Legal Ethics Opinion #l556
Fee Division and Financial Disincentive Arrangements
Between Law Firm and Lawyers
Withdrawing to Practice in Competition with Law Firm
INQUIRY:
The Committee is asked to opine generally with respect to
provisions of employment/shareholder/partnership agreements
(hereinafter referred to as "Agreements") between lawyers and a
law firm whereby (i) withdrawing lawyers who take clients of the
law firm and compete with it following their withdrawal are
obligated to pay a certain portion of such clients' post-
withdrawal fees to the law firm, (ii) the law firm is obligated
to pay withdrawing lawyers some portion of fees received for
their unbilled work or work in progress existing at the time of
withdrawal, and (iii) financial disincentives are exacted from
lawyers who withdraw from a law firm, with or without taking
clients from the law firm, and practice in competition with the
law firm.
APPLICABLE DISCIPLINARY RULES:
DR 2-l05(D): A division of fees between lawyers who are not in
the same firm may be made only if
(l) The client consents to the employment of
additional counsel;
(2) Both attorneys expressly assume
responsibility to the client; and
(3) The terms of the division of the fee are
disclosed to the client and the client
consents thereto.
DR 2-l06(A): A lawyer shall not be a party to a partnership or
employment agreement that restricts the right of a
lawyer to practice law after the termination of a
relationship created by the agreement, except as a
condition to payment of retirement benefits.
PRIOR RELEVANT LEOs:
LEO #246: It is not permissible for law firms to have
employment agreement which prohibits attorney from
practicing in same geographical area as the firm
for a specified period after termination of
employment.
LEO #428: A provision in a partnership agreement among
lawyers which tied a partner's right to receive
termination compensation to a covenant against
competition violated DR 2-l06.
LEO #880: It is not permissible for a PC to implement an
unqualified deferred compensation plan containing
a restriction against attorneys practicing within
a "reasonable radius" after withdrawal if the
attorneys seek to obtain deferred compensation or
interest on the ivnestment of that attorney's
compensation. Such a provision is permissible
with respect to benefits under the plan which come
from funding by the PC or third party.
LEO #985: It is permissible for a PC to have an employment
agreement with an attorney which provides for a
reduction in the liquidation value of his stock if
he (a) withdraws from the PC in concert with other
attorneys and/or (b) carries clients of the PC
with him. DR 2-l06(A).
OPINION:
I. Withdrawn Lawyer's Division of Fees with Former Firm for
Post-Withdrawal Services to Former Clients of the Firm.
A lawyer who withdraws from a firm to compete with it and takes
clients of the firm with him cannot be contractually obligated to
divide his post-withdrawal fees from those clients with the firm.
See, Texas Professional Ethics Committee, Op. No. 459, dated Oct.
7, l988; Pennsylvania Committee on Legal Ethics & Professional
Responsibility No. 87-l05, dated Jan. l988; and Illinois State
Bar Association, Op. No. 86-l6; dated May l3, l987.
Clients electing to go with a lawyer withdrawing from a firm are
no longer clients of the firm. The firm no longer renders legal
services to them. The withdrawn lawyer alone renders legal
services and, in turn, earns the fees. Hence, DR 2-l05(D)'s
conditions precedent to a division of fees between the firm and
the withdrawing lawyer cannot be satisfied. See LEO #l488.
Under those circumstances client consent to a division of post-
withdrawal fees would be unavailing since the firm from which the
lawyer withdrew would not be additional counsel, and both the
firm and the withdrawing lawyer would not render legal services
to the clients accompanying him.
The rationale for the ethical proscription is well stated, as
follows:
[T]he interjection of a fee [to the firm from which the
lawyer withdrew] obviously impairs the creation of a lawyer-
client relationship between the departing lawyer and client
of his former firm. The impairment arises on both sides of
the transaction. The attorney may be unwilling to work at
substantially reduced rates for even his best clients, and
pressure against acceptance in favor of clients paying full
value to the firm would arise within the new [firm employing
the departing lawyer]. The attorney would thus be compelled
to decline employment and the client would be deprived of
the attorney of his choice....
Texas Professional Ethics Committee, Opinion No. 459 at pp. 2-3.
II. Firm's Payment to Withdrawn Lawyer for Fees Received fro
Lawyer's Unbilled Work and Work in Progress at Time of
Withdrawal.
DR 2-l05(D) speaks to a division of fees "between lawyers who are
not in the same firm." (emphasis added.) Though a lawyer who has
withdrawn is no longer in the firm, his unbilled work and work in
progress existing at the time of withdrawal were produced while
he was in the firm. The fees attributable to such work, though
received by the firm after his withdrawal, had been earned for
services rendered as a member of the firm before his withdrawal.
