For years, selling a law practice was prohibited because ethics regulators believed clients, files, and a firm’s good will were not something that could be sold. This prohibition did not really affect larger law firms, which would just buy out partners, i.e. the partnership would return the percentage of the equity owned by the retiring partner. Smaller law firms were able to “sell” themselves by merging with other firms.
Solos had to be more creative. Selling the firm’s physical fixtures and furnishings for more than their reasonable market value was a common way to get around the prohibition. Another way was to create a sham partnership, in which the departing lawyer received retirement benefits from the new partner. Solos who were unwilling or unable to take advantage of one of those options, would simply give away their clients — or just close up shop.
All of this began to change about 25 years ago. In 1989, California became the first state to adopt a rule permitting the sale of a practice. The following year, the ABA adopted Model Rule 1.17 allowing the sale of an entire practice. In 2002, the Model Rule was amended to permit the partial sale of a practice. Most, states, though not all, have adopted Model Rule 1.17 or a modified version.
This change in policy was largely based on a desire for transparency and to level the playing field between solos and firms of all sizes. In addition, regulators decided it would be better to have client matters placed in the hands of a (presumably) pre-screened lawyer rather than force clients find new counsel on their own.
Before the deal is done: confidentiality and competence
Generally speaking, Model Rule 1.6 prohibits lawyers from disclosing confidential information. However, comment 7 to Rule 1.17 states that the disclosures pursuant to a sale are treated in the same manner as disclosures when attorneys switch law firms or law firms merge. The release of generalized information about clients and files is permissible — and to a certain extent is indeed required — in order to identify possible conflicts of interests.
Disclosure of information beyond the general requires actual client consent. And, of course, prospective buyers have a duty to maintain the confidentiality of any information they learn during the sales process.
Model Rule 1.1 states that a lawyer shall provide competent representation to clients. Comment 11 to Rule 1.17 provides that the duty of competence applies in a sale. Sellers are obligated to exercise competence in identifying purchasers qualified to take over the practice, and buyers are obligated to undertake its future representations competently.
What must be sold
To prevent lawyers from selling only those clients who are less-valuable, a lawyer must put the entire practice or an entire area of practice up for sale. No cherry-picking allowed. Rule 1.17 (b)
Permissible terms: covenants not to compete
Under Model Rule 5.6, lawyers are prohibited from entering into any agreement that restricts the right of a lawyer to practice. However, comment 3 to the same rule specifically states that Rule 5.6 does not apply to prohibit restrictions contained in a sale. Such restrictions would still have to comply with the applicable state’s law on non-competes, of course.
As a practical matter, such covenants are presumably unnecessary since the selling lawyer is usually retiring and has no desire continuing to practice. With that said, it is better to be safe than sorry. Lawyers have been known to change their minds. Moreover, there are times when selling lawyers are middle-aged. In those instances, covenants not to compete are very much needed to protect sellers.
After the deal is done: client notifications and fees
Once sold, the lawyer must notify her clients, in writing, that the practice will be sold, that they can hire a lawyer other than the buyer and have their file returned, and that consent will be presumed if the client does not take action or object within 90 days of receiving the notice.
Without this notice (if a client cannot be found, for example), a court order is necessary to transfer the representation to the buyer.
The sale cannot increase the cost of representation. In other words, the buyer cannot increase fees in order to recoup the purchase price.
Pricing the deal
In the vast majority of sales, buyers finance the purchase in one of two ways. They can either agree to a fixed sum (which may include a payment plan), or the amount paid may be contingent on future revenue.
There are no ethics issues with a fixed sum. However, when the amount paid to the seller is contingent upon the future revenue of the buyer, ethics rules involving fee sharing could be problematic because the buying lawyer would be sharing client fees with the selling lawyer.
The first issue is whether lawyers have to jump through the various hoops of Model Rule 1.5 (e) that governs fee sharing between lawyers. That rule basically requires written individual client consent to the sharing arrangement. The division must also be either proportionate to the work performed or each lawyer must assume joint responsibility.
A second issue arises in those situations where the selling lawyer relinquishes her license. Here, future payments are arguably an improper referral fee since the fee is being shared with a non-lawyer. Rule 5.4
The New York State Bar Association’s Committee on Professional Ethics, considered these issues in an opinion issued earlier this year. Although the opinion only applies to New York, its well-reasoned analysis will likely be persuasive in other states. In a nutshell, the committee opined that since a purchase price, whether fixed or contingent, contains a component for goodwill, it makes little sense to permit that component in fixed sum deals where the parties attempt to place a present value on anticipated revenue when negotiating a purchase price, but not for deals where the purchase price is based on actual future revenue.
The committee provided the ground rules for payment of future fees. It noted:
The extent of fee sharing must bear a reasonable and bona fide relationship to the value of the “goodwill” involved. Even the most well-known lawyer’s reputation and connections fade over time. Any provision for fee sharing must there be limited in amount and time.
Twenty percent of seller’s net income for 3 years was used as an example of reasonableness by the committee.
End-around the rules with an “of counsel” relationship
One way to avoid any fee-sharing and future-payment issues is to make the retiring lawyer “of counsel” with the successor’s firm. By doing so, there is no actual sale, and Rule 1.17 does not apply. And since both attorneys are still working at the same law firm, Rule 1.5’s fee-sharing prohibition does not apply, either.
The term “of counsel” is not defined in the Model Rules. The ABA defines it as a “close, regular, personal relationship” with the law firm. So long as the relationship is bona fide and is not a sham, state regulators should have no problem in the way that the retiring lawyer and the successor lawyer decide to share future revenue.
The “of counsel” alternative can be a very attractive means to structure a succession arrangement for those retiring lawyers who still want to practice on a limited basis during their last years of practice.
As Baby Boomer lawyers start to retire, the legal profession should see a significant uptick in the sales of law firms. Although a handful of states still ethically prohibit selling law practices, for the vast majority of states that allow them, lawyers should familiarize themselves with the ethical parameters governing such transactions.
First, when negotiating a deal, client confidences must be protected. Second, the buying lawyer must be able to competently represent the seller’s clients. Third, sellers must sell the entire practice or area of practice. Fourth, covenants not to compete are generally permissible as a deal term. Fifth, clients must be notified and their fees not raised by the buyer. Finally, although few states have analyzed the issue, most states will likely allow sellers to be paid by buyers based on future revenue.