[1]Over the last 30 years, dozens of notable U.S. law firms have dissolved or gone bankrupt. Although many of those firms were relatively small, others were among our country’s largest and most venerated.[2]
A law firm’s demise is often years in the making. But once circumstances become dire, a law firm’s collapse can happen swiftly. Sensing the end, equity partners, contract partners and laterals may leave individually or in groups, taking the most profitable business with them and accelerating a teetering firm’s death spiral. If the firm ends up in bankruptcy, though, departed partners, retired partners, lateral hires and others may learn, to their chagrin, that they have not escaped unscathed. Their former firm (as a chapter 11 debtor-in-possession (DIP)) or the firm’s trustee in chapter 7 may sue them under a variety of theories, seeking to recover money with which to pay the firm’s creditors.[3]
Historically, law firms ordinarily were general partnerships whose general partners would be liable for the partnerships’ debts, and whose creditors could pursue and collect from individual partners’ assets. Today, law firms are often organized as limited liability partnerships. That structure circumscribes limited partner exposure to the value of their capital contributions (except, of course, for those limited partners who may personally guaranty a firm’s office or equipment leases, lines of credit or other major debts). In a law firm bankruptcy, though, this structure can leave partners and other equity owners more exposed than they anticipated.
Compensation Clawbacks
Departed lawyers may have to fight to keep the compensation they received before their old firm collapsed. In many law firm partnerships, partners receive periodic draws based on anticipated profits. In others, they may receive monthly salaries with annual bonuses — distributions of what later might be labeled as firm profits. Distributions such as these that occur while the firm is insolvent may be recoverable as impermissible dividends under state law.[4] Alternatively, such distributions may be attacked as fraudulent transfers under § 548 of the Bankruptcy Code or under the corresponding state fraudulent transfer statutes that § 544 of the Bankruptcy Code empowers a DIP or a bankruptcy trustee to utilize.[5]
Similarly, retired partners can also be at risk. Retirement benefits, tax advances and other remuneration that the firm pays them during its insolvency may be recoverable as constructive fraudulent transfers, except in the unusual circumstance that a retired partner somehow conveyed reasonably equivalent value to the firm in exchange for those payments.[6]
If bankruptcy ensues, attorneys’ ability to keep their compensation may be jeopardized for contractual reasons, too. For instance, equity partners, contract partners or laterals may be required to disgorge draws, other distributions or retirement contributions if those amounts exceed what was permitted under the partnership agreement or contracts governing their compensation. One reason overpayment claims may arise is if the firm collapses before the partner’s or lateral’s periodic compensation has been “trued-up” against the firm’s actual profits for the period in question.
Depending on the circumstances, even an attorney who was not a partner or an equity owner in the failed firm might sometimes have to disgorge compensation. Laterals are one example. Section 548(a)(1)(B)(ii)(IV) of the Bankruptcy Code provides that a transfer (payment) made within two years before the firm’s bankruptcy can be set aside if the firm received less than reasonably equivalent value in exchange and the transfer was made under an “employment contract” and not in the ordinary course of business. This is so even if the firm was solvent at the time the payment(s) occurred.
The Bankruptcy Code does not define “employment contract.” A firm that is struggling and needs to attract “rainmakers” may enter into an agreement with a lateral candidate that guarantees the new hire lucrative, minimum compensation or bonuses. Those agreements might potentially be considered “employment contracts.” If a distressed firm pays the lateral what the contract requires, but the compensation exceeds the reasonable value of the lateral’s services, the compensation might be recoverable unless the transaction is “ordinary course” for the firm — an uncertain, fact-sensitive question that may leave the lateral dangling long after the firm dies.
Preferential Transfers
Partners and others may try to defend against fraudulent transfer claims under § 548 (or the corresponding state law provisions) by arguing that they are entitled to reasonable compensation or that they received compensation in good faith that was “reasonably equivalent” to the value of the services they rendered while with the firm. Even if a court decides that the partners’ or others’ compensation is not recoverable as a fraudulent transfer for such reasons, the compensation nonetheless might be recoverable anyway — as a preferential transfer under § 547 of the Bankruptcy Code.
