Interest Rates or Collateral?

Every once in awhile, a genuinely novel idea comes up in economics, and you would think that given the generally impenetrable, contradictory, and confused commentary emanating from far and wide about our current situation, now might be a propitious time for a truly new idea to arise. Parenthetically, I do not wish to single out any particular source or category of publications as blameworthy for disappointing commentary. It seems universal, from the ed and op-ed pages of our most distinguished papers to (most) magazine backgrounders, and even to the relatively few snippets of academic economic commentary that have emerged. All seem equally at a loss for a coherent explanation of what's happening.

In other words, we need some new ideas, or at least one.

I actually have a nominee.

I credit the reliable David Warsh of Economic Principals for first bringing this to my attention. The essential concept is simple: Every debtor/creditor transaction involves the negotiation of two critical terms, but economic literature has focused on only one: The interest rate.

That is to say, as far as macroeconomics is concerned, the Fed's key job in terms of maintaining relative equilibrium is to focus on interest rates. But the other key variable we've ignored is that of collateral. Or, stated differently, leverage. How much collateral is the debtor putting up? How much leverage are they relying upon?

For this insight, in turn, Warsh credits John Geanakoplos, a professor of economics at Yale since 1994. (Interestingly for our purposes, Geanakoplos also served 5 years in the early 1990's as Managing Director and Head of Fixed Income Research at Kidder, Peabody, which, until it flamed out in the wake of the Joseph Jett scandal was an innovative firm, particularly in the greenfield territory of CMO's.)

Here's the gist of the theory (emphasis mine):

For at least a century, economists have been accustomed to thinking of the interest rate as the most important variable in the economy - lower it to speed things up, raise it to slow them down. Yet especially in times of crisis, collateral demands - alternatively, margin requirements, loan-to-value ratios, leverage rates or "gearing" - become much more important.

Everybody knows that when interest rates go down, prices rise. Less widely recognized is that when margin requirements go down - say, the down payment on a house - prices rise too, often even more. Without some form of control, leverage becomes too high in boom times, and asset prices soar disproportionately. When they crash, leverage crashes with them, and then prices suddenly are too low. This is the leverage cycle, Geanakoplos says, and the current crisis is the result of a particularly virulent specimen. Intervention can mitigate its worst effects.

Central banks, therefore, should rethink their priorities. The Fed should learn to manage system-wide leverage, reining in on it in ebullient times and propping it up in anxious times, in order to prevent the worst outcomes. Leverage cycles happen not because people are stupid, or because they ignore danger signs. It's in the nature of competition to drive leverage to unsustainable levels, whereupon it collapses, with various effects.

I find this fascinating on several levels.

For one thing, it partially explains why the dot-com bubble didn't bring the entire global financial system to its knees. Stock margin requirements have always been essentially 50%, not zero money down. As well, of course, that was limited to one industry in (largely) one geographic territory, not the national housing market.

Second, it has potential implications for our professional judgment and behavior when we act for debtors and for creditors. I will leave you to be the conscience and the brains of your own professional conduct, but just a thought.

The key point is that in certain circumstances, it's the collateral terms and not the interest terms that assume overwhelming importance. If you want a memorable "hook" to understand this, look no further than The Merchant of Venice. Geanakoplos writes:

"Who can remember the interest rate that Shylock charged Antonio? But everybody remembers the pound of flesh that Shylock and Antonio agreed upon as collateral. The upshot of the play, moreover, is the regulatory authority (the court) decides that the collateral level Shylock and Antonio agreed upon was socially suboptimal, and the court decrees a different collateral -a pound of flesh but not a drop of blood."

What, you should be asking by now, are the implications of this for getting out of our current predicament?

As hard as it may be to stomach, if you believe (as do I) that getting "underwater" homeowners to have a real stake in continuing to pay their mortgages, so as to staunch the bleeding of foreclosures, bank writeoffs, deteriorating or unguessable values of "toxic" or "legacy" CMO's and CDO's, and all the follow-on destruction that causes, we may need to swallow deeply and simply absorb big writedowns on those underwater mortgages in order to give the homeowners an incentive to keep paying.

Again, Geanakoplos has written about this:

Despite all the job losses and economic uncertainty, almost all owners with real equity in their homes, are finding a way to pay off their loans. It is those "underwater" on their mortgages -- with homes worth less than their loans -- who are defaulting, but who, given equity in their homes, will find a way to pay. They are not evil or irresponsible; they are defaulting because -- for anyone with an already compromised credit rating -- it is the economically prudent thing to do.

Isn't it against the interest of bondholders to have "cramdown" writedowns of the value of the collateral in the form of homes with underwater mortgages? In a perfect world, it would be, but we've traveled a long way from that perfect world. Consider:

For subprime and other non-prime loans, which account for more than half of all foreclosures, the best thing to do for the homeowners and for the bondholders is to write down principal far enough so that each homeowner will have equity in his house and thus an incentive to pay and not default again down the line. This is also best for taxpayers, who now effectively guarantee the securities linked to these mortgages because of the various deals we've made to support the banks.

For these non-prime mortgages, there is room to make generous principal reductions, without hurting bondholders and without spending a dime of taxpayer money, because the bond markets expect so little out of foreclosures. Typically, a homeowner fights off eviction for 18 months, making no mortgage or tax payments and no repairs. Abandoned homes are often stripped and vandalized. Foreclosure and reselling expenses are so high the subprime bond market trades now as if it expects only 25 percent back on a loan when there is a foreclosure.

As usual, a graphic can illustrate succinctly what a multitude of words cannot.

What this shows is the default percentage rate by month on the horizontal axis (0-2-4-6-8-10-12-14%) and the amount owed on all mortgages on a home divided by the current value of the home on the vertical axis, from 0% at the top to 100% where the green shaded field begins through 300% at the bottom.

The four different right-downward descending lines represent, from left to right, prime loans, ALT-A loans, option ARM loans, and subprime loans.

What's notable to me in eyeballing this is:

• In the white area, where homeowners have positive equity, defaults are relatively low, even for the lowest-quality loans.
• At above 25% equity (75% loan to value), defaults are not material.
• But at about 150% loan to value (50% underwater), defaults go up dramatically, at all levels of loan quality.
• This suggests that if writedowns could occur, giving deeply underwater homeowners equity of at least 25%, much of the national and global problem could be resolved by hardworking people getting back to work to save their homes. Not too much further bailout needed. At least so it suggests.

And again, lessons for us in all of this?

First of all, I hope it's simply been informative and eye-opening. The worst thing about all those liar loans may not have been the teaser interest rates but the no-downpayment scourge.

As I said earlier, your professional obligations, as you interpret them in your mind and your soul, will dictate the extent to which you will participate in negotiating and drafting highly-leveraged transactions in future. As a capitalist at heart, I imagine--with rueful confidence--that you will, by and large, negotiate and draft transactions with every last ounce of leverage your clients can negotiate. It is advisedly the Fed's role, and not yours, to regulate the extension of credit in our economy. But you are not thereby exempted from telling your clients, in the immortal words, that "they're a damned fool and they oughtn't do it."

