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Double Jeopardy for Law Firms: Jewel v Boxer


Seal of the United States District Court for t...

Seal of the United States District Court for the Southern District of New York (Photo credit: Wikipedia)

Jerome Kowalski

Kowalski & Associates

July, 2012

 

In the last month or so, BigLaw was jarred by two disruptive events:  First, there was the tragic collapse of Dewey & LeBoeuf and the second, the reasoned decision issued by the United States District Court for the Southern District of New York in the Coudert bankruptcy holding that the “unfinished business” doctrine, commonly known as Jewel v Boxer, applies to New York law firm partnerships and that it does so with equal weight to both matters billed on an hourly basis as well as contingency fee work.  Both events have chilled the lateral partner market.

Added to that is the fact that liquidators of imploded law firms are also desperately seeking recoveries for creditors and are therefore anxiously investigating potential breach of fiduciary duty claims against former partners of the law firms, and, like Jewel claims, the reach of these claims is likely to put the law firms these former partners subsequently joined into their cross hairs. Deep pockets and all of that.

These events are occurring in the open for all to see. Unfortunately, too many managing partners, lateral hiring partners, law firm general counsels and risk managers have neither taken note nor taken adequate steps to protect their firms.

In light of recent events, law firms will be woefully remiss if they fail to include in their standard agreements for lateral partners language protecting and indemnifying the firm from Jewel v Boxer and breach of fiduciary duty claims.  If the firm has hired a lateral partner from a firm that is going through the throes of imploding, a la Dewey or if a lateral partner comes from a law firm that subsequently unwinds unexpectedly, there is some reasonable likelihood that the hiring firm will be targeted as a defendant should the liquidators of the defunct law firm form a reasonable basis to assert such claims.  The issue is that there is almost always a likelihood that such claims are lurking about. These skulking claims are all of the more problematic because they are typically not asserted for a couple of years after a law firm implodes.  When the pain comes, law firms should preserve the right to share some of that pain in a reasoned and rational way.

Law firm liquidators typically spend the first several months of their tenure tending to the gargantuan tasks of shutting down the law firm.  They simultaneously undertake a “sources and uses” analysis to determine what potential sources exist for payment of administration expenses and obligations due to creditors.  Because expenses and creditor typically far exceed the amounts available from monetizing accounts receivable and works in progress, successor law firms are more frequently found to be routinely available resources for adding to the honey pot. And nobody is more motivated to add to the honey pot than law firm liquidators whose fees are often contingent on maximizing recoveries; a primary resource for them has been pursuing clawbacks and claw forwards.  They are unrestrained by market place considerations which dampen the appetite of viable law firms to  go after other competing law firms who have hired laterally from its ranks because they would inevitably subject themselves to the very same claims, as they continue to drink the Kool Ade and hire laterally.

The problem is that it takes law firm liquidators an extended period of time to get their hands around the behemoth of the law firm that once was and is no longer. For example, one of the tasks typically undertaken by the liquidators is recasting the firm’s balance sheet and profit and loss statements retroactively, to among other things, determine when the law firm was first insolvent from a technical bankruptcy point of view.  Any payments made to partners during the insolvency period are gratuitous transfers and are subject to clawbacks. Determining the date of insolvency is both art and science and often requires extended analyses. Similarly, determining where former partners went and which firm assets (in the form of client files, other partners and associates) also takes time. Thus, we most often see that these claims are filed en masse upon the expiration of the statute of limitations, which is two years from the date of filing.

Here is the rub:  Law firms typically prudently pay new lateral partners in whole or in part during the course of that partner’s initial tenure at the law firm on a performance basis. One of the key drivers is most often cash generation and the metric law firms use in calculating the new partner’s entitlement is the law firm’s historical profit margins. To be sure, those margins do not include clawbacks. Thus, the typical scenario is that the new lateral partner is timely rewarded for production, with the law firm completely oblivious to the very real likelihood that two years or more down the road, law firm liquidators will be sending the law firm a due bill for all of the profits earned by the law firm (not just the new partner’s distributions) for unfinished business based on either Jewel v Boxer or breach of fiduciary duty claims. Successor law firms have not yet been the target for recovery of voidable transfers made during the insolvency period made to the new partner during his prior tenure at the now defunct law firm.

Thus, the new firm is in the unenviable position of having to pay twice for the same revenue generation: First, to the lateral partner and thereafter to the estate of the former law firm.

