Vol. 78, No. 5, May
2005
Saying Goodbye: Compensating Departing Law Firm Partners
Most courts have held that financial disincentive provisions in law
firm partnership agreements are invalid, because they restrict
competition. A few courts have decided the other way. These provisions
have been the subject of increasing litigation nationwide, but Wisconsin
appellate courts have yet to weigh in.
by Dean P. Laing
any law firms in Wisconsin and elsewhere have partnership
agreements1 that provide that a departing
partner's deferred compensation or equity interest will be reduced if
the departing partner subsequently engages in the practice of law in
competition with his or her former firm. Such provisions technically are
not covenants not to compete, as they do not prohibit the departing
partner from competing with the firm. Instead, they are financial
disincentive provisions, whereby the departing partner can freely
compete, but usually at a significant cost. Are such provisions
enforceable? Most courts say "no."
Ethical Rules
Ethical opinions and rules governing attorneys prohibit attorneys
from entering into covenants not to compete.2 As the American Bar Association Committee on
Ethics and Professional Responsibility stated more than 30 years
ago:
"The practice of law, however, is a profession, not a business or
commercial enterprise. The relations between attorney and client are
personal and individual relationships. The practice of law is not a
business which can be bought or sold. Clients are not merchandise.
Lawyers are not tradesmen. They have nothing to sell but personal
service. An attempt, therefore, to barter in clients, would appear to be
inconsistent with the best concepts of our professional
status....
|
Laing
|
Dean P. Laing, Marquette
1983, is a shareholder with the Milwaukee law firm of O'Neil,
Cannon, Hollman, DeJong S.C., where he concentrates in personal injury
and commercial litigation. He is board certified as a Civil Trial
Specialist by the National Board of Trial Advocacy, has been recognized
as one of the top trial lawyers in Milwaukee by Milwaukee Magazine, and
was recently selected as a Leader in the Law for 2005 by the Wisconsin
Law Journal. He is a frequent author and speaker on insurance, evidence,
tort, and general litigation issues.
"[A] general covenant restricting an employed lawyer, after leaving
the employment, from practicing in the community for a stated period,
appears to this Committee to be an unwarranted restriction on the right
of a lawyer to choose where he will practice and inconsistent with our
professional status. Accordingly, the Committee is of the opinion it
would be improper for the employing lawyer to require the covenant and
likewise for the employed lawyer to agree to it."3
Wisconsin follows this general prohibition against attorney covenants
not to compete. Supreme Court Rule 20:5.6(a) provides that "[a] lawyer
shall not participate in offering or making a partnership or employment
agreement that restricts the rights of a lawyer to practice after
termination of the relationship, except an agreement concerning benefits
upon retirement...."
Case Law
When a partner leaves a law firm, the departure can have a
significant negative financial impact on the firm, particularly when the
departing partner takes clients and subsequently competes against his or
her former firm in the same geographical area. Recognizing that the
ethical rules prohibit attorneys from being restrained by covenants not
to compete, many law firms include financial disincentive provisions in
their partnership agreements that require a departing attorney who then
competes with the firm to forfeit all or a portion of the deferred
compensation he or she would receive if the departing attorney did not
compete against the firm.
Such provisions have two purposes: 1) to discourage departing
attorneys from competing by making the financial consequences of doing
so generally quite harsh; and 2) to compensate the law firm for
financial losses sustained due to the departing attorney's
competition.
The great majority of courts considering attorney financial
disincentive provisions have held that they are indirect covenants not
to compete and, as such, are void as being against public policy. A few
courts, including a Wisconsin trial court, have upheld such provisions,
finding them to be warranted by legitimate business concerns.
The Majority Rule
At least nine states have held that financial disincentive provisions
tied to competition by a departing partner are unenforceable and void.
The first state to consider the issue was Oregon. In Gray v.
Martin,4 a 1983 decision, a law firm's
partnership agreement provided that a departing attorney was entitled to
one-fourth of his or her share of the firm's profits during the 24
months following the partner's withdrawal from the firm, unless the
departing attorney engaged in the practice of law within any of the
three counties generally serviced by the law firm, in which case all
such deferred compensation would be forfeited. The court held that the
provision "fits squarely" within the prohibition against covenants not
to compete for attorneys, "violates the public policy that prohibits
restrictions on the right of attorneys to practice law," and therefore
was unenforceable.5
The next court to consider the issue was New York's highest court. In
Cohen v. Lord, Day & Lord,6 the
plaintiff was an attorney who had been with the defendant law firm for
almost 20 years. The law firm had a partnership agreement that included
a provision entitling a departing partner to his or her share of the
firm's unpaid and unbilled fees at the time of departure, unless the
departing attorney continued to practice law in any state in which the
law firm maintained an office, in which case all deferred compensation
would be forfeited. The New York Court of Appeals struck down the
provision, finding it void as against public policy:
"We hold that while the provision in question does not expressly or
completely prohibit a withdrawing partner from engaging in the practice
of law, the significant monetary penalty it exacts, if the withdrawing
partner practices competitively with the former firm, constitutes an
impermissible restriction on the practice of law. The
forfeiture-for-competition provision would functionally and
realistically discourage and foreclose a withdrawing partner from
serving clients who might wish to continue to be represented by the
withdrawing lawyer and would thus interfere with the client's choice of
counsel.
