The legal market has its Lehman Bros. moment

by Ida Ince | 30 May 2012

A lawyer leaving Dewey & LeBoeuf's New York offices for the last time

As partners and associates of 190 equity partner US law firm Dewey & LeBoeuf filed out of their 6th Ave. New York office, cardboard boxes of desk clutter in hand, one could not help noticing the similarities with the images of the collapse of Lehman Bros.

The superficial similarity is not merely ostensible, however; the reasons for the collapse of both major “institutions” have striking parallels. The case of Dewey & LeBoeuf (D&L) has its particular interest in that yesterday’s application for US Ch.11 bankruptcy protection allows us to gaze across the ruins of what the modern law firm has become.

So what parallels may be drawn?

1) A “Big Bang”

As in banking, the opening up of the possibilities of financial “innovation” in the 1970s initiated a period in which new products were invented, traded and new sources of profit invented. The unleashing of the investment banks in the 80s acted as an exponent on such developments. How did this affect some law firms? Consider this simple example of pre- and post-financialistion legal work. In pre-financialisation, MiniBank lends money to borrower, law firm drafts one loan contract = fee. In post-financialisation, Megabank lends money to borrower (= contract = fee) and Megabank lends money to 19 other borrowers (= 19 contracts = fee x 19) and Megabank writes hedging contracts for all those loans (= contracts = fee x 20), and Megabank warehouses all the loans (transfers, SPV memo, structuring and tax fees) and Megabank initiates the securitisation of the loans as the SPV issues securities (big fee), plus attendant CDOs and trustee/agent agreement (fee, fee, fee). The logic is simple from a legal business perspective – complex transaction equals lots of complex documents to draft, all of which flow from just one client’s one idea over lunch.

Profitable legal work if you can get it; and a select “circle” of firms did.

2) The desire to “punch above one’s weight”

D&L was not one of the select few, being based in its previous guises as the separate Dewey and Leboeuf firms on litigation, insurance and real estate, which they were good at and it paid well enough. But the perceived wealth and glamour of big finance acted as a huge magnet to lawyers bred on the motto “grow or die”. For firms of the so-called second and third tiers, internal dynamics of partner promotion and external rankings based on turnover and client caché pressured partnerships to pursue the big banks for work, and when this failed for want of previous expertise, to adopt one of two strategies:

live off the crumbs from the big firms’ table. To put it brutally, the bigger firms would structure complex deals and then smaller upstarts would come in at lower cost and do the grunt work of replicating the structure (sometimes badly) across multiple copycat structures for the same bank.
try and lure partners from the big firms in the hope that they would bring their deal pipeline and client contacts with them.

3) Buying into the myth of “talent”

D&L largely opted for the second option: nabbing what are called “rainmakers” from the legal powerhouses. The problem for firms from lower tiers is that the rainmakers tend to be happy with their current remuneration, access to big clients, and prestige. the belief that merely taking one person out of a specific market context and dropping them somewhere else would somehow cause some of the original market (clients) to follow, by virtue of the rainmaker’s talent, seems to have been enough for D&L to pay exorbitant sums to these rainmakers to lure them away. As at the banks, the perception of talent became dislocated from actual results. In the banks this resulted in excessive pay and a belief in invincibility, mitigated by the ability to sack poor performers at an instant. At D&L this resulted in excessive pay, a belief in invincibility, and a willingness even to waive the possibility of ousting poor performers, exacerbating the general inertia conferred by equity partner status.

In specific terms, this meant D&L’s managing partners guaranteed profits for incoming big-hitters, in effect requiring 90 of the 190 equity partners to pay the profits of all during the Great Recession.

4) Over-leveraging

As one can imagine, this was not a viable model, so, as with the banks, D&L went looking for debt finance to meet these costs until the rain started falling.