If you're in a position of leadership in your firm, this would be the most opportune of times to re-examine your firm's capital structure. What level of commitment are people in for? Are you over-leveraged, as a firm? What's the level of "equity" that your partners feel you have in your firm?

This is not only financial equity, of course. But you know that.

Update (15 April):

A reader preferring anonymity (but a regular correspondent) writes:

Great post today.  You made one assertion that is worth exploring.  You said that unlike the dot-com bubble (which was limited to one industry in (largely) one geographic territory), the housing crisis is national in scope.  I thought you might find the following map of interest.  According to these data, 32 counties account for more than half of all foreclosures.  Therefore, the current housing crisis really isn't national but instead is highly concentrated in a few discrete regions.

Therefore, not only is a mortgage bailout sub-optimal economically it is also a hidden income transfer from most of the country to a few counties (as well as an income transfer from responsible borrowers to less responsible borrowers).  

32 Counties Account for 50 Percent of Foreclosures

As someone who has all four feet planted squarely in the "responsible" camp—and whose primary residence is a Manhattan co-op, famously immune from speculative fever because of both the vigilance of co-op boards and the non-negotiable requirement of sizable down-payments and substantial post-closing liquidity—I am deeply sympathetic to our correspondent.  Reckless economic behavior is anathema to me even when I'm immune from collateral damage, and as a taxpayer, here I'm not immune.

But I'm also a pragmatist at heart; I think most Americans are.  So let me quote from the conclusion of Geanakoplos' original piece, which suggests very pragmatic reasons to throw expensive life-jackets at the underwater homeowners:

We know there are some who will be outraged at the idea that their neighbors might get a break, while they -- so much more responsible -- get nothing. To these outraged folks we say, you would benefit too. It is not just your home values and your neighborhoods that will deteriorate if you insist that your underwater neighbors not get relief; it is your tax dollars and that of your children that will be needed to make up for the plummeting value of those toxic assets held by banks, which we taxpayers now guarantee and may soon own outright. It is your job that will be at stake when your neighbors can no longer afford to buy goods and services, causing more companies to cut jobs. So you need to act responsibly again, for your own sake and for the welfare and future prosperity of the entire nation.

This type of cool, ratiocinated argument may come off as a bit too close for comfort to those who defended the AIG bonuses as a trivial amount of money in the larger scheme of things:  That is to say, probably true, but completely tone-deaf in terms of public outrage and more likely to inflame than to cool passions.  You have probably also heard the strained analogy that just because your neighbor smokes in bed doesn't mean you want to short-change the fire department. 

I honestly don't know how to respond to or rebut the "morally outrageous" argument since, as noted, I could easily be tempted to incline in that direction myself. 

The problem is that succumbing to that mildly vengeful instinct doesn't get us out of this.  And at the moment, I want out.  I want out bad. 

If anyone has a suggestion for what "out good" would look like, I'm all ears.  Barring that, I'll take out bad.

The Balance Sheet Recession

More than ample is the ink that's been spilled over trying to explain just exactly what we're going through economically: Is it a bad recession? A near depression? Is it analogous to 1929? Is it analogous to....? Does our salvation lie in monetary policy? In fiscal policy? Are trillion-dollar budget deficits as far as the eye can see a monumental threat to the economy, or not nearly enough to deal with the crisis? Is capitalism fundamentally challenged? Was this all the fault of the hubristic financiers and bankers of Wall Street, whose greed for outsized bonuses is unsated even to this day, or was it in fact the decade of irresponsible self-indulgence engaged in by middle America as they serially re-financed their McMansions to buy Hummers and over-sized flat screen LCD TV's?

We're not going to solve this right now--and the reality is we'll only begin to create informed judgments when we have some perspective, years from now.

But I'd like to pull together a few perspectives at this juncture.

First of all, what can we learn from the past? Unfortunately, less than we think. As The American put it in "Our Epistemological Depression:"

History rarely repeats itself. There are some standard patterns in economic recessions, but major recessions are characterized by something novel. If only this were not the case: economists have devoted a great deal of attention to learning the lessons of the Great Depression that began in 1929, not least Ben Bernanke. As a result, we are unlikely to make the errors of monetary policy made by the Fed in that era (of tightening money when it should have been loosened); or the errors of fiscal policy made by the Treasury (such as raising taxes when they should have been lowered); or the errors of ideological tone made during the 1930s, when anticapitalist rhetoric frightened many potential investors from making new investments. In all of these respects, we have learned from the past.

Unfortunately, initial conditions are too different from case to case to simply apply some historical template that would permit us to fully understand what is currently happening, let alone how to deal with it. Instead of explaining why this recession (or depression) is just like the others, we should attend to what is new and especially problematic about the current downturn and why it may not respond to policies modeled on avoiding the errors of the past.

This is not a counsel of confidence. It suggests there's not so much we can learn from the past and that, by implication, we're flying relatively blind. That's not to say deny that by and large, this piece defends--as do I!--capitalism. Only consider its opening lines (emphasis original):

The history of socialism is the history of failure--and so is the history of capitalism, but in a different sense. For the history of socialism is one of fundamental failure, a failure to provide incentives and an inability to coordinate information about supply and effective demand. The history of capitalism, by contrast, is the history of dialectical failure: it is a history of the creation of new institutions and practices that may be successful, even transformative for a while, but which eventually prove dysfunctional, either because their intrinsic weaknesses become more evident over time or because of a change in external circumstances.

Opposing this counsel of faith in the long-run wisdom of capitalism is a piece written by a former chief economist of the International Monetary Fund, The Quiet Coup, from The Atlantic, which posits essentially that the US is "becoming a banana republic:"

In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). In each of those cases, global investors, afraid that the country or its financial sector wouldn't be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling, as banks that couldn't roll over their debt did, in fact, become unable to pay. This is precisely what drove Lehman Brothers into bankruptcy on September 15, causing all sources of funding to the U.S. financial sector to dry up overnight. Just as in emerging-market crises, the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people.

But there's a deeper and more disturbing similarity: elite business interests--financiers, in the case of the U.S.--played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.

This piece reaches its rhetorical apogee in "The great wealth that the financial sector created and concentrated gave bankers enormous political weight--a weight not seen in the U.S. since the era of J.P. Morgan (the man)." There are other counts to the indictment:

• Under "The Wall Street/Washington Corridor:" "Just as we have the world's most advanced economy, military, and technology, we also have its most advanced oligarchy. [...]
• The American financial industry gained political power by amassing a kind of cultural capital--a belief system. Once, perhaps, what was good for General Motors was good for the country. Over the past decade, the attitude took hold that what was good for Wall Street was good for the country. The banking-and-securities industry has become one of the top contributors to political campaigns, but at the peak of its influence, it did not have to buy favors. [...]
• Wall Street is a very seductive place, imbued with an air of power. Its executives truly believe that they control the levers that make the world go round. A civil servant from Washington invited into their conference rooms, even if just for a meeting, could be forgiven for falling under their sway. [...]
• A whole generation of policy makers has been mesmerized by Wall Street, always and utterly convinced that whatever the banks said was true. Alan Greenspan's pronouncements in favor of unregulated financial markets are well known. Yet Greenspan was hardly alone.

