Partners are now digging deeper than ever into their earnings for the privilege of partnership. Many large firms are hiking equity partner paid-in capital obligations or broadening their capital calls to include formerly excluded income partners.
But paid-in capital is an investment; and like any investment, it comes with risk. The return of capital is not a given. It can be withheld when disputes arise between firms and former partners over lateral moves. And as recent history has shown, firm failures typically wipe out partner capital.
One common scenario: Management at the former firm claims that the departed partner communicated with a client or legal staff at the firm about the move prior to leaving, a breach of fiduciary duty to the partnership. "Lots of times, the firm will withhold [the capital contribution] and dare the partner to go to arbitration, which they know is costly and risky for the partner," says Arthur Ciampi, a New York lawyer who has handled many such conflicts on behalf of lawyers. "Many partners decide not to fight. They’ll just let it go."
Such disputes can snowball quickly into bigger problems. The departed partner needs the capital back as soon as possible, to cover obligations at the new firm, and to pay off the bank note that he or she used to fund the previous firm’s capital obligation. And in the past five years, Ciampi says, banks holding capital loan debt have increasingly been getting involved in those disputes. Negotiations now often include the bank, the firm, and the partner. Almost always, according to Ciampi, the bank that lends capital to partners is the same bank that the firm uses. And too frequently, partners have also tapped that bank for personal loans, such as home mortgages or equity lines of credit. Often, all those loans are cross-collateralized. "They really have you over a barrel then," says Ciampi. Banks have also been referring such disputes to collection agencies sooner than they used to.
Bank capital loan programs have become increasingly popular for several reasons. Most partners don’t have several hundred thousand dollars in free cash to fund capital when they join a firm or become a partner; interest on the loans is generally low; and some firms even cover the interest. There are also tax advantages to the loans: Because paid-in capital is considered a business investment, loan interest is tax-deductible. "It is a very seductive system," says Jeffrey Gans, a Pillsbury Winthrop partner. "It feels like you haven’t paid anything. It only comes back to bite you when things don’t go well."
Many partners, Gans notes, wrongly believe that "their" capital is segregated from other firm funds. "I have been surprised at the number of partners who seemed to think that capital was a rainy day fund, kept in a lockbox," he says. In fact, "partner capital" is simply a line on the balance sheet, and the cash a partner puts in is basically fungible. When a firm fails, any available cash on the balance sheet is immediately claimed by bank creditors.
Gans, a former Howrey partner, should know. He’s one of a growing number of partners in recent years who have lost capital when their firms failed. Many have learned firsthand that high-level capital obligations are no protection against a firm’s demise. At three recently failed firms (Thelen, Howrey, and Dewey & Le­Boeuf), partners left behind capital that totaled approximately a third of a full year’s compensation. Those who departed within a few months of their firm’s bankruptcy filing have recovered little or nothing; under bankruptcy law, partner capital is considered equity, not debt. As equity holders, partners are the last in line to recover funds.
Laura Shores, a Pepper Hamilton health litigation partner, has also felt the sting of loss. Shores left Howrey six months before it collapsed, and the firm, which had a year to return capital, had not yet returned hers. That left her high and dry, with a $240,000 capital loan to Citi Private Bank to repay. Citi called Shores’s loan, and "of course, Citi also had my mortgages, so I said ‘fine,’ " she says. To pay it, Shores has had to refinance her home several times and tap other lines of credit. Meanwhile, her borrowing costs have risen significantly. "It’s been very stressful," says Shores. (She has not taken any legal action against the estate of her former firm.)
Most disputes with bank lenders are resolved through negotiation. But Citibank N.A., which extends loans to many partners via its Private Bank arm, has recently shown a more aggressive stance, according to Ciampi. Last June the bank sued former Dewey partner Steven Otillar in New York state court, seeking to reclaim $209,670 that Otillar had borrowed to pay his capital obligation to Dewey a year before the firm collapsed. Cit­ibank’s lawyer, Michael Luskin of Luskin, Stern & Eisler, noted in a court filing that it was handling numerous other matters related to loans taken out by former Dewey partners. (He did not respond to emailed inquiries about the case.)
Otillar struck back at the bank, becoming one of a handful of partners from failed firms to do so in the past two years. In August, in court filings opposing Citibank’s summary judgment motion, he alleged that the bank knew of Dewey’s financial problems when it loaned him money and purposefully left him in the dark. On January 16, U.S. District Judge Louis Stanton in New York denied Citibank summary judgment until after Otillar could file a counterclaim; at press time that counterclaim was scheduled to be filed on February 19.
Capital loan programs "are a very big business for banks," says Otillar’s lawyer, Becker & Poliakoff’s Helen Chaitman. "The real question is, when Citi made those loans, did the bank know the firm was teetering? And did the loan proceeds go to pay down [Dewey's] debt to Citi? Because if so, what Citi was actually doing was reducing its exposure to the firm by getting in a solvent rainmaker." (Citi Private Bank’s senior client adviser to the Law Firm Group, Gretta Rusanow, declined to comment on whether its capital loan program has grown in recent years.)
A similar suit against Citibank filed in 2011 by two former Howrey partners was scheduled to go to trial in state court in San Francisco on March 25. In it, former Thelen chair Stephen O’Neal and a colleague, David Buoncristiani, both of whom joined Howrey in 2008, make allegations similar to Otillar’s. O’Neal, who took out a $315,000 capital loan from Citi Private Bank, and Buoncristiani, who took out $420,000, claim that they repeatedly asked the bank’s representatives about Howrey’s financial health and were told that the firm was well positioned. In fact, Howrey had already defaulted on loan covenants in 2007 and 2008, and was $23 million overdrawn on its existing line of credit, facts that the two allege that Citi Private Bank, as one of the firm’s banks, should have known. "The capital contribution loan program permitted Citibank to shift risk from Howrey to individual partners," the two assert in their complaint. (Citibank’s lawyer, Roger Mead at Folger Levin, did not respond to requests for comment.)
Partners formerly at failed firms say that the risks of lost capital, and the costs of anteing up capital again, weighed heavily on them in choosing where to move. All say they chose firms that seemed to be conservatively managed. In spite of their losses, some say they believe that capital is still necessary to build in a sense of shared risks and rewards.
"I would feel leery of firms that want me to pay a lot up front," says Andrew Ness, a Jones Day partner who lost the equivalent of 70 percent of a year’s compensation when he lost capital at Thelen and later at Howrey in the space of a few years. But Ness says he would be just as wary of a firm that doesn’t require any capital: "Joining a firm is a leap of faith. The firm is putting a lot of trust in you. Obviously you’re doing the same."