A law firm without an operating or buy-sell agreement wound up in a protracted court battle when an owner withdrew after the other owners discovered he had mishandled cases and clients. The case is a powerful illustration of how costly disputes can be preempted with an effective buy-sell agreement.

Misconduct prompts member withdrawal

The owner who brought the case was one of five attorneys in a limited liability company (LLC) that had neither a written nor an oral operating agreement. He held a 26.5% interest in the firm. Each LLC member received $10,000 per month in “guaranteed payments.” They agreed that income from legal services fees would be aggregated regardless of what individual members generated. The aggregate fees would be distributed as quarterly profits according to each member’s ownership percentage in the firm.

In January 2017, the members discovered a $3,000 personal check the plaintiff wrote to a client from his personal bank account. An adjuster subsequently found that there was no known settlement in the client’s case and the last noted activity had been in 2010. The plaintiff admitted that he’d “self-settled” the case with his own money to preempt a complaint from the client about the delay in resolving the claim. Malpractice counsel advised the firm that he’d committed fraud against the client, so the other members asked him to leave. The plaintiff withdrew from the LLC and was eventually suspended from practicing law indefinitely.

Remaining owners see a pattern

The four remaining members unearthed a pattern of problems involving the plaintiff after his departure. In one instance, the firm’s malpractice insurance company settled a claim involving the plaintiff for almost $600,000. Notably, though the firm didn’t dissolve after the plaintiff’s withdrawal, it didn’t purchase his interest. The LLC made distributions only to the remaining members for 2017, 2018 and 2019.

Two years after his departure, in January 2019, the former member sued the firm, seeking compensation for his ownership interest. He claimed that the fair value of his interest was 26.5% of the total value of the firm’s current assets on his withdrawal date, less current liabilities — with no discounts for lack of control or marketability.

Courts come to different conclusions

Because the firm didn’t have an operating or buy-sell agreement, the courts turned to Maryland’s LLC law. That statute defines “economic interest” as a “member’s share of profits and losses … and the right to receive distributions.”

The trial court found that the plaintiff had an ongoing economic interest in the firm’s post-withdrawal profits, losses and distribution. It then concluded that he was entitled to 26.5% of the firm’s profits in 2017, before he lost his license — about $85,000. 

The Court of Special Appeals of Maryland disagreed. It concluded that the plaintiff’s withdrawal changed him from a member with an economic interest (that is, a current right to share in the LLC’s profits, losses and distributions) to an assignee of that interest (with no membership interest in post-withdrawal profits, losses and distributions). As such, he had the right to share only in the LLC’s assets, liabilities, profits, losses and distributions that existed on the withdrawal date — what the plaintiff originally sought, before the trial court weighed in.

The appeals court said that the trial court’s interpretation of the LLC law would give the withdrawn member a “perpetual share” in the profits of a firm to which he has since contributed nothing. The court noted, too, that his professional misconduct resulted in indefinite suspension of his right to practice law, as well as civil claims against the law firm. It also highlighted the ethical problems related to fee-sharing with a non-attorney.

Preempt the risk

The appellate court acknowledged the “bare bones” rights and procedures governing withdrawal provided to LLCs under the state statute. But it pointed out that LLC members who want more certainty or different rights and procedures can adopt an operating agreement that lays out more specific terms. Having failed to do so, the court said, the parties couldn’t now complain about the consequences of that decision.

Sidebar: Build a better buy-sell agreement

A buy-sell agreement is generally advisable, but it doesn’t necessarily ensure a smooth transition when an owner leaves a business. Disputes often arise over the value of a departing owner’s business interest — especially if the agreement relies on a formula to establish the amount.

Predetermined buy-sell agreement formulas tend to be oversimplified and backward-looking. For example, a formula might base value on a multiple of past earnings, ignoring critical factors such as the business’s risk premium, future growth, prevailing economic conditions, and other factors that may require professional judgment and analysis. The result? It may not accurately capture current market value.

A more reliable approach is to include a clause in the agreement which requires a full independent valuation. Such a valuation determines an objective, unbiased fair market value of the subject interest. An agreement could provide for hiring a joint valuation expert, or it might require that both sides retain their own experts. If the experts’ conclusions vary by, say, more than 10%, a third expert could be required to settle the difference. The agreement also should specify who will pay the valuation fees — the buyer, the seller or the company. Contact us if you have any questions.