HOWARD v. BABCOCK (1995)

OPINION

Theodore R. Howard, Robert J. Moss, James E. Loveder and Michael J. Strickroth (appellants) appeal from a summary judgment entered in favor of George Babcock, Preston Craig Combs, Gary E. Kinnett, Thomas L. Waddell, Robert H. Bergsten, Arthur T. Schaertel, Stephen H. Osborne, Lynn J. Cicotte, Douglass H. Mori, and John D. Barrett, Jr. (respondents).

I

This is the second time we consider this matter.   To understand the present controversy we first review the facts and procedural history.

On December 15, 1982, lawyers Babcock, Combs, Kinnett, Waddell, Moss, Howard, Bergsten, Loveder and Schaertel executed a partnership agreement which included a noncompetition clause in article X providing in pertinent part:  “ ‘Should more than one partner, associate or individual withdraw from the firm prior to age sixty-five (65) and thereafter within a period of one year practice law ․ together or in combination with others, including former partners or associates of this firm, in a practice engaged in the handling of liability insurance defense work as aforesaid within the Los Angeles or Orange County Court system, said partner or partners shall be subject, at the sole discretion of the remaining nonwithdrawing partners to forfeiture of all their rights to withdrawal benefits other than capital as provided for in Article V herein.’  [¶]  Article V provided that a general partner who withdraws from the partnership shall be paid his or her capital interest, and a sum ‘equal to the share in the net profit of the firm that the withdrawn ․ partner would have received during the first twelve months following the withdrawal ․ if he had remained with the firm ․ during the said twelve month period.’ ”  (Howard v. Babcock (1993) 6 Cal.4th 409, 412, 25 Cal.Rptr.2d 80, 863 P.2d 150, fn. omitted.)   Despite several partnership changes, the agreement was never amended.

On December 8, 1986, appellants left the firm, starting a competing practice.  “The assets of the original ․ firm on December 31, 1986, included the capital of the firm, namely, the profits shown on the balance sheet;  the accounts receivable, that is, work performed and billed, but in which the bill had not been paid;  and the unfinished business, that is, open files that required additional work that would be billed in the future.”  (Howard v. Babcock, supra, 6 Cal.4th at p. 413, 25 Cal.Rptr.2d 80, 863 P.2d 150.)   The parties could not agree on what was owed to whom.   Respondents paid appellants their share of the firm's capital, but refused to make any other payments.   Litigation ensued.   The appellants contended the 1982 agreement was not binding on them because the partnership had dissolved.   They also argued even if the agreement was controlling, Article X was void as against public policy.   The appellants sought their share of the accounts receivable, work in progress and unfinished business.

The trial court judge determined the partnership dissolved when new partners were admitted (Corp.Code, § 15031(7)), but concluded the parties were nevertheless governed by the 1982 agreement and Article X was valid.   As a result, appellants were not entitled to any share of the firm's accounts receivable and work in progress and owed respondents $382,686, representing respondent's 82.5 percent share of appellants' net profits for work completed for former firm clients.   In short, the court found the agreement deprived appellants compensation for the firm's goodwill or profits (Howard v. Babcock, supra, 6 Cal.4th at p. 415, 25 Cal.Rptr.2d 80, 863 P.2d 150) and mandated that respondents be paid for their share “of the net profits [appellants] had billed or collected from clients who wanted [appellants] to continue work in progress when [appellants] left the ․ firm.”  (Ibid.)

We reversed the trial court, finding Article X void as against public policy.   We therefore did not reach appellants' other arguments regarding the overall validity of the agreement.   We remanded the matter to the trial court for such accountings as necessary to finish dividing the firm's assets as of December 31, 1986, and to go forward with the remaining causes of action.   We affirmed the trial court's judgment that appellants pay respondents $382,686.

The Supreme Court granted review to decide whether “an agreement between law partners is enforceable if it requires withdrawing partners to forego certain contractual withdrawal benefits if they compete with their former law firm.  [The court] conclude[d] that an agreement among law partners imposing a reasonable toll on departing partners who compete with the firm is enforceable.”  (Howard v. Babcock, supra, 6 Cal.4th 409, 412, 25 Cal.Rptr.2d 80, 863 P.2d 150.)

The Supreme Court remanded the matter to the trial court for a determination of whether the toll actually imposed was reasonable.   The trial judge concluded it was.   This appeal followed.

II

 Most of appellants' arguments are identical to those presented in their first appeal.   They argue the trial judge erred in failing to consider these issues because they either have been denied a trial court hearing and/or appellate review on many of them.   As we now explain, appellants fail to understand the parameters of the appellate process.  “The trial court is empowered to act only in accordance with the direction of the reviewing court․”  (Hampton v. Superior Court (1952) 38 Cal.2d 652, 655, 242 P.2d 1.)   The scope of our review is limited to matters properly before the trial judge.   Here the Supreme Court remanded the matter to the trial court with specific directions to determine one issue only.   The trial court could do no more and our review is limited accordingly.

