Arthur J. Ciampi
Arthur J. Ciampi (NYLJ/Rick Kopstein)

Partners or shareholders transitioning in law firms from equity to non-equity positions is somewhat commonplace. A recent unpublished decision from the U.S. Court of Appeals for the Ninth Circuit provides insight into the nature of such transitions and their ramifications for both the law partner and the law firm. In this month’s column, we discuss the decision, Heller Ehrman LLP v. K. William Neuman, No. 15-17124 (9th Cir. April 10, 2017).

Heller Ehrman LLP (the LLP) was an international law firm that had been in operation for 130 years at the time of its dissolution and bankruptcy. Heller Ehrman LLP v. K. William Neuman, No. C 14-4002 at 2 (N.D. Ca. Sept. 30, 2015). Although it was based in San Francisco, the firm operated on three continents and employed 730 lawyers. Id. Local professional corporations (PCs), each operating in a different region, served as the partners of the LLP. Id. The LLP was governed by a Partnership Agreement that provided “Basic Documents” (the Employment Agreement, the Shareholders Agreement, the Partnership Agreement and the Retirement System) which created the framework by which the individual PCs interacted with the larger LLP. Id.

Heller Ehrman had two categories of employees. Id. The first category was shareholders, a group akin to “equity partners” in that they received a percentage of the firm’s yearly profit, but were employed by one of the PCs. Id. The “Basic Documents” provided only for “variable, percentage-based compensation” for shareholders. Id. at 2-3. In addition, the Employment Agreement provided that, when a shareholder departed the PC, the firm would repurchase their “preferred stock.” Id. at 3. Finally, the Agreement set limits on how its terms could be amended not only by vesting certain shareholders with the ability to amend, but also by stating that “[the] Agreement may not be amended in any respect unless all other Employment Agreements to which the Company is a party and which are then in effect are amended in identical respect.” Id.

The LLP also hired fixed income employees, including staff, retired shareholders, and associates, who were employed by the LLP (rather than by a PC) and paid a fixed wage. Id.

K. William Neuman became an associate at the LLP in 1976 and a shareholder in the 1980s. Id. He also served as the head of the Real Estate Practice Group, and ultimately as the firm’s Vice President—Real Estate Operations. Id. In this role, Neuman was required to spend a significant number of hours working on the firm’s internal real estate needs. Id. at 3-4. For both this, and certain medical reasons, his number of billable hours fell in the early 2000s. Id.

In 2007, the firm’s Compensation Committee proposed that Neuman be moved to fixed-income compensation under a four-year employment contract. Id. at 4. Neuman agreed. Id. According to the contract, the parties being bound were Neuman and the LLP, and, indeed, the LLP’s managing shareholder signed the agreement. Id.

The 2007 Employment Contract stipulated that Neuman would not be listed as a recipient of variable compensation, that he would not make capital contributions, and that he would be paid $775,000 annually. Id. Neuman would also “retain eligibility for the non-profit sharing benefits associated with shareholder status.” Id. The contract further stated that the “signed letter will constitute the complete understanding of our agreement as to the matters covered herein.” Id. at 4-5.

By accepting this agreement, Neuman was removed from the 2007 financial reports dealing with profit allocation and was informed of his 2007 compensation separately. Id. at 5. However, none of Neuman’s “preferred stock” was repurchased, either by the LLP, or by any of the PCs. Id. Furthermore, Neuman, for certain purposes, remained among those listed as active shareholders. Id.

Bankruptcy Petition

In September 2008, the LLP, with Neuman’s support, voted to adopt a plan of dissolution after defaulting on its line of credit. Id. That December the firm filed a petition for relief under Chapter 11 in the Northern District of California. Id. In 2010, the LLP began to liquidate itself, following a plan which “subordinate[d] shareholders claims for the return of capital and [stated that there] ‘will be no return of capital’ to former Shareholders, although ‘Shareholders may pursue claims based on contractual rights arising from or related to their employment’” Id. at 5-6.

At this time, Neuman filed a claim demanding $1,161,066.43 in compensation, citing the terms of his 2007 contract. Id. at 6. The Bankruptcy Court found that: “1) Neuman was not a Heller Ehrman shareholder at the time of the LLP’s dissolution, so he could claim a right to compensation as an employee 2) the firm’s bankruptcy and dissolution did not prevent Neuman from fulfilling his duties under the 2007 employment contract, and 3) Neuman’s claims were not subordinated by the Plans of Dissolution and Liquidation.” Id.

Moreover, the Bankruptcy Court concluded that, since Neuman did not have an “attributed percentage” and understood that the agreement re-defined his position as that of an employee and not a shareholder of the LLP, he must be considered an employee. Id. at 7. Furthermore, the Bankruptcy Court found that, because the 2007 Letter Agreement was between the LLP and Neuman, and was, in fact, signed by the managing shareholder of the LLP, Neuman must be considered an employee of the LLP. Id. The Employment Letter Neuman received in 2007, the court concluded, must be not be considered merely a “modification of Neuman’s original employment agreement,” but rather, a completely new and separate agreement. Id. Heller Ehrman appealed to the U.S. District Court for the Northern District of California. Id. at 1.

