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Double Jeopardy for Law Firms: Jewel v Boxer


Double Jeopardy for Law Firms: Jewel v Boxer.

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Double Jeopardy for Law Firms: Jewel v Boxer


Seal of the United States District Court for t...

Seal of the United States District Court for the Southern District of New York (Photo credit: Wikipedia)

Jerome Kowalski

Kowalski & Associates

July, 2012

 

In the last month or so, BigLaw was jarred by two disruptive events:  First, there was the tragic collapse of Dewey & LeBoeuf and the second, the reasoned decision issued by the United States District Court for the Southern District of New York in the Coudert bankruptcy holding that the “unfinished business” doctrine, commonly known as Jewel v Boxer, applies to New York law firm partnerships and that it does so with equal weight to both matters billed on an hourly basis as well as contingency fee work.  Both events have chilled the lateral partner market.

Added to that is the fact that liquidators of imploded law firms are also desperately seeking recoveries for creditors and are therefore anxiously investigating potential breach of fiduciary duty claims against former partners of the law firms, and, like Jewel claims, the reach of these claims is likely to put the law firms these former partners subsequently joined into their cross hairs. Deep pockets and all of that.

These events are occurring in the open for all to see. Unfortunately, too many managing partners, lateral hiring partners, law firm general counsels and risk managers have neither taken note nor taken adequate steps to protect their firms.

In light of recent events, law firms will be woefully remiss if they fail to include in their standard agreements for lateral partners language protecting and indemnifying the firm from Jewel v Boxer and breach of fiduciary duty claims.  If the firm has hired a lateral partner from a firm that is going through the throes of imploding, a la Dewey or if a lateral partner comes from a law firm that subsequently unwinds unexpectedly, there is some reasonable likelihood that the hiring firm will be targeted as a defendant should the liquidators of the defunct law firm form a reasonable basis to assert such claims.  The issue is that there is almost always a likelihood that such claims are lurking about. These skulking claims are all of the more problematic because they are typically not asserted for a couple of years after a law firm implodes.  When the pain comes, law firms should preserve the right to share some of that pain in a reasoned and rational way.

Law firm liquidators typically spend the first several months of their tenure tending to the gargantuan tasks of shutting down the law firm.  They simultaneously undertake a “sources and uses” analysis to determine what potential sources exist for payment of administration expenses and obligations due to creditors.  Because expenses and creditor typically far exceed the amounts available from monetizing accounts receivable and works in progress, successor law firms are more frequently found to be routinely available resources for adding to the honey pot. And nobody is more motivated to add to the honey pot than law firm liquidators whose fees are often contingent on maximizing recoveries; a primary resource for them has been pursuing clawbacks and claw forwards.  They are unrestrained by market place considerations which dampen the appetite of viable law firms to  go after other competing law firms who have hired laterally from its ranks because they would inevitably subject themselves to the very same claims, as they continue to drink the Kool Ade and hire laterally.

The problem is that it takes law firm liquidators an extended period of time to get their hands around the behemoth of the law firm that once was and is no longer. For example, one of the tasks typically undertaken by the liquidators is recasting the firm’s balance sheet and profit and loss statements retroactively, to among other things, determine when the law firm was first insolvent from a technical bankruptcy point of view.  Any payments made to partners during the insolvency period are gratuitous transfers and are subject to clawbacks. Determining the date of insolvency is both art and science and often requires extended analyses. Similarly, determining where former partners went and which firm assets (in the form of client files, other partners and associates) also takes time. Thus, we most often see that these claims are filed en masse upon the expiration of the statute of limitations, which is two years from the date of filing.

Here is the rub:  Law firms typically prudently pay new lateral partners in whole or in part during the course of that partner’s initial tenure at the law firm on a performance basis. One of the key drivers is most often cash generation and the metric law firms use in calculating the new partner’s entitlement is the law firm’s historical profit margins. To be sure, those margins do not include clawbacks. Thus, the typical scenario is that the new lateral partner is timely rewarded for production, with the law firm completely oblivious to the very real likelihood that two years or more down the road, law firm liquidators will be sending the law firm a due bill for all of the profits earned by the law firm (not just the new partner’s distributions) for unfinished business based on either Jewel v Boxer or breach of fiduciary duty claims. Successor law firms have not yet been the target for recovery of voidable transfers made during the insolvency period made to the new partner during his prior tenure at the now defunct law firm.

Thus, the new firm is in the unenviable position of having to pay twice for the same revenue generation: First, to the lateral partner and thereafter to the estate of the former law firm.

The issue with breach of fiduciary claims is far more devious and invidious. Among other things, we know full well that the rule is that a partner may not solicit a client, associate or partner to join him or her at a new firm until he or she has given notice. Nor can a partner share with another law firm confidential billing and collection information of his or her current law firm, Yet, we can all take judicial notice that no sane partner on the prowl will accept an offer from a new firm before he or she has received adequate assurances from his or her clients will be following him or her. Similarly, every hiring law firm demands assurances that the clients will indeed be coming along. By the same token, when a group leaves a law firm simultaneously to the same new climes, it is readily apparent that a partner, typically the group leader, has engaged in actionable recruiting of partners and associates prior to giving notice. The new law firm is clearly complicit, since it almost always interviews partners in the group at length before an offer is extended and even where associates are first interviewed after the partners give notice, it is more often the case than not that these associates were advised by law firm partners to start packing – again, actionable conduct. Even where the successor law firm gives a potential lateral recruit written admonitions not to violate any fiduciary obligations or partnership agreements and somehow feigns ignorance of any fiduciary breaches, at best, it is most often clear that it has simply engaged in willful (and often dubious) blindness and may be subject to some serious claims.

