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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.

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Difficult Times Sometimes Create Desperate People Who Do Desperate Things: Loss Prevention in Handling Client Escrow Funds


Atla Escrow

Image by Thomas Hawk via Flickr

Jerome Kowalski

Kowalski & Associates

January, 2012

My copy of the Model Code of Professional Responsibility runs to some 500 pages, with sundry commentaries.  The Code plumbs virtually aspect of a practicing law and details that which can be done by lawyers and that which may not. One relatively brief section deals with lawyers handling of client funds held in the law firm’s escrow account, sometimes called “Escrow Accounts,” “Special Accounts,” “Trust Accounts” or “IOLTA (Interest on Lawyers Trust Accounts – but this one is a long and irrelevant boring story).   Cut to the quick, the Model Rules say just three things:  (1) Don’t co-mingle these funds with any other account; (2) deal with these funds exactly as instructed by the client and affected parties, as detailed in an appropriate escrow agreement and (3) if you even think about screwing around with these rules, you’re gonna fry.

In New York City, the Departmental Disciplinary Committee, the judicial authority having authority over lawyers’ compliance with applicable rules, investigates thousands of complaints filed against lawyers for all sorts of alleged violations of the applicable rules.  Yet, perhaps 80% of all suspensions and disbarments result from either defalcations or co-mingling of client funds. Here, justice is swift and certain. The Committee has long had a zero tolerance policy with regard to any impropriety concerning client funds, a view held by all governing bodies. Suspension or disbarment is the only result.

These facts are well known to all practitioners and may even strike some as a hackneyed topic. But recent reports of significant defalcations by a former counsel at a BigLaw firm of what may be as much as $20,000,000 and in another instance of the chair of a global law firm’s Asian gaming group having allegedly slipped out some $2,000,000 from client escrow funds to allegedly cover his own gambling losses suggest that this topic requires  careful review.  Indeed in year-end reviews by several of our law firm clients, prompted by the recent tawdry headlines, controls over client escrow funds were studied and found to be lacking. There have also been a recent spate of unsubstantiated rumors concerning of escrow account improprieties that are, simply put, more than troubling.

Some law firms dispense with the entire issue by simply eschewing, as a general rule, the maintenance of any escrow accounts. Where funds are required to be escrowed, these firms advise the retention of an independent trust company, bank, title company or where permitted, a duly licensed escrow agent.  However, often, local custom and usage requires law firms to maintain escrow accounts, which are fraught with peril, if not subject to stringent controls by the law firm. These controls should be described in writing and the firm’s policies regarding client funds should be in writing and part of its employee  handbook.  These rules should also be part of every new lawyer’s orientation session as he or she arrives at the law firm.

The required controls begin with the commencement of the client relationship. Every engagement letter must contain a disclosure regarding the law firm’s escrow policies. The letter should describe the firm’s policies concerning escrowed funds and, particularly, the requirement that all funds released from escrow require two partner signatures. Funds released by wire transfer require a separate email confirmation from a law firm partner to the escrowee.  The engagement letter should require the client to report any departure from these rules to the firm’s managing partner. The need for the double signature and reporting is best demonstrated by the fact that in one of the recently reported instances of trust fund defalcation, a counsel of a national law firm is reported to have taken a check drawn payable to his law firm, as escrow agent, walked across the street and simply opened an account in the firm’s name, making himself the sole signatory, without the bank requiring any certification from any partner at the law firm.

The law firm should not allow the deposit of any escrow funds without an accompanying escrow agreement. Thus, the firm should have a tightly drafted model form of escrow agreement, with appropriate exculpatory language, from which there should be no material departure, except upon written consent from department head, an office head or an executive committee member.  Each such agreement should also require the signature of such a member of management. When funds are deposited in to the escrow agreement, the requested deposit should only be permitted to be made to the accounting department of the escrow agreement, the underlying agreement, stipulation or other instrument giving rise to the creation of the escrow, as well as a memo (or standard form) from the responsible lawyer describing underlying transaction and the conditions precedent for the ultimate release of the escrow. This initiating memo should also include the client’s contact information. The memo form should be countersigned by a member of management. A member of the accounting department should examine the entire submission for regularity and completeness.  Any departure from the firm’s escrow policies must be reported in writing by the escrow clerk to the responsible lawyer, as well as to a member of management (optimally, if the firm has an in-house general counsel, the mater should be addressed to him or her), even if the departure seems to be only clerical or ministerial.

When funds are mature and are required to be released, the responsible lawyer should prepare a new memo (or standard form), describing the transaction should be prepared by the responsible lawyer and countersigned by two partners with management responsibilities, such as an office head, department chair or member of the executive committee. The submission should again include the underlying escrow agreement and governing instrument. Again, the escrow clerk should examine the entire submission for completeness and be obligated to report in writing any irregularities to each of the lawyers who have already put their fingerprints on the escrow arrangement as well as general counsel or a designated separate member of management. As I mentioned above, all checks drawn on the escrow account should require the signature of two partners, neither one of which is directly involved with the matter.  If a wire transfer is required, the clerk should send a confirmatory email to the client, using the email address originally provided at the time of the original submission.

Where law firms sometimes screw up is in connection with smaller branch offices, at which smaller support staffs and reduced lawyer headcounts often breeds shortcuts, for the sake of expediency. The fact is that far greater scrutiny is essential for smaller branch offices, which often takes on a degree of laxness and informality, primarily because of the greater sense of intimacy such smaller offices promote. In the age of the Internet, emails and paperless offices, there is no excuse for departing from the required controls. There simply must be zero tolerance for any departure from these controls. After all, bar associations and other governing bodies have none.

The law firm’s general counsel, chief financial officer and its chief risk manager should be responsible for regularly monitoring activities in the firm’s escrow accounts and its escrow clerical staff. As much as law firms are allergic to certified financial audits, the law firm’s outside accounting firm should be required to annually audit its escrow funds and provide written certification that all controls are in place and there is full compliance with the firm’s stated policies.

Finally, as too few lawyers realize, defalcations from escrow funds are not covered by a law firm’s malpractice policies. A separate fiduciary policy is required. Insurance carriers tend to be rather chintzy on these policies, often limiting coverage to $5,000,000. That may be far too low, if your firm’s escrow balances or individual escrow accounts exceed that amount.  You should explore increased coverage or excess coverage with your insurance adviser. And, finally, always be prepared for the public relations hailstorm that will assuredly ensue if you are indeed the victim of a nefarious lawyer with your firm.

© Jerome Kowalski, January, 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.

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