Division of Fees in Departure Provision of Law Firm's Employment Agreement
Opinion rules that a provision in a law firm employment agreement for dividing legal fees received after a lawyer's departure from a firm must be reasonable and may not penalize or deter the withdrawing lawyer from taking clients with her.
Rule 5.6(a) of the Rules of Professional Conduct prohibits a lawyer from participating in, offering, or making "a partnership, shareholders, operating, employment, or other similar type of agreement that restricts the right of a lawyer to practice after termination of the relationship except an agreement concerning benefits upon retirement." This prohibition on restrictive covenants protects the freedom of clients to choose a lawyer and promotes lawyer mobility and professional autonomy. Rule 5.6, cmt. ; 2001 FEO 10 (agreement reducing the amount of deferred compensation lawyer receives if the lawyer leaves the firm and engages in private practice within a 50 mile radius of the lawyer's former firm violates Rule 5.6(a)); 2007 FEO 6.
Many law firms include provisions in a partnership, shareholders, or employment agreement (referred to collectively herein as "employment agreement") that address the division of legal fees received by a lawyer after she withdraws from the law firm for the representation of clients who followed the departing lawyer to her new firm. The provisions do not directly prohibit the withdrawing lawyer from engaging in competition with the firm, but may create financial disincentives for the lawyer's continued representation of former clients of the firm. These provisions frequently appear in employment agreements for personal injury law firms that regularly represent clients on a contingent fee basis. The provisions typically require the withdrawing lawyer to pay her former firm a percentage of any contingent fee that she subsequently receives for the representation of a client who left the law firm with her. The provisions may also include a requirement that the withdrawing lawyer reimburse the firm prior to the resolution of the case for costs advanced on behalf of a departing client.
Example provisions from three employment agreements appear below.
Employment Agreement No. 1
Attorney acknowledges that Law Firm will expend a considerable amount of time and money to assist in his education in the assigned practice areas. Additionally, Attorney acknowledges that Law Firm will transfer to him/her current cases which have a significant amount of current work in process and that the firm is NOT prorating or penalizing his bonus program for this work in process. Further, the firm will transfer to Attorney considerable technological information both substantive and operational. Finally, Attorney acknowledges that Law Firm has and will spend considerable sums of money in marketing and advertising the Medico-Legal practice areas. Attorney also acknowledges that under the North Carolina State Bar Rules, a client is free to choose, in the event a lawyer shall leave the employment of a firm, whether the client will stay with the firm or go with the departing lawyer. Attorney specifically agrees to the following should he leave the firm for any reason:
A. Upon a client choosing to have Attorney represent them in the future, Attorney shall, within 30 days, pay to the firm any funds the firm has advanced to the client.
B. Attorney agrees to pay to the firm 70% of the fees he may receive from his continued representation of the client in the matter for which the firm was representing the client at the time of his departure. If this amount is greater than the amount of money that the firm could obtain as a legal fee, then the balance of the monies paid by Attorney to the firm under this provision shall be considered as compensation to the firm for the marketing, advertising, technological, and other information and knowledge provided by the firm to Attorney during his employment at the firm and as consideration for the work in process provided to Attorney on the cases he was assigned to at the beginning of his employment.
Employment Agreement Number 2
Costs and Escrows. At or as soon as is practicable on or after the Transfer Date [date file is transferred], the Firm shall provide departing Associate with a statement of costs for each Transferring Client (which may be in the form of one or more ledgers) showing expenses the Firm has advanced on the matter. Within five (5) days of receipt of such statement of costs, Associate shall pay the Firm the full amount of the costs advanced as reflected in such statement.
Compensation for Services Rendered to a Transferring Client. The parties acknowledge that in a typical Transferring Client matter, the Firm makes a substantial investment of initiative, goodwill, time, money, risk, and effort which the Firm will not ordinarily have been compensated at the time of the Transfer Date. That investment includes, but is not limited to: building the Firm's reputation for skillful, energetic, competent, effective, prompt, and dedicated service on behalf of clients; attracting clients to engage the services of the Firm; fostering the respect of other parties and tribunals for the legal services performed by the Firm and its attorneys; serving the needs of the Firm's clients; utilizing time, skill, and resources in investigation, client and witness interviews, collection and organization of medical and other records; factual and legal research; drafting of pleadings and correspondence; preparation for hearings; and many other tasks, too numerous and varied to mention, relating to a client's particular legal matter. Associate acknowledges that he/she has received or will receive compensation in the form of salary, benefits, and/or other Associate compensation for any work done or services performed by Associate on behalf of a Transferring Client prior to the Transfer Date; Associate understands and agrees that he/she has no right, claim, or interest in remuneration for work performed by Associate and/or the Firm prior to the Transfer Date on behalf of a Transferring Client or a Remaining Client. The parties agree that Associate should receive fair compensation, but no windfall, for work performed by the Associate subsequent to the Transfer Date on behalf of a Transferring Client. Furthermore, the Firm and Associate acknowledge that, with respect to a Transferring Client, any attempt to apportion fair compensation between the Firm and the Associate on a case-by-case basis, and to place a fair value on the Firm's investment (as referred to above), would be extremely complex, time-consuming, difficult, imprecise, uncertain, and debatable. In order to avoid uncertainty and litigation that might arise in connection with fee allocations performed on a case-by-case basis, and to insure that the Firm and Associate will each receive fair and equitable compensation for the value of their contributions and investments, the parties have developed the simple and easily-applied formulas set forth in the following paragraph in order to apportion the relative shares of compensation to which they would be respectively entitled upon consummation of an award, judgment, or settlement in a Transferring Client's case.
