what kind of lawyer to retain for a failed business deal

Why Law Firms Collapse

Police firms don't but go bankrupt—they plummet

By John Morley

This commodity is derived from a more expansive piece of work later on published in The Business Lawyer, volume 75, issue 1 (Winter 2019/2020). The total paper is also bachelor on the Social Science Research Network here. Comments are welcome.

Law firms don't just go broke—they collapse. Dewey & LeBoeuf. Heller Ehrman. Howrey. Brobeck Phleger & Harrison. Thelen. All these firms and many others have blown up with extraordinary strength and speed. Some large police firms have survived more 100 years and then fallen to pieces in a affair of months or even weeks.

The force with which constabulary firms shatter is amazing because information technology has no parallel in other kinds of businesses. Amazon lost coin for more than 20 years. Chrysler filed for bankruptcy seven years agone. However both companies—like countless others that suffered financial problems before them—are nonetheless shipping goods and churning out cars. Law firms show no such resilience. No big law firm has ever managed to reorganize its debts in bankruptcy and survive. And the pressures that bring law firms down are often surprisingly mild. Most complanate firms crumpled when they were still current on their debts and earning a profit. Police firms dice with extreme ease and astonishing speed.

Why? Cartoon on a review of every large law business firm collapse in the past xxx years, I argue that the answer lies in the unusual way that police force firms are owned. Dissimilar Amazon and Chrysler, law firms tend to be owned by their partners rather than by investors. And this makes the partners unusually sensitive to decline. Every bit a firm'south profits drop, the reject can feed on itself and turn into a cocky-reinforcing spiral of partner withdrawals.

Law firms dice with extreme ease and amazing speed.

Partner ownership encourages a cascade of partner withdrawals for ii reasons. The first is that, as owners of their firms, partners become paid in profit shares rather than fixed salaries or wages. This makes partners acutely sensitive to problems in a firm because information technology links their individual bounty to the fortunes of the business firm as a whole. For some partners, at least, a refuse in profits means a decline in pay. Every bit profits drib, some of a house's partners will inevitably outset to go out for meliorate-paying opportunities elsewhere. But this causes profits to drop even more, which drives fifty-fifty more partners to leave. Profits and so decline withal further, causing even more partners to get out, and and then on, until the business firm finally collapses. If partners were paid in stock-still salaries, they would non care about the declining profits. Just considering they are paid in profits, departures become cocky-reinforcing. As each partner leaves, the benefits of staying decline for all those who remain.

The second problem is that because partners are owners of their firms, they face crushing personal liability when a firm finally dissolves. All the compensation partners receive in the months leading upwards to bankruptcy can be clawed back as a fraudulent transfer, for example, and the partners' uppercase investments in a firm can be taken abroad every bit well. Partners who stay besides long may even have to give upwards billings they generate after the firm dissolves. All these liabilities flow directly from partners' condition equally owners. The staff and associates face none of these liabilities. And unfortunately, these liabilities encourage partners to leave, because the only way to avoid them is to be among the commencement to withdraw.

Therefore, the net effect of partner buying is to make law firms remarkably fragile. As nosotros pick through the burnout ruins of firms like Dewey & LeBoeuf, it becomes obvious that partner ownership exposes police firms to the aforementioned horrifying logic of withdrawal that animates bank runs. A constabulary business firm can collapse, in other words, considering partner buying can bulldoze a run on the partnership.

The pattern of collapse

Although the expiry of a large police force business firm tends to come up equally a shock to the people who work for it, law firms actually collapse in surprisingly anticipated ways. Every large law firm blowup has followed the aforementioned bones blueprint. This design emerged from a review of news and litigation records I conducted for every major constabulary firm collapse since 1988. I reviewed 37 firms in all, starting with Finley Kumble (aka "Finley Crumble") in 1988 and ending with Bingham McCutchen in 2014. The list of firms includes marquee names like Dewey & LeBoeuf, Heller Ehrman, and Coudert Brothers, and slightly lesser known but all the same important firms like Darby & Darby, Adorno & Yoss, and Lord Mean solar day & Lord.

At the fourth dimension a typical partner run commences, the firm is still generating a large turn a profit, but profits have diminished relative to a previous high. This decline in profits is pregnant, just not catastrophic, and the firm is nonetheless hands electric current on its debts. The firm'due south management is struggling to concord partner draws steady at the previous loftier, withal, and the firm increasingly borrows from banks and starts to run downwards upper-case letter reserves to generate extra greenbacks.

The partner run commences with the divergence of a senior rainmaker. The divergence might happen for a purely random reason—the rainmaker might die, for example, or exit for government service. Or the rainmaker might exit afterward his or her defeat in a power struggle—perhaps even a power struggle over how to improve the firm's poor performance. The departing rainmaker will take along a grouping of other partners and assembly who likewise service his or her clients.

Inside a few months after the senior rainmaker's difference, another, slightly less senior rainmaker will besides leave, over again with an entourage of partners and assembly in tow. This rainmaker's get out will be followed within well-nigh a month by still more departures, besides in large clumps every bit exercise groups decamp for other firms.

The departure of all these marquee partners will leave the firm with fewer customer revenues, even every bit it has the same role leases, pensions, banking concern loan payments, and other obligations that still have to be paid. Every bit more partners leave, the firm will borrow more than and more than money to keep partner compensation on a level plane. Senior partners remaining with the firm volition as well attempt to renegotiate their bounty. They volition make large, sometimes outrageous demands, knowing that the firm may have no selection but to concur, since it cannot survive if they depart. Equally more partners exit, the business firm'south financial position will worsen. Besides taking clients, the departing partners will likewise oft withdraw their upper-case letter from the former firm, leaving the firm short on greenbacks fifty-fifty as the demands on its cash increment.