 The result is no different when we examine the substance of appellants' claims.   Appellants have consistently maintained the first trial judge erred in finding the 1982 agreement generally and Article X specifically binding on them.   Because we concluded Article X was void, we did not consider the effectiveness of the entire agreement.   The Supreme Court reversed to the extent we held Article X unenforceable.   Appellants now contend they have been denied appellate review on whether the 1982 agreement controls their relationship.   Because the appellants' premise is faulty, their conclusion fails.

The Supreme Court, in determining Article X was not void, implicitly accepted the first trial judge's finding the parties were bound by the 1982 agreement.   The Supreme Court would have had no reason to consider Article X if it concluded the entire agreement was inapt.  (Olson v. Cory (1983) 35 Cal.3d 390, 399, 197 Cal.Rptr. 843, 673 P.2d 720.)   The Supreme Court, in its factual recitation, also explicitly accepted the first trial court's finding.   (Howard v. Babcock, supra, 6 Cal.4th 409, 414–415, 25 Cal.Rptr.2d 80, 863 P.2d 150.)   Evidently, the Supreme Court was satisfied the appellants' review rights had not been infringed.

Appellants explain pursuant to the parties' stipulation the first trial judge was to consider which terms of the 1982 agreement governed.   Appellants maintain the court instead determined they had withdrawn from the partnership, but never considered whether this resulted in a dissolution of the partnership.   As a result, appellants claim they were denied a hearing on and appellate review of whether a dissolution of the partnership had occurred and therefore what rules govern the division of the firm's income and assets.

Again, appellants misunderstand the significance of the Supreme Court's decision.   Articles V and X specify the formula by which the firm's income and assets are to be divided upon a competing partner's withdrawal.   Whether the partnership had dissolved was therefore an irrelevant determination because article X was valid.

Appellants next complain they have yet to receive a further accounting or a trial on their second cause of action for breach of fiduciary duty.   They forget we remanded the matter for a further accounting only because we found article X void.   The Supreme Court's holding obviated this need.   Indeed, it said exactly that.  “The judgment of the Court of Appeal is reversed to the extent it holds article X unenforceable and orders an accounting to plaintiffs on that basis.”  (Howard v. Babcock, supra, 6 Cal.4th 409, 426, 25 Cal.Rptr.2d 80, 863 P.2d 150, italics added.)   Footnote 9 reiterates the message:  “[The] reversal only affects the judgment of the Court of Appeal to the extent that court's orders were based on the conclusion that article X of the partnership agreement is void.”  (Ibid.)

The Supreme Court's holding left intact both the 1982 agreement and article X.   Appellants' second cause of action therefore was also rendered moot because respondents could hardly be deemed in breach of a fiduciary duty while acting in accordance with the terms of the agreement.

Appellants argue because the “Supreme Court did not expressly or impliedly decide the extent of the forfeiture permitted by Article X,” the trial court erred in failing to interpret articles V and X.   In short, they wanted this trial court to decide not only the amount of the penalty and its reasonableness, but also which assets and income streams were to be included.

Again, they fail to understand the import of the Supreme Court's decision.   The court designated that which comprised the penalty.   Appellants received nothing but their capital contributions.   They gave up their share of the firm's net profits and accounts receivable, work in progress and unfinished business.   Moreover, they paid respondents their share of the net profits they realized from business completed by them.  (Howard v. Babcock, supra, 6 Cal.4th 409, 413, 415, 25 Cal.Rptr.2d 80, 863 P.2d 150.)

III

 On remand, the trial court was to determine whether “those terms” (i.e., arts. V & X) were reasonable under “these facts.”  (6 Cal.4th at pp. 412, 426, 25 Cal.Rptr.2d 80, 863 P.2d 150.)   The trial court found they were.   Appellants maintain the trial judge erred.   This time we agree with appellants.

The trial court determined article X to be reasonable because it placed only time, place and activity restrictions on the departing partners.   The court commented the appellants, having been told what the penalty would be if they left to compete, could not later complain.   Specifically rejected by the court was consideration of the amount of money involved because as the court stated, “that is not the issue.   The issue is the reasonableness of the clause, the intent of the parties.”   The trial court failed to consider any evidence of the specific economic consequences of the agreement.¹

Respondents maintain this was appropriate.  Civil Code section 1671, subdivision (b), provides the reasonableness of a liquidated damage clause is determined in context of circumstances existing at the time of the agreement.   True, but the Supreme Court did not intend for the trial court's review to be so limited.