You get the gist: The "oligarchs" of the financial services industry have thoroughly captured the mewling and subservient regulators, Cabinet officials, and Congressmen and Senators. If this is an accurate diagnosis, the solution follows inevitably:

Oversize institutions disproportionately influence public policy; the major banks we have today draw much of their power from being too big to fail. Nationalization and re-privatization would not change that; while the replacement of the bank executives who got us into this crisis would be just and sensible, ultimately, the swapping-out of one set of powerful managers for another would change only the names of the oligarchs.

Ideally, big banks should be sold in medium-size pieces, divided regionally or by type of business. Where this proves impractical--since we'll want to sell the banks quickly--they could be sold whole, but with the requirement of being broken up within a short time. Banks that remain in private hands should also be subject to size limitations.

Fundamentally, this posits the economic meltdown as just desserts for the over-reaching of the priviliged few, who now need to be put brusquely in their place by force majeure.

Warrant you, I do not subscribe to this ideology or this explanatory device for a moment, but I have dwelt on it herein to bring attention to what a substantial stream of thought it is. The Atlantic, after all, is not exactly a fringe publication.

Having presented these two dueling explanations--the first that capitalism, the best of all possible worlds, is still subject to episodic paroxysms of dysfunction in the face of endogenous excesses or exogenous shocks, and the second that (democratic) capitalism, not necessarily the best of all worlds, is subject to capture by oligarchies to the supreme detriment of the commonweal--I'd like to present a third and, I believe, more informative, perspective: What if this recession is not the usual "income statement" recession but instead a "balance sheet" recession.

For suggesting this train of thought I'm indebted to Roger Altman, Chairman and CEO of Evercore Partners but perhaps better known as deputy Treasury secretary under President Clinton, who recently wrote in the FT that:

The rare nature of this recession precludes a cyclically normal US recovery. Instead, we are consigned to a slow, painful climb-out [...]

What is unusual is that this is a balance-sheet driven recession, centred on the damaged financial condition of both households and banks. [...]

For households, net worth peaked in mid-2007 at $64,400bn but fell to $51,500bn at the end of 2008, a swift 20 per cent fall. With average family income at $50,000, and falling in real terms since 2000, a 20 per cent drop in net worth is big - especially when household debt reached 130 per cent of income in 2008..... Now that wealth effect has reversed with a vengeance. The crisis and unemployment have frightened households into raising savings rates for the first time in years. They had been stagnant at 1-2 per cent of income but have surged to nearly 5 per cent.

Why do I emphasize this?

Recessions as described or dissected by Econ 101 are income-shock driven, not balance-sheet shock driven. Typically, rising inflation compels the Fed to tighten money and raise interest rates and the predictable slowdown follows as (a) business investment contracts because of higher funding costs (b) causing all the industries and suppliers associated with that investment to contract (c) laying off their workers and cutting their orders to their own suppliers (d) leading to further employment contraction (e) decreased consumer spending (f) decreased demand for business products and services, and so on until inflation is tamed and the Fed can ease off the brake and back onto the gas.

Alternatively, of course, a single sector can become a bubble unto itself (the dot-com boom or the S&L crash of the 1980's) or an exogenous shock (the OPEC price spike of the early 1970's) can prompt a recession, but the single-sector bubbles are typically self-contained and parochial in scope and the exogenous shock bring forth a plethora of innovation and plain old readjustments (turn down the thermostat and stock up on sweaters?) that hasten recovery.

This time is different.

This time everyone--households, small businesses, big busineses, banks, investment banks, and yes, law firms--has seen their net worth hosed. The problem with recovering wealth is that it takes so much longer than it does to recover income.

The famous arithmetic tautologies still hold, alas: If your portfolio drops by 20%, it takes a 25% gain to recover; if by 33%, a 50% gain; and if by 50%, a doubling.

By contrast, replacing "lost" income isn't all that simple, especially if, blessings upon you, you're unemployed in this environment. But once you are re-hired, the bleeding instantly stops. Not so easy and not so fast in terms of regaining lost wealth.

Aside from having had a tour d'horizon of how we might have gotten here, where does this leave us?

Actually, with some perspective.

Law firms are not, permit me to suggest, the worst industry to be in right now. Would you rather work for a large retail chain? A resort or hotel or entertainment complex? A bank? An investment bank? A hedge fund or private equity house? A magazine or newspaper publisher? An auto company?

If this is a "balance sheet recession," be grateful at least that, while no firm you work for and no industry you work in can bulletproof your 401(k) or the "mark to market" value of your home, the long-term prospects for your income are, I maintain, as bright or brighter than ever.

Chin up.

Is Capitalism Dead?

Is capitalism dead?

The Financial Times has an ongoing series, The Future of Capitalism (I haven't read it all, but "dubious" would seem to be the most apt one-word review so far),  Knowledge @ Wharton has "revisited" the question whether capitalism is working, and even the normally staid and circumpsect McKinsey Quarterly has The New Normal, positing that "the business landscape has changed fundamentally." 

Meanwhile, the redoubtable Economist has Greed--and fear: a special report on the future of finance (for a taste, try "Financial services are in ruins....") and I will commend to you again Amartya Sen's Capitalism beyond the crisis from The New York Review of Books.

I've written before--but it's worth reprising--that a smart friend of mine observed that today "people are reading too many newspapers and not enough history." So a quick bit of history (Wharton):

The April 21, 1980, cover of Time magazine carried the stark headline: "Is Capitalism Working?" The American economy was in crisis after years of stagflation. The story recounted the ills: Mortgage rates were 17%, business loans carried 20% interest rates and productivity had collapsed. The article quoted Robert Lekachman, a left-leaning City University of New York economist, as saying, "The central economic fact of our day is the declining vitality and élan of capitalism and capitalists." On the opposite side of the political spectrum, Chrysler Chairman Lee Iacocca was quoted as saying, "Free enterprise has gone to hell."

Is the doubt now being sown on the fertile fields of capitalism surprising? Not in the least.

For perspective, we've come off a tremendous 2-1/2 decade bull run favoring capitalism: The Reagan Revolution here, the Thacher Era in the UK, China and India opening up, the fall of the Berlin Wall and the spontaneous resurgence of beaten-down Eastern Europe, even the technology bubble can be seen (charitably) in hindsight as a period of glorious experimentation, with some durable innovators that have changed the daily conversation (Google, Microsoft, Apple, just for starters).

Perhaps, then, we should have been more prepared for a backlash.

But what precisely are the terms of that backlash?

A large part of it, I respectfully submit, stems from the outsized importance that the financial services sector took on (Economist).

For a quarter of a century finance basked in a golden age. Financial globalisation spread capital more widely, markets evolved, businesses were able to finance new ventures and ordinary people had unprecedented access to borrowing and foreign exchange. Modern finance improved countless lives.

