Ethics Opinion 325: Agreement to Distribute Former Firm Profits to Partners From Former Firm Only as Long as They Continue to Practice in New Merged Firm

Opinion 325

Agreement to Distribute Former Firm Profits to Partners From Former Firm Only as Long as They
Continue to Practice in New Merged Firm: Rule 5.6(a)

When a law firm is about to merge with another firm, its partners agree to distribute profits already earned by the former firm, but which will be paid in the future, only to partners who continue to practice with the post-merger firm. This agreement violates Rule 5.6(a) because it creates a financial disincentive to partners to leave the merged firm and practice with another firm. The exception in Rule 5.6(a) for an agreement relating to benefits upon retirement applies only to the type of retirement typical at the end of a career and not to all departures from a firm.

The inquirer poses a question of the interpretation of Rule 5.6(a) as applied in the context of law firm mergers. As stated by the inquirer, the facts are these:

Factual background
The inquirer was a partner in a Law Firm, which merged with another firm to become Merged Law Firm. Before the merger, the Law Firm was owed fees by some clients for work that had already been completed. These fee payments were to be made over time, but the Law Firm needed to do nothing further to be entitled to them. Anticipating the merger, the partners of Law Firm assigned the future right to receive these fees to a new entity, Receivables LLC. Under the agreement of those partners that created this LLC, each Law Firm partner was entitled to a fixed and specifically stated percentage share of the LLC’s receivables equal to that partner’s share of Law Firm profits. This was called a Management share. In addition, those partners who were regarded as having originated client business that led to the receivables were entitled to a further specifically enumerated percentage of the receivables, called an Originator’s share. The inquirer was an Originator and thus was entitled both to a Management share representing his share of the pre-merger Law Firm’s profits, plus an Originator’s share. Thus, after the merger the LLC received sums attributable to Law Firm work done before the merger and paid those out to the partners of the pre-merger Law Firm.

Under the documents creating Receivables LLC, the partners’ rights to receive Management and Originator’s shares were not unconditional. The agreement creating the LLC provides that if any partner of the pre-merger Law Firm who is a member of Receivables LLC leaves the Merged Law Firm before December 31 of the year following the year of the merger (a period of two years from the effective date of the merger), that partner’s Management share in Receivables LLC ceases at that time - does not vest1 in the terminology of the agreement - and the payments stop, unless the departure within that period from the Merged Law Firm is attributable to death, illness, or retirement from the practice of law, in which case the payments do not stop with the departure from the Merged Law Firm. If the partner leaves the Merged Law Firm after two years have elapsed since the merger, then the payments continue despite the departure. In addition, if any partner who is also an Originator, like inquirer, leaves the Merged Law Firm at any time and for any reason, then that Originator’s share becomes void and the payments of the Originator’s share stops. Thus, documents creating Receivables LLC condition the right to receive sums owed to the pre-merger Law Firm in such a way as to create incentives to partners of the former Law Firm to continue practicing with the Merged Law Firm.

The inquirer reports that after the merger, the Merged Law Firm decided to pursue clients whose interests tended to conflict with those of the clients whom the inquirer tended to represent. It was not possible for inquirer to continue to represent the clients that were the inquirer’s traditional client base. The inquirer states, "At the [Merged Firm’s] direction, I am forced to find a new firm to practice with." The departure of the inquirer would effectively be before the expiration of the two-year period, so that departure would result in the loss by the inquirer of all rights to a continuing share, including both a Membership share and an Originator’s share of income from Receivables LLC.
The applicable Rule
Rule 5.6(a) provides that a lawyer may not "make or participate in making a partnership or employment agreement that restricts the rights of a lawyer to practice after termination of the relationship, except an agreement concerning benefits on retirement . . . ." While there has been a great deal written about Rule 5.6(a) (including our opinions 291, 241, 221, and 652), we think it useful to discuss its basic framework.

The Rule first bars a lawyer from participating in the offering or making of a partnership or employment agreement that "restricts the right of a lawyer to practice after termination of the relationship . . . ." There is then an exception for agreements "concerning benefits upon retirement . . . ." Rule 5.6(a) is "substantially similar" to its predecessor, DR 2-108(a) of the Model Code of Professional Responsibility. See the report of the District of Columbia Bar Model Rules of Professional Conduct Committee, with the changes recommended by the Board of Governors, submitted with the Board’s Petition recommending adoption the Rules to the D.C. Court of Appeals, November 1986 at page 210.