The trial court was to consider whether the toll placed on appellants was so burdensome that it constituted a forfeiture or was it a reasonable penalty for leaving.   In making this determination, the trial judge was to consider the specific economic impact on both the departing and remaining partners.  “The practical fact is that when partners with a lucrative practice leave a law firm along with their clients, their departure from a competition with the firm can place a tremendous financial strain on the firm.  [Citation.]  [¶]  Not only is the income from the clientele of the firm diminished when partners withdraw and take clients with them, but the expenses attributable to the remaining partners may increase as withdrawing partners seek to escape liability for mutually incurred debt.  [Citations.]”  (Howard v. Babcock, supra, 6 Cal.4th at p. 421, 25 Cal.Rptr.2d 80, 863 P.2d 150.)

Citing rule 1–500 of the Rules of Professional Conduct,² the court concluded an agreement may only assess “a reasonable cost against a partner who chooses to compete with his or her former partners․”  (Howard v. Babcock, supra, 6 Cal.4th at p. 419, 25 Cal.Rptr.2d 80, 863 P.2d 150.)   The penalty is reasonable when it “operate[s] in the nature of a tax on taking the former firm's clients [in consideration of] the financial burden the partners' competitive departure may impose on the former firm․”  (Id. at p. 424, 25 Cal.Rptr.2d 80, 863 P.2d 150.)  “[T]o the extent the agreement merely assesses a toll on competition within a specified geographical area, comparable to a liquidated damage clause, it may be reasonable.”  (Id. at p. 425, 25 Cal.Rptr.2d 80, 863 P.2d 150.)   Such a liquidated clause is valid if it represents compensation for the firm's losses “that may be caused by the withdrawing partner's competition with the firm․”  (Ibid.)

 The toll is unreasonable when it “restrict[s] the practice of law [but only in doing more than simply] ․ attach[ing] an economic consequence to a departing partner's unrestricted choice to pursue a particular kind of practice.”  (Howard v. Babcock, supra, 6 Cal.4th at p. 419, 25 Cal.Rptr.2d 80, 863 P.2d 150.)

Despite respondents' protestations to the contrary, the Supreme Court expected the trial court to consider further evidence.   Any reference to Civil Code section 1671 is not indicative of its intent the reasonableness of the clause should be confined to facts in existence at the time the agreement was executed.   It refers to that section by analogy only for purposes of defining the difference between a penalty and forfeiture.³

The Supreme Court relied on Haight, Brown & Bonesteel v. Superior Court (1991) 234 Cal.App.3d 963, 971, 285 Cal.Rptr. 845, as the standard by which this trial court was to determine whether articles V and X were reasonable.   The Haight court defined a noncompetition clause as reasonable when it “represents a balance between competing interests.   On the one hand, it [should] enable[ ] departing attorneys to withdraw from a partnership and continue to practice law anywhere within the state, and to be able to accept employment should [the lawyer] choose to do so from any client who desires to retain him [or her].   On the other hand, the remaining partners [should] remain able to preserve the stability of the law firm․”  (Id. at pp. 969–970, 285 Cal.Rptr. 845.)

The Haight court remanded the matter to the trial court to decide whether the agreement was reasonable.   The court realized this determination could not be made by looking to “the plain language of the partnership agreement.”   (Id. at p. 971, 285 Cal.Rptr. 845.)   The court explained, “Without additional evidence being presented[,] it cannot be determined whether the sum of money the [departing] partners will waive ․ can be characterized as a forfeiture when compared to their gain, and the partnership's loss, resulting from the clients whose business they have undertaken.”  (Ibid.)

And so it is here.   The Supreme Court remanded the matter to the trial court to determine whether this agreement was reasonable.   In attempting to comply, the trial court refused to consider the amount of money involved—the very evidence the Supreme Court deemed determinative.⁴

The entry of judgment is reversed and remanded to the trial court to determine whether article X “when applied to [these] facts amounts to an agreement for liquidated damages or an agreement resulting in a forfeiture.   The parties are to be allowed to present evidence on the issue of the amount of money involved, the intent of the parties at the time they entered into the agreement, and any other facts which may aid the court in reaching its decision.”  (Haight, Brown & Bonesteel v. Superior Court, supra, 234 Cal.App.3d at p. 972, 285 Cal.Rptr. 845.)   Appellants shall recover their costs on appeal.

I concur in the result but write separately to emphasize the most important aspect of Howard.   True, the Supreme Court concluded noncompetition clauses are not per se void.   But this holding must be read in context.   The Supreme Court did not give law firms carte blanche to impose these clauses on departing partners.   To the contrary, Howard permits noncompetition clauses in only the most limited situations.

