Law Firms Paying Price

Dewey & LeBoeuf LLP can’t win. In late March an embarrassing exodus of partners prompted the global law firm to announce a management shake-up. In explaining the reshuffle, the head of Dewey’s corporate department, Richard Shutran, mentioned the firm earned about $250 million last year.

Whoops. That was a lot less than what Dewey had reported a few weeks earlier to the legal trade publication American Lawyer, which is now revising its financial database to reflect reduced results for Dewey in both 2011 and 2010.

John Altorelli, one of more than 60 Dewey partners taking their practices elsewhere, told the Am Law Daily blog that he sees two potential futures for his former colleagues: a significant downsizing or “a firm busted up into a bunch of little pieces.”

The turmoil at Dewey isn’t an isolated event, Bloomberg Businessweek reports in its April 23 issue. Elite corporate law firms -- Wachtell, Lipton, Rosen & Katz; Cravath, Swaine & Moore LLP; Sullivan & Cromwell LLP -- and a few others thrive on their scrupulous maintenance of quality and reputation.

Beneath that exalted caste, though, a dozen large and prominent partnerships have called it quits in the past decade. They include Howrey & Simon; Thacher, Proffitt & Wood LLP; Heller Ehrman LLP; Thelen Reid; Jenkens & Gilchrist; Coudert Brothers LLP; Brobeck, Phleger & Harrison LLP; and Arter & Hadden LLP.

Existential Challenges

Many more, like Dewey & LeBoeuf, confront existential challenges that were unimaginable just a few years ago. J. Stephen Poor, chairman of Seyfarth Shaw LLP, 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’s more at work here than the Great Recession. Inept management and the weakness of the partnership model have also played crucial, if lesser known, roles. And as unsettling as this shakeout will be for employees of many large law firms, it’s one that is overdue.

The legal profession wasn’t always seen as a path to wealth. From 1940 to 1960, inflation-adjusted income for lawyers in the U.S. eroded significantly, while that of physicians rose, according to Declining Prospects, a forthcoming book on law firm economics by Michael Trotter, a practicing corporate attorney in Atlanta.

Choice Destination

In the 1960s and 1970s, increased regulatory complexity and corporate consolidation spurred growth in the size of corporate law firms and the fees they charged. By the early 1980s, law school had become a choice destination for top college graduates. American Lawyer began gathering and publishing revenue and profit statistics for top-grossing firms, ratifying the J.D. as a ticket to the upper class.

The high-tech revolution, globalization and Wall Street’s dubious expansion have generated still more demand for sophisticated legal services. In 1985 the 50 top-grossing firms had a combined revenue of $3.4 billion. If their collective top line had increased at the rate of inflation, it would have been the equivalent of $6.9 billion in 2010, Trotter notes. Instead, the figure rose to $48.4 billion.

“Hourly rates just went up and up,” Trotter says. Fancy lawyers charged whatever the market would bear.

Defections

Attorneys began defecting like mad to rival firms willing to promise them million-dollar paydays. Head counts at large firms swelled, with 1,000-attorney behemoths becoming commonplace. Trotter, a former partner at the predecessor to Atlanta-based Alston & Bird LLP, with about 800 attorneys, observes tartly that corporate clients didn’t applaud the development.

In his book, Trotter quotes Robin Sangston, now the general counsel of Cox Communications Inc., on what happened when one specialty partnership merged into a mega-firm: “Their rates went up, their hourly requirements went up, and I started getting marketed” to buy unwanted additional services.

As firm size increased, so did leverage -- the ratio of salaried attorneys to partners, who share in the profit. Yet as Trotter’s research shows, size and leverage don’t correlate with profitability. Baker & McKenzie LLP , the largest U.S.-based firm with almost 4,000 lawyers and a leverage ratio of 4.48 associates to each partner, ranks 79th in average per-partner profitability. Wachtell Lipton, with 231 attorneys and leverage of 1.69 to 1, ranks first in average per-partner profit, with $4.3 million.

More Vulnerable

By bulking up so aggressively, law firms made themselves more vulnerable to economic downturns. Partners at many firms failed to appreciate that all those salaried employees needed to be paid every month, whether or not new business is coming in the door.