Rule 5.6(a) seeks to prevent lawyers from entering into agreements that will discourage lawyers from moving from one firm to another. The reason for the Rule is that clients may benefit when their lawyers (either at the beginning of their careers or later) can improve their work environment. The D.C. Court of Appeals has favorably quoted the Committee’s determination in Opinion No. 241 that the Rule is a mechanism "to protect the ability of clients to obtain lawyers of their own choosing and to enable lawyers to advance their careers." Neuman v. Akman, 715 A. 2d 127, 131 (D.C. 1998). The Committee has more recently stressed that clients not infrequently recommend a change of law firm to lawyers, for various reasons, and Opinion No. 273 (1997) requires lawyers to consult with their clients before changing firms precisely because such changes are often important to clients. This principle of facilitating lawyers’ changes in their practice environment to benefit clients finds expression elsewhere in our Rules, such as the special provisions seeking to facilitate the movement of lawyers from firm to firm in Rule 1.10. See Comments [10], [11], and [21] to Rule 1.10.3 Such considerations are not unique to the District of Columbia but are shared by other jurisdictions. See 2 Hazard & Hodes, The Law of Lawyering § 47.4 at 47-5 (3d ed. 2001).

It has long been clear that Rule 5.6(a) bars not only agreements that would explicitly restrict lawyers’ practices but also reaches agreements that may not explicitly bar such actions but create financial disincentives to taking these actions. In Opinion No. 65 (1979) this Committee considered an agreement that sought to compel a lawyer to pay 40 per cent of any fees received from a client of the lawyer’s former firm if earned within two years after the lawyer’s departure from the firm. It concluded that such an agreement violated DR 2-108(a) because "[i]ts effect is to impose a barrier to the creation of a lawyer/client relationship between the departing lawyer and the clients of his former firm." Even if it did not do so literally, the Committee noted, such a barrier interfered with clients’ choice of attorney because "[t]he departing attorney would find work for clients of the former firm economically less attractive than work at similar rates received from other clients, and might be deterred from accepting employment from such clients."

Opinion No. 241 (1991) concluded that an agreement created a financial disincentive on a departed lawyer’s competition with the lawyer’s former firm. There, a law firm’s partnership agreement provided for the repayment of a partner’s capital account over a period of five years, except that where after departure a partner practiced law in the District of Columbia, the repayments were delayed for five years or until the departing partner had reached the age of 65 or stopped practicing in the District of Columbia. The Committee concluded that the agreement violated Rule 5.6(a) because "the financial penalties imposed on a departing lawyer serve no other purpose than restricting practice and insulating the firm from potential competition."

We note, however, that the simple existence of an economic cost to leave a firm does not necessarily mean that Rule 5.6(a) has been violated. To constitute a violation, an agreement must effectively "restrict the rights of a lawyer to practice after termination of the relationship." Where such a restriction is not explicit, the effect of the agreement must be to create such a restriction on competition or other limitation on practice. For this reason, it can be necessary to examine surrounding circumstances to determine whether a violation of the Rule 5.6(a) has occurred where the restriction on a lawyer’s practice is not expressed.4