At some point in the spiral of departures, the firm will trip a serial of covenants in its banking concern loans and lease agreements. By this point the firm will have substantial borrowings from a single bank—most probable Citibank (See this result's Speaker's Corner to hear from the chairman of Citi Private Banking concern's Law Firm Group). These borrowings will exist secured past a general lien on all the firm's assets. The covenants will require the house to maintain a minimum number of partners or to avert more than a sure number of partner departures in a fixed menstruum of fourth dimension. When these covenants have been tripped, the lenders will seek to renegotiate, often demanding accelerated payment or new covenants in exchange.

At some point the business firm volition begin merger negotiations with a healthier firm. If the negotiations succeed and the merger occurs, the firm volition be saved. If the merger negotiations fail, the firm will die. And when information technology does, the end will come up swiftly. The management committee will call a meeting of the partners to announce that the game is up, and the partners volition vote to formally dissolve. The associates and staff will be stunned (come across "Defenseless in the Collapse"). Unlike many of the partners, relatively few of the staff and associates volition have left of their own accord prior to the dissolution.

Strangely, the firm may still exist profitable on the day of its dissolution. Although it will accept distributed more than profit than information technology actually earned in the months prior to plummet, it will even so be earning a meaning accounting profit up through the very end, and it may even remain current on its debt payments.

Later on the firm has dissolved, its creditors may strength it to enter bankruptcy. Because the house will have few physical possessions, its major assets will consist of claims against others, nigh notably the onetime partners. Although the shield of limited liability volition protect the partners from general personal liability for the firm'south debts, this shield will be useless confronting a multifariousness of indirect claims that flow from the partners' status as owners and come out of the laws of fraudulent transfers, preferential transfers, and unfinished business organisation. The value of all these claims, if pressed to their limit, would be enough to push many of the partners into personal defalcation. Fortunately for the partners, however, the bankruptcy trustee or creditors will settle these claims for a fraction of their value. The creditors will recognize that although the legal merits of their claims may be potent, the obstacles to drove are profound. The partners will exist widely dispersed across multiple states and strange countries, making litigation extremely expensive. And even if the creditors obtained judgments, collection efforts would yield little since the partners would exist capable of declaring personal defalcation and might have sheltered many of their assets in estate-planning devices.

Even so, the partners' fate will not be happy. Nigh of the partners will have left the old business firm not because they expected more money but because the spiral of departures left them with no choice simply to leave. And although some of the partners may take gained a raise by leaving, much of the value of these raises volition take been eaten up past liabilities.

The puzzles

The screw of partner departures that drives a business firm into plummet might seem obvious—even ordinary. Simply if we approach it advisedly, information technology looks quite puzzling. It is not clear why the partners would leave in the confront of reject because the employees of other kinds of businesses don't leave in the same way. During the 2 decades that Amazon lost coin, the employees didn't exit—they flocked to the firm en masse. And even when Delta Air Lines and Chrysler went bankrupt, almost all their employees stuck around.

Another puzzle is why the intensity of law firms' declines was and then out of proportion to their financial distress. Figures 1 and 2 (below) use data from the American Lawyer's almanac ranking list to show that the finances of defunct firms declined only slightly in the years but prior to the plummet. Things got worse at these firms, merely they weren't most bad enough to put an ordinary visitor like Amazon or Chrysler out of business—or fifty-fifty into bankruptcy.

Figure 1. Gross Revenues

Figure 2. Profits per Partner

And another puzzle is why police force firms should experience financial distress at all. Law firms' capital letter structures are freakishly robust. Since a law firm is owned past its partners, its largest expense—partner compensation—is non technically an expense at all and doesn't fifty-fifty accept to exist paid. Profit distributions are purely discretionary. This leaves police force firms with huge amounts of revenues that they tin can theoretically divert to whatsoever expense they wish, including the repayment of debt. Far from being fragile, police force firms would seem to be near unbreakable.

Partner buying and partner runs

Just, of course, law firms pause anyway—often with astounding force. And so there must exist something else going on. Since the problem cannot be mere fiscal distress, it must instead be a deeper structural weakness that other businesses don't share. And that weakness is a vulnerability to a partner run.

A partner run takes its strength from the peculiar fashion in which law firm partners decide to leave or stay. That is, every day a constabulary firm partner compares the costs and benefits of leaving to those of staying, and so chooses the option that offers the greatest benefits internet the expected costs. On about days, the choice is implicit and unthinking. Just on the 24-hour interval a partner starts to seriously contemplate leaving, the choice becomes quite deliberate.

In the United States, the costs of leaving tend to be low considering of our peculiar professional person ideals rules. Dissimilar legal ethics rules in the United Kingdom and elsewhere, the American Model Rule of Professional person Carry 5.6(a) says, in essence, that a house cannot ask a partner to sign an agreement not to leave. The dominion prohibits, among other things, the competition of covenants and the retention of partners' upper-case letter contributions. The cyberspace effect of these restrictions is to make leaving comparatively like shooting fish in a barrel.

What ultimately drives a partner run, though, is not just the low cost of leaving simply the style that successive partner departures tend to reduce the benefits of staying for the partners who remain. As more partners leave, the advantages of staying decline. This is a direct consequence of partner ownership.