But more recently something went awry. Through insurance and saving, financial services are supposed to offer shelter from life's reverses. Instead, financiers grew rich even as their industry put everyone's prosperity in danger. Financial services are supposed to bring together borrowers and savers. But as lending markets have retreated, borrowers have been stranded without credit and savers have seen their pensions and investments melt away. Financial markets are supposed to be a machine for amassing capital and determining who gets to use it and for what. How could they have been so wrong?

The core function of finance, after all, is not complicated. It's to channel capital from investors (be they private equity and hedge funds, university endowments, or CD buyers at your corner Bank of America) to productive users of capital. And to reallocate risk in the process from those less willing or able to be exposed to it to those more willing and able.

This is where financial services failed us in the past several years. And in the process, or as the result, of that failure, they have betrayed our trust. Again, to the Economist:

Financial transactions are a series of promises. You hand your money to a bank, which promises to pay it back when you ask; you invest in a company, which promises you a share of its future profits. Money itself is just a collective agreement that a piece of paper can always be exchanged for goods or services.

Imagine, for a second, how finance began, with small loans within families and between trusted friends.... Trust in a modern economy has evolved to the miraculous point where people give complete strangers sums of money they would not dream of entrusting to their next-door neighbours. From that a further miracle follows, for trust is what raises the billions of dollars that fund modern industry.

Trust's slow accumulation pushes financial markets forward; its shattering betrayal batters them back.

A new era of financial regulation is, to be sure, called for (and more work for us, not incidentally). Our patchwork of largely Depression-era regulators, supplemented by rudely bolted-on encrustations designed in haste and for which we can only repent at leisure (see: Sarbanes Oxley), could stand a blank-sheet-of-paper rethink.

After all, were we to task ourselves with the challenge of designing a 21st-Century financial services regulatory structure for the world's leading economy, what are the odds that it would bear any resemblance to what we have today?

But we have strayed a bit from the initial question.

To answer it, I can only recur to first principles, and to do that, I submit to the wisdom of the masters.

First, of course, is the intellectual namesake and virtual godfather of the publication you're reading, Adam Smith himself.

I honestly believe--without meaning to slide into exaggeration or aggrandisement--that Adam Smith did more to improve the lives of more people than anyone in human history who is not reputedly a deity.

His wisdom is too overwhelming to abandon. So I hope.

Second, Joseph Schumpeter. I hope that Wharton is right when they write that:

Stripped down to its core and at its best, American capitalism is ideologically close to the theories espoused by Joseph Schumpeter.... The centerpiece of his thinking is the concept of "creative destruction..."

Creative destruction means that old established companies under capitalism tend to lose their dynamism with time and atrophy under a layer of corporate bureaucracy and complacency. Then entrepreneurs, who usually have few links to the past, introduce bold and fresh ideas for new products, manufacturing techniques, or distribution and displace the old order. The process is often destructive, but also creative. This corporate lifecycle has repeated itself again and again in numerous fields.

The moral here is both harsh and liberating.

Harsh because it involves destruction. Liberating because it involves creativity.

Permit me to make this less abstract. We have traded:

• Howard Johnson's for Starbucks;
• American Motors for Lexus;
• Faxes for emails;
• Trunk-size "mobile" phones for BlackBerry's; and
• Google for almost everything.

Is capitalism, then, done?

As has often been said about America (but not often enough, of late) and has equally often been said about New York City (same), "nobody ever won by betting against them." The same, I devoutly believe, goes for capitalism--although it will surely have a longer reign in the history of the human race than, as passionately as I love both, either America or New York City.

And what has this to do with Law Land?

We're about to experience an unprecedented multiplication of business models in our industry, an exhilarating and tragic journey through what works and what doesn't, an effervescence of creativity and a mournful descent into destruction, all carried out in accelerated time.

Global law firms are not "over" unless you believe that globalization is over. Wall Street law firms are not over unless you believe that Wall Street is history. Boutiques are not over unless you believe we will never see visionary iconoclasts again. Regional firms are not over unless you believe in the brotherhood of man.

The only future that's certain is one of an efflorescence of creativity, right in front of our eyes.

Hold on to your hats.

What I'm Reading

From time to time, people ask me what I'm reading when trying to figure out what is going on in the economy these days. A glib response might be, "anything I can get my hands on," but the question deserves a more thoughtful response, so herewith a book review and a few pointers to online sites that are more helpful than most.

The online sites, first as they're easy to handle in a condensed fashion:

• David Warsh's Economic Principals is perhaps the single most studious, well-written, thoughtful, and occasionally (but not doctrinally) contrarian site I know of. David publishes on a faithful, if quaint, once-a-week schedule, just like the print journalist he was, with provocative pieces such as "More than two aspirin," and "What comes after a golden age?."
• Truth on the Market bills itself as 'academic commentary on law, business, economics, and more," and it's surely worth checking out for that promise alone. While uneven at times, at its best it can be great fun.
• Matrix (on interpreting the real estate economy, with a focus on New York City) is a remarkably wide-ranging and thoughtful site covering the industry that's arguably at the root of all our evil woes, written by Jonathan Miller, who is the gold standard of appraisers in the New York City market.
• Academic Earth bills itself as "thousands of video lectures from the world's top scholars."  And it is.  Origins of the Financial Mess (Alan Blinder, Princeton) is a good place to start.
• Marginal Revolution talks about a wide variety of topics in an often irreverent tone. A current post about the AIG bonus PR nightmare consists in its entirety of:
  

  Outrage, outrage, blah, blah, blah, etc. Often I feel that some topics are too obvious to blog.
  The real lesson is that this is another reason not to nationalize banks. It means politicizing every decision which ends up in the newspaper.
  Here is a good post on why the bonuses should be paid.
  Outrage, outrage, blah, blah, blah, etc.

But forthwith to the book review.

Animal Spirits, by George Akerloff (Nobel Prize Winner in Economics) and Robert Shiller, father of the famous Case-Shiller real estate index, was reviewed in the Financial Times:

[The authors] argue that the key is to recover Keynes's insight about 'animal spirits'--the attitudes and ideas that guide economic action. The orthodoxy needs to be rebuilt, and bringing these psychological factors into the core of economics is the way to do it. . . . The connections between their thinking on the limits to conventional economics and the issues thrown up by the breakdown are plain, even if they were unable to make every link explicit. Even more than Akerlof and Shiller could have hoped, therefore, it is a fine book at exactly the right time. . . . Animal Spirits carries its ambition lightly--but is ambitious nonetheless. Economists will see it as a kind of manifesto.

What are "animal spirits," again?  The most concise explanation was actually provided by a reviewer on Amazon:

In his epoch-making General Theory of Employment, Interest, and Money (1936), John Maynard Keynes noted that concerning investment decisions, "most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits--a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities." Because of this propensity of investors to base decisions on variables other than "market fundamentals," the aggregate investment function of an economy will tend to be highly variable and erratic. Indeed, even today, it is virtually impossible to predict aggregate investment successfully, although the other sources of aggregate demand and supply are relatively well understood.

