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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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How to Succeed in BigLaw While Really Trying: A Four Act Unfinished Play, Now Playing at a Law Firm Near You


Is that Herman above the tree?

Is that Herman above the tree? (Photo credit: mali mish)

Jerome Kowalski

Kowalski & Associates

March, 2012

 

Dramatis personae:

Herman Laforge; 64 year-old chairman of Biglaw, Global and Powers, an international law firm with roots in the Midwest.

Marvin Shades; managing partner of BG&P;

Sheila Shuster; CFO of BG&P;

Setting:

Tower floor of Manhattan skyscraper overlooking the canyons of Manhattan.  Act I takes place in late January 2009.

Act I

Laforge:

I am still breathless.  What a year 2008 has been! Those banks going out of business weren’t as harmful to our business as I feared.

Shuster:

I don’t know Herman. We had some deals and some litigation work from these banks for which we collected fees through the third quarter, but then new deal flow stopped and the lawsuits were then stayed by the bankruptcy filings. New matter openings in the firm slowed by about 40% in the fourth quarter and hourly billings were down about the same in Q4.  I don’t see those picking up during the first few weeks of this year. We could be in for a disaster this year. We just don’t have enough work to keep everybody busy.  If this continues, we may be in for a disaster this year.

Laforge:

Have we got the preliminary numbers for 2008 yet?

Shuster:

Yes, Herman, they are in your packet. Be careful about these – these are the real numbers – not what we release to the media.  As you can see, our gross was down 11% and our net was down by 14%.  The net might have been worse, but, fortunately, we laid off about 60 lawyers and about 100 support staff.

Laforge:

How does our profits per equity partner look?

Shuster:

We took a pretty big hit here. PPEP was down about 16%.  We may take a beating from the media on this one, but from what I hear, there are lots of firms that are in the same shape.

Laforge:

That doesn’t make me any happier.  Look, I built this firm by growing, merging and opening offices in the major US markets. I was only able to do that by boasting about our growing PPEP and showing potential acquisitions that our PPEP was up there with the top New York, California and Washington firms.  I had to get it out of everybody’s head that we were just another sleepy Midwestern law firm. That’s why I move to New York. If our PPEP takes a dip, I am afraid that we’re going to have trouble growing.  We’ve got to get our PPEP back up there.  Shirley – you got any bright ideas?

Shuster:

Well, Herman, PPEP is just a function of dividing up profits among our equity partners. We could increase PPEP by either raining profits, which are is going to pretty impossible in this economy or having fewer equity partners.

Laforge:

You may be on to something there, Shiela. Look, our partners are actually paid pretty much what I tell them they are going to be paid. Our budgeting is pretty good in stable years. Why don’t we take a bunch of our equity partners and take them out of the equity class – we’ll de-equitize them. We’ll just call them income partners. We’ll just explain to them that at the end of the year, they’ll make as much money as before and that we just have to make this adjustment temporarily to please the media. We’ll give them contracts so that their incomes will be protected.

Shuster:

But, Herman, we already have a problem with our non-equity partners. They weren’t as busy as they had been in the past. In fact, their hours billed were down about 20% last year.

Laforge:

Tough times require tough decisions. Let’s lay off about 10% of our income partners. That should seal the deal. And as long as we’re at it, let’s take another look at our associates and support staff and see if more cuts should be made there. If we’re going to take on some hard nasty news, let’s do it all at once. Get O’Brien in the media department to have a press release ready if word about this gets out to Above the Law. Say something about aligning our partnership and support structures to an ever changing and challenging economy.  And throw something about how we are very strong and confident. Oh – and say something about how we’re looking forward to a great year.

Shades:

Can we do all of this?  I mean, legally. These guys are partners, after all.

Laforge:

These are tough decisions, but we get paid big bucks to make these tough decisions. We made these folks partners and I guess we can unmake them as partners.  Everybody will understand that we are doing this for the good of the firm. Let’s also be strict about our mandatory retirement policy. No waivers. Period.

Act II

January 2010.

Laforge:

It’s been another doozie this year.

Shades:

At least cutting some of our equity partners last year kept our PPEP respectable.

Laforge:

But our gross still keeps slipping. We have to pump that up.

Shades:

Any ideas, Herman?

