Expert Article Library

Professional Firm Disputes

by Peter H. Burgher, CPA

By: Peter H. Burgher, CPA

  • General Information About Professional Firm Disputes
  • If Money is Important, How Do you Measure It?
  • What Other Information Must be Taken Into Account?
  • Why Must Inventory and Unbilled Time Be Adjusted For?
  • What About Operating Expenses
  • Is Goodwill an Asset of the Firm?
  • What Happens When a Professional Divorces?
  • How are Courts Dealing With These Issues?
  • Is there a Generally Accepted Method of Calculating Goodwill?
  • What Methods are Available to Mitigate the Effects of Large Goodwill Sums on Law Firm Dispute or Breakup Determinations?
  • What Provisions Should One Look For In Evaluating Partnership or Firm Agreements?
  • What Other Factors Are Often Overlooked
  • Do These Principles Apply to Professionals Other Than Lawyers?

General Information About Professional Firm Disputes

Disputes among professionals can occur in any number of ways. The most common is a law firm or other professional practice has one or more groups that have decided they can do better without the other parties remaining in the firm. Sometimes a majority group of lawyers will "gang up" on another lawyer whom they believe is not producing effectively. Sometimes a small group will conclude they can secede from the firm and do more effectively on their own without the "high overhead and development expense" of the larger firm. At the base of all of these disputes in "fear, greed and money" to quote the lawyers who testified in the famous Cadwalader Wickersham & Taft cases in which I testified. Because money is often at the root of these disputes it is important that calculations presented to the court, arbitrators or juries be rooted in sound principles and have the proof of successful use over time.

If Money is Important, How Do you Measure It?

Most law firms maintain their books and accounts on a cash basis because that is the most tax efficient and often the easiest day-to-day method of keeping their records. However, a fair presentation of any accounts, including those of a professional firm, require that the business’ operations and assets be stated on an accrual basis. What is an accrual basis? An accrual basis is that which takes into account all the revenue that is earned and all the costs that are associated with earning it and matches the assets (in professional firms usually inventory and receivables) against the liabilities (usually payroll and accounts payable) that are necessary for a fair presentation. Some firms present their accounts on a month-to-month basis using cash operating results only and do not take into account unbilled or uncollected time or amounts owing for services received but not paid for and then convert once a year to an accrual basis for a summary annual report. Some firms, including many large ones, never even do that. It is important not to go before a finder of fact without this information carefully organized and presented in a highly professional manner because it is often confusing to lay people and to the court. Experience has shown that simple graphic presentations of the concepts of unbilled and uncollected time, for example, can make clear what seem to most lay people the most obscure of subjects.

What Other Information Must Be Taken Into Account?

In determining the financial status of a professional firm, there are certain other assets that must be included as well as unbilled time and inventory. These include deposits and prepaid expenses, that is, expenses that have been paid for but for which the benefit will be received at some future time. Also there are fixed assets such as furniture, fixtures, computer programs, and other longer lived assets that have been paid for and even maybe expensed on an income tax return but for benefit will be received over long periods of time.

Why Must Inventory and Unbilled Time Be Adjusted For?

In the typical law firm, engineering company or accounting firm there is always an accumulation of time that is yet to be billed to clients and a certain amount of billed time that has yet to be collected. That all must be considered in making an accrual statement adjustments. The reasons such adjustments are needed is that as the firm grows or contracts there is difference in the amount of time unbilled and uncollected at the beginning of the year and the amount at the end of the year. To allow such difference to fall into the statements without correction would distort the operations of the particular period of time at which you are looking. Consider that the billed time at the beginning of the year that has not been collected is actually collected during the year but the work was performed and the services earned in the preceding period. Accordingly an adjustment must be made to deduct the collections from the beginning of the year that relate to the prior period. Correspondingly, an adjustment must be made at the end of the year to correct the statements for the time that was earned but not actually billed or collected until the following period. These adjustments correct the revenue in the statements for the year to show the actual revenue of the enterprise on the basis of the services rendered during the period.

What About Operating Expenses

The same concept holds true for the operating expenses of the firm. Expenses which were incurred and should be properly charged to operations of one period are sometimes are carried over as accounts payable and actually paid for in the subsequent period. It is important in times of significant growth or contraction that such adjustments are made so that the operating expenses of the firm are charged to period to which they relate. Remember, the concept is to relate all expenses to the revenue stream with which they are associated. When these concepts are presented to the typical court or lay jury in accountant’s language the people usually get a glossy look in their eyes and pass them over as if they are of no consequence. In fact, they can be material in relation to a particular party’s business outcome for the failure to properly state operating income could significantly distort the results. Sometimes the best way to present these ideas is to do it live before the court with a chalk or flip chart using block diagrams. When people can see a spatial difference in numerical values they sometimes grasp them more easily.

