Partnerships filing for bankruptcy protection, partnerships going into dissolution with partners taking business to and joining other firms, partnerships pruning "deadwood" to bring relationships of partners and staff into line; all these things make the partners' and aspiring partners' heads spin. What's a partner to do? To help answer the question, James L. Craig, Jr., CPA, Managing Editor of The CPA Journal, had a discussion with attorney Leslie D. Corwin. Also presented in a sidebar are the thoughts of attorney Robert Segal on the importance of the partnership agreement.

The CPA Journal: A few months ago the accounting profession was shocked when Laventhol & Horwath filed for protection from creditors under the U.S. bankruptcy laws. As accountants and businesspeople, we have a fairly good understanding of what takes place when a corporation files for bankruptcy. How does it work for a partnership?

Leslie D. Corwin: There is a great deal of similarity. There will be a trustee appointed to oversee the partnership and to deal with the secured and unsecured creditors. However, a major difference is that the partnership will also have to file for injunctive relief temporarily prohibiting the creditors from proceeding directly against the individual partners.

To clarify, let me explain what is happening legally. The partnership filing for protection and becoming a partnership in dissolution remains a legal entity, albeit a different legal entity than the one we knew just minutes before. Its obligation is to marshall the assets of the partnership, validate the liabilities and wind up the affairs of the firm. The winding-up process of a large accounting firm, or in another recent example, a large law firm such as Finley, Kumble, Wagner, Heine, Underberg, Manley, Meyerson & Casey, can take years. Laventhol & Horwath's management obviously concluded that the assets of the firm were insufficient to meet the liabilities and so therefore sought the protection of bankruptcy. They were also faced with a big unknown with respect to malpractice litigation that the firm was defending. Forgetting the merits of the cases, the costs of defending the firm were becoming a severe drain on the firm's resources.

In seeking protection, Laventhol & Horwath filed for interim protective relief for its individual partners, as well. This was necessitated by the fact that under partnership law, generally speaking, partners are jointly and severally liable for the firm's obligations. As an example, if a bank had made a $10 million loan to the partnership that it could not pay, and the bank obtained a judgment against the partnership, the bank could attempt to attach the assets of any particular partner in the firm. The bank could pick and choose the partners it wished to proceed against in order to satisfy the judgment. If a partner ended up paying more than his or her share, he or she would have a right to recover from the other partners, based upon their percentage interest in the partnership.

As I said earlier, another important benefit to the partnership in bankruptcy is that lawsuits are put on hold.

CPAJ: How long will this stay or injunctive relief be in place to protect the partners?

LDC: Probably as long as it takes to get a plan of reorganization approved by the creditors. Try to visualize what will happen. All the various groups with an interest in the assets of the firm--the secured creditors, the unsecured creditors, the employees, the retired partners, the equity partners, the principals--will present their claims against the partnership. The trustee in bankruptcy will, I assume, develop a plan for these various groups to be paid. The trustee, in trying to get the plan approved, might say: "Listen creditors, I may not be able to get you 100 cents on the dollar, but here is how you can get 70 or 80 cents on the dollar. Will you release your claims and settle for that amount?"

In the Finley, Kumble situation, the Trustee went to each of the partners, and based upon an assessment of their interest in the partnership, asked for a contribution. It is my understanding that with regard to Finley, Kumble many partners have already agreed to their "assessment," but some have not, and we are now past the third anniversary of the Finley, Kumble filing. I believe a stay against the creditors proceeding against the firm and its individual partners has continued over this entire period.

CPAJ: In the matter of lawsuits, how does the plaintiff join in line to share in assets of a bankrupt firm?

LDC: Plaintiffs can defer bringing a claim or delay a pending lawsuit until the bankruptcy proceeding is concluded, or simply prosecute their claims against other defendants. In the latter scenario, the plaintiff might use the outcome of the suit against other defendants to assess and negotiate a settlement with the trustee with respect to the bankrupt firm.

CPAJ: If the lawsuits that are put on hold don't actually resume, does the plaintiff become another creditor with whom the trustee negotiates?

LDC: That's usually the way it works, although a plaintiff could petition the bankruptcy court to allow the suit to proceed. Then the judgment, if any, would be added to the liabilities of the firm for purposes of a plan. Normally the lawsuits will be settled in the Bankruptcy Court through negotiations between the trustee and the plaintiffs.

CPAJ: Why would creditors with established liabilities agree to have the litigation claims added to the long list of what's due?

LDC: The creditors would not like to see litigants proceeding against assets of individual partners and the firm while at the same time they were agreeing to a plan. It is disruptive and might prolong the whole matter. Time, legal fees, and other running costs, works against creditors.

CPAJ: What about the pension plans of the partners?

LDC: If the partnership had a pension plan that is funded and ERISA qualified, there is no problem. It would be protected from creditors' claims. However, if the plan is unfunded and payable out of the earnings of the partnership, we have a different matter. Unfortunately, pension plans at many professional service firms are unfunded. Under these circumstances the retired partners become creditors with respect to the retirement benefits; what is not known is where this liability stands relative to third-party creditors. To my knowledge, the matter has not been litigated. If I were representing third-party creditors, I could make a strong case that the pension obligations to retired partners should be below my client's claim in priority. On the other hand if I were representing retired partners, I could make a strong case for their claims being ahead of or at least pari passu to those of other unsecured creditors.

CPAJ: At the point that a partnership files for protection, what liabilities are the partners, past and present, responsible for?