Dewey broke the mold in oh so many ways

Dewey’s implosion was unprecedented in too many ways to count.

One unique aspect of the Dewey collapse was its failure to hold a formal dissolution vote. One Dewey law firm leader, when asked about a formal vote of dissolution as the firm was plainly at the tail end of its death spiral, blithely and rather incredibly denied that the firm was going to vote to dissolve, even Quixotically asking his interlocutor, “why would he do that?” even as he presumably was actively looking for a new home and subsequent to the time that he issued an email in his official capacity to other partners encouraging them to leave. The answer to the question sort of seems obvious:  The reason you would take a dissolution vote is because the law requires you to do so and the firm’s managing partners, as fiduciaries of other partners as well as of the firm’s other creditors, have a duty to call for such a vote as the firm, in fact, is actually in a state of very real dissolution.

The issue may well be that Dewey’s leaders, very smart lawyers one and all, may well have wanted to protect their colleagues and themselves from Jewel v Boxer claims. You see, these claims arguably first arise once the partnership votes to dissolve.  In Coudert, the only partners (and their new law firms) sued for unfinished business profits were those who left after the dissolution vote. I certainly have no information to support the notion that this was the reason for the failure to formally vote to dissolve Dewey.  But, if this was the reason for the ploy, it seems unlikely that it will succeed.  First, it may be that a court of equity may determine that Dewey went into formal dissolution as it stumbled through various critical paths:  For example, when Dewey leadership tried to auction off pieces to other law firms, when those efforts failed, when the firm’s then sole managing partner advised the partnership in January 2012 that the firm was basically insolvent in that it couldn’t pay its debts when due, the date of the bankruptcy filing or some other earlier date. We are in largely uncharted waters here, folks.

But, the refusal to take a formal dissolution vote solved nothing and protects nobody. Every former partner and most of their new law firms are still subject to breach of fiduciary claims, violations of the partnership agreement and violations of the Revised Uniform Partners Law. Those in management are presumably more at risk.

Simply arguably eliminating Jewel v Boxer claims still leaves the door wide open for breach of fiduciary duty claims. We do not suggest that Jewel claims preclude breach of fiduciary duty claims. They are all still out there.  In short, it doesn’t matter whether you call it a “tax” or a “penalty”.  A clawback is still a clawback.

Protecting law firms who hire partners laterally

In light of all of the foregoing, it is critical that any law firm which hires laterally must include indemnities from new partners from both Jewel v Boxer and breach of fiduciary claims.  The full nature, scope and content of these indemnities must be left to the sound business judgment of law firm leadership.  It is likely that the amount of the precise amount for particular indemnities will first be the subject of negotiation after issue is formally joined on the claims.  Those indemnities should be standard issue in every lateral partner agreement. Every single one.

All such agreements should require binding confidential mediation and arbitration.

Moreover, as we continue to watch even an already bankrupt Dewey continue to fall, law firm risk managers must be engaged in active discussions with its insurance carriers to see what insurance might be available with regard to potential future Deweys and partners who leave those sinking ships to join new law firms. It may be too late to insure Dewey-related claims, but it isn’t too late to seek coverage for the next generation of imploded law firm refugees. These claims are certainly outside the scope of standard issue malpractice claims, but may well be within the scope of fiduciary insurance coverage or errors and omissions policies.  The real problem here is that most often, these claims specifically exclude work done by a partner at a former law firm.

I leave it to professional liability professionals to craft an insurance based solution.  But be forewarned, time is short; the next law firm implosion may be around the corner.

An important note: Those law firms which carefully assesses its likelihood of liability, includes the amount of exposure into its calculus (and may even have appropriate insurance) and then eschews the need for an indemnity, while extending a viable offer, puts itself at a competitive advantage for a desirable candidate. However, it does so at some risk and eliminates the ability to tell all comers that these indemnities are required of all lateral partners. At the same time, if a law firm picks and chooses which lateral candidates should be required to provide indemnities, there may be some explaining to do of and when it comes to pre-trial discovery in the inevitable Jewel or breach of fiduciary duty claims rears its head.

Is this a fight you really want to get into?

 

It isn’t very surprising that every Jewel v Boxer and breach of fiduciary duty claim previously brought under these circumstances involving BigLaw has settled prior to trial. Many settle before the first pleading is served. The balance settle well prior to trial. Several are still pending in the pleading phases in Thelen and in Coudert with the antagonists vowing to fight on to trial and through the appellate process, never to give in. Never. We’ll see.

The real problem here is the fact that pretrial discovery will be brutishly invasive and certainly expensive.  Remember, that the Jewel v Boxer rule is that the plaintiff has an entitlement to recover the profits not the gross fees from unfinished business. Thus, discovery will necessarily include minute details of a law firm’s most sensitive and confidential pricing and profitability information, stuff that even in the most transparent of law firms do not regularly share even with partners.

Sure, we all love confidentiality agreements and protective orders and advocate for them all of the time both to the courts and to our skeptical and justifiably paranoid clients. But, today, the shoe is on the other foot: Do you really want this information disclosed to your key competitors even under a protective order?  Can you, dear advocate, feel safe with a protective order? Bear in mind that at trial, the veil of confidentiality comes off and should any of these cases ever come to trial, the world at large will be informed of your most sensitive information, with journalists, bloggers and pundits at the ready in the courthouse to report information never previously having seen the faint light of day.

Is it time for some rule changes?

 

While getting the American Bar Association and fifty-one agencies to change extant provisions of the Model Code of Professional Responsibility is a Herculean task, which, at best, would proceed at a glacial pace, it is time to at least begin to consider those issues.

