How some of America's top law firms devoured profits before the Great Recession, got too fat, and are now suffering the consequences 



This month, the legal industry has been fixated on the gathering storm clouds around Dewey & LeBoeuf, a high-end international law firm based out of New York. The issue is not so much whether Dewey is in trouble -- that much is obvious -- but whether the firm is in the midst of an accelerating death spiral. About 20 percent of its partners have defected to other firms this year. More may be jumping ship. Former partners are speculating about whether the firm will merely shrink, or be "busted up into a bunch of little pieces." 

But no matter what Dewey's final fate may be, its travails are a sign of something larger, which Bloomberg Businessweek calls out in a new article this week: Slowly but surely, the rarefied world of corporate law appears to be coming apart at the seams. 

Last year saw the collapse of Howrey, a venerable Washington, D.C. firm that had once been among the most powerful forces in corporate litigation. In the last decade, Businessweek notes, a dozen major firms have crumbled, and more may be in trouble: 

Many more, like Dewey & LeBouef, confront existential challenges that were unimaginable just a few years ago. J. Stephen Poor, chairman of Seyfarth Shaw, an 800-attorney firm in Chicago, sums up the predicament of corporate law firms he refers to as "the 99 percent": "We have to improve or die."

There are any number of ways to interpret the crisis in Big Law, as the top tier of the industry is known, but the story, at its core, is a simple cautionary tale. (Disclaimer: I worked on the business side a firm for about a year and a half.) During the early and mid aughts, firms built unsustainable business models that survived off the froth flying from Wall Street. Now, many have become too bloated to change course and adapt to a new era in business. 

It starts with the two graphs below, from a report this year by Citi, which is a major law firm lender, and the Hildebrandt Institute. Do yourself a favor and ignore the acronyms. In essence, it shows the growth in profits at top law firms pre- and post-recession. The left axis on each is a measure of profitability. The bottom axis is the percentage growth of profits over time. And here is the upshot for our purposes: Before the economy crashed, business was plentiful and growth was easy. After the economy crashed, business was lean and growth became very, very hard. 


You might notice that a few firms still appear to be producing stellar results. In fact, they seem to be doing better than ever. And it's true -- a few are. These are the metaphorical 1 percent of the legal industry, the elite firms based mostly in New York that have been able to maintain their performance by focusing on the most expensive, sophisticated work. For everyone else, the wrenching changes that followed the recession have disrupted their business. 

How did firms set themselves up for a fall? To put it bluntly, they got fat. The last decade saw a spate of mergers, as firms tried to expand nationally and internationally with the aim of catering to rich multi-national clients. Dewey, created out of a merger between Dewey Ballantine and LeBoeuf, Lamb, Greene & MacRae, was a prime example. And as they expanded, they also hired associates with abandon. Yet as firms grew into bigger, more complicated organisms, their leadership structures remained rudimentary. Firms still organized themselves as partnerships and were managed by attorneys themselves, many of whom spent most of their time practicing. The arrangement worked because, in many ways, there weren't any hard strategic decisions to make. Firms were able to finance their growth and maintain their obscene profitability by pushing through through large yearly rate increases that met little resistance from clients. 

When the recession hit, these slow and flabby firms were broadsided. Business dried up. Clients balked at the annual rate hikes, and many started demanding discounts. Most firms maintained profits by laying off associates and staff (that's reflected in the graph below as the decrease in expenses). 


In other words, they resorted to temporary pain relief -- taking aspirin to treat a broken leg. But the problems that began in the recession were not a momentary blip. Rather, they seem to have been the beginning of a long term shift, where companies are simply not willing to spend as much on lawyers. Legal outsourcing firms, the use of inexpensive contract attorneys, the decision by companies to bring more work in-house, and demands for cheaper rates have all put permanent pressure on profits. The march of improved information technology will only slim margins further. 

How are firms responding? They've taken up poaching. Many are now trying to grow by nabbing senior attorneys with profitable books of business from other firms. There are two problems with this. First, the dirty secret in law firm land is that a large portion of these hires turn out to be busts. They fail to bring over the promised clients, but still get to collect large pay packages, at least for a few years. Second, and more importantly, the hunting has turned into an attack on the basic partnership model itself. 

This is because law firms, like banks, work based on confidence. When individual partners are satisfied that things are operating smoothly, and are happy with their pay, the organization functions. When partners leave, even if it's for an unjustifiably large paycheck elsewhere, it cuts into the firm's revenues and its confidence. The more partners depart, the worse the damage. And, in a severe situation, it can turn into a mass exodus -- or a run on the bank. At that point, things can quickly disintegrate. If a law firm's partner count drops too low, lenders will cut off their lines of credit, effectively pulling the plug on their operations. 

So rather than finding ways to innovate and improve profits, much of the legal world has turned to cannibalizing itself. Dewey may be the victim today, but there'll probably be others tomorrow. This is what happens when an industry can't see past the good times, then gets sacked by the bad. 

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