A group of former partners of Dewey & LeBoeuf LLP are doing everything they can to hold on to monthly partnership draws they received in the months and years leading up to Dewey’s collapse. The trustee of the Dewey Liquidation Trust has argued, among other things, that monthly partnership draws are avoidable and recoverable as constructively fraudulent transfers under section 548(a)(1)(B) of the Bankruptcy Code and sections 273 through 275 of the New York Debtor and Creditor Law. In response, the partner defendants have each argued, among other things, that they gave reasonably equivalent value to the firm in exchange for their monthly draws in the form of billable hours worked, business generated, fees collected, marketing, and client and practice development. The Bankruptcy Court shot this argument down, however, in its recently issued Memorandum Opinion Granting in Part and Denying in Part Cross-Motions for Partial Summary Judgment (2014 Bankr. LEXIS 4564 (Bankr. S.D.N.Y. Oct. 29, 2014)).
Judge Glenn framed the issue as follows: “… should the services performed by the Defendants, as Dewey partners, be considered in determining whether the Defendants exchanged ‘reasonably equivalent value’ for the compensation they received.” In Judge Glenn’s opinion, under the terms of the Dewey partnership agreement and applicable New York partnership law, the answer is an unqualified no.
Under New York partnership law, partners are not entitled to receive “remuneration for acting in the partnership business … [.]” N.Y. P’Ship Law § 40(6). This restriction – known as the “no compensation rule” – is the default rule applicable to New York partnerships. Although the default rule can be modified by agreement to provide for special compensation for certain partners, the Court was clear that its ruling does not extend to those situations. It extends only to the default “no compensation rule” adopted by the Dewey partnership agreement as the rule generally applicable to all Dewey partners. Because the partner defendants were not entitled to compensation for their services, their services could not be counted as reasonably equivalent value given in exchange for the monthly draws.
The Court did not address whether the partners’ services had value – clearly they did, as evidenced by the eventual collapse of the firm under the weight of partner departures. Had monthly payments to partners ceased at any point, partners would undoubtedly have left the failing firm and the implosion would have occurred that much quicker. However, the value of the services was irrelevant to the Court’s analysis. As the Court noted: “Dewey’s partners must accept the benefits and burdens attached to the firm’s status as a New York LLP and terms of the [partnership agreement].”
This ruling puts significant risk on equity partners in New York partnerships simply on account of receiving monthly draws. If a law firm falls into distress and files for bankruptcy relief even years down the line, its equity partners might be on the receiving end of a constructive fraud lawsuit and at risk for having to disgorge significant amounts depending on the date of the firm’s insolvency. Under this ruling, partners will not receive any credit for staying with the firm.
Although the risk is real, it may not cause significant changes in the way New York firms are organized or deal with partner compensation. Insolvency is often viewed as something that happens to “the other guy” and firms may very well continue to operate with blinders on. Firms that want to take action to mitigate this risk, however, can consider a variety of options. Firms might consider organizing as a business entity other than a New York partnership to avoid being bound by the “no compensation rule.” Alternatively, we could see an uptick in the level of special compensation agreements that firms have with equity partners – an alternative that would be particularly ironic as special compensation agreements (such as guaranteed compensation) are largely credited as being a significant contributing factor to the recent spate of law firm distress in the first place. In that vein, the Dewey cases, especially in light of this ruling, can be viewed as having dueling and conflicting lessons when it comes to special compensation agreements – (i) avoid them like the plague if you want the firm to survive and (ii) never leave home without them if you want to have a shot at a reasonably equivalent value defense when things go south.
In the words of Colonel Nathan Jessup and Lieutenant Daniel Kaffee: “Are we clear … Crystal.” [credit: “A Few Good Men”].