The New Normal

Is Your Firm Playing ‘Dewey Roulette’?

Posted Aug 15, 2012 7:52 PM CDT
By Paul Lippe

Paul Lippe

The question “who is the next Dewey?” comes up a lot these days. Because most law firm financial information isn’t public, that’s not an easy guess to make. But it’s no exaggeration to say there are a number of firms effectively playing a form of “Dewey Roulette,” distributing more than 100 percent of the cash they generate to partners and not investing in their capacity to create greater profits in the future. As Dewey showed, any of the following could precipitate a rapid-fire demise:

• A capital call.
• An expiring or shrinking credit line from a bank.
• A requirement to fund pension obligations.
• A defection of a significant partner (or cluster of partners).
• The failure of a major contingency fee or other deferred compensation arrangement.
• Malpractice exposure.

None of these triggering events should be fatal by themselves, but they will invariably occur in the context of a 5 percent to 15 percent shortfall in the firm’s projected collections, which probably translates into a 10 percent to 30 percent shortfall in profits.

Why so many shortfalls? Because law is four years into a 10-year structural change.

I’ve written before about FMC Technologies general counsel Jeffrey Carr’s “four buckets” model, in which he argues that lawyers add a lot of value in advocacy and counseling, but not so much in process and content. In the last few weeks I’ve seen very innovative offerings from start-up companies in due diligence (process) and legal research (content). These companies, like many other ventures (including new law firms and legal process outsourcers), are systematically applying technology and modern methods to find ways to do a portion of legal work better, faster, cheaper. These New Normal innovations won’t replace lawyers, but they will strip away big firms’ ability to make big profits from repetitive content and process work, which means revenue shortfalls will be commonplace. My friend Bruce MacEwen had an excellent post last week in which he imagines putting a law firm into a wind tunnel to “examine its design for every element that creates unnecessary drag and friction.” How much unnecessary drag and friction would you find? If you were starting from scratch, how much of that would you build in?

Dewey’s fundamental weakness was its poor balance sheet, depleted by pension obligations, dependence on “juiced” revenues and capital contributions from lateral partners, merger expenses, partner guarantees and then defections. The key indicator obviously was the ratio of debt (both short and long-term) to capital. The key catalyst was the beginning of partner defections, which turned into a rush for the exits, facilitated by headhunters. Presumably few firms will have made as many poor decisions as Dewey—especially borrowing to pay guaranteed distributions to “inner circle” partners—but I’m not sure it takes as many bad decisions as Dewey made to undermine a firm.

Too many firms today are being managed just as Dewey was, for one purpose only—to maximize cash distributions to top-earning partners—and don’t feel they have the “luxury” of building up their balance sheet by retaining capital or strengthening their long-term position by making investments in technology, skills and process that would enable them to deliver more value to clients.

Instead of a plan to increase distributions to top earners by 6 percent to 8 percent per year, firms should embrace a plan to increase value to clients by 20 percent per year. That will require them to ask clients how to improve value, study best practices elsewhere, invest in improvements and compensate those partners who improve value. Otherwise, you’re just hoping the other guy gets unlucky before you do.

Personally, I’ve never felt the attraction of Russian roulette, although I can comprehend the mix of compulsiveness and desire not to lose face that would cause someone to take the 1/6 chance rather than step away from the table. For whatever it’s worth, only one player at the table loses at Russian roulette, and the same will be true for law firms—any one’s failure creates a residual stability for others as partners and clients sort out the long-term survivors. But given the chanciness (and let it be said, flat out stupidity and nihilism) of the game, why not step away from the table and play a smarter one?

Related coverage: “Ex-Dewey Partners Agree to Pay at Least $50M; Proposed Individual Payments Between $5K and $3.5M”

Paul Lippe is the CEO of the Legal OnRamp, a Silicon Valley-based initiative founded in cooperation with Cisco Systems to improve legal quality and efficiency through collaboration, automation and process re-engineering.

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