Under those circumstances, neither the letter nor the spirit of
DR 2-l05(D) is violated by an Agreement which obligates the firm
to make payment(s) to a withdrawn lawyer for fees received by the
firm based upon the value of his Legal unbilled work and work in
progress at the time of withdrawal. See, Illinois State Bar
Assoc., Op. No. 86-l6 at p. 3:
"With respect to the division of fees....[F]ees earned while
the associate was an employee of the firm are subject to
division according with [sic] the terms of the employment
agreement."
III. Financial Disincentives to Competition
with Law Firm Following Lawyers' Withdrawal.
A law firm's partners and associates form the nucleus of its
income-producing assets. Thus, law firms often seek a buffer
against the economic consequence of one or more of their lawyers
withdrawing and practicing in competition with the firm--with or
without taking clients with them.
Various financial disincentives have been fashioned in Agreements
to protect the economic interest of the law firm. In each
instance financial disincentives exhibit the inevitable friction
between the practice of law as a profession, on the one hand, or
as a business enterprise, on the other hand. See Covenants Not
to Compete and the Legal Profession, 29 St. Louis Univ. L.J. 423,
438-446 (l985). The two recent cases which follow are paradigms
of the competing philosophies.
Denburg v. Parker Chapin Flattan & Klimpl, 82 N.Y.2d 375, 662
N.E.2d 995, 605 N.Y.S.2d 900 (l993), addressed a provision of a
partnership agreement, executed in l983, that if a partner
withdrew and entered private practice before July l, l988, he had
to pay the law firm the greater of (i) l2.5% of the firm's
profits allocated to him over the two previous years, or (ii)
l2.5% of his billings to former clients of the firm over the
ensuing two years. In addition, the agreement authorized the
firm to apply the withdrawn partner's capital account to satisfy
his payment obligation to the firm. A partner withdrew from the
firm in l984, and in l986 the firm requested information about
his billings to its former clients in order to determine his
liability to the firm.
The New York Court of Appeals held that the provision was
unenforceable as against the public policy expressed in DR 2-
l08(A) (adopted in Virginia as DR 2-l06(A)).
[R]estrictions on the practice of law, which include
"financial disincentives" against competition as well as
outright prohibitions, are objectionable primarily because
they interfere with the client's choice of counsel: a clause
that penalizes a competing attorney by requiring forfeiture
of income could "functionally and realistically discourage"
a withdrawing partner from serving clients who might wish to
be represented by that lawyer....
* * *
[W]e conclude that [the effect of the disincentive provision
of the partnership agreement] is to improperly deter
competition and thus impinge upon clients' choice of
counsel. First, it applies only to lawyers continuing in
private practice--and thus potentially in competition with
the firm--but not other practitioners (for example,
government lawyers) who do not threaten the firm's client
base. Ability to pay cannot explain this discrimination
because a departing partner becoming a high-paid corporate
officer or embarking on a lucrative business venture is
exempt from the required payment but an attorney starting a
sole practice is not.
The provision, moreover, requires a departing partner to pay
the greater of two amounts, one computed on the basis of
billings to former clients of the firm. This bears little
relation to the purported compensatory purpose of the clause
and instead exacts an amount directly proportional to the
success of a departing partner's competitive efforts....
82 N.Y.2d at 380, 38l.
The Supreme Court of California reached a diametrically opposed
result in Howard v. Babcock, 6 Cal. 4th 409, 863 P.2d l50, 25
Cal. Rptr. 2d 80 (l993). Howard addressed a provision in a law
firm's partnership agreement that if more than one lawyer
withdrew before age 65 and thereafter within a period of one year
engaged in practice handling liability insurance defense work
within a designated court system, such withdrawn lawyers were
subject to a forfeiture of all of their withdrawal benefits
except for their capital contribution.
The withdrawal benefits under the partnership agreement consisted
of the capital account plus a sum equal to the withdrawn
partners' shares of net profit that, but for withdrawal, would
have been received during the twelve months immediately following
withdrawal from the firm.
In December of l986, four partners gave notice of their
withdrawal to form their own firm effective January of l987 and
practice liability insurance defense work in the proscribed court
system. Clients of the withdrawn partners' former firm
substituted the withdrawn partners' firm for their former firm in
some 200 cases.
The withdrawn partners' former firm tendered payment of their
capital account. It refused compensation to them for
undistributed profits, accounts receivable for work billed but
not paid, and work in progress to be billed in the future.
