State Supreme Court says legal matters belong to clients

SAN FRANCISCO -- The state Supreme Court weighed in on what happens to active cases when a law firm goes bankrupt, ruling Monday that defunct firms don't have a right to future profits from matters their former partners take with them to new jobs.

The case involves Heller Ehrman LLP, the San Francisco-based law firm that dissolved in 2008. Attorneys representing Heller's estate argued effectively in bankruptcy court that active cases become the property of an estate at the moment a firm becomes insolvent, meaning the firms that hire the attorneys handling those cases must share some of the profits with the estate of the firm where the matters originated.

The estate sued firms that hired those former partners, demanding payment. The firms in question were Davis Wright Tremaine LLP, Foley & Lardner LLP, Jones Day, and Orrick, Herrington & Sutcliffe LLP.

District court judges in San Francisco have disagreed with that logic in the cases of Heller and of another defunct firm, Howrey LLP.

The 9th U.S. Circuit Court of Appeals sent the Heller case to the state Supreme Court for further clarification, because bankruptcy law involves applying federal rules to property, and it's up to each state to designate what legally constitutes property.

"Under California law, a dissolved law firm has no property interest in legal matters handled on an hourly basis, and therefore, no property interest in the profits generated by its former partners' work on hourly fee matters pending at the time of the firm's dissolution," wrote Justice Mariano-Florentino Cuellar.

"The partnership has no more than an expectation that it may continue to work on such matters, and that expectation may be dashed at any time by a client's choice to remove its business," he added. Heller Ehrman LLP et al. v. Orrick, Herrington & Sutcliffe LLP, 2018 DJDAR 2052.

The case will return to the 9th Circuit for a final adjudication. Shay Dvoretzky, a partner with Jones Day who argued on behalf of the defendant firms, said the ruling leaves little wiggle room for the federal appeals court and likely spells the beginning of the end of the suit. Dvoretsky said the case will likely follow the path of two previous law firm bankruptcy cases, involving Thelen LLP and Coudert Brothers LLP, which were adjudicated under New York law.

"In those cases, once the New York Court of Appeals held there was no property interest, there was very little left for the 2nd Circuit to do," he said. "Given how narrowly, and appropriately so, the California Supreme Court defined that concept,I expect that this case will be over."

A host of firms experienced financial problems after the economy crashed in 2008 and went bankrupt, leading to novel claims about the assets they held.

These cases arose in the court of Dennis J. Montali, a respected bankruptcy judge famous in his field for untangling the unwieldy insolvency of Pacific Gas and Electric Co.

Montali had little direct precedent involving cases in which partnerships dissolved due to bankruptcy in this manner and had to dig through a variety of bankruptcy rulings involving far-flung topics, such as the estate of Anna Nicole Smith, to come to a decision.

He ruled that the moment of insolvency freezes a firm's assets and, under bankruptcy law, those include any active matters the firm was handling at the time.

Next the case went to U.S. District Judge Charles R. Breyer of the Northern District, who disagreed with Montali, explaining that this area of law is all a matter of perspective.

While a bankruptcy judge is tasked only with examining bankruptcy rules, a district judge has to determine how well those rules work in the real world, Breyer wrote.

This made it Breyer's responsibility to weigh the rights of creditors in bankruptcy proceedings against the rights of the clients who paid the lawyers to handle their legal problems. The judge ruled that cases belong to the clients, who must be able to make choices about which lawyer to use without worrying about bankruptcy laws.

The two judges then sat back to see whose perspective would ultimately win out. They actually watched together a feed of the state Supreme Court oral arguments.

Eric Shumsky, a partner with Orrick, Herrington & Sutcliffe LLP and one of the attorneys who argued on behalf of firms who hired former Heller attorneys, said he was pleased the state Supreme Court emphasized clients ultimately own their legal matters.

"The court's ruling ensures that when lawyers do switch firms, clients have complete control over who handles their matters and who gets paid for doing so," he wrote in an email.

Steven A. Hirsch, a partner with Keker, Van Nest & Peters LLP, who also represents the defendants, said a ruling for the plaintiffs would have been disastrous for clients and law firms because it would have created a set of perverse incentives. Attorneys who left a firm before it became insolvent wouldn't have to share their profits, but lawyers who left later would, he said.

Hirsch said this could actually lead to more law firm bankruptcies because attorneys would be encouraged to leave at the first sign of financial trouble.

"That means everybody rushes for the door and the firm collapses," he said.