by Matthew A. Hodel and Ashley E. Merlo
When partners leave law firms can they take ongoing client business out the door without compensating their former partners? This issue recently has been at the forefront in law firm dissolution litigation. As mega firms implode and go out of business—the Brobecks, Howreys, Hellers, to name a few—bankruptcy trustees chase rainmakers who take ongoing business to their new firms.
The question becomes: who owns the ongoing business of the dissolving law firm? For quite some time, the answer was thought to be controlled by Jewel v. Boxer, 156 Cal. App. 3d 171 (1984) holding that, in the absence of an agreement to the contrary, unfinished business remains the asset of the dissolving law firm. Thus, the bright line was, “you can’t take it with you,” unless your partnership agreement gives you that right. Since 2012, however, several federal courts have called into question whether Jewel remains valid law, suggesting “you can take it with you.” In the end, this discussion also implicates ethical duties to clients.
Fiduciary Duty and Client Business Taking business from the firm—be it a law partnership or corporation—is constrained by rules of fiduciary responsibility and good faith and fair dealing. There are duties to: (1) account, and hold in trust, any property, profit, or benefit obtained in the conduct and winding up of the business of the firm; (2) refrain from engaging in business adverse to the interests of the firm; and (3) refrain from competing with the firm before dissolution. Cal. Corps. Code § 16404; Fox v. Abrams, 163 Cal. App. 3d 610, 617 (1985) (fiduciary obligations apply to lawyers practicing in corporate form). These obligations, except for the duty not to compete, continue through dissolution of a law firm until the winding up of the firm’s business affairs is complete. Cal. Corps. Code § 16404(b); Dickson, Carlson & Campillo v. Pole, 83 Cal. App. 4th 436, 445 (2000).
Absent breach of fiduciary duty, before dissolution, withdrawing partner/shareholder attorneys can take client business with them to their new firms without having to account to their former law partners. Champion v. Superior Court, 201 Cal. App. 3d 777, 785 (1988). They need only reimburse their former firm for the firm’s contribution to the matter. Id. Depending on their agreement, however, such a partner may be penalized for taking business from the prior firm, provided that such penalty is reasonable. Howard v. Babcock, 6 Cal. 4th 409 (1993); Anderson, McPharline & Connors v. Yee, 135 Cal. App. 4th 129 (2005) (enforcing partnership agreement requiring withdrawing partner to pay former firm 25% of revenues on legal services rendered on open files of former firm for twenty-four-month period following withdrawal). Such an agreement, if properly drafted, does not violate Rule of Professional Conduct 1-500, which prohibits members from being party to or offering to make an agreement restricting the right to practice law. Howard, 6 Cal. 4th at 418-19.
Jewel v. Boxer—Unfinished Business Remains Property of the Prior Firm Jewel v. Boxer held, absent an agreement to the contrary, partners of a dissolving law firm cannot keep fees subsequently earned on matters under way when they left the firm. 156 Cal. App. 3d at 174. Rather, such fees must be “shared by the former partners according to their right to fees in the former partnership, regardless of which former partner provides legal services in the case after dissolution.” Id. Although acknowledging the client’s right to the attorney of its choice, the court reasoned, “Once the client’s fee is paid to an attorney, it is of no concern to the client how that fee is allocated among the attorney and his or her former partners.” Id. at 179. The court repeatedly emphasized, if not condemned, the partners of the law firm for failing to have a written agreement covering this situation. Id. at 179-80.
The “unfinished business” rule has been extended and defined to apply:
The Antidote to Jewel—Written Waivers The court’s decision in Jewel emphasized that the consequences of its holding can be avoided by written agreement. Departing partners may, therefore, take unfinished business with them pursuant to a written waiver. See Rothman v. Dolin, 20 Cal. App. 4th 755, 759 n.4 (1993). The following language was found to be a valid Jewel waiver in bankruptcy court litigation arising from the demise of Brobeck, Phleger & Harrison LLP:
Except as specifically set forth below, neither the Partners nor the Partnership shall have any claim or entitlement to clients, cases or matters ongoing at the time of the dissolution of the Partnership other than the entitlement for collections of amounts due for work performed by the Partners and other Partnership personnel on behalf of the Partnership prior to their departure from the Partnership. The provisions of this Section 9(e) are intended to waive, opt out of and be in lieu of any right any Partner or Partnership may have to ‘unfinished business’ of the Partnership, as that term is defined in Jewel v. Boxer, or as otherwise might be provided in the absence of this provision through application of the California Revised Uniform Partnership Act.