The book explores, in its Part I, five different dimensions of animal spirits and how they affect the economy: 

• Confidence
• Corruption
• The "money illusion" (basically, people's propensity to ignore modest levels of inflation and deflation and to believe in a constant value of money)
• "Stories" which can mislead (for example, "the Internet will revolutionize everything..."); and
• Lack of perceived fairness (for example, AIG bonuses).

Part II, in turn, looks at some consequences of animal spirits' role in economic decision-making, and how they can help explain the answers to such questions as:

• Why do economies suffer depressions?
• What's to be done about the current financial crisis?  (Caveat:  Events are moving so quickly on this front that the authors' discussion is already looking quite dated.)
• Why can some people not find a job?
• Why is saving for the future so arbitrary?
• Why are financial prices and corporate investments so volatile?

The most valuable aspect of the book is that the authors show how human decisionmaking—as it's really performed, animal spirits and all—violates the classic notion of purely rational homo economicus.  Consider this thought experiment they offer:

Of course, neoclassical economic theory essentially addresses only the top left cell, whereas animal spirits help inform our understanding of the other three cells.  Actually, I would argue that we can ignore the entire right hand column for present purposes, since it's by hypothesis in the realm of the "non-economic," but even if you wipe that from the attention of your cortex, the bottom left quadrant is clearly where a lot of the fascinating debate today around "fairness" (AIG bonuses again), "moral hazard," "fragility," "systemic risk," and so forth revolves.

Indeed, our again-helpful Amazon reviewer, who has simulated the behavior of individuals in markets, reports:

There is nothing in economic theory that says that rational individuals interacting on markets will produce stable, efficient outcomes. The Walrasian general equilibrium model says that if there are no market externalities, there are market-clearing equilibria that are Pareto-efficient, but this model has absolutely NO attractive dynamical properties. When I subjected this model to an agent based simulation (Herbert Gintis, "The Dynamics of General Equilibrium", Economic Journal 117 2007:1289-1309), I found that there is a robust tendency towards market clearing equilibrium, but this is always offset by highly volatile stochastic movements in prices, wages, capital demand, and other macroeconomic variables. This stochasticity is due to the fact that the macroeconomy is a complex, nonlinear, dynamical system, not because of "animal spirits."

Jargon patrol:  A "Walrasian equilibrium" essentially means a competitive environment and not one populated by players with market power.  "Externalities" are costs imposed upon, or benefits enjoyed by, actors not participating in the market in question.  "Pareto-efficient" means that there is no possible change which would leave every player no worse off and at least one player better off.

The fascinating point here is that a core result is "always" "highly volatile stochastic [random] movements in [key] macroeconomic variables." 

And isn't that just what we've seen in the subprime meltdown and its aftermath?

The really stunning fact about the current macroeconomy is that disequilibrium in the home mortgage market could so seriously compromise the American financial system. Even those who foresaw the housing crisis did not predict so massive and credit collapse, leading to levels of government intervention that would have been inconceivable in the past.

Animal Spirits is without doubt an intriguing, thoughtful, and timely book (and a quick read as well at 264 pages including notes and index), but I fear that its very focus on the quirkiness of human decision-making might serve as a pleasant distraction from the core and unavoidable truth that under- or improperly regulated markets cannot be counted upon to produce economically or socially desirable results.

Given the general level of surprise and intellectual shock that have accompanied this global meltdown,, it has become increasingly common to hear calls for a "new capitalism" or for some inchoate reworking of the received canon of wisdom in economics to help us navigate these seemingly unprecedented times.

If you're tempted, as I admit I occasionally have been, to pursue this path, I commend to you Amartya Sen's Capitalism Beyond the Crisis in the March 26,2009 issue of The New York Review of Books.  Sen was the 1998 Nobelist in economics for his contributions to "welfare economics,"  ("Welfare economics," roughly speaking, is the branch that concerns allocative efficiency within a society, income distribution, and—you guessed it—achieving Pareto-optimal results.)

Sen's article is, by and large, an effective effort to debunk the mythologies that have been attributed, for motives base and innocent alike, to the Big Thinkers in economics including Adam Smith and John Maynard Keynes.  Perhaps we should not be surprised that the imprimatur of these legendary names would be appropriated for ideological or expedient means, but it's worth going back to what they actually said, as Sen does, to realize that we may have the blueprint for recovery in front of us if only we choose to see it. 

Here is Sen on the "public/private mix" that undergirds all of today's First World economics.  Forgive the somewhat lengthy excerpts, but Sen's argument is subtle and his prose pleasant:

What are the special characteristics that make a system indubitably capitalist--old or new? If the present capitalist economic system is to be reformed, what would make the end result a new capitalism, rather than something else? It seems to be generally assumed that relying on markets for economic transactions is a necessary condition for an economy to be identified as capitalist. In a similar way, dependence on the profit motive and on individual rewards based on private ownership are seen as archetypal features of capitalism. However, if these are necessary requirements, are the economic systems we currently have, for example, in Europe and America, genuinely capitalist?

All affluent countries in the world--those in Europe, as well as the US, Canada, Japan, Singapore, South Korea, Australia, and others--have, for quite some time now, depended partly on transactions and other payments that occur largely outside markets. These include unemployment benefits, public pensions, other features of social security, and the provision of education, health care, and a variety of other services distributed through nonmarket arrangements. The economic entitlements connected with such services are not based on private ownership and property rights.

[...]

[T]he pioneering works of Adam Smith in the eighteenth century showed the usefulness and dynamism of the market economy, and why--and particularly how--that dynamism worked. Smith's investigation provided an illuminating diagnosis of the workings of the market just when that dynamism was powerfully emerging. The contribution that The Wealth of Nations, published in 1776, made to the understanding of what came to be called capitalism was monumental. Smith showed how the freeing of trade can very often be extremely helpful in generating economic prosperity through specialization in production and division of labor and in making good use of economies of large scale.

Those lessons remain deeply relevant even today (it is interesting that the impressive and highly sophisticated analytical work on international trade for which Paul Krugman received the latest Nobel award in economics was closely linked to Smith's far-reaching insights of more than 230 years ago).

[...]

Even though people seek trade because of self-interest (nothing more than self-interest is needed, as Smith famously put it, in explaining why bakers, brewers, butchers, and consumers seek trade), nevertheless an economy can operate effectively only on the basis of trust among different parties. When business activities, including those of banks and other financial institutions, generate the confidence that they can and will do the things they pledge, then relations among lenders and borrowers can go smoothly in a mutually supportive way. As Adam Smith wrote:

When the people of any particular country have such confidence in the fortune, probity, and prudence of a particular banker, as to believe that he is always ready to pay upon demand such of his promissory notes as are likely to be at any time presented to him; those notes come to have the same currency as gold and silver money, from the confidence that such money can at any time be had for them.[1]

Smith explained why sometimes this did not happen, and he would not have found anything particularly puzzling, I would suggest, in the difficulties faced today by businesses and banks thanks to the widespread fear and mistrust that is keeping credit markets frozen and preventing a coordinated expansion of credit.