Laforge:

Let’s get back to our game plan for growth. We got to 1,200 lawyers by lateral hiring. Lots of it.  A lot of other law firms have done what we have done – de-equitize partners.  Partners at law firms are just free agents. Let’s now hire some real big producers and shell out some real money for these guys. Real money invested begets real returns if you hire carefully. If necessary, we’ll lean on some of our partners to defer some of their comp to cover these costs. After all, it’s for the good of the firm. Make sure O’Brien sends out a great release saying how we are continuing to grow.

Shades:

Sounds like a plan.

Act III

January 2011

Shades:

It looks like we are beginning to bounce back. We got some really good talent and bought some nice business. Even after paying for our ramp up expenses, we are showing some real improvement in gross, net and PPEP.

Shuster:

Yes, but the expense side keeps going up at a higher rate than the profit margin.

Laforge:

Sheila – you’re going to have to cut some support staff again.

Shuster:

I’m on it, Herman.

Laforge:

What are we going to grow the revenue side this year, Marvin?

Shades:

We are going to continue to buy talent and business. I’ve also been speaking to a bunch of other managing partners whose firms have pretty good numbers. A lot of these guys have pretty good networks of international offices. They say that these networks of international branches are great for servicing clients with global needs. They also say that having these networks gets them on the short lists for big ticket items where clients have the needs for international resources on matters where the stakes are high and they can charge big bucks. They also say that these international offices are pretty good feeders of business to the US offices.

Laforge:

You’re saying –

Shades (Interrupting):

Yes, let’s go global big time.

Laforge:

Sounds like a plan.

Act IV

January, 2012

Shades:

Hermann, on paper, we’re looking pretty good. Our gross is up 4%; Sheila got our net up by 11% but we are still getting killed with expenses rising quicker than revenues. On top of that, in order to get the cash in the bank, we have squeezed our clients to pay every bill possible before year end. We did a pretty good job on that with the help of Sheila’s staff. Sheila also did a great job on juggling our accounts payable, deferring payments until 2012 to keep our net as high as possible.

Shuster:

Thanks you, Marvin. But, we now have some new problems. Getting those clients to pay quickly ate in to our inventory. Our accounts receivable are at an almost unacceptable level.  The banks have noticed that and have raised some questions. On the expense side, we are cutting and pruning and we are way down on what we can cut. Our accounts payable numbers are much higher as a percentage of revenue than they ever have been. And while a 4% increase in revenue seems commendable, it is only slighter better than flat. We still need to increase the revenue side.

Laforge:

Look, guys – this isn’t a complicated business- we put in hours, charge by the hour and get paid by the hour. Just tell everybody to bill more hours. I’ve read that a couple of firms are doing that.

Shuster:

We have another problem, Herman. We lost a couple of our old time producers last year. They took a chunk of business with them and the press is starting to ask questions. The truth is that I tool this pretty hard – after all I’ve known these lawyers for thirty years and I found it hard to believe that they didn’t appreciate what we were doing for them in building the firm.

Laforge:

I don’t get it. What ever happened to loyalty?

Shuster:

It’s just not like the good old days, is it, Herman, is it?

But we have another problem brewing, you know when we went on that lateral hiring spree a couple of years ago, we asked some of our second and third tier partners to defer their comp to help pay for the new business. Well the total of deferred comp is getting a little out of hand and some of our partners and the banks are beginning to worry about that.  Some of the guys leaving are telling me that the whole deferred comp idea is one of the reasons they decided to bail out. And the press is starting to ask some hard questions.

Lafarge:

Look, Marvin, you get O’Brien to prepare another press release saying how we’re really doing well and that these partners leaving is part of our ongoing efforts to align ourselves with market realities. And you may as well let everybody know that we’re going to be laying off some more lawyers and support staff. You know, the alignment thing.  We’re not the only ones going through this.

Shades:

Herman – with all due respect, I think we need a more comprehensive approach on the media side.  Look, we saw Howrey go down last year.  The leadership there just didn’t appreciate how what they were telling the media helped sink them.

Lafarge (rising, very agitated):

Are you saying that we’re in danger of sinking? Is that what you’re saying?

Shades:

No Herman. Calm down. Every law firm is at its essence a fragile business. The point is that we need to recognize the realities. We must level with all of our partners. We need to make sure we are all working together as a team for a common purpose.

We also need to make sure that our partners understand that if we continue to get bad press and they continue to bail, we could, heaven forbid, be this year’s Howrey. We need to make sure that every partner understands that the personal consequences to the partners if we tank are extremely dire.

