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Difficult Times Sometimes Create Desperate People Who Do Desperate Things: Loss Prevention in Handling Client Escrow Funds


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Jerome Kowalski

Kowalski & Associates

January, 2012

My copy of the Model Code of Professional Responsibility runs to some 500 pages, with sundry commentaries.  The Code plumbs virtually aspect of a practicing law and details that which can be done by lawyers and that which may not. One relatively brief section deals with lawyers handling of client funds held in the law firm’s escrow account, sometimes called “Escrow Accounts,” “Special Accounts,” “Trust Accounts” or “IOLTA (Interest on Lawyers Trust Accounts – but this one is a long and irrelevant boring story).   Cut to the quick, the Model Rules say just three things:  (1) Don’t co-mingle these funds with any other account; (2) deal with these funds exactly as instructed by the client and affected parties, as detailed in an appropriate escrow agreement and (3) if you even think about screwing around with these rules, you’re gonna fry.

In New York City, the Departmental Disciplinary Committee, the judicial authority having authority over lawyers’ compliance with applicable rules, investigates thousands of complaints filed against lawyers for all sorts of alleged violations of the applicable rules.  Yet, perhaps 80% of all suspensions and disbarments result from either defalcations or co-mingling of client funds. Here, justice is swift and certain. The Committee has long had a zero tolerance policy with regard to any impropriety concerning client funds, a view held by all governing bodies. Suspension or disbarment is the only result.

These facts are well known to all practitioners and may even strike some as a hackneyed topic. But recent reports of significant defalcations by a former counsel at a BigLaw firm of what may be as much as $20,000,000 and in another instance of the chair of a global law firm’s Asian gaming group having allegedly slipped out some $2,000,000 from client escrow funds to allegedly cover his own gambling losses suggest that this topic requires  careful review.  Indeed in year-end reviews by several of our law firm clients, prompted by the recent tawdry headlines, controls over client escrow funds were studied and found to be lacking. There have also been a recent spate of unsubstantiated rumors concerning of escrow account improprieties that are, simply put, more than troubling.

Some law firms dispense with the entire issue by simply eschewing, as a general rule, the maintenance of any escrow accounts. Where funds are required to be escrowed, these firms advise the retention of an independent trust company, bank, title company or where permitted, a duly licensed escrow agent.  However, often, local custom and usage requires law firms to maintain escrow accounts, which are fraught with peril, if not subject to stringent controls by the law firm. These controls should be described in writing and the firm’s policies regarding client funds should be in writing and part of its employee  handbook.  These rules should also be part of every new lawyer’s orientation session as he or she arrives at the law firm.

The required controls begin with the commencement of the client relationship. Every engagement letter must contain a disclosure regarding the law firm’s escrow policies. The letter should describe the firm’s policies concerning escrowed funds and, particularly, the requirement that all funds released from escrow require two partner signatures. Funds released by wire transfer require a separate email confirmation from a law firm partner to the escrowee.  The engagement letter should require the client to report any departure from these rules to the firm’s managing partner. The need for the double signature and reporting is best demonstrated by the fact that in one of the recently reported instances of trust fund defalcation, a counsel of a national law firm is reported to have taken a check drawn payable to his law firm, as escrow agent, walked across the street and simply opened an account in the firm’s name, making himself the sole signatory, without the bank requiring any certification from any partner at the law firm.

The law firm should not allow the deposit of any escrow funds without an accompanying escrow agreement. Thus, the firm should have a tightly drafted model form of escrow agreement, with appropriate exculpatory language, from which there should be no material departure, except upon written consent from department head, an office head or an executive committee member.  Each such agreement should also require the signature of such a member of management. When funds are deposited in to the escrow agreement, the requested deposit should only be permitted to be made to the accounting department of the escrow agreement, the underlying agreement, stipulation or other instrument giving rise to the creation of the escrow, as well as a memo (or standard form) from the responsible lawyer describing underlying transaction and the conditions precedent for the ultimate release of the escrow. This initiating memo should also include the client’s contact information. The memo form should be countersigned by a member of management. A member of the accounting department should examine the entire submission for regularity and completeness.  Any departure from the firm’s escrow policies must be reported in writing by the escrow clerk to the responsible lawyer, as well as to a member of management (optimally, if the firm has an in-house general counsel, the mater should be addressed to him or her), even if the departure seems to be only clerical or ministerial.

When funds are mature and are required to be released, the responsible lawyer should prepare a new memo (or standard form), describing the transaction should be prepared by the responsible lawyer and countersigned by two partners with management responsibilities, such as an office head, department chair or member of the executive committee. The submission should again include the underlying escrow agreement and governing instrument. Again, the escrow clerk should examine the entire submission for completeness and be obligated to report in writing any irregularities to each of the lawyers who have already put their fingerprints on the escrow arrangement as well as general counsel or a designated separate member of management. As I mentioned above, all checks drawn on the escrow account should require the signature of two partners, neither one of which is directly involved with the matter.  If a wire transfer is required, the clerk should send a confirmatory email to the client, using the email address originally provided at the time of the original submission.

Where law firms sometimes screw up is in connection with smaller branch offices, at which smaller support staffs and reduced lawyer headcounts often breeds shortcuts, for the sake of expediency. The fact is that far greater scrutiny is essential for smaller branch offices, which often takes on a degree of laxness and informality, primarily because of the greater sense of intimacy such smaller offices promote. In the age of the Internet, emails and paperless offices, there is no excuse for departing from the required controls. There simply must be zero tolerance for any departure from these controls. After all, bar associations and other governing bodies have none.