In a lengthy opinion, the California Supreme Court acknowledged
but rejected the conventional wisdom of courts and commentators
alike that the practice of law is a profession which is set apart
from for-profit business enterprises. The rationale underlying
validation of the disincentive agreement in Howard was stated, as
follows:
[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....
* * *
Withdrawing partners are able to announce their departure to
clients of the firm, and many clients defect along with the
attorneys with whom they have developed good working
relationships. The practical fact is that when partners
with a lucrative practice leave a law firm along with their
clients, their departure from and competition with the firm
can place a tremendous financial strain on the firm....
* * *
Recognizing these sweeping changes in the practice of law,
we can see no legal justification for treating partners in
law firms differently in this respect from partners in other
business and professions.
6 Cal. 4th at 420, 42l.
Turning to the Disciplinary Rules, the California Supreme Court
addressed the substance of DR 2-l06(A), as follows:
We are not persuaded that this rule was intended to or
should prohibit the type of agreement that is at issue here.
An 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. Rather, it
attaches an economic consequence to a departing partner's
unrestricted choice to pursue a particular kind of practice.
* * *
The firm has a financial interest in the continued patronage
of its clientele.... The firm's capital finances the
development of a clientele and the support services and
training necessary to satisfactorily represent the
clientele.... In earlier times, this investment was fairly
secure, because the continued loyalty of associates to the
firm was assured....
6 Cal. 4th at 4l9, 420.
Justice Kennard wrote a stinging dissent. His premise was that
DR 2-l06(A) sets forth an unwavering ethical standard.
Although the law is a business in the sense that an attorney
in a law firm earns a living by practicing law, it is also
and foremost a profession, with all the responsibilities
that word implies. The ethical rule that this court is
called upon to interpret exists to enforce the traditional
and sound view that service to clients, including protection
of the
clients' ability to employ the attorneys they have come to
trust, is more important than safeguarding the economic
interests of established attorneys and law firms. I would
enforce the rule according to the ordinary meaning of its
terms to bar all agreements by which established firms seek
to protect themselves against competition from attorneys who
leave the firm.
I cannot accept that the practice of law has been so altered
that it is now irretrievably profit-centered rather than
client-centered. If ethical rules for attorneys must
accommodate the "realities" of practicing law, then those
realities ought to include this court's insistence that
attorneys serve more than their own interests and
accomplisdh more than amassing fees. Protection of the
public and preservation of public respect for the law
require no less.
* * *
[I]n refusing to enforce a rule of ethics that prohibits
attorneys from entering into agreements that restrict their
right to practice law after leaving a firm, the majority
diminishes the rights of clients in favor of the financial
interest of law firms based on its one-sided view of the
realities and equities of the practice of law.
6 Cal. 4th at 427, 434.
The majority in Howard acknowledged, and the dissent reiterated,
that upholding the disincentive covenant was contrary to the
weight of authority. See Ethical Pitfalls and Malpractice
Consequences of Law Firm Breakups, 6l Temple L. Rev. l055, l072-
l075 (l988); ABA/BNA Lawyers' Manual on Professional Conduct
9l:7l0-9l:7ll. The majority suggested that the contrary
decisions were inconsistent with reality and flawed by "lofty
assertions about the uniqueness of the legal profession." 6 Cal.
4th at 423. See Covenants Not to Compete and the Legal
Profession, supra.
Prior Virginia LEO's, excepting No. 985 in part, addressing the
right of a lawyer to practice in competition with his former firm
reflect the philosophy articulated in Dansburg and in the dissent
in Howard. The inquiry in LEO No. 985 was whether it was
permissible for a lawyer and a law firm, incorporated as a
professional corporation, to have an agreement which provided for
a reduction in the value of the stock of a withdrawn lawyer if he
(a) withdrew in concert with other lawyers, and/or (b) took
clients of the law firm with him.
The Committee concluded that the agreement did not violate DR 2-
l06(A), stating:
The Committee opines that only those agreements that
restrict the right of a lawyer to practice law after the
termination of the relationship are prohibited[;] there is
no prohibition on agreements that affect the termination of
the relationship itself.
Significantly, the linchpin of the reduction in value of the
stock was withdrawing from the law firm in concert with others
and/or taking clients of the law firm. The agreement did not bar
or by its terms restrict the withdrawn lawyer from practice in
competition with the law firm, either generally or within a
particular area for a specified period of time following his
withdrawal, yet it exacted a financial penalty if law firm
clients elected to go with the withdrawn lawyer.