Is Goodwill an Asset of the Firm?

The question of whether goodwill is an asset of the firm has been beaten about in courts and in trials for most of professional firm history. Goodwill refers to the "hope that customers will come back to the same old place" as Teddy Roosevelt was quoted as saying. Goodwill refers to the intangible asset of accumulated higher than average earning power attributable to the name, reputation and client base of the professional firm. Some large law firms, for example, have goodwill that is valued in the hundreds of millions of dollars because of their higher than normal earning power attributable to their long lives, good reputations and diamond-studded client lists. Goodwill, as an asset of the firm, is not customarily recognized in the firm’s books and records. However it has increasingly become recognized as an asset of the firm when it comes to the resolution of disputes, breakups and mergers. And it has become an important factor in marital disputes.

What Happens When a Professional Divorces?

The issue of firm valuation, and especially that of goodwill, has become increasingly important in measuring the "holders value in interest" in the professional firm. In some midwestern states goodwill has become "a societal asset" in the eyes of courts and must be recognized in determining the value of the estate to be divided. Key cases in this important line of decisions involving the divorces of professionals are cited below. Some of them, including those involving several physicians and dentists, are particularly troublesome when applied to other professionals.

How Are Courts Dealing With These Issues?

Courts are generally uncomfortable in dealing with issues involving goodwill for a number of reasons. First, judges are increasingly noticing the extraordinary amounts of money that have been attributed to the goodwill in large professional firms and when contrasted with their own puny levels of compensation find it difficult to believe that other lawyers should be "paid so well". Second, courts have difficulty in understanding and interpreting the complex issues involved in establishing just how much goodwill exists in a particular case. It takes a competent and seasoned professional to explain to the court and to lay juries the concepts involved. Further it is important to rely upon well-known, published or other reliable and seasoned sources of information in establishing goodwill. Some key sources of information are cited below. Often the reaction of courts when faced with the difficulties of choosing between one expert who says there is goodwill and another one who says there is none or other professionals taking equally contrary points of view tend to rule the subject out or ignore it completely to the detriment of all of the parties involved. In the historic Cadwalader Wickersham & Taft cases in which I testified both courts failed to find specific amounts for goodwill, however, it is clear that the testimony presenting the facts regarding goodwill enticed the courts into allowing enormous awards of lost income to stand.

Is there a Generally Accepted Method of Calculating Goodwill?

There is no one universally accepted method for calculating goodwill, however, most calculations involve the determination of the excess of the firm’s earnings over what would have been the normal earnings of lawyers in the same locale performing the same practice that were not in the firm and multiplying the result by a capitalization factor. Determination of these values requires insight and skill and a great deal of experience. There are some useful references such as some of the articles which are listed below and for lawyers incomes the American Lawyer Annual Report on Law Firm Profitability and The Altman Weil Pensa Report on Lawyer Incomes are useful references. I have talked to the individuals who actually compiled these reports and understand their methodology completely. Such as knowledge is absolutely necessary in preparing for testimony on these subjects.

What Methods are Available to Mitigate the Effects of Large Goodwill Sums on Law Firm Dispute or Breakup Determinations?

Some courts have found that there are no mitigating factors where the calculation of the value of "holders value in interest" is involved in a divorce case. I have testified successfully that the existence of a mandatory fixed value buyout effectively caps the share an individual lawyer may receive from a firm’s goodwill. No doubt other mitigating factors are available but the literature is sparse.

What Provisions Should One Look For In Evaluating Partnership or Firm Agreements?

Believe it or not many law firms despite having long and complicated partnership agreements failed to specify the manner and means by which a lawyer shall leave the firm other than simply referring to them as a "withdrawing partner". The failure to have a means for resolving disputes or for terminating a partner whose performance or collegiality with the rest of the firm is less than desirable often leads to long drawn out disputes and extensive litigation. One should look for not only provisions involving the termination or expulsion of partners but the provisions for admitting or anointing new partners. It matters little whether a "partner" is admitted as a shareholder, partner, or some other popular current title. The lack of explicit criteria for accomplishing any of these can lead to difficulty.

What Other Factors Are Often Overlooked

When professional firms are involved in disputes, sometimes the issues involved are so emotional that the parties fail to consider other important factors such as pension rights, disability insurance, health and medical insurance, assigned areas of practice, assigned territories, availability of associates, use of firm assets, services and other day-to-day operating matters. It takes someone with experience in professional firm management to ferret out all the things that need to be considered when a professional firm dispute is being discussed.

