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April 1991

Take a careful look at your partnership agreement.

by Segal, Robert E.

    Abstract- Many partnerships of accountants fail to give adequate attention to their partnership agreements, setting the groundwork for subsequent legal problems. Business analysts estimate that over half of all small and mid-sized accounting and law firms lack adequate partnership agreements. Partnership agreements should not be standard boilerplate agreements, but should be custom-designed for each partnership, taking into account unique circumstances and the specific needs of the partners. Several provisions can be written into partnership agreements to protect partnerships against subsequent actions by disaffected partners or partners who have defected from the firm. The provisions include reverse hold-harmless clauses, retroactive termination agreements, and financial penalty clauses.

Mergers, mobility and stiffer competition have all contributed to the increasingly unsettled atmosphere of today's professional businesses. Among accountants, physicians, and attorneys, firm loyalty is no longer paramount. Now partners "trade in" their old firms for new models, while many firms, for their part, no longer carry "unproductive" partners. Those who refuse to terminate partners risk nothing less than the continued viability of the firm. Movement of professionals in and out of partnerships is on the rise.

Meanwhile, analysts estimate that more than half of small and mid-size accounting and legal firms are still working with incomplete, out-of- date or non-existent written agreements. Such figures are particularly surprising, because accountants and attorneys would seem to be the very people who should know better. They all too often assume that if problems do arise, they'll be able to work things out.

Professionals need to take their own advice: prepare for possible problems, and take appropriate steps to avoid costly risks.

Tough Times, Tough Questions

Too many partnership agreements, once considered standard, omit or gloss over the toughest questions. These boilerplate agreements typically address the usual questions of management, decision-making, and compensation; but neglect, for example, to provide any ground rules for asking or forcing a partner to leave. Agreements must anticipate and address a broad range of future occurrences: death, disability, retirement, expulsion, or voluntary withdrawal. Again and again, disputes among professional partners demonstrate the need for specifying the terms and conditions that can deal with these frequently "unexpected" events.

A recent case involved two accounting partners, who together held a majority interest in a Professional Corporation. These two individuals wished to expel a third partner. There was concern that the third partner's questionable professional conduct might expose the business, as well as themselves, to unnecessary liability. The shareholder's agreement, however, did not adequately address this situation, and, as a result, an issue that could have been resolved with little difficulty escalated into a crisis. A litigation among partners under these circumstances, even if successful, takes its toll on all. A well- designed agreement would have avoided the problem.

There was a mid-sized organization whose agreement, like that of many professional partnerships, was drafted in-house. In addition, it was completed some 15 to 20 years ago. At that time the partners saw no need to include provisions for dealing with a "disabled" or "unproductive" partner. Now, after two decades, a senior partner was exhibiting erratic behavior, with the result that there was a marked deterioration in his work and billable time. The firm requested that the senior partner take a leave of absence and seek medical treatment, but since the partnership agreement did not address this eventuality, the firm could not directly force the issue.

During this time, the partner under criticism became belligerent and threatened litigation, a path which would have led to a public accounting of the firm's business. For reasons of cost, time and preserving confidentiality, the firm was anxious not to go to court. An eventual compromise solution was achieved, but only after an investment of considerable time, aggravation and expense.

Professionals Are Not Immune

The frequency and often vitriolic nature of current partnership litigations are sending shock waves through the professional world. Although accountants tend to view themselves as less likely to litigate than attorneys, they would be foolish indeed to ignore the warnings these disputes dramatize.

These partnership break-up's illustrate the need for written partnership agreements which cover problematic situations, such as grounds for termination, lease liability, and key partner withdrawal. In the well-publicized instance of Londin v. Carro Spanbock, for example, only one partner wanted to leave--Mr. Londin. The firm had no written agreement, and consequently, the voluntary withdrawal of a partner automatically pushed the partnership into the category of "partnership in dissolution." Pursuant to state partnership law, the lease became an asset of all the partners, including Mr. Londin. Although the firm sought to evict him, Londin exercised his "right" to remain in his office as a "tenant in partnership" subject to his payment of proportionate expenses. Carro Spanbock sought to expand its space, but could not take over Mr. Londin's share of the lease. As it happened, the lease was a valuable asset. The rent was $15 per square foot at a time when its market value was more than double that amount. In its decision, the Court pointedly mentioned that a written partnership agreement would have avoided the dispute.

The circumstances leading to the case of Dawson v. White & Case show that having a partnership agreement is not always enough. In fact, White & Case's partnership agreement was a massive document and had been amended several times since its formulation in 1978. Inexplicably, the agreement did not specify provisions for terminating a partner. When the issue of termination arose, and the firm sought to amend its agreement to cover such an event, White & Case was unable to muster the unanimous vote as required by basic partnership law. A simple clause, authorizing a quorum vote to terminate a partner, including a definition of what constitutes a quorum, would have prevented such an impasse.

Somewhat similarly, the demise of Kadison Pfaelzer came out of a careless assumption that partners would leave one at a time, rather than in a group. When suddenly 20 out of 56 partners departed, the firm was left to bear the entire rent liability. Consequently the firm was forced to dissolve.

Don't Forget The Basics

Had a reverse hold-harmless clause been written into Kadison Pfaelzer's partnership agreement, releasing the remaining partners from the ex-partners' liabilities, the firm would have remained financially sound. Such a clause is a standard "must" for agreements.

A retroactive termination agreement is also strongly recommended. This can be designed to go into effect 60 or 90 days after one or more partners leave and become retroactive to the day before the withdrawal.

How can you protect against partners who may leave to enter competing firms? Several provisions are recommended, including: a right of offset when a departed partner fails to assist with collecting accounts receivable; a financial penalty clause; and appropriate restrictive covenants.

Some partnership agreements today go even further. They include provisions that act as incentives for partners to remain within the firm while their ability to bring in business is at its greatest.

An Off-The-Shelf Agreement May Not Fit Your Firm

The overall partnership agreement for a firm must be custom-designed, not simply to anticipate a variety of eventualities, but also to meet your partners' specific needs. The older boilerplates do not work.

Each form of partner departure, for example, should be treated separately, rather than in "lump" form. Each instance has its own potential script or scripts, which must be anticipated and addressed individually. The loss of a "key partner" may have a different significance than the loss of a junior partner. The defection of a group of partners is qualitatively different from the defection of one partner.

Hammering out the details of a partnership agreement, unfortunately, is neither inexpensive nor quickly done, and many professionals neglect the task or postpone it indefinitely. Certainly time spent working to achieve the final agreement is not billable. Nevertheless, it is a vital investment for every professional.

As accountants, you are trained to help your clients to look ahead, avoid risks, and overcome obstacles. Be sure that you work as hard to protect your own business. See that your partnership agreement anticipates and confronts the difficult issues before they arise. The failure to do so has resulted in the ruin of many a professional business.

Robert Segal, Esq., is a senior partner of Segal & Tesser Attorneys at Law, New York City. His areas of concentration include partnership agreements and corporate law. Segal & Tesser specifically concentrates on representing professionals including accountants, attorneys and physicians.

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

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