Advertisements

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.

Advertisements

Citibank’s 2011 Mid-Year Survey of Law Firms: Instead of Giving Its Customers New Toasters, Citi is Telling Many of its Law Firm Customers that They May Become Toast If They’re Not Careful


                                                           

                                                                                                      Jerome Kowalski

                                                                                                     Kowalski & Associates

                                                                                                      September, 2011

 

My, my, how things have changed.  When I was a kid, banks would induce prospective customers to open a new account by giving away a toaster to new customers. Today, Citibank is warning some of its law firm customers that they may be toast, or at least the may be seriously singed in the current economic climate.

I refer, of course, to the 2011 mid-year report by Citibank on the economic conditions of the profession.  Citibank’s law firm lending group, led by Dan DePietro, is uniquely suited to provide an in depth analysis of  the financial conditions of the profession, since it serves some 600 law firms and 58,000 lawyers in the United States and the UK, by far the leading lender to the profession. We start with the good news:  Says Citi “For the first half of 2011, revenue was up 3.7 percent across the industry. The increase was driven by strong inventory levels coming into 2011, increased rates, a 1.8 percent growth in demand and likely improvement in realization.”  The bad news:  Expenses are growing at a faster rate and the rate of increase in expenses is outstripping revenue growth.

As Citibank noted, one  portion of expense growth is attributable to those law firms which engaged in what many see as the  silliness of associate “Spring bonuses,” an artifice designed to stem the metastasis of associate attrition.   That carcinoma is far better treated by taking less expensive and more productive steps to assure associate job satisfaction and otherwise improving the quality of life for associates. Not a single lawyer left his or her firm because it wasn’t providing Spring bonuses.  Yet scores left within nanoseconds after  their Spring bonus check cleared.  Simply put, Spring bonuses do not get associates to stay a little bit longer.

Citi also reported that AmLaw 50 firms reported that realizations were beginning to return to pre-recessionary times.  Before we toss out the confetti, bear in mind that this refers only to AmLaw 50 firms; moreover, it does not address the real concern about a still stagnant economy, the continued volatility in the capital markets, the continuing fear of a double dip recession and the coming tsunami should the current turmoil in the Euro Zone erupt into utter chaos.  Add to those unknown factors, Citi notes that “headcount was flat,” and expenses continue to increase at a rate of 4.7%, which obviously exceeds the rate of revenue increase.  Citi put it to us straight: “the economy appears to be in for a protracted period of slow growth.”  Frankly, in light of the light of Citi’s
litany of gloomy statistics, even this mild bit of optimism strikes the informed reader as being unwarranted exuberance, unsupportable by economic realities.

Inexplicably, Citibank viewed it as a positive sign that many firms increased their “inventory” be retaining a larger portion of WIP (that is, for the uninitiated,  recorded but unbilled “work in progress”).  In reality, stale WIP may be theoretically billable, but rarely collectible.

There are other significant factors in the marketplace, not specifically addressed by Citibank which must further dampen any enthusiasm:  First, law firms have too long delayed making needed investments in infrastructure.  The need to make these investments is becoming increasingly crucial, indeed vital,  as alternate vendors of legal services continue to gain market share.  One of the only ways to meet this competition is through acquisition of state of the art technology.   Failure to meet this challenge, these alternate vendors will eat many law firms’ lunch within five years.

Citibank also foresees a period of significantly increased lateral movement, as  organic growth becomes more difficult to achieve, productive performers will jump ship from underperforming firms, and underperformers will be eased off the gangplanks.  I’m afraid Citi is missing part of the boat here in that it does not address the fact that taking on laterals requires substantial investment in ramp up and other expenses, while reduction in headcounts will reduce revenues (although there is always a short term illusory positive blip in ramp down).  In essence, Citibank is reporting that we may be in for a period of cannibalism as firms eat each other’s flesh.

