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The Financial and Legal Consequences of a Law Firm Dissolution on the Partners of the Defunct Firm

Howrey

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Requiem for a Law Firm

 

 

                                                                             Jerome Kowalski

                                                                             Kowalski & Associates

                                                                             February, 2011

 

The financial effects of the death of a law firm on its partners

 

This week, as we mourn the loss of Howrey, we look at the typical death rattles of a law firm suffering a fatal condition and the individual ramifications to law firm partners upon the dissolution of a law firm.  While the demise of Howrey seemed quite inevitable a year ago, it could have been and should have been avoided.  [Update:  Following the announced dissolution of Howrey, Florida based 250 lawyer Adorno & Yoss, LLP, now known as Yoss, LLP also imploded . Adding to these losses, 150 lawyer Austin based Clark Thomas & Winters announced on April 11, 2011 that it was shutting down as well.]

[Update; May, 2012]:  Dewey & LeBoeuf appears about to be about ready to join the parade of failed law firms. Predictions of more imminent BigLaw firm implosions abound.

This post is sorrowfully grim reading and a précis of lessons we learned over twenty years in advising law firms and partners of law firms that have escaped implosion as well as some that have imploded, largely because of a failure of leadership and management. I would hope that a reading of this requiem will provide a mighty incentive for law firms to recognize warning bells and avoid early on implosion and dissolution.  On the brighter side, we have successfully worked with law firms when the first signs of distress appeared and we succeeded in avoiding the painful consequences described below. And we have successfully charted safe passage for many partners through the minefields described below.

In recent years, we have watched the unfortunate demises of too many fine and venerable law firms, including, among others, Thacher Proffitt, Heller Ehrmann, Thelen Reid, Wolf Block and Coudert.  It is not unlikely that before this year is out, others may follow.

The syndrome leading to law firm implosions are all too common.  The malady begins with diminished profitability, caused by general business slowdowns, a burst economic bubble (dot.coms, S&L’s, securitizations, real estate, to name just a few), and the defection of a major client or a partner who is a major producer of business. As profitability slides, partners producing significant business begin to quietly seek alternatives for themselves as their own compensation suffers.  A slow trickle often escalates.

Management too often initially reacts to these phenomena by severe cost cutting including laying off partners not deemed sufficiently productive.  Too often,  management of failing firms do not adequately grasp the gravity of the firm’s condition and address the onset of distress signs in a series of whack-a-mole activities. Managers are loathe to acknowledge the gravity of a declining situation.  As the firm’s condition continues to decline, partners begin to lose confidence in management. And, thus, the rush to the exit doors begin.

When the trickle of defecting partners starts to turn in to a torrent, and there are insufficient fingers to plug the holes in the dike, management then reluctantly begins pursuing a merger partner. The ability to consummate such a merger is almost nil as partners’ resumes flood the streets and the blogosphere creates a cascade of rumors and innuendo, often given legitimacy by traditional media. And, when partners learn that a merger candidate is being sought, they are even more incentivized to seek personal alternatives in order to maximize their own options.

The first “code red” sirens and lights often occurs when the firm finds itself in violation of covenants with its lenders regarding items such as reduction in the number of partners or timekeepers, loss of revenue or failure to abide by a revolving credit facility’s annual thirty day cleanup period.  Lenders, almost always secured by an assignment of all accounts receivable, are no longer charitable in granting waivers, nor are they keen to restructure loans.  Demands for personal guaranties are often made, which often hastens the retreat of partners.

The foregoing is an exceedingly brief synopsis of the course leading to an implosion.  But, what are some of the consequences as the firm shutters?

Most often, law firms endeavor to dissolve through a dissolution group without judicial intervention.  Some of these arrangements have worked relatively well, although for a voluntary dissolution to succeed, the dissolution committee needs to gain the confidence of the firm’s creditors.  Law firm landlords are most frequently the major players here.  These landlords have learned, as have law firm lenders, through too many experiences that the value of accounts receivable upon a law firm’s dissolution are worth a small fraction of their sated value. Accordingly, in the absence of a compelling argument, creditors, often led by the landlords, file an involuntary petition for bankruptcy under Chapter 7 of the Bankruptcy Code. Most often, the only available response by the law firm is the filing of a voluntary petition for reorganization under Chapter 11, which inevitably leads to the appointment of a receiver, who is statutorily mandated to marshal all assets available.  As discussed below, this often leads to a receiver dipping in to individual partner’s pockets to pay for any shortfalls.

We have often seen potential suitors of decline to make a full acquisition and instead, cherry pick some significant number of lawyers.  In many instances, these law firms are charged with either successor liability or with inducing partners to breach their fiduciary obligations to their law firms.