Partner departures across time

Partner departures ramp up exponentially as a firm starts to collapse. The summit figure (figure 3) uses data from the American Lawyer on partner movements to show the average percentage of partners who departed collapsed firms in each month prior to collapse. The bottom figure (figure 4) presents the same data over the same fourth dimension periods for good for you non-collapsed peer firms with similar profits per partner. In both graphs, time 0 represents the date a collapsed firm ceased operations.

Figure 3.

Figure 4.

Residual gamble bearing

When a partner decides whether to leave or stay, the benefits of staying depend heavily on whether other partners stay as well.

Ownership links partners together considering it transforms the firm's partners into its residual take chances bearers. The partners win or lose if the firm'southward profits go up or downwards. Since partners are paid in profits rather than in fixed wages or a cash bonus, the value of their shares in the firm fluctuates with everything that affects a firm's profitability. Even events entirely outside an individual partner's control—a fasten in electricity rates for the role space, say, or an increase in marketplace rates for associate bonuses—can reduce the puddle of profits and the partner's have-abode pay.

The partners' status as residual hazard bearers is important considering it sensitizes the partners to i another's departures. If one partner'southward deviation makes the firm less profitable, the remaining partners bear the loss. If partner A leaves and profits drop as a result, the compensation of partner B will automatically have to be cut. This in turn volition brand partner B more likely to leave for some other firm every bit well. And, of course, one time partner B heads out the door, the profits might driblet still further, putting partner C on the edge, too. The issue is a run on the partnership.

The fundamental to a run on the partnership, in other words, is that when a partner decides whether to leave or stay, the benefits of staying depend heavily on whether other partners stay every bit well. The benefits of staying are a function of a firm's profits. And the firm'south profits are a part of whether other partners are choosing to stay. The more partners who leave, the less attractive staying becomes. And when staying becomes less attractive, even more than partners exit, so on until the firm falls autonomously.

Partners would non run like this if they did not ain their firms. If partners were ordinary employees rather than owners, they would be paid in wages or performance bonuses that did not fluctuate with profits. And the partners' bounty would therefore be basically independent of the firm's overall profitability—and the number of other partners who accept left. As other partners depart and the profits decline, the remaining partners compensation could stay basically the same, just every bit it did for the employees of Amazon and Chrysler when those companies were losing money. If a police business firm were not endemic by partners—if, like Amazon and Chrysler, it were owned by investors—then the drop in profits caused by a partner's departure would be borne by the investors rather than the remaining partners. One partner'due south departure might reduce the firm's profits, only there would be no reason for any other partner to care about it, and it would not increase the odds that other partners would withdraw likewise.

Thus a run happens whenever successive waves of partner withdrawals brand a firm less profitable. This is the fundamental reason law firms collapse. But we should be cautious, of course, to assume that every difference makes a firm worse off. Some departures actually improve a firm's bottom line by saving the house the cost of the departed partner's compensation and administrative expenses. If the firm loses less in client revenue than it saves in bounty and administrative expenses, so the business firm might actually be improve off when a partner leaves. This is why firms occasionally fire their underperforming partners.

Merely fifty-fifty though some departures can brand a firm better off, other departures can be devastating. The biggest problem is that many of a firm's costs tend to remain fixed even after a partner leaves. Even if a business firm saves the toll of a departed partner'south compensation, it may not be able to fully cover the driblet in client revenues by saving money in other areas. The business firm might still take to pay the hire on the departed partner's corner office, for example, and pay banking concern debts and pension obligations, which stay the aforementioned regardless of how many offices at the firm accept the lights on.

Partner departures can too hurt for other reasons. I problem is a kind of selection bias in partner withdrawals. In general, the partners who leave first tend to exist the ones who are virtually underpaid, since they are the ones who observe it more appealing to leave than to stay. Simply the underpaid partners are precisely the ones who do the most to do good the business firm'due south bottom line. Partner departures can also hurt a firm by siphoning away its capital. Model Rule of Professional person Conduct 5.6, which requires a firm to return capital letter to partners as they depart, tin bleed a business firm to expiry. In Howrey'due south terminal total twelvemonth of operation in 2010, the business firm paid out more than than $113 million in uppercase to departed partners even every bit the business firm took in full revenues of only $262 million.

Another cause of declining profits is the renegotiation of remaining partners' bounty. As the pie shrinks, everyone who remains inevitably wants a larger slice in order to keep his or her full takeaway the aforementioned. These demands for more pay tend to exist credible because a dollar of compensation at a collapsing business firm is actually worth less than a dollar of compensation at a healthy firm, due to the risk of personal liability on a firm's collapse. Partners can thus seriously threaten to go out unless they are paid even more than their market place value. But all these demands for more pay ultimately bulldoze more lawyers from the business firm because the division of profits is a zip-sum game: more money for 1 partner means less for another. And the partners who lose get more probable to get out.

In Howrey's terminal full year of operation, the firm paid out more $113 million to departed partners even as the firm took in only $262 one thousand thousand.

Personal liability

Profits are not the just thing partners lose as a business firm declines. Their status as owners likewise exposes them to significant personal liability. This is the 2d reason ownership drives partners to run, considering the simply fashion partners can avoid personal liability is to become out early.

Fraudulent transfer l iability for c ompensation . The most serious liability comes from the doctrine of fraudulent transfers, which allows a creditor to void any payment a business firm makes after it becomes insolvent if the firm does not receive something of reasonably equal value in exchange. Basically, fraudulent transfer doctrine prevents a debtor from giving away its assets to its friends on the eve of bankruptcy. A law firm partner's status as an owner exposes his or her compensation to fraudulent transfer doctrine because it turns the bounty into a profit distribution rather than a wage. Since partners are owners, their draws are distributions of profits, not payments of wages or salaries.