The Citibank is silent with respect to one important feature of great interest to law firms; that is, how open will Citibank make its own coffers to law firms in a  market it characterizes as one “of
protracted slow growth,”  particularly as Citibank is likely to take a some form of haircut in the Howrey bankruptcy.

My own sense is that Citibank will undertake a greater degree of vigilance in reviewing its own existing credits and in extending new credits.  And, as it did in Howrey, where Citi loses confidence in the credibility of its borrowers, it will more quickly pull the plug.

Okay, so what’s the takeaway?

Here’s my views:

1.   In many respects Citibank is functioning very much like a typical consultant.  By that, I refer to the classical definition of a consultant:  Somebody who takes off your watch and then tells you what time it is.  There is little that Citibank has told us that we didn’t already know, but when somebody smart tells you something that should be obvious, the listener tends to stand up and pay attention.

2.  As we approach the fourth quarter, it is imperative for management to start planning for the coming storms and share with the partnership that management has taken a look at the sonar and  advise the partnership how the firm proposes to weather the inevitable storms.  The cruise ships of old always had two captains:  One who appeared in dress whites and instilled  confidence in the passengers; the second was a seasoned and wizened sailor who worked tirelessly at the helm to bring the ship to port. Law firm partners need to have the confidence that its ship of state has both on board and the captains need to enjoy the confidence of all stakeholders.

3.  In days of yore, pressure on profits resulted in simply billing existing clients more hours. These days are gone. General counsel, aided by purchasing agents and corporate project
managers are more likely than ever to put an early stop to inflated hours.  They also have alternate providers of legal services whispering into their ears, “we can do this better, quicker and cheaper.” Firms need to figure out how to do so as well.  This may require the firm to form a strategic partnership with an alternative provider of legal services or create its own subsidiary or affiliate. In all events, despite some great advances in technology, you still can’t produce a product at cost of $100 and sell it at $80 and then make up the difference in volume.

4.  Firms cannot delay infrastructure investment any longer.  That may require biting the bullet and investing firm profits in essential infrastructure and simply swallowing the dubious ignominy of a short term drop in PPP. If you take this route, issue a press release early on announcing that the firm has such a high degree of confidence in its own future, it is making a substantial investment in its  own future, foregoing short term PPP in favor of  long term growth and viability. Alternatively, private equity firms are prepared to invest in a state of the art legal processing law firm affiliate, but will obviously be a significant equity participant in the profits of that venture. The paradox of this essential new technological infrastructure is that it will result in the delivery of legal services at costs lower than currently prevail in BigLaw, but is made essential by the mounting competition of alternative providers of legal services.   The ethical rules precluding non lawyer ownership of law firms play no role here. (Professor Larry Ribstein of the University of Illinois School of Law very recently conducted a compelling online symposium on the de facto and de jure deregulation of the practice of law).  Indeed, Clearspire, a breathtaking new model law firm is built entirely a new model, owned in essence by non-lawyers. The result is that Clearspire offers an array of quality BigLaw legal services by BigLaw trained lawyers, primarily at fixed fees and bills at a fraction of BigLaw rates. An important warning here:  Do  not look to private equity as the safety net that will allow BigLaw to weather the coming storm.

5.   We know what many of the unknowns are.  Gaze carefully over the horizon and be mindful of oncoming unknown unknowns.  As Captain Smith of the Titanic said “We do not care  anything for the  heaviest storms in these big ships. It is fog that we fear. The big icebergs that drift into warmer water melt much more rapidly under water than on the surface, and sometimes a sharp, low reef  xtending two or three hundred feet beneath the sea is formed. If a vessel should run on one of these reefs half her bottom might be torn away.”  We may have survived the big storms, but if we permit the fog to cloud our vision, we might sink.

© Jerome Kowalski, September, 2011.  All rights reserved.

 

Jerry Kowalski, who provides consulting services to law firms, is also a dynamic (and often humorous speaker) on topics of interest to the profession and can be reached at jkowalski@kowalskiassociates.com .

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.

%d bloggers like this: