The New Normal
The Dewey Dozen: Capital Sufficiency and Survival
Posted Apr 3, 2012 9:20 PM CDT
By Paul Lippe
When news first broke about troubles at Dewey LeBoeuf, I wondered whether problems like Dewey’s are an outlier or representative of broader trends. Then, I explored the long-term trends that are likely to lead to more Deweys.
In this third piece, I want to describe what happens in the very short term when a firm finds itself in a liquidity squeeze.
According to the published reports, Dewey:
• Missed targets, announced layoffs and deferred payouts.
• Has both outstanding notes ($125 million and a bank revolving credit.)
• Has had significant and ongoing partner defections.
• Says that its primary problem is not profitability or revenues, but collections.
• Has been the subject of somewhat critical coverage, including from the Wall Street Journal and New York Times.
So let’s look at the “Dewey Dozen,” the 12 factors—some of which are a function of partnership economics, some are market, some are cultural and some are leadership—that make it surprisingly difficult for any law firm, even a well-established, profitable firm, to work through a liquidity problem:
1) Debt must be paid. In addition to “normal” bank lines of credit, Dewey issued notes, some of which are due in 2013. Often, companies in trouble with lenders because of changed circumstances can force the lenders to “cram down” (restructure or take less than the principal), but that tactic doesn’t work for a partnership. The old saw “if you owe the bank $10,000 they own you; if you owe the bank a million, you own them” doesn’t work if the $1 million you owe them is guaranteed by 100 partners and can be divvied up among into $10,000 recourse obligations. Then they own you. In its restructuring, GM could cram down its lenders and other stakeholders because if GM went away, they’d get nothing, but there’s no one for law firm partners to cram down except themselves.
For those who argue that the alternative business structures (aka nonlawyer ownership of firms) would alter law firm ethics, perhaps you can explain how Dewey’s incentives and effective governance at this point are any different from an investor-owned firm?
I am not a proponent of ABS (firms can get the benefits without it, and a law firm is generally a lousy investment) but at least equity holders would be interested in the long-term success of the firm and would be willing to invest in a turnaround. Dewey’s lenders are only concerned with its short-term ability to repay outstanding indebtedness; if they could convert their position to equity as debt-holders would in a “normal” enterprise, then Dewey’s chance of survival would be materially enhanced, and the financial pressure that ABS opponents worry about clouding lawyer judgment and independence would actually be reduced.
2) Is it better to go before the other guys do? A firm’s obligations (bank loans, notes, long-term leases, severance costs, “underwater” guarantees to laterals and unfunded pension obligations) are pretty much fixed. Each time a partner leaves, the share of obligations held by each remaining partner increases, while the overall revenue decreases. From a “prisoner’s dilemma” perspective, it becomes pretty compelling to not be the last one out the door. The only way to trump the prisoner’s dilemma incentives is a culture of deep cohesion and reciprocal obligation led by trusted, self-sacrificing leaders. As a matter of common sense, firms with lots of laterals, or wide disparity in compensation among partners, are less likely to have such cohesion. Of course, if the firm goes down all the way, creditors can collect against departed partners as well.
3) Everyone is thinking of leaving. Every headhunter on the planet is pinging their contacts at Dewey to test their interest in moving. In theory, half the partners in Dewey (assuming their business is portable) could make more money elsewhere. But in Lake Wobegon (where we lawyers all live) more than half of the partners will be thinking they would be better off financially by moving, and in any event are marking to market their practice either in their heads or in discussions with headhunters and other firms, so some are concluding that they are underpaid. Most partners will be inclined to stay out of loyalty and inertia, but what if only another 10 percent decide to move? Even if those 10 percent are below average, that might be a 5 percent haircut to revenues in addition to 13 percent in departures already announced. Law firms pay huge fees to headhunters for lateral moves (way more than companies pay to investment bankers for comparable size mergers and acquisitions), so they have created an industry that accelerates instability in a time like this.
4) The press keeps the story alive. Being annoyed at the press for covering a story about law firm demise is like being mad at water for running downhill. That’s what they do. And obviously in a 24-hour, Internety world, there are many sources who can keep the story alive by adding details as ongoing partner defections stir the pot. Public companies are “attacked” by activist investors all the time, and they know the only way to respond is by getting the truth out. Blaming the messenger is a sign of weakness. This story will keep percolating unless Dewey cowboys up and presents a bulletproof survival plan and there are no more defections to announce.
5) Getting the cash from clients is not so easy. While big companies are reliable payers, increasingly, they are slower payers. Many unilaterally change payment terms from 30 to 45 or 60 days and take a while to process. So if work was done on Nov. 15, it might not be billed until Dec. 31 and paid until Feb. 29. Law firms traditionally funded that working capital out of partner capital, but increasingly they’ve been funding it from banks. If a firm increases the risk by layering both long-term debt and lateral partner obligations on top of that, then a small blip in collections can imperil the firm.