The issue with breach of fiduciary claims is far more devious and invidious. Among other things, we know full well that the rule is that a partner may not solicit a client, associate or partner to join him or her at a new firm until he or she has given notice. Nor can a partner share with another law firm confidential billing and collection information of his or her current law firm, Yet, we can all take judicial notice that no sane partner on the prowl will accept an offer from a new firm before he or she has received adequate assurances from his or her clients will be following him or her. Similarly, every hiring law firm demands assurances that the clients will indeed be coming along. By the same token, when a group leaves a law firm simultaneously to the same new climes, it is readily apparent that a partner, typically the group leader, has engaged in actionable recruiting of partners and associates prior to giving notice. The new law firm is clearly complicit, since it almost always interviews partners in the group at length before an offer is extended and even where associates are first interviewed after the partners give notice, it is more often the case than not that these associates were advised by law firm partners to start packing – again, actionable conduct. Even where the successor law firm gives a potential lateral recruit written admonitions not to violate any fiduciary obligations or partnership agreements and somehow feigns ignorance of any fiduciary breaches, at best, it is most often clear that it has simply engaged in willful (and often dubious) blindness and may be subject to some serious claims.

Dewey broke the mold in oh so many ways

Dewey’s implosion was unprecedented in too many ways to count.

One unique aspect of the Dewey collapse was its failure to hold a formal dissolution vote. One Dewey law firm leader, when asked about a formal vote of dissolution as the firm was plainly at the tail end of its death spiral, blithely and rather incredibly denied that the firm was going to vote to dissolve, even Quixotically asking his interlocutor, “why would he do that?” even as he presumably was actively looking for a new home and subsequent to the time that he issued an email in his official capacity to other partners encouraging them to leave. The answer to the question sort of seems obvious:  The reason you would take a dissolution vote is because the law requires you to do so and the firm’s managing partners, as fiduciaries of other partners as well as of the firm’s other creditors, have a duty to call for such a vote as the firm, in fact, is actually in a state of very real dissolution.

The issue may well be that Dewey’s leaders, very smart lawyers one and all, may well have wanted to protect their colleagues and themselves from Jewel v Boxer claims. You see, these claims arguably first arise once the partnership votes to dissolve.  In Coudert, the only partners (and their new law firms) sued for unfinished business profits were those who left after the dissolution vote. I certainly have no information to support the notion that this was the reason for the failure to formally vote to dissolve Dewey.  But, if this was the reason for the ploy, it seems unlikely that it will succeed.  First, it may be that a court of equity may determine that Dewey went into formal dissolution as it stumbled through various critical paths:  For example, when Dewey leadership tried to auction off pieces to other law firms, when those efforts failed, when the firm’s then sole managing partner advised the partnership in January 2012 that the firm was basically insolvent in that it couldn’t pay its debts when due, the date of the bankruptcy filing or some other earlier date. We are in largely uncharted waters here, folks.

But, the refusal to take a formal dissolution vote solved nothing and protects nobody. Every former partner and most of their new law firms are still subject to breach of fiduciary claims, violations of the partnership agreement and violations of the Revised Uniform Partners Law. Those in management are presumably more at risk.

Simply arguably eliminating Jewel v Boxer claims still leaves the door wide open for breach of fiduciary duty claims. We do not suggest that Jewel claims preclude breach of fiduciary duty claims. They are all still out there.  In short, it doesn’t matter whether you call it a “tax” or a “penalty”.  A clawback is still a clawback.

Protecting law firms who hire partners laterally

In light of all of the foregoing, it is critical that any law firm which hires laterally must include indemnities from new partners from both Jewel v Boxer and breach of fiduciary claims.  The full nature, scope and content of these indemnities must be left to the sound business judgment of law firm leadership.  It is likely that the amount of the precise amount for particular indemnities will first be the subject of negotiation after issue is formally joined on the claims.  Those indemnities should be standard issue in every lateral partner agreement. Every single one.

All such agreements should require binding confidential mediation and arbitration.

Moreover, as we continue to watch even an already bankrupt Dewey continue to fall, law firm risk managers must be engaged in active discussions with its insurance carriers to see what insurance might be available with regard to potential future Deweys and partners who leave those sinking ships to join new law firms. It may be too late to insure Dewey-related claims, but it isn’t too late to seek coverage for the next generation of imploded law firm refugees. These claims are certainly outside the scope of standard issue malpractice claims, but may well be within the scope of fiduciary insurance coverage or errors and omissions policies.  The real problem here is that most often, these claims specifically exclude work done by a partner at a former law firm.

I leave it to professional liability professionals to craft an insurance based solution.  But be forewarned, time is short; the next law firm implosion may be around the corner.

An important note: Those law firms which carefully assesses its likelihood of liability, includes the amount of exposure into its calculus (and may even have appropriate insurance) and then eschews the need for an indemnity, while extending a viable offer, puts itself at a competitive advantage for a desirable candidate. However, it does so at some risk and eliminates the ability to tell all comers that these indemnities are required of all lateral partners. At the same time, if a law firm picks and chooses which lateral candidates should be required to provide indemnities, there may be some explaining to do of and when it comes to pre-trial discovery in the inevitable Jewel or breach of fiduciary duty claims rears its head.