Do These Principles Apply To Professionals Other Than Lawyers?

Most of the same principles apply in the cases of lawyers as well as doctors, dentists, accountants, engineers, architects and, in fact, anyone whose loyalty is to the work they perform as opposed to the firm with whom they are employed (see PROFESSIONAL EXCELLENCE by Peter H. Burgher, The Agnes Press, 1986). The high degree of mobility that enables professionals to move about from one operating venue to another increases the likelihood that application of these principles must be utilized. It matters little whether the professional involved is an equity holder or partner in a law firm, an accounting firm or an engineering firm. It matters little whether the equity holder is a doctor, dentist, an osteopath or homeopath. Beware of the concept of "holders value in interest" especially in divorce cases involving professionals and in the breakup of professional firms.

Selected References:

"When a Professional Divorces", Am. Bar Assn., Chicago, Orenstein and Skoloff (revised from time to time)
"Valuing Professional Practices and Licenses", 2nd ed., R. L. Brown, Prentice Hall, NY, 1995 et seq.
"Law Firm Accounting and Financial Management", Revised Ed., J.P. Quinn et al, Law Journal Seminars Press, NY 1994 et seq.
"Firm Valuation, Picking the Appropriate Formula", M. E. Kline, Nat. Law Journal, Vol. 12, No. 19, 1/15/90
Altman Weil Pensa annual survey of Law Firm Economics
IRS Revenue Ruling 59-60, 77-287- 83-120
"Business Valuation Methods", Am. Inst. Of CPAs, 1989
"The Holders Interest Concept Defined, Discussed, Expanded", O.B. Lefko, Michigan Bar Journal, March 1992
Kowalesky v. Kowalesky, Michigan App. 384 N.W. 2d 112 (1986)
"Holders Interest Valuation", J. Stockdale, Michigan Bar Journal, July 1993
"Equitable Distribution and Professional Practices", J. W. Lunningham, Michigan Bar Journal, July 1994
McNamara v. McNamara, 178 Michigan App. 382 (1989)
Johnson v. Johnson, Michigan App. No. 132388 (1993)
Business Valuation Methods, A.S. Zipp, 1990
The 1990 AICPA National Conference on Divorce, Divorce Valuation of Businesses and Professional Practices, Chap. 2
Kilbride v. Kilbride, 172 Michigan App. 421 (1988)
Dawson v. White & Case, 622 NYS 2d 269 (app. Div. 1995)
Uniform Partnership Act, especially par. 29-31, and 18, 22, 24, 38.
"Partnership Law Issues in the Break-up and Dissolution of Law Firms", Callison, 21 Colorado Law 409 (March 1992)
"Indissoluable Partnerships", Hillman, 37 U. Florida Law Rev. 691, et seq (1985)
Hyman v Cohen, 73 So. 2d 393, 397 Florida (1954)
Cohen v. Lord, Day and Lord, 550 N.E. 2d 410 New York (1984)
Frates v. Nichols, 140 So. 2d 321 Florida (3rd DCA 1962)
Clark v. Gunn, 134 N.Y.S. 2d 206 (S. Ct. 1954)
Millet v. Slocum, 167 N.Y.S. 2d 136, 140 (1957), 177 N.Y. S. 2d 716 (1958)
Dow v. Beals, 268 N.Y.S. 425 (1933)
Haynes v. Allen 482 .W. 2d 85, 88 Missouri (1972)
Erlich v. Howe 848 F. Supp, 482 SDNY (1994)
"Misconduct as a Basis for Excluding or Expelling a Partner", Hillman, 78 NWU U.L. Rev 527, 565 (1983)
"Comment, The Expulsion Clause in a Agreement: a Pre-Planned Dissolution", 13 U.C. Davis L.R. 868, 871 (1980)
Beekman v. Farmer, 579 A. 2d 618, 634 D.C. (App. 1990)
Kerrick v. Hannaman, 168 U.S. 328, 335, 18 S. Ct. 135, 138 (1897)
Price Waterhouse Surveys – local, regional and national law firm statistical surveys
Hagen v. O’Connell, Goyak & Ball, 68 Oregon App. 700, 623 P. 2d 563
Am. Law 100, American Lawyer survey of 100 largest firms.
National Law Journal, annual statistical survey of law firm compensation practices, lawyer’s earnings, judges and law schools.
N. Y. Disciplinary Rules of the Code of Professional Responsibility (22 NYCRR Part 1200)
Harmon v. Harmon, 17113 AD 2d 98, 578 N.Y.S. 2nd 897
"The Mess We Have Made of Partnership Law", A.W. Vestal, Washington and Lee Law Review, Vol. 54, No. 2, Spring 1997