Compensation Formulas. For purposes of the formulas below, compensation for services rendered to a Transferring Client shall be allocated between the Firm and Associate as of the date the attorneys' fees or other remuneration or consideration in the matter are fixed (the "Fee Determination Date"). The Fee Determination Date shall be the earlier of (1) the date that payment of such fees, remuneration, or consideration is received or receivable; or (2) the date upon which a final and binding award of attorneys' fees is determined (as, for example, in the case of a fee award from a court or other tribunal) or can readily and positively be determined (e.g., as by applying a contractual contingency fee factor such as one-third to a final and binding award on behalf of the client). In the event that Associate has caused or allowed, or suffered the Fee Determination Date with respect to a matter concerning a Transferring Client to be unnecessarily and unjustifiably delayed, the Fee Determination Date shall be deemed to be the day before the Associate's Termination Date. The Firm and Associate hereby irrevocably agree that such compensation shall in each case concerning a Transferring Client be apportioned between the Firm and Associate in accordance with the formulas below:
On or Before Transfer
On or Before First Anniversary of
On or Before Second
Anniversary of Transfer Date
After Second Anniversary
of Transfer Date------50%--------------50%
Employment Agreement Number 3
Post Termination Fees. In the event that Employee's employment is terminated for any reason, voluntarily or involuntarily, or the Employee resigns, and a client requests that Employee, rather than Corporation, represent the client after Employee's employment is terminated, Employee shall pay to Corporation immediately out of any settlement, award, or verdict a portion of the attorney fee based on the following formula:
.20 x attorney fee
((a - b)/a) x attorney fee =
amount due to Corporation
- Where .20 or 20% of any such attorney fee shall be paid to Corporation representing the advertising and marketing costs of acquiring the client's case.
- Where "a" represents the total number of months or portion thereof Employee represented the client both before and after Employee's departure up to the date of the settlement, award, or verdict.
- Where "b" represents the number of months or portion thereof Employee represented the client after Employee's departure up to the date of the settlement, award or verdict.
As an example: If the client was represented a total of ten months, two of which were before departure and eight months after departure and the attorneys fee was $10,000, then Corporation would be entitled to 20% of 10,000 (representing market costs) plus 2/10 or 20% of $10,000 (representing time spent while working for Corporation on client's matter) for a total of $4,000.
In the event that clients of Corporation request that Employee continue to represent them after Employee's departure, Employee shall immediately reimburse Corporation for any outstanding expenses which Corporation has incurred as an expense or advanced as a disbursement in its representation of such clients. In the event that Employee is unable to immediately reimburse Corporation for such outstanding expenses, Employee shall give to Corporation a promissory note in the amount of such outstanding expenses payable in ninety (90) days from the date thereof with interest at [bank's] prime rate on the date of said note plus 2%.
May a lawyer participate in the offering or making of an employment or other similar agreement that includes provisions, like those above, requiring a withdrawing or departing lawyer to pay her former firm some portion of any legal fee that she receives for the subsequent representation of a client who leaves the firm with the lawyer?
Yes, a lawyer may participate in the offering or making of an employment or other similar agreement that includes a provision for dividing fees following a lawyer's departure from a firm provided the formula or procedure for dividing fees is, at the time the agreement is made, reasonably calculated to compensate the firm for the resources expended by the firm on the representation as of the date of the lawyer's departure and will not discourage a departing lawyer from taking a case and thereby deny the client access to the lawyer of his choice.
