How To Define The Capital Account In Your Law Partnership Agreement

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How To Define The Capital Account In Your Law Partnership Agreement

With the current state of economic unrest, senior staff turnover and apparent unhappiness occurring at so many law firms in this country, it is important for all partners and senior associates (who are potential partners) to remember some basic concepts with respect to the organizational documentation of the firm. The first and major priority is the preparation of a written and signed partnership agreement with related amendments, as needed. The basic document should be well drafted to cover all the elements that are important to your particular firm.

For purposes of this article, a sample partnership agreement taken from a large Northeastern law firm has been selected as an illustration. The following language is copied directly from that agreement:

ARTICLE III: CAPITAL CONTRIBUTIONS

3.01 Capital of the Partnership: The capital of the Partnership shall consist of the equity of the Partnership in all of its assets, plus such additional amounts as may hereafter be contributed or transferred to capital by the Partners. Commencing February 1, 1978, each Partner shall be required to maintain a capital account in the amount set forth on the schedule annexed hereto as Schedule 2 and made a part hereof. In the event and to the extent that the capital account of any Partner, as determined from time to time, is less than the amount set forth opposite such Partner's name on Schedule 2, such Partner shall be required to contribute such deficiency to the capital of the Partnership promptly upon notification thereof. In the event that the capital account of a Partner exceeds the amount set forth opposite such Partner's name on Schedule 2, the amount of such excess may be withdrawn, subject to the approval of the Management Committee. Interest shall accrue at the rate of nine (9) percent per annum on the paid-in capital account of each Partner, as determined from time to time and such interest shall be payee by the Partnership semi-annually.

3.02 Additional Contributions to Capital: In addition to the amounts referred to in Section 3.01, hereof, the Partners shall contribute such sums of money as and when the same shall be required to meet the costs and expenses of all business activities with respect to the Partnership and to pay for property to be purchased or leased by the Partnership and when the purchase price or rental therefore shall be due and payable, and to pay all other costs and expenses incurred by the Partnership in connection with the other activities of the Partnership. Such contributions shall be made by each Partner in the same proportion as their respective required capital accounts in the Partnership, as set forth on Schedule 2 annexed hereto, bear each to the other. The Management Committee of the Partnership shall determine from time to time the capital requirements of the Partnership.

3.03 Withdrawals: The Partners may, from time to time, withdraw their capital contributions, in whole or in part, only with the express consent of the Management Committee of the Partnership.

3.04 Capital Accounts: An individual capital account shall be maintained for each Partner.

3.05 Extraordinary Losses: Uninsured losses of the Partnership arising from fire, theft, malpractice, third party claims or judgments against the Partnership or otherwise, which by their size or nature would be deemed extraordinary, will be borrowed by the Partnership from a lending institution (to the extent such loan or loans are available) and be charged against the annual profits of the Partnership as and when such loans are repaid. In the event and to the extent that such loan or loans are not so available, such amounts will be charged directly against the capital accounts of each Partner in the same proportion their respective required capital accounts in the Partnership, as set forth on Schedule 2, bear to the other.

Comments on Section 3.01

The wording in the first sentence is cumbersome. For example, it does not specify whether or not the working inventory (work in process and accounts receivable) is included on a "modified cash" basis of accounting. We must assume that as of February 1, 1978, a minimum capital account was established for each partner determined on some basis not revealed in this agreement. In today's economic climate, it is quite common to either require no initial capital contribution or to require an arbitrary amount determined annually by the entire partnership when new partnership offers are made.

Some few firms still require new partners to contribute capital which is calculated by a complicated formula and then used to "buy- out" existing partners. The new funds do not add anything to general working capital, which is the only reason for requiring capital from the initial founding partners. This archaic practice usually is found only in the very small firm or one where modern management practices are virtually nonexistent.

For many well managed firms, an initial capital contribution from the new partner(s) is not required. Working capital requirements are met from normal cash flow and periodic use of an open line of credit. Major purchases of equipment, facilities repair/renovation and expenses of a relocation are funded by a separately negotiated long term loan.