"Defendant also urges in a policy argument that forfeiture of
departure compensation is justified because of the economic hardship
suffered by a firm when a partner leaves to join a competitor
firm.... While a law firm has a legitimate interest in its own
survival and economical well-being and in maintaining its clients, it
cannot protect those interests by contracting for the forfeiture of
earned revenues during the withdrawing partner's active tenure and
participation and by, in effect, restricting the choices of the clients
to retain and continue the withdrawing member as counsel."7
Decisions in Alabama,8 Illinois,9 Iowa,10
Massachusetts,11 New Jersey,12 Tennessee,13 and
Texas14 have all agreed with the holdings
set forth in Gray and Cohen. The most thorough explanation
of these courts' rationale was set forth by the New Jersey Supreme
Court:
"Financial-disincentive provisions differ from direct restrictive
covenants. They do not impose a blanket or geographical ban on the
practice of law nor do they directly prohibit an attorney from
representing former clients. By selectively withholding compensation,
however, such provisions strongly discourage `competitive'
activities.
"By forcing lawyers to choose between compensation and continued
service to their clients, financial-disincentive provisions may
encourage lawyers to give up their clients, thereby interfering with the
lawyer-client relationship and, more importantly, with clients' free
choice of counsel. Those provisions thus cause indirectly the same
objectionable restraints on the free practice of law as more direct
restrictive covenants.... Because the client's freedom of choice is
the paramount interest to be served ... a disincentive provision is
as detrimental to the public interest as an outright prohibition.
Moreover, if we were to prohibit direct restraints on practice but
permit indirect restraints, law firms would quickly move to undermine
[the ethical rules] through indirect means."15
Recognizing that this rule "may be holding attorneys to a higher
standard than the commercial sector in general," the Texas Court of
Appeals held that "[w]hile an indirect financial disincentive against
competition or a reasonable covenant not to compete may have vitality in
a commercial setting, we believe the strong public-policy concerns
surrounding client choice warrants prohibition of lawyer
restrictions."16
The Minority Rule
California courts have approached the issue differently, electing not
to join the states whose courts have held that an attorney financial
disincentive provision is unenforceable as an indirect covenant not to
compete. In Haight, Brown & Bonesteel v. Superior
Court,17 a 1991 decision, the law
firm's partnership agreement provided that if a departing partner
competed with his or her former firm within the 12 months following
departure, the departing partner would forfeit all rights to receive any
interest in the firm's capital accounts and accounts receivables. The
California Court of Appeals held that while the ethical rules prohibit
an attorney from agreeing "to refrain altogether from the practice of
law," they do not "prohibit a withdrawing partner from agreeing to
compensate his former partners in the event he chooses to represent
clients previously represented by the firm from which he has
withdrawn."18 The court observed that its
holding represented a balance between two competing interests:
"On the one hand, it enables departing attorneys to withdraw from a
partnership and continue to practice law anywhere within the state, and
to be able to accept employment should he choose to do so from any
client who desires to retain him. On the other hand, the remaining
partners remain able to preserve the stability of the law firm by making
available the withdrawing partner's share of capital and accounts
receivable to replace the loss of the stream of income from the clients
taken by the withdrawing partner to support the partnership's
debts."19
The court concluded that "[w]e find no reason to treat attorneys any
differently from professionals such as physicians or certified public
accountants, for example, by holding that lawyers may not enter into
noncompetition agreements...."20
Two years later, the California Supreme Court held in Howard v.