Erosion of the Jewel “Unfinished Business” Rule Jewel has not been overruled by any California state court decision. Very recently, however, federal decisions arising from bankruptcy litigation strongly suggest that the Jewel “unfinished business rule” is on its way out. These cases rely upon revisions to the Uniform Partnership Act enacted post-Jewel and, at least in their mind, a more “modern view” of the realities of law firm business.
Impact of Revisions to the Uniform Partnership Act After Jewel, the Uniform Partnership Act was revised in 1994 (the “RUPA”). 1996 Cal. Legis. Serv. Ch. 1003 (A.B. 583) (West). Two provisions in RUPA are now being construed as undermining the unfinished business rule. First, under RUPA partners are permitted reasonable compensation for services rendered in winding up the business of the partnership, thus suggesting to some courts that post-dissolution fees need not be shared. Cal. Corp. Code § 16401(h). Second, RUPA specifies that the duty to refrain from competing only applies before dissolution of the partnership. Cal. Corp. Code § 16404(b)(3).
Working from these revisions, in 2012 the court deciding In re Brobeck, Phleger & Harrison LLP, recognized a deduction of “reasonable compensation” from the profits before sharing with the former partners. 408 B.R. at 326. Thereafter, a bankruptcy court sitting in the Southern District of New York stated more directly that “the RUPA abolished the ‘no compensation rule,’” but then, similar to In re Brobeck, suggested that profits above reasonable compensation must be shared by the former partners. Geron v. Robinson & Cole LLP, 476 B.R. 732, 744 (S.D.N.Y. 2012). That same court, in evaluating fraudulent transfer claims, rejected arguments that hourly fee matters were property of the dissolving law firm’s bankruptcy estate, noting, “over the last three decades, courts have cited Jewel reflexively and uncritically.” 476 B.R. at 742-44, n. 3.
Further damage was done to Jewel this year by a bankruptcy court for the Northern District of California in Heller Ehrman LLP v. Davis Wright Tremaine, LLP, __ B.R. __, 2014 WL 2609743 (N.D. Cal. June 11, 2014). This decision found “RUPA’s impact on Jewel [] significant,” citing the RUPA provision that partners are free to compete on the eve of dissolution. Id. at *4. Based on this provision of the RUPA, the Heller Ehrman court explained: “if a former Heller shareholder signed a new retainer agreement with a former Heller client, this would not violate the ‘fiduciary duty not to take any action with respect to unfinished partnership business for personal gain.’” Id. Thus, under the RUPA, there is no basis for a dissolved firm to demand an accounting for profits earned by its former partners under new retainer agreements with clients. Id.
The same court stated: “A law firm never owns its client matters. The client always owns the matter, and the most the law firm can be said to have is an expectation of future business.” Heller Ehrman LLP, __ B.R. __, 2014 WL 2609743, *5. The court also predicted that the California Supreme Court “would likely hold that hourly fee matters are not partnership property and therefore are not ‘unfinished business’ subject to any duty to account.” Id. at *1.
At least one other court—the Court of Appeals of New York—has reached the same conclusion. In re Thelen LLP, __ N.E. 3d __, 2014 WL 2931526 (N.Y. July 1, 2014) (“pending hourly fee matters are not partnership ‘property’ or ‘unfinished business’”; a law firm “is only entitled to be paid for services actually rendered”).
