     
    |
|
|
October 1993
Published in 81 Illinois Bar Journal
(Cite as: 81 Ill. B.J. 530)
© Illinois State Bar Association. Used with Permission.
Flynn v Cohn: Payment of Overhead
in Winding Up a Partnership
By Michael L. Shakman and Barry A. Miller
In Flynn v. Cohn, the Illinois Supreme Court considered an issue of increasing importance in light of the frequency of law firm split-ups – how the overhead costs of winding up the dissolved firm’s business are to be shared among the former partners.
Unfortunately, the court’s decision does not provide a precedent that will guide lawyers facing this problem in the future. While the policies that should govern a definition of overhead are spelled out by the Illinois Uniform Partnership Act ("UPA"), a majority of the court ignored those policies and treated the issue solely as a question of fact – affirming the trial court because its decision was "not against the manifest weight of the evidence." The extent to which the court was divided on the issue is underscored by the fact that one justice specially concurred and two others concurred in part and dissented in part.
The court could have avoided the confusion that will result from its decision if it had followed the lead of an earlier Illinois Appellate Court decision and cases from other states that have treated the issue of overhead allocation as presenting primarily a question of law. Under the UPA, the costs of winding up the partnership’s unfinished business are like other costs incurred during the windup process. Like debts owed to third party creditors, windup costs must be calculated and paid before the profits realized during the windup process are distributed to the former partners.
In addition to failing properly to apply the UPA, in our view the supreme court’s decision in Flynn raises doubts about the court’s exercise of its responsibility to develop and clarify the law when it takes a case for review. Flynn is the second time the court has addressed the same issue in recent years without generating either a consistent rule or an analytical foundation to guide the trial courts.
Before discussing the court’s decision, we will briefly review the UPA’s rules for dissolution of a partnership.
I. The UPA’S Rules for Partnership Dissolution
Under the UPA, a partnership dissolves when one partner dies or withdraws, or in certain other ways. But when a law firm, or any other partnership, dissolves it does not immediately end. Instead, the UPA says that after dissolution "the partnership is not terminated, but continues until the winding up of partnership affairs is completed."
Unless otherwise agreed, each partner may wind-up the affairs of the partnership. "Winding up" its affairs includes completing "transactions begun but not then finished." In the case of a law partnership, this means completing cases and other matters underway on the date the firm dissolves.
The Partnership Act states that "[n]o partner is entitled to remuneration for acting in the partnership business, *531 except that a surviving partner is entitled to reasonable compensation for his services in winding up the partnership affairs." Illinois courts have held that a "surviving partner" means only a partner who survives after the death of another partner.
In cases where dissolution is not caused by the death of a partner, Illinois courts, like those in most jurisdictions that have adopted the UPA, interpret the Act to mean that a partner who winds up the affairs of his or her dissolved law firm by taking responsibility for and completing unfinished cases is not entitled to be paid for those services. All the winding-up partner is entitled to is his or her partnership share of the net income realized by the dissolved partnership from the cases in question.
As part of the wind-up process, the partnership must pay its liabilities. Section 40 of the UPA provides that the liabilities of a dissolved partnership include, in addition to those owed to third parties, liabilities owed to partners "other than for capital and profits." Section 40 has been interpreted as meaning that the overhead attributable to the winding up of partnership business must be deducted from gross partnership income in computing the profits of a dissolved partnership.
Since overhead often represents between 40 and 70 percent of a law firm’s total fee income, and since partners who wind up cases for a dissolved firm are not separately compensated for their effort, the manner in which overhead is computed becomes one of the central economic issues in winding up a law partnership.
II. How the Various Opinions Viewed the Issue
In Flynn two lawyers who had practiced together for many years dissolved their practice. Under their oral partnership agreement, they had divided revenues and expenses equally. One partner had brought in many more cases than the other, and he continued to handle more of the unfinished cases after dissolution. In the wind-up period Flynn handled 37 cases generating $37,000 in fees, while Cohn handled 140 cases generating $531,233 in fees.
After an evidentiary hearing, the trial court ordered both parties to prepare an accounting of expenses and fees for the wind-up period. Flynn called an accountant to testify as to how the overhead attributable to these cases should be determined. The accountant reviewed the partnership’s tax returns for the five years prior to dissolution and computed that the firm’s overhead had averaged 62.64 percent of gross income. He testified that a formula he created properly reimbursed the partner who completed a case for the overhead incurred during the wind-up period. The formula was:
fee x 62.64 percent x A/B x 50 percent = C
A = number of months case pending after dissolution.
B = total number of months case pending.
C = each partner’s share of overhead incurred after dissolution.
The defendant’s expert presented a competing formula.