Babcock21 that "[a]n agreement that
assesses a reasonable cost against a partner who chooses to compete with
his or her former partners does not restrict the practice of law," but
instead "attaches an economic consequence to a departing partner's
unrestricted choice to pursue a particular kind of practice."22 The court stated that "our interpretation of the
rule must be illuminated by our recognition that a revolution in the
practice of law has occurred requiring economic interests of the law
firm to be protected as they are in other business enterprises."23 Noting that such agreements merely "operate in
the nature of a tax on taking the former firm's clients," the court
concluded that "the contemporary changes in the legal profession to
which we have already alluded make the assertion that the practice of
law is not comparable to a business unpersuasive and unreflective of
reality."24
To date, the California approach has been followed by only one other
state, Pennsylvania. In Capozzi v. Latsha & Capozzi
P.C.,25 a 2002 decision, the
Pennsylvania Superior Court extensively quoted from the Howard
decision and held that "a forfeiture for competition clause is
enforceable in Pennsylvania for lawyers" if the clause "meet[s] the
applicable standard for restrictive covenants."26
The Wisconsin appellate courts have not considered this issue. A
Milwaukee County circuit court, however, adopted the California approach
in a 1997 ruling. In Polsky v. Trebon & Mayhew,27 a partner of nine years in a Milwaukee law firm
left the firm, allegedly taking 50 clients with him. The law firm's
partnership agreement provided that if a departing attorney "takes any
of the partnership's clients with him at any time within one year after
the effective date of his withdrawal," the departing attorney's equity
interest in the firm "shall be decreased by the product of the
withdrawing partner's percentage interest in the partnership times the
amount of fees billed by the partnership to such clients during the 12
months preceding the effective date of the withdrawal."28
When the law firm refused to pay the departing partner his equity
interest, the departing attorney sued, seeking a declaratory judgment
that the financial disincentive provision contained in the partnership
agreement was invalid. The circuit court disagreed, holding the
provision valid for four reasons. First, the preamble to the Rules of
Professional Conduct for Attorneys specifically provides that violation
of an ethics rule should not give rise to a cause of action. Second, a
financial disincentive provision does not "improperly or unduly
restrict[ ] the right of a lawyer to practice law in any material way."
Third, "there is something untoward about an attorney claiming he
entered into a contract which violates ethical rules, and that he should
be rewarded for this ethical lapse by having the Court enforce those
parts of the agreements which enhance[] his interest and void those
parts which reduce his interests." Fourth, the court "simply
disagree[d]" with the majority rule because a financial disincentive
provision does not create "any kind of material disincentive to the
clients' detriment."29
The Retirement Benefits Exception
Wisconsin Supreme Court Rule 20:5.6(a) provides that "benefits upon
retirement" are an exception to the general prohibition against attorney
covenants not to compete. This exception "acts as a safe harbor,
permitting restrictions on the practice of law not otherwise tolerated
under the rule."30 Not surprisingly, law
firms routinely argue that financial disincentive provisions in
partnership agreements fall within this exception and are thus
enforceable.31
In order to qualify for this type of exception, payments "must
... be [made] pursuant to a bona fide retirement plan."32 In determining whether the payments to be made
under a partnership agreement are deferred compensation or retirement
benefits, courts consider various factors, including: 1) whether a
minimum age and/or length of service requirement exists; 2) whether the
source of the payments is future firm revenues or earned but uncollected
income; 3) whether the payments are made over a short or extended period
of time; and 4) whether the partnership agreement contains other
provisions dealing independently with retirement benefits.33 In essence, the more the payments look like true
retirement benefits, the more likely they will be found to be such.
Courts have, however, "caution[ed] that scrutiny is warranted of
purported retirement benefits that may be forfeited upon continued
practice following withdrawal from a firm,"34 since "treat[ing] departure compensation as a
retirement benefit would invert the exception into the general rule,
thus significantly undermining the prohibition against restraints on
lawyers practicing law."35 For this reason,
the standard for fitting within the retirement benefits exception is
quite high.
Conclusion
Financial disincentive provisions in law firm partnership agreements
have been the subject of much litigation nationwide. Most courts hold
that such provisions are invalid, because they indirectly do what they
cannot directly do, that is, restrict competition. A few courts have
gone the other way, viewing the issue more from a business perspective
than an ethical perspective. No Wisconsin appellate court has weighed in
on the issue, but with financial disincentive provisions being fairly
commonplace in attorney partnership agreements in this state, that could
change soon.
Endnotes
1The term "partnership agreement"
is generically used in this article to include all agreements entered
into among equity members of a law firm, regardless of whether the firm
is structured as a partnership, service corporation, professional
corporation, or limited liability company.
2See, e.g., Ill. State Bar
Ass'n, Advisory Op. on Prof'l Conduct No. 97-09 (1998) ("It is unethical
and a violation of Rule 5.6(a) for a lawyer to make such an agreement or
for a law firm, lawyer, or group of lawyers, whether in a partnership,
corporation or proprietorship, to make such an agreement."); N.C. State
Bar, Formal Ethics Op. 10 (2002) ("The proposed provision set forth in
the inquiry above clearly creates a specific financial disincentive for
a lawyer ... [which] is a violation of Rule 5.6(a) and is
prohibited.").
