Recently across my desk came a copy of a thoughtful and comprehensive article on why law firms collapse. Or rather, I should say, a pair of articles on that topic, both by John Morley, Yale law professor {his name was not familiar to me). The pair of articles consists of a shorter version published in Harvard’s “The Practice” and a longer version published in the Business Lawyer and available on SSRN.   

Morley begins with the most straightforward of descriptions :

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

The force with which law firms shatter is amazing because it has no parallel in other kinds of businesses. Amazon lost money for more than 20 years. Chrysler filed for bankruptcy seven years ago. Yet both companies—like countless others that suffered financial problems before them—are still shipping goods and churning out cars. Law firms show no such resilience. No large 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 collapsed firms crumpled when they were still current on their debts and earning a profit. Law firms die with extreme ease and astonishing speed.

So far, a recitation of something we all know far too well, but find impolite to discuss in ordinary company.  You may recall the same chorus of  outraged distinction-drawers when Dewey failed:  “Our firm is nothing like them…would never do what they did…doesn’t throw money around..isn’t obsessed by laterals and rainmakers…couldn’t be held up by a rancorous few…&c. & c., &c.”  I remember thinking that this “can’t happen here” mantra sounded like nothing so much as the neighbor-in-the-street being interviewed on local TV news immediately after a shooting:  “This is such a nice neighborhood!  Nothing like that would ever happen here!”  Well, guess what?

For our purposes here at Adam Smith, Esq, there is one particularly noteworthy observation in that opening chunk of Morley’s.  Namely , the fact that there is no parallel to this phenomenon across the other 98% of the economy. and yet we pretend that the law firm failure model is normal and indeed perhaps inevitable. At the very least, nothing is to be done. We are going to probe whether that is precisely correct.

But first, a little bit more from Morley about the specific dynamics leading to the massive, irreversible, and shockingly swift meltdowns of even the most pedigreed firms:

Partner ownership encourages a cascade of partner withdrawals for two reasons. The first is that, as owners of their firms, partners get paid in profit shares rather than fixed salaries or wages. [The second has to do with potential forfeiture of their capital and other liabilities.] This makes partners acutely sensitive to problems in a firm because it links their individual compensation to the fortunes of the firm as a whole. For some partners, at least, a decline in profits means a decline in pay. As profits drop, some of a firm’s partners will inevitably start to leave for better-paying opportunities elsewhere. But this causes profits to drop even more, which drives even more partners to leave. Profits then decline still further, causing even more partners to leave, and so on, until the firm finally collapses. If partners were paid in fixed salaries, they would not care about the declining profits. But because they are paid in profits, departures become self-reinforcing. As each partner leaves, the benefits of staying decline for all those who remain.

The funny thing about this dynamic, at least to students of the industry like yours truly, is that in between marquee name law firm failures, almost all of us seem to forget how it happens. But it happens again and will happen again in almost exactly the same way, names of the players excepted. 

The inevitable starts when one or more senior rainmakers decides the grass would be greener elsewhere. When they leave, their revenue and contribution to profits leave with them.

What stays behind, of course, are all of the firm’s ordinary and necessary fixed expenses: Office leases, IT contracts, associate, staff lawyer, and business personnel salaries and benefits, professional malpractice insurance, and all the other things which in normal times are barely worth noticing. The devilish aspect of these fixed expenses is given away by that adjectives: “fixed.” They’re not forever fixed, of course, but they certainly cannot be changed in the short run. 

Not particularly emphasized by Morley, but key to the economic dynamics, is that partners who can leave are, surprise, the most mobile and highly valued on the lateral market. The consequence of this is that toting up the headcount of stayers and leavers does not give you a fair picture of the impact on the firm. Moreover, there are two well-known economic phenomenon which now kick into gear. Morley does not mention either one, but since you are reading Adam Smith Esq, here they come.

 The first is the familiar concept of externalities. An externality, in econ speak, is simply a cost imposed on B by A’s activity. The classic example is the downstream impact on B of A’s upstream dumping pollutants in the river. Here, partners who depart impose a very real cost on their remaining brethren, in the form of lower revenue over that fixed cost base plus the materially greater risk of the firm itself ultimately failing. 

