Law firms do not just go bankrupt – they collapse. Law firms go from apparent health to liquidation in a matter of months or even days. This pattern has no parallel among ordinary businesses that go through long periods of financial distress and many even file for bankruptcy. But almost none collapse with the extraordinary force and finality of law firms (Morley, John D. ‘Why Law Firms Collapse’ (January 2020), (https://dx.doi.org/10.2139/ssrn.2580616, accessed 10 – 03 – 2022)). And the pressures that bring law firms down are often surprisingly mild. Most collapsed firms crumpled when they were still current on their debts and earning fees. Law firms die with extreme ease and astonishing speed.
John Morley analyses the mechanics behind law firm failures based on the internal analysis of law firms themselves – the business practice, regulatory structures, and organizational dynamics. He argues that law firms are fragile in part because they are owned by their partners rather than by investors. As owners of their firms, partners get paid in profit shares rather than fixed salaries (The Practice – Harvard Law School ‘Why Law Firms Collapse’ (thepractice.law.harvard.edu, accessed 10 – 03 – 2022)). This makes partners acutely sensitive to problems in a firm because it links their individual compensation to the fortunes of the firm as a whole.
The second problem is that because partners are owners of the firms, they face crushing personal liability when a firm finally dissolves. The net effect of concentrated ownership is to make law firms remarkably fragile (The Practice (op cit)). Law firms collapse in predictable ways. Every large law firm blow-up has followed the same basic pattern. Increasing debt, no capital reserves to generate extra cash – substantial borrowings secured by lien on the firm’s assets are a common trend in their demise.
Law firms’ capital structures are freakishly robust that the firms rarely become incapable of paying their debts until almost the moment of their death (The Practice (op cit)). Since a law firm is owned by its partners, the largest expense – partner compensation is not technically an expense at all and does not have to be paid ( Morley, John D. (op cit)). Profit distributions are purely discretionary. This leaves the law firms with huge amounts of revenue that they can theoretically divert to any expense they wish, including the repayment of debt. Far from being fragile, law firms would seem to be almost unbreakable (The Practice (op cit)).
Since the problem cannot be mere financial distress, it must be a deeper structural weakness that other businesses do not share (The Practice (op cit)). And that weakness is a vulnerability to ownership concentration. If partners were not owners of the firms and were ordinary employees, they would be paid in wages or performance bonuses that did not fluctuate with the profits. The partners’ compensation would therefore be basically independent of the firm’s overall profitability.
The regulatory requirements in the legal profession prohibit ownership of law firms by non-lawyers and therefore neither investors nor managers can be given any equity stake in a law firm – s 37(4)(a) of the LPA. Legal practitioners determine the organizational form of their firms, and practitioners dominate the formal managerial positions within a law firm, tying managerial power to the practitioner’s position in the firm (Alan James Kluegel ‘The Ties That Bind: The Internal Structures Of Law Firms And The Dynamics Of Law Firm Dissolution’ (2020)(https://digitalassets.lib.berkeley.edu, accessed 10 – 03 – 2022)). Since law firms are primarily structured as incorporated companies, partners owe fiduciary duties to one another by virtue of their membership in the partnership. Ordinarily, such fiduciary duties would prohibit opportunistic behaviour by firm members, including taking opportunities that rightfully belong to the firm itself. Practitioners serve a dual role, and as such have a competing incentive to promote their own autonomy and maintain a firm structure.
The field in which law firms sit is quite unique in that firms are regulated in such a manner so as to maximize their professional status, yet law firms are competitors in a fierce market and remain wholly dependent on clients for business. Law firms are certainly no exception to resource dependence, as they are financially dependent on the clients they service, that is, their success or failure depends not only on their immediate environment (their internal demography and their competitors) but also on the environmental conditions of their client base they serve (Alan James Kluegel (op cit)). Corporate law firms well placed have a substantial competitive advantage vis-a’-vis client base security of revenue. Thus, maintaining ties with existing clients is even more critical for their survival.
Vulnerability is a weakness that can cause or contribute to a risk manifestation (Tristan Mohn ‘Introduction to risk management’ Feb 05, 2020 (https://reciprocitylabs.atlassian.net, accessed 02-05-2022)). It is a gap that increases the likelihood that something will happen. Vulnerability is real, e.g. structural. Controlling, and avoiding vulnerability equals remediation. By remediating and controlling vulnerabilities, organizations can proactively reduce the likelihood that risks will become reality. Understanding your vulnerabilities is just as vital as risk assessment because vulnerabilities can lead to risks (Joseph Mathenge ‘Risk Assessment vs Vulnerability Assessment: How To Use Both’ (May 27, 2020) (www.bmc.com, accessed 02-05-2022)).
The forces pulling law firms apart are not irresistible. Most firms manage to survive them because most of the time, they enjoy a kind of equilibrium in which partners are inclined to stay at their current firms (The Practice – Harvard Law School (op cit)). A firm begins to collapse only when partners fall out of this equilibrium. The key to figuring out which firms will collapse is to identify the forces that tilt a firm out of equilibrium. Diminishing profitability is one such force. Although elite law firms have almost all become much larger, most of the collapsed firms expanded with a speed and aggressiveness that was unusual even among their peers. Expansion poses a number of risks, each of which can worsen a firm’s relative performance. One such risk is the cost of investing in the expansion since expansion is directly related to profitability.
You can’t manage what you don’t measure (The Deming Institute ‘Myth: If you can’t measure it, you can’t manage it’ (August 13, 2015) (https://deming.org, accessed 02-05-2022)). Assessing your enterprise’s weaknesses is critical for strengthening defense and minimizing business risks. Partner ownership cuts the steel chains of contract and replaces them with leather cords of friendship and loyalty. These leather cords can bind strongly. But if these cords are ever cut—if all that partners care about is money—then partner ownership, instead of binding a firm together, can become the very force that blows it apart (Morley, John D (op cit)). Debt, macroeconomic forces, and the recent decline in demand for legal services are all much less important than we might think. Governance failures and social factors, by contrast, are much more important (John D. Morley ‘Why Law Firms Collapse’ May 11, 2015 (https://clsbluesky.law.columbia.edu, accessed 01-05-2022)).
Morley, John D. (op cit) opines that the first solution is for law firms to structure their partnership liability agreements appropriately. Firms should also consider characterizing their partners’ compensation as salaries and bonuses rather than as profits. He argues that there are several ways to stop these financial incentives from wrecking a firm, but one of the most important is to strengthen non-financial commitments. Informal bonds like friendship, loyalty, and trust can hold a firm together even in the face of financial decline.
Partner ownership also weakens financial ties between partners and their firms ( MorleyJ ohn D. (op cit). The experience of working together as co-owners can cultivate a sense of friendship, loyalty, and trust. The lawyers who run law firms can sometimes feel like more than just employees—they can feel like true partners, bound together by values and deep commitment. The trouble, though, is that partner ownership does not merely cultivate values like friendship, loyalty, and trust; it also depends on them (John D. Morley (op cit). Without these values, the financial incentives created by partner ownership can become too weak to sustain a firm.
|Please note that our blog posts are informal commentaries on developments in the law at the time of publication and not legal advice.