Let’s take our own statements seriously. Let’s really make sure that all of our partners are actually properly aligned and that all are compensated fairly.

Lafarge:

Sounds like a plan.

Curtains Draw to a Close

Author’s Curtain Call invitation to his audience:  Please help me with writing the fifth act. How do you think this production should end?

 

 

© Jerome Kowalski, March, 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.

What is the Fair Market Value of a Full Service Commercial Law Firm?


The Mumbai Stock Exchange stands tall, and is ...

Image via Wikipedia

Jerome Kowalski

Kowalski & Associates

February, 2012

 

 

A short piece in today’s the Wall Street Journal caught my eye: The Journal reported that a report was just issued that “estimates that top U.K. law firms are worth between $711 million to $4.1 billion, with Magic Circle firm Allen & Overy leading the pack.”    The report the Journal made reference to was brief and from Europa Partners which stated that it had just completed its second annual valuation of UK based law firms and found that “Law firms are valuable businesses; six of the top ten by value are large enough to be included in the FTSE100 if they were listed.”

I wonder.

When I went to school, I learned that the definition of value was “the price a willing buyer would pay a willing seller, each negotiating n good faith and neither under duress.”  Well then, is there a willing buyer out there for any of these firms?  We don’t see any. The Alternative Business Structure, sometimes called the Tesco law, does allow for non-lawyer ownership of law firms in the United Kingdom and Wales. But, as I predicted some time ago, there aren’t any non-lawyer buyers lining up or kicking the tires for large commercial law firms. With the top ten magic circle firms valued in the eye-popping range of $711,000,000 to $4,200,000,000, I suspect that more than a few equity partners at these well heeled law firms would be seriously thinking about cashing in their chips if there were a willing buyer out there. I know you would. I certainly would.

We have all learned the hard way that lawyers, trusted business advisers to the global markets, have concocted the silliest business model for their own business.  In any other endeavor, a business owner invests capital, sweat equity and builds a viable enterprise and looks forward to an exit strategy, where he or she could sell the business or perhaps leave it to his or her children. Lawyers can do neither. If they are lucky, they get to retire voluntarily when they are ready (not when they are forced to) and then simply get their own money, namely, their capital contributions, back over a period of years. Maybe a nice dinner with a couple of partners is thrown in as well. But no premium and no premium for having built a successful business. Anti-nepotism rules typically preclude a bequest of a partner’s ownership rights to his or her offspring.

More painfully, a large commercial law firm has less than zero value on liquidation or winding down.  In fact, such scenarios have been enormously costly for partners in such law firms.

Well, then, what is a commercial law firm worth? Nothing, really. I have no idea what Europa Partners’ valuation methodology was, but whatever methodology was deployed, it certainly couldn’t result in a fair market value with the standard textbook definition of value.

The Achilles’ heel in valuing a law firm is that its most valuable assets, its working partners, ride that old elevator down every night and in this age of partner free agency, there is only a hope and a prayer that these assets will return the next day to contribute to the production line. Our colleagues across the pond do have an advantage in maintaining some value for these assets in some respects in that the rules in the UK do allow for “garden leaves,” under which a withdrawing partner can be compelled to spend many months after he or she withdraws from a law sitting at home enjoying the garden or just sucking wind. But, in most of the United States, Rule 5.6 of the Model Code of Professional Conduct bars a lawyer from entering into any agreement which restricts him or her from practicing law. No restrictive covenants here.

But, I digress.

The point is as we go through the wrenching changes wrought by The Great Recession, clever lawyers, with a bit of self interest should be thinking about re-designing the entire business model of law firms and the delivery of legal services. While the American Bar Association dithers with little bits of the non-lawyer ownership of law firms issue for no good or productive reason, the market – and clever lawyers – will develop a new structure which create a new structure for the delivery of legal services, which will have real value, be saleable and scalable. Our LPO competitors have already figured out how to do so and may be soon eating our lunch. And their enterprises have real value.

© 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.

 

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.

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


Citigroup Center
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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.

Private Equity Investments in Law Firms Have Arrived in the UK and Have Largely Ignored BigLaw; What Will Happen as This Phenomenon Arrives in the United States?


Tesco in St Peters Street, St Albans. Historic...

