March 02, 2016
Law Firm Can’t Require Departing Partner to Forfeit Equity If Partner Takes Clients
In an important order that impacts the field of partner departures nationwide, a district court judge in the the Eastern District of Virginia held that a provision in a law firm’s operating agreement that provides that a withdrawing partner who “takes clients” forfeits up to fifty percent of his equity in the firm is void and unenforceable because it places an impermissible restriction on the partner’s right to practice law. (Moskowitz v. Jacobson Holman, PLLC, (E.D. Va. Jan. 28, 2016.)
The Court’s ruling was based on Rule 5.6 of the District of Columbia Rules of Professional Conduct, which prohibits lawyers from placing restrictions on the right to practice law, and is modeled on the ABA Model Rules. Versions of this rule have been adopted in every state, except California, although California has its own Rule of Professional Conduct which prohibits “agreements restricting a member’s practice” in certain circumstances. (See California Rules of Professional Conduct, Rule 1-500.)
Prohibition Against Outright Restrictions, As Well As Indirect Restraints
In analyzing whether or not the forfeiture provision in the Jacobson partnership agreement was valid, the Court interpreted Rule 5.6 to prohibit, “not only outright restrictions on practice, but also indirect restraints, such as financial disincentives.” (Order, Page 5.)
Under the firm’s governing documents, all departing equity members were entitled to the value of their partnership interest, except that a departing partner that “takes clients” forfeits fifty percent of his or her otherwise accrued equity interest. Under any other circumstances, the partner would receive the full value of their equity upon departure.
And while this provision on its face does not impose a direct restriction on the member’s right the practice law, the Court noted that it certainly “attaches a financial cost to a withdrawing member’s decision to continue to represent any of his or her clients.” Under the Rule, for the provision to amount to an impermissible restriction the penalty must be “substantial” – which the Court found that it was, holding that substantial “when used in reference to degree or extent,” the word “denotes a material matter of clear and weighty importance,” citing to the District of Columbia’s Rules of Professional Conduct, Rule 1.0 (m). As such, the Court found that a fifty percent forfeiture of a withdrawing member’s equity interest in the firm is a financial penalty “of clear and weighty importance” – regardless of the actual financial amount at issue and/or whether it represented only a small amount of the departing attorney’s compensation package at his new firm. (Order, Page 5-6.)
What Does California Say?
Although California also has a Rule of Professional Conduct, Rule 1-500, which prohibits agreements that restrict an attorney’s right to practice law, the California Supreme Court’s longstanding opinion on the validity of non-compete agreements between partners in certain circumstances – Howard v. Babcock (1993) 6 Cal.4th 409 – is the starting point for any similar analysis in California.
Howard v. Babcock, which is still good law in California, is now seen as a “minority view” by other jurisdictions in interpreting the validity of non-compete agreements for lawyers. However, Howard is also premised on the interpretation of California law, namely California Business and Professions Code Section 16602, which allows for non-compete agreements among partners in certain circumstances, as applying to law firms. In fact, the Court in Howard expressly rejected the idea that Section 16202 conflicted with Rule of Professional Conduct, Rule 1-500, stating, “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.” (Howard at 419.)
However, the Court in Howard agreed that not every agreement between partners in restraint of competition is permitted. The Supreme Court held that the common law “rule of reason” should apply to evaluate a non-competition agreement under Section 16602. (Howard, 6 Cal.4th at 416.) The amount fixed in an agreement as liquidated damages for competition must represent “a reasonable endeavor to estimate a fair compensation for the loss that may be sustained, and must bear some reasonable relation to such loss.” (Id. at 417.) The Howard court did not evaluate the reasonableness of the agreement at issue, instead remanding it to the lower court for further proceedings.
What Should Law Firm Partners in California Do?
It is critically important for law firm partners, or potential partners, to analyze their partnership agreement properly for various types of non-compete provisions prior to entering into a partnership or planning a law firm departure. This a multilayered and complex issue, because the economic consequences of these provisions, if found to be valid or left unchallenged, can be significant for any partner.
Dena M. Roche
O’Rielly & Roche LLP