Although circumstances will vary, it is conceivable that some (or perhaps all) of an attorney’s compensation may satisfy § 547’s elements — i.e., a transfer (payment) of property in which the debtor has an interest, made to a creditor (the attorney) on account of a pre-existing debt (earnings owed for services rendered) at a time when the debtor law firm was insolvent (which it is presumed to have been during the 90 days preceding its bankruptcy) and that enabled the recipient to recover more than any distribution he or she otherwise would have received in a chapter 7 liquidation of the debtor (which often is the case).[7] Further complicating matters, if a partner or equity owner is classified as an “insider” for purposes of § 547, the “look-back” period increases from 90 days to one year preceding the bankruptcy. This can place even more of the lawyer’s compensation at risk.[8]
Mismanagement Claims
Partners or equity owners who managed the firm before bankruptcy may encounter additional problems. A chapter 7 bankruptcy trustee (or any committee of unsecured creditors, if the firm is in chapter 11) will typically scrutinize management’s decisions leading up to and during insolvency. Former management can expect to be sued if the trustee concludes that those in charge did not fulfill their fiduciary duties of care and loyalty to the firm, or that they allowed firm opportunities to be lost or usurped, or committed other managerial mistakes, or if irregularities or improprieties occurred that injured the firm.[9]
Other State Law Claims
Depending on the circumstances, a law firm bankruptcy may yield a variety of other state law claims against partners, equity owners and others. Claims for breach of the firm’s partnership agreement, unjust enrichment, tortious interference with a contract, and breach of the implied covenant of good faith and fair dealing are potential examples. Partners or other lawyers may be pursued for repayment of any funds they borrowed from the firm before its demise. They may also be sued to fulfill any unsatisfied contractual obligations they owe to the firm under its partnership agreement or formative documents.
Potential Defenses
Not surprisingly, partners or equity owners sued under these or other theories may seek to raise various defenses or counterclaims. Those could include rights of set-off or recoupment for any distributions owed but not made to the partner or equity owner for prior periods, or counterclaims for unpaid guaranteed minimum compensation, bonuses, deferred compensation, unreimbursed expenses, or lost retirement benefits or pension contributions, if applicable. For partners or equity owners admitted shortly before the firm imploded, allegations of fraud or fraudulent inducement against the defunct firm or its management may be available. If only management is sued, this may trigger indemnification rights against the firm and, thereby, transmute the individual partner’s claim against management into an indirect claim against the firm itself. Newly admitted partners who borrowed money from third-party lenders to fund their capital contributions might likewise allege fraudulent inducement against the firm or its management, given that the firm’s demise would not usually discharge their obligation to repay those loans.
Nonetheless, the debtor law firm or its bankruptcy trustee may have arguments or remedies that can undercut these and other defenses and counterclaims. For example, the debtor or its trustee may be able to equitably subordinate a partner’s or equity owner’s claims to all other unsecured creditors’ claims — meaning that the partner could not recover on its “counterclaims” against the firm unless the firm or its trustee recovers first on its claims and pays other unsecured creditors in full.[10] Set-off or recoupment does not ordinarily apply to chapter 5 avoidance actions. Claims for unpaid salary and contract-based compensation may be re-characterized as equity contributions, subordinating them to trade vendors’ claims. And if a partner or equity owner received a payment that the debtor or its trustee is capable of recovering as a fraudulent or preferential transfer, § 502(d) of the Bankruptcy Code disallows the partner’s or equity owner’s (counter)claims until the recoverable transfer is returned to the debtor’s estate.[11]
Conclusion
If a law firm is shaky or about to implode, its partners, equity owners or contract attorneys may head for the exits — but they may not escape the repercussions that follow them out the door. Claims for alleged fraudulent transfers, excessive compensation, impermissible equity distributions during insolvency, preferential payments, breaches of fiduciary duty and unjust enrichment are merely a few of the many theories on which defunct law firms or their bankruptcy trustees may seek to recover money from the firm’s departed personnel to satisfy the firm’s unpaid creditors.