The District Court Decision

The District Court reviewed the decision and found that the Bankruptcy Court’s discussion of the signature by the LLP and the terms of the agreement persuasive. Id. at 9. The 2007 Letter Agreement, the court held, was not an amendment to Neuman’s prior standing agreement, for, under California Law, “[t]erms set forth in writing intended by the parties as a final expression of their agreement…may not be contradicted by evidence of a prior agreement.” Id. The ‘”plain meaning” of the contract, the court held, was that “Neuman became a salaried employee of the LLP.” Id.

The LLP argued that Neuman must be considered a shareholder because: “1) he retained some of the privileges associated with shareholder status, 2) he was listed as a shareholder on some firm documentation, 3) the firm did not buy back his preferred stock, and 4) he received his paychecks from the California PC, rather than the LLP with whom he signed his employment contract.” Id. at 10.

Yet, the District Court found this argument unpersuasive finding that Neuman did not know that he was being listed as a shareholder on some documents until 2013, and, in fact, believed he was an employee once he signed the agreement. Id. at 10-11. Accordingly, the District Court affirmed the Bankruptcy Court’s order entitling Neuman to $1,161,066.43 in unpaid dues. Id. at 6 &14.

The Ninth Circuit Decision

The LLP petitioned the Ninth Circuit to review the District Court decision. Heller Ehrman LLP v. K. William Neuman, No. 15-17124 at 1 (9th Cir. April 10, 2017). The Ninth Circuit found a number of reversible errors. Id.

The primary difference in the courts’ interpretation of the facts centered on a 2007 Letter Agreement between Heller Ehrman LLP and Neuman. Id. at 3. The Bankruptcy Court found that the letter, which designated Neuman as a “fixed income shareholder,” “made him an employee of Heller Ehrman LLP.” Id. The Ninth Circuit, however, found that “when read with the Employment Agreement […] [it is] clear that the 2007 Letter Agreement simply modified how Neuman was to be paid; it did not modify his status as a shareholder.” Id.

The Ninth Circuit based its conclusion on a number of factors. First, the 2007 Letter Agreement identified Neuman as a “fixed income shareholder.” Id. While the lower considered Neuman’s fixed income status a “critical fact” as to the claim that he was an employee, the Ninth Circuit concluded that the Employment Agreement did not bar one from being a “fixed income shareholder.” Id at 3-4.

Next, the Bankruptcy Court found that the 2007 Letter Agreement was a novation, and thus, the previous Employment Agreement should be considered terminated. Id. at 4. The Ninth Circuit, on the other hand, found that no clear evidence existed that either party was intentionally trying to terminate the initial agreement, and, therefore, the initial agreement was enforceable. Id. at 4-5. The Ninth Circuit held that “a new arrangement for payment under a contract is not, in itself, sufficient to effect a novation.” Id. at 5. Thus, the Employment Agreement, insofar as it defined Neuman as a shareholder at Heller Ehrman LLP, was enforceable. Id.

Moreover, while the Bankruptcy Court found Neuman had neither any “units of compensation,” nor an “Attributed Percentage” (i.e., the weight of a shareholder’s vote, which is proportional to both his or her compensation, and the LLP’s net profits), the Ninth Circuit found that Neuman did indeed have an “Attributed Percentage,” for his income, fixed though it was, was used in the calculating shareholder voting power, a power which Neuman exercised. Id. at 5-6. Given this, the court determined that, despite his new role in the LLP, “Neuman remained a shareholder” Id. at 6. Whereas Heller Ehrman typically terminated shareholder relationships “unambiguously,” and in accord with the terms laid out in the Employment Agreement, such was not the case with Neuman, whose shares and capital contribution were not repurchased or repaid, who was still permitted to attend meetings designated for shareholders, who voted at meetings (a privilege reserved for shareholders), and who was paid by his regional PC as only shareholders were. Id.

In light of this assessment, the Ninth Circuit reversed the District Court’s decision concluding that, while Neuman’s fixed income status was similar to that of an employee, the work he did and the privileges he enjoyed clearly illustrate that he should be treated as a shareholder. Id. at 6-7.

Conclusion

The Ninth Circuit’s decision presents a number of useful criteria to apply in determining a “shareholder’s” or “partner’s” status. In concluding that Neuman remained a shareholder, the court focused upon the facts that his preferred shares were not repurchased, his capital was not repaid, he was allowed to and did vote with other shareholders (who were the only ones permitted to vote), he was paid from a Professional Corporation, and only shareholders were paid by the PCs. Firms should carefully review these legal indicia to determine the legal relationships of partners and shareholders and to ensure that the intended legal statuses (e.g., ownership, equity, non-equity employee) are consistent with the parties’ agreements and conduct.