Is this a fight you really want to get into?

 

It isn’t very surprising that every Jewel v Boxer and breach of fiduciary duty claim previously brought under these circumstances involving BigLaw has settled prior to trial. Many settle before the first pleading is served. The balance settle well prior to trial. Several are still pending in the pleading phases in Thelen and in Coudert with the antagonists vowing to fight on to trial and through the appellate process, never to give in. Never. We’ll see.

The real problem here is the fact that pretrial discovery will be brutishly invasive and certainly expensive.  Remember, that the Jewel v Boxer rule is that the plaintiff has an entitlement to recover the profits not the gross fees from unfinished business. Thus, discovery will necessarily include minute details of a law firm’s most sensitive and confidential pricing and profitability information, stuff that even in the most transparent of law firms do not regularly share even with partners.

Sure, we all love confidentiality agreements and protective orders and advocate for them all of the time both to the courts and to our skeptical and justifiably paranoid clients. But, today, the shoe is on the other foot: Do you really want this information disclosed to your key competitors even under a protective order?  Can you, dear advocate, feel safe with a protective order? Bear in mind that at trial, the veil of confidentiality comes off and should any of these cases ever come to trial, the world at large will be informed of your most sensitive information, with journalists, bloggers and pundits at the ready in the courthouse to report information never previously having seen the faint light of day.

Is it time for some rule changes?

 

While getting the American Bar Association and fifty-one agencies to change extant provisions of the Model Code of Professional Responsibility is a Herculean task, which, at best, would proceed at a glacial pace, it is time to at least begin to consider those issues.

First, since the skein of precedent and statute in the area of fiduciary laws governing partnerships is a foolhardy a mission hardly imaginable, let’s for the moment, at least, forget about undoing Jewel v Boxer under the rubric of amending a century or more of common law and statutory mandates and suggesting that we are simply modifying rules of professional conduct. Instead, an initial focus should be on the question of lateral partner movement. We all know what the rules say and we all concede that these rules are far more honored in the breach.  A new set of rules are critical and should, even reluctantly, yield to the realities created by the marketplace: Partners are free agents, just as law firms freely de-equitize partners and otherwise treat them as employees at will. Market realities create lateral movement.  The marketplace also has required client solicitation before partnership withdrawal, disclosure of historical billing and collection history and even solicitation of associates and other partners. The ethical rules need to be amended to yield to these market realities. The issue here is not those fiduciary rules of partnership described in the Jewel line of cases and in the Coudert decision. Rather, the rules that need to be addressed relate to those fairly unique to the profession; namely, those rules primarily regarding client solicitations in a free agency market.

More significantly, given the likelihood of a torrent of post Dewey Jewel v Boxer and breach of fiduciary claims, as well as a next round of similar claims from the inevitable next BigLaw failures, the rules should require that all disputes between law firms and their successors and assigns be arbitrated before a panel of those appointed in each jurisdiction to review lawyer conduct.

Until the rules are actually amended, BigLaw should consider acting on its own: I would propose a compact by and among the nation’s largest law firms under which any disputes among the signatories of the compact, inter se,  be finally resolved through mediation and then arbitration by a designated panel of arbitrators,  consisting of retired jurists as well as present and past BigLaw partners.  This compact should specifically bind the signing law firms as well as their successors and assigns.  It would take only a relatively small number of numbers of law firms to seize such an initiative and then some prodding to get other law firms to join in.

Waves of litigation brought by law firm liquidators seem inevitable.  A uniquely qualified panel of arbitrators are perhaps the most efficient way to handle these issues. At the same time, this panel could also be designated to be the forum in which disputes among partners inter se, as well as between a partner and his or her former law firm can be most efficiently finally resolved.

Jerry Kowalski is the founder of Kowalski & Associates, a consulting firm serving the legal profession exclusively. Jerry is a regular contributor to a variety of publications and is a frequent (always engaging and often humorous) speaker to a variety of forums. Jerry can be reached at Jerome_kowalski@me.com or at  jkowalski@kowalskiassociates.com or at 212 832 9070, Extension 310

 

© Jerome Kowalski, July, 2012. All Rights reserved.

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Protecting a Law Firm’s Crown Jewels


Protecting a Law Firm’s Crown Jewels.

Protecting a Law Firm’s Crown Jewels


English: Replicas of Polish crown jewels, made...

English: Replicas of Polish crown jewels, made in 2003. Polski: Repliki polskich klejnotów koronacyjnych wykonane w 2003 roku. (Photo credit: Wikipedia)

Jerome Kowalski

Kowalski & Associates

June, 2012

 

The problem with the law firm business model, we are told repeatedly, is that its principal assets, namely, its productive partners, go down the elevator every night and may not return the next day. The issue arises out of our arrival to an era of law firm partners as free agents and a lack of institutional loyalty, a subject about which there is much railing.