[1] The material in this article is meant to be educational in nature and to provide general information only. It is not a substitute for legal advice.
[2] Some of these firms dissolved out-of-court, such as Shea & Gould (1994), Bogle & Gates (1999), Thacher, Proffitt & Wood, and Wolf, Block, Schorr & Solls-Cohn (both in 2009). Others became debtors in chapter 11, including Finley, Kumble, Wagner, Underberg, Manley, Myerson & Casey (converted from chapter 7) (1988), Myerson & Kuhn (1990), Altheimer & Gray (2003), Coudert Brothers LLP (2006), Heller Ehrman LLP (2008), Dreier LLP (2009), Howrey LLP (2011), and Dewey & LeBoeuf LLP (2012). Still others ended up in chapter 7 liquidations: Brobeck, Phlager & Harrison LLP and Arter & Hadden LLP (both in 2003), and Thelen Reid & Priest LLP (2008), for instance.
[3] The law firms to which departed partners flee can also become targets. For example, a bankrupt firm in chapter 11 or its trustee in chapter 7 may allege that the defunct firm can recover — from departed partners’ new firms — the value of any “unfinished business” that the departed lawyers took with them when heading out the door. Numerous courts have examined this doctrine, and many of them have followed it. But recent appellate decisions have placed the doctrine’s continuing vitality in doubt (as to hourly-rate matters, at least). See, e.g., In re Thelen LLP, 2014 WL 3844145 (2d Cir. Aug. 6, 2014) (upholding the dismissal of “unfinished business” hourly-rate claims against a defendant law firm under New York law, as articulated by that state’s highest court in In re Thelen LLP, 2014 N.Y. Slip Op. 04879, 2014 WL 2931526 at *1 (N.Y. July 1, 2014)); Heller Ehrman LLP v. Davis, Wright, Tremaine LLP, 2014 WL 2609743 (N.D. Cal. June 11, 2014) (presently on appeal before the Ninth Circuit).
[4] See, e.g., Cal. Corporations Code § 16957; Del. Code § 15-309; N.Y. Partnership Law Art. 8-A, § 121-607; Ohio Rev. Code §§ 1776.84 (LLPs); 1782.37 (LPs).
[5] See, e.g., Original Complaint filed June 4, 2013, in Diamond v. Corbin, et al., Adv. Pro. No. 13-03163, Case No. 11-31376 (Bankr. N.D. Cal.) (chapter 11 trustee of Howrey LLP sought to set aside and recover draws, base compensation, bonuses, interest on capital and return of capital from certain former partners — as actual or constructive fraudulent transfers, and for other reasons). Section 548(a)(1) of the Bankruptcy Code permits a DIP or a bankruptcy trustee to set aside any transfer the debtor made or obligation the debtor incurred, within two years before the bankruptcy filing, either:
- with the “actual intent to delay, hinder, or defraud” any entity to which the debtor then was or thereafter became indebted; or
- for which the debtor received less than “reasonably equivalent value” in exchange and (i) was insolvent at that time or became insolvent as a result of the transfer or obligation, or (ii) was engaging or about to engage in a business or transaction for which its remaining property was an unreasonably small capital, or (iii) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to repay as those debts matured or (iv) made the transfer or incurred the obligation for the benefit of an insider under an “employment contract” and not in the ordinary course of business.
With respect to partnership debtors, § 548(b) enables a DIP or a trustee to avoid any transfer of an interest of the debtor in property (or any obligation that the debtor incurred) that occurred within two years before the bankruptcy filing, to any general partner of the debtor, if the debtor then was insolvent or became insolvent as a result of the transfer or obligation. Section 544 provides that a DIP or a trustee have, as of the commencement of the case, and without regard to their or any creditor’s knowledge, the rights and powers of, or may avoid any transfer of the debtor’s property or any obligations the debtor incurred that is voidable by, a judicial lien creditor or a creditor holding an unsatisfied execution. See 11 U.S.C. § 544(a)(1) and (2).
