The one question I’m asked most frequently these days, in the aftermath of Dewey, is "Who’s next?"
Even if I had an answer to that—which is, as one apocryphal job applicant replied when asked his greatest weakness, "for me to know and you to find out"—I will not be mentioning any other firm in the same breath, sentence, or paragraph, or hopefully on the same day, as Dewey.
But the second-most frequently asked question I get is, "What are we supposed to learn from Dewey?" and on that score I’m happy to elaborate.
Here’s my Cliffs’ Notes version of what they did wrong:
- shocking levels of debt;
- misrepresenting revenue to (so we are told) internal partners and prospective laterals;
- guarantees upon guarantees, an unheard-of proportion of which went to legacy/incumbent partners;
- 20:1 or higher partner compensation ratios which were, critically, not entirely based on economic contribution or merit but evidently on brinksmanship and audacity;
- a culture of the "haves and have-nots;" and
- management by extreme secrecy.
If we put this in the context of what we all know has gone on in our industry over the past 20-odd years, I think we can begin to sketch the following lessons.
It’s hard to go cold-turkey on a hiring practice that seems to have first invaded and later occupied the core of what many firms consider to be their "strategy," but the time is long overdue for a serious re-evaluation of what the lateral hiring obsession could possibly achieve to offset its costs.
I believe this re-think needs to occur at both the micro and macro levels.
"Micro" means heightened due diligence on both sides about the potential fit: Firms need to scrutinize laterals’ promised books of business more carefully and laterals need (and I believe have the right to) more information about the firm’s financials. What might that mean in practice?
- For laterals, I’ve suggested that law firms ought to get in the habit of preparing—and updating, needless to say—the rough equivalent of a private placement memorandum, disclosing all material financial, strategic, organizational, and operational issues to people who, after all, are presumably about to bet their future income stream and a not-inconsiderable amount of personal capital investment on that firm.
I believe the discipline of preparing and updating the PPM is a virtue in and of itself. Walter Lippmann, the legendary mid-20th Century intellectual, writer, and political commentator, once recommended that Presidents hold an open-forum press conference every 30 days: Not because the press was entitled to kid-glove treatment but because knowing another chance to be interrogated on anything and everything was always imminent would force the Administration to constantly be prepared to articulate its views on all issues of any magnitude.
- For firms, it means examining the lateral’s track record in careful detail, and analyzing their promised performance with a gimlet eye. More than one is the managing partner who’s told me that "2 out of 3" (a rough median of the estimates people have provided to me, ranging from 3 out of 5 to nearly 9 out of 10) laterals underdeliver on their promised book of revenue.
I suggest that, at the very least, two questions be added to the mandatory discussions with each putative lateral: (1) With respect to each important client you anticipate bringing over, tell us exactly why they will not prefer to stay at your existing firm; and (2) Revenue is nice; itemize how profitable each of your clients is (not knowing the answer to this one is grounds for your standing up and leaving the room on the spot).
Altogether too many partner sponsors and practice group leaders seem never to have seen a lateral they didn’t like. I submit that approach is backwards: The burden of proof, by clear and convincing evidence, needs to be on those advocating the lateral come on board. The strong default presumption should be against it. And if it takes holding the sponsors accountable (and I mean at compensation time) for underperformers, so be it.
"Macro:" Indicators far and wide point to the widespread belief in the importance of pursuing laterals as strategy. For example, Altman-Weil’s annual survey of managing partners reports with relentless consistency, year after year, that the #1 source of frustration to managing partners ("where we could do better" is roughly the way the question is phrased) is underperforming efforts to recruit laterals. Meanwhile, 92.3% of respondents indicated that "acquiring laterals" was a "growth option…your law firm will pursue in 2012." Another 3.2% "weren’t sure," leaving a lonely 4.5% apparently not in the game. Even stronger confirmation of how dominant this "strategy" has come to be is that for firms over 250 lawyers, 98.5% said it was a growth option. (I wonder who the lone holdout was.)
Finding myself in the distinct minority, I’ve long been skeptical of the sustainability of the lateral hiring arms’ race. Here are a few articles addressing that issue directly and indirectly; I won’t rehearse their substance, but if diverging from the conventional wisdom requires at least colorable justification, I’ve posited that:
- Evidence shows laterals consistently underperform, both in the short run (adjustment and transition lags) and in the long run (high performers are rarely if ever solitary artistes, and depend more than they know or admit on established and well-oiled teams at their old firms, built over time and difficult to duplicate on a dime);
- Attention lavished on courting, integrating (you do lavish attention on their integration, don’t you?), and generally coddling laterals demoralizes the loyal incumbents;
- Outsized compensation paid laterals, particularly when perceived as less than fully earned, generates profound, deep-seated, and extremely durable resentment;
- Finally, the best predictor of getting divorced is having been divorced. Need I say more?