But, those partners who take the elevator down and out and don’t return the next day are taking with them valuable assets that are the property of the law firm and which law firms as well their lenders and landlords need now consider preserving and protecting.  I refer to unfinished business that law firm partners take with them to new law firms. The simple fact is that the profits derived from unfinished business of a client of law firm partnership is the partnership’s asset, just as are the outstanding accounts receivable, work in process, furniture, artwork and equipment.  And, I’m not just referring to law firms in dissolution. These are recoverable assets of healthy thriving law firms.

One of the results of the recent spate of law firm bankruptcies was to alert lawyers that upon the dissolution of a law firm, profits from unfinished business can be clawed back under the doctrine now known as Jewel v Boxer. Judge Colleen McMahon of the United States District Court for the Southern District of New York, in a much publicized well reasoned and articulate opinion in the Coudert case explained the basis of the unfinished business doctrine. The essence of her ruling is that “A departing partner is not free to walk out of his firm’s office carrying a Jackson Pollack painting he ripped off the wall of the reception area.” Profits from unfinished business are akin to the Pollack painting and departing partners are statutorily obligated to return both the painting removed from the wall and profits from unfinished business. This has been the law in New York for a century.

Under the Uniform Partnership Act, absent an agreement to the contrary, a partnership goes into dissolution upon the death or withdrawal of a partner.   Thus, all modern partnership agreements typically provide for the continuation of the business of the partnership upon the death or withdrawal of a partner and these agreements go on to describe the rights, entitlements and obligations of the partnership and the partner on a going forward basis.  The overwhelming majority of law firm partnership agreements are completely silent on the issue of unfinished business that follows a partner that withdraws from a law firm. But it is completely within the fabric of the partnership fiduciary relationship, as articulated in Meinhard v Salmon, and further expounded upon by Judge McMahon, for law firms to require departing partners to account to the partnership for profits from unfinished business even absent a dissolution of the partnership. Moreover, the agreement can further obligate a withdrawing partner to inform his or her new law firm that profits from unfinished business belong to his or her former law firm. Fancy that. I know this is probably a shocker to most readers, but it’s clearly the law.

Intuitively, most lawyers will simply shudder when reading this. Their reaction, when I have previously spoken of this, is to instinctively say that this can’t be so; it constitutes an impermissible restriction on a lawyer’s ability to practice law, unbridled by covenants not to compete.  The Jewel v Boxer line of cases, as well as the long parade of authority cited by Judge McMahon makes clear that the unfinished business doctrine does not trample on that issue, even in New York which is completely restrictive on the prohibition barring any form of covenants not to compete and certainly not in states like California which does permit some restrictions in limited circumstances.

We certainly now know from Coudert and Dewey & LeBoeuf that principal assets of a law firm are unfinished business (although, in fairness, these claims were pursued in a host of other major law firm bankruptcies, with a tad less fanfare).   For the first time of which I am aware, in Dewey, the firm’s secured creditors have actually purported to take a security interest in the proceeds of unfinished business claims.

Thus, the question now emerges: Why shouldn’t law firms include in their partnership agreements provisions requiring withdrawing partners to account to the firm for unfinished business even absent dissolution?  The ancillary question is why wouldn’t lenders and law firm landlords mandate such provisions as a condition of borrowing or tenancy?  The short answer is that in due course, these provisions are likely to be standard fare.

Let’s turn to the likely effects on lateral partner recruiting.

It is a standard practice in lateral partner recruiting for a law firm to prepare a pro forma analysis of income and expenses derived from a lateral candidate. In analyzing this pro forma, law firms make informed decisions as to the likely profitability of any candidate. With the recent unfortunate spate of law firm failures and the increased recourse to Jewel v Boxer recoveries, I have regularly counseled every law firm client to include in its pro forma examination a projection of any possible unfinished business remittances and to pay particular heed to this analysis when   there is evidence that the candidate is from a law firm suspected to be in difficult financial circumstances. In doing so, it must be remembered that Jewel v Boxer remittances are only for the profits derived from the unfinished business. Even the former partner can bill for his time in a unique metric, as Judge McMahon noted, based not on standard hourly rates, but based on his or her “efforts, skill, and diligence.” Thus, neither the former partner nor his or her new firm is forced into indentured servitude.   They are simply barred from deriving a profit for any of the particular matters the new partner brings along with him or her.

