When law firms fail.

• Author: Heinz, John P.

I can never get this straight: Is it "grow or die" or "grow and die"? In late 2008, the Heller Ehrman and Thelen firms failed. (1) Heller Ehrman, founded in 1890, had 730 lawyers spread across fifteen offices in the U.S. and abroad. Thelen, dating from 1924, had more than 600 lawyers in offices on both the Atlantic and Pacific coasts and in Shanghai. In mid-February 2009, other large law firms terminated 1,100 lawyers and staffers in only two days. (2) A week or two later, Latham and Watkins, which had 2,300 lawyers in twenty-eight offices, terminated 190 lawyers and 250 members of its staff. (3) Over a six-month period in 2008, Cadwalader, Wickersham and Taft, a 206-year-old New York based firm, laid off 131 lawyers, 20% of the firm. (4) Cadwalader and Latham are both aggressively managed firms that have been among the most profitable in recent years.

Until last year, high-powered, high-priced consultants made money by advising law firms to invest in expansion, seek broader horizons, and jettison routine, high-volume, "commoditized" work. Firms were told that to prosper they had to double their size, move into new cities, open offices abroad serving multinational Fortune 500 clients, and specialize in high-end financial transactions. To hell with portfolio theory! (5) That was an old-fashioned, outmoded strategy used by the faint at heart; not the way to make big money.

The deterioration in the culture of major law firms is an old story, and it is always seen as deterioration--a change from groups of colleagues, once characterized as "families" or "clubs," into corporate-style businesses governed by full-time managers, heartless and impersonal. A thousand lawyers wrote that old story, and it made for some good copy. Peter Megargee Brown, a former head of the litigation department at Cadwalader who resigned from the firm in an acrimonious dispute with management, said of his antagonists:

The nature and function of a law firm, they felt, was no different from an automobile company or a fish market. So-called professionalism was, they said, a cover for Dickensian inefficiency; professional values that had guided the partnership since 1818 were "old fashioned" and, in today's world, "irrelevant." (6) Patrick Schiltz, an academic lawyer who was a partner at Faegre and Benson, gave this advice to law students:

If you are going into private practice--particularly private practice in a big firm--you are going to be immersed in a culture that is hostile to the values you now have.... You will work among lawyers who will talk about money constantly. (7) But, so long as the money was rolling in, most lawyers were willing to tolerate the unpleasantness. They were well-compensated for the loss of afternoon tea. When the credit bubble burst, however, the absence of tradition, civility, solidarity, and goodwill was all too apparent.

The mobility of lawyers among firms and the resulting changes in the culture of the firms have made it easier to terminate partners. In a firm with hundreds of lawyers, partners do not recognize one another on the street. According to one report, 48 percent of the lawyers who were made full partners in a sample of U.S. law firms between 2000 and 2006 were lateral transfers from other firms, not lawyers who had matured within the partnership. (8)

The clients have also made it easier for firms to make changes. Clients now move their work more often than in the past. Rapid turnover in the management teams at the companies also weakens ties between the businesses and their lawyers, and mergers among businesses mean that there are now simply fewer clients in many industries. Typically, the company's relationship (if there is a continuing one) is with a particular lawyer or set of lawyers, not with the firm. That is why lawyers are often able to take clients with them when they move from one firm to another.

But the most important changes in large law firms over the past decade or two were not matters of culture, style, or ambiance. Rather, they amounted to a fundamental restructuring of the firms and their markets. This was driven by what were seen as competitive imperatives. Top law firms compete for "bet the company" work, where the stakes are so high that the clients do not complain about top dollar fees. To attract clients with these big, make-or-break matters, the firms need to recruit and retain big name talent. When the fate of the company hangs in the balance, the client wants to hire The Best. Should the outcome be sour, the CEO can then tell the board: "But we used Sullivan & Cromwell!"

Competition among law firms was heightened during the last quarter of the twentieth century by ready access to comparative data concerning the business of the firms. The most important statistic, "profit per partner," is a straightforward measure of the profitability of a firm. James Holzhauer, the chairman of Mayer Brown, referred to it as "our 'stock price.'" (9) It has consequences. Partners are mobile; those who have relationships with valuable clients have opportunities to go to more profitable, higher-paying firms, quite possibly taking clients with them. Such "rainmakers" are the lifeblood of the practice. Thus, firms sometimes resort to extreme measures, including pay that is more than those partners are worth in the short run, ventured in the hope that the firm will end up in the winner's circle and collect the big prize. The partners who move often get guaranteed compensation for a couple of years--after which they can move again.

This competition for talent is both a cause and an effect of increasing inequality in the earnings of law firms. That is, to maximize profits per partner, firms must take risks. When the risks pay off, profits increase and lawyer recruitment is enhanced. The winning firms then get their pick of the ambitious lawyers, the rich get richer, and the gap between winners and losers widens. Some firms apparently believed that their very survival depended upon being among the biggest, most prestigious, most profitable firms doing high-end corporate work. Second best would not do.

In early 2007, Mayer Brown, a multinational firm based in Chicago, eliminated forty-five of its equity-holding partners. Its annual revenues at the time were over $1 billion, the highest in the firm's history, and according to the American Lawyer its profits per partner in 2005 were $955,000. (10) But this wasn't enough. Two other Chicago-based firms were doing better: Sidley Austin had profits per partner of $1.2 million and Kirkland Ellis earned $2.1 million per partner. (11) Mayer Brown concluded that it had to do better, and the fastest way to do that was to divide the available profit among a smaller number of partners. The chairman-elect of the firm said: "[E]ven though we've had recent record revenues and profits, our profits are not as strong as they need to be to attract the best lateral candidates and retain the best people at our firm." (12) American lawyers have a keen eye for hierarchy.

In part, Mayer Brown was engaged in manipulation of the criterion used by the American Lawyer in its computations of profit. only partners holding equity in the firm count in determining the rate per partner. Lawyers who are "income partners," or "of counsel," or "special counsel" are not included. Only about half of the Mayer Brown partners who were "de-equitized" (in the professional patois) had to leave the firm--the others kept their jobs, with some other title. (13) But profits per partner increased. This is a typical example of the tactics used by firms to make their numbers look better.

The gap between lawyers at the top firms and lawyers practicing anywhere else has been referred to as a "winner-take-all" market. Serious scholarly work on the concept began, I think, with a 1981 article by the late Sherwin Rosen, an economist at the University of Chicago. Rosen noted that "[i]n certain kinds...