The trial court found in favor of the plaintiff, and adopted the formula presented by his expert. The appellate court affirmed, ruling that the trial court’s adoption of the plaintiff’s expert’s formula was not against the manifest weight of the evidence.
A. The Majority’s Opinion
The supreme court affirmed, approving the formula applied by Flynn’s expert. In his opinion for a four-justice majority, Justice Moran treated the case as involving solely an issue of fact, applying an "against the manifest weight of the evidence" standard. The court wrote as follows:
The trial judge was in the best position to resolve the conflicts between the experts’ testimony and determine their credibility. Based on our review of the record, we agree with plaintiff that the trial and appellate court’s finding, that Burke’s formula equitably distributes the post-dissolution overhead between the partners, was not against the manifest weight of the evidence.
The supreme court distinguished its prior opinion in In Re Estate of Barbera, where it applied a 60 percent *532 factor for overhead in a similar case. The court held that the Barbera case did not set up any particular method for computing overhead, and that the computation of overhead would turn on the facts of each case.
B. Justice Heiple’s Concurrence
Justice Heiple specially concurred. In his view, overhead should not be allocated between the two former partners. Justice Heiple concluded:
Overhead is overhead; when profit exceeds it, it does not matter where overhead is spent. A proper formula would just deduct total overhead expended from gross fees collected to determine the net fees collected by each partner.
Justice Heiple would have deducted the overhead percentage that had historically been incurred by the partnership, as computed by Flynn’s expert witness, from gross fee income. Under that computation, Flynn, the appellee, was entitled to a greater award than he received below, while Cohn, the appellant, was entitled to a smaller award than he received below. This paradox led Justice Heiple to an odd conclusion:
Neither Cohn nor Flynn, in my opinion, presented a correct formula to the trial court. The resulting error was thereby invited by the two of them. The fundamental problem with their suggested approaches, and the approach adopted by the trial court, is that they seek to distribute losses when in actuality there are profits to be divided. Since appellant Cohn would lose money by winning the reversal he seeks and since appellee Flynn, who would lose money by the affirmance, asks that the decision be affirmed, and since both invited the error, I concur in the result but not the rationale.
C. Chief Justice Miller’s Dissent
Chief Justice Miller, with whom Justice Freeman joined, dissented. He reasoned that the majority erred in applying that part of the formula that reduced the overhead charged to the handling attorney by 50 percent.
Chief Justice Miller wrote:
During the post-dissolution period, the partners pay from their own pockets the overhead expenses they incur in winding up the affairs of the partnership. Accordingly, with respect to fee-generating files concluded during that time, the partners are entitled to full reimbursement from the partnership for overhead expenses attributable to the partnership matters they have handled. . . .
The multiplier fails to accomplish what the plaintiff claims it does. It is clear that the formula actually computes only one partner’s share of the post-dissolution overhead for a particular file, not the total amount of post-dissolution overhead incurred in connection with a file. . . . As the defendant points out, the plaintiff’s formula effectively reimburses the winding-up partner for only one half of the overhead incurred on a particular file, leaving the other half to be split as profit.
Chief Justice Miller concluded that the formula could be corrected by removing the 50 percent factor. Accordingly, he wished "simply to eliminate the 50% multiplier from the plaintiff’s formula."
III. How the Majority Erred
The majority made four basic errors, in our view: (1) It failed to recognize that the UPA provides a set of rules that should be applied, as a matter of law, in determining how to measure overhead; (2) It failed to recognize that the UPA requires a determination of actual overhead ratios, not historical pre- dissolution ratios; (3) it failed to recognize that since overhead is not necessarily incurred evenly over time, a method is needed to determine the amount attributable to the windup period; and (4) it gave weight to an irrelevant consideration – the number of partners in the firm during the windup process.
A. The Role of the UPA
The majority’s first and most serious error was its failure to recognize that the principal issue presented was one of law, not fact. The majority treated the competing testimony of two accountants about how to compute overhead solely as a question of fact. But since the question arises within the legal framework created by the UPA, the first place to look for guidance in defining overhead is the UPA. Had the court started its analysis with the Act, as did the concurring and dissenting opinions, it would have been clear that the formula advanced by plaintiff’s accountant and accepted by the lower courts was wrong – as a matter of law.
As Chief Justice Miller noted, the case should have been controlled by section 40 of the UPA. As discussed above, that section includes as partnership liabilities "[t]hose owing to partners other than for capital and profits" – which includes wind-up expenses advanced by a partner. This point was correctly explained by the appellate court in Ellerby v Spiezer:
[T]he partnership profits are not the entire amounts of the fees it earns. Liabilities owed to creditors other than partners; owed to partners other than for capital and profit; and owed to partners in respect of capital are all payable before distribution of profits. . . . Among the liabilities of the partnership (owed either to a non-partner creditor or to a partner other than for capital and profits) is the overhead attributable to the winding up of partnership business. . . . Therefore, prior to the distribution of any profits, each partner is entitled to be reimbursed for the reasonable and necessary overhead expenses attributable to winding up the partnership’s business.