This last point require some emphasis: it is only the particular discrete matters that fall into the rubric of unfinished business. As Judge McMahon said in Coudert:

“’ Unfinished business” must be distinguished from “finished business” – business that has been completed prior to dissolution (the merger done and documented; the lawsuit tried to verdict or settled). If a firm has finished a piece of business but has not collected its fee, in whole or in part, the resulting receivable is, obviously, an asset of the firm. If the firm liquidates, the fee has to be collected for the benefit of the members of the firm in liquidation. Jackson v. Hunt, Hill & Betts, 7 N.Y.2d 180, 183 (1959). 23 “New business” is an entirely new contract or engagement to do a piece of work. New business that is contracted for and undertaken only after a partnership dissolves – even business from a client of the dissolved firm – is not an asset of the dissolved firm, because a partnership has no more than an expectation of obtaining future business from a client. For that reason, the attorney who conducts the business and collects the resulting fee owes no duty to his former partners to account for any profit he may earn. Stem, 227 N.Y. at 550; see also Conolly v Thuillez, 26 A.D.3d 720, 723 (3d Dep’t 2006); In re Brobeck, Phleger & Harrison LLP, 408 B.R. 318, 333 (Bnkr. N.D. Cal. 2009) (applying California law). Retainers from former clients on new matters – even matters, like appeals, that are related to finished representations – have been treated as “new” business and are not subject to the duty to account. See, e.g., Talley, 100 N.Y.S.2d at 117-18 (no duty to account for fees earned on appeals from matters originally handled as partnership business).5

Between “finished business” and “new business” lies unfinished business: executory contracts to perform services, begun but not fully performed by the partnership on the date of its dissolution. Unfinished business is presumptively treated as a partnership asset subject to distribution.”

 

Thus, the new firm must make an informed decision as to whether it is prepared to make an investment in the new partner and his or her clients until it can start earning a profit on those clients coming along.  The cost of the investment is largely an opportunity cost; namely, the lost opportunity to bill profitable time on different clients and matters.

Will this dampen the lateral partner market?  Quite likely, but, frankly, not in a material way, I suspect and certainly not long term as such contractual provisions begin to metastasize, at the instance of lenders and landlords, as well as law firm leadership, separately incentivized to dampen the enthusiasm of profitable and productive partners to seek a higher bidder. In due course, there will likely develop an open market in which firms will both be remitting and collecting unfinished business remittances.  And, I am sure, the market will ultimately require law firms to simply arrive at negotiated deals early on as valuable free agents rise to their highest level and less productive partners eased out the door.

These results are all inevitable. Well informed lawyers will counsel lenders and landlords on these issues and these clients, who have bargaining leverage will require unfinished business recoveries as a staple of law firm partnership agreements. Law firms will being compelled to pay unfinished business remittances will in turn take steps to keep its assets corralled by requiring the same of its partners.

In coming months, law firm leaders will be sitting across the table from lenders and landlords requiring law firms to include unfinished recoveries in their partnership agreements. Partners will be presented with proposed amendments to their partnership agreements containing these provisions.

Now is the time to begin considering your bargaining position.

© Jerome Kowalski, June, 2012. All Rights reserved.

Jerry Kowalski is the founder of Kowalski & Associates, a consulting firm serving the legal profession exclusively. Jerry is a regular contributor to a variety of publications and is a frequent (always engaging and often humorous) speaker to a variety of forums. Jerry can be reached at jkowalski@kowalskiassociates.com or at 212 832 9070, Extension 310

 

For Law Firm Liquidators, There’s a Lot of Gold in Them Thar Hills Aside from Jewels


For Law Firm Liquidators, There’s a Lot of Gold in Them Thar Hills Aside from Jewels.

Avoiding Law Firm Implosions by Mandating Firms to Undergo Annual Stress Tests


Avoiding Law Firm Implosions by Mandating Firms to Undergo Annual Stress Tests.

Avoiding Law Firm Implosions by Mandating Firms to Undergo Annual Stress Tests


Stock footage taken at Beaumont Hospital. 14:1...

Stock footage taken at Beaumont Hospital. 14:18, 28 October 2006 (UTC) (Photo credit: Wikipedia)

Jerome Kowalski

Kowalski & Associates

May, 2012

The horrific death spiral of Dewey & LeBoeuf, which started within the firm in October of 2011 and debuted its public spectacle in March, 2012, continues to evoke gasps and cries from all observers and participants. The latest horrors, not unexpected, are the loss of hundreds of jobs and the disappearance or dramatic reduction of thousands of pensions.  To be sure, more ugliness lies ahead: Draconian financial penalties to partners and prosecutorial inquiries of potential criminal liability for some key Dewey players.

The question I pose to you today, dear readers, is whether we are simply voyeurs or whether a sense of professional high mindedness should prevail so that urgent steps are taken to prevent the next seemingly inevitable law firm implosion? Did we come to the speedway pretending only to be interested in the competition but hoping for carnage or are we among those who seek to promote safety and prevent future crashes?