From an industry perspective, the lateral pursuit obsession is, by definition, a zero-sum game. Clients are not going to spontaneously increase their overall legal spend, nor is the BigLaw legal sector going to grow as a percent of GDP, because high-stakes games of musical chairs are being played. Actually, from the perspective of law firms overall, the investment in laterals is not even as good as a zero-sum game; it’s a negative-sum game insofar as a rich chunk goes to headhunters.
But, you protest, the laterals our firm hires benefit from a superior "platform." Yes, this can happen. A top-tier private equity lawyer could be at the best firm in (I threw darts at a map to come up with these) Austin, Columbus, or Reno, and would be constrained in the size and sophistication of their practice; they need to move to New York, Chicago, or one of a very very few other magnet capital markets cities. This is a real phenomenon. It’s also like an Italian farmer ploughing up a priceless Roman coin. Don’t count on its happening, in other words.
Three years ago Professor Bill Henderson of Indiana/Maurer Law (a friend, as regular readers of Adam Smith, Esq. know) published An Empirical Analysis of Lateral Lawyer Trends from 2000 to 2007, which used exhaustive data to demonstrate that the vast majority of lateral partner moves over that period added little or nothing to the bottom lines of the acquiring firms, and might actually be destabilizing them. As Bill put it in his conclusion:
[W]hen the Am Law 200 is analyzed based on lateral movement, the data reveal a difficult conundrum: lateral movement is greatest among firms with mid-range profits but consistently low among firms with the highest profitability. In pursuit of higher profits—presumably to attract and retain lawyers with valuable books of business—a large proportion of middle-profitability firms have aggressively pursued business strategies, such as higher leverage and rapid geographic expansion, that are unsustainable, inflate a firm’s cost structure, and/or create environments in which lawyers are more reluctant to share risk. Partners who have worked in large law firms for 25 or 30 years may not fully appreciate the fact that the rules and payoffs of the promotion to partnership tournament have changed; and that the incoming generation of lawyers is not necessarily impressed by the career path being offered to them. Further, clients are rebelling at billing rates that go up faster than the underlying quality or value of legal services being rendered.
Given that this was written before the severity and duration of the Great Reset was known, Bill’s analysis appears clairvoyant.
The industry should be increasingly skeptical about taking on debt. Firms (meaning their partners) should ask whether it’s prudent to rest the financial superstructure on banks who are increasingly trigger-happy when covenants are violated or in threat of violation. Across the table, as it were, banks may rationally be expected to impose more stringent lending standards, or to insist on enforcing standards currently in place but which may be observed in the breach.
As a hypothetical example of the latter, it’s an all but universal covenant in law firm loan documents that the firm not pay out more to its partner in distributable income than its net income (subject to all sorts of definitions and caveats, but you get the idea). We now know that Dewey was doing just this for the last four years of its existence. I have no idea whether such a covenant was in place with its banks, but if so it must have been waived by the banks or simply ignored. Such forbearance (if so it was in Dewey’s case) cannot be counted on going forward.
For years, even decades, bank law firm lending groups have viewed firms as solid credits, with reliable cash flows, stable business models, little year to year revenue volatility, and non-cyclical compared to the overall economy. I have to believe that’s going to change. We’ve seen several high-profile law firm collapses, to be sure, but aside from that, the competitive landscape for firms has never been more uncertain and challenging. Without fail, managing partners I talk with tell me these days that they’re never experienced less forward visibility and more plain old doubt about what’s the right thing to do. Banks have to be hearing the same thing. Let’s assume that bank lending officers will want to continue to do what they do, which is lend, but what if their leashes are reeled in?
As an aside, I’ve recently been asked a question on a recurring basis that, the first time I heard it, surprised me, but makes more and more sense. That question is, "Do lending banks have any culpability in enabling the firms to get in so deep?" I’m not a banking (or plaintiffs’) lawyer so I shall let that lie but what’s interesting to me is that people are even asking the question.
Understand: Bank lending to law firms has a very profitable and successful track record, and it’s not going away. But more questions may be asked, fewer equivocal answers tolerated, and more stringent standards—and enforcement of those standards—applied..
Back to the law firm side of the table.
Not only is it overall levels of debt to which I believe rank and file partners are becoming sensitized, it’s also the hitherto stealth issue of unfunded pension liabilities. For years I’ve been baffled that this topic hasn’t gotten
more prominent any attention, but perhaps that’s at long last about to change thanks not only to the widely reported size of such obligations at Dewey Ballantine and LeBoeuf Lamb, but thanks the American Lawyer finally publishing an article focusing attention on it ("A Heavy Burden," March 1, 2012). According to that piece, the obligations are endemic within the industry and quite material in size:
"This is an issue that cuts across all regions and all sizes of firms," says Dan DiPietro, chair of the Law Firm Group of Citi Private Bank. "It’s a generational issue: As firms face the bubble of baby-boomer partner retirement, the problem will only get bigger." […]
Many partners we interviewed told us they had little knowledge or understanding of their benefit plans or their firms’ financial liabilities. But it’s not surprising that some firms aren’t being open with their partnership: Unfunded plans, in particular, tend to divide partnerships along generational lines. […]
It’s a division that will only intensify with time. Simple demographics dictate that payouts to retired partners will be an increasing weight on profits for at least the next decade, and maybe two. "The 45-year-old types are enormously productive and are diverting money to satisfy 68-year-olds," says Peter Kalis, chair of K&L Gates, a firm that phased out its unfunded plan in the late 1980s. "When those [younger partners] are attracted to go to firms without that overhang, that business model [of the firm with the pension] fails. That day may never come, but it’s important to consider."
