A number of Pennsylvania’s largest law firms are caught up in a dispute in the Second Circuit over whether “unfinished business” of a disbanding firm from which they’ve hired attorneys is property of that defunct firm and needs to be returned.

And by “property,” the lower court meant profits the new firms earned on cases initiated at a defunct firm — in this case the long-since disbanded Coudert Brothers.

Dechert, Duane Morris and K&L Gates are among 10 law firms asking the U.S. Court of Appeals for the Second Circuit to reverse a Southern District of New York judge’s decision that client matters left unfinished by Coudert at the time of its dissolution are the property of Coudert. Based on that finding, U.S. District Judge Colleen McMahon ruled the partners at the 10 law firms sued by Coudert’s bankruptcy plan administrator have a duty to account to Coudert with respect to profits on post-dissolution services they performed on client matters after they became partners at the new firms.

The other seven firms involved, which include some with Pennsylvania offices, are Akin Gump Strauss Hauer & Feld, Arent Fox, Dorsey & Whitney, Jones Day, Morrison & Foerster, Sheppard Mullin Richter & Hampton and DLA Piper.

In the July 30 petition for permission to appeal McMahon’s ruling, which was certified for interlocutory appeal, the firms said the money they were paid on matters that originated at Coudert was only for work done at their firms and not at Coudert. The profits on that work should remain at their firms, they argue.

The law firms aren’t fighting the fight just for themselves. They reference in their petition that a ruling clarifying the law in this case will have an effect on similar disputes in bankruptcies involving Thelen and Dewey & LeBoeuf — two firms from which several Pennsylvania firms poached lawyers around the time of their dissolutions.

In their petition, the law firms accuse McMahon of ignoring New York law and instead adopting the 1984 California case Jewel v. Boxer and its progeny. Under Jewel , when a law firm dissolves, pending client matters remain business of the firm and must be wound up. Therefore, a partner who continues work on a firm’s pending matters after joining a new firm is merely winding up those affairs of the former firm.

“This rationale encourages partners of a firm that is having financial problems to withdraw early, and penalizes partners that remain to help the firm recover, if they fail to withdraw prior to dissolution,” the firms said in their petition.

The firms also argue that the weight of Jewel is in doubt because California has adopted the Revised Uniform Partnership Act. The revised act makes room for the argument that any partner engaged in winding up a defunct firm’s business is entitled to reasonable compensation, not just surviving partners who were at the firm at the time of its dissolution, the firms argue.

Unlike Jewel , New York case law apportions fees between the dissolved firm and the new firm, similar to how a contingency fee would be split when a lawyer switches firms in the midst of a matter, the firms said.

The dispute over post-dissolution profits was not one that arose in Pennsylvania’s most notable law firm dissolution. Wolf Block’s March 2009 collapse never resulted in a bankruptcy filing, in which many Jewel claims are often raised. That didn’t mean the firm’s wind-down committee couldn’t look to sue former partners or their new firms raising Jewel claims outside a bankruptcy context, but that never happened.

One reason for that may have been a promise by the firm at the time of dissolution to waive its Jewel claims. Instead, Wolf Block sued in arbitration nearly 50 of its former partners in an effort to claw back two months’ worth of pay given out just before the firm’s dissolution vote. In filings as part of the arbitration fight over that clawback attempt, one former partner said the firm agreed at the time of the dissolution vote to waive its Jewel claims, telling the partners it had enough money in its collectible accounts receivable to pay off debts.

Why Now?

Jewel has been around since 1984 and the Uniform Partnership Act it interpreted had been around longer than that.

Los Angeles-based legal consultant Edwin Reeser said that for a long time law firm leaders looked at it as some law “those crazy surfer dudes in California” came up with and nothing that would be applied elsewhere.

They also mistakenly took solace that Jewel dealt with a general partnership, not a limited liability partnership. The issue has gained prominence for larger LLPs in the last few years, however, for two reasons.

First, in the old days of general partnerships at law firms, personal liability attached to the individual partners and paying back the estate of a dissolved firm wasn’t a question, Reeser said. Firms organized as an LLP have felt protected from Jewel claims because individual partners don’t have liability for certain firm obligations under an LLP.