6) The bigger the matter, the harder to collect. Big matters like M&A tend to be very profitable, but it’s harder to bill or collect until the matter is complete, and so the cash-flow signature is even worse.
7) New business will be slower in coming. Let’s be generous and assume that for half the work Dewey does, the firm is the only choice a client might consider. What about the other half? f you were a sophisticated client, and you were choosing between three equally terrific firms for a new piece of work, would you give the work to a firm that seemed unstable? What if you were a risk-averse client? Even if Dewey loses only 10 percent of that 50 percent of new work as a result, that’s a 5 percent haircut to business over the next 12 months. So now we’ve got a 23 percent haircut.
8) “Friends” are not so helpful. In perhaps an idealized world, institutions like big law firms built up reciprocal loyalty and trust, in part by sharing, collaborating, subordinating their self-interest to others. Both recent research and time-honored wisdom suggest that collaboration is the secret sauce of human competitiveness. But some (I won’t say many) lawyers have elevated short-term gain to the highest principle, which means that when you’re in trouble, no one is going to knock themselves out to help you. The headhunters and consultants you paid a lot of money to get you to the place you’re in can’t help you, and at least some of the people you need will be feeling bruised. When Intel was in trouble in the early ‘80’s, IBM invested because Intel was a strategic supplier. After Steve Jobs returned to Apple in the 1990s, Microsoft invested because Bill Gates felt Apple’s survival was important to Microsoft (the worm does turn). Which of a firm’s clients or other business partners would consider the firm’s survival so important to them that they would invest? Which of their clients would feel that their firm had subordinated its interests to theirs sufficiently to create a deep reservoir of trust and reciprocal obligation? Which law firm, if their suppliers ran into trouble, would accelerate payments to help the supplier? Asked and answered.
9) All of this is distracting. How many pageviews of Above the Law are emanating from Dewey domains? How many hours of work are being lost?
10) No one is going to join the firm. Obviously, no laterals are going to join the firm until all this is truly sorted out. So the revenue injections via laterals are not an option for a while.
11) The only way to restore confidence is to shake it. As Chicago Mayor Rahm Emanuel once said: “a crisis is a terrible thing to waste.” It gives you the chance to cut through clutter to do the right thing. But that requires getting everyone to confront the problems, which most leaders are averse to doing, in part because they think it will lead to loss of confidence and defections. In Dewey’s case, getting to the root of the problem means sorting out what happened to the money that was borrowed and paid to highly compensated partners. It’s one thing to take out a home equity loan to remodel the kitchen, pay for college or fund a new business; but taking out a home equity loan to pay for a cruise when house prices are dropping is not such a good idea.
12) The most valuable asset is illiquid. The most valuable asset of a large firm is its reputation. In simple economic terms, a good reputation allows lawyers at the firm to charge more for work, and reduces their cost of sales in getting more work. Not only is reputation diminished at least in the short term, but reputation is a wasting asset that can’t be used to generate cash. Again, I’m not a proponent of ABS structures, but if real financing were available to Dewey that enabled them to “monetize” their reputation, at least as a backstop, they would be in a better position to navigate their current problem.
I spent about a decade out of law (call me “Rip Van Lippe”) and was surprised when I got back to find that many law firms had embraced overwhelmingly commercial values in how they ran themselves without being explicit about that value shift, and without developing the institutional models to support a truly commercial culture. That didn’t matter during the boom.
If Dewey were a “normal company” like GM, it would get its owners around the table and those owners who were ready to recapitalize would own more going forward and those who weren’t would take a big haircut.
Being halfway commercial and halfway professional is going to lead to a series of rolling catastrophes, so law needs to do some soul searching and pick a coherent path.
Three obvious changes would be to re-visit ABS structures, explore changes to partnership tax rules so firms have incentives to retain more cash on the balance sheet, and sit down with the American Lawyer magazine and come up with a more reliable method of financial reporting.
If the folks at Dewey (and their lenders) want it to survive, it will, but they have to put their money behind it and demonstrate a level of capitalization that will survive a 20 percent drop in revenue. Anything else is just talk while the inevitable happens.
For any other law firm that has incurred debt to shift cash from working capital to partner income, now is the time to recognize that navigating the Dewey Dozen is perilous. It’s much safer to clean up your balance sheet, focus on client value, and be serious about real differentiation.
Managing partners should stand down from the fruitless profit-per-partner arms race and invest in their institutions. A profession which is supposed to be about the long term needs to live up to its values.
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.