When arbitrary amounts are used, members of the partnership use their own self-generated criteria to decide how much a new partner will be required to contribute. The simplistic concept basically is "that a new partner is being allowed to have access to a profit generating entity and that there is a cost associated to that access, almost like buying a ticket to a closed party". Therefore, the present partners can justify charging any amount as a capital contribution from the newly admitted partner(s). The amount so determined has no relationship to anything other than perhaps to be relevant to previous year's decisions and the current economic state of the firm.

Some clarifying language should be added in this Section to indicate that the initial capital contribution referred to as Schedule 2 will be the minimum capital that must be maintained as long as the partner remains with the firm in an active status. In no event will an active partner be allowed to withdraw capital at any time that will reduce his respective capital account below this initial minimum.

A "capital call" for additional funds should have a more definitive date for timing of the contribution. For example, the wording should include "within 90 days" or "will be taken from the Partner's draw for the ensuing 90 days" under what is generally known as the "haircut" method of collecting the required amounts.

If, for some extraordinary reason, the partnership believes that capital accounts can be reduced, then there should be a pro-rata distribution to each partner in the same proportion as their respective capital accounts have to the total capital account. One of the first signs of potential internal dissension occurs when selective partners are allowed to withdraw their capital forcing the firm to operate solely with operating revenues and/or borrowings from the credit line to meet cash flow requirements. This becomes a prelude to financial disaster when these short term borrowings are used exclusively to fund partner draws/distributions.

Payment of interest on capital accounts has both pro and con arguments. Basically, the reason for payment of interest at a competitive rate is to compensate each partner for an investment in the firm when the funds theoretically could be invested alternatively.

Comments on Section 3.02

This Section actually expands on a portion of Section 3.01 with regard to the handling of an additional "capital call" when and if required. Capital accounts actually change each time a financial statement is calculated based on the profits or losses of the firm added or subtracted to the individual accounts prorated. As shown in Section 3.01, more capital may be required if the firm sustains several months of operating losses (or at least, partners will be forced to forego periodic draws until the losses are eliminated).

Section 3.02 appears to be unduly cumbersome in language. The applicable portion of Section 3.01 should be added to this Section for clarity. Comments made above relating to the issue of additional capital requirements in Section 3.01 should be removed to this Section.

Comments on Section 3.03

This Section should be revised to indicate that a partner's capital account (in excess of the initial capital contribution) will be paid out only in the event of termination of the partner's association with the firm (either through death, permanent disability, retirement, expulsion or voluntary departure). The decision to withdraw capital should be made by the partnership and should not be an option for each individual partner.

Comments on Section 3.04

The wording in this Section should be added to the beginning of Section 3.01. It is a basic part of the definition and should actually be expanded to include some of the information that is recommended in paragraphs referring to Comments on Section 3.01 in this article.

Comments on Section 3.05

The effect of Section 3.05 could be to trigger a special "capital call" similar to Section 3.02. The treatment will be the same; therefore, there appears to be no need for this separate Section. The information contained herein can be included in Section 3.02 with the changed previously recommended.

Summary

The improper handling of capital accounts has been the cause of initiating the breakup of several law firms over the past few years. The language in the partnership agreement must be clear and concise as to how additions and deletions will be handled. Specific methods and written procedures must be an integral part of the currently executed partnership documents to reduce ambiguity.

Maintenance of accurate capital accounts is paramount to building and maintaining trust among partners. The key to harmony among partners regarding this critical issue is to have concise language in the partnership agreement; to maintain accurate and timely records; and to ensure that every partner is treated fairly and equitably with respect to additions and withdrawals with no exceptions.

Consistent treatment in the handling of partnership capital accounts is vital to maintaining good partner relations. Nothing can cause internal fractions quicker than perceived favoritism relating to the admission or departure of a partner and the handling of that partner's financial agreement. The solution is consistency and fairness with strict adherence to the terms of the partnership documents with no exceptions.