NY State law bars non-lawyers from owning legal firms (this restriction was recently scrapped in England & Wales), so the possibility of equity finance from non-lawyers was out of the question. D&L naturally enough sidestepped this by issuing about USD200m worth of bonds to some pretty gullible insurers. I say gullible because surely it is obvious that such debt is unsecured, and the assets of any professional firm are its people and their client lists. If there were any need to liquidate such assets, the bondholders would have found these assets long since gone, as has turned out. All that would be left is the expected claim against the issuing partners for breach of securities regulations, mis-selling and so forth

Coming back to D&L’s perspective, this debt heavily leveraged a business already in a recession climate, placing additional debt service burden on the balance sheet on the back of a pure belief that big signings would perform. Had D&L had to refinance the bonds at any point they would have been in big trouble anyway in current conditions, but the state of the balance sheet may well have already borne down on partner sentiment for the future.

5) Internal complexification

Except that according to ex-partner Stuart Saft¹ D&L partners had limited knowledge of what was going on. In a partnership structure, where liability is joint and several (though limited in an LLP), this is fatal. D&L had just merged into one entity, was being flooded with new partners, and was moving in a direction which was a subject of contention amongst these three blocs. A civil war broke out, Saft alleges that a group opposing managing partner Steve Davis reported him to the NY District Attorney. This was bound to freeze the flow of management information to all partners.

Furthermore, it seems that D&L were concerned that management data was being leaked to consultancy and recruitment firms, who were using deal and client details to inform other firms and build up files on target partners for lateral hire. To prevent this partners accepted that lateral parts of the practice would remain over a notional horizon, and that management matters were only discussed in broad terms. As with the banks, people ceased to know what other parts of the organisation were doing, and partners were forced to read newspapers to find out.

6) Getting shorted out of existence

The choke on information and the strong interests of recruitment agencies in data led to a kind of hedge-fund shorting frenzy. It was in these agencies interests to amplify every rumour in order to place pressure on target partners to jump ship. Stuart Saft reports a stream of a partner per day leaving the firm as the rumours intensified. The agencies were in effect selling down D&L’s stock so that investors (partners) dumped their interests and were “bought” at a lower price by competitors, with a hire fee to the agency. D&L took six months to sink, the critical tipping point being hit in the last two weeks as news of guaranteed profits hit the headlines.

The big difference from Lehman of course is that Lehman was proprietor of its various assets (however worthless) whereas D&L’s assets were largely intangible (partner deal books) and any deals in the pipeline are merely following ex-partners into other second tier firms who are mopping up the mess. Nevertheless, the case of D&L is instructive for examining the financialisation of the legal market in the last three decades, not least because like Lehman Bros., no-one would have believed D&L could fail until it happened, and the failure was precisely a failure of belief about a business model. The FT’s John Gapper² has wondered whether this is the end of the line for all but the top 10-15 Anglo-Saxon style law firms, with much of the remaining business being split between what amount to corporate claims/deal factories staffed by managers and paralegals, and boutique firms offering specialist advice. This would seem to mirror the consolidation of banking into a small set of hugely influential institutions, a wider set of faceless retail banks, and a small set of private banks such as Hoares. As in that case, could we see something like a too-big-to-fail aura around the leading circle of firms insofar as it is they which characterise the legal structure and innovations of the world’s capital flows, and thus provide the sole source for knowledge, expertise, and advocacy for an increasingly independent and self-organising law of international finance?

As with studies of traders and deal-based bankers, there is much interest in the possibility of the study of lawyers in the financial legal market. There can be too great an emphasis on court law (important though it is), with even Bruno Latour addressing legal sociology from within France’s highest court. A significant proportion of lawyers operate in firms not unlike D&L, and their mode of operation and dealings with the world are largely driven by their proximity to and thus culture of finance.

The transplant of the financial legal regime of NY and London to other jurisdictions, the currency of the financial world view in many political centres, the financialisation of areas of law (e.g. public law), all these can be traced through (if not back to) the training of lawyers with the Dewey & LeBoeufs of this world. And is this “training” not one of the fundamental foci of critical legal theory? Your author welcomes recommendations of research into this area.

1
His admittedly dry 10 May 2012 interview with Bloomberg Law‘s Lee Pacchia is a remarkably candid assessment of the failure of D&L: http://www.youtube.com/watch?v=ypq5V4y1sAc
2
Law firms have struck the limits of partnership, Financial Times 29 May 2012 http://www.ft.com/intl/cms/s/0/3d4b8fb0-991a-11e1-948a-00144feabdc0.html#axzz1wG9ZY81j