The law firm’s general counsel, chief financial officer and its chief risk manager should be responsible for regularly monitoring activities in the firm’s escrow accounts and its escrow clerical staff. As much as law firms are allergic to certified financial audits, the law firm’s outside accounting firm should be required to annually audit its escrow funds and provide written certification that all controls are in place and there is full compliance with the firm’s stated policies.

Finally, as too few lawyers realize, defalcations from escrow funds are not covered by a law firm’s malpractice policies. A separate fiduciary policy is required. Insurance carriers tend to be rather chintzy on these policies, often limiting coverage to $5,000,000. That may be far too low, if your firm’s escrow balances or individual escrow accounts exceed that amount.  You should explore increased coverage or excess coverage with your insurance adviser. And, finally, always be prepared for the public relations hailstorm that will assuredly ensue if you are indeed the victim of a nefarious lawyer with your 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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What are the Most Significant Legaltech Changes You Have Seen During Your Careers?


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Jerome Kowalski

Kowalski & Associates

December, 2011

 

While our heads continue to spin with emerging technologies which have dramatically changed the way we practice law, the ABA has asked me to write a piece for its Spring GP Solo Magazine, marking the journal’s fiftieth anniversary,  describing how technology applying to the practice of law has evolved over the past one-half century.

I certainly remember the old days of secretaries taking dictation through Greg and Pittman shorthand, with spiral bound special steno pads, with the wire spiral on the top so that the pages could be quickly turned.  I also remember old fashioned Dictaphones, which were ultimately replaced with microcassette tape recorders.  I also remember carbon paper and the old fashioned wet waxy photocopy machines.

The next big change was electric typewriters which ultimately morphed into ubiquitous IBM Selectric typewriters and then the birth of IBM Mag Card machines, a word processor of sorts that had no screen. A few years later, word processing was born, first with the Vydec machine, improbably manufactured by Exxon.

We used to send urgent messages by Telex and we had cable addresses.

Do you remember any of these?

I think that the first rattling change was the advent of the fax machine (printing out on endless roles of waxy paper at the rate of four minutes a page).   A few years later, law firms acquired mainframe computers for accounting and word processing.  CRT’s hadn’t yet found their way on to each secretary’s desk and certainly not on any lawyer’s desk.  The next big change was the birth of the personal computers.  That was followed by Al Gore’s invention of the Internet.  The Internet begat emails, which frankly was one of the business world’s most rattling game changers.

Some lawyers carried pagers. Then one day, we all had cell phones. Cell phones morphed in to Blackberries. Blackberries in turn morphed in to smart phones.

Once upon a time, we had conference calls; today we have video conferences.  We used to travel to CLE classes and bar association meetings, today we attend webinars sitting at our desks or in our dens.

We finally put computers on our desks and then laptops came along. Laptops are now being replaced by tablets.

We used to send our clients detailed legal memoranda and other complex legal documents by mail or fax.  Today, we are in the business of Knowledge Management and manage elaborate Extranets.

We once had armies of young lawyers reviewing documents.  Today, that function is handled by computers.

Clients used to come in to the office and meet with their lawyers and obtain their counsel. Today, clients are just as likely to obtain legal services from an Internet based provider of legal services.

Lawyers used to look for jobs through recruiters; today they use job boards.

We used to have young associates and paralegals assemble documents.  Today, we have computer document assembly systems.

We used to record time on slips of paper. Today they are recorded real time on a mobile app. And in some instances, we no longer even record time.

While many lawyers resisted every change to the way they do business, they were often left with little choice but be dragged along, often kicking and screaming.

Let me know what you think the most significant technology changes you have witnessed over the past many years and why.  Tell me about your own experiences in adapting to each of these technologies as they came along.  And also let me know where you see the next wave of changes coming in over the horizon and what, if anything you plan on doing to cope with the next technological revolution.

© Jerome Kowalski, December, 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

The Key for Law Firm Growth and Survival for the Coming Years is Contingent on Mastering Collaboration


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                                                                             Jerome Kowalski

                                                                             Kowalski & Associates

                                                                             December, 2011

 

In the 1967 Academy Award winning Mike Nichols film, “The Graduate” a young Dustin Hoffman starred in his breakout leading role as Ben Braddock, a recent college graduate, who was floundering about trying to figure out what to do with his life after graduation. Early in the film, Braddock’s parents hold a graduation party for Ben, during which friends and family offer Ben all sorts of career advice. In one famous line, a family friend takes Ben aside and whispers “Ben, all I have to say to you is one word: Plastics” and then walks away,

As we contemplate what will doubtless be a challenging 2012, I have one word to say to all of you:  Collaboration.

In 2010 the concept of the year was “Alternative Fee Arrangements” and value billing. In 2011, it was LPO’s and outsourcing. Plastics, AFA’s and LPO’s have stayed with us since they each emerged as the flavor of the month; so too will collaboration.

Yesterday, I had the pleasure of attending The National Law Journal’s Managing Partner’s Breakfast, which was led by a panel consisting of Tom Mills of Winston & Strawn, Alice Fisher of Latham and Elizabeth Stern of Baker & Mackenzie, each of which served as their respective law firms’ Washington offices managing partners.

All generally had some serious concern, but guarded optimism for 2012.  Panel Moderator, NLJ Editor in Chief David Brown asked many probing questions. Interlocutor Brown based much of his probing predicated on Citibank’s foreboding report on law firm profitability for the third quarter of 2011.

Each panelist separately presented his or her own version of the same theme:  Their firms were engaging early and often with their clients and were being proactive in both anticipating their clients’ needs, objectives and issues were on every level. The key to success was adopting a collaborative mode on every front.