It is difficult to imagine a solution to these externalities short of imposing some sort of head tax on the departing partners, which would be laughed off the table before the thought could be finished.  But at least in theory the best tool for containing externalities is to tax or regulate them. 

The second economic phenomenon is slightly less familiar but perhaps even more toxic: the failure of collective action. A more familiar context to non-economists may be the notion of the tragedy of the commons, which is one incarnation of what we’re discussing here. If a Village Commons is open to all for grazing their sheep, it will very quickly be grazed right down to the dirt with “tragic” results. After all, every sheep owner has an incentive to graze their animals for free, and there is no logical stopping that perfectly rational self-interest playing itself out.

 A failure of collective action is essentially the same thing, where the individual incentives facing each one of the players dictate a self-interested course of action which, nevertheless, are consummately destructive to all of them combined. The logic of short-term self-interest eliminates the prospect of a far superior outcome that could be obtained by collective action. 

The remedy for a failure of collective action is obvious in principle and easy to state, if rarely seen in the wild:  Solidarity.  An ideal context for the Platonic ideals of partnership to kick in, no?  In Cardozo’s immortal words,  “not honesty alone but, the punctilio of an honor the most sensitive, is…the standard of behavior.”  (That is what he said, and our profession and our industry would be prudent to recall it a bit more often.)

Back to economics:  Here’s the weird thing and what makes Law Firm failures unique in the economy: 

Strangely, the firm may still be profitable on the day of its dissolution. Although it will have distributed more profit than it actually earned in the months prior to collapse [in cash, that is–Bruce], it will still be earning a significant accounting profit up through the very end, and it may even remain current on its debt payments.

Reflect on this for a moment. First, law firms do not fail because the enterprise ceases to be a viable going concern, unable to meet its obligations in the ordinary course. They fail because of a lack of faith of the partners in their fellow partners.   Maybe law firms are the ultimate faith-based organizations. Who knew?

Second, do you see the same lurking and awkward moral dimension to how law firms fail that I do? As I said, this is uncomfortable to discuss, but consider the examples Morley offers early on of Amazon and Delta Airlines. When they lose money, or even enter bankruptcy, no employee or executive is forced to count on the goodwill of their colleagues to sustain their gainful employment. Rather, whether Amazon or Delta will live to fight another day is determined by market conditions and the decisions of the leaders of those organizations and the loyalty of their customers. The stereotype of the cold, uncaring, top-down and dictatorial world of corporations suddenly doesn’t look so bad.

But with law firms, the partners who leave early– motivated by, let’s face it, self-interest– at some level betray their brethren they are leaving behind.

Stated so baldly some will view this as an exaggeration. The departure of no single partner, no matter how prominent, will suffice to turn the lights out on the enterprise. However, at some point no one can deny the long-run implications of their own choices.

 But let’s leave this unhappy proposition behind for a moment.

I want to close by pointing out what has been crystal clear not just from Morley’s analysis but from everything else we have discussed here today. Law firms are different. By no stretch of the imagination do they “fail” the way for-profit organizations fail across the rest of the economy. And none of us notices this. 

Every time a major law firm fails, the industry-wide reaction is how shocking and surprising it was and how unique the circumstances were to the no longer extant firm. This is why Dewey was dismissed with great confidence as a one-off with no lessons to be derived for the rest of us. Yes, but.

My question for you: what other essential business practices do law firms embrace that would be deemed unthinkable or unimaginable elsewhere in the economy? Should we look at any of those? How do we know they are optimal and not another structure or alternative? 

And, I submit, we can lay all this at the feet of our unblinking obeisance to the ideals of partnership model.  I hate to verge on a faux pas in public, but that model seems to have fallen down on the job royally  just when you  might need it most: When things start getting sporty.

Of course, none of this matters.  We can sally forth confident in the belief that the lawyers have it right and everyone else has it wrong.

Courtesy Unsplash