By Paul L. Warner
Category: Business Organizations
Most lawyers are not very good businesspeople, especially when it comes to their own legal affairs. An informal survey of 30 to 40 small- and medium-size Cali-fornia law firms indicates that fewer than half of them have any sort of written agreement and, therefore, rely on statutory or common law to govern their affairs. The Revised Uniform Partnership Act of 1994 (Corp C §§16100 et seq.) allows attorneys to deviate from its default provisions by written agreement, and in the case of a professional corporation, a buyout agreement is required by State Bar Law Corporation rule IV(C)(2) (see www.calbar.org/2cer/lawcorp/rules.htm). Although lawyers would never let their clients operate without some kind of written agreement, they seem never to get around to taking care of business at home. This can be a big mistake, especially if there is a change in partners (shareholders) or if the firm reorganizes or dissolves.
Limited Liability Partnerships (LLPs)
Since the advent of limited liability partnerships in 1995, most law firms that were common law partnerships have converted to LLPs, which substantially have all the advantages of a partnership (ease of distribution of profits, no double taxation, flexibility of structure) and yet provide qualified protection of individual assets. Partnership assets, including undistributed profits and capital, are subject to claims by creditors, although the partners' nonpartnership assets generally are not. Corp C §17101(a). If a partner is sued individually for malpractice, only that partner can be personally liable. The same rule applies to shareholders in a professional corporation. Corp C §17101(b). Changes in the tax laws (which used to allow much more liberal pension contributions for professional corporations) have eliminated the principal advantage for law corporations. Unless there are special circumstances, California attorneys in common law partnerships are well advised to form LLPs to practice law.
Division of profits is not usually a problem when a law firm is formed; the partners must resolve this issue before commencing business. But without a written agreement or formula, there is often no mechanism either to change the split of profits or to set the profit share of a newly admitted partner. The default arrangement is equal shares. Corp C §16401(b). Without a written agreement, such decisions are made by majority vote of the partners. Corp C §16401(j). The same result follows in professional corporations since each shareholder is a director with one vote. Corp C §13406.
A written agreement might change the voting structure, giving more votes to someone with a larger profit percentage or requiring a supermajority for certain decisions. And the written agreement can establish formulas to adjust profit percentages in the future and to determine a new partner's profit share.
The addition of a new partner or shareholder can present difficult questions regarding a buy-in, or capital contribution. In most small firms, a newly added partner or shareholder immediately becomes an equity partner or shareholder and has a true ownership interest in the firm. But absent a prior agreement, there is no easy way to determine how much the buy-in should be. Some firms take the position that the issue can be dealt with when it comes time to add a partner. But in fact, coming up with a uniform approach to the capital structure of a firm is usually advisable. For one thing, the partner you are recruiting will surely ask, as will the associate who is coming up in the ranks. Deciding this issue in advance will prevent a partner from trying to discourage a potential partner addition by making the financial terms unattractive.
Other governance issues that are best addressed in advance are the extent to which partners or shareholders will be required to guarantee firm obligations and the circumstances under which the partnership or corporation can require additional capital to be contributed. Most firms operate with some kind of line of credit, to smooth the bumps in cyclical collections. Firms should decide in advance whether they will have such a line of credit, or instead have capital calls when necessary. A formula should be established to govern what happens to a partner's share of the profits when he or she fails to meet a capital call. And smaller firms are routinely asked to guarantee bank loans and leases. A well-drafted partnership agreement will require all partners to do so when the vendor requires a guarantee.
By default, an issue in the ordinary course of partnership business is resolved by a majority decision, whereas an act outside the ordinary course of business requires a unanimous decision. Corp C §16401(j). Most firms that have a written agreement permit the entry of new partners with a supermajority vote. Without an agreement, new partners may only be admitted on unanimous vote of the partners. Corp C §16401(i). This may be advisable for small firms (five partners or fewer), but do you really intend that the junior partner recently added to your partnership have a veto over admitting any new partners thereafter? Similar issues arise should the partnership wish to expel a partner. Without an agreement, a partner can be expelled, or disassociated, only on unanimous vote, and only if certain conditions are met. Corp C §16601(4). Most firms, if they consider the issue, will require a supermajority and not require any showing of good cause. Unanimous or majority vote is not always the correct choice.
