Y. App. Div. 1992).
[7] 24 N.Y.3d at 22.
[8] Id. at 28 (quoting In re Cooperman, 83 N.Y.2d 465, 473 (1994)).
[9] Id. (quoting Verizon New England, Inc. v. Transcom Enhanced Servs. Inc., 21 N.Y.3d 66, 72 (2013)).