It is also worth mentioning in this context, especially since the "welfare state" emerged long after Smith's own time, that in his various writings, his overwhelming concern--and worry--about the fate of the poor and the disadvantaged are strikingly prominent. The most immediate failure of the market mechanism lies in the things that the market leaves undone.

And here, if you will, is the punch line:

Smith called the promoters of excessive risk in search of profits "prodigals and projectors"--which is quite a good description of issuers of subprime mortgages over the past few years. Discussing laws against usury, for example, Smith wanted state regulation to protect citizens from the "prodigals and projectors" who promoted unsound loans:

A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which were most likely to waste and destroy it.[4]

The implicit faith in the ability of the market economy to correct itself, which is largely responsible for the removal of established regulations in the United States, tended to ignore the activities of prodigals and projectors in a way that would have shocked Adam Smith.

The present economic crisis is partly generated by a huge overestimation of the wisdom of market processes, and the crisis is now being exacerbated by anxiety and lack of trust in the financial market and in businesses in general.

Sen also writes that unappreciated in the current crisis is the relevance of Arthur Cecil Pigou (a contemporary of Keynes, also at Cambridge and also in fact at King's College).  Whereas Keynes viewed the economy primarily through a mechanistic and hydraulic lens (the value of the famous "multiplier" being a primary example), Pigou put his focus on psychology, where Sen (and yours truly) believe it belongs.  At the root of economic fluctuations, Pigou wrote, were "psychological causes," namely "variations in the tone of mind of persons whose action controls industry, emerging in errors of undue optimism or undue pessimism in their business forecasts.[5]"  Sen goes as far as to say that "the real crisis...has become many times magnified by a psychological collapse," and he scarcely overstates the case.

Perhaps we should conclude with the culminating irony of this short tour of the landscape of Fabled Economists:  It is that while Smith and Pigou are traditionally seen as "conservative," and Keynes as something of a rebel, the first pair were far more outspoken, insightful, and insistent upon the importance of non-market institutions and non-profit values.

What else am I reading? Alpha by author:

• Geoff Colvin's Talent is Overrated:  What Really Separates World-Class Performers from Everybody Else.  This book, based soundly in empirical research, delivers the hard message that true excellence depends upon hours and hours (10,000 hours, to be precise) of "deliberate practice"—be it the young Mozart composing, the young Tiger Woods practicing, or any aspiring concert violinist.  The same, by extension, is true of surgeons, mathematicians, CFO's—and lawyers and writers.  As Colvin puts it, this is good news and bad news:
  
  "What would cause you to do the enormous work necessary to be a top-performing CEO, Wall Street trader, jazz, pianist, courtroom lawyer, or anything else? Would anything? The answer depends on your answers to two basic questions: What do you really want? And what do you really believe? What you want - really want - is fundamental because deliberate practice is a heavy investment."
  
  
• Jerry Coyne's Why Evolution Is True.  Demolishes creationism and "intelligent design"—and then intellectually carpet-bombs them again, to make sure "the rubble bounces," as Churchill described the goal of a particular bombing campaign in WWII—but does so with respect and patience.  I can do no better than to repeat the aphorism that "Nothing in biology makes sense except in the light of evolution."  Coyne explains why, and brings you up to date on recent developments in this endlessly fascinating science in the bargain.
  
  
• Niall Ferguson's The Ascent of Money: A Financial History of the World:  Ferguson recapitulates the history of money from the pre-Christian era through today's subprime meltdown and global credit freeze, noting that bubbles are as much a part of economic history as are booms and concluding with a warning that excessively precautionary regulation  cannot and should not remove the possibility of extinction for institutions which are weak.  That is to say, financial crises should and must result in casualties.  Or, as Joseph Schumpeter put it in The Theory of Economic Development (1934):  "This economic system cannot do without the ultima ratio of hte complete destruction of those existences which are irretrievably associated with the hopelessly unadapted."
  
  
• Dexter Filkins' The Forever War  A harrowing account of the "war on terror" from the rise of the Taliban in the 1990's through virtually today in Iraq and Afghanistan, by one of the New York Times' star reporters.
  
  
• Michael Lewis' Panic:  The Story of Modern Financial Insanity, a tour de horizon of recent financial embarrassments, using the tool of reproducing contemporaneous (and a few subsequent) accounts and analyses, and covering the collapse of Long Term Capital Management, the Asian financial crisis of the 1990's, the dotcom meltdown, and early warning signals of our present distress.  Plus c'est change.
  
  
• Jessica Livingston's Founders at Work:  Stories of Startups' Early Days.  The stories of mostly legendary (and a few relatively obscure) entrepreneurs, told in their own words through extensive interviews, about the early days at their would-be companies, including:  Max Levchin/PayPal, Steve Wozniak/Apple, Mike Lazaridis/Research in Motion, Mike Ramsay/Tivo, Charles Geschke/Adobe, and Ron Gruner/Alliant Computer.  Utterly charming.  And the moral?  (1)  Expect the unexpected.  (2) And meet it with persistence. 
  
  
• Daniel Pink's A Whole New Mind:  Why Right-Brainers Will Rule the Future.  Pink's thesis, fairly widely adopted today, is that human economic organization has moved from the agricultural to the industrial to the information and now to the conceptual age, where the value is on those individuals and firms capable of integrating empathy, meaning, design, and a narrative (a/k/a "story") to their products and services.  If you or your firm can't master those skills, beware of "Asia, Abundance, and Automation."
  
  
• Robert Samuelson's The Great Inflation and Its Aftermath:  The Past and Future of American Affluance.  An economic and political history of what is now a curiously forgotten period, the "great inflation" of the 1970's and early 1980's, famously cut off at the knees, along with much economic activity, by Paul Volcker and Ronald Reagan in the 1981-'82 recession.  Not, perhaps, a deep or subtle read, but a fascinating and thorough portrayal of, as I say, an oddly invisible era.
  

Enjoy.

The Profit Imperative

The news out of Dewey & LeBoeuf--that 66 partners, or about one in five of their 350 partners, have seen their compensation cut over the past 15 months by up to 80%--begs for an explanation, or at least some commmentary. First, what's going on in the firm's own words:

The reductions are meant to weed out less-productive partners, firm Chairman Steven Davis tells The Am Law Daily.

Those affected by the "substantial performance-related reductions to their compensation" represent a wide range of practices, Davis says. The partners include some who have been practicing for 25 or more years.

Of the 66, the more fortunate are now taking home $25,000/month, the standard draw for partners. Lower-tier partners have faced more drastic reductions, with monthly draws of as little as $10,000, or an annual total of $120,000 -- $40,000 less than the starting salary for a 2008 incoming first-year.

Both Davis and executive director Stephen DiCarmine characterize the recent actions as an intensification of the firm's long-term strategy of replacing poor performers with higher-producing laterals. "We have a merit-based compensation system," Davis says. "There are a variety of outcomes that people have experienced. It probably occurred to a greater and enhanced extent due to the merger."