In most jurisdictions, a contractual provision that imposes a financial disincentive on a withdrawing lawyer if the lawyer competes with the firm is prohibited because it may have the same effect as a restrictive covenant and prevent or discourage the departing lawyer from the representation of firm clients that want to follow the departing lawyer. ABA/BNA Lawyers' Manual on Professional Conduct, 51:1201- 1214, Restrictions On Right To Practice (51:1205). For example, Ohio (Supreme Court) Ethics Opinion 91-3 (1991), holds that an employment agreement that contains a provision requiring a departing associate to pay the law firm a percentage of fees earned from former firm clients who follow the departing associate is an unethical restriction on the lawyer's right to practice.
Whether a provision in a shareholders agreement constitutes a prohibited financial disincentive on competition after a lawyer leaves a firm was considered in 2007 FEO 6. This opinion examined a provision in shareholders agreement that reduced the repurchase value of a withdrawing lawyer's shares in the event the lawyer took clients with him. In the opinion, it was observed that the provision was:
not like the typical covenant not to compete in that it does not have geographical or temporal restrictions; [however] it does tie the decrease in share value to the fact that the departed lawyer represents former clients of the firm. By so doing, the provision provides a disincentive for the departing lawyer to represent clients with whom the lawyer has a prior relationship, penalizes the departing lawyer for representing former clients of the firm, and restricts the lawyer's right to practice.
Although the opinion prohibits financial disincentives on the continued representation of clients, it does not prohibit an agreement for repurchasing the shares of a withdrawing lawyer if the agreement "represents a fair assessment of the forecasted devaluation in the ownership interest in the firm engendered by a lawyer's departure and does not penalize the lawyer for taking clients with him."
Similarly, an agreement on the division of fees after a lawyer's departure from a firm may not be a prohibited restrictive covenant if the agreement seeks merely to compensate the firm for the loss of firm resources invested in the representation of a client who leaves the firm prior to the realization of the fee. As favorably noted in Ethics Decision 2000-6, agreements that resolve the division of contingent fees received after a lawyer leaves a law firm "prevent clients from being put in the middle of a dispute between lawyers." For this reason, lawyers are encouraged to enter into agreements that will resolve such potential disputes fairly and without rancor. Nevertheless, such agreements may not be so financially onerous or punitive as to deter a withdrawing lawyer from continuing to represent a client if the client chooses to be represented by the lawyer after the lawyer's departure from the firm. Any financial disincentive in an employment agreement that deters a lawyer from continuing to represent a client restricts the lawyer's right to practice in violation of Rule 5.6(a); 2007 FEO 6.
Each employment agreement must be analyzed individually to determine whether it violates Rule 5.6(a); however, some general principles can be articulated. The procedure or formula for dividing a fee must be reasonably calculated to protect the economic interests of the law firm while not restricting the right to practice law. It should fairly reflect the firm's investment of resources in the client's representation as of the time of the lawyer's departure and the investment of resources that will be required for the departing lawyer to complete the representation. See Maryland State Bar Ass'n., Op. 89-29 (1989) (approving employment agreement "sliding chart" for dividing fees based upon the time that the law firm worked on the case and the time required for the departed lawyer to resolve the case and collect the fee). The formula may take into account the work performed on the representation prior to the lawyer's departure, non-lawyer resources that the firm allocated to the representation not including costs advanced for the client, firm overhead that can be fairly allocated to the client's representation prior to departure, and the legal work, non-lawyer resources, and overhead that will be required of the withdrawing lawyer to complete the representation.
The provision in Employment Agreement No. 1 above, for example, does not satisfy the reasonableness standard. It requires the departing lawyer to pay 70% of any fee received from the continued representation of a client regardless of whether the departing lawyer provides the majority of the legal representation of the client after the lawyer's departure from the firm. Because it applies a "one size fits all" formula for the allocation of the fees and fails to take into account the amount of work performed and the resources expended on the representation before and after the lawyer's departure, the provision is likely to discourage a lawyer from taking any case that requires substantial additional legal work.
The formula for fee divisions in Employment Agreement No. 2 attempts to take into consideration the resources devoted to the representation of a client by allocating the fee according to the amount of time between the date the lawyer departs taking a case and the date on which the legal fee for the case is "determined" or realized. However, the formula relies on an arbitrary timeframe unrelated to the actual legal work performed within this timeframe and is likely to create a substantial financial disincentive for a lawyer to continue to represent clients. Accord Maryland Ethics Opinion 93-21 (1993) (prohibiting employment agreement requiring lawyer to divide fee with former firm according to arbitrary percentages based on number of days elapsed since client retained firm before leaving with lawyer).
With the exception noted below, the formula for fee division in Employment Agreement No. 3 is the best attempt at allocating the fee based upon the resources that the firm expended on the representation prior to the lawyer's departure. The formula allocates to the firm a percentage of the fee equivalent to the amount of time that the lawyer represented the client while the lawyer was employed by the firm and receiving compensation from the firm. Thus, the departed lawyer will be fully compensated for any work that he performs on a case after he leaves the firm and will not be discouraged from the continued representation of clients who desire her services.