Salaried employees of a suddenly shuttered law firm most frequently avail themselves of claims under the WARN Act : WARN offers protection to workers, their families and communities by requiring employers to provide notice 60 days in advance of covered plant closings and covered mass layoffs.  These claims are asserted against the dissolution committee, if it exists, the law firm’s bankrupt estate and firms who are claimed to have successor liability.

In addition,  a line of cases in California beginning with Jewel v Boxer  state that the law “requires that attorneys’ fees received on cases in progress upon dissolution of a law partnership are to 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 the dissolution. The fact that the client substitutes one of the former partners as attorney of record in place of the former partnership does not affect this result.”  In short, Boxer holds that fees received by a partner and his or her firm in connection with a case which was started at the now dissolved law firm belongs to the former firm.   The Boxer case and its progeny have been heavily criticized and are not followed in many jurisdictions, but they do provide mighty weapons to a receiver or a dissolution committee.  (More on Jewel v Boxer  can be found here.)

The impact of a law firm dissolution is exceedingly financially severe to individual partners.

Virtually all law firms require partners to maintain capital accounts, which as far as partners are concerned is very real money: it is money borrowed from banks by individual partners or deductions from profit distributions.  In the former instance, the debt is not discharged by the firm’s dissolution or bankruptcy; in the latter, the partner paid income tax on such deductions.  Most partners view their capital accounts as a retirement benefit which will be paid out as a partner withdraws or retires.  Insofar as the law firm is concerned, these capital accounts are not segregated funds; they are simply accounting entries.

As the law firm goes in to dissolution mode, these capital accounts are reduced to negative numbers, often substantial six figure amounts.  Upon the conclusion of the dissolution, these negative capital accounts are “zeroed out.”  Under applicable federal tax law, the effect of zeroing out a capital account is that the amount of the negative account is deemed to be income (actually, phantom income) and is taxable. A simple example:  if at the time of the dissolution a partner’s account is deemed to be (-$100,000), that negative $100,000 is deemed taxable income. And, as an added whammy, the money actually invested in the capital account simply disappears, as far as the partner is concerned.  That retirement nest egg is as good a having been invested with Bernie Madoff. It’s gone forever.

To the extent that individual partners have personal liability as a result of a personal guarantee provided to a lender or a landlord and a portion of that indebtedness is compromised or otherwise discharged in connection with the law firm’s final plan of liquidation, the forgiveness of that debt is considered income (this form of phantom income is commonly called “cancellation of debt” or “COD”) for tax purposes.  For example, if an individual partner’s several personal liability on an outstanding bank loan is $100,000 and the loan is compromised at fifty cents on the dollar, the partner must recognize as income the $50,000 cancellation of debt and is taxed on that amount.

In addition, since partners are not salaried employees but instead receive instead profits, in the form of draws and distributions, they are subject to clawbacks for any payment they may have previously received from that point in time when the law firm is deemed insolvent, from a bankruptcy point of view.  Thus, compensation received by partners during the period of insolvency (again, from a bankruptcy law point of view) are subject to being recouped by a receiver.

[Update:  while the Heller Ehrmann partners were each required to take out their checkbooks, they were fortuitously shielded from some of this pain when fortuitously, for those partners, counsel for the Bank of America and Citibank erroneously terminated a UCC filing, thereby losing the entitlement to a $20,000,000 secured claim.  The bankrupt estate of Heller Ehrmann  had anticipated that the banks would pursue remedies against individual partners and set aside a $6,000,000 defense fund for those claims. Presumably, that $20,000,000 clerical gaffe may be the subject of an independent claim by the banks against its counsel.  In all events, the Heller Ehrmann saga is a cautionary tale concerning how landlords so often push a presumed orderly extra-judicial wind-down to a bankruptcy court proceeding. http://www.law.com/jsp/pa/PubArticlePA.jsp?id=1202489077698&src=EMC-Email&et=editorial&bu=The%20Legal%20Intelligencer&pt=TLI%20AM%20Legal%20Alert&cn=TLI_AM_LegalAlert_20110405&kw=Settlement%20Lets%20Heller%20Lawyers%20Move%20On&slreturn=1&hbxlogin=1 ]

Breach of fiduciary duty claims are also regularly made against those in management who defect prior to dissolution, with these new partners’ law firms made co-defendants for inducing such breaches.

A particular thorny issue always arises in connection with the collection of accounts receivable.  Clients often perceptively see that their outstanding obligations to a law firm in dissolution are going to be heavily discounted.  Receivers often seek to impose fiduciary obligations on former partners in collecting accounts receivable and partners are simultaneously often conflicted in connection with their relationships with existing clients.  Moreover, aggressive collection tactics by a receiver are often reflexively met with malpractice claims.