Nether well-established principles of defalcation and state law, a profit distribution is a fraudulent transfer because it doesn't technically have to exist paid. Similar Apple tree, which sits on tens of billions of dollars in retained profits, a law firm could, in theory, choose not to distribute profits if it wished. And and then any decision to pay profits basically amounts to a gift, making it recoverable by creditors under fraudulent transfer police force. Profits stand up in contrast to wages because wages become a contractual obligation in one case an employee has earned them. Profit distributions are optional; wage payments are not. Hence profit distributions are voidable under fraudulent transfer doctrine, whereas wage payments are non.

The threat of losing pay to fraudulent transfer law encourages partners to go out early because the sooner they leave, the less of their pay volition be eaten up by fraudulent transfer police. If a approximate rules in bankruptcy that a firm became insolvent one twelvemonth prior to dissolution, partners who stayed on through the moment of dissolution will have to return an entire year'southward worth of pay to the house's creditors. Partners who left ten months prior to dissolution, nonetheless, will but have to return two months of pay. And partners who left more than a twelvemonth prior to dissolution will not accept to return annihilation at all. The lesson is to leave early.

The only style partners can avoid personal liability is to get out early on.

Preferential transfer liability for capital contributions . Model Rule of Professional person Behave 5.half dozen requires a law house to repay a partner'southward capital letter contribution when he or she withdraws, so when a business firm starts sinking, many partners showtime leaving in the hope that they can grab their capital letter before the firm goes completely underwater. Merely a partner has to act quickly, because the defalcation code'south doctrine of preferential transfer stands ready to catch anyone who waits too long. The purpose of preferential transfer doctrine is to prevent a debtor from paying some of its creditors in full on the eve of defalcation when others will be paid just in office later on. It does this by letting a defalcation trustee void an overly generous payment to a creditor if the debtor made it at a time when the debtor was insolvent. Preferential transfer law encourages partners to leave early because partners who get their uppercase out before the business firm becomes insolvent are allowed to go along their capital, whereas partners who get out after insolvency lose it. Partners who get out early enough may even exist protected by the statute of limitations. The lesson, over again, is to get out quickly.

Unfinished business liability. The saddest source of liability is the so-called unfinished business concern, or "Gem," doctrine. This doctrine has vague origins in the Compatible Partnership Act (UPA) and the Revised Uniform Partnership Act (RUPA), but information technology finds its clearest foundation (and its colloquial proper name) in Jewel v. Boxer, a 1984 California Court of Appeals opinion involving the breakup of a small police firm. The Jewel doctrine says that partners who remain with a business firm up through the fourth dimension of its dissolution must share with the business firm the gain of any work they perform afterward dissolution on matters that belonged to the firm at the time of dissolution. Jewel liability is not only an obligation to help a business firm collect on billings accrued prior to a partner'southward deviation; it is an obligation to share new billings for work a partner does after the firm dissolves. The dominion has been applied widely to all types of dissolved law firms. It reaches non only firms organized as general partnerships but likewise firms organized as limited liability partnerships, professional person corporations, and limited liability companies. Jewel claims were often among broke law firms' largest assets, and settlements commonly reached millions of dollars.[1]

The logic of the Jewel dominion is to protect the partners from one another. In the absence of the rule, the argument goes, partners could back out of their partnership agreements and accept partnership profits for themselves past absconding with valuable business. Forcing partners to return fees to their old firms is supposed to ensure that all the partners share the fruits of partnership business on the terms dictated by the partnership understanding. Information technology stops the partners from stealing opportunities from the firm.

This makes a good bargain of sense, merely in do information technology encourages a race to the exits. This is considering Jewel has been interpreted to flip on like a switch at the moment of dissolution: it applies to partners who stay until dissolution, but not to partners who leave just prior. This creates terrible incentives. Partners who stay until dissolution face millions of dollars in liability, while partners who leave i twenty-four hour period prior to dissolution walk away completely free. Although Jewel was designed to punish partners for leaving early, it actually punishes them for leaving tardily. The lesson of Jewel is to get out before the business firm dissolves.

In Comparison

The reason police firms are so frail is that their structural makeup encourages partners to leave in spiraling cycles. Ownership exposes partners to the risks of declining profits and serious personal liability, and the all-time way to avoid those risks is to get out early in the wheel of decline. The effect is a race to the exits.

Ideally, nosotros would exist able to test this ownership-based theory experimentally or statistically, by comparison firms that are owned by partners to firms that are owned by others, and asking which were near probable to collapse. But that isn't possible, because Model Rule of Professional Conduct 5.4 effectively requires every firm in the Us to be owned by its partners. The best style to validate this theory about the connection between ownership and collapse is thus to look a little more widely for comparisons. We may non be able to compare partner-owned law firms to investor-owned police force firms, but we tin can expect around for other comparisons.

Associates and staff. One comparing is the associates and staff of a constabulary firm. It is often said that law firms are delicate considering "their assets go down the elevator every nighttime." But some assets are more probable to come up back up the elevator than others: associates and staff tend to stay at comparatively high rates even as the partners go out. Although associates and staff seem to leave at higher rates in times of pass up, they primarily leave on the heels of the partners they work for. They practise not announced to go in search of other jobs as quickly as partners do.

One caption is that associates and staff have fewer options in the labor market than partners practice. This may be truthful, and if so, it would tilt the associates and staff in favor of staying. But, of course, at that place is another explanation besides: the associates and staff are not owners. They might lose their jobs, but every bit partners might if the firm dissolves. But unlike partners, associates and staff will non have their pay cut as the firm declines and they won't get sued if they stay too long. This makes staying until they get laid off much more attractive.

