'Phantom Income' Haunting Ex-Howrey Partners

, The Am Law Daily

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When Howrey trustee Allan Diamond struck a $41 million settlement with Baker & Hostetler last year to claim a chunk of the fees tied to a pair of contingency cases that Howrey partners took with them amid the firm's 2011 collapse, the deal handed the defunct firm's bankruptcy estate some much-needed cash to help pay off its largest secured creditor, Citibank.

But that wasn't the settlement's only effect. The financial infusion it yielded will come back to haunt former Howrey partners this year in the form of a hefty tax bill—and some of them don't believe that's fair.

Under provisions of partnership and tax laws, former Howrey partners are obligated to pay taxes on the $41 million the estate took in related to the Baker & Hostetler settlement, as well as recoveries from other lingering contingency fee cases. That money will appear as "phantom income" on those attorneys' tax filings this year, with each of them liable to cover a portion of what could be a sizable tax obligation.

This week, three former Howrey partners—all of whom joined the firm in July 2009 when Howrey absorbed intellectual property boutique Day Casebeer Madrid & Batchelder—asked a U.S. bankruptcy court judge in San Francisco to rule that they are not obliged to pay taxes on the estate's settlement-related income.

The three—Lloyd "Rusty" Day, a Day Casebeer founder who is now retired; James Batchelder, who heads Ropes & Gray's Silicon Valley office; and Wilmer Cutler Pickering Hale and Dorr partner Robert Galvin—claim that under the agreement struck when Howrey took over Day Casebeer, they were actually fixed-income partners who did not share in Howrey's profits or losses.

Diamond, meanwhile, says in a filing countering the trio's claim that "desperate to avoid this liability, these former partners have manufactured an argument that contradicts every document they signed."

Both sides in the squabble lay out their arguments in filings made Thursday after the court approved a December deal between the Howrey estate and Day, Batchelder, Galvin and four other Day Casebeer partners that acknowledges the phantom income dispute.

Under the terms of the December deal, the lawyers could either pay the Howrey estate a negotiated sum to cover so-called clawback claims brought against them, or take their chances—and risk paying more—by letting U.S. Bankruptcy Judge Dennis Montali rule on those claims. Those who chose to settle also agreed to pay their share of the phantom income taxes.

According to court documents, each of the three former Day Casebeer lawyers still fighting the estate face more than $100,000 in clawback claims alone, plus an unspecified amount in the tax payments. If the estate prevails, Day will owe Howrey $148,307 in clawbacks; Batchelder will owe $113,074; and Galvin will owe $110,504. If the trio is successful, the Howrey estate gets nothing. Both sides previously agreed that Montali's decision will be the last word in the matter.

None of the three returned calls seeking comment Friday, nor did the attorney representing them, Morrison & Foerster partner Larry Engel.

The Day Casebeer partners insist in their filings that Howrey promised to pay them fixed compensation for two-and-a-half years and that they "were not entitled to any percentage of interest or share in the profits of Howrey prior to 2012" apart from a theoretical bonus for good performance. By not sharing in the profits, they argue, they were not to be taxed beyond their own personal earnings. (The three lawyers acknowledge that they were to become regular equity partners in 2012, but never did because Howrey dissolved in March 2011 and was forced into bankruptcy by creditors the following month.)

The Howrey estate, meanwhile, says official firm documents show that the three partners "contributed capital, shared in its profits and losses, and cast votes" like every other so-called Level II, or equity, partner. "Now plaintiffs seek to avoid the liabilities of their bankrupt partnership."

The initial agreement between Howrey and Day Casebeer, the Howrey estate argues, lists budgeted compensation and compensation goals, but does not specify that the amounts are guaranteed. According to court filings, Day was to receive $2.2 million, while Batchelder and Galvin were to receive $1.75 million apiece. The capital contributions for each is listed as 35 percent of those amounts. "All Level II partners received compensation using a 'budgeted' compensation process and none of it was guaranteed," the estate says.

Andrew Ryan, a Diamond McCarthy partner who filed Howrey's motion for summary judgment, said the estate had no comment.

Before its combination with Howrey, Day Casebeer was a respected Silicon Valley IP boutique representing clients including Sun Microsystems Inc. and Amgen Inc. In 2008 the firm came under scrutiny after five of its lawyers—including Batchelder—were sanctioned for alleged discovery mistakes in a case between its client Qualcomm Inc. and Broadcom Corp. A judge dropped the sanctions two years later.

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    Obviously they were not tax lawyers.

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