LDC: Obviously, the active partners would be responsible. Under partnership law, a retired partner would be responsible for all debts incurred while he or she was a partner. And the new partner at the time of filing could be held responsible for all the debts of the partnership, even that bank loan of $10 million that was incurred a year ago, but always based on his or her proportionate interest.

CPAJ: Assume I'm that brand-new partner. Are the personal assets of a newly made partner at risk for the firm's outstanding bank loan? Even wealth I may have accumulated from other sources?

LDC: Unfortunately, yes. Of course you could proceed against the other partners to the extent you paid out more than your proportionate share.

CPAJ: What about the retired partner?

LDC: Those former partners would be responsible for liabilities that arose and were on the books on the date they terminated their interest in the firm. There may be situations in which retired partners and former partners are called upon by the trustee to make a contribution to the pot, but again proportionate to their individual interests. And so it is quite possible to have retired partners who end up losing retirement benefits and who also have to make a contribution.

CPAJ: Dissolving a partnership in a bankruptcy setting is no fun. Has the partnership form of doing business outlived its usefulness?

LDC: No, I don't think so. When I look at failed partnerships, the deficiencies in management that existed at these organizations never cease to amaze me. They seem to have committed the very acts of mismanagement that they advise their clients against. What I have seen is expansion and acquisitions of businesses without proper fiscal control. I see firms going deeper and deeper into debt to bring in practice groups or partners with the great expectation of huge profits and revenue growth. Unfortunately, it doesn't always work. The business is slow in coming, the new groups don't get fully integrated, nor are they properly controlled, and what you have is disaster.

It all comes down to one word--management.

CPAJ: What about the Professional Corporation?

LDC: Your journal has had a number of articles informing your readers about the benefits of PCs. Clearly, every firm should consider taking advantage of the benefits that may be available. These include protection against the torts and malpractice of other shareholders, protection from the normal business liabilities such as lease commitments, bank loans, trade payables, employee compensation, etc.

However, in my experience, the major banks and savvy landlords dealing with a PC will ask for the personal guarantees of the partners, especially with the smaller firms. And so, in such a situation, protection of vicarious liability is the main benefit.

A PC shareholder who has not personally guaranteed his or her firm's debts may nevertheless accept personal liability rather than engage in long and costly litigation.

CPAJ: What about a partnership of PCs? Or in the case of a multi- office, interstate organization, a partnership of PCs from each of the cities or states?

LDC: Some law firms have gone the route of a partnership of PCs. The ethics requirements state that the structure must be clearly spelled out on the firm's letterhead.

But remember, in order to be an effective PC, each PC has to keep a set of books, pay taxes at the corporate level and at the shareholder level, keep minute books, have shareholder and director meetings, ad infinitum. Some professionals don't think the extra administrative matters are worth the trade-off of protection from vicarious liability, especially with banks, landlords, and major creditors requiring the shareholder or shareholders giving their personal guarantees on the obligations.

I don't know of a partnership of regional or local PCs. But I imagine the administrative consequences would be more difficult. How do you share profits among the PCs? The cross charges among the PCs would be a nightmare.

CPAJ: So what's a partner to do?

LDC: Be careful with whom you go into partnership. Be careful who you bring in.

Have a carefully written partnership agreement that has been drafted with the assistance of qualified legal counsel. Update it annually.

Have a funded, ERISA qualified pension plan.

Have a strong system of quality control, in all areas of practice.

When you acquire or are about to acquire another practice group, use due diligence, just like you advise clients to do. Hire an accountant to help. Don't do it yourself. "He who represents himself has a fool for a client." Hire your competitor. The job will get the attention it deserves.

And as I said earlier, the business always has to be properly managed. The bottom line can't be left to a matter of chance or someone's unrealistic dream of what might be.

Why do major partnerships declare bankruptcy even in some cases where growth is vigorous and new business development is at all time highs? Because the partnership was out of control. Very often because of expansion and new ventures, debt is being incurred to pay the draws of rainmakers and the acquisition costs of practice groups. Power struggles have been known to erupt to decide who should control. Money is borrowed against receivables to pay operating expenses and partners. It all comes down to the management of changing circumstances.

Because of the enormous risks of being a partner, you will also see a lot movement of professionals, including partners, from one firm to another, taking their clients with them. You will also see more housecleaning where firms ask non-productive or non-cooperative partners to go elsewhere.

CPAJ: Are you suggesting that bankruptcies of professional firms are more the result of becoming overburdened with hard debt, bank loans and the like--rather than from legal claims--arising out of "shoddy work?"

LDC: Yes. But there also may have been the threat of the continued costs of these legal battles, which take their toll and may have added to the hard debt as you call it.

CPAJ: In light of the Laventhol & Horwath experience, why would a CPA firm ever merge with another?

LDC: Only if it economically and professionally makes sense. The culture has to match. But once the merger occurs the practices must be integrated and a high level of communication among partners must occur. The partners must be partners in the classic sense--share clients, spend time together, go away together, even be able to be wrong together, with no cover-ups.

CPAJ: Thank you, Les, for this discussion on the effects of these very difficult business times. I hope our discussion will cause professionals to evaluate their own situations.

Leslie D. Corwin, Esq., is a partner in the New York law firm of Morrison Cohen Singer & Weinstein, where he spends much of his time in the practice area of partnership break-ups, firm dissolutions, partner ousters and defections, and similar partnership changes.