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I am Shocked, Shocked to Learn that Some Law Firms Puff their Own Financial Reports

Cover of "Casablanca [Blu-ray]"

Cover of Casablanca [Blu-ray

Citibank recently let the cat out of the bag, leaking a “secret” actually rather notoriously well known to the legal profession for decades: In an article appearing in the August 22, 2011 edition of The Wall Street Journal, Citibank revealed that a significant number of law firms materially misstate their profits when reporting to AmLaw. In particular, it appears that almost one-half of the top 50 law firms in the AmLaw 200 gamed their numbers when reporting to AmLaw.  While the fact is that this piece was hardly news (we addressed the issue in May of 2010), and later addressed the fact that some law firms unfortunately game the financial statementsthey distribute to their own partners.

While this “disclosure” by Citibank and The Journal ought to yield either a yawn or a response akin to that of Rick Blaine (played by Humphrey Bogart) to Captain Louis Renault in the 1942 classic, Casablanca: “I’m shocked, shocked to find out that there’s gambling going on here!”  But, remarkably the Journal piece had legs. The Journal’s own legal blogger, Vanessa O’Connell,  commented on the piece. Bruce MaCewan, writing as Adam Smith Esq., commented on the piece. Law 360 had some interesting observations. The ever eloquent and astute Steve Harper chimed in with important observations.   Jordan Furlong joined the discussion, noting that the “system inherently prone to inflationary bias.”  He further noted “We use rankings of the previous year’s self-reported partner  profitability as a surrogate for the prestige and desirability of a law firm, and what that says about our profession isn’t good.” There was enough chatter on the issue that it might have even been a “trending” note on Twitter on the issue. Based on telephone calls I’ve been receiving, the issue will continue to trend for the foreseeable future.

The question of who shoved whom first in the current round of this bout between AmLaw and Citibank, is beyond enigmatic, as Aric Press, publisher of American Lawyer magazine, impetuously, apparently, elected to re-publish a column originally written by him in 2006 in which he first took issue with the accuracy of law firm financial reporting by law firms to both AmLaw and Citibank, and dated the re-release, some might say disingenuously, August 15, 2011, prior to the Wall Street Journal piece.  I suppose only Mr. Press knows why he felt a sudden need to re-publish five year old work.

Rather than personally commenting on the entire issue of law firm financial reporting, Ed Reeser, a noted California bar leader, wrote a piece on the subject, which Ed was kind enough to allow me to reprint here.

If every law firm is misrepresenting their financial performance, and everybody knows it, does it matter?

 By Edwin B. Reeser

August, 2011

The law industry is a huge one (as we would expect), with an estimated $100 billion in annual gross revenue. Firms like Baker & Mackenzie, Skadden, Arps, Slate, Meagher & Flom LLP, and DLA Piper each hover around $2 billion in annual revenue, and virtually every firm in the AmLaw 50 is more than $500 million in revenues annually (actually the top 57 firms are over that mark).  So when the Wall Street Journal reports that a majority of the firms in the AmLaw 50 are misrepresenting their financial performance, according to sources referring to a Citibank report, it is big numbers, and big news, that more than 22% are overstating net income by 20% or more.

The article also reveals a “spat” between Citibank and The American Lawyer (AmLaw) that reflects a complicated issue over financial performance reporting with some seriously competing interests, and more than a few skeletons in the closet for both the lender and the magazine. Of course, we cannot forget the law firms that fundamentally are called out for lying about their financial performance.

We must take note that [neither] of the players here are disputing or denying that the numbers supplied by a majority of law firms are wildly out of the realm of truth.  Citibank is allegedly saying more than half of the top 50 law firms in America are materially misstating their financial performance, and that AmLaw numbers are misleading.  AmLaw is claiming it’s not their fault, they just report the numbers firms have told them.  What they have not said is “and we have known for a long time they were misleading.”

Indeed, Am Law has replied they really don’t think their numbers are that different from Citibank’s.  They both do know and have known for a long time that there are problems with the numbers reported by law firms. Doesn’t everybody?  But admitting it could prove to be uncomfortable for Am Law as the follow up question become: So why did you folks at Am Law not do anything to correct it, why did you persist in using survey results you knew or had strong reason to believe were bogus?  And of course, the lens spins back to Citibank with the same inquiries, which leads to a panoply of concerns over lending practices and decisions.

Citibank has the lion’s share of the Am Law 50, and even Am Law 100, law firm market for lending.  It has been a lucrative and relatively secure lending field, at least until the last three years.  While the banks have not typically lost serious money in lending to this sector as of yet (the Bank of America loss of $25 million due to the erroneous handling of a UCC-2 filing being an exception in the Heller Ehrman LLP bankruptcy), this is now the season for working line of capital renewal discussions, and there is growing anxiety about the dependence of law firms on their use of debt.

Underwriting will probably be tougher, covenants will almost certainly be more numerous, interest rates may be higher, maximum loan amounts may be lower than prior years, and demands for increased partner capital could be higher.  And tolerance for baloney in the numbers from “creative” modified cash basis accounting practices could be headed towards zero.  The Howrey LLP  bankruptcy is probably the wake up call.  Why?  Because the typical approach of lending, say 60 percent of the receivables base, and expecting to be able to comfortably collect all of the outstanding working line didn’t work (there is still more than $25 million outstanding). The “no brainer” credit became a “brain damager” problem with full recovery dependent on future contingent fee collections; and as previously reported the law firm turned on its lender and blamed it for its inability to make pension and employee severance payments by holding back on the extension of more credit.  Remember the parable of the frog and the scorpion?)