Liz Stern of Baker & Mackenzie put it best, when she said the old model where lawyers were simply like taxi drivers with their meter running. “The meter is running, but the taxi driver doesn’t really care where you’re going,” Stern said. “It’s about getting your fare.”  That model, Ms. Stern said, just doesn’t apply any longer. Lawyers need to understand why the client is embarking on the journey, what the most efficient route is to that destination and arrive at an understanding as to what a reasonable fare is for the journey, predicated on the value of the journey is to the client. Client and law firm need to reach a shared understanding of each of those issues and the only way to do that is by engaging early and continuing to engage as the journey proceeds.

Collaboration must be conducted both horizontally and vertically.  Client collaboration is if course essential, as is collaboration among the law firm partnership. In addition, I would suggest that further collaboration among other stakeholders, such as LPO’s, e-discovery vendors, staffing companies and other law firms serving these same clients. Clearly, a strong hub and spoke system is required with the client at the hub. Those who master collaboration on each of these fields will emerge as the winners in 2012.

Collaboration begins of course with the direct attorney client relationship, bearing in mind that given the shift in supply and demand, clients are fully empowered, as never before. Legal services are now being acquired through the prism of purchasing agent mentality.  Under that lens, the purchasing agent often first makes a “make or buy” decision; and more often, making is less expensive than buying.  Thus, we have seen a rather universal growth of legal departments and a reduction in budgets for the outside legal spend. As Jones Lang general counsel Mark Ohringer recently said, “I am law firms’ biggest competitor.” Said Ohringer “If I could have 100 percent of the work not done by law firms, I would.”  Ohringer  currently keeps 75 percent of his corporation’s legal work in-house or sends it to non-firm vendors.

Recognizing this reality, law firms need to engage proactively with such general counsel and collaborate with non-firm vendors demonstrating through such proactive engagement that the firm, working collaboratively with general counsel could provide better value and more favorable total pricing. Failure to engage here, is that general counsel of the mind set of Ohringer may well succeed in keeping all work out of the law firms. Such general counsel are primarily interested in getting the job done better, cheaper and faster.  That mindset does not denote a universal fatal allergy to outside law firms. The antidote to this allergy is engagement and collaboration.

Mark Hermann, chief litigation counsel at AON and a former BigLaw lawyer recently wrote a compelling essay concerning one of his company’s outside law firms regularly assigning a litigation partner to handle work for his company and Hermann consistently found this partner’s work sub-par.  The law firm just didn’t get it and it appeared that the relationship was becoming strained. Hermann explained that greater enragement and collaboration was necessary to maintain the relationship. He even laid out in direct terms how law firms should engage:

 First, have disinterested lawyers — partners not involved in representing the client — solicit candid feedback from clients. Solicit that feedback mid-year, so the conversation doesn’t conflict with an annual year-end review. During that session, listen carefully to what the client says. (Hint: “I rate the quality of your firm’s work as just below middle of the pack” is not praise.) Ask the client what your firm can do to improve (or expand) the relationship, and heed the advice you receive.

Second, impose real quality control on partnership decisions. A client that has a bad experience with just one of your partners may mistakenly choose to condemn your entire institution. This makes the quality of your partnership awfully important. Try to apply uniform criteria, applied equally across all offices, when you make partnership decisions. Hire lateral partners sparingly (because you probably know little about the true quality of those folks’ work).

Finally, think about how you can encourage clients to switch lawyers, rather than firms, when clients are unhappy with the service they’re receiving. If it were easier (and less embarrassing) to replace the lawyers working on a team, then firms would not lose clients unnecessarily.

We have all read about the explosive success of Clearspire. Clearspire’s success is not merely that it is a virtual law firm, with minimal expenses. It is built on an elaborate custom digital platform which provides for real time, full time collaboration among its lawyers and in real time among its clients.

 

            Some other vital areas for collaboration:

  • Understanding fully the strategic goals and objectives of your clients by engaging in detailed face to face regular discussions with them.
  • Recognize that some of your clients work will be downsourced to smaller firms.  Offer the clients your availability to collaborate with these firms so that they can take advantage of your pool of built up knowledge and experience so that the smaller firm can work more efficiently. And, yes, offer to share your work product with them. After all, the client already paid for this work.
  • If you are one of the smaller firms that is the beneficiaries of the downsourcing, ask the client to assist you in collaborating with other firms with which it has worked so that you are not reinventing the wheel.
  • In some engagements, a law firm will essentially function as a general contractor, with clients directing the law firm to subcontract work to a variety of vendors.  There are many moving parts and disparate players in these engagements.  For the law firm/general contractor to succeed, its principal function is not only to direct and supervise the work of the various subcontractors, but to also share full time, real time collaboration.
  • Build a strong collaborative relationship with LPO and e-discovery vendors, making sure that the clients is very much part of this process. Insist on full time and active collaboration and choose an appropriate real time extranet platform for such engagement.
  • Recognize that general counsel’s office is overloaded and offer a program of secondments.   Liz Stern of Baker & Mackenzie explained how her firm has effectively established a global system of regular secondments that has stood her firm in good stead for many years.
  • Build up your extranet capacity. Engage your clients on the extranet. Get them to utilize the extranet for real time collaboration and feedback. Ask the clients if your extranet platform is adequate.
  • Monthly bills should be a further platform for client engagement and collaboration. Every monthly bill rendered should be accompanied by a letter that describes the objectives the firm had set out for the preceding month for the matter, the steps the firm had taken to meet those objectives, the results and the objectives for the next month. Even where the matter is undertaken on a fixed fee or an AFA, these monthly letters are essential.
  • Engage the clients regularly on discussions regarding bills you have rendered, preferably through either a relationship partner or a non-lawyer professional. Identify issues early and address them collaboratively with the client.
  • Collaborate internally on all strategic goals. Make sure your partnership is fully engaged on all key strategic decisions. Tom Mills of Winston and Alice Fisher of Latham made it clear that all lateral acquisitions are strategic, based on firm leadership and partner consensus.  Latham apparently has most of its laterals visit each of its domestic offices and sometimes each of its foreign offices.
  • Be sure that the legal work the firm is handling is fully integrated with those best suited to do the work are handling the work.  That means that originating partners should not assign work only to members of his or her own “team.” Rather, practice group leaders should guide the assignment of work. Do not allow partners to create silo practices.
  • Keep the partnership fully informed and engaged in the firm’s strategic goals.  Share both the good news and the bad news in real time. Fiats emanating from behind smoke and mirrors breed resentment and distrust,
  • Build consensus.