Bookkeeping firms. Accounting firms are also owned by their partners. Arthur Andersen, the partner-owned accounting firm that audited Enron, collapsed and went into liquidation with astonishing speed subsequently it was charged with a criminal offence in connectedness with the Enron scandal. And Andersen was not the only bookkeeping house to blow up like a law house. In early 1990, Laventhol & Horwath was the 7th-largest bookkeeping firm in America. Just after that year, the firm complanate and filed for defalcation in a blueprint virtually identical to that of many law firms: the business firm dissolved subsequently about a quarter of its partners fled in a six-month period in response to a reject in profits.

Shareholders in investor-owned companies.Police force firm partners also stand up in interesting contrast to investors who own ordinary industrial companies. Like police house partners, investors in an ordinary company besides have an incentive to run, since they, too, will suffer when profits decline. Different police force firm partners, however, investors in an ordinary company cannot run because the corporate lease prohibits them from withdrawing unilaterally. Shareholders in an ordinary company like General Electric can sell their shares, just they cannot actually accept back their money from the firm. They cannot unilaterally ask GE to give them back the portion of its factories, make names, and greenbacks that corresponds to their shares.

The only fashion for GE shareholders to become their coin dorsum is to pay themselves a dividend, but this is subtly dissimilar from a constabulary firm partner'due south right to exit. Dividends in ordinary companies have to go to every shareholder at the same time and on the aforementioned terms. No shareholder tin can individually leave on his or her ain. There is thus no reason for investors to race to get out because everyone has to leave simultaneously. The terrible inertia of private decision making disappears.

[i] For examples of settlements of unfinished concern claims, see Order Granting Motion by Liquidating Debtor for (1) Approval of Settlement of Claims Confronting Covington & Burling LLP and IP Shareholder Defendants Under Defalcation Dominion 9019, (2) A Finding of Proficient Faith Settlement Under California Code of Civil Procedure § 877, and (three) Leave to File Second Amended Complaint,In reHeller Ehrman LLP, No. 08-32514 (Bankr. N.D. Cal. Aug. 11, 2011) (approving a $4,996,213 settlement for unfinished business organization claims); Lodge Pursuant to Dominion 9019 of the Federal Rules of Defalcation Procedure Authorizing and Approving a Settlement Understanding Between the Program Administrator and Baker & McKenzie LLP,In reCoudert Brothers LLP, No. 09-01150 (Bankr. Due south.D.N.Y. Aug. 20, 2010) (approving a $6,650,000 settlement for unfinished concern claims); Social club Blessing Settlement Understanding with Morgan Lewis & Bockius LLP & Finding That Settlement Is in Good Faith at four,In re Brobeck Phleger & Harrison LLP, No. 03-32715 (Bankr. North.D. Cal. Nov. 10, 2004) (approving a $10,200,000 settlement for unfinished business claims).

Dewey & LeBoeuf

Partner ownership seems to be one of the key factors in explaining why police force firms collapse with such unusual force and speed. But does it really change anything near how we understand law house blowups? Unremarkably, we explain the bankruptcy of a business such as Chrysler or Delta Air Lines as a simple combination of declining revenues and increasing costs. Do partner ownership and the notion of a partner run add annihilation to our understanding that mere financial distress does not?

To see why information technology does, consider the collapse of Dewey & LeBoeuf, still the largest law firm bankruptcy in history. Many people—including the Manhattan commune chaser—have attributed Dewey'due south sudden and astounding collapse to the fraud of its managers. How else, one might ask, could such an quondam, prestigious, and profitable house have fallen apart and then swiftly? A focus on partner runs actually provides an answer. Although the house'due south managers may well have been telling lies, the swiftness of Dewey'south collapse has parallels fifty-fifty in firms where the managers were not telling lies. Partner ownership creates a gear up of incentives that might have pushed Dewey to a swift and deadly end even if its managers had been completely honest.

Partner buying also gives the states a new perspective on the role of debt and fixed salaries. It has oft been said that the cause of Dewey'south collapse was its tendency to pay fixed salaries to partners who were recruited laterally from other firms. News reports tell us that Dewey fabricated too many compensation guarantees, and when the partners who received these guarantees failed to perform, the firm didn't accept enough money to become around. Dewey was, on this telling, no dissimilar from Chrysler or Delta Air Lines or whatever number of other bankrupt businesses that took on also many costs without enough revenues.

This story makes intuitive sense, but a focus on partner ownership would tell the story rather differently. Guaranteed partner salaries alone could non take driven the firm to exist incapable of paying its debts considering, as we take already seen, partner buying gives constabulary firms freakishly robust capital structures. Even at the fourth dimension of its death, Dewey, like every other constabulary firm in America, had many partners who were nevertheless being paid in profit shares rather than fixed salaries, and so it had huge free cash flows over which its managers had full discretion. Although Dewey's managers chose to pay out these cash flows as profit distributions to partners, they could in theory have used them instead to pay the stock-still salaries, as well equally debts, utility bills, and any number of other contractual commitments that might have come up. Far from being insolvent, Dewey remained profoundly profitable—at least as an accounting affair—almost upwardly through the day of its dissolution. The focus on stock-still partner salaries is besides a scrap naive because information technology ignores the extent of other salaries in the business firm. Every law firm—including healthy ones—has many people who commonly get paid in salaries. These people are called assembly and staff. The addition of a handful of salaries for the partners thus could not, by itself, take bankrupted the firm. Something else must have been at play: the trend of partners to run in the face of failing profits.

