Bankruptcy Court Rules Against Business Partners

February 17, 2015
A recent bankruptcy decision from the Southern District of New York should caution business partners about the risks presented if the partnership becomes bankrupt. Limited liability partnerships present advantages such as flexibility in the operation of the business and tax advantages. LLPs also provide protection for partners from the business’ debts. As a result, LLPs are popular among professionals, including attorneys.

Jacobs v. Altorelli (in re Dewey & LeBoeuf LLP) involves the bankruptcy of Dewey & LeBoeuf (Dewey). At its peak, Dewey was one of the largest and most prestigious law firms in America. Following a wave of partner departures during the first half of 2012, Dewey filed for bankruptcy protection on May 29, 2012.

Analysts have offered reasons for Dewey’s collapse, but one oft-noted suggestion is Dewey compensation guarantees to certain coveted partners. When Dewey’s profits flagged, it could not meet these guarantees. Moreover, when partners without guarantees learned others had them, it led to friction among partners. As a result, many partners began leaving the firm. These departures only hastened the firm’s demise.

In 2013, Alan Jacobs was appointed as Dewey’s liquidating trustee, with the right to bring actions against third parties to recover partnership draws that Dewey transferred to them before it filed for bankruptcy. The Altorelli case involves Mr. Jacobs’s efforts to recover fraudulent transfers from certain former Dewey partners. Under federal bankruptcy law, a trustee may recover transfers made pre-bankruptcy to a third party from a debtor where the transfer was made with the actual intent to defraud the debtor’s creditors or where the debtor did not receive “reasonably equivalent value” in exchange for the transfer. The Trustee sought to recover payments made to the former partners under Dewey’s partnership agreement based on lack of reasonably equivalent value.

The former partners admitted they had received the funds at issue but asserted that they provided reasonably equivalent value to Dewey in the form of their work as attorneys. The Trustee responded that, under New York partnership law, the former partners were not entitled to compensation from a partnership and therefore Dewey had no obligation to pay them and received no value from doing so.

The Bankruptcy Court sided with the Trustee. While acknowledging that ordinarily services by an employee to a company could constitute reasonably equivalent value, the Court deemed the partners’ situation different because their payments were not compensation but instead distributions to them on account of their partnership interest. Under New York partnership law and Dewey’s partnership agreement, all fees and proceeds earned by the partners were the property of Dewey and no partner was entitled to compensation for the work performed for Dewey. This “no compensation rule” is consistent with the general partnership principle that partners should split the net profits of the partnership after all expenses are paid. Based on the “no compensation rule”, the Court held that the former Dewey partners could not rely on the “reasonably equivalent value” defense to the Trustee’s claims against them. This ruling has had a dramatic personal effect on Mr. Altorelli personally; he filed for personal bankruptcy on November 25, 2014.

In its opinion, the Court specifically stated its ruling as to the former partners did not apply to partners who received a salary or to those partners who had special compensation arrangements. Those arrangements were outside the scope of the opinion due to the “individual facts” that pertained to them.

While the Altorelli decision is understandable as a matter of statutory construction, its formalistic reading of New York partnership law is harsh and creates unfortunate incentives for partners when their partnerships begin to deteriorate financially. The “no compensation rule” holds that partners are not entitled to compensation from their partnerships absent a separate contractual arrangement or provision in a partnership agreement. However, despite the Court’s reasoning, just because a partnership has no legal obligation to compensate partners does not necessarily mean that those partners’ contributions to the partnership are valueless. The partners in question stayed with Dewey and continued to work for Dewey. Based on the Court’s rulings, their contributions to the firm during that time period will likely go completely unpaid, because the Trustee will be able to recover payments they received in the period leading up to the firm’s bankruptcy as fraudulent transfers.

The Altorelli case presents partners in financially troubled partnerships, and the partnerships themselves, with difficult decisions. Based on the Court’s logic in Altorelli, a partner would be better off leaving a potentially insolvent partnership than staying and helping it through its difficulties. If the firm were to file bankruptcy, then the partners could expect any remuneration they received in the lead-up to the bankruptcy to be clawed back by a trustee. Partners could perhaps avoid this difficulty by entering into contracts with their partnerships for payments; the Altorelli decision specifically exempted such contractual arrangements from the scope of its decision. However, even with such a contract, any payments received just before bankruptcy could be attacked as preferences. Further, many analysts believe guaranteed compensation contracts of this sort were a huge factor in Dewey’s ultimate failure. Thus, firms are in the unenviable position guaranteeing their partners’ compensation or risking the mass defection of partners at the first sign of financial difficulty. As the value of most professional partnerships comes from the partners, this departure would be a death knell for such firms.

Altorelli is still a new case, and at this time is not the law in Kentucky or the Sixth Circuit. However, Kentucky’s partnership law is similar to New York’s, with KRS 362.1-401 and 362.235 both stating the “no compensation rule” the Court referred to in Altorelli. As a result, Kentucky partners and partnerships should be aware of the decision and anticipate how they can best protect themselves if a Court in Kentucky adopts that decision’s reasoning.