Approval of financial affairs is another issue that should be addressed in a well-drafted law firm agreement. The principals usually put a limit on the amount any partner (or the managing partner) can spend on any one item without majority approval; and the agreement will define how many signatures are required on checks (usually two if over a certain amount).
A related issue that should be addressed in the firm's agreement is the kind of cases that can be accepted. Most firms that bill on a fee-for-service basis have a written rule, or at least an understanding, that the originating partner vouches for (but probably does not guarantee) the creditworthiness of the incoming client. But absent a written agreement, any partner could take on any case, even a contingent fee case that might expose the firm to a substantial expenditure of time and expense. Similarly, absent an agreement, any partner could bind the partnership to an executory contract such as a lease or a loan, although a savvy landlord or bank will usually require more than one signature.
Death and Disability
Under the Revised Uniform Partnership Act, the death of a partner, or appointment of a conservator, automatically causes his or her disassociation (the equivalent of a voluntary withdrawal) from the partnership. Corp C §16601(7)(A). If there is no buyout formula, difficult valuation issues might have to be litigated in a probate context, with a spouse who may not be familiar with the business. A written partnership agreement can define the rights of the estate of the deceased partner and the right of the firm to continue to use the deceased partner's name, which may be very valuable.
Moreover, the process of drafting a written partnership agreement will force the partners to consider whether they should fund the buyout of a deceased partner's share with life insurance. Ironically, the smaller the partnership or corporation, the less likely that there will be a written agreement and the more the surviving partners should consider life insurance to fund a buyout. This follows because it is much more difficult to fund the buyout of one-half or one-third of a partnership than it is to fund the buyout of one-tenth.
Disability issues can also cause friction in a small partnership. Though it is conceivable that the firm might wish to command a malingering partner to return to work, more usually the other partners face a difficult time convincing the disabled partner that he or she should not work. No one, after all, wants to force a judicial determination that a partner has become incapable of performing his or her duties, which is a "disassociation" event under Corporations Code section 16601(7)(C). The agreement should define disability and require the appointment of disinterested physicians to determine the issue.
A written agreement will also define the firm's obligations to the disabled partner. For example, it might make sense to purchase group disability insurance with a 180-day waiting period and provide that the disabled partner receive his or her draw during the waiting period. The mere drafting of the agreement forces the partners to at least consider buying insurance.
Serious problems can arise when a law firm needs to reorganize or dissolve. Often this occurs when the firm is in financial trouble, and, without a written agreement, the results can be unsatisfactory to everyone.
In a partnership there is a legal distinction between a partner's withdrawal as opposed to dissolution of the firm. Withdrawal means the partnership continues and the withdrawing partner is cashed out; dissolution means that the entire partnership ceases business and proceeds to conclude its business with a wind-down phase. Corp C §16802(a). A well-drafted partnership agreement will prevent a single partner from dissolving and set a formula for payment of interest in the firm.
Partners or shareholders often require notice (anywhere from 30 days to the end of the pending fiscal year) before withdrawal becomes effective. Without a written agreement, no notice is required, and the first to leave can choose withdrawal or dissolution based on his or her own financial self-interest. One common issue is the partner who is first to decide to leave and withdraws and claims his or her partnership share as a priority. The remaining partners are simply stuck with extra overhead and a loss of income. A well-drafted agreement gives the remaining partners the option to dissolve the partnership within a certain time frame. If the firm is dissolved, the attempted withdrawal becomes a nullity. See Corp C §§16601(6), 16801(1).
Professional corporations have different issues. A buyout agreement is required by State Bar Law Corporation Rule IV(C)(2), whether contained in the articles of incorporation, the bylaws, or some other agreement. It is arguable that the failure to have the buyout agreement required by State Bar rules makes the corporation illegal and is grounds for dissolution, but no case has decided this issue. Without an agreement, there is no mechanism for a shareholder to cash out of a professional corporation, unless either the shareholders agree after the fact to the buyout or the corporation dissolves.