In a law firm, debt tends to be a lagging, rather than a leading, indicator of decline.

Also, a focus on partner ownership gives a clearer motion-picture show of why exactly Dewey started paying all these fixed salaries. News reports have told us that all the fixed partner salaries were given out every bit recruitment incentives to partners coming laterally from outside the firm. But in fact, virtually of the salaries went to partners who had already been at the business firm for years. And we can now see why these partners wanted the fixed salaries then badly. It wasn't just that the partners were greedy; it was that they were seeking shelter from the chance that the firm'south profits would decline. By demanding to exist paid in salaries rather than profit shares, some of the partners were trying to transform themselves from owners into creditors. They were hoping to avoid the slide profits that inevitably hurt the owners of a firm in reject. And from the perspective of the house's managers, fixed salaries made sense, because they knew that paying salaries was the only way to go on many partners at the firm. If partners were paid in profits, they would leave, making the firm fifty-fifty less assisting and even more than precarious for everyone who remained. The popularity of salaries among Dewey's elite is proof of the importance of ownership in pushing a firm to collapse. Information technology shows united states of america how precarious ownership can be in a time of decline.

Dewey'southward experience with fixed salaries is more broadly typical of other collapsed firms' experiences with debt. A salary is a kind of debt because it represents a contractual obligation that has to be paid in a fixed corporeality at a stock-still moment in fourth dimension. Debt, like partner salaries, is often said to be the main cause of constabulary firm collapses, for the same reasons information technology is said to make businesses similar Chrysler and Delta Air Lines insolvent. But this isn't exactly right, because police firms' uppercase structures are so robust that the firms rarely go incapable of paying their debts until about the moment of their death. So debt plays a different role in law firms than in other businesses. In a law business firm, debt tends to be a lagging, rather than a leading, indicator of decline. Firms often take on big amounts of debt only after profits have begun to decline, generally equally a way of desensitizing their partners to profit declines. When a firm'southward profits are declining, the management can muffle the pass up and therefore keep the partners from leaving past paying partner draws with borrowed coin. At Finley Kumble, which in the late 1980s became the first big American law firm to collapse, many of the partners realized how serious the firm's distress was only when they received their K-1 partnership taxation returns at the end of the year, which showed how much of the distributions they received over the prior yr had been funded with debt. Debt surely made things worse at Finley Kumble. But the firm took on the debt only afterwards the firm's profits were already declining and its partners were departing.

Debt is so unimportant in a police force firm that we can imagine a law firm collapsing even without any financial debts at all. If profits declined enough, partners could start to leave the firm in a self-reinforcing spiral fifty-fifty if the firm never took out a loan and never fell behind on its debt payments. A business firm's partners could leave simply because profits were dropping.

Perhaps the most of import lesson a theory of partner runs can teach us about the Dewey collapse is to show why fiscal distress was so much more destructive at Dewey than at other kinds of businesses. Many businesses lose money, simply almost none blow up similar Dewey & LeBoeuf. And Dewey didn't even lose all that much money. Dewey was, as we have seen, technically assisting almost until the end. To empathize why Dewey complanate, we accept to go beyond mere financial stress and understand how that financial stress became magnified and distorted by the force of a partner run. Financial stress might have pushed Dewey off a cliff, simply it was the weakness of Dewey's ownership structure that caused it to shatter when it hit the ground. Other businesses are made of rubber, but Dewey was made of drinking glass.

Why some firms alive while others die

The forces pulling police firms apart are non irresistible. Most firms manage to survive them because most of the time, they relish a kind of equilibrium in which partners are inclined to stay at their current firms. A firm begins to collapse only when partners autumn out of this equilibrium. The fundamental to figuring which firms will collapse is to identify the forces that tilt a firm out of equilibrium and starting time the snowball of partner departures rolling.

Although elite law firms have almost all become much larger, most of the collapsed firms expanded with a speed and aggressiveness that was unusual fifty-fifty amid their peers.

Fiscal s tress . Although fiscal stress is non the simply cause of police firm collapse—ane of the lessons we learned from Dewey—financial stress does affair, albeit in a surprising and unconventional way. Firms plummet not because their profits pass up in absolute terms, but considering their profits turn down in relative terms. Since they pay their partners in discretionary profit distributions rather than fixed wages or bonuses, they have enormous free cash flows that they tin can use for about any purpose, including the repayment of debts. What really matters, therefore, is not a house's overall profits but its ability to convince its partners to stay. And this depends not and then much on a firm'due south absolute profits but on its relative profits—i.e., its ability to pay its partners more than its competitors. The relative nature of profits is so important that a firm could theoretically collapse even at a time when its profits were increasing if the profits were not increasing fast enough to keep pace with competitors.

To exist a bit more precise, what truly matters is the change in relative profits. Some constabulary firms volition always be more profitable than others. This is just a fact of life. Simply most firms nevertheless remain stable because the marketplace for partners usually sits in an equilibrium in which each lawyer settles at the firm that offers him or her the best bargain. Partner runs commence when the market falls out of this equilibrium because a firm has changed its profitability relative to competitors.

Knowing the importance of relative profits is useful because it tells us that law business firm collapses should actually be surprisingly unrelated to large, industrywide shocks like financial crises and recessions. A truly widespread upshot may diminish the profits at every firm, but partners will start to move effectually only if profits diminish more at one house than some other. Slowdowns in need for legal services will bulldoze firms to plummet but when they damage those firms relative to their competitors, perhaps because one house is more exposed to a particularly ho-hum do surface area than other firms. For this reason, a truly industry wide pass up like the ones now afflicting newspapers and recorded music would non necessarily crusade individual police force firms to collapse. If crises and recessions cause firms to collapse, information technology is just considering some firms are more heavily damaged by the declines than others.