Paying partners less than first-year's? What on earth, you may be asking yourself, is going on here?

To begin with, I have nothing to say about the selection criteria for who's taking these hits and who isn't (or, as the firm puts it, who is "experiencing which outcomes"). I can only take the firm at its word that they are intended to be performance-related and to alter the mix of partners over time.

The point I'm interested in is a larger one. Why would a firm feel compelled to take such drastic measures in order to--at least partially--protect the very high incomes of its other partners?

This brings us to what I call the "profit imperative."

First, required is a small digression into the wonderland that is law firm accounting. Partners (we're talking equity partners) actually wear three different and distinguishable hats, in terms of their economic participation in the firm:

• Workers/producers, in which role their job is to actually bill hours and perform client work. In this role, their appropriate compensation is what the firm would have to pay a non-equity partner to perform the same work.
• Managers/administrators, in which role they help run their practice groups or departments, manage staff, mentor associates, participate in firm committees, and so forth. In this role, their appropriate compensation is what the firm would have to pay nonlawyer executives to perform the same work.
• And last and only last, equity partners, which is to say, owners with a residual claim on the profits of the enterprise after all other expenses and claims have been satisfied--including, if you want to be rigorous about it (and some of us do), paying the first two sums listed above out of operating income.

But of course, in wonderland, partners view themselves as wearing one and only one hat, namely the last one. This means they view their compensation as coming entirely from their role as equity owners. And given the current realities of law firm organization, finance, and accounting, they are entirely right to see it that way, however economically irrational that might be in the abstract.

Why does this matter? Only because, as we're about to see, "profits" in law firm land have a special meaning, and that's why they're imperative.

If equity partners across BigLaw had been raised from 3L status on to understand, internalize, comprehend, and expect that their compensation would consist of those three different components, the last of which is highly variable, profits would not be as imperative as they are. But that's not the world we live in.

So now that we're all agreed on the financial irrationality of partners' compensation being paid entirely out of "profits," and are equally agreed that this is culturally embedded and not about to change in your lifetime or mine, it's a baby step to seeing why profits in a law firm cannot fall precipitously and expect the firm to remain in equilibrium. It comes down to expectations.

Perhaps the simplest way to explain this is to contrast it to a normal company, say, Toyota or GM.

As is exhaustively known, GM has been bleeding cash and losing money hand over fist for most of this young Century, yet it continues to exist. The fact that it may not continue for too much longer, and that its pleas for help from Washington may be rewarded, only speaks more strongly of its durability. As for Toyota, it's been coining money during the same period and, even though it may suffer its first loss in its 70 years of operations, there is absolutely zero doubt about its continued viability as a global industry leader.

And the point would be?

• Law firms cannot survive a single year with zero profits.
• That, as we know, is all that partners have to take home.
• If partners have nothing to take home, they will be gone.
• And the firm will be no more.

This may provide perspective on the drastic measures Dewey has taken. There are, of course, other examples of unprecedented Hail Mary's techniques being employed:

• Norton Rose is floating the notion of a four-day work week;
• CMS Cameron McKenna is asking partners to "volunteer for de-equitization" (no, I'm not making this up);
• 92% (92%!) of City of London partners recently polled by Legal Week predicted a drop in profits of more than 15%;
  • 65% predicted it would be more than 20%;
  • 47% predicted it would be more than 25%; and
  • 17% predicted more than 30%.
• And the drastic cuts being implemented far and wide are, at the moment, unavoidable:  "Tony Williams, former managing partner of Clifford Chance and the co-founder of Jomati consultancy [and a good friend of mine—Bruce], said: "You always have to look forward. Cutting people has not just been a knee-jerk reaction [to falling profits]. You have to take the appropriate decision at the appropriate time.""

The point?

Simply that noisy protestations about how firms are cutting people loose in wholesale numbers—be those protests boisterous and cynical or heartfelt and agonized—miss the point that a reasonable level of profitability for a law firm is not a luxury and not an option.  It is as required for survival as oxygen is to us.

The Non-Equities (& Others) Heard From On "The Great De-Leveraging"

Well, that'll teach me...

The volume of commentary following my publication earlier this week of "The Great De-Leveraging" has been unprecedented.  Depending on your attitude, that is either deeply gratifying or almost overwhelming.  As one who takes the positive view by default, I choose option A.

Therefore, I wanted to recap and respond to some of the very thoughtful remarks I've received.  First, a few quick preliminaries:

• "Comments" on "Adam Smith, Esq." are broken.  Yes, I know, I know.  This is a technical issue and not an editorial decision.  We have a complete revamp of the site in the works--currently under wraps--but my devout hope is that that will cure this issue.
• I have attempted to keep the identity of all commenter's scrupulously anonymous, and I hope I have succeeded.
• Without exception--even where people disagreed with my original piece--the remarks and observations have been thoughtful, reflective, and generous.
• I have, as editor-in-chief, reserved the right to condense comments.

Without further ado.

First, "Regular Guy" takes issue with my description of the non-equity position to begin with:

One of my friends forwarded to me your article on The Great De-Leveraging. She was particularly interested in a section in which you wrote "Non-equity lawyers don't have to beat their brains out.  So they don't.  Their deal--again, a perfectly rational one, to them--is that, premised on good behavior, they have a job essentially for life at, say, $350,000 to $450,000/year, adjusted for inflation.  If you think that's not an attractive deal, I suggest you immediately take the elevator down to the street and ask the first ten people you encounter if they'd like such a job."

I am a non-equity partner in Philadelphia, but there's almost nothing in the quoted section which rings true. I (and my friends who are non-equity partners in Philly, DC and in NY) are under incredible pressure to bring in new business and to meet billable hours requirements. And we do it (at least in Philly) for substantially less than $350,000. And on top of it, we get to pay for our own benefits out of pocket. I agree: if we ever had the deal you describe, it would be perfectly rational to do it forever. But I don't know anyone at any firm who ever collected $350,000 to $400,000 for good behavior. I'll be on the lookout for it, though . . .

Frankly, I'm not quite sure what to make of this, since it was an "outlier" in terms of reactions.  Clearly different firms operate at  different economic levels and for some paying a non-equity the amounts I mention might not make sense within their overall compensation structure or not be feasible financially, so I don't doubt that "Regular Guy" is describing his world accurately. 

My point was that, regardless of the exact level of the numbers, they're quite respectable incomes in the US economy as a whole--indeed, according to our President, you'd almost certainly qualify as "wealthy" and worthy of paying additional taxes.

Next up, we have a commenter at  Legal OnRamp who provided a remarkably thorough canvas of the non-equity partner landscape.  I've highlighted key points.

Some excellent data.

Some conclusions I would respectfully differ with.

Nonequity partners, properly applied, are more profitable than associates, notwithstanding their lower production of hours, for a number of reasons. Firstly, they are considerably more experienced and efficient, and thus a higher proportion of their hours worked are billed and collected.

Secondly, their billing rates are higher, and every hour worked has a higher margin as against the allocation of fixed overhead to them as timekeepers.

