Court values law firm goodwill (and their contingency cases)

Weinberg v. Dickson-Weinberg, 2009 WL 3294784 (Hawai’I App.)(Oct. 14, 2009)

Has the majority rule on the disposition of goodwill in divorce resulted in “gross under-valuations of countless successful businesses” simply because their “fortunate owners” happened to be professionals?

Does the majority rule properly hold that a law firm professional’s pending contingency-fee cases are marital property and subject to division and distribution on divorce?

These were the wife’s two primary arguments on appeal from the divorce of her lawyer husband in Hawai’i. The Court of Appeals takes a long, hard look at both issues, drawing from the laws of many states, to render a comprehensive opinion based on its view of “the better practice.”

Husband’s expert used asset approach. At trial, the husband called a certified business appraiser to value his law practice as of the date of marriage (1997) and the date of separation (2005) to ascertain its appreciation. The expert used the asset approach for both “since the husband was the only attorney at his law firm and there was no agreement compelling him to stay.” He also excluded the husband’s professional goodwill from the overall value, citing the controlling case in Hawai’i (which follows the majority rule on distinguishing enterprise from professional goodwill, finding the former marital property).

Because he chose the separation date as the most “practical” for valuation purposes, the expert did not include three contingency cases that settled in early 2006, netting the husband over $1.1 million in fees. He also excluded any pending but unliquidated contingency fee cases, due to their speculative nature and the husband’s ability to “take those cases with him.”  He noted that the law firm’s primary asset was a loan to the husband (approximately $600,000 in 1997 and $900,000 in 2005). Finally, the expert applied a 30% discount for lack of marketability to reach a fair market value for the husband’s law practice of $293,000 in 1997 and $347,000 in 2005—or an appreciated value of $54,000.

The wife did not present a valuation expert. Instead, she called two local trial attorneys who’d worked with her husband to testify on their fee-sharing arrangements. She also testified at trial, expressing her desire for 5% of “every case” in her husband’s firm, saying she helped him bring in what amounted to $6 million to $10 million in fees.

The trial court adopted the husband’s expert's valuation, including his application of the marketability discount and his exclusion of pending contingency cases and professional goodwill. The wife appealed, asserting the two key questions regarding the status of the majority rule in Hawai’i, with implications for other jurisdictions and their interpretation of the same issues.

Flexible approach to valuing goodwill. In addition to her key argument, the wife claimed that by excluding professional goodwill from the value of private practices, the leading case in Hawai’i amounted to a “bright line” rule that conflicted with the general policy permitting trial courts wide discretion in making equitable distributions of marital property. She further maintained that “most courts use an earnings-based approach, including the value of the professional’s goodwill” and noted that when Hawai’i adopted its precedent in 1988, it was in the minority.

Five years later, however, there were an equal number of jurisdictions on both sides of the rule, the appellate court noted; and by 2004, most states precluded the valuation of professional goodwill. Hawai’i is now firmly in “the nationwide majority,” the court observed. Its adoption of the majority rule still permitted a “flexible approach to determining whether the tangible and intangible assets of a professional business constitute marital property.” More specifically, the 1988 case held that the “true goodwill” of a business is a marketable asset that can be valued and divided; any goodwill that is attributable to an individual practitioner’s reputation is not property, “but instead may be characterized as the ability to obtain future earnings.” Further, trial courts are permitted to make these determinations on a case by case basis.

Thus the court declined the wife’s “invitation” to abandon the majority approach and confirmed the trial court’s application of the same.

Contingency-fee cases are problematic. The valuation of unliquidated contingency fee cases presented an issue of first impression in the state. “It is well-accepted that hourly-fee contracts for attorney services constitute divisible marital property,” the court began, citing a well known treatise (Brett R. Turner, Equitable Distribution of Property, 3d. ed., 2005). “Like any other receivable, they should be discounted by expenses of collection and a reasonable bad debt percentage.” Similarly, a contingency fee settlement or verdict recovered before an attorney’s divorce trial is “universally regarded” as marital property to the extent that the attorney’s work occurred during the marriage.

“The classification of contingent fees that are potentially due on cases that remain pending at [the divorce valuation date] has proved far more problematic,” the court added. Their contingent nature makes it “impossible” to place an accurate value on them at the time of distribution. “There is no way to predict with any certainty whether the client will recover and, if so, in what amount.”

For this reason, some jurisdictions decline to classify a contingent fee contract as divisible marital property, the court noted (e.g., Georgia, Pennsylvania, and Illinois). These cases also cite concerns about breaching attorney-client privilege and ethical prohibitions against fee-splitting between lawyers and non-lawyers. Generally, however, these same courts permit the use of contingency fee arrangements in determinations of income and support.

By contrast, the majority of courts now hold that unliquidated contingency fee arrangements constitute marital property and are divisible. (These states include Arkansas, Arizona, California, Connecticut, Minnesota, New Jersey, West Virginia, and Wisconsin.) To resolve the risks inherent in valuing these contracts, the courts retain continuing jurisdiction to distribute fees as received and pursuant to an equitable formula representing time-worked on the case prior to divorce, “much in the way pensions are divided,” the court said. They do so despite the “unwieldiness” of maintaining an open case and the general policy in divorce law that discourages bifurcation of issues.

In this case, the husband’s expert erred by valuing the law practice as of the separation date when state law required values as of the trial date. Thus he (and the trial court) should have included the $1.1 million in fees that the husband received in early 2006.

Ten steps for valuing contingent fee cases. As for the pending contingency fee cases, the Hawai’i court decided to follow the majority rule and treat these arrangements as marital assets subject to division. However, state law prohibits Hawaii family courts from maintaining jurisdiction for longer than one year following divorce, which might lead to intentional delays by an attorney spouse in collecting on contingent cases.

To resolve this problem, the court relied on another general treatise (Robert Feder et al., Valuing Specific Assets in Divorce, eds. 2008), which describes the asset approach to reaching a law firm’s present value “in practical terms.” In particular, the authors provide this 10-step, work-in-progress (WIP) analysis for law firm contingency fee matters:

1. Identify the outstanding cases at the valuation date.

2. Estimate the average fee per case, net of direct expenses.

3. Assess the success rate or “batting average” of the firm.

4. Determine/estimate the percentage overhead per case.

5. Multiply the number of open cases (step 1) by the net average fee per case (2) by the batting average (3) less the percentage overhead (4) to obtain the estimated future profit attributable to the WIP.

6. Estimate the average length of time that the firms cases are open. (i.e., compare the start date and recovery date for a number of cases.)

7. Calculate the estimated date of completion for each case by comparing its start date to the average length of the case (step 6).

8. Select an appropriate discount rate to apply to the present value calculations.

9. Determine the present value of the WIP by discounting the estimated future profit (step 5) by the discount rate (8) using the estimated completion date per case(6) as a time factor.

10.After completing this analysis, add the value of the WIP to the firms adjusted balance sheet. Other types of adjustments to fair market value may include:

  • Adjustment of cash and investments (operating and non-operating)
  • Recognition of prepaid expenses (e.g., malpractice insurance)
  • Adjustment of fixed assets
  • Recognition of accounts payable (may be minimal for acash basis taxpayer)
  • Recognition of unearned retainer fees

On remand, the family court could use this methodology to value the husband’s unliquidated contingency fee cases that were pending as of the date of trial, the Hawai’i Court of Appeals held. Alternatively, if the husband recovered fees on any of those cases, the court could divide his net receivables by using a fractional apportionment based on the time worked on the case(s) during the marriage and the total time worked.