The “crack pipe of debt” is now more widespread in the industry than ever, in some cases out of control, and thus threatens the viability of a greater number of law firms.  The use of debt is corrupted to arguably inappropriate uses beyond the working needs of the business (distributions to partners of uncollected income is only one of them).

What is not addressed, but lurking under the surface, is the way some law firms have made use of personal lines of credit to partners from the same banks that finance their working capital
lines, to finance capital contributions, all of which capital will be lost in most law firm failures and for which the individual partners will still have liability for unpaid balances due to the lender.  Then, of course, there are the personal lines of credit to lawyers to pay for their annual living expenses as they wait for yearend draws and distributions, which in a failing firm do not arrive or are subject to clawback to pay creditors in a bankruptcy. And the car and home mortgage loans to the lawyers.  And we cannot forget the handling of the law firm pension plan accounts, which are a terrific fee
generator for the banks. There is a lot more money in play than just the aggregate of the working lines of capital, or secured term loans to the law firms.

Am Law is struggling in the new age of information to maintain its profitability, and this survey of comparative law firm financial performance is a franchise, it defines it.  If the survey is discredited, and Am Law with it, what will the damage be financially to AmLaw?  It is too soon to tell, but the risk is that it could be significant.

Citibank is struggling with – well the list is so long we can just leave it with Citibank has more than a few challenges of its own in the current business environment.

But what is really powerful is that both sides will, in the defense of themselves, be incented to spill the beans about how misleading the majority of the most prestigious law firms in the nation are
with their financial performance reporting.  That is not very promising for impressing clients, or recruiting talent, or for the prospect of future stories about large law firms.  This could be the opening
chapter in a revealing series from many sources on what leadership, governance and decision making law firms have adopted.

I  was asked “If every law firm is misrepresenting their financial performance, and everybody knows it, does it matter?”  My opinion is that not every law firm is misrepresenting their financial
performance, and that yes it does matter.  If it didn’t matter, there would be no need to do it.  I think that is a fair message for Citibank to convey to their law firm clients.  Citibank may not have relied on the creatively presented numbers given to AmLaw when making their business decision to lend.  I don’t believe that top law firms would provide anything other than the “real” financial performance numbers to their bankers.  But I do believe that deliberately releasing false results for publication is corrosively damaging on a wide range of issues beyond reputational, and can incent law firms to undertake imprudent business decisions that destabilize their business, increasing risk and jeopardizing the credit extended to them. That is a fair and relevant concern for a bank.  You are free to differ.

But there is another troubling question that this now public tiff has released.  When the question of absence of veracity legitimately surfaces as characterizing law firm financial reporting, it quickly spreads to, “And what else have you been saying, and to whom, that you knew was untrue?”

Edwin B. Reeser is a business lawyer in Pasadena specializing in structuring, negotiating and documenting complex real estate and business transactions for international and domestic corporations and individuals. He has served on the executive committees and as an office managing partner of firms ranging from 25 to over 800 lawyers in size.  Ed can be reached at edwin.reeser@att.net

The views expressed herein are solely those of the author.

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7 Responses

  1. Thanks for this, Jerry. And to think that 2010 PPP reports had been causing me to have second thoughts about my prediction in early 2009, i.e., within five years, half of the AmLaw 50 wouldn’t exist, either due to dissolution or merger.

    My reasoning at the time was that, in what (behaviorally) mirrored a newly-deregulated industry, i.e., featuring firms competing largely on price because they didn’t know any other way, each successively lower tier would cannibalize the bottom 20% of clients from the tier above. (Most firms aren’t set up to service those clients and shouldn’t have had them to begin with.) The AmLaw 50 would be the only tier without someone above them to cannibalize, and would still have their massive cost structure.

    While it’s believable that clients may always be willing to pay $1000/hr+ for luminaries whose experience, wisdom and judgment can be worth billions on critical matters, they’ve also shown that they’ll no longer pay for all the minions grinding out the thousands of hours implementing that wisdom at huge hourly rates.

    Who knew that these top dogs were playing games with their financial reporting, suggesting that they were never as flush as presented to begin with?

    I’ve never run a big firm, so I have no direct knowledge of these things. I’m merely looking at the macro forces, comparing it to business history and drawing deductive conclusions.

  2. Mike — you are spot on, both now and in 2009. The real issue is still, in my mind, is the strong competition in the market from non-law firm providers of legal services, as I didscussed in http://kowalskiandassociatesblog.com/2011/08/11/are-law-firms-going-to-be-replaced-by-internet-based-providers-of-legal-services/

    Jerry

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  4. […] objection is the vereins “debased the financial results upon which [AmLaw] ranking rests.”  My own view is that too many AmLaw firms debase those rankings by gaming their own reported numbers. The […]

  5. […] if not most, large law firms had a lockstep system of compensation for associates and partners. The AmLaw 200 listings, the source of more tall tales than any gathering of fishermen at a tavern, would not surface for a decade. Lateral partner […]

  6. […] later advised its partners that gross revenues for 2011 were actually only $780,000,000.  Sure, everybody puffs their AmLaw numbers, but $155,000,000 is well beyond mere […]

  7. […] financial reporting, whether it be to the firm’s partners, its lenders, vendors or the media. The self reporting through The American Lawyer is largely recognized to be unreliable at best, or a large bad commercial joke at worst. Let’s […]

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