Dewey & LeBoeuf’s Current State of Play

The crescendo of public discourse of the Dewey disaster escalates daily. One of the most recent cogent pieces, sets forth a seemingly well informed and apparently factual exposition of the events leading up to the inevitable denouement.  Other well informed pieces analyzes the root causes of the Dewey & Leboeuf debacle.  A brief moment of levity was inserted into the mix as an avuncular former Dewey & LeBoeuf partner and department head stared straight faced into a  television news camera and calmly explained that the reasons for the firm’s implosion was that after Steven Davis, the now ousted chairman of Dewey, sat down with his partners in January and apparently revealed to them for the first time that the firm was functionally insolvent, headhunters had the gall to help partners find new positions, the media had the temerity to report on the facts and the district attorney had the audacity to conduct an investigation of serious allegations of criminal wrongdoing by senior managers at Dewey & LeBoeuf. These bon mots brought to mind the tale of the owners of a bus company who were called to task because they had employed an alcoholic bus driver who in his stupor caused a horrendous crash resulting in awful carnage. The owners calmly explained that they were not to blame.  The reason so many people were taken to the hospital was because of the fleet of ambulances that descended on the scene and the cause of so many reports of broken limbs was attributable to the zeal of the hospital’s ex ray technicians.

The fact is that since the 1988 implosion of Finley Kumble, then the world’s second largest law firm, there have been some 43 major law firm bankruptcies.  Each major law firm bankruptcy brings disgrace to the profession, disrupts lives, erodes confidence in the profession and creates a cascade of unemployment, poverty, death and disease (the rate of stress related diseases and mortality post law firm bankruptcies, reported only anecdotally, is staggering) and divorce (again, reported only anecdotally).

The blight on the profession is not simply the fact of these law firm failures, but the utter failure of the profession to address these failures and take any steps to prevent them. The appalling nature of this Ostrich like  stance is the generally accepted belief that a number of large law firm failures in the coming months seems inevitable.

The problem

The three inch thick annotated American Bar Association’s Model Rules of Professional Conduct that sits in every law firm in America is completely silent on the issue of law firm 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 simply look at the soft, puffing (and apparently demonstrably false) report that Mr. Davis gave The American Lawyer in March, 2012 as a prime example. Neither the firm nor Mr. Davis was called to task for gross overstatements of revenues; The American Lawyer, which derives significant revenues from theses annual reports and the hoopla leading up to them did not immediately exercise the requisite journalist imperative of rigorously subjecting Davis to the crucible of informed journalistic inquiry (although it did, to its great credit, after public disclosure of the Dewey deception, take the unprecedented step of unilaterally restating Dewey & LeBoeuf’s financial reports).

The Model  Code is also strangely silent on the issue of law firm governance. Based on what has this far been revealed and now seems indisputable, based on the public record to date,  the demise of Dewey & LeBoeuf is largely attributable to a complete and abject failure of proper governance. The tragic irony is that Dewey still boasts on its web site of its superlative corporate governance practice group. Read it now, while the web site is still up and running. If you missed it, here is a pertinent excerpt:

“Based on decades of experience in corporate law, governance, restructuring and litigation, Dewey & LeBoeuf has assembled a next generation capability to achieve clients’ goals… Our multidisciplinary approach enables us to develop special tools that allow directors and management to avoid ‘not knowing.’”

We can apparently now conclude that Dewey did not capitalize on its “generations of experience” in establishing a system for itself of checks and balances, oversight and accountability required of this generation of commercial enterprises. The firm’s culture seems to have been built on partners proudly “not knowing.” The firm’s mascot may well have been an ostrich; the firm seems to be a paradigm of the cobbler’s children going barefoot.

Of the two score and some firms that failed over the past three decades, all have seen complete failures of appropriate governance, inaccurate financial reporting and excessive leverage and debt.  Some, like Dewey have fallen victim to excessive compensation paid to laterals.  More have flawed partner compensation systems.

The Solution

The need to address these issues could not be more urgent. To rely on the sloth of the ABA to urgently address these issues, then followed by fifty-one local bar rule making deliberative bodies, which collectively makes the ABA seem lightening-like, would require the complete suspension of disbelief. To suggest that large law firms could be brought into line fearing disciplinary action by state disciplinary bodies would require the confidence of a naïf.  Despite the three inch thick annotated tome that comprises the Model Rules, the overwhelming number of disciplinary actions brought by these bodies only relates to escrow account defalcations and disbarments of convicted felons. Witness the fact that the current public record shows an ongoing criminal investigation of Dewey managers, as well as seemingly clear evidence of deception by some of these lawyers, some rather facially convincing prima facie evidence of securities fraud by the firm as an issuer of securities, violations of fiduciary obligations to partners, violations of statutory duties to employees and violations of rights owed to the pension beneficiaries of the firm. Certainly, there may well be complete defenses to each of these matters and I invite my many Dewey readers (or their counsel) to provide them below. But the real point is that while investigations by disciplinary committees are secret, we each can sleep soundly tonight assuming that no such investigation has commenced.