But Reeser noted bankruptcy law has become a growing factor as large firms that dissolve are increasingly finding their way into bankruptcy. And bankruptcy law provides for clawbacks of money paid to a partner when the firm was insolvent and clawbacks of assets a partner took from the firm, whether it be a conference table or profits from a case, Reeser said.

Reeser said these law firms are trying to create a special class of debtor in which any other LLP would have to pay back assets to a partnership’s estate but lawyers wouldn’t have to.

“I don’t think that’s going to go over real big,” he said.

The second reason Jewel claims are on the rise relates to the bankruptcy issue. Years ago, even if a firm went into bankruptcy, it wasn’t worth the trouble of chasing down hundreds of partners to get back profits on unfinished business. But as large firms’ business models have evolved to the point that large-scale debt and financing is required to fund expansion and operations, Reeser said there are too many creditors breathing down the necks of a firm’s trustee for the trustee to avoid going after those partners.

And while the initial obligation to pay back the money to the estate falls on the individual partner, that partner has paid that money into the profit pool of his new firm, putting all of the other equity partners who have already taken home those profits in their paycheck on the hook for the payment, Reeser said. That can create tension between existing partners and their firm management hiring lawyers from disbanding firms.

When competing for top talent from a disbanding firm, the new firms will agree as a recruiting tool to pay on behalf of the lateral any Jewel claims that may arise. In an increasingly difficult environment for revenue growth, some firms find the prospect of hiring a partner with a large book of business worth the risk of having to settle a Jewel claim down the line, Reeser said.

And settle they do.

Airing Firms’ Dirty Profits

Jewel disputes have almost never, if ever, gone through a trial or full discovery because they always settle with the new firm writing a check, New York-based recruiter Jerry Kowalski said. The claims allow for the accounting of profits the new firms made on the dissolved firms’ unfinished business and no firm wants to divulge its most sensitive financial data, he said.

As the law firms in the Coudert case point out in their petition, even McMahon asked the Second Circuit to reverse her on the finding that law firms must account for their profits.

McMahon said she “firmly believe[d]” the Second Circuit should reverse her on the issue of firms having to give an accounting of the profits they earned on Coudert-initiated matters. She said such an accounting would require extensive discovery as to how matters were staffed, how much progress was directly attributable to the former Coudert partner and would require experts to opine on how much of the profit was owed to the Coudert estate. She said it would lengthen by several years a bankruptcy that was already six years old.

Kowalski said he highly doubted the Second Circuit would take up the case despite its “pizzazz,” because every court across the country to address the issue has affirmed the Jewel concept, including in New York.

Jewel has already had an impact on firms’ hiring, including most recently in the Dewey dissolution. In the last few years, Kowalski said he has had at least 30 conversations about Jewel with law firm leaders looking to grab lawyers from troubled firms. The initial reaction is typically that such a ruling couldn’t apply because it restricts a lawyer’s ability to practice where he or she wishes or a client’s ability to choose his or her lawyer — similar arguments made by the firms in the Coudert case.

But, Kowalski said, after a little research they see how the case law has developed in this area.

Kowalski said there were at least three firms he knew of that walked away from hiring Dewey lawyers because of Jewel concerns. Other firms simply create a reserve account to prepare for possible Jewel claims or work out arrangements with the partners they hire from the disbanding firms. He said firms have to include potential Jewel claims in the cost analysis done before hiring a partner.

Kowalski said he is very slowly starting to see firms include Jewel claim provisions in their partnership agreements, considering the fact that, under general partnership law, any time a partner leaves a firm, the firm is considered to be in dissolution. Including a Jewel provision that allows the former firm to collect the profits on fees the departing partner earns at his new firm from cases originated and the old firm is “a great set of golden handcuffs” that can limit partner mobility, Kowalski said. He said he could see those types of provisions in partnership agreements increasing in the next 10 years.

Gina Passarella can be contacted at 215-557-2494 or at gpassarella@alm.com. Follow her on Twitter @GPassarellaTLI.