“How did it get so late so soon? It's night before it's afternoon. December is here before it's June. My goodness how the time has flewn. How did it get so late so soon?” - Dr. Seuss

This year (which has “flewn”) saw a number of interesting decisions concerning the identity, rights and obligations of non-equity owners, including partners and shareholders. As more firms utilize non-equity members to play vital roles within their firms, it will become more important for them to take note of these decisions and the guidance they provide.

'Heller Ehrman v. Neuman'

In April, the U.S. Court of Appeals for the Ninth Circuit addressed the transition of a shareholder to a non-equity position. Heller Ehrman LLP v. K. William Neuman, No. 15-17124 (9th Cir. April 10, 2017).

Heller Ehrman had two categories of employees: shareholders, a group akin to “equity partners” in that they received a percentage of the firm's yearly profit, and fixed income employees, including staff, retired shareholders, and associates paid a fixed wage. Id.

Neuman became an associate at the firm in 1976 and a shareholder in the 1980s. Id. In 2007, the firm's Compensation Committee proposed, and Neuman agreed, that Neuman be moved to fixed-income compensation. Id. at 4.

In September 2008, the LLP, with Neuman's support, voted to adopt a plan of dissolution after defaulting on its line of credit. Id.

At this time, Neuman filed a claim demanding $1,161,066.43 in compensation, citing the terms of his 2007 contract. Id. at 6. The Bankruptcy Court found that: “Neuman was not a Heller Ehrman shareholder at the time of the LLP's dissolution, so he could claim a right to compensation as an employee.” Id. at 7.

The District Court affirmed the Bankruptcy Court's order entitling Neuman to $1,161,066.43, id. at 6 & 14, and the LLP petitioned the Ninth Circuit to review the District Court decision. The Ninth Circuit found a number of reversible errors. Id.

The primary difference in the courts' interpretation of the facts centered on a 2007 Letter Agreement between Heller Ehrman LLP and Neuman. Id. at 3. The Bankruptcy Court found that the letter, which designated Neuman as a “fixed income shareholder,” “made him an employee of Heller Ehrman LLP.” Id. The Ninth Circuit, however, found that “when read with the Employment Agreement […] [it is] clear that the 2007 Letter Agreement simply modified how Neuman was to be paid; it did not modify his status as a shareholder.” Id.

The Ninth Circuit based its conclusion on a number of factors. First, the 2007 Letter Agreement identified Neuman as a “fixed income shareholder.” Id. While the lower court considered Neuman's fixed income status a “critical fact,” the Ninth Circuit concluded that the Employment Agreement did not bar one from being a “fixed income shareholder.” Id at 3-4.

Next, the Bankruptcy Court found that the 2007 Letter Agreement was a novation, and thus, the Employment Agreement was terminated. Id. at 4. The Ninth Circuit, on the other hand, found no clear evidence that either party was intentionally trying to terminate the initial agreement, and, therefore, the initial agreement was enforceable. Id. at 4-5. The Ninth Circuit held that “a new arrangement for payment under a contract is not, in itself, sufficient to effect a novation.” Id. at 5. Thus, the Employment Agreement, insofar as it defined Neuman as a shareholder at Heller Ehrman LLP, was enforceable. Id.

Moreover, while the Bankruptcy Court found Neuman had neither any “units of compensation,” nor an “Attributed Percentage,” the Ninth Circuit found that Neuman did indeed have an “Attributed Percentage,” for his income, fixed though it was, was used to calculate shareholder voting, a power which Neuman exercised. Id. at 5-6. Given this, the court determined that, despite his new role in the LLP, “Neuman remained a shareholder.” Id. at 6.

'Borteck v. Torzewski'

On Sept. 25, 2017, the Superior Court of New Jersey, Appellate Division, decided the case of Borteck v. Torzewski, 2017 WL 4228015, which relates to a non-equity partner in a law firm and found, unlike in Neuman, that there was no equity ownership.

In this case, on appeal from Superior Court of New Jersey, Chancery Division, plaintiff/third-party defendant Robert Borteck, and Defendant/third-party plaintiff Thomas Torzewski, each filed motions for summary judgement in a dispute over the nature of their former law partnership. Borteck v. Torzewski, 2017 WL 4228015 at *1.

According to Torzewski, although he and Borteck never agreed to the terms of a partnership, the fact that in 2012 he received a K-1, that the K-1 stated he was to be paid $233,326, or 23.8 percent of the firm's net profit, that the firm began paying his health insurance, and that he had certain management rights and responsibilities within the firm, were basis for his being an equity partner. Id.

According to Borteck's motion for summary judgement, while, in early 2012, he and Torzewski discussed Torzewski's possibly acquiring an equity interest, no conclusion had been reached. Id. Thus, a compensation agreement, set forth in a number of emails between Torzewski and the firm, and which governed since 2010, still stood. Id. According to the compensation agreement, Torzewski would receive a fixed salary provided he brought in a certain amount of income. Id. In the event he failed to reach the required amount, his compensation would be reduced in proportion to the underage. Id.