Rather.  the solution to this clear and present danger of future large law firm failures must come from BigLaw itself and its stakeholders, including law firm lenders, institutional clients and the academy.

What is required is for law firms to retain independent professionals who would annually conduct a stress test, having full and unfettered access to all of the firm’s data and information,  and then report to the firm and its partners (equity and non-equity) that (a) the firm has adequate procedures in place to provide adequate oversight of its management group; (b) an appropriate system of accountable governance is in place; (c) the firm’s financial reporting (audited or not) fairly states the firm’s financial condition as of the reporting dates; (d) the firm’s general counsel is timely provided with all information necessary to discharge his or her duties and that he or she has full and open access to all relevant information as well as the ability to report any concerns to a full governing body; (e) the firm has an appropriate risk assessment and management officer, adequately performing the require objectives of that office; (f) the firm has an appropriate mechanism in place to avoid conflicts of interest and to otherwise insure full compliance with all applicable ethical rules, laws and regulations, (g) the firm maintains adequate insurance coverage; and, finally, (h) no set of facts was discovered that raises any apprehension that the firm is at risk in continuing as a going enterprise. Any failures or suggested improvements in any of these areas should also be described in detail. Similarly, any deficiencies detected in previous reports and the adequacy of any steps taken to ameliorate those deficiencies should be further described. Should management of the law firm elect to discharge the independent professional because of any disagreements in interpretation, the professional should be contractually bound to disclose those facts to the partnership.

There may well be other items that should be included in these reports and suggestions will doubtless appear in the comments section below. If you have a thought, feel free to pony up.

I would further propose that the independent professionals conducting these tests prepare at least two forms of reports: The first being the detailed report described above and the second a summary form which might be made available to clients and prospective clients, lateral candidates and law schools as part of a NALP disclosure. Every one of these stakeholders has a simple right and need to know that the firm will be there next year.

As I suggested, it is extremely unlikely that any regulatory body will timely and efficiently create a mandate for these reports. Rather, a forward looking well managed law firm will certainly see the universal benefit and advantage of having such reports issued to provide comfort and assurances to its stakeholders and to avoid being tarnished by the reputation of a failed law firm.  The reports would be potent marketing and recruiting tools. These reports would certainly be most beneficial to top down management style law firms and those that operate in a black box.

I could certainly also see institutional lenders and clients routinely requiring their borrowers and counsel, respectively, requiring these stress tests, particularly as they have been seriously burnt by previous law firm failures and certainly as to lenders, they may correctly feel that what’s sauce for the goose is sauce for the gander.  It will, I suspect, take only a very small number of lenders and important clients to make these reports a required norm; indeed, mandatory. Similarly, it will take only a handful of the AmLaw 200 to come forward and proudly offer these reports to make their annual production an industry requirement. The market will require nothing less.  The implosion of a law firm casts a pall on the entire profession and creates a blot on every large commercial law firm. Those blots can be avoided by having  large law firms don the Teflon that these stress tests should provide.

© Jerome Kowalski, May, 2012. All Rights reserved.

Jerry Kowalski is the founder of Kowalski & Associates, a consulting firm serving the legal profession exclusively. Jerry is a regular contributor to a variety of publications and is a frequent (always engaging and often humorous) speaker to a variety of forums. Jerry can be reached at jkowalski@kowalskiassociates.com or at 212 832 9070, Extension 310

Dewey, Sex, Lies and Videotape


Cover of "Sex, Lies, and Videotape [Blu-r...

Cover of Sex, Lies, and Videotape [Blu-ray]

Jerome Kowalski

Kowalski & Associates

May, 2012

 

Do you really want to be a partner in a law firm?

As we all daily sit transfixed staring at the horrific train wreck of Dewey & LeBoeuf, a firm with glorious legacies, many have already begun to undertake the post mortem to try to determine what went so horribly wrong as to bring the demise of one of the twenty largest law firms in the nation, a swift final journey that is barely two months in duration, which is remarkable for a 1,000 lawyer firm with a century of history.

.  The most comprehensive piece that has appeared to date comes from the brilliant and articulate Bruce MacEwen, writing as Adam Smith, Esq., in which Bruce dissects what is now obvious to most informed observers.  Some claim that some of the partners were simply too greedy and that the firm’s leadership was too eager to accommodate that greed, providing those partners with guaranteed incomes, regardless of productivity or law firm profitability. The fault, according to some, is base criminality and greed at the hands of the firm’s leadership.  Still others point to the firm’s unsustainable leverage:  Well over $700,000,000 in bank, institutional,  legacy and similar liabilities (not taking into account current liabilities for rent, wages, and vendors), an amount that simply cannot be sustained under any circumstances on the backs of 300 partners, bringing in $900,000,000 in gross revenues.  There are those suggesting sexual peccadilloes by the firm’s senior leadership.   Still others point to ongoing deception by current firm leadership, which one day encouraged partners to seek alternative employment in rather plain language and the next day, in the tradition of Lewis Carol, said that the epistle didn’t mean what it said. In other instances of unfortunate lack of candor, the firm’s leadership said that help was on its way in the form of a major law firm merger partner which was being discussed with “a number” of firms, only to fail to mention that all of those preliminary inquiries were politely previously declined.   Or one day promoting a bankruptcy strategy, while eschewing bankruptcy as an option a day or so later, no matter that the initially promoted bankruptcy strategy had no likelihood of succeeding.

