Measuring Damages When a Partner Leaves a CPA Firm

In the past, achieving the level of partner in an accounting firm was akin to a college professor earning tenure: high-performing accountants were often ensured a valued and lucrative role in the firm for the remainder of their career, and partner turnover was unusual. But times have changed, and mobility has arrived.

The aging of the baby boomer generation, a volatile economy, evolving technology, and the ability to cheaply outsource tax preparation and other accounting services have caused accounting firm economic models to transform dramatically. Due to company mergers and firm specialty changes, turnover occurs more frequently- becoming a partner no longer means lifetime employment at the firm. Recognizing this, many firms now require partners, managers, and senior staff members to sign noncompetition and protective covenant agreements intended to protect or compensate the firm for the loss of clients when partners or staff members leave the firm and take clients with them.

Provisions in Partnership Agreements

Nonsolicitation and nonservice provisions contained in accounting firm partnership agreements (or their equivalent) describe the firm's protected interests and prohibited competitive activities for partners and employees, such as restrictions on leaving with the firm's clients and staff. Certain provisions in these agreements (e.g., a "liquidated damages clause") quantify the economic remedy to the firm in the case of the breach of a nonsolicitation or nonservice provision-that is, a liquidated damages clause is an estimate, made by the parties at the time they enter into their agreement, of the extent of the injury that the firm will probably sustain as a result of a breach.

Under New York law, the courts will enforce such a clause if the amount fixed by the parties is a reasonable measure of the probable loss, and if the actual loss suffered is impossible or difficult to determine with precision. (See BDO Seidman v. Hirschberg, 93 N.Y. 2d 382 [1999]; Bates Advertising, USA Inc. v. 498 Seventh LLC, 7 N.Y. 3d.l 15 [2006]; Truck RentA-Center Inc. v. Puritan Farms 2d Inc., 141 N.Y. 2d 420 [1977]; Central Irrigation Supply v. Putnam Country Club Associates LLC, 57 A.D.3d 934,935 [2d Dept. 2008].) But if the amount of actual damages that would probably be suffered by the firm is readily ascertainable when the contract is made, or the amount fixed as liquidated damages is conspicuously disproportionate to the foreseeable loss, the liquidated damages clause will not be enforced; instead, it will be characterized as a penalty (Bates and Central Irrigation Supply). By analyzing liquidated damages clauses in this manner, courts seek to ensure that liquidated damage provisions are "reasonable."

Separation of a Partner After a Merger

Consider a relatively common occurrence: a regional accounting firm acquires a smaller firm, and the smaller firm's partners become partners of the acquirer. (Note that this article does not address a situation where nonpartners leave the firm with clients that they brought to the firm; a different analysis applies for that case.) As part of the transaction, the acquired firm's partners sign the acquirer's partnership agreement, which typically contains nonsolicit, nonservice, and liquidated damage provisions obligating a partner who leaves with clients to reimburse the firm for additional expenses taken on to service file acquired partner's clients.

Hie liquidated damages amount is often calculated as a percentage of the firm's historical annual billings to such lost clients for the year preceding the partner's departure, and it is triggered if the departing partner or the firm services the clients taken during the two-year period after the partner leaves the firm. The liquidated damages percentage referenced in the agreement may be different for lost clients that the partner brought to the firm when becoming a partner (75% in the following example) than for clients originated by file partner while at the firm. In the case of partners who brought clients to the merged firm, the partnership agreement typically states that its liquidated damages provision is designed to compensate the firm for the additional overhead it took on to service the partner's clients. It is important to note that simply choosing a percentage that is excessive might result in the unenforceability of the liquidated damages clause.

Next, consider what occurs after the transaction, when one of the acquired firm's former partners leaves the newly combined firm and takes his practice with him. Having signed the combined firm's partnership agreement, the departing partner is subject to its provisions. Is the 75% liquidated damage provision reasonable? Specifically, is 75% of the prior 12 months' billings a reasonable measure of the probable actual loss (in terms of extra overhead) sustained by the firm as a result of the partner's actions?

In estimating the probable loss sustained by the acquiring firm as a result of the loss of client billings, one needs to consider the concepts of "avoidable costs" and "mitigation."

Avoidable costs. From an accounting perspective, avoidable costs are those incurred to generate the lost revenues that the firm will no longer receive as a result of losing clients and related revenues. The firm should not be entitled to reimbursement for avoidable costs because such costs are no longer incurred and are not a measure of the probable damages.

Mitigation. Also known as the doctrine of avoidable consequences, mitigation efforts on file firm's behalf are required from a legal perspective. The law requires a plaintiff to take "reasonable steps" to mitigate damages caused by a defendant's conduct. Mitigation does not require an injured party to do what is unreasonable or impractical; rather, a party injured by another's wrongful conduct will not be compensated for damages that the injured party could have avoided by reasonable efforts or expenditures (Nancy J. Fannon, "The Comprehensive Guide To Lost Profits Damages for Experts and Attorneys," Business Valuation Resources, 2010, p. 371).