A More “Modern” View of Who Owns Law Firm Business? By 2012, some courts were speculating about whether Jewel still made sense:
In the context of the “mega-firm” model—divisions among classes of partners, client hoarding, and mercenary lateral hiring—one could argue that the law’s presumption that partners are mutual owners of all of a law firm’s business, and that all contribute to its success and so are entitled to share in the profits, no longer reflects the reality of practice. Many partners at such firms no longer view their “book of business” as an asset of the firm, but as a jealously guarded piece of personal property. Such a view undermines the conclusion that such client matters really are property of the firm, as well as the premises of the no compensation rule. But the Partnership Law says otherwise.
Heller Ehrman emphasized that policy and equitable considerations undermined Jewel. As matter of equity, the firm that performs the work should keep the fees; otherwise, the former partners of the dissolving firm would enjoy a windfall of indefinite duration. Heller Ehrman LLP, __ B.R. __, 2014 WL 2609743, *6. There was also the harsh irony that partners who withdrew from the firm before dissolution would have no duty to account for subsequent fees, but those who stuck around to the end would need to cough them up. Thus, the rule “would incentivize partners of a struggling firm to jump ship at the first sign of trouble to avoid the kind of suit [d]efendants now find themselves in, even if that would destabilize an otherwise viable firm.” Id. at *7. The prior rule “would discourage third-party firms from hiring former partners of dissolved firms and discourage third-party firms from accepting new clients formerly represented by dissolved firms.” Id. The court further explained: “It is not in the public interest to make it more difficult for partners leaving a struggling firm to find new employment, or to limit the representation choices a client has available . . . .” Id.
The In re Thelen decision cited similar considerations of equity and public policy, and concluded: “In the end, the trustees’ theory simply does not comport with our profession’s traditions and the commercial realities of the practice of law today, a deficiency beyond the capacity of a Jewel waiver to cure.” __N.E. 3d __, 2014 WL 2931526 *7-9. On September 2, 2014, the Second Circuit adopted the New York Court of Appeals’ holding in In re Thelen, thus reversing a district court decision applying the Jewel unfinished business rule. In re Coudert Bros. LLP, 547 Fed.Appx. 15, 2014 WL 4290547 (2d Cir. Sept. 2, 2014).
Conclusion and Implications Under the Rules of Professional Conduct Taking, or just planning to take, clients with you upon leaving a law firm entails careful consideration of fiduciary duties to the other lawyers in the firm and any applicable provisions of partnership agreements. But that is only the start. The potential claw back of the “unfinished business” rule cannot be ignored. How far that rule reaches, and will continue to reach in the future, is an open question.
Running as unspoken subtext to the above is the question: what is best for the client? The lawyer embroiled in disputes with former partners and bankruptcy trustees over the client’s business has several immediate ethical concerns.
Does the client fully understand the implications of possibly having his or her lawyer sharing fees with two law firms? Will the new law firm, if it must share fees, be willing to devote the necessary resources to the client’s interest? Will the lawyer taking the business become distracted, lose incentive, and fail to render services competently? See, Rules of Professional Conduct 3-110 (duty of professional competence); 2-200 (fee sharing without disclosure to and consent of client); and 3-500 (duty to keep client reasonably informed regarding significant developments). See also State Bar Formal Opinions 2014-190 (duties owed by lawyer in dissolving law firm to clients he or she has provided services to but will no longer be representing following dissolution); 2007-174 (duties to release client files upon termination of employment); 2001-157 (duties regarding retention of former client’s files); 1994-134 (ethical obligations to prevent prejudice to client after employment has been terminated but before substitution of counsel form has been filed); and 1985-86 (ethical obligations re notice to clients when private law firms dissolve or attorneys withdraw). These questions also cannot be ignored as attorneys withdraw from law firms or during law firm dissolutions.
Matthew A. Hodel and Ashley E. Merlo are litigation attorneys with Hodel Wilks LLP in Irvine, California. Matt is also a member of the OCBA’s Professionalism and Ethics Committee, and can be reached at mhodel@hodelwilks.com. Ashley can be reached at amerlo@hodelwilks.com.