The Collapse: How a top legal firm destroyed itself
newyorker.com
newyorker.com
The Dewey collapse is a fairly typical story of greed, too much leverage, and borrowing against uncertain future earnings destroying a company. Its also a great example of cargo cult thinking. Law firms see their clients merging and think: we need to get bigger too. Thus, there has been a huge trend in law firm mergers the last couple of decades. Yet, law firms as businesses bear almost no resemblance to the sort of traditional companies that benefit from mergers. There's very little economics of scale in a law firm. They have little to no physical capital, and almost all their value is wrapped up in their people, who are only there as long as it suits them.[1] And legal ethics rules penalize larger firms, because they impute conflicts of interest for every lawyer onto the whole firm.
The only value to merging beyond a certain size,[2] is for the managers and administrators, who can use the mergers as an opportunity to funnel more profits up to themselves. At Dewey, Di Carmine and the CFO, two non-lawyer administrators, were making over $2 million per year. They also had golden parachutes and clauses saying they could only be fired if they committed crimes. Their justification for all that was of course the role they played in the merger. Its notable that at lockstep firms, where partner pay is based strictly on seniority, and there is not a huge incentive for partners who take on managerial roles, merger mania has not taken hold.
The collapse is also a wonderful example of how intelligent people can make dumb decisions based on the narratives they create for themselves. Prior to the merger, LeBouef & Lamb was financially sound, while Dewey Ballantine was facing declining revenues. The folks pushing the merger, Davis and the consultants, painted this narrative of LeBouef merging its way into a prestigious brand, and Dewey shoring itself up with a profitable marriage-partner. Of course in hindsight the narrative was ridiculous. The pedigree of the brand wasn't particularly valuable in the end, and LeBouef was not large enough to successfully absorb an ailing firm that was almost as large as itself.
[1] Law firms face a more extreme version of the "talent exodus" problem that plagues tech companies. At a firm, almost all of the value of the business is wrapped up in the partners. If they leave, they take their billings with them and your bottom line is in trouble overnight. The top partners might want to stick with the firm through a rough patch, but they have an enormous game-theoretic incentive to jump ship because if the firm does implode, the folks that don't leave will be left holding the bag.
[2] Practice areas ebb and flow, so you need enough lawyers to support diversified counter-cyclical practices and to be able to cross sell clients internally. The point of diminishing returns for that are probably a quarter of the size Dewey ended up after the merger.
In reality clients are probably smart enough to realize bigger != better, but it's not just pure cargo cult thinking that leads to firms trying to stay large.
Does the federated style of these firms minimize the damage from key walkouts?
> “Rather than speak openly with creditors about mounting debt and shrinking revenue, the defendants began deliberately manipulating the firm’s financial statements,” said Richard Frankel, who heads the FBI’s criminal division in New York, in a statement. “They backdated checks, changed write-offs and even misappropriated loan payments as revenue. All in an elaborate attempt to cover up the increasingly dire situation.”
> Aviva Life & Annuity Co. has sued Davis, DiCarmine and Sanders, alleging they induced the insurer to buy $35 million of secured notes in April 2010. Des Moines, Iowa-based Aviva said Dewey kept its debt secret from partners to avoid the “possibility of a mass defection” of lawyers.
You have a lot of good points on the nature of law. If you're selling billable hours, it is very hard to scale up. Profitability is still per partner. You can find ways to charge more money, or increase the worker bees per partner, but that's about it. Some firms find a way to leverage the connections between partners (think McKinsey, but not a law firm) but that's rare.
The partners and worker bees can leave at any time leaving behind very little IP.
This is why these firms rarely trade at high multiples, and frequently stagnate post-IPO.
Very unlike an engineering company where you have to keep your head down and do the work. Good for them.
If they're lucky enough to make it to partner, they frequently still have huge billing expectations. If they don't pull in clients, they're gone. And if there is a down year before they make it to partner, they can easily get sacked. 80% of law grads are clawing to get these jobs, and the ones who don't wind up underpaid with massive debt.
Compare this to engineering... The median workers do well. The lifestyle isn't that awful. The CEO and top salespeople are still the best paid people in most technology firms.
As he once said - there shouldn't be any law against financial fraud; as the markets themselves will take care of that.
And he himself got away with all the mess by saying there was a flaw in his model of the world.
There's half of their problem right there.
I know, hindsight is 20/20.