Vol. 78, No. 5, May 2005

Saying Goodbye: Compensating Departing Law Firm Partners

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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