The Rule also contains an exception for "an agreement concerning benefits on retirement." Much of the attention that has been paid to this rule by courts, ethics committees, and commentators has dealt with this exception, whose scope is often debated. See, e.g., Borteck v Riker, Danzig, Scherer, Hyland & Perretti LLP, 844 A. 2d 521 (N.J. 2004) (in which, at 530-31, the New Jersey Supreme Court called upon its Professional Responsibility Rules Committee to review Rule 5.6(a) "to determine whether the rule should define ’retirement’ and, if so, to propose a definition or related criteria"); Neuman, supra, 715 A. 2d at 136 (in which the D.C. Court of Appeals discussed, but found it unnecessary to decide, the issue of the scope of the exception). Courts that have decided the issue have generally concluded that the exception extends only to the kind of retirement that occurs at the end of a career. E.g., Cohen v. Lord, Day and Lord, 550 NE 2d 410 (N.Y. 1989); see Borteck, 844 A. 2d at 527. Professors Hazard and Hodes agree that if "retirement" meant simply the termination of the "partnership or employment" relationship, then the exception would swallow the rule. It would except from the Rule’s prohibition every agreement made on termination of every relationship. 2 Hazard and Hodes, The Law of Lawyering § 47.4 at 47-5 to 47-6. (3d ed. 2001). Although in Neuman v. Akman, 715 A. 2d at 126, the D.C. Court of Appeals did not have to decide the issue, by extensively describing why the agreement there at issue constituted a "retirement agreement" within the meaning of a retirement at the end of a career, and by favorably citing Gray v. Martin , 663 P. 2d 1285, 1290 (Oregon App. 1983), see Neuman, 715 A. 2d at 134, the court suggested that if called upon it would view this issue no differently from the other authorities we have cited. We therefore conclude that the provisions in question here, which apply when a partner leaves the Merged Law Firm regardless of age, do not come within the "retirement" exception of Rule 5.6(a).
Discussion
We first note that it might be argued that the agreement to form Receivables LLC was not a "partnership" agreement within the meaning of the Rule. However, the LLC was created by the partners of the pre-merger Law Firm solely to obtain and distribute to those partners funds owed to the pre-merger Law Firm in payment for its previously completed legal work. We therefore conclude that the agreement that created Receivables LLC is a "partnership . . . agreement" within the meaning of the Rule. Otherwise, a firm could avoid the prohibition of Rule 5.6 by creating a separate organization to handle portions, but not all, of the firm’s law practice. Law firm mergers have become more frequent in recent years. Individual lawyers in a firm that is contemplating merging with another may be concerned about whether the firm that would result from the merger would be as satisfactory a place for them to practice for clients as was their pre-merger firm. Similarly, the question of which partners in the negotiating firms are likely to remain at the merged firm can be a feature of merger negotiations. In these contexts the limitations of Rule 5.6 can be particularly significant. It would not be consistent with the language or purpose of that Rule to allow partners of one or both of the merging firms to escape scrutiny under it by forming separate organizations to achieve some of their purposes.

We now examine in turn the two kinds of payments made under the agreement forming the LLC. We note as a preliminary point that we do not think that it could be argued that for purposes of this analysis under Rule 5.6 the Merged Firm is somehow a continuation of the pre-merger Law Firm. The LLC was formed only by the partners of the pre-existing Law Firm (and not by others involved in the merger) and applies only to them, and operation of the LLC is independent of the compensation of the Merged Law Firm.

Under the LLC, the Membership share amounts are paid to former Law Firm partners pursuant to fixed percentages attributable to each partner’s ownership share of the pre-merger firm. These Membership interests expire, i.e., do not "vest," if a lawyer leaves the Merged Firm before the end of the two-year period, unless the reason for departure during that period is death, disability, illness, or retirement from the practice of law, in which case the right to continue receiving the payments vests even though the lawyer in question has departed before the two years had passed. As we have seen, the inquirer left within the two years, before his interest became fixed, because he felt that he could not pursue his practice freely and serve the clients that would most benefit from his experience and developed expertise, in the new direction that the Merged Firm took.

In effect, the imposition of the two-year vesting period is an action by the partners of the pre-merger Law Firm that uses assets belonging to them to induce themselves not to depart from the Merged Firm for at least two years after the merger. The pre-merger firm’s entitlement to the payments was fixed before the merger. With the termination of the pre-merger Law Firm, its partners had the unconditional right to receive those sums as they were eventually paid. The agreement creating the LLC provides that these payments are to be distributed based on a formula using each lawyer’s percentage share of the profits of the pre-merger Firm, a fixed formula entirely based on past events. But the agreement goes further and adds the condition that each lawyer’s entitlement to continue to receive these payments depends on that lawyer remaining with the Merged Firm for two years. The fact that there is an exception to the two-year vesting requirement for partners who may retire from practice, die, or become disabled before the end of the two years underscores that those partners who are capable of leaving the firm to practice elsewhere are the ones who are affected by a financial disincentive inherent in the vesting period.5