The opinion expressed in LEO No. 985 is overbroad. Whatever the
occasion for a law firm's break up, the clients' interests remain
paramount. In LEO No. l403, for example, the Committee concluded
that a law firm's employment agreement prohibiting a withdrawn
lawyer from contacting clients about his withdrawal until the
firm had done so constituted a restrictive covenant in violation
of DR 2-l06(A), stating:
The policy behind the ban on such restrictions is to protect
the ability of clients to freely choose counsel and to
protect the autonomy of that counsel. The agreement
provision restricts the ability of the client [of the law
firm] to make an informed and free choice of counsel.
See also LEO No. l506.
The fundamental premises, though at times unspoken, are that
clients of a law firm are not commodities, and that the law firm
is not a merchant. If there is a break up of the firm initially
chosen by a client, the client selects the lawyer or law firm to
represent him thereafter. Ethical Pitfalls and Malpractice
Consequences of Law Firm Breakups, supra, at l064-65. A client's
freedom to hire counsel of his choice transcends a law firm's
interest in being protected against "unfair" competition.
ABA/BNA Lawyers' Manual on Professional Conduct 5l:l202.
Hence, LEO No. 985 is overruled to the extent that it approves a
provision in an employment agreement permitting a law firm to
exact a financial penalty from a lawyer (or lawyers) who withdraw
and take clients of the law firm with them. Clients are not
"taken;" they have an unfettered right to choose their lawyer.
Correspondingly, lawyers withdrawing from a law firm have an
unfettered right to represent clients who choose them rather than
choose to remain with the law firm.
A recent request for an opinion presents a variation of the law
firm agreement addressed in LEO No. 985. A law firm formed as a
professional corporation (the "PC") has an agreement which
provides for periodic payments over three years to a Withdrawing
Lawyer, defined as one who withdraws from the PC to retire, take
a judicial appointment, or become employed with any entity not
engaged in the practice of law in competition with the PC. If a
lawyer withdraws to enter private practice and competes with the
PC for clients within a fifty-mile radius during a period of
three years following withdrawal, he is defined as a Competing
Lawyer.
The PC agreement provides that if a Competing Lawyer represents
any client originated by a Withdrawing Lawyer, the Competing
Lawyer shall reimburse the PC for its payments to the Withdrawing
Lawyer over the three years following the Competing Lawyer's
withdrawal from the PC and practice within a fifty-mile radius in
competition with the PC. The amount of the payments to a
Withdrawing Lawyer is determined in large part by the fees which
the Law Firm received from the clients originated by the
Withdrawing Lawyer.
Since the Competing Lawyer's liability to the PC under the
reimbursement formula is not fee-specific or based upon the
quantum of fees received by him from clients originated by a
Withdrawing Lawyer, the agreement is not an impermissible
division of fees under DR 2-l05(D). The Committee is of the
opinion, however, that the agreement is violative of DR 2-l06(A)
as an impermissible restriction of the Competing Lawyer's right
to practice law.
The agreement is essentially the obverse of the agreement found
to be impermissible in LEO No. 428. There a withdrawn lawyer was
denied termination compensation if he competed with his former
firm. Here the Competing Lawyer incurs a liability to his former
firm if he competes with it within a radius of fifty miles for a
period of three years following his withdrawal. In each case,
the withdrawn lawyer pays a financial price which is tied to his
practice of law in competition with his former firm.
The Committee recognizes that the Competing Lawyer's liability to
the PC is not measured by the amount of the fees which he
receives from clients originated for the law firm by a
Withdrawing Lawyer. Even so, liability to the law firm is
inextricably tied to competition; a Competing Lawyer is defined
as one who "competes for clients directly or indirectly within a
geographic area within a radius of 50 miles from the Firm's
primary business location, at any time during a 3-year period
commencing on the date of his or her departure from the Firm...."
(emphasis added.)
In short, the Competing Lawyer could compete for clients within a
radius of 5l miles from the PC without liability because he would
not fall within the definition of "Competing Lawyer." The
financial disincentive is fashioned in order to give the PC a
fifty-mile safe harbor from competition by Competing Lawyers for
three years following their withdrawal. DR 2-l06(A) does not
permit any agreement that "restricts the right of a lawyer to
practice law after the termination of a relationship created by
the agreement, except as a condition to payment of retirement
benefits."
Hence, the Committee is of the opinion that the agreement
violates DR 2-l06(A). See Gray v. Martin, 63 Or. App. l73, 663
P.2d l285, pet. for app. den., 295 Or. 54l, 668 P.2d 384 (l983);
compare Covenants Not to Compete and the Legal Profession, supraat 437-38.
Committee Opinion
July 21, 1994
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