Viewed from this perspective, the UPA instructs the trial court to determine the actual, reasonable overhead costs incurred by each former partner in handling partnership matters during the windup process. Those costs should be paid to the partner that incurs them, and the remaining portion of the fees should be divided as profits.
The trial court made an error of law in accepting Flynn’s expert’s formula. By viewing the issue as a question of fact, the majority inappropriately deferred to the trial court’s resolution of expert testimony.
B. The Court Should Have Focused On Actual Overhead Ratios
The formula advanced by Flynn’s expert – even as corrected by Chief *533 Justice Miller’s exclusion of 50 percent – does not calculate the actual post-overhead expense of each partner handling firm matters during the windup process. Following the cost-repayment mandate of section 40 of the UPA requires that the parties introduce evidence of the actual overhead expenses of each partner engaged in winding up partnership work.
The legal issue presented by Flynn, and in Barbera before it, is how to pay a partner who winds up unfinished business for the overhead the partner incurs in doing so. Both Flynn and Barbera err in permitting the use of pre-dissolution overhead ratios. They applied those ratios to the post-dissolution revenue of the dissolved firm, and thus purported to determine post-dissolution overhead. In both cases the supreme court permitted the use of such evidence, apparently because it was the only evidence of record.
Since the objective in both cases under section 40 of the UPA was to repay each partner for actual post-dissolution overhead, it is surprising that the court did not base payment of overhead on the actual post-dissolution overhead of the partners engaged in completing unfinished business. That approach was followed by courts in New York and Indiana – albeit with little discussion – in determining post-dissolution overhead in winding up dissolved law firms.
C. The Majority Erred In Assuming Overhead is Incurred Evenly
The majority also erred in assuming that overhead is incurred ratably over the life of the case. This is rarely true. To comply with the cost-repayment rule of section 40, the majority should have required that the allocation of overhead – whatever ratio was used – be based on the actual portion of total overhead incurred on each matter in the windup period. If there is no direct evidence of such expense for each matter during the windup period, there are likely to be several types of evidence that approximate it – such as a comparison of the number of hours spent on the case before and after dissolution, or the amount of discovery taken before and after dissolution, or the like.
Applying such criteria to the total overhead incurred in handling the matter should permit a fair determination of the portion of overhead allocable*534 to the windup period. To implement the actual-expense-reimbursement goal of the UPA, the court should have encouraged the use of such actual post-dissolution overhead information and remanded Flynn for further hearings if the record failed to contain the necessary basis to determine how overhead should be allocated. In the Ellerby case, the appellate court, when faced with a similar lack of adequate evidence of overhead, did remand the case for further proceedings. That course was proper.
D. The Majority Erred in Emphasizing the Number of Partners
Even if the majority’s decision in Flynn to permit the use of pre- dissolution overhead ratios is accepted on pragmatic grounds – because no better evidence was available – the formula it approved was not correct. Both Justice Heiple’s and Chief Justice Miller’s separate opinions correctly criticized the majority for reducing the overhead allocation by the number of partners in the dissolved firm. Under the formula approved by the majority, the overhead determined from the 62.64 percent historical pre-dissolution expense ratio, as reduced by the adjustment for the period the case was pending before dissolution, is further reduced by dividing it by the number of partners in the dissolved firm. (In the actual formula, the reduction is achieved by multiplying by a percentage – 50 percent in the Flynn case, since there were two partners.)
This adjustment for the number of partners in the dissolved firm is contrary to the UPA’s policy of reimbursing actual expenses incurred by a partner in winding up firm business. Indeed, the majority opinion does not even attempt to justify it, apart from stating that "[o]ne-half of the post-dissolution overhead was credited to the partner who handled the case after dissolution, since there were two equal partners." Accepting this adjustment disregards the reason for attempting to determine post-dissolution overhead in the first place: to pay the partner who incurred it for his or her necessary contribution to the fee received.
Indeed, post-dissolution expenses are incurred only by the partner who winds- up the case, not by all the partners. Reducing the overhead by one-half does exactly what Chief Justice Miller says: it reimburses the winding up partner for only one-half of the overhead that partner has advanced, and splits the other half as profit. Since this reduction now has the unexplained sanction of the Illinois Supreme Court, it is likely to be used in future partnership dissolution litigation until the supreme court corrects its error.
IV. How the Separate Opinions Erred
While Chief Justice Miller’s opinion in Flynn comes the closest, none of the three opinions reaches the right result in our view.
