Bankrupt Law Firms Can't Claim Future Profits From Clients, Court Rules

Robert T Abney & Associates Bankruptcy Law, Commercial Law – A New York court has resolved a long-simmering question about what happens when law firms blow up: Can a bankrupt firm claim the profits from a valuable client relationship even after partners have moved on?

No is the answer, and that could provide the catalyst for more big-firm breakups as partners seek to leave law firms that are saddled with too much debt and shrinking fee revenue.

The opinion earlier this week by the New York Court of Appeals holds that because clients are free to choose who represents them in legal matters, a defunct firm cannot effectively follow them, seeking a piece of their fees, when their lawyer switches firms. The state appeals court issued its opinion upon request from the Second U.S. Court of Appeals in New York, which was considering the issue as it arose in the bankruptcies of Thelen LLP and Coudert Brothers, two examples of large law firms that slipped into bankruptcy as they failed to cut costs fast enough to stay in front of increasingly frugal corporate clients.

“This is a major, major decision, and it’s an issue that’s been out there a long time,” said Les Corwin, a partner with Blank Rome who focuses on law-firm mergers and dissolutions and was involved in the shutdowns of Wolf Block and Gaston & Snow, two venerable firms that failed in recent years.

The New York court said that for reasons of public policy, bankrupt firms couldn’t claim a piece of the profits — the difference between top-line fee revenue and overhead costs — that partners earn from clients they take with them. Not only would such a practice cut down on client mobility, the court ruled, but it would clash with New York ethics rules prohibiting fee-splitting.

Corwin said the main effect will be making it easier for partners to leave failing firms. Under the previous “unfinished business” doctrine, partners might have worried they’d effectively be working for free if they took their clients with them.

“If I’m representing you in a major matter in your life, I can’t pick up the phone and say `I’m going to another firm and I can’t take you because it will cost me a lot of money,’” Corwin told me.

The result might seem puzzling to other professionals, who frequently work under strict non-compete agreements and can be sued if they poach firm clients when they defect. Stockbrokers, for example, generally can’t take their clients with them when they go. A leading New York case that supported the arguments of bankrupt law firms involved the architects who designed Grand Central Terminal; when one of the architects died, the partner in charge of the other firm quickly negotiated a new contract that cut the estate of the dead architect out of the business.

The analogy doesn’t hold to law firms, however, because the Sixth Amendment guarantees a right to counsel. As with consumer-protection laws, malpractice and competition from non-lawyers, attorneys operate by a different set of rules. In this case, however, they had the Bill of Rights on their side.