The Corporations Code requires a majority of shareholders or directors to dissolve (Corp C §1800(a)(1)), which means that technically one-third of the shareholders cannot cause a dissolution. However, the Corporations Code permits one-third of the shareholders to dissolve the corporation if those in control of the corporation have engaged in fraud, mismanagement, abuse of authority, or persistent unfairness toward any of its shareholders, and does not count the shares of the shareholders who are committing the wrongful acts. Corp C §1800(b)(4). But this kind of litigation and proof is not advisable for a firm in distress.
Another issue that is difficult to resolve after the fact is the valuation of physical assets. Although law firms are not as capital intensive as heavy industry, lawyers usually have a substantial investment in furniture, fixtures, computers, office equipment, and legal texts and software. Without a written agreement, a court is likely to use fair market value in a dissolution.
There are three ways to value every asset: (a) liquidation value, which can approach zero, especially for large, hard-to-move items; (b) book value, which is cost minus depreciation; and (c) replacement cost, which is often more than the original cost. One fair way to proceed is to allow the partners to bid on items they wish to retain. Although a court might order this anyway, it is far better to address this issue in the law firm agreement than to leave it for argument later.
The most significant issue that arises in law firm dissolutions is how to value a departing partner's share when there is no agreement. The courts have held that, for both partnerships and professional corporations, the unfinished business of the firm (which is all lawsuits in progress and all uncompleted transactional matters) belongs to the firm and must be completed by the partners or shareholders on behalf of the firm without additional compensation to the partner or shareholder. Instead, the partner or shareholder gets his or her usual share of the profits of the partnership or corporation in the dissolution process. Jewel v Boxer (1984) 156 CA3d 171 (partnership); Fox v Abrams (1985) 163 CA3d 610 (law corporation).
However, these cases also recognize that the expense of completing unfinished business (both costs and presumably the cost of the time of other nonpartners) is chargeable to the partnership. There is a default provision for reasonable compensation for some services rendered winding up the partnership. Corp C §16401(h). And if any partner does not perform a fair share of the work to conclude the partnership's cases, that partner has breached a fiduciary duty to the other partners. Jewel, 156 CA3d at 178-79.
Though these rules have a certain logic to them, in practice the rules are difficult to apply, and the results rarely meet the expectations of the attorneys. Most attorneys are shocked to learn that they must essentially work for nothing to complete old firm matters. A partner has an incentive for associates to complete cases, since that expense is chargeable to the dissolved partnership. Some partners may be rainmakers only and unable to conclude cases or matters. Indeed, Jewel and Fox acknowledge how difficult the rules are to apply, and chastise any lawyer who does not provide for a more logical result in a written agreement. See Jewel, 156 CA3d at 180.
Note that the agreement should contemplate buyout claims by either the abandoned partners or the partners who leave. See Fox, 163 CA3d at 615. After all, it is not unheard of for departing partners to take important clients with them. See, e.g., Dickson, Carlson & Campillo v Pole (2000) 83 CA4th 436.
A related issue is the timing of payments to a departing partner. Without an agreement, a withdrawing partner can immediately demand his or her capital account and undistributed profits. In practice, a departing partner often takes cases and associates with him and can cause an increased share of overhead for the remaining partners. For this reason, it is prudent to give the firm flexibility on how soon a departing partner is paid the buyout price, which can be tied to firm cash flow.
Covenants Not To Compete
A final issue that can only be addressed in a written agreement is a covenant not to compete if a partner or shareholder withdraws. Such covenants, although generally disfavored under California law (Bus & P C §16600), are permissible if the departing partner is bought out and the covenant is reasonable in duration and scope. Bus & P C §16602. There may be difficulties in interstate enforcement. See Bennett v Medtronic, Inc., (2002) 285 F3d 801. Often partnerships or corporations will have a different formula for buyout depending on whether the partner really retires or simply moves on to another practice.
No one-size-fits-all formula fits the difficult issues that confront law firms. The age and experience of the partners, the relative sizes of their practices, their role in the firm, and the mix of fee-for-service or contingency work all affect what should be in a partnership or corporate agreement. But simply relying on common law is almost always a mistake.
Paul L. Warner chairs the litigation department at Jeffer, Mangels, Butler and Marmaro in San Francisco. He specializes in corporate and partnership disputes, and securities fraud and consumer fraud class actions.
Article updated: January 2004