Plastics were indeed a boom industry in 1967.  Collaboration will be a boon to those who master  the art in coming months. Those who fail to adequately collaborate both vertically and horizontally and vertically do so at their own dire peril.

© Jerome Kowalski, December, 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


Much Ado About Nothing: The ABA’s Ideas About Admitting Nonlawyers to Law Firm Partnerships; “Alternative Law Practice Structures”


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                                                                             Jerome Kowalski

                                                                             Kowalski & Associates

                                                                             December, 2011

The American Bar Association’s Commission on Ethics 20/20 just released its long awaited “Discussion Paper on Alternative Law Practice Structures.”  The report immediately brought to mind  Judge Posner’s recent decision in which he bench slapped a lawyer in a written and illustrated opinion by comparing him to an ostrich for ignoring an obvious case which the court felt controlled in the matter sub judice. My take is that the Commission simply ignored facts already on the ground and, more significantly, completely sidestepped the more urgent question, namely whether the United States would follow the lead of the United Kingdom and permit non lawyer ownership and equity investments in law firms. Our cousins across the pond call this model “Alternative Business Structures” or sometimes the “Tesco” model (the latter based on the ubiquitous retailer of that name).

The essence of the Commission’s report, predicated on the notion that lawyers in the United States some current ethical strictures relaxed so that they can effectively compete on the global stage, mandate the following changes which would permit nonlawyers to hold equity in a law firm, subject to the following strictures:

 such law firms would be restricted to providing legal services;

 nonlawyer owners would have to be active in the firm, providing services that support the delivery of legal services by the lawyers (i.e., the firm cannot be a multidisciplinary practice);

 nonlawyer ownership and voting interests would be restricted by a percentage cap sufficient to ensure that lawyers retain control of the firm;

 nonlawyer owners would be required to agree in writing to conduct themselves in a manner consistent with the Rules of Professional Conduct for lawyers; and

 lawyer owners would be responsible for both ensuring that the nonlawyer owners in their firm were of good character and supervising the nonlawyers in regard to compliance with the Rules of Professional Conduct.

These recommendations are, frankly, superfluous and add nothing to the current marketplace. . More significantly, market forces and realities have already pushed the envelope way beyond the Commission’s shortsighted vision.

For example, the Commission noted that many proponents argued that in order to attract the highest quality management and support staff that today’s legal market demands, law firms should have the opportunity to provide these personnel with an equity kicker. But, the fact is that the market long successfully dealt with this issue by simply paying top quality nonlawyer support personnel partner level compensation and bonuses. Famed comedian Jackie Mason does a great riff on how some people just want to be called partners for bragging rights, but the fact is that as Jerry McGuire said, “just show me the money.” And as we well know, law firm partners are nothing more or less than employees at will.

Second, the purported extant strictures limiting the services a law firm can offer to the delivery of legal services have long been ignored and circumvented through the creation of law firm subsidiaries that offer a plethora of services, some not even law related.

Moreover, substantial nonlawyer control currently exists in that many law firms are rather tightly controlled by their lenders.  It is often said that Citibank owns more law firms in the world than anybody. And banks can exercise the ultimate control:  they can force a law firm to shut its doors.

The final piece of what is to me plain silliness are the peculiar requirements that nonlawyer partners need to be vetted to be assured that they have the character and fitness required for bar admission and their conduct must be monitored by lawyer partners to assure that they are in full compliance with the Rules of Professional Responsibility.  Who is going to do this vetting?  And should a nonlawyer partner violate one of the Rules, who is going to be subject to discipline?  As I said before, top notch professionals just want to be “shown the money” and treated with professionalism and respect.  Having a business card that contains the word “partner” is no assurance of financial reward, job security or being treated with respect or dignity.

The tonier topic, is of course private equity investment in law firms.  As for that issue, the Commission blithely said

The Commission has ruled out certain forms of nonlawyer ownership that currently exist in other countries. In particular, the Commission rejected: (a) publicly traded law firms, (b) passive, outside nonlawyer investment or ownership in law firms, and (c) multidisciplinary practices (i.e., law firms that offer both legal and non-legal services separately in a single entity).

But whether you are a believer or a doubter concerning the Alternative Business Structures, it is a topic that demands immediate attention and public debate.  But as with so much else that Commissions do, it simply kicked the can down the road and agreed to continue to study the issue.

