With the unfinished business rule, breaking up is hard to do

Should partners from a dissolving firm be obligated to pay the dissolved firm's creditors from profits earned on work performed after they leave the dissolved law firm and join a new law firm? Claiming a right under the "unfinished business rule," bankruptcy trustees for dissolved firms have pursued unfinished business litigation against departing partners and their new firms, seeking to claw back post-dissolution profits as an asset of the dissolved firm's bankruptcy estate.

The issue stems from a 1984 California case, Jewel v. Boxer, 156 Cal. App. 3d 171, which held that when a lawyer moves from a failing firm to a new firm, the new firm must pay the failed firm any profits on unfinished business taken to the new firm. The rule was based on longstanding partnership law stating that when a partnership dissolves, the former partners are responsible for winding up the business of the partnership for the benefit of the partnership. In the post-Jewel years, some firms attempted to avoid the Jewel result by the usage of clauses in the partnership agreements waiving the unfinished business rule - a so-called "Jewel waiver." Bankruptcy trustees have successfully challenged many of those waivers as fraudulent transfers. Thus, lawyers leaving dissolving firms, and the firms that hire them, have operated under a cloud of uncertainty. It appears the uncertainty may finally be heading towards resolution. On June 11, in Heller Ehrman v. Davis, Wright, Tremaine, 2014 WL 2609743 (N.D. Cal.), the Heller bankruptcy trustee brought unfinished business litigation against third-party law firms who had hired former Heller partners and took on former Heller client matters. U.S. District Judge Charles Breyer granted summary judgment in favor of the defendant firms.

Framing the question as one of first impression, Breyer asked "whether a law firm - which has been dissolved by virtue of creditors terminating their financial support, thus rendering it impossible to continue to provide legal services in ongoing matters - is entitled to assert a property interest in hourly fee matters pending at the time of its dissolution." In emphatically answering the question in the negative, Breyer stated that "neither law, equity, nor policy recognizes a law firm's property interest in hourly fee matters." Breyer first noted Jewel to be inapplicable under the facts, and then that no state Supreme Court decision supported such a result. He further noted that he believed the state Supreme Court would hold hourly fee matters were not partnership property, and therefore, not "unfinished business" subject to a duty to account. Second, Breyer observed that the equities favored the third-party law firms who earned the compensation paid to them, over the dissolved Heller, who had been already paid in full for its services. And third, public policy favored the primary right of clients over lawyers, and it was essential to provide a market for legal services unencumbered by claims of disgruntled attorneys and their creditors.

In reaching his holding, Breyer noted five distinguishing factors rendering Jewel inapplicable. First, the Jewel dissolution was voluntary, while Heller's was involuntary, after its bank withdrew its line of credit. This was significant because the Jewel partners could have, but chose not to, finished representing the clients for the old firm. The Heller lawyers had no such choice.

Second, in Jewel, the new firms represented the clients under fee agreements entered into between the clients and the old firm. In Heller, all clients signed new fee agreements with the new firms.

Third, in Jewel, the new firms consisted entirely of partners from the old firm, each of whom owed fiduciary duties to each other and the old firm; in Heller, all defendant law firms were existing third-party firms providing substantively new representation well beyond the capacity of the dissolved Heller or its shareholders. These third-party firms owed no fiduciary duty to the dissolved Heller.

Fourth, Jewel treated hourly and contingency matters as indisguishable; in Heller, no contingency fees were at issue.

Finally, Jewel was decided in 1984, and applied the Uniform Partnership Act (UPA), which was materially different from the Revised Uniform Partnership Act (RUPA) which has since superseded the UPA in California. RUPA permits partners to obtain reasonable compensation for helping to windup partnership business, which undermines the legal foundation upon which Jewel rests. RUPA's duty not to compete does not extend to winding up a business, and a partner is free to compete immediately upon an event of dissolution. No RUPA provision gives the dissolved firm a right to demand an accounting for profits earned by its former partner.

Turning to the equities, Breyer was emphatic: "A law firm never owns its client matters. The client always owns the matter, and the most the law firm can be said to have is an expectation of future business."

Finally, addressing policy, Breyer rejected the trustee's arguments. Public policy "cannot favor" an outcome where Heller's estate is entitled to a share of profits earned on litigation long after Heller ceased to function, into the indefinite future. Further, the trustee's rule would incentivize partners of struggling firms to jump ship at the first sign of trouble to avoid unfinished business suits - even if such acts would destabilize an otherwise viable firm. Finally, such a rule would discourage third-party firms from hiring former partners of dissolved firms, and discourage them from accepting new clients formerly represented by dissolved firms. It is not in public interest to make it difficult for partners from struggling firms to find new employment - or to limit the choices a client has available by establishing a rule that prevents third-party firms from earning a profit off the investment they make in taking on a matter formerly handled by the dissolved firm.

Less than one month later, on July 1, New York's highest court reached a similar conclusion, upon request from the 2nd U.S. Circuit Court of Appeals for guidance on New York law. Matter of Thelen, No. 136; Matter of Coudert Brothers LLP, No. 137, 2014 WL 2931526. Like Breyer, the New York court rejected the unfinished business rule, holding it does not apply to law firms. The court held a firm's attorney-client relationship, whether contingency or hourly, is not firm "property" under New York law - clients have the "unqualified right to terminate the attorney-client relationship at any time" with obligation only to compensate attorneys for completed services. Thus, clients control the attorney-client relationship. Further, lawyers should be free to move from firm to firm without unwarranted financial restrictions. Thelen and Coudert now return to the 2nd Circuit for a final ruling. While it is likely we will see an appeal of Breyer's ruling to the 9th U.S. Circuit Court of Appeals, with dual decisions now bracketing the nation, industry watchers are hopeful that the 9th Circuit will not reverse Breyer, and bring much needed certainty to this area of the law.