First, since the skein of precedent and statute in the area of fiduciary laws governing partnerships is a foolhardy a mission hardly imaginable, let’s for the moment, at least, forget about undoing Jewel v Boxer under the rubric of amending a century or more of common law and statutory mandates and suggesting that we are simply modifying rules of professional conduct. Instead, an initial focus should be on the question of lateral partner movement. We all know what the rules say and we all concede that these rules are far more honored in the breach.  A new set of rules are critical and should, even reluctantly, yield to the realities created by the marketplace: Partners are free agents, just as law firms freely de-equitize partners and otherwise treat them as employees at will. Market realities create lateral movement.  The marketplace also has required client solicitation before partnership withdrawal, disclosure of historical billing and collection history and even solicitation of associates and other partners. The ethical rules need to be amended to yield to these market realities. The issue here is not those fiduciary rules of partnership described in the Jewel line of cases and in the Coudert decision. Rather, the rules that need to be addressed relate to those fairly unique to the profession; namely, those rules primarily regarding client solicitations in a free agency market.

More significantly, given the likelihood of a torrent of post Dewey Jewel v Boxer and breach of fiduciary claims, as well as a next round of similar claims from the inevitable next BigLaw failures, the rules should require that all disputes between law firms and their successors and assigns be arbitrated before a panel of those appointed in each jurisdiction to review lawyer conduct.

Until the rules are actually amended, BigLaw should consider acting on its own: I would propose a compact by and among the nation’s largest law firms under which any disputes among the signatories of the compact, inter se,  be finally resolved through mediation and then arbitration by a designated panel of arbitrators,  consisting of retired jurists as well as present and past BigLaw partners.  This compact should specifically bind the signing law firms as well as their successors and assigns.  It would take only a relatively small number of numbers of law firms to seize such an initiative and then some prodding to get other law firms to join in.

Waves of litigation brought by law firm liquidators seem inevitable.  A uniquely qualified panel of arbitrators are perhaps the most efficient way to handle these issues. At the same time, this panel could also be designated to be the forum in which disputes among partners inter se, as well as between a partner and his or her former law firm can be most efficiently finally resolved.

Jerry Kowalski is the founder of Kowalski & Associates, a consulting firm serving the legal profession exclusively. Jerry is a regular contributor to a variety of publications and is a frequent (always engaging and often humorous) speaker to a variety of forums. Jerry can be reached at Jerome_kowalski@me.com or at  jkowalski@kowalskiassociates.com or at 212 832 9070, Extension 310

 

© Jerome Kowalski, July, 2012. All Rights reserved.

Protecting a Law Firm’s Crown Jewels


Protecting a Law Firm’s Crown Jewels.

Protecting a Law Firm’s Crown Jewels


English: Replicas of Polish crown jewels, made...

English: Replicas of Polish crown jewels, made in 2003. Polski: Repliki polskich klejnotów koronacyjnych wykonane w 2003 roku. (Photo credit: Wikipedia)

Jerome Kowalski

Kowalski & Associates

June, 2012

 

The problem with the law firm business model, we are told repeatedly, is that its principal assets, namely, its productive partners, go down the elevator every night and may not return the next day. The issue arises out of our arrival to an era of law firm partners as free agents and a lack of institutional loyalty, a subject about which there is much railing.

But, those partners who take the elevator down and out and don’t return the next day are taking with them valuable assets that are the property of the law firm and which law firms as well their lenders and landlords need now consider preserving and protecting.  I refer to unfinished business that law firm partners take with them to new law firms. The simple fact is that the profits derived from unfinished business of a client of law firm partnership is the partnership’s asset, just as are the outstanding accounts receivable, work in process, furniture, artwork and equipment.  And, I’m not just referring to law firms in dissolution. These are recoverable assets of healthy thriving law firms.

One of the results of the recent spate of law firm bankruptcies was to alert lawyers that upon the dissolution of a law firm, profits from unfinished business can be clawed back under the doctrine now known as Jewel v Boxer. Judge Colleen McMahon of the United States District Court for the Southern District of New York, in a much publicized well reasoned and articulate opinion in the Coudert case explained the basis of the unfinished business doctrine. The essence of her ruling is that “A departing partner is not free to walk out of his firm’s office carrying a Jackson Pollack painting he ripped off the wall of the reception area.” Profits from unfinished business are akin to the Pollack painting and departing partners are statutorily obligated to return both the painting removed from the wall and profits from unfinished business. This has been the law in New York for a century.

Under the Uniform Partnership Act, absent an agreement to the contrary, a partnership goes into dissolution upon the death or withdrawal of a partner.   Thus, all modern partnership agreements typically provide for the continuation of the business of the partnership upon the death or withdrawal of a partner and these agreements go on to describe the rights, entitlements and obligations of the partnership and the partner on a going forward basis.  The overwhelming majority of law firm partnership agreements are completely silent on the issue of unfinished business that follows a partner that withdraws from a law firm. But it is completely within the fabric of the partnership fiduciary relationship, as articulated in Meinhard v Salmon, and further expounded upon by Judge McMahon, for law firms to require departing partners to account to the partnership for profits from unfinished business even absent a dissolution of the partnership. Moreover, the agreement can further obligate a withdrawing partner to inform his or her new law firm that profits from unfinished business belong to his or her former law firm. Fancy that. I know this is probably a shocker to most readers, but it’s clearly the law.

Intuitively, most lawyers will simply shudder when reading this. Their reaction, when I have previously spoken of this, is to instinctively say that this can’t be so; it constitutes an impermissible restriction on a lawyer’s ability to practice law, unbridled by covenants not to compete.  The Jewel v Boxer line of cases, as well as the long parade of authority cited by Judge McMahon makes clear that the unfinished business doctrine does not trample on that issue, even in New York which is completely restrictive on the prohibition barring any form of covenants not to compete and certainly not in states like California which does permit some restrictions in limited circumstances.

