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Protecting a Law Firm’s Crown Jewels


Protecting a Law Firm’s Crown Jewels.

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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

 

Saving Dewey & LeBoeuf


Saving Dewey & LeBoeuf.

Leverage is Back: The Return of the Pyramid Business Model for Law Firms, with a Twist


Leverage is Back: The Return of the Pyramid Business Model for Law Firms, with a Twist.

Leverage is Back: The Return of the Pyramid Business Model for Law Firms, with a Twist


English: Great Pyramid of Giza.

Image via Wikipedia

Jerome Kowalski

Kowalski & Associates

February, 2012

 

Yesterday marked the 35th anniversary of my admission to the bar. The day passed quietly, without note or fanfare. But it did cause me to reflect on how things have changed.

In 1976, when I graduated from law school, there were some basic covenants to which all subscribed: If you did well in college, you got in to law school; if you worked hard in law school, you got a job at a good law firm; if you worked very hard as an associate, had the tenacity, appropriate degree of intellectual rigor and good humor, managed not to offend for the term of your clerkship, you were promoted to the partnership and looked forward to lifetime tenure, a sinecure from which you could not be removed and would not dream of leaving until you entered your dotage. Many, 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 movement was as rare as hen’s teeth. If a law firm partner in those days suggested that the firm should de-equitize partners so that the firm’s numbers would look better, he would be directed to a psychiatrist for emergency treatment. Partnership had real meaning, it was not an at will employment status and partners would not for a moment think of themselves as free agents, available to the highest bidder. Partners were proud owners of the enterprise. There was genuine esprit de corps, mutual respect, pride, loyalty and genuine collaboration.

These ruminations were prompted by the piece recently written by my friend, Professor Steve Harper, entitled “The Lateral Bubble,” a must read for anyone toiling away at or near BigLaw. Frankly with all of the buzz in the blogosphere and elsewhere concerning Harper’s piece, it seems that all have read it already or pretended to have done so, at the very least.

Professor Harper, no fan of partner free agency, observes that partners are no longer proud owners of the enterprise. Rather, he observes that BigLaw’s “currently prevailing business model encourages partners to keep clients in individual silos away from fellow partners, lest they claim a share of billings that determine compensation. Paradoxically, such behavior also maximizes a partner’s lateral options and makes exit more likely. In other words, the institutional wounds are self-inflicted.”

Harper quotes admiringly another recent article by Ed Reeser and Pat McKenna entitled “Crazy Like a Fox” in which the authors articulately demonstrate in cogent fashion how meaningless the Profits Per Partner metric is  (disclosure: Ed Reeser is also a good friend of mine and has been an occasional contributor to these pages; Ed and Steve do not know each other, but I can assure you that they are kindred spirits in every possible respect).

Say Reeser and McKenna:

“Over the last few years there has been a dramatic change in the balance of compensation, to a large degree undisclosed, in which increasing numbers of partners fall below the firm’s reported average profits per equity partner (PPP)…Typically, two-thirds of the equity partners earn less, and some earn only perhaps half, of the average PPP.”

In 2010, I wrote about the emergence of a three tiered caste system for associates in BigLaw:  Firms now employ “partner track associates”, “non-partner track associates” and “staff lawyers”.  The partner track associates are those from the best schools, with the best grades who toil away the hardest and whose academic credentials are touted to clients and potential lateral partners. Non-partner tracks associates are those who fared a little less well, and who have a fairly short shelf life. The staff lawyers are those who are most akin to day laborers, who float from gig to gig, often paid subsistence wages and receive no benefits.

Well, then, what’s good for the sauce for the goose  is good for the gander. Partner ranks have now evolved into a new three tiered caste system as well:  Highly compensated equity partners, a second tier of less handsomely paid equity partners and a great swathe of contract partners. As Harper, Reeser and McKenna observe, the ratio of compensation from the most highly compensated equity partner to the lowest is staggering; in some firms it’s ten or twelve to one.  The ratio for most highly compensated equity partner to the lowest level of contract partner is often even greater.

While we may have thought that The Great Recession brought about the demise of the leverage model for law firms and that the new model for the Twenty-first Century Law Firm is an inverted pyramid, the good news, folks, is that leverage is back and the pyramid has similarly returned to its old footings.  Except that the pyramid is no longer one with a broad base of associates and partners decreasing in number at each higher level of the edifice. With the devolution of associate ranks to the caste system, the refusal of clients to pay for first and second year associates and clients’ not permitting law firms to mark up and sell at a profit the work of temporary staff lawyers, associates no longer make up the base of the pyramid. Rather, it’s the ranks of contract partners who lie at the base of the pyramid and support those at its summit. As those at the top need more support for their compensation requirements, some equity partners find themselves cast into supporting roles keeping the rich and famous comfortably enjoying the view from the top. If more financial support is needed, partners are simply de-equitized, move down a notch and then fill out the base of the pyramid. Partners deemed insufficiently productive are asked to leave. The notion that partners are owners of the enterprise is gone.