Justice Heiple’s conclusion is to ignore the issue of how to define or compute post-dissolution overhead. He does not seek to allocate overhead between the partners in any way, except by assuming that each former partner’s overhead incurred during the windup was the same as the firm’s pre-dissolution overhead. This approach penalizes the partner who does more than his or her share during the windup process. Justice Heiple’s opinion also errs in rejecting any split of overhead into pre-dissolution and post-dissolution periods. Pre-dissolution overhead has already been paid by the partners.
Thus, if a case was pending for 24 months before the dissolution and one month after it, Justice Heiple’s approach would call 62.64 percent of the fee recovery (the historical overhead ratio in Flynn) "overhead," leaving the non- winding up partner with only one-half of 37.64 percent, or 18.82 percent of the recovery. But it is likely that almost all of the overhead had already been paid by the partnership prior to the date of dissolution. It is contrary to the policy of the UPA to repay the partners for their pre-dissolution overhead expense that had already been paid by the partnership. In that respect, the majority at least tried to match revenues and expenses to the same time period. Justice Heiple’s approach failed to do so.
Justice Heiple’s opinion also seems unfair in arguing that neither party should win an appeal if the relief each side requests would leave it worse off than it was in the trial court. That approach takes the sporting theory of litigation too far, and neglects the court’s obligation to render justice. A reviewing court has a duty to remand when, as a matter of law, lower courts have neither applied the correct legal rules nor admitted the evidence necessary to reach a correct result. A remand is the only way justice can be done.
Chief Justice Miller correctly concluded that the majority’s formula had the effect of treating half of the assumed overhead as if it were profit and dividing it. But his opinion, like the other two, failed to address whether the record was sufficient to determine the expenses the parties actually incurred following dissolution, relying instead on the pre-dissolution expense formula. Chief Justice Miller’s opinion was also less persuasive because it did not spell out as clearly as it might the way in which the case was controlled by section 40 of the Partnership Act or how Ellerby had correctly applied that section.
V. The Court Should Have Clarified the Law
A supreme court with discretionary jurisdiction should exercise that jurisdiction to decide important, disputed issues of law. Under most circumstances, it is an inefficient use of the court’s limited time for it to decide cases on factual points without articulating rules of general applicability.
The Illinois Supreme Court can fairly be criticized for its failure – despite two chances in Barbera and Flynn – to articulate the correct legal standard so that lower courts and dissolving partnerships can apply it. In the supreme court’s earlier opinion in Barbera, the court noted that the post- dissolution records and the testimony at trial were inadequate to permit the trial court to determine the actual allocation of overhead between partnership cases handled during the wind-up period by the surviving partner and the overhead attributable to the new cases initiated by that partner for his own account after dissolution. The supreme court failed, however, to articulate the correct rules under the UPA and then remand the case to permit the trial court to apply them.
Instead, the court used the pre-dissolution overhead of 60 percent as the appropriate overhead factor, stating that "there is no evidence that allocation of time and expense between new and old business differed from that which prevailed during the period when the 60% overhead was experienced."
In Flynn, the supreme court compounded the error, approving a formula for overhead that is inconsistent with the UPA. In future litigation, some parties will likely adopt the allocation formula approved by the court in Flynn, or parts of it. Other parties will advance one or another of the positions asserted in the concurring and dissenting opinions and will attempt to support them with stronger testimony than in Flynn. Still others will read Flynn as permitting other, entirely different, formulae. All these positions are permitted under the majority opinion.
In effect, the majority opinion in Flynn invites more litigation over an issue that does not warrant it – and it does so because it fails to consider the policies of the UPA or attempt to apply them.
Just as Flynn was required because Barbera did not articulate the proper standard, the supreme court will now be required to accept another case to state properly the general principles that will govern future conduct. The majority opinion in Flynn correctly noted that "Barbera did not adopt a specific method to allocate overhead to the exclusion of other methods." Unfortunately, the court did not recognize the need to settle the issue.
The Flynn case expands the existing uncertainty concerning how post- dissolution overhead should be determined. The issue will undoubtedly come back to the court again. The Barbera and Flynn decisions invite a return visit.
Michael L. Shakman is a partner in the Chicago law firm of Miller, Shakman, Hamilton, Kurtzon & Schlifke. He received an A.B. degree with honors, an A.M. degree in 1964, and a J.D. degree in 1966 from the University of Chicago, where he was a member of the Order of the Coif.
Barry A. Miller is also a partner in Miller, Shakman, Hamilton, Kurtzon & Schlifke. Mr. Miller received his B.A. from Yale College cum laude in 1975 and his J.D. magna cum laude from Harvard Law School in 1978.
Copyright © 1993 by the Illinois State Bar Association; Michael L. Shakman and Barry A. Miller
Back to top
Footnotes
Back to top | Download PDF
|
|