We certainly now know from Coudert and Dewey & LeBoeuf that principal assets of a law firm are unfinished business (although, in fairness, these claims were pursued in a host of other major law firm bankruptcies, with a tad less fanfare).   For the first time of which I am aware, in Dewey, the firm’s secured creditors have actually purported to take a security interest in the proceeds of unfinished business claims.

Thus, the question now emerges: Why shouldn’t law firms include in their partnership agreements provisions requiring withdrawing partners to account to the firm for unfinished business even absent dissolution?  The ancillary question is why wouldn’t lenders and law firm landlords mandate such provisions as a condition of borrowing or tenancy?  The short answer is that in due course, these provisions are likely to be standard fare.

Let’s turn to the likely effects on lateral partner recruiting.

It is a standard practice in lateral partner recruiting for a law firm to prepare a pro forma analysis of income and expenses derived from a lateral candidate. In analyzing this pro forma, law firms make informed decisions as to the likely profitability of any candidate. With the recent unfortunate spate of law firm failures and the increased recourse to Jewel v Boxer recoveries, I have regularly counseled every law firm client to include in its pro forma examination a projection of any possible unfinished business remittances and to pay particular heed to this analysis when   there is evidence that the candidate is from a law firm suspected to be in difficult financial circumstances. In doing so, it must be remembered that Jewel v Boxer remittances are only for the profits derived from the unfinished business. Even the former partner can bill for his time in a unique metric, as Judge McMahon noted, based not on standard hourly rates, but based on his or her “efforts, skill, and diligence.” Thus, neither the former partner nor his or her new firm is forced into indentured servitude.   They are simply barred from deriving a profit for any of the particular matters the new partner brings along with him or her.

This last point require some emphasis: it is only the particular discrete matters that fall into the rubric of unfinished business. As Judge McMahon said in Coudert:

“’ Unfinished business” must be distinguished from “finished business” – business that has been completed prior to dissolution (the merger done and documented; the lawsuit tried to verdict or settled). If a firm has finished a piece of business but has not collected its fee, in whole or in part, the resulting receivable is, obviously, an asset of the firm. If the firm liquidates, the fee has to be collected for the benefit of the members of the firm in liquidation. Jackson v. Hunt, Hill & Betts, 7 N.Y.2d 180, 183 (1959). 23 “New business” is an entirely new contract or engagement to do a piece of work. New business that is contracted for and undertaken only after a partnership dissolves – even business from a client of the dissolved firm – is not an asset of the dissolved firm, because a partnership has no more than an expectation of obtaining future business from a client. For that reason, the attorney who conducts the business and collects the resulting fee owes no duty to his former partners to account for any profit he may earn. Stem, 227 N.Y. at 550; see also Conolly v Thuillez, 26 A.D.3d 720, 723 (3d Dep’t 2006); In re Brobeck, Phleger & Harrison LLP, 408 B.R. 318, 333 (Bnkr. N.D. Cal. 2009) (applying California law). Retainers from former clients on new matters – even matters, like appeals, that are related to finished representations – have been treated as “new” business and are not subject to the duty to account. See, e.g., Talley, 100 N.Y.S.2d at 117-18 (no duty to account for fees earned on appeals from matters originally handled as partnership business).5

Between “finished business” and “new business” lies unfinished business: executory contracts to perform services, begun but not fully performed by the partnership on the date of its dissolution. Unfinished business is presumptively treated as a partnership asset subject to distribution.”

 

Thus, the new firm must make an informed decision as to whether it is prepared to make an investment in the new partner and his or her clients until it can start earning a profit on those clients coming along.  The cost of the investment is largely an opportunity cost; namely, the lost opportunity to bill profitable time on different clients and matters.

Will this dampen the lateral partner market?  Quite likely, but, frankly, not in a material way, I suspect and certainly not long term as such contractual provisions begin to metastasize, at the instance of lenders and landlords, as well as law firm leadership, separately incentivized to dampen the enthusiasm of profitable and productive partners to seek a higher bidder. In due course, there will likely develop an open market in which firms will both be remitting and collecting unfinished business remittances.  And, I am sure, the market will ultimately require law firms to simply arrive at negotiated deals early on as valuable free agents rise to their highest level and less productive partners eased out the door.

These results are all inevitable. Well informed lawyers will counsel lenders and landlords on these issues and these clients, who have bargaining leverage will require unfinished business recoveries as a staple of law firm partnership agreements. Law firms will being compelled to pay unfinished business remittances will in turn take steps to keep its assets corralled by requiring the same of its partners.

In coming months, law firm leaders will be sitting across the table from lenders and landlords requiring law firms to include unfinished recoveries in their partnership agreements. Partners will be presented with proposed amendments to their partnership agreements containing these provisions.

Now is the time to begin considering your bargaining position.

© Jerome Kowalski, June, 2012. All Rights reserved.

Jerry Kowalski is the founder of Kowalski & Associates, a consulting firm serving the legal profession exclusively. Jerry is a regular contributor to a variety of publications and is a frequent (always engaging and often humorous) speaker to a variety of forums. Jerry can be reached at jkowalski@kowalskiassociates.com or at 212 832 9070, Extension 310

 

The Coming Invasion of the Body Snatchers: Are Offshore Law Firms Going to Invade the United States?


English: The United States Esperanto: Loko de ...

Image via Wikipedia

                                                                             Jerome Kowalski

                                                                             Kowalski & Associates

                                                                             December, 2011

 

They’re coming.

