Ten Steps to Value Law Firm Contingency Cases

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

On her appeal of the divorce from her lawyer husband in Hawai’i, a wife asked two questions, which have important implications for other state jurisdictions:

• 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?

Healthy plaintiff’s practice. At trial, the husband’s expert used the asset approach to value the sole proprietorship’s appreciation during the marriage. After choosing the separation date as the most “practical,” he did not include three contingency cases that settled soon after (but prior to trial), netting over $1.1 million in fees. He also excluded any pending but unliquidated contingency fee cases, due to their speculative nature. Finally, the expert excluded professional goodwill, citing the controlling case in Hawai’i (which follows the majority rule on distinguishing enterprise from professional goodwill, finding the former is marital property but the latter is not). He found the practice value had appreciated by only $54,000. The wife did not present a valuation expert, and the trial court adopted the husband’s values, setting the stage for appeal.

As a first matter, the appellate court declined the wife’s invitation to abandon the majority rule concerning goodwill. The valuation of contingency fee cases, however, was an issue of first impression. “It is well-accepted that hourly-fee contracts for attorney services constitute divisible marital property,” the court began (citations omitted). “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.

Pending contingency fee cases are more problematic, specifically because they defy an accurate value at the time of distribution. For this reason, a few jurisdictions decline to classify a contingent fee contract as divisible marital property (e.g., GA, PA, and IL). The potential breach of attorney-client privilege and ethical prohibitions against fee-splitting between lawyers and non-lawyers is also a concern. 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 (e.g., AK, AR, CA, CT, MN, NJ, WV, and WI.) These courts retain continuing jurisdiction to distribute fees as received and pursuant to an equitable formula, similar to pension divisions.

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 contingency fees. In remanding the case, the Hawai’i court adopted the majority rule regarding contingency cases. However, since state law prohibits family courts from maintaining jurisdiction for more than a year after divorce, its ruling might lead to intentional collection delays by an attorney spouse. To resolve this problem, the court endorsed the following 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 of open cases (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. Add the value of the WIP to the firm’s adjusted balance sheet, with additional adjustments for cash, investments, and other assets/expenses.