While the compensation agreement meant that Torzewski received a W-2 form at the end of 2010 and 2011, the fact that he received a K-1 for 2012, did not, Borteck argued, demonstrate that Torzewski was an equity partner, for the issuance of a K-1 had been done at Torzewski's request. Id. at *1-*2. Moreover, although the 2012 K-1 stated that Torzewski was to be paid $233,326, or 23.8 percent of the firm's net income, this did not, Borteck claimed, indicate that Torzewski's profit distribution was calculated based on the firm's net income, as the $233,326 he was paid in 2012 was the same salary Torzewski had received in 2010 and 2011. Id. at *2. The reason the 23.8 percent appeared on the K-1 was simply that, already knowing Torzewski's annual salary, the firm's accountant calculated what percentage of the firm's net income said salary was and entered that percentage on the K-1, as per the form's requirements. Id.

The motion court determined, among other things, that there were no issues of fact, and ruled that the absence of a partnership agreement establishing Torzewski as an equity partner undermined his case. Id.

Both parties appealed and the appellate court affirmed. Id.

Torzewski's appeal was comprised of five arguments, all of which were found unpersuasive by the appeals court, but two of which received an in depth treatment. Id. at *3-*5.

Of these two, in the first, Torzewski claimed that he established under the Uniform Partnership Act, that he was an equity partner insofar as such stipulates that two or more people who are “co-owners” of a business are a partnership. Id. at *3.

The court countered by determining that, despite the fact that Torzewski had a 1 percent capital interest in the firm starting in 2010, there is no evidence that he was ever a co-owner. Id. at *3. Indeed, in spite of having this 1 percent interest in 2010 and 2011, Torzewski did not claim he was an equity partner at that time. Id. Moreover, the court stated, the term “co-owner,” as far as the New Jersey Law is concerned, refers to individuals in business together who share profits—and Torzewski did not receive a share of the firm's profits. Id. at *4. Rather, his salary was allotted on a discretionary basis determined by his personal performance. Id. Even the K-1 Torzewski received in 2012 was not, the court found, evidence that he was a co-owner, for the percentage entered on this form was based on a predetermined salary which was itself determined by the 2010 email compensation agreement. Id. According to the court, Torzewski's argument is based on the presumption that a partnership, and the necessary sharing of profits and losses this entails, can exist without a partnership agreement. Id. And, given that Torzewski was unable to establish that any such agreement existed, the court concluded that this argument is without merit. Id.

The second of Torzewski's claims was based in common law. Id. The court addressed eight indicia which determine whether an equity partnership exists: “(1) the intention of the parties; (2) the sharing of the partnership's profits; (3) the sharing of the partnership's losses; (4) the ownership and control of the partnership's property and business; (5) the 'community of power in administration and the reservation in the agreement of the exclusive control of the management of the business'; (6) whether the language of the agreement excludes one party from 'most of the ordinary rights of a partner'; (7) the conduct of the parties toward third persons, including taxing authorities, clients, and others; and (8) the rights of the parties on dissolution.” Id. at *4.

Regarding (1) (intention) the court determined there is no evidence Borteck agreed to Torzewski becoming an equity partner. Id. at *5. There was no partnership agreement between the parties, merely an email compensation agreement. Id. at *2 and *5. The fact that Torzewski received a K-1 and health insurance are not sufficient to make him an equity partner. Id. at *5.

As to (2) and (3) (sharing profits and losses), the court held that Torzewski's discretion-based salary was not a share in the firm's profits and losses. Id. For (4) and (5) (“ownership” and management), the court found that, while there were certain administrative roles and advantages that Torzewski enjoyed in 2012, he enjoyed these while he was undisputedly a non-equity partner. Id. Concerning (6) (exclusion of rights as a partner) and (8) (rights on dissolution), the court reasoned that they did not apply given that, as discussed above, there was no partnership agreement between Borteck and Torzewski. Id. Finally, while Borteck admits that Torzewski was a partner from 2010 to 2012, there is nothing which shows that, during this time, he was an equity partner. Id. Thus, Torzewski also fails to meet criteria (7) (conduct towards third-parties). Id.

Conclusion

As demonstrated by Neuman and Borteck, determining one's status as an equity or non-equity member of a firm can have significant ramifications. Firms and their members should, as a result, carefully analyze their agreements and conduct to determine if the desired commercial status is supported by the applicable legal standards.

We wanted to thank the readers of this column for the very kind and encouraging words we heard throughout 2017. We hope this year's columns have been helpful and even somewhat enjoyable. They are certainly a labor of love, and their writing remains a privilege.

Arthur J. Ciampi is the coauthor of the treatise 'Law Firm Partnership Agreements' and is the managing member of Ciampi LLC. Maria Ciampi, of counsel to Ciampi LLC, assisted in the preparation of this article.