The coming months and the coming years will mark an increased invasion of foreign based law firms and other providers of legal services into the United States.  They will likely be coming from all corners of the world. And, they will be looking to snatch your business.

First, we have the acknowledged intention of UK based behemoth Herbert Smith (1,500 or so lawyers) to re-open a United States office, after an absence of two decades. The new office, expected to open within the year will be populated by both United States and foreign qualified lawyers. Jonathan Scott, a senior Herbert Smith lawyer announced that the new New York City office focused on dispute resolution, including international arbitration and investigations.  Following the Watergate era admonition to “follow the money,”   the premium fee yielding dispute resolution and internal investigation practices seem extremely likely areas for firms like Herbert Smith (and AmLaw 100 firms) to continue to exploit.  The issue, of course, is that as the supply of high end law firms having the capacity to deliver quality dispute resolution work and internal investigations on a global scale and the competition for this work  continues to grow, price competition will ineluctably come in to play.

The British invasion is not new, nor will it end soon. British Magic Circle firms have invaded and have taken an increasingly dominant role in the US market for almost two decades.  London, which seems hell bent on being the Imperial home for the lawyers to the world, has already sent formidable firms here, including Clifford Chance, Linklaters, Allen & Overy, Freshfield, and Lovell Hogan. The last British invasion on these shores began with the Beatles in 1963 and last I heard, Mick Jagger and Paul McCartney are still playing to sell out audiences. The point is that, based on my count, fewer than 20 of the UK’s 100 largest law firms have taken to the US stage at this writing.

As the market in the Euro Zone continues to stagnate, law firms in that market will likely look to the American market as new sources for revenue. One recent example is Ireland’s A&L Goodbody, which long had a single lawyer outpost in New York, announced just yesterday ambitious plans to open a Silicon valley branch and reinvigorate its New York operations.   The Germans may not be far behind.

From the other side of the globe, the real game changer may well be the announced merger of   China’s King & Wood and Australia’s Mallesons Stephen Jaques. As announced in The Asian Lawyer , “[t]he combined firm will number some 1,800 lawyers, and is positioning itself clearly as an alternative in the region to the large U.S. and U.K. firms that have traditionally dominated major cross-border deals.”  It matters little if the combined entity will soon open a US office (although my raw guess is that they eventually will), the combined firm will be competing directly with both AmLaw 100 and Golden Circle firms for core cross border work.

As I previously observed,  “the profession must be mindful of the Chinese business model, which seems to be the Chinese asking foreigners to come to China and perform a service or build a product, followed by the Chinese saying “let me see how you do that.” That in turn is followed by “teach us how to do that,” and ultimately “okay, we now know how to do that on our own, so you can leave and we will do so on our own.’”

The West has not only taught Chinese law firms how to practice law in the Western style, but, the West has also taught the Chinese to operate globally and on the global expanse. Indeed, the two largest law firms in China, Dacheng and Yingke, are preparing to open bases in London. The United States will not be far behind.   Broad & Bright, one of China’s leading law firms with 60 lawyers,  is set on moving to the West.  It is now in merger talks with 2,900 lawyer Clifford Chance.    Since you have by now read the Broad & Bright web site through the link above, you know that Broad & Bright has acted as counsel in China for some of the world’s largest corporations and on its surface, does not need Clifford Chance to funnel more work to its offices. Broad & Bright is one of those rare firms that can easily be a net exporter of legal services. Thus, should the Clifford Chance talks fail, it would not come as much of a surprise that Broad & Bright (or a similar sized and placed Chinese law firm will simply say “okay, we now know how to do this on our own and we don’t need a Western law firm to open our own international law firm.”

LPO’s, sometimes called “non-traditional law firms”  have watched their gross revenues increase almost ten-fold over the last five years, to an estimated $2,500,000,000 in 2012 with some estimating a doubling of that number by 2015.  As I have said in the past, it is a major mistake to simply think of LPO’s as limited resource providers of ancillary services to law firms and corporate legal departments. Rather, they are alternate providers of legal services, which can provide a full range of legal services to United States consumers of legal services at an enormous price advantage. The only areas in which these entities are precluded from competing directly with United States law firms are appearing in judicial proceedings, signing legal opinion letters or otherwise directly providing advice to a corporation on American law.  A number of LPO’s, particularly on the Indian sub-continent, have affiliations of one form or another with Indian law firms.

The thin barrier preventing LPO’s from grabbing even more slices of the legal spend pie will easily evaporate.   There are a variety of different means for those affiliates to establish or acquire a United States law firm.  Thus, an LPO could easily establish a very real law firm branch office in the United States, populated by US duly qualified lawyers which in term could make eviscerate the thin boundary which would give these offshore entities the ability to offer the full array of legal services – including appearing in judicial proceedings,  signing legal opinions and direct counseling,

LPO’s, owned by offshore entities and owned by either US investors or by US law firms are sprouting United States branch offices like weeds. Those US branch offices already have the infrastructure in place to function as full service law firms, often with technology already in place that is complete state of the art. And there are many a small or medium sized law firm that would presumably welcome the capital and assured revenue stream from a successful well capitalized offshore LPO to buttress its own sagging fortunes.

In 2011, United States law firms met the challenges of reduced legal spends and new competition through reducing headcounts,  merging to create more critical mass and consolidating back office and support funtions, or by shutting their doors. Professor Steve Harper avers that in 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 didn’t quite go down without a fight) , New York’s Snow Becker and Krause, Atlanta based Shapiro Fussell Wedge & Martin, Los Angeles based Silver & Freedman, Denver based Isaacson Rosenbaum,  foreclosure mills Steven Baum and David Stern and150 lawyer Austin based Clark Thomas & Winters.  And there are more than a few commentators who suggest that  Arnold & Porter’s acquisition of the remnants of Los Angeles based Howard Rice and Bryan Cave’s acquisition of Denver based rapidly shrinking Robert Holme & Owen largely staved off the closures of the acquired firms.  A similar suggestion arguably applies to McKenna long’s “acquisition” of Luce Forward, with the former plainly planning on doing a material house cleaning of the latter.