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                                                                                      Jerome Kowalski

                                                                                      Kowalski & Associates

                                                                                      February, 2012

After so much anticipation, the law permitting nonlawyer equity investment in law firms (“Alternative Business Structures” or “Tesco” laws) took effect in England in November and for BigLaw, it is much more of a yawn than a yowl. I can’t say I am very much surprised. I previously predicted this result.

As some have noted, the proceeds of capital infusions by outside investors in large law firms will likely be applied to technology and most particularly knowledge management systems, all with a view of lowering costs to consumers of legal services. The result would be increased commoditization and reduced revenues per lawyer. Thus, the consequence of such investments may well be that unless one creates a Goldman Sachs-type leverage ratio (10,000 to 1?), an extremely unlikely result for any law firm; the investor will simply not get the anticipated return. Moreover, as clients become increasingly reluctant to pay for associates’ time, particularly first and second year associates and the profession continues to move to an inverted pyramid model, that kind of leverage just won’t happen.

The practice areas which yield the highest return still remain in the plaintiffs’ class action bar and in big stakes high end plaintiffs’ contingency cases. The recent acquisition by Australian based, publicly held Slater & Gordon of Liverpool personal injury firm Russell, Jones & Walker for £58 Million serves to prove that point. Similarly, just yesterday, private equity firm Duke Street announced an LBO for insurance litigation firms Cogent Law and Plexus Law.  Massive class actions and other high end cases chew up enormous amounts of capital. Law firms which have been active in this world have already amassed substantial capital and have the internal resources to fund these cases. Some still utilize traditional institutional lending from banks at favorable rates. Others utilize litigation funding companies which do tend to charge exorbitant interest rates; but, then again, these funding companies accept all of the risk in making non-recourse loans and at the end of the day, they do not remain partners of the law firm.

Others have noted that outside investors in a firms would exert some degree of control within a law firm and the danger they highlights is that such investors will impair the independence of the lawyers’ judgments in directing that efficiency, rather than the clients’ best interests will be a driver in handling a client engagement, all in violation of Rule 1.1 of the Model Rules of Professional Conduct.

An added impediment is the preservation of client secrets and confidences. Non lawyer investor participation in law firm management necessarily makes non-lawyers privy to such secrets and confidences, with no mechanism to police the maintenance of such confidentiality by these non-lawyers.

Ultimately, the killer ethical rule in the United States that dooms private equity investment is not the confidentiality provisions or the requirement that lawyers act with independence. Rather, it’s one never mentioned in the discourse on this subject: The prohibition that bars lawyers from entering into agreements that limit their ability to practice law. Thus, equity investors in law firms could never have any assurance that a law firm’s most valuable assets — its partners– would exercise their free agency rights and ride down the elevator one day, never to return.

As the ABA agonizes over whether US law firms should permit nonlawyer employees of a law firm to hold an equity investment in law firms, the real question concerns the underlying issue of adoption of Tesco laws in the United States. The New York State Bar Association announced just a few days ago that it would create a committee, under the capable leadership of immediate past NYSBA president Stephen Younger to study the issue. But, even as he seated this committee, current NYSBA President Vincent Doyle proclaimed that the Association “remains opposed to nonlawyer ownership of law firms.” Sounds like a fair unbiased hearing on the subject won’t be very likely here.

The reality is that bar associations and government regulators were and continue to be asleep at the switch as nonlawyer owned and unlicensed LPO’s moved and continue to move to openly practice law in the United States and nonlawyer owned and unlicensed Internet providers of legal services do the same, These phenomena were the result of market forces and a bit of ingenuity and brazenness by these entities and the sloth of the regulators. The fact is that we do have a model under which non lawyers can effectively invest in law firms (yes, even commercial law firms), earn a solid return and even exercise some degree of control in what we believe to be an ethically compliant fashion. Interested, call me and ask about it.

© 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.

It Shouldn’t Suck to be an Associate at a Law Firm, Part II


Front page of the first issue of The Wall Stre...

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                                                                             Jerome Kowalski

                                                                             Kowalski & Associates

                                                                             January, 2012

                                                                            

Today’s Wall Street Journal  features a piece entitled “Law Firm Keep Squeezing Associates,” which will likely engender some great buzz on the blogosphere serving the law firm associate population and, in all likelihood, a yawn from law firm partners. This article comes on the heels of the second annual extravaganza, attendance for which is appropriately limited to but a few elites, entitled “The Annual Spring Bonuses Follies.” In all events, I would suggest that perhaps law firm partners and law firm leadership ought to take a closer at some of the issues raised in the Journal.