With regard to compensating the law firm for overhead and non-lawyer resources devoted to a case (apart from costs advanced), a reasonable amount of the legal fee may be allocated to the firm for its overhead and non-lawyer expenses including the firm's investment in legal advertising and marketing. However, any such allocation must be reasonably related to the actual cost of such resources or expenses for the particular client. If it is not, the firm will receive a windfall that will deter the departing lawyer from taking cases. For example, the formula in Employment Agreement No. 3 above, which allocates 20% of every fee to the law firm to recover advertising and marketing costs, is not reasonable.
Will any ethical infirmities in an employment agreement be cured by a provision in the agreement that guarantees that the departing lawyer will receive, at a minimum, hourly compensation for the time the lawyer expends on a case after the lawyer leaves the firm? An example of such a minimum compensation provision appears below:
No Effect in Restricting the Practice of Law. Law Firm and Associate recognize that the client's right to choose counsel takes precedence over the fee division arrangement set forth in this section. The parties agree these provisions do not have the effect of restricting the practice of law or restricting any client's right to choose counsel so long as, for work performed for a Transferring Client, Associate receives hourly compensation at a rate of $150 per hour. To the extent that Associate does not receive compensation for his/her time on any Transferring Client's matter at a rate of at least $150 per hour, the Firm's allocation of fees calculated under paragraph 2.12 will be reduced (but not below zero) in order to increase Associate's compensation to the rate of $150 per hour; provided, however, that Associate shall be required to substantiate his/her time expended on each such matter by verified, contemporaneously maintained time records. In light of this arrangement, Associate will not decline to represent any Transferring Client for any financial reason.
Such a provision, by providing a floor below which the departing lawyer's compensation may not fall, may lessen the possibility that the formula or procedure for dividing fees will discourage the lawyer from taking a case after the lawyer leaves the firm. Therefore, such a provision is beneficial but it will not rectify a fee division provision that fails to take into consideration the factors set forth in Opinion #1 above. Moreover, the hourly rate set forth in a minimum compensation provision must be determined in a manner that is reasonable and fair under the circumstances. This means that it must take into consideration the skill, knowledge, and experience of the lawyer at the time that the lawyer leaves the firm, the difficulty of the work to be performed, and the hourly rates paid to lawyers of similar experience in the relevant geographic area.
May the agreement for allocating legal fees include compensation to the law firm for the goodwill that initially induced the client to seek the legal services of the law firm?
Yes, if goodwill is valued fairly and reasonably and is not such a significant proportion of the fee that it creates a financial disincentive for the departing lawyer to continue the representation of clients who desire her services.
May the agreement require the departing lawyer to reimburse the firm for the costs advanced (e.g., costs for depositions, expert witnesses, medical records, etc.) on behalf of a client immediately upon the departure of the lawyer or soon thereafter? May the agreement require the departing lawyer to sign a promissory note for the costs advanced?
No. The costs advanced for a client are the client's financial responsibility and the departing lawyer may not be made liable for this debt. Such a provision would have a chilling effect on the departing lawyer's willingness to continue the representation of a client. See Ethics Decision 2000-6 (by conditioning departing lawyer's ability to represent client on the satisfaction of client's financial obligation to former firm, provision imposes financial penalty that will discourage continued representation of clients). However, the firm may pursue any legal claim that it has against the client and the employment agreement may require the departing lawyer to protect the firm's interest in receiving reimbursement for costs advanced from any final settlement or judgment received by the client.
Is an employment agreement that divides legal fees between a former law firm and a departed lawyer a violation of the prohibition in Rule 1.5(e) on the division of fees between lawyers who are not in the same firm?
No, comment  to Rule 1.5 provides that the prohibition on fee divisions in paragraph (e) of the rule does not prohibit or regulate division of fees to be received in the future for work done when lawyers were previously associated in a law firm.
May an employment agreement include a mandatory arbitration or alternative dispute resolution provision in the event the departing lawyer and the former firm cannot amiably resolve disputes over the division of legal fees?
Yes. Lawyers are urged to include such provisions in employment agreements to foster early resolution of disputes without litigation and without drawing clients into the disputes. As observed in RPC 107, which approves of a mandatory alternative dispute provision in a fee agreement with a client, "[a]s a matter of professionalism, lawyers should avoid litigation to collect fees wherever possible. In that regard lawyers are encouraged to employ reasonably available alternative forms of dispute resolution." See also RPC 48 (clients should not be drawn into disputes upon dissolution of firm).