Jenkens & Gilchrist, a Dallas-based national law business firm, is illustrative. The firm collapsed in 2006 later three partners in the firm's Chicago office were sued for selling fraudulent tax shelters. The liability ultimately became a major financial problem: $81.55 million in the terminal settlement. But the firm could easily have remained solvent in the face of this liability if it could take kept its partners. Only, of course, the firm could non hang on to its partners because the liability was unique to Jenkens & Gilchrist. None of the house'south competitors shared this huge loss, so none of the competitors' profits were diminished. This made Jenkens & Gilchrist's partners easy picking for headhunters. Jenkens & Gilchrist spiraled downward in a archetype partner run, declining from 600 lawyers when the liabilities showtime emerged in 2001 to 281 lawyers when the firm finally airtight its doors five years later.

Expansion.Although it is difficult to pinpoint a single effect that causes the most partner runs, the well-nigh important effect seems to be expansion. Although aristocracy police force firms have almost all become much larger in the by 40 years, most of the collapsed firms expanded with a speed and aggressiveness that was unusual fifty-fifty among their peers.

Expansion poses a number of risks, each of which can worsen a firm'south relative functioning and drive its partners to leave. One adventure is the cost of investing in new role space and partners. Brobeck Phleger & Harrison about doubled the number of its attorneys from 1997 to 2000, and it invested in a cute new office to contain all these new lawyers. Merely the cute office brought some very ugly costs. Brobeck earned about the aforementioned amount of revenue in 2002 as information technology did in 1999, but its real estate costs had ballooned from 6.6 percent of revenues to 15.two pct. Although the firm could easily have paid these costs if it had suspended profit distributions, the decline in profit distributions was not sustainable because it pushed the partners to run in early 2003.

Client l oyalty.The placement of client loyalties is also important. If clients are loyal to firms rather than to individual partners, partners will exist less likely to leave and the firms volition endure less damage when they do. Ofttimes, nevertheless, firms neglect to cultivate firm-level client loyalties, and when this happens, a lot tin depend on how widely the loyalties are distributed among the partners. When customer loyalties are concentrated in a handful of large rainmakers, information technology tin can exist either expert or bad for a firm. On the one hand, the concentration of client loyalties in a few big rainmakers can benefit a firm by making it robust to the deviation of everyone other than one of the cardinal rainmakers. Since no i but the rainmakers tin can take the firm'south clients away, no one but the rainmakers can damage the firm by leaving. On the other manus, if one of these rainmakers decides to go out, the result tin be disaster. Altheimer & Gray, an 88-year-old Chicago house, tells the tale clearly. The business firm spiraled downward in a matter of months in the early on 2000s after Gery Chico, the business firm'due south charismatic chairman and central rainmaker, stepped away to run for the U.S. Senate in 2002.

Bonding c apital. Partner ownership places huge strains on partners' fiscal ties to a business firm during times of turn down by reducing the partners' compensation as other partners leave. Weak financial ties can force a firm to depend instead on breezy nonfinancial ties. A business firm tin start to rely on what a sociologist might phone call bonding uppercase—the investment in relationships that inculcates feelings of friendship, loyalty, and trust. Firms are less likely to collapse when bonding capital letter is stiff. If partners respect and value their colleagues, they will tend to stay even as their pay gets cut. If bonding capital is particularly potent, partners may even cease to think in terms of coin at all and might instead prioritize values and people. Ties of trust tin be particularly important considering they can make it possible for partners to rely on one another in times of stress. In May 2014 the chairman of Patton Boggs slowed down a partner run—and may have saved the firm—by asking each of the remaining partners to commit to stay (around 90 percent agreed). These commitments were never written downwardly, and would have been unenforceable fifty-fifty if they were, but the partners had enough trust in one another that they were able to stay long enough to consummate a merger that saved the firm.

Size. Some other risk factor is size, thought its issue can be ambiguous. A larger size decreases the odds of collapse by reducing the proportional significance and diversifying the risk of withdrawals. In a firm of three partners, the death or departure of just one partner is catastrophic; in a business firm of i,000 partners, information technology is meaningless. In other ways, however, a larger size can make collapse more likely. One of the biggest problems is that size can inhibit the sense of identity and the bonding capital that binds partners to a firm.

Possible Solutions

When the combination of bonding upper-case letter and financial upper-case letter fails, the resulting run on a partnership can be terrifying. How, and so, tin a run be stopped? And how can a firm protect itself from ever suffering a run in the first place?

The starting time solution is for all large constabulary firms to meliorate their partnership agreements to waive liability for Precious stone-style unfinished business organization claims. Recall from above that a want to avoid unfinished business organisation liability tin can push partners to race for the exits to avert getting stuck in a house when it finally dissolves. Courts clearly permit firms to waive unfinished business organisation liability, merely amazingly none of the big firms that accept collapsed in recent years have properly done then. An unfinished business concern waiver is effective only if it happens early, because if a house waits until later a bankruptcy determines the business firm to be insolvent, the waiver will be deemed unenforceable as a fraudulent transfer in bankruptcy. Brobeck, Thelen, and Heller Ehrman all learned this lesson the difficult style. Another strategy for reducing unfinished business liability is not to dissolve at all. Since unfinished business liability applies only to a business firm'south partners at the moment of a firm'south dissolution, a firm can avoid unfinished business liability by simply not dissolving. Perchance for this reason, Bingham McCutchen has still not dissolved, more than two years after the last lawyers left the business firm.