As that can goes rolling down the road beyond any visible horizon, the United Kingdom, hell  bent  on being the home base to the world’s great law firms, will take robust advantage of its substantial head start, legal services will be increasingly be provided by nonlawyer owned and unregulated Internet providers of legal services and  offshore LPO’s will continue to take larger market share, again in an environment where they are not owned by lawyers, not regulated and often under insured.

My expectation is that the next step in the evolution of  law firms will largely continue to evolve and form significant joint ventures with non-traditional providers of legal services.

In one of the next belated iterations of the Commission’s discussion papers, the Commission and the bar will arise from its long slumber and look around at a brand new world and perhaps even wonder “how did all of this happen; who was asleep at the switch?”

© Jerome Kowalski, December, 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


Lateral Law Firm Partner Movement in This Winter of Our Discontent


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                                                                             Jerome Kowalski

                                                                             Kowalski & Associates

                                                                             November, 2011

 

With the lateral market heating up at year end, a quick reference guide for essential due diligence for law firms looking for successful lateral partner candidates and for the candidates themselves

Not quite like the precisely predictable annual migrations of the swallows of Capistrano, this winter will mark a greater movement than usual of law firm partners as partners are likely to seek lateral moves in numbers not seen in many years.  As recently reported by Citibank, many law firms are looking for lateral partners to meet recently declining revenues. Many partners are looking for lateral opportunities because of the opposite side of the same coin:  Declining profits per partner are taking large chunks of change out of their own pockets and, accordingly, they are looking for greener grass in other pastures.

Added to this are serious disruptions  at many firms caused by law firm partners who have engaged in various departures from acceptable behavior, such as one law firm partner who is alleged to have engaged in improprieties resulting in a $32mm loss to his law firm; another law firm which appears to be exposed to clients’ claims arising out of improper tax shelters promoted by a former partner; and the recent tragic tale of a BigLaw partner who allowed a client to launder some $19,000,000 in apparently improperly obtained funds through his firm’s escrow accounts. Some of these claims may be covered in whole or in part by insurance.  But these events are, in the very least, major disruptors, since nobody enjoys his or her income reduced by another’s improprieties and management diversions in dealing with the attendant issues keeps management’s hands off the till, which must be held steady in these stormy waters.

An increasingly significant additional disruptor is the disproportionate number of AmLaw 200 firms with rock solid middle market practices who are aspiring to elbow their way to be among the rarified few at the very top of the food chain whose practices involve the “bet the company” cases where $1,000+ hourly fees and waves of assault troops are deployed, without particular reference to the cost of the particular project.  These middle market law firms often have a fair number of productive partners with commendable and substantial practices of many years standing, but their middle market practices, while yielding many millions of annual fees to the law firm, simply do not fit the firm’s aspiration to serve only the titans.

The final disruptor is the fee pressure imposed on law firms in general, as the legal spend for outside counsel continues to diminish and, at the same time, competing vendors, not always traditional law firms, compete for pieces of the diminishing pie. More significant practice areas have become commoditized, putting more pressure on firm profitability.

            The short fact is that there are more partner resumes floating around than in many, many years. And all of these folks are looking for places to land the day after their final distribution for 2011 clears.

Hiring lateral partners falls someplace between a high end art auction and a cattle auction.

While I have previously discussed the due diligence essential for a law firm to identify a lateral partner as well as the due diligence in which a lateral candidate should conduct, given the likelihood of more lateral movement than in many years, there are some essential basic points that require repetition and emphasis.

  1. Client conflicts.  After the initial meet and greets, the lateral should be asked to disclose his or her fifteen or
    twenty largest clients. The law firm should disclose its 100 largest clients. The law firm should obviously conduct a thorough client conflict review. All too often, the client conflict check is left as one of the final steps in the vetting process.  Huge mistake.  The exchange of client information must be one of the very first steps in the process.  And a thorough client and adverse party check should be among the second steps in the process. If a client conflict makes the deal a non-starter, so be it – but this is something easily enough determined early on.  There are times when a client conflict is less than obvious, such as when identifying adverse and related parties. I was involved last winter in an unfortunate situation in which a firm spent months recruiting a nine lawyer group, during which all of the disclosures were exchanged and deals were ultimately made. Literally, as the laterals were packing their boxes and preparing to move in the next day or so, the law firm’s conflicts department began to input all of the laterals’ detailed client matters, only to find that there was a serious conflict between one of the firm’s major clients and one of the lateral’s large clients.  The conflict could not have been discerned by any cursory review of a client list.  Yet, the conflict was irreconcilable.  The firm was compelled to withdraw its offer and the lateral had to go back to his management and essentially say “never mind, I think I’ll stay for a while.”

          2.      Historical Financial Performance.  As I discussed elsewhere, a thorough review of prior years’ performance is essential – both for the candidate and the law  firm.  Trendlines are of the essence. Has a major client or business segment been lost?  Is the graph showing a steady downward, upward or straight line?  A guide for a lateral candidate’s review of a law firm’s financial reports is available here.

3.    Business Plan.  Both the lateral candidate and the law firm should have a business plan and each should familiarize himself or himself with the other and make sure they mesh. Is, for example, the law firm about to embark on a major hiring campaign or is it looking to be acquired or merge with a firm of equal size?  If that’s in the cards, the firm you will ultimately be working for won’t be the same one you are negotiating with.

