Professional Corporations

A decision last week by New York’s highest court may have registered an uptick on the public’s schadenfreude meter, at least among the portion of the public who hold the legal profession in low esteem and who therefore might enjoy the sight of internecine warfare among splitting partners of a law firm.

In Ederer v. Gursky, 9 NY3d 514 (2007), Lawyer A joined and became a 30% shareholder along with Lawyer B (who then held 70%) of a small law firm organized as a professional corporation (PC). Several years later they re-organized the firm as a registered limited liability partnership (LLP) and took in three new partners who collectively held a 15% partnership interest, leaving Lawyer A with 30% and Lawyer B with 55%. Two years later, Lawyer A decided to leave the firm – according to him, because of a falling out with Lawyer B over a firm client; according to Lawyer B, because the firm was in financial dire straits for which Lawyer A was partially responsible – following which he entered into a written withdrawal agreement with the LLP setting forth various financial and case-sharing arrangements. Six months later, Lawyer A sued the LLP and each of its four remaining partners claiming breach of the withdrawal agreement and seeking an accounting and certain profit shares.

Garden variety financial disputes among former business or law partners do not usually garner the attention of New York’s Court of Appeals. This one did, however, because of the defendant partners’ reliance on a provision in the statute governing LLPs that, in general terms, shields partners of LLPs from vicarious liability for obligations of the LLP or for the negligence of their law partners. The case thus raised a novel question of statutory construction whether Section 26(b) of the Partnership Law was meant to protect only against partner liability asserted by third parties or whether, as the defendants argued, it also encompasses liabilities among the partners.

The Court’s decision traces the highly interesting history of partnership liability laws, including the nationwide surge of LLP formations in the aftermath of the savings and loan crisis of the 1980s when regulators went after deep-pocketed law firms to recover massive bank losses. In a 5-2 majority decision, the Court handed victory to Lawyer A by concluding that Section 26(b) only addresses a partner’s vicarious liability for partnership obligations to third parties and does not extend to claims among the partners of the LLP.

The dissenting judges note that Lawyer A’s withdrawal caused the firm’s finances to deteriorate and thereby rendered the firm unable to satisfy its obligations under the withdrawal agreement. They raise two provocative questions: Under these circumstances why should a former law partner be able to collect the firm’s debt from the “innocent” individual partners where a third-party creditor could not, and why should partners of an LLP be saddled with an obligation from which they would be shielded had the firm remained organized as a PC? The majority’s decision, laying emphasis on statutory construction rather than policy, means it will be up to the legislature to amend the law if it sees the same anomaly as do the dissenters.

Update (May 2, 2008)In Kuslansky v. Kuslansky, Robbins, Stechel & Cunningham, LLP, 50 AD3d 1100 (2d Dept 2008), the Appellate Division, Second Department, under the authority of the Court of Appeals’ Ederer decision, reversed a lower court’s decision dismissing an action brought by a former law firm partner for breach of contract based on the alleged failure of the defendants to pay him the value of his interest in the subject partnership as provided for in the parties’ partnership agreement upon a partner’s withdrawal from the partnership.

 

Individuals and companies have a choice of entities – some requiring more formalities than others – through which to pool their resources and efforts in pursuit of a common business goal. Joint ventures and general partnerships are on the less formal side of the spectrum and are often used in the early stages of a business project to keep costs down before the project’s viability is established, and before limited liability becomes an issue. Until the proliferation of limited liability partnerships and like statutory business forms, many professional firms including lawyers and doctors traditionally operated as general partnerships.

It is not uncommon for written joint venture or partnership agreements to include a buy-sell agreement. If the joint venture or partnership later converts to a corporation or limited liability company, and the owners do not make a superseding shareholder or operating agreement, is the prior agreement enforceable when a shareholder or LLC member wants out or seeks judicial dissolution?

The answer is complicated by a long line of New York case precedent, most notably Weisman v Awnair Corp., 3 NY2d 444 (1957), decided by New York’s highest court, holding that a partnership may not exist where the business is conducted in corporate form, and parties may not be partners between themselves while using the corporate shield to protect themselves against personal liability.

A couple of newer decisions by intermediate appellate courts, however, take a modified approach to the issue permitting enforcement of the pre-conversion agreement. In Matter of Hochberg (Manhattan Pediatric Dental Group, P.C.), 41 AD3d 202 (1st Dept 2007), two dentists formed a practice and entered into a partnership agreement containing an arbitration clause and also requiring that a partner seeking dissolution first offer his interest to the other. Years later they converted the practice to a professional corporation, but without making a new agreement. When one of them later sought dissolution, the other sought to compel arbitration under the old partnership agreement. The appellate court, reversing the trial court’s decision, ruled that such pre-conversion agreements are enforceable as long as the rights of creditors or other third parties are not involved and the parties’ rights under the partnership agreement are not in conflict with the corporation’s functioning. Judicial dissolution of the dental practice would be inappropriate, the court added, in that it would allow avoidance of the buyout provisions by seeking such dissolution.

The best practice, of course, is to make a new written agreement when converting to a new form of entity, or at least indicate in writing whether the old agreement survives the conversion.

Under the Mohawk Maintenance doctrine, named after a case decided by New York’s highest court, the seller of a business including its good will is under an implied covenant not to solicit the seller’s former customers. Yet to be decided by the same court, although it’s come close on a couple of occasions, is whether a stock buyout resulting from an election to purchase in a dissolution proceeding likewise triggers the implied covenant. The key issue in these cases in whether the sale is deemed to be one “under compulsion” and therefore not within the Mohawk Maintenance rule. Lower court decisions have been less than uniform in their approach and the results.

A dissolution case decided earlier this year raised the issue anew in an interesting context. In Matter of Autz, 16 Misc 3d 1140(A) (Sup Ct Nassau County 2008), the antagonists were minority and majority shareholders in a professional corporation that operated walk-in medical clinics. The petitioner sought dissolution as an oppressed minority shareholder under Section 1104-a of the Business Corporation Law (BCL). The majority shareholder did not elect to purchase the petitioner’s shares. Rather, he consented to dissolution and asked the court (a) to determine that the corporation is not a going concern, and (b) to order a liquidation sale of the corporation’s hard assets and the division of its receivables. The petitioner sought a sale of the corporation as a going concern, inclusive of good will, along with a determination that such a sale is voluntary and therefore imposes a restrictive covenant upon the unsuccessful shareholder-bidder.

In a decision by Justice Leonard B. Austin of the Nassau County Supreme Court, Commercial Division, the court ruled that there was evidence that the corporation had saleable good will, but that a transfer of shares resulting from an involuntary dissolution, in the absence of an election to purchase the petitioner’s shares for fair value under BCL Section 1118, is a sale under compulsion and thus does not implicate the non-solicitation covenant.

Like so many other issues that come to haunt partners who find themselves embroiled in business divorce litigation, covenants not to compete or to solicit customers and employees are most efficiently dealt with in a shareholders agreement made at the beginning of the relationship.