The Limited Liability Partnership in Bankruptcy

The last twenty-five years have brought about widespread changes in the organizational forms through which individuals organize economic activity. Once momentum built, the creation of hybrid entities such as limited liability partnerships, limited liability companies and even limited liability limited partnerships seemed inevitable, as did the surrendering of flow-through taxation to all of them by the U.S. Treasury. However, how these strange mash-ups of management power, limited liability, and fiduciary duty would operate was left to work itself out over time. The limited liability partnership in particular has evolved with very little judicial or legislative scrutiny as LLPs are usually not large or publicly-traded and are generally owned by professionals known to one another. Partners in LLPs are generally not a litigious lot, so we know very little about the inner workings of these private entities. What is ironic is that many lawyers, and law professors, are or have been partners or associates in LLPs, yet they operate somewhat under the radar of the law.

Until now. The financial crisis took its toll on many industries, and the legal profession in particular. A few well-known law firm LLPs had gotten very large and though not publicly-traded, had very public bankruptcy proceedings: Coudert Brothers, LLP, Heller Ehrman LLP, Thelen LLP, Howrey LLP and Dewey Le Boeuf LLP. My paper The Limited Liability Partnership in Bankruptcy (forthcoming in the American Bankruptcy Law Journal and available on ssrn here) attempts to analyze a latent problem in LLPs – the strange combination of co-management rights among all the partners and limited liability at the time of insolvency. Bankruptcy laws are poorly suited to partnerships with limited liability – partnerships in which the creditors must look to the capital of the partnership to satisfy claims. Bankruptcy law is even more poorly suited to general partnerships, which historically were not insolvent unless each and every partner was insolvent. The LLP is a strange hybrid – a general partnership in which each partner has the right to co-manage, but without the personal liability that usually comes with that power. When the LLP approaches insolvency, this conflict plays out with the partners splitting the spoils of the partnership, waiving fiduciary duties to one another and the partnership, and leaving the LLP. Bankruptcy law attempts to cure this with the fraudulent conveyance doctrine, but that doctrine has hit a snag.

Fraudulent conveyance doctrine attempts to constrain debtors from distributing their dwindling assets prior to insolvency under certain circumstances.   In the law firm setting, bankruptcy trustees have used this doctrine to argue that dissociating partners departing with lucrative client accounts received fraudulent transfers from their insolvent LLP. To that end, trustees have sued third-party law firms that those dissociated partners subsequently joined for any profits that were later earned from those ongoing client matters. As one might imagine, both the trustees and the third-party law firm parties have great incentives to pursue and defend these claims and have faced off in various federal bankruptcy and federal district courts. At issue is precedent from the bankruptcy of Brobeck, Phleger & Harrison LLP, a shocking law firm victim of the technology bubble. In that case, the partners had signed a standard “Jewel waiver,” named after a case in a California district court, waiving any property rights to client accounts, thereby bypassing a fraudulent transfer claim against departing partners and their new firms. Former Brobeck partners freely took their clients to their new firms as Brobeck dissolved. However, the district court concluded that the Brobeck partners’ Jewel waiver was itself a fraudulent transfer, reasoning that at the time the waiver was signed (always at the eve of bankruptcy), the mere waiving of the property right in the client accounts was a fraudulent transfer of a property right, even if the subsequent taking of the client accounts was not. All of the law firm bankruptcies currently in the public eye have similar, if not identical Jewel waivers, signed immediately before dissolution.

Based on Brobeck, the issue seems fairly clear– the Jewel waivers are fraudulent transfers. However, courts addressing the issue in the recent round of high-profile bankruptcies are currently split on a threshold issue, namely whether the partnership could have a property right in client accounts for which work has not been performed or billed (“unfinished business”). Absent a property right in unfinished business, there could be no fraudulent conveyance where a partner “takes” unfinished business to a new firm. As of fall 2014, the Second Circuit, relying on a question certified to the New York Court of Appeals, has held that “unfinished business” (as opposed to accounts receivable or unrealized contingency fees) are not property of the law firm and never were, at least under New York law. In other words, the law firm had no property right to waive and no fraudulent transfer occurred. In addition, a federal district court in California has followed the Second Circuit’s example and held similarly under California law. However, a different district court in California has held that under D.C. law, unfinished business is the property of the law firm.

Several policy concerns seem to be driving these decisions. Clients of law firms have an unfettered right to terminate representation at any time. Client autonomy is important. And, important to at least the lawyers, the ability of lawyers in failing firms to leave and be re-employed is a concern. Furthermore, from a practical standpoint, calling client matters “property” does not fit into our definitions of property – a law firm can’t sell unfinished business and a bankruptcy court could not auction off an ongoing client representation either. One countervailing concern is the rights of creditors. In particular, purchasers of $150 million of bonds issued by Dewey believed they had a security interest in unfinished business. All of these ongoing cases are on appeal, and the Jewel waiver issue in Dewey has not been heard yet. As you may imagine, the outcome is quite important to law firms and their partners.

The preceding post comes to us from Christine Hurt, the Rex J. & Maureen E. Rawlinson Professor of Law at BYU Law. The post is based on her recent article “The Limited Liability Partnership in Bankruptcy”, which is available here.