Ample anecdotal evidence from the field corroborates the return of the leverage model, albeit at the nominal partner level. We have heard from scores of managing partners that those at the partner at the partner ranks busier than ever, working longer hours and grinding out the work as never before. Equity partner compensation at the pinnacle is at eye popping numbers.

The only issue not yet adequately addressed is the future of the pyramid when those at the top see the lush neighboring pyramid across the expanse with a taller peak, more lavish accommodations emitting a siren call for all those who want even more. Collapse of the structure comes not from erosion at the supporting base, but rather from the loss of the pinnacle.

Keeping the structure erect and enduring simply requires a return to the days of yore when all partners truly felt like they were proud owners of the enterprise, and a return to feelings of genuine esprit de corps, mutual respect, pride, loyalty and genuine collaboration.

© Jerome Kowalski, February, 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.

Citibanks’ Fourth Quarter Report on Law Firm Profitability: Bleak, But, on the Bright Side, That’s As Good As It Gets


Citibanks’ Fourth Quarter Report on Law Firm Profitability: Bleak, But, on the Bright Side, That’s As Good As It Gets.

Citibank’s Fourth Quarter Report on Law Firm Profitability: Bleak, But, on the Bright Side, That’s As Good As It Gets


Citigroup Center
Citigroup Center (Photo credit: LifeSupercharger)

Jerome Kowalski

Kowalski & Associates

February, 2012  

                                                                   

Don’t have enough to fret about?

Citibanks’ report for law firms for the fourth quarter of 2011 is out for and there is little in it that brings cheer. It also gives some us some sense of prescience in that our 2012 forecasts seem to be being realized. Earlier observations on Citibank’s third quarter report and its mid year report, all read in sequence, paint a rather unhappy portrait.

Consistent with what we all have all been seeing in recent weeks as law firms begin announcing results for 2011, last year generally saw a barely perceptible rise in revenues (4.1%) and continued rising expenses. The continued escalation on the expense side is of some serious concern as law firm managers continue to devote substantial energy to irradiate an ever metastasizing wave of expenses, with the wave of rising expenses seemingly unstoppable.

Here is some of the other disturbing news:

  • Citibank noted that in the second half of 2011, demand for legal services, “particularly in transactional work, withered away and has yet to bloom again.” In our view, we do not see transactional work flowering soon because of the moribund capital markets, the decline in asset value and the business world’s disinclination to take risk in uncertain times.
  • The report notes that profits per equity partner at the law firms surveyed rose an average of 3.3% in 2011. However, by hewing to the PPEP artifice, the report does not report how much of this increased profit was derived by de-equitazation, “shortening of the collection cycle,” expense deferrals or other accounting legerdemain. While Citi did report that “equity partner head count grew only marginally, reinforcing the view … it has become a lot harder to become an equity partner and remain an equity partner.”
  • While hourly rates increased slightly, realizations declined. Of course, that’s like the law firm partner who, when asked what his hourly rates are replies “$1,000 an hour when I can get it, but that’s rare, otherwise it’s $450.”
  • Headcount grew marginally more than demand, resulting in a decline in productivity.
  • In order to get to the modest increase in PPEP, law firms slogged the living daylights out of their accounts receivable. Well, that’s good for the take home pay for partners in 2011, but it adds to the challenges of 2012, since both demand is weak and there is less A/R in inventory to turn into cash in the current year.

What does this all mean for the current year? Citi tells us “all said, not a bad year and we suspect likely to be the new definition of a good year for the legal industry at least for the foreseeable future.”  In other words, this is about as good as it gets. By that, could it be that like Jack Nicholson’s character, could we find happiness in this somewhat addled state?

Citi is also telling law firms that it’s time to trim the herd again in order to increase productivity and realizations. So, I am afraid that we will see another round of layoffs, lateral moves, de-equitizations, and mandatory retirements. If you are a partner in law firm, pay very close attention to how your firm is doing, since there is a strong likelihood that we will sadly see some law firm failures; you need to be prepared and not caught by surprise.   And if you are a vendor or service provider to law firms, look for cutbacks and a longer remittance cycle.

© Jerome Kowalski, February, 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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