3ABA Comm. on Ethics and Prof'l
Responsibility, Formal Op. 300 (1961) (citations omitted). See
also ABA Comm. on Ethics and Prof'l Responsibility, Informal Op.
1072 (1968) ("The right to practice law is a privilege granted by the
State, and so long as a lawyer holds his license to practice, this right
cannot and should not be restricted by such an agreement. The attorneys
should not engage in an attempt to barter in clients, nor should their
practice be restricted. The attorney must remain free to practice when
and where he will and to be available to prospective clients who might
desire to engage his services. We, therefore, conclude that a
restrictive covenant that you contemplate, as between partners and the
law firm, would be unethical and it would be improper for the firm and
the attorneys to enter into such an arrangement.").
4663 P.2d 1285 (Or. Ct. App.
1983).
5Id. at 1290-91. See also
Hagen v. O'Connell, Goyak & Ball P.C., 683 P.2d 563 (Or. Ct.
App. 1984).
6550 N.E.2d 410 (N.Y. 1989).
7Id. at 411, 413 (emphasis
omitted) (citation omitted). See also Peroff v. Liddy, Sullivan,
Galway, Begler & Peroff P.C., 852 F. Supp. 239 (S.D.N.Y. 1994);
Denburg v. Parker Chapin Flattau & Klimpl, 624 N.E.2d 995
(N.Y. 1993); Judge v. Bartlett, Pontiff, Stewart & Rhodes
P.C., 610 N.Y.S.2d 412 (N.Y. App. Div. 1994).
8Pierce v. Hand, Arendall,
Bedsole, Greaves & Johnston, 678 So. 2d 765 (Ala. 1996).
9Dowd & Dowd Ltd. v.
Gleason, 693 N.E.2d 358 (Ill. 1998); Stevens v. Rooks Pitts &
Poust, 682 N.E.2d 1125, 1130 (Ill. App. Ct. 1997) (holding "courts
have overwhelmingly refused to enforce provisions in partnership
agreements which restrict the practice of law through financial
disincentives to the withdrawing attorney").
10Anderson v. Aspelmeier,
Fisch, Power, Warner & Endberg, 461 N.W.2d 598 (Iowa 1990).
11Pettingell v. Morrison,
Mahoney & Miller, 687 N.E.2d 1237 (Mass. 1997).
12Heher v. Smith, Stratton,
Wise, Heher & Brennan, 785 A.2d 907 (N.J. 2001); Jacob v.
Norris, McLaughlin & Marcus, 607 A.2d 142 (N.J. 1992);
Katchen v. Wolff & Samson, 610 A.2d 415 (N.J. Super. Ct. App.
Div. 1992).
13Spiegel v. Thomas, Mann
& Smith P.C., 811 S.W.2d 528 (Tenn. 1991).
14Whiteside v. Griffis &
Griffis P.C., 902 S.W.2d 739 (Tex. App. 1995).
15Jacob, 607 A.2d at
148-49.
16Whiteside, 902 S.W.2d at
744.
17285 Cal. Rptr. 845 (Ct. App.
1991).
18Id. at 848.
19Id.
20Id. at 850.
21863 P.2d 150 (Cal. 1993).
22Id. at 156.
23Id.
24Id. at 159.
25797 A.2d 314 (Pa. Super. Ct.
2002). See also Cohen, 550 N.E.2d at 414 (Hancock, J.,
dissenting).
26Capozzi, 797 A.2d at
320.
27No. 96-CV-6970 (Wis. Cir. Ct.
Milwaukee County Oct. 1, 1997).
28Id. at 15.
29Id. at 17-21.
30Borteck v. Riker, Danzig,
Scherer, Hyland & Perretti LLP, 844 A.2d 521, 525 (N.J.
2004).
31See, e.g., Schoonmaker v.
Cummings & Lockwood of Conn. P.C., 747 A.2d 1017 (Conn. 2000);
Neuman v. Akman, 715 A.2d 127 (D.C. 1998); Hoff v. Mayer,
Brown & Platt, 772 N.E.2d 263 (Ill. App. Ct. 2002); Donnelly
v. Brown, Winick, Graves, Gross, Baskerville, Schoenebaum, & Walker
P.L.C., 599 N.W.2d 677 (Iowa 1999); Miller v. Foulston, Siefkin,
Powers & Eberhardt, 790 P.2d 404 (Kan. 1990); Borteck,
844 A.2d at 521, 526-27.
32Donnelly, 599 N.W.2d at
682.
33Neuman, 715 A.2d at 135;
Schoonmaker, 747 A.2d at 1032-33; Borteck, 844 A.2d at
527-29.
34Schoonmaker, 747 A.2d at
1037.
35Cohen, 550 N.E.2d at
412.
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