In addition to waiving unfinished business organization liability, law firms should also amend their partnership agreements to delay paying out capital to departing partners. The Model Rules of Professional Conduct permit a firm to filibuster capital repayments to withdrawing partners by making the payments incrementally over several years. Delaying repayments can forestall a firm from bleeding to death as departing partners enquire for their money dorsum. Firms should be aware that in that location is a downside to hanging on to capital letter payments, however—if the firm ultimately does collapse, the partners will never go their capital dorsum.

Firms should also consider recharacterizing their partners' compensation as salaries and bonuses rather than as profits. This might brand compensation less vulnerable to recovery equally a fraudulent transfer in bankruptcy, since the bounty would become a contractually required payment in exchange for labor rather than a discretionary distribution of profits. To be articulate, this is an untried strategy, but it might be worth a shot.

If management sees a run starting, another solution is to talk with partners directly and get their informal, verbal commitments to stay. Model Rule of Professional Conduct five.6 prohibits partners from signing agreements to stay, just the partners can nevertheless give handshakes agreeing to not leave. And a handshake, though softer than a contract, is surely better than goose egg at all.

Investor ownership would powerfully diminish the risk of a run past diminishing lawyers' sensitivity to turn down.

Another tried-and-true strategy is to merge with a healthier firm. Virtually every complanate firm has gone to its grave only subsequently failing to observe a merger partner. Heller Ehrman, for example, was publicly reported to have seriously discussed mergers with at to the lowest degree three firms—Baker & McKenzie, Winston & Strawn, and Mayer Brown—and it probably held conversations with many more. Other firms, like Patton Boggs, accept found saviors to keep them alive. In Patton Boggs' case, the savior was Squire Sanders. The point of these deathbed marriages is not to build abstract "synergies" but to restore confidence. A merged house has more partners to absorb the damage of departures and cover stock-still costs. Struggling police force firms are similar in this respect to struggling banks. At the tiptop of the financial crisis in 2008 and 2009, almost every struggling bank desperately sought a merger partner. This is how we ended up with the odd combination of Bank of America and Merrill Lynch. A merger is a classic style to finish a run.

Across these solutions, which are all within the command of a firm and its management, there are as well broader solutions in public policy that would require a reform of existing constabulary. One public policy solution would be to eliminate the rules requiring police firms to be endemic by their partners. England, Wales, and Australia all recently began permitting law firms to be owned past investors, and in these countries investor-endemic law firms now have a large share of the market for personal injury litigation and other types of personal legal services (meet "How Regulation Is-and Isn't-Changing Legal Services"). Investor buying would powerfully diminish the run a risk of a run by diminishing lawyers' sensitivity to pass up. The risk of runs alone might not exist a sufficient reason to permit investor ownership. Just information technology is ane reason and should get function of a more than complete assay of investor ownership.

Another solution is to permit restrictions on partner withdrawals. This is perhaps a more realistic possibility than investor ownership. The United Kingdom has long immune restrictions on partner withdrawals, and elite corporate firms in the United Kingdom ofttimes retain partners' capital contributions on withdrawal and forcefulness them to sign noncompete agreements equally a condition of admission to the partnership. These withdrawal restrictions raise the cost of withdrawal, making departures less probable fifty-fifty when profits decline. It is peradventure no coincidence, and so, that no big law business firm in the United Kingdom has ever collapsed. Similar investor ownership, though, withdrawal restrictions have many drawbacks. Although withdrawal restrictions would reduce the odds of runs by making information technology costlier to withdraw, they would also lock lawyers into unhappy work relationships and forbid clients from hiring the lawyers of their choice.

The ties that bind

When we await closely at the swift and fierce collapses of constabulary firms like Dewey & LeBoeuf and Heller Ehrman, one fact becomes undeniable: this is not normal. Many businesses endure financial bug, but almost none blow upward with the extraordinary force of law firms. If we want to empathise why a law business firm collapses, we need to understand not just why it suffered financial issues but also why it was so frail in the face up of these bug.

My answer is structural. Police force firms are frail considering (1) they are owned by their partners and (two) these partners tin can freely withdraw. Partner ownership weakens a firm because it forces the remaining partners to suffer when another partner withdraws. Partner ownership creates financial incentives that encourage partners to follow ane some other out the door.

There are several ways to stop these financial incentives from wrecking a firm, but one of the almost important is to strengthen nonfinancial commitments. Informal bonds like friendship, loyalty, and trust tin hold a firm together even in the face up of financial refuse.

Partner ownership thus presents a paradox. Even as information technology weakens financial ties between partners and their firms, it can strengthen nonfinancial ties. At its best, the experience of working together every bit co-owners tin cultivate a sense of friendship, loyalty, and trust. The lawyers who run law firms tin sometimes experience like more than but employees—they can feel like true partners, bound together by values and deep commitment. The problem, though, is that partner ownership does not merely cultivate values similar friendship, loyalty, and trust; it also depends on them. Without these values, the financial incentives created past partner ownership can become as well weak to sustain a house. Partner ownership cuts the steel chains of contract and replaces them with leather cords of friendship and loyalty. These leather cords tin can bind strongly. But if these cords are e'er cut—if all partners care about is money—then partner ownership, instead of binding a business firm together, can become the very force that blows it apart.

John Morley is a professor of law at Yale Constabulary School. Questions and comments tin be directed to [email protected].

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Source: https://thepractice.law.harvard.edu/article/why-law-firms-collapse/