Other areas of potential liability arise in connection with recruiting associates to join defecting partners, defending against malpractice claims, complying with partnership agreements particularly in regard to notice of withdrawal requirements, retention of client files where the firm may have a retaining lien on account of fees owed and occasionally restrictive covenants.

Law firms and certainly partners of law firms finding themselves in these circumstances need to be guided carefully through these treacherous shoals by an independent adviser.

© Jerome Kowalski, February, 2011.  All rights reserved.

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26 Responses

  1. […] the interests of the law firm as an institution. Indeed, even as I write this, while Howrey (about which I had written earlier)  appears to be taking its last grasps of air, Sean Boland, Howrey’s vice chairman responding […]

  2. […]             Among the reasons Google’s simple principles struck me is that they appeared as Bob Ruyback was being pilloried for his failed stewardship at Howrey by, among others, Professor Steve Harper and minions of anonymous Howrey staffers and lawyers on an a blog entitled “It’s Howrey Doody Time.” At the time of this writing,  that Howrey blog, which has been in existence for only a couple of months, seems to have received an astounding 262,000 hits.  And at the same time, Mr. Ruyback is also being criticized by his former partners (whom he said “abandoned him”) for putting them is serious  long term financial jeopardy. […]

  3. […]  The first focus must be on the partnership. In this era of law firm partner free agency, it is imperative that every effort be made to instill confidence in the partnership that management is substantively and productively dealing with the crisis.  This cannot be accomplished by an Alexander Haig fiat that “I’m in charge here.”   Those who are actually in charge are the firm’s partners who will make their own determinations about the adequacy of management’s handling of the crisis.  The partners have a voice and their voices must be heard as many will doubtless have productive suggestions. The partners must also fully appreciate the dire personal consequences to each of them in the event of a complete law firm collapse. […]

  4. […]                      But, certainly don’t stop there.  You must also look at monthly income and expense statements (on a cash basis) for a three year period and aged WIP and A/R statements over the same period.  If the firm has credit facility, obtain a copy of all of the firm’s loan agreements and copies of the reports the firm sends the banks as required by the lending documents. Be sure to obtain any requests the firm has made for waivers for any covenants and copies of any waivers granted.  Also pay particular attention to all of a firm’s real estate leases and significant capital equipment leases. Yes, of course this a boatload of materials but always recall that when law firms slip beneath the waves, the biggest  class of largely unsecured creditors is always the landlords and equipment lessons. And in virtually every law firm failure over the past thirty years, it was these creditors who kept waterboarding partners at firms in dissolution until they agreed to write checks out of their own pockets to repay the creditors, as I’ve previously discussed. […]

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  6. […] 2011 there were a total of 43 law firm mergers. Those shutting their doors, often with disastrous consequence to the firm’s individual partners, include the splashy Howrey implosion, Florida based Yoss, LLP as well as Ruden McCloskey (which […]

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  12. […] Sadly, we will also see additional law firm failures. […]

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  14. […] arrived:  Fired with enthusiasm. Other partner will be seeking more hospitable climes because of law firm failures in the coming […]

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  17. […] firm is doing, since there is a strong likelihood that we will sadly see some law firm failures; you need to be prepared and not caught by surprise.   And if you are a vendor or service provider to law firms, look for cutbacks and a longer […]

  18. […] More painfully, a large commercial law firm has less than zero value on liquidation or winding down.  In fact, such scenarios have been enormously costly for partners in such law firms. […]

  19. […] We also need to make sure that our partners understand that if we continue to get bad press and they continue to bail, we could, heaven forbid, be this year’s Howrey. We need to make sure that every partner understands that the personal consequences to the partners if we tank are extremely dire. […]

  20. […] While it is still way too early to write a postmortem, it is timely to review how this noble firm finds itself in crisis. It is equally timely to consider the potential of failure and its consequences. […]

  21. […] court of public opinion, where the firm is now being badly battered. These outstanding lawyers have much to lose in the event the firm implodes and for that reason should be motivated to provide an oath of […]

  22. […] have some of the torments of Dante’s financial inferno visited upon them, as, among other things, they will be subject to clawbacks, loss of capital, adverse tax consequences and […]

  23. […] or dramatic reduction of thousands of pensions.  To be sure, more ugliness lies ahead: Draconian financial penalties to partners and prosecutorial inquiries of potential criminal liability for some key Dewey […]

  24. […] form of governance with appropriate checks and balances in place; (c) a detailed explanation of the disastrous personal consequences to each partner if the firm should implode; (d) implementation of a public relations crisis […]

  25. […] case of an imploded law firm has the incentive to find assets to pay down debt been greater. Here, former partners looking at a world of pain, are even now scrambling to limit or divert that […]

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