Change your fate: How to avoid a future of financial ruin

 

Why are a growing number of prominent American corporate law firms collapsing? Among the large firms that have closed are Brobeck, Coudert Brothers, Arter & Hadden, Heller Ehrman, Thacher Proffitt, WolfBlock, Howrey, and now Dewey & LeBoeuf. Some major firms have merged into other major firms – perhaps to avoid a similar fate.

Large and highly-leveraged law firms like those that have failed are a relatively recent phenomenon in the United States. The largest law firm in America in 1960 was Shearman, Sterling & Wright with 125 lawyers. In Atlanta, Georgia, the largest firm had 21 lawyers.

The firms were small, partly because their clients did not need more legal assistance than they were already receiving and partly because, as general partners in a general partnership, each partner was responsible for all of the firm’s liabilities. No one wanted to be in a general partnership with partners he did not know well and trust implicitly.

The risks of being a partner in a larger US partnership were reduced by the advent in 1945 of the first legal malpractice insurance policies. The risks were further reduced by the adoption of limited liability partnership laws in various states during the 1990s. A partner in such a partnership, absent an agreement to the contrary, is not liable for the obligations of the firm unless he is responsible for the malpractice or misconduct giving rise to the obligation or unless he has personally guaranteed some of their firm’s obligations.

As a result of these developments, the risks to partners in large law firms for the malpractice or misconduct of one of their partners have been significantly reduced.

Growth was also encouraged by the increasing national and international markets for American goods and services (which greatly increased the size and complexity of US companies), and by the great expansion of corporate law departments that often preferred to use a small number of firms nationwide to provide outside services in particular areas of practice.

The largest US-based law firm in 2012 was DLA Piper, with more than 4,000 lawyers, and there were more than 20 other American law firms reporting in excess of 1,000 lawyers each.

Causes of financial instability

As major business practice firms have become larger, many of them have also become increasingly unstable. Why has this instability occurred?

The primary problem is that there is not enough high-paying legal business available to law firms to produce the compensation that so many partners at major law firms now expect.

Consequently, to improve their financial performance, many firms have decided to grow the size and scope of their practices by employing or bringing into their partnerships lawyers with established books of business and by opening new offices in new locations.

The adoption of the strategy of expansion by hiring laterals has been facilitated by the availability of professional malpractice insurance and the ability to organise limited liability partnerships.

At the same time, law firm partners with books of business have been seeking to improve their individual financial positions by accepting lucrative compensation arrangements from ?such firms.

American Bar Association Model Rule 5.6, which has been widely adopted by the governing bodies of the various state Bars, provides that:

“A lawyer shall not participate in offering or making: (a) a partnership, shareholders, operating, employment, or other similar type of agreement that restricts the right of a lawyer to practice after termination of the relationship ?except an agreement concerning benefits upon retirement”.

The Comment on Rule 5.6 states in part that:

“An agreement restricting the right of lawyers to practice after leaving a firm not only limits their professional autonomy but also limits the freedom of clients to choose a lawyer”.

As a result of the unlimited free ?agency enjoyed by the partners and lawyer-employees of American law firms, lawyers with portable books of business are able to move from one firm to another, taking ‘their’ clients with them to another firm that offers better compensation and/or working conditions.

Free agency has also facilitated the growth of large firms into much larger ones geographically. It is difficult to open new offices nationally or internationally without the assistance of well-known and highly-respected local attorneys. Most firms expanding geographically have done so by staffing a portion of their new offices with laterals from local firms.

Under these circumstances, it is not surprising that there has been an extraordinary amount of lateral movement between major US law firms by partners seeking better financial or practice arrangements or escaping uncertain ones while their firms have been seeking to increase their revenues and profitability.

The lateral hiring trap

The research of Professors William Henderson and Leonard Bierman ?indicates that, between 2000 and 2007, over 33 per cent of the partners in Am Law 200 firms had moved to their firms from other firms (many of which were other Am Law 200 firms).¹

Is it possible for major law firms to stabilise themselves while deterring the cherry-picking of their most productive lawyers by their competitors? Could Dewey & LeBoeuf have stood still and survived? I doubt it.

Under the present rules of the game, once a firm’s competitors are able to recruit a few of its most productive partners, other top partners are likely to follow suit. Therefore, over time, major law firms must either grow stronger or fail.

There is a small group of business law firms that have been able to avoid the lateral hiring trap. Most of them are already at or near the top of the profession in competence, compensation and reputation. Most have only one class of partner, have eschewed high leverage and lateral hiring, have focused on high-quality service rather than on volume, have remained relatively small, and have exercised great caution in expanding. These are the firms that all the others would like to emulate.²

What can other major firms do to avoid the lateral partner rat race? Should Model Rule 5.6 and its progeny be modified or repealed to increase the stability of major law firms? Does the rule exist to protect individual lawyers, law firms or clients?