4.       Responsible vs. Originating Partner.  In reviewing the list of matters a potential lateral partner is bringing, carefully review whether the lateral partner candidate is in fact the responsible partner for the bulk of the work he or she is bringing with him or her. In these continuing finder, minder and grinder allocations of profits, partners are sometimes wont to overstate their roles.  Thus, a corporate lawyer with a close relationship with a client that has a rewarding penchant to engage in litigation, may be receiving a great deal of current credit for the litigation fees generated by the client.  But, when the rubber meets the road, the client may well leave a great deal of its litigation work behind under the care and feeding of litigators who have been doing work on particular matters for years. By the same token, an outstanding service partner, who may have been performing the same type of work for particular clients for which another partner may be taking the originating credit for historical imperatives, is often likely to walk away with that client’s business, since clients are largely indifferent to “origination” or “responsible” partner nuances. Clients simply prefer to call the lawyer they have known for years and who the client knows will get the job done.

5.      “Why have you decided to leave your law firm?”  Every interviewer asks this question and every lateral candidate has a rote response.  The recent instance of a lawyer joining a new law firm the day before he was apprehended for allegedly absconding with some $2,500,000 in client funds held in the trust accounts of his former firm, suggests that the response to the question requires more than unblinking acceptance of any rote response.

6.   Prior litigation. Most, but not all, law firms include in their questionnaire for lateral partners questions concerning prior litigations in which they have been named as a party. In the case of one disgraced former BigLaw partner, who not only had an impressive number of law firms at which he served, he also left a long trail of litigation, most sounding in malpractice, in his wake. I don’t know if his last stop, before pleading guilty, asked the question, but if the firm did, it does not appear to have either been fully answered or whether somebody thoroughly read the answers. Similarly, every lateral candidate should be informed of pending or threatened litigation in which the firm is involved.

7.    Fiduciary Relationships. Every lateral law firm questionnaire typically asks if the candidate serves as an officer or director of any corporation or LLC.  Few ask if the lawyer serves as a fiduciary, such as an executor, guardian or other legal representative of another party.  Serving in such capacities, which is not an automatic disqualifier, frequently involves managing the financial affairs of another party, which is not covered by any standard malpractice policy. The firm should obtain a solid understanding of the lawyer’s role and impose standard checks and balances to assure that all funds are properly monitored and disbursements subject to a triple set of signatures.  In addition, the firm should also be sure it has adequate fidelity and E&O coverage.

8.     Unfinished Business.  I recently discussed the long arm of Jewel v Boxer clawbacks. Under this doctrine, if a firm dissolves, the revenue derived by a partner of the defunct firm as well as the revenue derived from his new firm based on matters begun at his current law firm are assets of the defunct firm. Some mistakenly believe that Jewel v Boxer is an aberration of California jurisprudence. It is, for better or worse, good law in New York and elsewhere. The point is that if you, as a hiring or managing partner have a large pile of resumes of partners from a given law firm and you are hearing troubling news about the financial affairs of that law firm, stand up and take note.  Be aware that a lateral coming from that firm, should it fail, will be the payee on your firm’s accounts payable schedule for the duration of those matters.

9.    Google.  Conduct a Google search for every lateral candidate and ask about any entry that is of any concern to you. Similarly, every lateral partner candidate should conduct a Google search concerning the law firm and ask the hard questions where appropriate,

10.    References.   Every firm asks for at least three references.  I have yet to meet (as I doubt you have) any lawyer who would provide anybody other than one who would provide a reference that might make a mother blush. Dig a little deeper.  Seek out former partners and adversaries.  And ask the tougher questions. The candidate should ask about the last four or five partners who left the firm and should not hesitate to reach out to them. Sure, there may be some sour grapes, but there will also be some newly acquired wisdom.

11.   Know the Market. Cattle prices are fixed by the market and are easily accessible. Similarly, there is literally a bluebook for checking on market prices for fine art. Partner compensation is similarly market driven. A lateral candidate with a known amount of portable business has a fairly good sense of what his or her compensation should be in any given market.  If he or she doesn’t know, he or she can figure it out fairly quickly (and if you don’t know, just call me).  Lateral partner compensation bears virtually no relationship to PPEP.  If a law firm offers a partner compensation dramatically disproportionate to the market, politely decline and move on.  Similarly, a lateral candidate demanding compensation materially above the market is probably not going to be a colleague whose company you enjoy.

12.   Practice Integration Plans. I have too often heard managing partners complain that lateral hiring is a hit or miss proposition.  When I inquire about the firm’s disappointments, I always ask what the firm did to integrate the lateral partner in to the firm’s practice, the response is that the lateral partner was given an orientation to the firm’s IT system and was taken to a number of lunches by various partners.  I am afraid that this just doesn’t do the trick.  A practice integration plan is a carefully crafted written plan jointly prepared by the candidate and the firm laying out in detail how the lateral partner will be fully integrated into the fabric of the firm, maximizing synergies, making the lateral and his or her client base a vital organ of the firm, while simultaneously marketing his or her services to both other partners and clients of the firm. Failure to prepare and execute a practice integration plan assures that you will have more misses than hits.

Follow these important steps and you will end up with either an exquisite masterpiece or a prize steer.

© Jerome Kowalski, November, 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 .

Citibank’s Third Quarter 2011 Report on Law Firm Profitability: The Good News is That Cash Collections Were Up for the Quarter; The Bad News is There is a Lot More Tunnel at the End of the Tunnel


North East from 30 Rock (Including CitiGroup)

North East from 30 Rock (Including CitiGroup) (Photo credit: TGIGreeny)

 

                                                                             Jerome Kowalski

                                                                             Kowalski & Associates

                                                                             November, 2011

 

As law firm expenses continue to rise more quickly than revenues, law firms are looking at a real hole in their buckets

Like so many of us, I so admire and respect Citibank and the leader of its law firm lending group, ably headed by Dan DiPietro.  I not only look forward to Citi’s quarterly reports on law firm profitability, but as so many of us do, I carefully parse through Citi’s reports, since even when Citi informs us that storm clouds are about and more are to come, it somehow manages to give the impression that the climate is balmy and sunny days are ahead.