Part of the problem is that the partnership structure -- in which the owners jointly make all the major decisions, including how to divide the profits -- works better in smaller, more stable firms with simpler finances and more modest levels of acquisitiveness.

Partnership doesn’t nurture broad-minded managers skilled in running sizable operations. In a business increasingly characterized by fierce bidding for talent and high-level defections, many successful attorneys jealously hoard clients and keep an eye on the American Lawyer numbers to see whether they ought to take their “book of business” elsewhere. Under these circumstances, client loyalty at many firms has deteriorated.

‘Old Ways’

The recent economic downturn accelerated a trend already under way, said Seyfarth Shaw’s Poor: “Law firms whose business model remains what it has been for more than 30 years -- namely, every year we just raise our rates and expect clients to pay up -- well, those law firms will find the old ways aren’t sustainable.”

Dewey & LeBoeuf is learning that lesson now. The firm is the offspring of the 2007 marriage of Dewey Ballantine, whose founders was Thomas E. Dewey, and LeBoeuf, Lamb, Greene & MacRae LLP. Before this year’s exodus began, it had more than 1,000 lawyers and leverage of almost five associates per partner, according to Trotter’s book. American Lawyer is now revising the firm’s 2011 per-partner profits to $1.04 million from $1.8 million.

Dewey’s costs had risen sharply in part because of over- the-top multiyear guarantees it made to rainmakers lured from rivals. Hope replaced hard-nosed strategy.

‘Doesn’t Get Better’

“We kept thinking it’ll get better tomorrow, then it doesn’t get better,” said Altorelli, the former Dewey partner. “The next thing you know, it’s been four years.”

The firm said it will trim overhead and replace its sole chairman with a five-person committee made up of the heads of its most profitable practice groups. The new approach responds to “internal requests for more hands-on management,” Shutran said. Perhaps 10 hands will steer the firm more effectively than a single pair.

Another option would be to jettison partnership altogether and give management responsibilities to a chief executive officer steeped in leadership rather than litigation. But that’s unlikely to happen at many high-end firms.

Lawyers capable of generating top fees simply don’t want to become conventional employees, says Trotter. Partnership is a cherished status, blending the roles of director, major shareholder and big man on campus.

Alternatives do exist, however. At Seyfarth Shaw, project managers -- mostly non-lawyers -- help guide big transactions. Computer-generated flow charts determine the course and pace of litigation.

Back to the Future

“Last year was our best ever in financial terms,” Poor said. The firm saw revenue rise 7 percent, to $484 million, and profit per equity partner increased by 11.2 percent, to $816,000. Meanwhile, the Atlanta firm where Trotter now practices, Taylor English Duma LLP, represents a back-to-the- future model. It hires mostly experienced attorneys, keeps leverage and overhead low, and undercuts competitors on rates. Since 2006 it has grown from six attorneys to more than 100.

Yet even these approaches can’t fix the fundamental challenge facing the legal profession: At all levels, the industry suffers from excess labor.

The number of people with law licenses grew from 212,600 in 1950 to 1,225,000 in 2011 -- a sharp change from a ratio of one attorney for every 709 Americans to one for every 257. Forty- five thousand newly minted attorneys become available every year in a field with only 25,000 job openings. Law firms of all sizes laid off attorneys during the lean years of 2008 and 2009, and hiring has not fully rebounded.

Caveat Emptor

During the past year, unemployed young attorneys across the U.S. have banded together to sue their alma maters -- generally schools of modest repute -- for fraudulently exaggerating graduates’ job prospects. One such suit filed against New York Law School was dismissed in March by a judge who said aspiring attorneys should know the concept of caveat emptor.

Despite the disgruntlement of recent law school graduates, the decline of some white-shoe law firms has an upside. The number of people taking the Law School Admission Test has fallen by almost 25 percent in the past two years.

We have a lot of decrepit bridges in this country, factories that could use modernization, and clean-energy technologies that need inventing. It’s a moment for more engineers and entrepreneurs, not more lawyers.

To contact the reporter on this story: Paul M. Barrett in New York at pbarrett17@bloomberg.net

To contact the editor responsible for this story: Ellen Pollock epollock@bloomberg.net

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