Hopefully the trial court on remand will appreciate Howard's message.   Lawyers may not inhibit competition by making the penalties so unreasonable as to deprive clients of their choice of counsel and render lawyers indentured servants.

FOOTNOTES

1.   The trial court commented:  “I'm going to find that the clause is reasonable.   I have read Article X and I believe it's reasonable in its language and in its application.   It provides for reasonable restrictions on time, activity and territory.  [¶]  It restricts the practice of law— ․ it doesn't restrict the practice of law.   It doesn't prohibit [ ] ․ the practice of law.   It gives an option to the plaintiffs.   The plaintiffs may choose to open up a law office and continue practicing right here in Orange County, but should they do that, they forfeit the provisions of Article V or waive the provisions of Article V, which might be a substantial amount of money.”The trial court further stated, “Every moving paper here, every declaration is that these plain words in Article X and Article V, but Article X, were executed, were signed, agreed to by the plaintiffs freely and voluntarily.   That there was no fraud.   There is no allegation of any fraud.  [¶] ․ The Supreme Court has said that this is an enforceable provision.   Is it a reasonable one?   It seems to me that under the circumstances the plaintiffs here could have opened up a practice, if they chose to practice that kind of law, right over here in San Bernardino, not far up the road, right over here in Riverside, down in San Diego, or simply shifted the practice of law to another field, should they choose, for a period of a year.   The time period is not a lengthy period.”  “I don't believe an accounting exists where you have no right to any compensation under Article V.   I don't believe—it just violates common sense to think that.”  “The amount of money involved here, that actually worked out—I realize you want more financial disclosure.   That is not the issue.   The issue is the reasonableness of the clause, the intent of the parties.   There is no reasonable interpretation other than the fact that both parties wanted to provide some type of coverage in the event that the lawyers split from the law firm.  [¶]  And the intent of the parties—I think the intent is manifestly clear.   I can't think you can argue seriously that there was a secret intent or hidden agenda or hidden intent on the plaintiff—or the defendants here.   It seems to be an up-front partnership agreement clause, a restrictive covenant.   What could be more clear?  [¶]  I've already mentioned the issue of activity, also the time and territory.   Time is reasonable.   Territory is reasonable under the circumstances.   For those reasons, I believe that that is dispositive as to the entire case and that will be the court's order.”  (Italics added.)

2.   Rule 1–500 of the Rules of Professional Conduct provides:  “(A) A member shall not be a party to or participate in offering or making an agreement, whether in connection with the settlement of a lawsuit or otherwise, if the agreement restricts the right of a member to practice law, except that this rule shall not prohibit such an agreement which:  [¶] (1) Is a part of an employment, shareholders', or partnership agreement among members provided the restrictive agreement does not survive the termination of the employment, shareholder, or partnership relationship;  or [¶] (2) Requires payments to a member upon the member's retirement from the practice of law;  or [¶] (3) Is authorized by Business & Professions Code sections 6092.5, subdivision (l ) or 6093.  [¶] (B) A member shall not be a party to or participate in offering or making an agreement which precludes the reporting of a violation of these rules.”

3.   “As we have said with respect to liquidated damage clauses, ‘a contractual provision specifying damages for breach [of contract] is valid only if it “represent[s] the result of a reasonable endeavor by the parties to estimate a fair average compensation for any loss that may be sustained.”  [Citations.]   An amount disproportionate to the anticipated damages is termed a “penalty.”   A contractual provision imposing a “penalty” is ineffective, and the wronged party can collect only the actual damages sustained.’  [Citations.]   Under this standard, a partner's agreement to pay former partners, or to forego benefits otherwise due under the contract, in an amount that at the time of the agreement is reasonably calculated to compensate the firm for losses that may be caused by the withdrawing partner's competition with the firm, would be permitted.”   (Howard v. Babcock, supra, 6 Cal.4th at p. 425, 25 Cal.Rptr.2d 80, 863 P.2d 150, italics added.)

4.   Appellants complain they have been denied a hearing or appellate review on whether the effect of articles V and X is unconscionable.  (Rules Prof.Conduct, rule 4–200.)   Again, we remind the appellants the Supreme Court found the clauses were not void thereby implicitly concluding they were not unconscionable on their face.   Nevertheless, the Supreme Court in directing the trial court to determine the reasonableness of the toll, implicitly instructed it to do so in the context of conscionability.Appellants also maintain the first trial judge erred in concluding while the appellants owed the respondents for their share of unfinished business, the respondents did not owe them for the business finished by the firm.   As explained, the Supreme Court implicitly accepted this interpretation.   We cannot review it now.   This will be taken into account when the trial court determines whether the toll for leaving was reasonable.

SONENSHINE, Associate Justice.

SILLS, P.J., concurs.