It clearly doesn’t protect law firms. It is less clear that clients are the beneficiaries, although they may be in some circumstances. The impact on clients is at least disruptive and distracting – in some cases it can be substantial.

It is clear that individual lawyers are the principal beneficiaries. As you would expect, there is tremendous support among individual lawyers for retaining Model Rule 5.6. Who doesn’t want to be ?a free agent?

However, the growing risks to firms and their partners and the inconvenience for clients arising from the current environment suggest that some modifications of the rule may be worth considering.

Buying into the firm’s future

One thing that major US law firms could do to maintain their stability without a modification of the rule would be to require that all of their partners guarantee the firm’s obligations (bank debts and leases) in total or in proportion to their financial participation in the firm.

It is likely that partners would think twice about leaving for another firm if there was a possibility that their existing firm would fail while their guaranties remained outstanding (and their departure might increase such a possibility). Such requirements have not been treated as a violation of Model Rule 5.6 or of the similar rules adopted by the Bars of various American states.

Of course, banks and leasers routinely require such commitments from the partners of small and medium-sized firms to discourage promiscuous moves that would undermine the financial strength of their debtors, so this would not be something new or unexpected.

But, if major firms do so too, fewer firms would fall apart. Each existing partner would be expected to make such a commitment. The firm’s ability to attract lateral partners would, however, likely be undermined because many lateral candidates would be unwilling to assume such an obligation, especially if other firms did not impose such a requirement.

For a very few elite American firms, part of the answer has been lockstep compensation. For those partners who have committed a substantial portion of their careers within such a system, leaving before retirement would mean leaving some of the income forgone in prior years on the table, rather than receiving the benefits of such a system in their later years of practice.

In the current environment, it would be very difficult for most firms without a lockstep system to put one in place now. Changing the rules in the middle of the game is difficult to accomplish.

Issues to consider

Should a partner who packs his bags and moves ‘his’ clients to another US firm for purely economic reasons be entirely free to do so?

Should employment contracts between a lawyer and his firm be a one-way street – the firm has to pay in accordance with the contract, but the lawyer can leave without consequences at his whim?

Should a firm be able to impose some requirements on a moving partner such as responsibility for reimbursing expenses incurred as a consequence of his move, ?or refunding the bonus or guarantee ?he received for joining the firm in the ?first place?

Often avarice is not the most important issue. If a partner concludes that his clients cannot be adequately served by his existing colleagues and they are unwilling to bring in someone who could do so, shouldn’t he be entitled to move to a firm that can better serve his clients’ needs?

The client may be unwilling or unable to pay the increasing rates required by the partner’s existing firm, but may be happy to continue using its existing lawyer (or lawyers) at existing or lower rates at another firm. Should the lawyer be permitted to move to another firm in order to maintain his client relationship?

Client conflicts may arise that preclude a partner from continuing to represent one or more of his clients. Or a partner may not get along with some of his important colleagues or may not be paid fairly. Under such circumstances, shouldn’t a partner be entitled to move to another and more amiable firm?

Of course, major US law firms are not ignorant and defenceless. If they make ?bad choices, why should they be protected against their own mistakes? If they are unable or unwilling to provide sufficient opportunities and a healthy working environment, shouldn’t they have to pay the consequences?

Another issue worthy of consideration is the issue of agency law and the fiduciary duty of agents to their principals. Partners are agents of their law firms, and clients enter into their engagements with law firms and not with individual lawyers.

I believe agency law requires that partners discharge their duty of loyalty to their firms that would at a minimum prohibit a partner planning to leave his firm from discussing his departure with a client of the firm (regardless of the partner’s relationship with the client) or with employees of the firm, until the firm had been notified of his intentions and had the opportunity to protect its interests. I suspect that many departing partners are not so scrupulous and might have liability to their former firms as a result.

It’s time for the American Bar Association to give serious consideration to the impact of Model Rule 5.6 on the legal profession and its clients, and to consider modifications to the rule that would improve the character, stability and reputation of our profession.

Michael H. Trotter is a partner in the corporate and business practice group at US law firm Taylor English??

Endnote

1. See ‘An Empirical Analysis of Lateral Lawyer Trends from 2000 to 2007: The Emerging Equilibrium for Corporate Law Firms’, William Henderson and Leonard Bierman, Georgetown Journal of Legal Ethics, Vol. 22, Issue 4, Fall 2009

2. For further information, see Declining Prospects, Michael H. Trotter, CreateSpace Independent Publishing Platform, August 2012