Well then, Ollie, that’s a fine mess we’re in.

Despite admonitions concerning the imprudence of predicting the future by such luminaries as John Kenneth Gailbraith (“the only purpose served in making predictions about the future is to lend credibility to astrology”) and Yogi Berra (“the future is hard to predict because it hasn’t happened yet”), I tremulously suggest that we are certainly likely to see the following over the coming months:

  • Continued merging of middle market law firms to create larger regional or super regional law firms.
  • Further reducing headcount and support staff.
  • Acquisitions by foreign law firms or alternative providers of domestic US based law firms.
  • Some US law firms meeting the invasion of foreign law firms and alternative legal service providers by counter-attacks, landing branches on foreign shores, despite the known risks attendant to that approach.
  • Enhanced collaboration, both vertically between the law firm and its important institutional clients, as well as horizontally with alternative providers of legal services as well as with law firms to which the client may have downsourced work to.
  • Increased price competition for premium work as well as increased commoditization of other lines of work.

We are in for some challenging times.  Most well managed law firms will continue to survive and thrive. Some law firms will inevitably appear on lists published next December of law firms that sadly didn’t make it.

© Jerome Kowalski, December, 2011.  All Rights Reserved.

 Jerry Kowalski, who provides consulting services to law firms, is also a dynamic (and often humorous) speaker on topics of interest to the profession and can be reached at jkowalski@kowalskiassociates.com .

A Jewel [v. Boxer] is a Law Firm Bankruptcy Trustee’s Best Friend; Unfinished Law Firm Business Taxes Departing Partners and Their New Law Firms for Years


Boxer                                                                           

  Jerome Kowalski

 Kowalski & Associates

 November, 2011

In a recent post on these pages dealing with the consequences of a law firm failure on the firm’s partners, I described the clawback provisions of Jewel v Boxer, sometimes called the “unfinished business” doctrine:

[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.

Yesterday’s Wall Street Journal breathlessly described the long tail of the Jewel v Boxer clawbacks as if this were news. A number of commentators seemed rather surprised, indeed, even offended, that these clawbacks exist, including Professor Larry Ribstein and Ed Poll.

These clawbacks have been with us for quite some time. Nor is the doctrine an aberrant anomaly of California law, as a recent decision in the Coudert case demonstrates. In Coudert, a Southern District of New York case, three years after confirmation of the firm’s plan of liquidation, which itself had a five year gestation period, numerous Jewel v Boxer claims are still being actively litigated, involving “unfinished business” that spans the globe.

Law firm partnerships cannot, as Professor Ribstein suggests, contractually write their way out of Jewel v Boxer.  Bankruptcy Judge Dennis Montali of the Northern District of California, the jurist with the most experience in law firm dissolutions, having presided over Brobeck, Heller Ehrman, Thelen and now Howrey, has plainly ruled that so called “Jewel waivers” are unenforceable and has so held in several cases. As an aside, in several law firm dissolutions, as some law firms see the inevitable end as being around  some firms have attempted to create life preservers for their partners by amending their partnership agreements to include “Jewel waivers”  in the waning days of the firm.  Unfortunately, for these partners and the firms they join, last minute “Jewel Waivers” are simply voidable preferences and unenforceable.

Well then, what to do?  With some strong likelihood that the next 24 months will see at least several further law firm dissolutions, the prospect for lateral partners bringing along with them  nintended Jewel v Boxer liabilities as their former firms sink under the waves, is a material consequence that law firms must consider.  I am afraid that there is no way around it.  In assessing a potential new lateral partner candidate, law firms need to consider the prospect that they may be required to disgorge revenues brought along by the new partner should his or her former firm fail. Sometimes, the potential of a law firm is obvious from either media reports or simply based on the fact that a law firm is suddenly inundated with a raft of partner resumes from a particular firm. In these instances, I suggest that potential candidates be queried about the financial strength and viability of his or her former law firm.  In the ordinary course of risk and reward assessment, the otential exposure of Jewel v Boxer claims simply must be part of the calculus.

We have recently seen some law firms address the issue in a different fashion:  They have inserted provisions in their partnership agreements a provision which would require a partner upon withdrawal from the firm remit amounts ranging from 10 to 20% of revenues they derive from clients of the firm that follow them to their new firms for a period of one or two years.  The purpose of these provisions, it seems to me, is to attach mathematical certainty to Jewel v Boxer claims.  The unintended consequence is that lawyers burdened by these contractual provisions are essentially unmarketable. It is highly unlikely that a new firm would assume that kind of liability.  Additionally, that departure tax is a hefty and prohibitive additional tax for an individual partner to bear.

But, on the positive side, such departure taxes aren’t all bad.  In the 32 large law firm bankruptcies since Finley Kumble filed in 1988, the coup de grace has uniformly been the massive defections of partners with books of business. These departure taxes will necessarily provoke a “why can’t we all just all get along” dialogue with a view towards all working in synch to resolve what ails the firm.  And these departure taxes will provide potent shark repellent and keep those who would draw the lifeblood of a law firm at bay.

