Publication

 LAW FIRM COMPENSATION TO DEPARTING LAWYERS

By Don P. Foster

Don P. Foster, Esq. is a Principal at Offit Kurman (which he recently joined as a lateral from another Philadelphia firm.)  He has represented both attorneys and firms in matters related to departures, dissolutions, and related compensation.

This Article addresses two catalysts for disputes between a lawyer departing a law firm, and the firm: First, to what compensation, if any, is the withdrawing partner entitled for his contribution to firm revenues during the fiscal year in which he announces his departure; and, second, what financial penalty, if any, may a law firm enforce to prevent migration of lawyers out of the firm.   

Withdrawing partner compensation

 

If a partner withdraws from a law firm during or at the end of a fiscal year in which his contributions to firm revenues is such that he would be entitled to additional compensation beyond what he has paid up to the point of withdrawal, is that partner entitled to additional compensation by the firm commensurate to what he would have been paid had he not withdrawn”  In Pennsylvania, the answer to this question is not clear cut.

A typical compensation model in law firms is that the firm sets a budget at the beginning of each year based upon projected fee revenue.  Those projections assume different contributions to revenue by different partners.  A draw for each partner is set.  Some firms set the same draw for every partner with variations in contributions to revenue being rewarded at bonus time.  Other firms adjust for different levels of contributions to revenues by setting different levels of draw.

Once the books are closed at the end of a fiscal year, the firm accounts for annual revenue and decides what to pay partners above and beyond their accumulated draw during the year, if anything.  Some firms do this by formula.  Other firms apply metrics that are important to that firm, and decide on partners’ total annual compensation.  The bonus is the net between total draw and total compensation. 

The decision on total compensation is typically made early the following fiscal year, typically in January if the fiscal year is the calendar year. Some firms pay the bonus immediately in one lump sum.  Others pay it out incrementally over the first quarter.

The timing of the payment of the bonus could affect the timing of the withdrawing attorney’s notice of withdrawal to the firm.  Unless there is specific language in the partnership agreement to the contrary, law firms will typically take the position that bonuses are discretionary, and that an attorney who withdraws before bonuses are announced or paid forfeits any right to that bonus.

There is therefore a strong financial incentive for the partner contemplating departure to delay notifying the firm of his departure until after the bonus has been paid.  If the partner has decided to leave and is just hanging on for the bonus he likely is not going to be motivated to work as hard as he can during the time it takes the firm to pay the bonus.  He does not want to create an asset for the old firm, i.e. a large receivable account.  Client services also may suffer.

However, this financial incentive to violate duties to firm and client would not exist if the rule of partner compensation was that the firm has a fiduciary obligation to the departing partner to treat him fairly and equitably relative to the remaining partners for his performance while he was a partner in the firm.  What is “fair” and what is “equitable” could take into account the fact that the departed partner is no longer part of the team, as well as the fact that the firm may wish to provide remaining partners with an extra dividend by not leaving themselves, but to declare a bonus entirely forfeit as punishment for departing would, arguably,  not be fair and equitable, and would vest in the departed partner the right to claim that his old firm breached fiduciary duties and implied covenants of good faith and fair dealing by not treating him equitably relative to its treatment of the other partners in the firm.

There is not a great deal of law on the subject.  Those courts which have addressed the issue have concluded that there is a fiduciary duty to treat the withdrawing partner equitably in relation to the compensation paid remaining partners, despite the fact of withdrawal. (See, e.g., Starr v. Fordham, a  1995 Supreme Judicial Court of Massachusetts case holding that remaining partners in a law firm undercompensated a withdrawing partner relative to what he would have earned had he not withdrawn, and relative to the financial performances of the remaining partners; and that the firm and its partners were guilty of self-dealing and breached fiduciary obligations to the withdrawing attorney); (see also, Smith v. Brown and Jones, a 1995 New York Supreme Court opinion holding that a law firm that undercompensated a withdrawing partner relative to the compensation paid to remaining partners by applying different compensation criteria to the withdrawing partner, breached implied covenants of good faith and fair dealing, engaged in self-dealing and violated  duty of undivided and undiluted loyalty to withdrawn partner);  (see also Roan v. Keck, Mahina Cate, a 1992 7th U.S. Circuit Court of Appeals case where the court held that a firm owes fiduciary obligations to a withdrawing partner, but if the partnership agreement has specific provisions dealing with the disputed issue, and the firm follows the procedures spelled out in the agreement, then the fiduciary duty has probably been met.)

There does not appear to be a Pennsylvania case on point.  A Philadelphia Common Pleas court held in the 2001 case Poeta v. Jaffe that the fiduciary obligations of law firms and its partners to departing partners cease post-departure.  The court sustained preliminary objections to a complaint that alleged that post-departure conduct of firm partners violated on-going fiduciary obligations, and directed that an amended complaint be filed.  Subsequently, preliminary objections to an amended complaint that sought an accounting of firm assets while the law firm was in the process of dissolution were over-ruled.