For this reason, while the agreement here does not explicitly say that it cuts off payments where a lawyer leaves the Merged Firm to practice with others before the two-year vesting period ends, that is its clear impact - and it is what happened in the inquirer’s situation. The two-year vesting requirement applies to cut off payments of the Management shares only to those lawyers who depart because they intend to practice law elsewhere.6 It accordingly penalizes (by stopping the flow of previously earned income) those who continue to practice but do not do so with the Merged Firm. While it is of course possible that a partner would leave to practice law but not in competition with the Merged Firm (such as by moving to another city - although in specialized practice areas even such a move may not avoid competition with a lawyer’s former firm), we believe that that is a comparatively rare occurrence for lawyers who have reached the stage in their careers where they are partners in a firm. That mere possibility does not change the dominant practical impact of the provision, which is to penalize those partners who seek to serve their clients by practicing elsewhere than the Merged Law Firm by depriving them of a portion of previously earned fees that otherwise would be theirs. Nor does the fact that the inquirer left the Merged Law Firm to conduct a kind of practice that that firm was not interested in pursuing affect our view. The inquirer wished to continue to represent clients with views generally opposed to that of the Merged Law Firm’s clients. The purpose of Rule 5.6 is to bar agreements among lawyers that would create restrictions on a lawyer’s ability to move to a better practice environment within which to seek to represent his or her clients’ interests. An agreement that penalizes a lawyer for leaving a firm where most of the practice is hostile to the lawyer’s particular clients is just as harmful to the purpose of Rule 5.6 as trying to prevent a lawyer from competing for the same kinds of clients as his former firm.7

The Originators’ shares present a different and more difficult issue. The right to continue to receive an Originator’s share does not ever become fixed, or vest, and therefore a partner who departs from the Merged Firm for any reason, including death, illness, retirement, moving to another firm (whether in competition with the Merged Firm or not), or leaving the profession to pursue another endeavor, loses the right to continue to receive Originator’s shares. Indeed, the inquirer informs us that in the case of a partner entitled to an Originator’s share who died, the payment of that share was indeed terminated. Upon inquiry from the deceased partner’s estate, the Merged Firm stated that this treatment of Originators’ shares existed because while under the compensation arrangements of the pre-merger Law Firm, partners were given recognition for matters that they "originated" (i.e., were responsible for bringing in to the firm), such an arrangement was no longer possible in the Merged Law Firm, and the LLC treatment of Originators’ shares was created to mimic the compensation from these sources of income in the pre-merger Law Firm.

While we do not see the issue as wholly free from doubt, we conclude that the treatment of the non-"vested" Originators’ shares also falls afoul of Rule 5.6. With respect to these shares, the Receivables LLC agreement conditioned the distribution of the previously earned assets of the pre-merger Law Firm, which was ending its business, so that they continued to be paid only as long as the pre-merger firm’s ex-partners continued to practice at the designated new post-merger firm. If the pre-merger firm had simply wound up its affairs entirely, presumably the partners would have distributed this right to future income to themselves as individuals, unconditionally. But instead the partners of the pre-merger Firm conditioned the future distribution of that asset on continued practice with a new and different firm. Moreover, while the Originator’s share ceases to be paid to a partner who leaves the Merged Firm for any reason, including illness, death, and retirement, this fact would have more force if it were applied by a law firm that was operating and continuing to operate its own practice. With a firm that is an ongoing practice, it makes basic sense to stop compensating partners who depart. But in the context of a firm that has wound up its affairs and sought nonetheless to exercise some future control over the distribution of previously earned assets, it would blink reality to fail to observe that death and disability are not voluntary departures and that retirement, while it may be delayed, is also ultimately largely involuntary. Thus the clear effect of the non-vesting feature of the Originators’ shares is to discourage partners from voluntarily leaving the Merged Firm as long as the payments continue, and the primary route of voluntary departure is, as in the case of the inquirer, leaving to practice at another firm. We do not see why the future payout of a previously fully earned asset would be conditioned on a partner’s staying with the Merged Firm unless the purpose of the condition were to incentivize the recipients to stay with the firm by depriving them of that previously earned asset if they left it. We believe that Rule 5.6(a) does not allow the partners of a firm that is winding up its affairs because the partners are, as part of a merger, joining a new firm, to use their former firm’s assets to create financial disincentives to themselves to leave the new firm.

As just suggested we do not mean to imply that the same considerations apply when a firm has an ongoing practice and simply ceases to compensate lawyers who leave it. Firms whose method of current compensation takes account of contributions of partners in previous years, even identifying streams of income as having been attributable to partners’ work in previous years and increasing their compensation by a portion of that amount, do not run afoul of the Rule simply because when a partner leaves the firm, regardless of the reason, the firm stops compensating that partner and thus does not continue to compensate the partner for continued benefit of his or her prior work to the firm. Firms benefit presently and in the future from the contributions of their partners, and the quantification of this as part of the compensation process is common and does not violate the Rule (at least not without more, such as some inequality of treatment that falls disproportionately on those partners who leave to compete with the firm). Any partner who leaves a firm that has such a compensation system cuts himself or herself off from future compensation at that firm, even where the departing partner contributed measurably to the continuing success of the firm and could have continued to participate in that success by remaining there. Thus, we do not conclude that an ongoing firm that cuts off elements of compensation at the time of a lawyer’s departure from a firm, no matter what the lawyer intends to do after departure, necessarily violates Rule 5.6(a) merely because some departing lawyers would thereafter be competing with the firm, and we are not aware of any case or authority that so concludes.8