[Update: On May 24, 2012, Judge Colleen McMahon, ruling in the Coudert bankruptcy proceeding in the United States District Court for the Southern District of New York, ruled that Jewel v Boxer is the law in New York and that the liquidating trustee of the Coudert estate may recover from each former partner the profits derived from each case that followed each partner to his or her new law firm. The court ruled: “Under the [New York] partnership law, the client matters are presumed to be Coudert’s assets on the dissolution date, .. Because they are Coudert assets, the former Coudert partners are obligated to account for any profits they earned while winding the client matters up at the firms.” A link to the full opinion can be found at the foot of this article.]

© Jerome Kowalski, November, 2011.  All Rights Reserved.

 

Jerry Kowalski, who provides consulting services to law firms, is also a dynamic (and often humorous) speaker on topics of interest to the profession and can be reached at
jkowalski@kowalskiassociates.com
.

The Dummy’s Guide to Forensic Analysis of Law Firm Financial Accounting and Reporting While Leaving the PPP in the Commode


Added Assets, Income/Expenses, for a Full Fina...                                                                             Jerome Kowalski

                                                                             Kowalski & Associates

                                                                             May, 2011

 

Law firm financial statements: What you need to know and why you need to know it.

My friend and distinguished colleague, Ed Reeser, who previously served with distinction as a managing partner at major international law firms, along with  James Hunt, a retired PriceWaterhouseCoopers partner who headed PWC’s forensics accounting group,   recently published a series of articles entitled Super Fuel for the Law Firm PPEP Drag Race-Modified Cash Basis Accounting in The Los Angeles Daily Journal(subscription required; The articles are also available here.  ) addressing law firm financial reporting and some of the excessive – perhaps, better, unwarranted – exuberance sometimes contained in law firm financial reporting.

Ed and Jim assert that in analyzing financial statements of law firms which have failed, one almost always finds gimmickry and manipulation in the financial reporting of these now defunct firms. The essence of their work is that a law firm may be in a death spiral and creative accounting gimmickry serve to avoid detection of systemic failures, while management seeks to resolve the issue, without adequately disclosing the severity of the firm’s problem.  In short, in the absence of an audited financial statement, certified by a reputable accounting firm attesting that the report was audited in accordance with Generally Accepted Auditing Standards and certified that the firm’s books and records are maintained in accordance with Generally Accepted Accounting Principles, some firms too often game their own financial reports to deflect attention from material adverse events.

In this season of the issuance of AmLaw reports and law firms’ issuance of their own financial reports, the observations and warnings by Ed and Jim are timely. And, this season is also one in which some law firms are having advanced stage discussions about combining with another law firm, or acquiring a practice group, making some of these observations of further current interest.

We’ve previously discussed the absolutely critical need for due diligence in the world of lateral acquisitions accessible at this link .

Accounting Basics

Ed and Jim first begin with the basic premise that all law firms keep at least two sets of books (no, we’re not talking about double entry accounting):  Most often, the first is a report using the “cash basis” method of accounting and the second is the “modified cash basis.”

             The essence of cash based accounting is that income is reported when actually received and expenses are posted as either operating or capital costs. Operating costs are day to day expenses and reported as and when disbursed. Capital costs are expenses incurred for items that have longer term useful lives. Buying a pen or a pad is an operating cost. Buying a computer is a capital cost, because the computer has a longer term useful life and the cost of the computer is spread over the presumed useful life of the computer.

Cash based accounting is required by the IRS for all partnerships. But from an accounting point of view, the gold standard is accrual accounting, the darling of the AICPA and financial analysts.  Accounting on an accrual basis should require audited and certified financials – all done under the watchful eyes of independent auditors. They are pricey propositions which law firms generally prefer to avoid. The essence of accrual accounting is that assets and expenses are recorded when they accrue, determined in accordance with AICPA standards. But there is little doubt that a financial statement prepared on an accrual basis presents a more accurate snapshot of the reporting entity’s financial status as of the date of the report.

Enter a hybrid, the middle ground – neither fish nor fowl – “Modified Cash Basis Accounting.”  The modified cash basis accounting falls short of the rigors required of certified accrual statements, but provides a more accurate snapshot than the cash based system. But, it comes with a very big catch, namely it invites, to put it kindly, the exercise and abuse of both judgment and discretion, which too often allows a law firm to Photo Shop its financial statements to present an altered snapshot.

Altering Reporting of Actual Financial Performance 

For example, as Ed and Jim point out, cash based accounting means you include as income a contingent fee as income if and when collected and not a moment earlier. But under the modified cash system, some law firm managers may be tempted to juice up their reported income by recording as income a percentage of fees yet to be earned on contingent fee cases where there is a “high confidence” of success.

             Other Photo Shop opportunities available when using modified cash basis accounting:

  •  The Thirteen Month Year.  Some firms “hold their books” open and record receipts received after the last day of the year as if received on the last date of the year.
  • November and December Billing Mania.   Bill every potential item in the last two months of the year.  Bill often and bill early.
  • The Eleven Month Year.  Some firms stop paying vendors during the last month of the year.

 

  • December Discounts.  Clients are offered discounts to remit payments before year end.

 

  • WIP Prestidigitation.  Recording work in progress or some portion of WIP as income.

 

  • Aggressive Amortization of Capital Assets.  Accomplished by extending the anticipated useful life of capital assets.     

 

  • Reducing or eliminating cost reserves.

 

  • Defer start dates of laterals until after the first of the year, eliminating the “ramp up expense.”

 

  • Capitalize Partner Recruiting Expenses.

 

  • Extend useful lives on capital acquisitions.

 

  • Defer 401 (K) contributions. 

Most of the foregoing probably might not appear very unusual and you probably have seen all or most of this at your own firms. But, let’s recall something most of us too easily forget:  A financial statement is not an analysis of any law firm’s financial performance over an extended period.  It is a snapshot of a firm’s assets and liabilities on a given day, the date as of which the snapshot was taken, and that date is the last day of the firm’s fiscal year.  A financial statement is not a video or a documentary covering any extended period.  But, in understanding this snapshot, you must know how the frame was staged.