In this regard, Citi’s report for the  third quarter of 2011 does not disappoint. Not that Citi reports much good news nor does it predict coming good times; but, as always, Citi, the master of euphemism, posts some important warnings in terms that seem to provide some comfort. But, the fact remains that, after performing some exegesis of Citi’s most recent report, it is clear that Citi is telling us that current law firm economics are not very rosy and the coming months are foreboding.

Citi, which serves some 600 law firms and 58,000 lawyers in the United States and the United Kingdom, likes to lead with the good news and here it is: Cash collections for the third quarter were strong,  The bad news:  Demand for legal services continues to decline, marking the fourth quarter of consecutive decline in demand for legal services, while during the same period, expenses continued to rise,  consistent with Citi’s last report.

Says Citi:

 Cumulative growth in demand for the first nine months was 1.5 percent, down from 1.8 percent during the first six months. This indicates that growth in demand slowed to only 0.9 percent for the third quarter. This is likely a result of the slowdown in transactional work caused by the market shake-up. The slowdown has hit Am Law 50 firms (the 50 highest-grossing firms on The Am Law 100) particularly hard.

Citi went on to note that rate increases remained steady at 3.7% and realizations were strong.  But a moment later, it also cautioned as follows:

 Expenses, which had already risen by 4.7 percent during the first half of 2011, continued to gain momentum during the third quarter, as they have now increased 5 percent across the industry for the first nine months of this year. This was driven by a continued increase in operating expenses—and in compensation expenses, since we saw a slight uptick in head count during the third quarter, likely due to the entry of first-year associates.

Quite obviously, where your rates are increasing by 3.7% and your expenses increasing by 5%, you are slowly losing ground. Citi acknowledged as much:

This modest increase in associate head count, combined with the slowdown in demand in the third quarter, translated into a decline in productivity gains—from 1.6 percent growth for the first six months of 2011 to 0.9 percent growth for the first nine months.

Tucked away in the middle of a following portion of its report is the most disturbing news of all in the current report, dealing with the very troubling decline in demand for future legal services and continued decline in WIP:  Citi’s report on WIP showed that WIP is currently at

 3.6 percent for the first nine months (versus a cumulative growth rate of 6.3 percent for the first six months). The last time we saw the third-quarter inventory growth rate slowing from the first-half rate was in 2008.  [Emphasis Added].

Citi went on to report on the winnowing down of equity partner ranks at law firms, while increasing activity in lateral hiring. Lateral partner hiring is certainly a positive sign; it signals optimism by law firm leadership and the willingness to fill in valleys of revenue decline by bringing in new partners with loyal client followings. But robust lateral partner recruiting is far from a panacea.  Every lateral partner comes at a real cost, consisting of recruiting fees, where applicable, and the investment in “ramp up.”  For the uninitiated, ramp up consists of that period of time which commences when the lateral partner and his professional and support staff join the firm and are fully compensated until the time that their efforts result in revenue to the law firm, a period typically lasting approximately ninety days.  Thus, while successful laterals do contribute to WIP, they do add materially to the expense side, which some firms have attempted to treat as capital costs. But in simple cash accounting, laterals cost money and mitigate equity partner profitability.

The reader must be mindful that Citibank’s survey is skewed in that it is largely based on AmLaw 100 firms – “44 Am Law 1–50 firms, 36 Am Law 51–100 firms, 49 Second Hundred firms, and 54 additional firms.”  Those firms at the top of this food chain are largely hiring laterals by showering them with gold, not always a great idea..  Firms on the lower end of the food chain are faring much better, in our own experience.  We are seeing many mid-size firms picking up quite a number of attractive top tier law firm partners, who are being squeezed out of AmLaw100 firms simply because their client bases, often quite substantial just won’t swallow the $1,000 hourly rate level required by the top tier to feed its expense levels.  The fourth quarter of every tear is the season of redemption for many, as lateral candidates anxiously scour the market scooping up offers that they will formally accept as soon as the spoils of the previous year are distributed.  Mid-size law firms – the “additional firms” in Citibank’s report – have actually done remarkably well these past two years and they are scooping up many of the soon to be AmLaw 100 refugees at record rates.

The continuing decline in the leverage model and decreased work available for firm lawyers also did not escape Citi’s attention:

 We have recently begun highlighting in our roundtables the rising cost of leverage for law firms. Looking at the 100 most profitable firms from 2001–2010 in our database, we saw a discernable decline in the percentage of associates represented in the leverage composition and a significant growth in the income partner, counsel, and of counsel categories. The result is a much more expensive leverage model, which would be fine if these more expensive lawyers were as productive as equity partners and associates, but they are not. In looking at average annual lawyer productivity from 2001 to 2010, income partners and counsel worked about 150 hours less than equity partners and associates.

“Much more expensive leverage models” is simply a euphemism for the fact that the Cravath system continues to disappear and service partners and counsel as important profit centers are similarly withering.  In other words, the old pyramid model hasn’t really disappeared; it has just been turned completely upside down.

There was also rising concern at Citi concerning the continued growth of Alternative Fee Arrangements and lowered reliance on billable hours, which Citi is concerned might result declining law firm profitability. As I have discussed in the past, AFA’s can actually enhance profitability, if properly managed, and current economic climes, with both declining demand for legal services and increased competition for those legal services require law firms to be more agile and develop new, more efficient and more profitable models for the delivery of legal services.