When a partner leaves a CPA firm, the clients taken by the partner typically give notice to the former firm. Mitigation requires the predecessor CPA firm to take steps to limit its damages when it is known or knowable that such clients are engaging other accountants. The failure of the predecessor CPA firm to take appropriate, timely steps to reduce avoidable costs should not result in a claim for damages against the departing partner. The duty to mitigate damages, therefore, impacts the amount of avoidable costs that a firm may be able to use to justify the liquidated damages clause-75% in the authors' prior example.

Calculating Foreseeable Losses

In order to calculate foreseeable losses, one needs to identify recurring and nonre- curring costs and calculate the amount of avoidable and unavoidable costs. Unavoidable costs associated with lost revenues, both recurring and nonrecurring, are potentially eligible for recovery as a foreseeable loss (i.e., includable as a component of the assumed 75% liquidated damages clause), whereas avoidable costs are not.

At most firms, the most significant annual recurring costs of operations are salaries and employee benefits-retirement plan payments; health, disability, and other insurance; continuing professional education (CPE); and payroll taxes. Because the practice of accounting is labor intensive, a firm's revenues are often determined based on hours billed, and salary costs tend to be variable (i.e., they vary directly with revenues). Consequently, if a firm is well managed, staff is hired to satisfy client service needs and likely to be terminated when work is unavailable. Accordingly, certain costs as a percentage of annual revenues-the total cost of wages, owner compensation, payroll taxes, and benefits- should remain relatively constant through periods of growth, stability, or contraction. Employee benefit costs vary proportionally with salaries. For example, when fewer people are employed, fewer employees receive insurance benefits, training, and retirement plan contributions. Payroll taxes also decrease with wages; accordingly, salaries and employee benefit costs are often variable and avoidable.

Based on the facts and circumstances, however, a portion of salaries and employee benefit costs may be deemed as "unavoidable" (e.g., costs associated with the hiring of partner and staff replacements, or paying for excessive staff during the time that the firm needs to decide on cuts). Avoidable costs can be identified by examining the acquired and acquiring firms' accrual-basis historical results of operations for a reasonable period of time before, during, and after the combination of firms. (Accrual-basis information more closely matches the costs of operations with revenues than cash-basis information.)

An additional useful benchmark for estimating operating expenses as a percentage of total income is the Management of an Accounting Practice (MAP) Survey, a recognized source of accounting industry statistics conducted biennially by the AICPA and the Texas Society of Certified Public Accountants. The Exhibit summarizes the data compiled from firms located in the northeastern United States with revenues in excess of $10 million. (Smaller firms often have different cost structures than larger firms, which could impact the amount of unavoidable costs incurred.)

The 2010 MAP Survey (containing 2009 data) included 9 firms, with average revenues of $77 million; the 2012 survey (containing 2011 data) included 13 firms with average revenues of $52 million. (It should be noted that the information contained in the MAP Survey might not be exactly comparable to a given firm, due to a lack of information available on the firms included in the study-for example, the locations of the accounting practices or the mix and weighting of services.)

The authors do note that salaries (excluding owners), retirement plan costs, other employee benefits, CPE, and payroll taxes total approximately 45% of income in each survey. Such costs are avoidable, and therefore should not be considered when determining whether it is reasonable to measure liquidated damages by 75% of billings. Some of the costs included in the "other" category (totaling approximately 24% of income in 2010 and 21% in 2012) may also be avoidable, based upon the facts and circumstances.

This suggests that the 75% liquidated damages provision in the authors' example might be excessive, and thus not enforceable in New York State courts. Nonrecurring, one-time costs associated with the combination of firms (e.g., legal and professional expenses, the cost of combing two offices) might need to be considered in connection with the liquidated damages calculation. Depending upon the amount of these costs, the 75% calculations might be enforced as not conspicuously disproportionate to the actual loss.

The Need for Proper Planning

When a firm is acquired, a major business item that warrants the parties' consideration is the consequences faced when one or more of the acquired partners departs from their firm and takes clients that were brought with them to the firm. The parties frequently use a round number for the liquidated damages amount in order to compensate the firm for the additional overhead taken on to service the acquired partner's clients. If parties fail to consider the legal standard of enforceability and the economic components of an enforceable liquidated damages clause, they might be surprised when it comes time to seek enforcement of the clause in the New York State courts.

If parties fail to consider the legal standard of enforceability and the economic components of an enforceable liquidated damages clause, they might be surprised when it comes time to seek enforcement of the clause in the New York State courts.

Eric J Barr, CPA/ABV/CFF, CVA, CFE, is a cofounding member of Fischer Barr & Wissinger LLC, Parsippany, N.J.Samuel Feldman, JD, is a member of Orloff, Lowenbach, Stifelman & Siegel, Roseland, NJ. This article was conceived as a result of a case in which the authors participated as an expert and counsel, respectively.