Profits Per Partner and Profits Per Equity Partner

In doing so, the reader must always bear in mind that much of what appears in many firms’ financial report is geared towards a single purpose: The ability to report on the highest possible Profits Per Partner imaginable.  Thus, where the financial statement is gussied up through creative artifices, the PPP report simply doesn’t bear sufficient relationship, if any, to reality.  The simplest example is using the modified cash basis accounting method to recognize future contingent fee income. It sometimes can really look great, even eye popping. But you can’t deposit “high confidence” of success in a contingent fee case in a bank, nor can you send it along to your landlord or mortgage lender.

The problem in large measure is that the profession as a whole has attorned to the holy grail of PPP and the need to wave that number from the rooftops, a practice we previously suggested should just come to an end.  In truth, reports of average profits per partner or average profits per equity partner are meaningless. Reported PPP and PPEP are regularly manipulated in a variety of fashions, chief among them is simply changing the status of lawyers within the firm.  Thus, an equity partner might be demoted to a non-equity role; a non equity partner will be shifted to a “counsel” role, often with little change in the compensation of the affected partner. What does change is the PPP and PPEP number. It has often been suggested that, inflated PPP numbers are necessarily reported for recruiting purposes and because all of the other kids on the block also do so. In reality, nobody jumps ship because the firm across the street has eye popping PPP numbers and no firm with eye popping PPP numbers will compensate a lateral partner materially more than the market dictates. Partner compensation is based on the lawyer’s production, productivity and practice specialty and not a firm’s reported PPP.

The simple truth is that the best single metric in the AmLaw reports for determining a law firm’s true profitability if you are going to rely on any of the information reported by AmLaw is actual revenues per lawyer, a fact too often glossed over.

We must therefore confront the world as it exists and not as we would prefer it to be.  In the thirty years during which PPP and PPEP were hyped and simultaneously criticized nobody has been able to convince the community to abandon this charade.

Determining Actual Law Firm Performance: The Essence of Required Due Diligence

Thus, as Ed and Jim suggest, when presented with a financial statement of a law firm of which you are a member, which you are considering joining or you are considering acquiring and the financial statement of that law firm is prepared on a modified cash basis, you should first require the firm’s accountants to provide a reconciliation of the modified cash basis financial statement with its cash basis statement, upon which partner K-1’s are prepared.

Don’t stop there:  do the same for the preceding two years. Then, lay them out side by side and look for, among other things, trending or sudden aberrations.

If you are considering joining a law firm as a lateral, discuss openly the firm’s policies with regard to the items identified in the bullet points above.

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.

You will also want to have a list of the firm’s 100 largest clients and the billing and payment history of these clients. You also will want to see how the firm’s business is divided among its various practice groups.   By now, you should be well aware of the alarms that should be sounding if any one client is responsible for more than 5% of a firm’s revenues.  Similarly, practice concentrations should similarly be scrutinized. Recall those firms that were virtually minting money handling structured finance; or, a couple of years before that, handling dot.coms.

An additional item you you will want to see is the compensation of partners, both equity and non-equity (assuming, of course that the firm does not keep partner compensation in a black box, which some do as a matter of policy).  By this time, assuming you are a lateral candidate, you will have an understanding of the compensation you will be receiving. You must understand how draws and distributions are paid.  In this regard, you should also compare how these payment schedules have been met during the course of the three preceding years. It is obviously of some consequence if the firm is stretching final distributions later and later in to the following year. You should determine the sources of these payments, that is, whether they are paid out of current income or are the proceeds of bank lending.

Most significantly, you should have a complete understanding of the firm’s policies with regard to partner compensation, as it is fixed from year to year.  You should gain a full understanding as to how each category of partner, finder, minder or grinder is compensated.

Let’s be sure to add to the pile the firm’s partnership agreement, any pension plans to which the firm is obligated to contribute and a schedule of payment obligations that the law firm has to retired or withdrawn partners.

Yes, all of that is a boatload of stuff. If you are already partner at the firm, you should have a file containing all of these materials. If you are considering joining the firm as a lateral, you need to have all of the materials reviewed carefully, particularly, if as is so often the case, the firm’s financial reports are prepared utilizing modified cash basis accounting.  These reports are not inherently evil or intrinsically deceptive. But they can be.

Former New York City Mayor Ed Koch famously greeted constituents with “how am I doing?”  Too few managing partners greet partners with this inquiry.  Messrs. Reeser and Hunt submit that instead, management circulates financial reports that are, in their words, “manipulated” and “a good tool put to a bad purpose” in order to deflect attention from systemic problems.  The result, report these authors,  is that the partnership too often does not know how the firm is actually doing until the day arrives when a dribble of partners begin leaving the firm and this dribble escalates in to a torrent, ultimately with the firm having no choice but to dissolve.

Ed and Jim’s advice:  partners should know how their firm is doing and shouldn’t be lulled in to a comfort zone because of a rosy looking financial statement. Most law firm leaders welcome transparency and find that the firm moves forward best when partners are both fully informed and productively engaged.

The probabilities are that you’re doing just fine, thank you.  But in this world of AmLaw 200 and NLJ 250, we all need to keep in mind that in the last 25 years, over 40 major law firms failed (three thus far this year) and the implosions of those failed firms all followed identical patterns with the dissolution votes taking place with head-spinning swiftness and affected partners then rubbing their eyes wondering “how did that happen?”.

© Jerome Kowalski May 2011.  All Rights Reserved.

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