Law Firm Bankruptcies:

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1 Law Firm Bankruptcies: Clawbacks, Partner Liabilities and Other Issues October 24, 2014 Copyright 2013 Holland & Knight LLP All Rights Reserved

2 Law Firm Bankruptcy Issues Creditors typically include: Bank lenders with or without a security interest in Accounts Receivable and other Assets Landlord(s) Equipment Lenders and Trade Vendors Clients with malpractice claims Employees Retired partners Assets typically limited to: Accounts receivable: Firm dissolution may reduce value, limit collectability Billing partner involvement key Contingent fees subject to completion of matter, valuation issues Artwork, furniture and fixtures Potentially under-market leases Causes of Action

3 Law Firm Bankruptcy Issues Timing Most valuable assets, the lawyers, walk out the door every night Significant partner departures may create a death spiral that quickly spells demise of a firm if other partners lose confidence in firm management Firm culture plays a significant role in determining whether a few departures will lead to a tidal wave and make dissolution inevitable Dissolution also may occur upon failure of merger talks with another firm Unfunded pension obligations may create tension between current and retired partners, so that current partners feel less invested in the firm Pre-bankruptcy planning typically very limited: Rights of partners vis a vis each other and the firm are governed by a Partnership Agreement, applicable state partnership/entity law, state ethical rules and fiduciary obligations Wind-down process may occur in or out of formal bankruptcy proceedings Partners must appoint someone to lead the wind-down process Vote to dissolve the firm does not immediately terminate the partnership Does Partnership Agreement have a Jewel Waiver and if so, when was it added?

4 Partner Liabilities Traditionally law firms were general partnerships General partners are liable for the debts of the partnership Creditors could look to assets of individual partners Law Firms today usually are organized as LLCs or LLPs Use of entity form to limit individual partner liability to the value of his/her capital Treated as a pass through for tax purposes Two tier partnerships increasingly common Are partners employees or owners? Or both? Capital Contributions often funded with bank loans Partners may still have obligations under real estate or other leases or as guarantors of firm credit lines Equity partners may be obligated to indemnify contract partners for debts owed to third parties Are contract partners subject to claw back or other claims?

5 Individual Partner Liability Claims and Losses Contractual claims for: Over distributions during current and/or prior years Loans, taxes and other advances made by the firm Unpaid capital Interest paid on capital Avoidance claims Fraudulent conveyances Preferences Breach of fiduciary duty claims Cancellation of Law Firm s Indebtedness may result in phantom income and significant tax liability Obligations to repay capital contribution loans despite loss of capital Unfinished business

6 Partner Claims Issues Choice of Law Partnership Agreement may govern on contractual claims Avoidance claims not governed by Partnership Agreement choice of law provision Application of governing law clause to bankruptcy trustee What law applies to unfinished business claims against new law firms/mediate transferees? Setoffs and Counterclaims Potentially subject to subordination under section 510(b) Salary/contract claims may be treated as equity distributions Not applicable to Avoidance Claims Reasonably Equivalent Value Timing of Insolvency or Unreasonably Small Capital Fraudulent inducement Typically raised by recent hires Arbitration

7 Partner Contribution Plans Partners pay in to fund recovery for creditors Payments based on each partners distributions, claims that estate could assert and reduced by any amounts owed, risk of recovery Coudert bottom up model Dewey fast track top down model Plan releases cover claims arising out of liability among partners and to creditors of firm Sufficiency of the plan release/injunction Plan release will not cover creditors direct claims against the partner Dewey landlord Capital loans Other guarantees Requirement /incentive to partners who agree to assist with collection of account receivable Failure to participate in Plan may result in greater liability down the road

8 Bankruptcy Issues Personnel and client matters Potential WARN Act claims if sufficient notice not given to employees Retention of certain personnel may be necessary for A/R collection, reconciliation of accounts Obligation to pursue collection of outstanding A/R may interfere with work at new firm Client relationships Files must be transferred but what if A/R still outstanding? Old files must be transferred or disposed of Timing for discussions with clients/staff Clients may withhold outstanding amounts as a set off against fees and costs associated with moving matter to new firm Malpractice claims resulting from dissolution of firm, filing deadlines or other issues falling through the cracks Insurance coverage and tail policies

9 Avoiding Pitfalls Partners and firms should have full discussion about potential claims that could be asserted by the partner s prior firm New firm should support partner s obligation to help collect receivables owed to prior firm, and partner should encourage clients to pay outstanding bills Contemporaneous, expert valuations of any assets (A/R, WIP, Leases) purchased by new firm may be helpful in defending later fraudulent conveyance claims Firms should close all unfinished matters brought over from the old firm as soon as they are complete and should not use client general billing numbers when invoicing for such matters Candidate should keep good records of all financial dealings with firm Deferred compensation arrangements should be documented and if possible, set forth in a note from the prior firm to the candidate Partners should be aware of any firm liabilities for which he or she may be liable and if possible obtain a release upon departing the firm Jewel Waivers are enforceable and will protect against future unfinished business claims if entered into when a firm is solvent