Citibank, like everyone else, expects an exceptionally hard push for final quarter collections. After all, following a rather difficult year of rising expenses and weakening demand, the need to boast of high PPEP is largely contingent on an extraordinarily strong squeeze in coming weeks.  But as corporate clients have mightily increased their own cash management and stretched out account payable schedules, these efforts may very well be an irresistible force meeting an immovable object.  Something’s got to give.

My own advice is forget about boasting about your PPP; instead, make the far more important investment in enhancing the firm’s long term relationships with its clients.

© Jerome Kowalski, November, 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

A Jewel [v. Boxer] is a Law Firm Bankruptcy Trustee’s Best Friend; Unfinished Law Firm Business Taxes Departing Partners and Their New Law Firms for Years


Boxer                                                                           

  Jerome Kowalski

 Kowalski & Associates

 November, 2011

In a recent post on these pages dealing with the consequences of a law firm failure on the firm’s partners, I described the clawback provisions of Jewel v Boxer, sometimes called the “unfinished business” doctrine:

[A] line of cases in California beginning with Jewel v Boxer state that the law “requires that attorneys’ fees received on cases in progress upon dissolution of a law partnership are to be shared by the former partners according to their right to fees in the former partnership, regardless of which former partner provides legal services in the case after the dissolution. The fact that the client substitutes one of the former partners as attorney of record in place of the former partnership does not affect this result.” In short, Boxer holds that fees received by a partner and his or her firm in connection with a case which was started at the now dissolved law firm belongs to the former firm. The Boxer case and its progeny have been heavily criticized and are not followed in many jurisdictions, but they do provide mighty weapons to a receiver or a dissolution committee.

Yesterday’s Wall Street Journal breathlessly described the long tail of the Jewel v Boxer clawbacks as if this were news. A number of commentators seemed rather surprised, indeed, even offended, that these clawbacks exist, including Professor Larry Ribstein and Ed Poll.

These clawbacks have been with us for quite some time. Nor is the doctrine an aberrant anomaly of California law, as a recent decision in the Coudert case demonstrates. In Coudert, a Southern District of New York case, three years after confirmation of the firm’s plan of liquidation, which itself had a five year gestation period, numerous Jewel v Boxer claims are still being actively litigated, involving “unfinished business” that spans the globe.

Law firm partnerships cannot, as Professor Ribstein suggests, contractually write their way out of Jewel v Boxer.  Bankruptcy Judge Dennis Montali of the Northern District of California, the jurist with the most experience in law firm dissolutions, having presided over Brobeck, Heller Ehrman, Thelen and now Howrey, has plainly ruled that so called “Jewel waivers” are unenforceable and has so held in several cases. As an aside, in several law firm dissolutions, as some law firms see the inevitable end as being around  some firms have attempted to create life preservers for their partners by amending their partnership agreements to include “Jewel waivers”  in the waning days of the firm.  Unfortunately, for these partners and the firms they join, last minute “Jewel Waivers” are simply voidable preferences and unenforceable.

Well then, what to do?  With some strong likelihood that the next 24 months will see at least several further law firm dissolutions, the prospect for lateral partners bringing along with them  nintended Jewel v Boxer liabilities as their former firms sink under the waves, is a material consequence that law firms must consider.  I am afraid that there is no way around it.  In assessing a potential new lateral partner candidate, law firms need to consider the prospect that they may be required to disgorge revenues brought along by the new partner should his or her former firm fail. Sometimes, the potential of a law firm is obvious from either media reports or simply based on the fact that a law firm is suddenly inundated with a raft of partner resumes from a particular firm. In these instances, I suggest that potential candidates be queried about the financial strength and viability of his or her former law firm.  In the ordinary course of risk and reward assessment, the otential exposure of Jewel v Boxer claims simply must be part of the calculus.

We have recently seen some law firms address the issue in a different fashion:  They have inserted provisions in their partnership agreements a provision which would require a partner upon withdrawal from the firm remit amounts ranging from 10 to 20% of revenues they derive from clients of the firm that follow them to their new firms for a period of one or two years.  The purpose of these provisions, it seems to me, is to attach mathematical certainty to Jewel v Boxer claims.  The unintended consequence is that lawyers burdened by these contractual provisions are essentially unmarketable. It is highly unlikely that a new firm would assume that kind of liability.  Additionally, that departure tax is a hefty and prohibitive additional tax for an individual partner to bear.

But, on the positive side, such departure taxes aren’t all bad.  In the 32 large law firm bankruptcies since Finley Kumble filed in 1988, the coup de grace has uniformly been the massive defections of partners with books of business. These departure taxes will necessarily provoke a “why can’t we all just all get along” dialogue with a view towards all working in synch to resolve what ails the firm.  And these departure taxes will provide potent shark repellent and keep those who would draw the lifeblood of a law firm at bay.

[Update: On May 24, 2012, Judge Colleen McMahon, ruling in the Coudert bankruptcy proceeding in the United States District Court for the Southern District of New York, ruled that Jewel v Boxer is the law in New York and that the liquidating trustee of the Coudert estate may recover from each former partner the profits derived from each case that followed each partner to his or her new law firm. The court ruled: “Under the [New York] partnership law, the client matters are presumed to be Coudert’s assets on the dissolution date, .. Because they are Coudert assets, the former Coudert partners are obligated to account for any profits they earned while winding the client matters up at the firms.” A link to the full opinion can be found at the foot of this article.]

© Jerome Kowalski, November, 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
.

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