The Journal generally addressed the well worn issue of fewer openings at BigLaw and fewer job prospects for recently graduated law students. Anecdotal evidence suggests hiring is down about 30% (a fact we also have observed as generally true). The Journal also mentioned the longer and rockier road to partnership.

But the big takeaway in the piece, a fact well already known to many of us, is that since the crash four years ago, associate compensation has been stagnant, while the average associate has seen an increase in his or her workload by 2.3% since 2007, which the Journal calculates to be approximately 50 additional hours a year.  The new base “normal” appears to be approximately 1,650 hours a year, which the Journal Suggest amounts to about 37.5 hours a week; the Journal relies on the besieged NALP (hardly a bulwark for full and open disclosure where employment opportunities for lawyers are concerned) for arriving at this conclusion. Yale Law School last year did its own math and concluded that in order to bill 1,850 hours a year, an associate needed to spend at least 55 hours a week in the office, with three weeks of vacation and two weeks of vacation, sick days and holidays.  Yale concludes that in order for an associate to bill in the 2,000 a year range, he or she will need to work for about 12 hours a day and three weekend days a month. And that does not accurately include time spent at departmental meetings, firm functions, commuting, serving on administrative committees, recruiting, pro bono work, griping about being overworked or otherwise shooting the breeze with colleagues, friends or family. The reality, as we all know, is that an honest time reporter needs to work in the seventy hour a week range.

But let’s get back to that additional 50 hours a year squeezed out of associates since the onset of The Great Recession. Roughly translated, at an average of $300 an hour, associates have each contributed an extra $150,000 to their respective firm’s bottom line, without their firm’s incurring any incremental cost. A few firms, in an entirely short sighted fashion, in our opinion, have bestowed “Spring bonuses,” generally topped out at $37,000, while the bulk of BigLaw firms have simply enhanced partner profitability.

The fact is that Spring bonuses have a Marie Antoinette quality about them, a sort of noblesse oblige.  As Steve Harper noted, law firms should do better. They do not enhance associate morale nor do they halt associate attrition. The temporal cure to associate attrition has been an abysmal job market. But, for those who are planning on checking out, all that many law firms have done is have associates defer packing their bags until the bonus check clears. Spring bonuses not quite as satisfying as yesterday’s passing summer breezes, the recent autumnal foliage or Thanksgiving turkey. The breezes, foliage and turkey will likely return at their respective times and seasons; Spring bonuses, who knows?  With law firm revenues rising last year at a sluggish 3% and expenses at 9%, law firms, under pressure to keep PPP at the highest levels and the bulk of AmLaw 100 firms having gotten along just fine without them, this chimera will likely evaporate.

Well then, what’s the point?  There are two: We all know that associates are law firms’ most important profit centers. We also need to be reminded that keeping the young men and women toiling away productively at 60 hours a week, during their decade-long march to the brass ring, optimally requires them to have a high degree of job satisfaction, which has nothing to do with compensation or bonuses.  For nearly a century, every study performed by every industrial psychologist and labor economist has consistently reported that when people identify the reasons they leave their jobs, they rate compensation at the very bottom of their lists.  Overwork ranks at about the same. We know how to keep associates satisfied and productive, but we largely continue to ignore long learned basic human resources principles.

So, let’s take a look at the extra $150,000 per annum each associate is contributing to law firm revenue streams.  Why not engage your associates in a dialogue as to what should be done to improve their lives. Some might suggest an increase in base compensation to help them amortize student loans (and if you hear that don’t wince and worry what the neighbors might think), some might suggest rolling the work squeeze and laying off some of those collective additional 50 hours a year on a couple of new associates. After all, if you have 100 associates, you have effectively replaced two associates by having those remaining in the galleon just row harder. Exhausted oarsmen often collapse or jump ship. The golden chains of Spring bonuses won’t keep your associates tied to their oars. In fact, even The Great Recession and the burden of student debt do not necessarily keep them in the ship’s underbelly deprived of sunlight and overworked; one associate recently left his firm to open a bike shop, anther jumped ship to simply walk across the country.

The second point is quite simply, it still shouldn’t suck to be an associate at a law firm.

© Jerome Kowalski, January, 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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