Introduction
The collapse of a business is traumatic for any owner-operator. They worry about their employees, damage to their reputations, and may well face an uncertain financial future. If the business was operated as a corporation, the failure of the company may have a devastating impact on the owner-operator, but she will not likely be compelled to repay compensation she received as an officer of the company prior to the filing. The same is not true for members of a partnership. Depending upon the jurisdiction of their firm’s formation and the provisions of their partnership agreements, even those partners who have generated revenues far in excess of their earnings may find themselves obligated to repay all compensation that they received months, or even years, prior to their firm’s failure.
Two recent bankruptcy cases out of the Southern District of New York shine a light on the harsh realities that partners face when their firms fail. The Dewey & LeBoeuf LLP[1] case involved the failure of a New York limited liability partnership. In that case, the court applied unique features of New York insolvency and debtor-creditor law to recover all of the distributions made to the defendant former partners for more than three years prior to the filing. In contrast, the Thelen LLP[2] case involved the failure of a California limited liability partnership. There, the court applied a contractual analysis of the partnership agreement to recover all distributions made to defendant-former partners in excess of the firm’s net income during its last year of operation. While both decisions were unwelcome news for law firm partners, the Dewey decision and its grounding in uniquely harsh New York state law exposes partners to much greater risks than the Thelen decision.
The Dewey Opinion
In May 2012, Dewey filed for chapter 11 protection in the United States Bankruptcy Court for the Southern District of New York (Judge Martin Glenn). The firm’s liquidation plan contained a settlement under which about 400 former partners contributed approximately $71.5 million dollars to settle potential claims to disgorge prepetition distributions made to them. After the plan had been confirmed, the trustee pursued claims against those partners who refused to settle and sought to recover all distributions made to those former partners within three years prior to the bankruptcy filing.[3]
On October 29, 2014, Judge Glenn granted summary judgment in favor of the trustee on two critical issues. First, he held that New York Debtor and Creditor Law (NYDCL) § 277(a) applies to the partners of a New York limited liability partnership, establishing the trustee’s right to pursue recovery of all partner distributions made while the partnership was insolvent, allegedly dating back to January 2009. Second, he overruled the former partners’ principal defense, holding that the partners’ legal and business generation services cannot qualify as “reasonably equivalent value” for purposes of Bankruptcy Code § 548(a)(1)(B)(i) to offset that recovery.[4]
NYDCL § 277(a) states that every transfer made by an insolvent partnership to its partners is subject to avoidance, without exception. NYDCL § 277(b), on the other hand, deals with transfers made by an insolvent partnership to entities other than partners, and provides that such transfers are not subject to avoidance as long as the partnership received “fair consideration” from the transferee. The Dewey court noted that unlike many other provisions of NYDCL, the term “partner” as used in § 277(a) did not contain a “carve-out” for LLP partners, and thus concluded that § 277(a)’s strict liability standard applied to all transfers made to Dewey’s former partners after the firm became insolvent without allowing any offset for their services to the partnership.
New York is in the minority of states that still has in effect the Uniform Fraudulent Conveyance Act (UFCA), from which NYDCL § 277 derives. Most states have adopted the more “modern” Uniform Fraudulent Transfer Act (UFTA). Unlike the UFCA, the UFTA does not contain a special provision like § 277(a) that specifically covers transfers made by a partnership to its partners. Rather, the UFTA contains a single provision applicable to all types of transferees (including partners) that provides that transfers made by an insolvent transferor are avoidable only if the transferor did not receive “reasonably equivalent value” in exchange for the property transferred. Thus, in a UFTA jurisdiction, a transfer made by an insolvent partnership to any party, including a partner, may not be avoided if the transferee provided value to the transferor that was reasonably equivalent to the value of the property received by the transferee.[5]
While the UFTA provides that a transfer may not be avoided if the transferee provided “reasonably equivalent value,” it does not address whether a former partner’s services to a partnership constitute “reasonably equivalent value”. The answer to that question depends on whether the state has, like New York, retained the pre-World War I era Uniform Partnership Act (UPA) with its draconian “no compensation rule,” or, has adopted the mid-1990s Revised Uniform Partnership Act (RUPA) with its “reasonable compensation rule.”
After ruling that the distributions were avoidable under the strict liability provisions of NYDCL § 277(a), the Dewey court went on to conclude that the distributions were also subject to avoidance under the constructive fraudulent transfer provisions of Bankruptcy Code §548(a)(1)(B). Like the UFTA, Bankruptcy Code § 548(a)(1)(B)(i) provides that a transfer by an insolvent entity is not avoidable if the transferor received reasonably equivalent value in exchange for the transferred property.
The former Dewey partners argued that the trustee was not entitled to summary judgment under § 548(a)(1)(B)(i) because they were entitled to a factual hearing on the question whether the services they had provided to the firm constituted reasonably equivalent value. The court said no, holding that New York’s “no compensation rule” precluded the former Dewey partners from establishing a reasonably equivalent value defense. Embodied in New York Partnership Law § 40(6), this rule states that absent an agreement to the contrary, “[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.”
The Thelen Opinions
In October 2008, Thelen LLP filed for chapter 11 protection in the United States Bankruptcy Court for the Southern District of New York (Judge Allan L. Gropper). The trustee brought adversary proceedings seeking to disgorge prepetition compensation payments made to various partners of the defunct California limited liability partnership under both breach of contract and fraudulent transfer theories. The parties agreed to present the fraudulent transfer issues first. As California has adopted RUPA, Judge Gropper was not confronted with a “no compensation rule” and thus had no trouble denying the trustee’s motion for summary judgment on the issue of “reasonably equivalent value.”[6]
On November 20, 2014, Judge Gropper addressed the breach of contract causes of action in the adversary proceedings, particularly whether the former partners were entitled to retain draws that were paid as advances on partnership income, to the extent that those draws were subsequently determined to have exceeded the partners’ allocable share of net income for the applicable year. Turning to the partnership agreement, Judge Gropper noted that it provided that partners would from time to time be entitled to receive draws on their allocable share of the projected net income of the firm, with a “true-up” to be determined in connection with a calculation of the firm’s final net income at the end of each year. Concluding that under the partnership agreement, partners were entitled only to their share of the firm’s profits, Judge Gropper granted the trustee’s motion for summary judgment on the breach of contract claim and compelled the partners to repay any compensation received over the course of 2008 in excess of their allocable share of net income for the year.[7]
Conclusion
Both the Dewey and Thelen opinions are bad news for law firm partners, but to varying degrees. The Dewey opinion is firmly grounded in statutory law and thus the only relief for members of New York partnerships may be through the appellate or the legislative process. As the Thelen opinion was based on contract law, it leaves open the prospect that in a jurisdiction that has adopted the UFTA, the harsh result in that case might be avoided through careful drafting of the applicable partnership agreement to provide, for example, that upon a liquidation, partners may retain compensation received in an amount equal to the greater of their share of net income or the reasonable equivalent of their services (as determined under applicable law).
[1] Jacobs v. Altorelli (In re Dewey & LeBoeuf LLP), 518 B.R. 766 (Bankr. S.D.N.Y. 2014).
[2] Geron v. Fontana (In re Thelen LLP), 520 B.R. 388, 398 (Bankr. S.D.N.Y. 2014)
[3] The clawback period in Dewey was limited to a little over three years because the Dewey Trustee established an insolvency date of January 2009. However, because New York Civil Practice Law and Rules § 213 has a six-year look-back period, it is possible that a member of a New York partnership could be at risk of avoidance for up to six years of distributions.
[4] See 518 B.R. 766, 785–88(Bankr. S.D.N.Y. 2014).
[5] At least some of the remaining UFCA states, such as Maryland, have achieved the same result by affirmatively amending their version of § 277(a) to allow partners to prove “fair consideration,” instead of by eliminating their UFCA equivalent of § 277(a).
[6] See Geron v. Fontana (In re Thelen LLP), Ch. 11 Case No. 09-15631, Adv. No. 11-02648, 2014 WL 2178156, at *7 (Bankr. S.D.N.Y. May 23, 2014).
[7] See Geron v. Fontana (In re Thelen LLP), 520 B.R. 388, 398 (Bankr. S.D.N.Y. 2014).