But in the matter now before us, the pre-merger Law Firm wound up its affairs and distributed its assets to the partners, yet the former partners sought to retain some control over those assets after distribution, and sought thereby to continue - for years into the future - to condition future entitlement of the former partners’ right to receive payment on their continued work for the Merged Firm. It is this attempt by partners of the pre-merger Law Firm to continue to influence the future practices of partners some time after their departure from the pre-Merger Firm that leads us to conclude that treatment of this payment as well violates the Rule.

Adopted: October 2004

[Return to text] The term "vest", while perhaps not entirely legally accurate, is used in the LLC documents, and for convenience we will use it here.
[Return to text] Opinion 65 interpreted the former DR 2-108(A).
[Return to text] The case at hand is an example of the benefit that may flow to clients from a change of firm by a lawyer. The inquirer changed firms because the Merged Firm’s practice had become less hospitable to the clients he represented, and he sought to practice in a different firm where his clients’ goals did not conflict with those of other firm clients.
[Return to text] See Opinion No. 221, involving a lawyer who had departed from a firm taking contingent fee clients along with him. An employment agreement between the lawyer and that firm provided that in the event of such a departure and the later receipt by the lawyer of a contingent fee from that client, a portion of that fee would be allocated and paid back to the former firm, with the allocation made on the basis of a percentage formula depending on the length of time the lawyer had worked on the case while at the firm. The Committee concluded that if the percentage formula "represent[ed] a generally fair allocation of fees based on the firm’s historical experience there is no violation of Rule 5.6(a). On the other hand, if the firm’s share is excessive, this would have the effect of restricting the right of the departing lawyer to practice after the termination of the relationship in violation of Rule 5.6(a)." The Committee also pointed out that it "cannot make fact findings" and thus "can neither approve nor disapprove the specific percentages used by the firm."
[Return to text] Even with our conclusion that "retirement" means the end of a career practicing law, this portion of the agreement is not an "agreement concerning benefits on retirement" within the meaning of Rule 5.6(a). Its primary purpose is not to provide for retirement benefits, but to create a vesting period for continued entitlement to a division of fees earned in the past. This vesting period is imposed on partners who do not retire; the fact that it is waived for those who do retire does not alter its impact on those who do not. Moreover, none of the factors relied on by the court in Neuman as showing the kind of agreement that is a true retirement agreement under this view is present here. The funds distributed here are profits from work already done, not work to be done; there is no requirement that entitlement to those distributions is limited to partners of conventional retirement, and the payment of the benefits is not spread "over the entire remaining lifetime of the retiring partner." Neuman, 715 A. 2d at 136 - 38.
[Return to text] Presumably a partner who enters another field of endeavor has "retire[d] from the practice of law" and would thus be entitled to continue to receive the Management shares even if he or she left the firm before the two years had expired.
[Return to text] We also do not believe that the fact that a lawyer need remain at the Merged Firm for only two years before being able to depart assured of continuing to receive the Management share makes a difference. Clients whose situations would improve if their counsel could change firms should not be asked to wait while their preferred counsel fulfills a two-year vesting period. It is possible that in setting the two-year period the drafters of the Receivables LLC documents sought to derive some comfort from footnote 13 in Neuman, 715 A.2d at 136. That footnote deals, however, with a provision in a retirement plan approved by the Court under which a retired lawyer could resume practice after two years of retirement and still receive retirement benefits from the lawyer’s former firm. The Court describes that provision as having "limited anticompetitive effect". But under the retirement exception to Rule 5.6, when a lawyer retires is when a full restriction on the lawyer’s right to practice is permitted. Thus, as a condition to the continued receipt of retirement benefits a law firm could demand a much longer period of restricted practice than two years, and it is only by comparison to that possibility that a two year restriction is "limited." A two year restriction on practice in the middle of a lawyer’s career is not "limited."
[Return to text] Compare comment b. to § 13(b) of the Restatement of the Law Governing Lawyers (2000), which discusses denial of "benefits" effective at the time of a lawyer’s departure from a firm.