All of the facts will emerge as the long slog of litigation and bankruptcy proceedings take their inevitable course, Presumably, some depositions of key players will be videotaped for the benefit of interested parties, courts and perhaps the movie (documentary or fictionalized) that seems to be inevitable.

Instead of dawdling too long over all of the foregoing (too much ink and space on the Internet has already been taken), I turn to the repeated lament of Steve Harper of Northwestern University School of Law, retired Kirkland & Ellis partner, noted author and keen observer of the legal profession. Harper recently returned to a theme he has repeatedly previously eloquently addressed, namely, the devolution of the concept of law firm equity partner, particularly in the face of Dewey & LeBoeuf’s utter deconstruction.

The fact is that in Dewey World, a good number of the firm’s most highly compensated partners were not in fact equity partners, although they proudly bore and boasted of having that moniker.

The hornbook definition of a partnership is two or more people engaged in a business who agree to share the profits and losses of that business. The Dewey highly compensated partners did not share profits.  Rather, they were apparently bestowed with contracts which provided them with fixed premium incomes, regardless of their own production or the firm’s profitability.  I guess we all now know that this business model doesn’t work. Actually, we learned this lesson in 1987, with the demise of Finley, Kumble , then the world’s second largest law firm, but as Santayana said, those who have failed to learn the lessons of history are destined to repeat them.

The point is why did all of these very smart, accomplished and talented lawyers take on the visage of “equity partners,” when that was simply not the case? There doesn’t seem to be any rational explanation.  These soon to be former highly compensated Dewey equity partners are soon to have some of the torments of Dante’s financial inferno visited upon them, as, among other things, they will be subject to clawbacks, loss of capital, adverse tax consequences and clawforwards.

A noted bankruptcy lawyer, who himself suffered through these torments as his firm went bankrupt thirty years ago said that he would never be a partner in a law firm again. His observation was that partners can do things to you even spouses can’t do, without your express consent:  They can make you liable for substantial debt, they can encumber your assets and otherwise wreak very real financial and professional havoc. This lawyer continued to practice for many years quite successfully and with a substantial client following at several very large successful law firms. Yet, he always was simply “of counsel” or “counsel” to the firms. His income never suffered and he says he never missed out on an engagement because he didn’t possess the adornment of partner. Given his success and standing at the bar, he had a voice in all significant law firm decisions. He was never inclined to take less money than he was worth only to have what he described as a meaningless ego gratifying title on his business card.

So, let’s see what happens to those who took on the honorific of being an equity partner in a world where partners are free agents and where partners are employees at will:  These ex Dewey partners will probably face years of legal proceedings as well as serious adverse financial consequences. They will likely have to repay substantial sums. Had they been salaried employees dubbed as counsel or of counsel and subject to simple written employment agreements (which in many senses, they actually were), they would be creditors of the bankrupt estate, entitled to priority treatment with regard to payments to which they claim an entitlement. The estate would be sending them checks, not the reverse.

Surely, ego is likely to prevent accomplished lawyers from taking what is ostensibly a step down, but that bruise to the ego should be assuaged by simple financial and other real world vagaries.

The interesting irony is that some of these highly compensated partners may well take the position in ensuing litigation that in fact they were not partners at all but merely highly compensated salaried employees and should be treated accordingly in the bankruptcy process. I can’t predict how the courts will react, but I would note that for the last thirty years, the lower levels of the law firm partnership have frequently claimed that they, too, were not actually partners; they were nothing more than salaried employees working for wages only. They had no role in management, and at best, were “mushroom partners:” kept in the dark and fed muck. The argument, while repeatedly made, has never gained real favor, except that mushroom partners (a term of art in law firm liquidations) typically wind up writing smaller checks than those at the summit.

© Jerome Kowalski, May, 2012. All Rights reserved.

Jerry Kowalski is the founder of Kowalski & Associates, a consulting firm serving the legal profession exclusively. Jerry is a regular contributor to a variety of publications and is a frequent (always engaging and often humorous) speaker to a variety of forums. Jerry can be reached at jkowalski@kowalskiassociates.com or at 212 832 9070, Extension 310

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