The decisions in Poeta do not shed light on the state of Pennsylvania law on whether post-departure firm conduct (decision to not pay) relating back to a time when the departed  partner was a partner violates a fiduciary duty to that partner.  In the first Poeta decision, the parties apparently agreed on the general proposition that fiduciary duties inter se between departing attorney and firm cease upon departure.  The trial court cited to a Washington case for the general proposition that the fiduciary duties of a partner cease upon departure, Finkelstein v. Security Props Inc. However, Finkelstein addressed a claim by a former partner that involved the ongoing operations of the firm post-departure.  It did not address a claim for an accounting and equitable distribution of firm profits earned while the departed partner was a member of the firm.

                            

Restrictive covenants and financial penalties

   

The prevailing rule is that any restriction in a partnership agreement upon a departing lawyer’s right to practice law, or a client’s right to select an attorney of its choosing, is contrary to public policy and the rules of ethics.  Therefore, any restriction on a departing attorney’s ability to practice in a particular locale, or within a defined radius of the old firm or to contact clients of the firm after departure violates Rule 5.6 of the Code of Professional Responsibility and is unenforceable.

However, the restrictions can sometime be subtle.  Partnership agreements frequently contain some sort of financial disincentive to leaving the firm voluntarily.  Examples include paying the old firm a percentage of all fees paid by firm clients over a defined period of time; reducing post-departure payments to a departing partner if he joins a firm that the former firm considers a competitor; or delaying the payout of capital if the partner engages in the practice of law in the vicinity of the old firm.

                  Rule 5.6 provides in pertinent part that:

                         A lawyer shall not participate in offering or making:

                       

(a)  a partnership, shareholders, operating, employment, or other similar type of agreement that restricts the right of a lawyer to practice after termination of the relationship, except an agreement concerning benefits upon retirement or an agreement for the sale of a law practice consistent with Rule1.17.. . . .

This rule has been construed by the majority of courts and ethics committees to make it unethical to financially penalize a partner for withdrawing from a law firm.  The rationale is that such a penalty restricts competitive activity between attorneys and hinders clients’ unrestricted access to attorneys of their choosing.  [citations deleted]

At least two decisions have gone the other way, however, and have found  limitations on post-withdrawal, non-retirement, benefits to be enforceable against partners who withdraw from a law firm and compete with it.

In its 1993 opinion in Howard v. Babcock, the California Supreme Court enforced a provision in a partnership agreement that limited departing partners’ post-withdrawal benefits to return of their capital.  Any interest in work in progress or accounts receivables was forfeited. The court held that the rules of ethics did not create substantive legal rights and that the contract provision protected a valuable interest of the firm.

The reasoning and rationale of Howard was adopted by the Pennsylvania Superior Court in the 2002 case Capozzi v. Latsha & Capozzi, which addressed an oral agreement that limited a departing shareholder’s post-withdrawal entitlements to the value of his stock in the professional corporation.  The oral agreement also set that value as the amount of actual paid in capital.

The Superior Court held that employment law generally, and the law of restrictive covenants in particular, governed the analysis—not the rules of ethics.  It found that the firm had a legitimate business interest in limiting a withdrawing shareholder’s post-withdrawal benefits–that interest being to protect the financial wherewithal of the firm by limiting post-withdrawal payments of firm revenues to a competitor.  However, it found that the limitations on the value of the departing shareholder’s shares of stock to be unreasonable, and that  the absence of a temporal or geographic limit on the non-compete rendered that provision unenforceable as a matter of a law.

Capozzi remains good law in Pennsylvania.  Whether its holding that a contract forfeiture of payments by the firm to the withdrawing partner post-withdrawal is enforceable applies also to clauses calling for payment by the withdrawing partner to the firm out of fees earned post-withdrawal remains to be seen. 

In conclusion, the law relating to post-withdrawal compensation and to enforcement of financial penalties for withdrawal remain unsettled in Pennsylvania, regardless of what the underlying contract documents might say.  Departing attorneys should read their partnership agreement carefully and consider the ramifications of the timing of the announcement of their departure from the old firm.

Don Foster is a principal  in the Philadelphia  office of Offit Kurman, P.A.  He practices in the areas of complex business and commercial litigation, including compensation issues related to partner disputes, law firm dissolutions, and departures. He received his B.A. degree, cum laude, from the University of North Carolina and his J.D. degree from Dickinson School of Law. He lectures for the Dickinson School of Law Trial Advocacy Workshop, the National Business Institute and the Philadelphia Bar Education Center. Mr. Foster is a member of the Board of Directors of Highmark, Blue Cross/Blue Shield, and a member of the Philadelphia, Pennsylvania and American Bar Associations and the Philadelphia, Pennsylvania and American Trial Lawyers Associations.

If you are interested in contacting Mr. Foster, he may be reached by phone at (267) 338-1357 or via his e-mail address: dfoster@offitkurman.com.

Reprinted with permission from the March 6, 2012 edition of the Legal Intelligencer and Pennsylvania Law Weekly © 2012 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877-257-3382, reprints@alm.com or visit www.almreprints.com