Mr. Kalis has put his finger on the crux of it. Firms on the hook for generous pension payouts, funded perforce out of current income, are effectively levying a tax of up to X or XX% of the firm’s profits (some firms have imposed caps, but some "caps" are sizable indeed), often for as far as the eye can see, during young partners’ prime earning years—for the benefit of folks they probably have never met but who, to be fair, feel they earned it fair and square. To be blunt, something has to give. This may not be a recipe for a salubrious discussion, but avoidance as a coping strategy has a lousy track record.
Putting such unfunded plans in place to begin with is irresponsible; not having wound them down by now is inexplicable; and refusing to restructure them going forward is indefensible.
Permit me to introduce this final and last leg of today’s discussion with the introduction to a June 2012 McKinsey article, Leading in the 21st Century:
It is often said that the principles of great leadership are timeless, or based on immutable truths. But when we meet with the men and women who run the world’s largest organizations, what we hear with increasing frequency is how different everything feels from just a decade ago. Leaders tell us they are operating in a bewildering new environment in which little is certain, the tempo is quicker, and the dynamics are more complex. They worry that it is impossible for chief executives to stay on top of all the things they need to know to do their job. Some admit they feel overwhelmed.[Further setting the stage, emphasis McKinsey’s] A convergence of forces is reshaping the global economy: emerging regions, such as Africa, Brazil, China, and India, have overtaken economies in the West as engines of global growth; the pace of innovation is increasing exponentially; new technologies have created new industries, disrupted old ones, and spawned communication networks of astonishing speed; and global emergencies seem to erupt at ever-shorter intervals. Any one of these developments would have profound implications for organizations and the people who lead them. Taken together, these forces are creating a new context for leadership.
And grant you, this prefaces an article including interviews with leaders of some of the world’s most famous organizations: Josef Ackermann formerly of Deutsche Bank, Carlos Ghosn of Nissan and Renault, Moya Greene of Royal Mail Group, Ellen Kullman of DuPont, President Shimon Peres of Israel, and Daniel Vasella of Novartis.
Here are some of the challenges they describe (verbatim quotes):
- These days, there are things that just come shooting across the bow at much greater frequency than we’ve ever seen.
- Just to give you an idea of my calendar for the next ten days: Berlin tomorrow, then Seoul, then Munich, then Frankfurt, then Singapore, then the Middle East. I’m almost constantly on a plane. With all this traveling, physical stamina has become much more important. I remember a time when after flying to Hong Kong you could take a whole day off to recover. Today, right after landing you rush to your first meeting. And maybe you already have a conference call in the car on your way into town. You are lucky if you get enough time to take a shower.
- Physical discipline is crucial, for food, exercise, sleep. I live like a monk—well, maybe not a monk, but a Knight Templar.
- It is a paradox: on the one hand, you have to be more confident and secure, but on the other, you have to be a lot more open and empathetic. You need to listen, but then when you make a decision, that’s it—you must be a very hard driver. Usually, these are not attributes you find in the same person.
One might summarize these as: Unprecedented demands; enormously accelerated decision-making; complex and interconnected forces beyond any individual’s or organization’s control; and little forgiveness for error.
Finally, I found this observation particularly insightful, speaking to the challenge of being "micro" and "macro" at the same time:
In different ways, many leaders have told us they’ve needed to develop a facility for viewing the world through two lenses: a telescope, to consider opportunities far into the future, and a microscope, to scrutinize challenges of the moment at intense magnification. Most of us are naturally more comfortable with one lens or the other; we are “farsighted” or “nearsighted,” but rarely both. In times of complexity, leaders must be able to see clearly through either lens and to manage the shift between the two with speed and ease.
May I remind you that lawyers are by nature far more at home with microscopes?
This brings me to the "astronomer’s" view of where the constellation of BigLaw is today:
- We are increasingly comprised of multi-hundred-million dollar per year organizations;
- Often spanning the globe or at least several time zones;
- With multiple "product lines," some of which overlap nicely but some of which don’t remotely do so;
- And which typically have intrinsically divergent profit margins, geographic foci, client bases, and practitioners.
And managing these enterprises we have?
CEOs who came to their jobs as amateurs—not meant unkindly or uncharitably in the least, but as a simple statement of fact. People who are not professionally trained, that is, or not trained at all, and whose first experience with the multidimensional chess game we find ourselves presented with comes when they first sit down to the table.
One can only pray for fast learners.