[6] In one widely publicized example, retirees in Dewey’s chapter 11 case agreed to settle the firm’s claims against them by returning some of their retirement payments, tax advances, and Of Counsel and special counsel fees they received during the two-year avoidance period. See Debtor’s Application Pursuant to Section 105(a) of the Bankruptcy Code and Bankruptcy Rule 9019(a) for an Order Approving a Settlement Agreement Among the Debtor, the Official Committee of Former Partners, the Ad Hoc Committee of Retired Partners of LeBoeuf, Lamb...,” filed Feb. 7, 2013, in Dewey & LeBoeuf LLP, Case No. 12-12321(MG) (Bankr. S.D.N.Y.), Doc. 977 at ¶¶ 19-20 (summarizing the amounts the settling retirees agreed to refund to the debtor).
[7] In the payment hierarchy for claims in bankruptcy, unpaid employee compensation is entitled to a higher priority than ordinary “trade” claims; this may result in employee compensation claims being paid a larger percentage (perhaps even in full), thus immunizing them from partial or complete avoidance as preferential transfers. But the dollar amount of priority compensation claims is capped. See 11 U.S.C. § 507(a)(4). Distributions that exceed that capped amount would remain vulnerable.
[8] Even if a partner does not meet the literal, non-exclusive statutory definition of an “insider” under § 101(31) (such as a “person in control” of a debtor partnership), courts have shown increasing willingness to characterize persons as “non-statutory” insiders (making them subject to the same outcomes as statutory insiders) if, for example, “there is a close relationship [between the debtor and creditor] and ... anything other than closeness to suggest that any transactions were not conducted at arm’s length.” Schubert v. Lucent Tech. Inc. (In re Winstar Communications Inc.), 554 F.3d 382, 396-97 (3d Cir. 2009) (quoting In re U.S. Med. Inc., 531 F.3d 1272, 1277 (10th Cir. 2008)).
[9] Former management also may draw the ire of fellow partners or laterals who believe they were kept “in the dark” regarding the firm’s financial condition or who argue that they were induced to join the firm in order to personally obligate themselves on firm debt or to contribute capital while, unbeknownst to them, the firm was sinking into an abyss. See, e.g., Original Complaint filed June 12, 2012, in Bunsow v. Davis, et al., Case No. CGC-12-521540 (Superior Ct., Cal.) (lateral sued members of Dewey & LeBoeuf LLP’s management for alleged fraud and deceit, negligent misrepresentation, breach of fiduciary duties (e.g., the “obligation to conduct business with other partners in good faith and with fair dealing”), conversion, unjust enrichment and related claims).
[10] Subordination may occur for several reasons: The firm’s partnership agreement may provide for it, state law may require it, or the bankruptcy court may order it under § 510 of the Bankruptcy Code. Under a widely accepted formulation, § 510(c) permits a bankruptcy court to subordinate a claim if (a) the claimholder engaged in inequitable conduct, (b) that conduct caused injury to creditors or conferred an unfair advantage on the claimholder, and (c) subordination of the claim is consistent with Bankruptcy Code provisions. See, e.g., In re Baker & Getty Fin. Servs., 974 F.2d 712 (6th Cir. 1992); Matter of Fabricators Inc., 926 F.2d 1458 (5th Cir. 1991). If the claimholder is an “insider,” such as a “person in control” of a partnership debtor, his or her transactions with the debtor are subject to strict scrutiny, potentially increasing the odds that a court will order subordination.
[11] See, e.g., Debtor’s Motion for Entry of an Order, Pursuant to Bankruptcy Rule 9019 and 11 U.S.C. §§ 105(a) and 362, Approving Partner Contribution Settlement Agreements and Mutual Releases of Participating Partners, filed August 29, 2012, in Dewey & LeBoeuf LLP, Case No. 12-12321(MG) (Bankr. S.D.N.Y.), Doc. 399 at ¶¶ 24-26 (summarizing the estate’s potential claims against partners, their probable defenses, and the estate’s responses that the chapter 11 trustee considered in deciding whether to settle).