Thirdly, they tend to have some book of business, just not enough to justify a full equity partnership position. This provides some breadth and stability to the enterprise business base.

Fourthly, they tend to have some real expertise and help out in landing new cases.

Fifthly, they tend to contribute to the administration and partnership duties, from recruiting, mentoring new associates, all manner of committees, etc., thus spreading the burden among a wider group.

Sixthly, it tends to be very easy to project based on years of past experience what the contribution to the bottom line of the firm will be, and their compensation and benefits packages are correspondingly tailored so that the firm makes a profit spread from every one of them.

So....you do not as a manager need to have them working 2,000 hours (though you would like that!). You get 1600 hours at $500 collected from a service partner and she puts $800,000 into the kitty. Salary and benefits at $400k, overhead allocation $150k, net to the firm $250k. Bonus structures encourage more work and there is often generous sharing for it. But it is not required because there are all these other reasons not to force them out if you are making a quarter million a year from their efforts and they carry all these other burdens that would have to be borne by your equity partners otherwise.

Contrast that with an associate doing 1900 hours at $300 per hour, but a fairly typical post billing write down of 6% on hours...or 120. Net collected 1780. All in salary and benefits is $200k, less the overhead allocation of $150k and you net $114k. But, there is great variability in associate productivity. Many will work 2,000 hours or more, but the pre-billing write-offs can amount to 15% for the first two years. Frankly, if you can collect 1600 solid hours off an associate in each of the first two years, you are not doing all that badly. And that alas means that you are about at zero net contribution. Maybe.

Additional partner time is spent reviewing work product, much of which is not billed to the client. Associates in the first three to four years have little ability to carry administrative and other burdens, at least not to the extent of the service partners. And certainly they have no real expertise in the first few years. And there is the element that large numbers of them are going to leave to pursue other directions than big law, after a couple of hundred thousand dollars of sunk costs in recruitment, summer programs etc. per person, whereas the income/service partner has become a long term participant on the team.

There are other elements that merit consideration. The income partner position is also one that allows the firm to flex with people of talent that have issues in "life" that you want to accommodate. A disabled partner who can only work 1200 hours a year, or a partner that wants to dial down the demands while she raises three young kids, would be only two of dozens of examples of ways that the firm will "park" a valued talent that is not in a position to churn and burn like an equity partner must.

It is also an "incubator" position where young associates that the firm has picked out as the "best of the best" are made partner, or are lateraled in for a term to prove themselves. The ambition is to get them up to equity partner performance numbers, because by definition that is where the real economics happen. But obviously not all of them will make it. Not uncommonly there will be some in this class that are an "investment" and will be expected to generate more business, with a few less hours (say 1750 instead of 1950 but with a slug of development hours and activities in accord with a formal business plan).

And, partner culture notwithstanding, this is a class that is effectively "at will". There may be procedures and niceties, if you don't cut it you are out. There are no illusions about this. Whereas at the equity partner level, the protections and practices of the past make the process difficult and painful when they have to be implemented. But there is some stability and comfort in that too.

There is much more to it than just this, but I respectfully suggest that this income or service partner quadrant of the firm is not a wasteland of inattention and losers in a major firm. Yes, there are some that need to be looked after and in some cases counseled out. But the fact is, most of them are PROFITABLE and contributing in myriad ways that associates cannot and do not.   And that is but one reason why as the firm looks inward to decide where and how to cut....that it will not fall on the income partner ranks as heavily as you may suggest it should.

In a nutshell, I think many of these are valid points, especially the initial ones about billable rates and realization ratios being strongly superior to those of junior associates. 

But partly, I submit, this is simply a result of every junior person being at a natural and understandable disadvantage in terms of clients' willingness to pay.  Once associates reach their middle, and certainly their senior, years, their rates and realization rise to very comfortably profitable levels.  It's hard to imagine a world where lawyers vault magically from 3L grads to 4th or 5th years with nothing in-between.  Until we can invent a time machine that warp-bypasses those years, I'm not sure how having a larger cohort of non-equity partners helps alleviate the inevitable waiting-and-training game.  How did those non-equities get where they are, after all?

So it strikes me that those points may be less cause to celebrate non-equities than cause to be grateful that junior associates finally do acquire experience and talent, as costly as it may be to watch them do it.

The point about non-equities being able to assume "administrative and partner duties" including recruiting and mentoring is one I violently disagree with.  Indeed, part of the dysfunction I perceive in firms with large non-equity tiers is precisely that they act as a buffer and "sound insulation" between the partners and the associates.  This is neither healthy for associate development nor for partners' getting to really know the rising young talent pool--not to mention associates' prospects for partnership when that day finally comes.

This would also be the occasion for me to mention--as I did not in the original article--that a common complaint about non-equities is that they hoard work, depriving associates of essential training, implicitly overbilling clients for unnecessary seniority, and gumming up the discipline of proper staffing ratios.  To observe that this is an especially severe problem in this environment would be stating the gruesomely obvious.

Likewise, the points about "life" issues frankly echo one theme I tried to address, perhaps inarticulately, in my initial column on this topic.  

Let me hasten to confess that one reason I may not have been pellucidly clear about this issue is its potential for being viewed as politically incorrect, but here I'll say it: 

I do not believe that a law firm can be simultaneously a "lifestyle" or "work-life balance" firm and an uncompromising, bet-the-ranch, "go to" firm for only the highest-value and most prestigious work.

There, I've said it.  You have a choice, and both choices are eminently defensible and rational.  But I believe you must choose.

Next comes an observer who takes issue with The American Lawyer's definition of "non-equity partner," and who therefore concludes that my entire ratio calculation is askew and fundamentally uninformative. 

While I don't doubt that he has done has research assiduously, as noted in my original piece, I took the "TAL" data at face value as having at least the virtue of a consistent metric.

One failing of using the NEP to Partner ratio is that a number of the firms with low or zero ratios just use a different title--counsel, senior attorney whatever--to hide the economic equivalents of NEPs.  As you point out in the productivity chart, counsel are even less productive than NEPs--meaningfully so in the "more profitable" firms. 

Using Skadden as the first example--mostly because I know their web address off hand--they have 236 partners and 96 counsel (not counting "of counsel" or European, regional or pro bono counsel, but including "special counsel") for a ratio of 0.406.  This takes Skadden way, way out of your circle of cultural stalwarts, which is a much more select group than the NEP:P ratio implies. 

What follows is my quick counting of website listings [and he proceeds to conduct a similar analysis across another dozen or so firms]

[...]

Anyway, very interesting post.  Thank you.

I shall re-direct his critique to Aric Press.

Next, we have a very thoughtful, even soulful, response, gracefully outlining the pressures  generated when a high-performance culture collides with the life of a mere human (highlights mine).

I would agree with you that some of those non-equity partners, senior counsel, etc. are drags on the system.  But it is profoundly difficult to make that out from just the "hours" figure.  The very deal in becoming a senior counsel is that you have something the firm wants to keep, but you aren't willing to accept as remuneration the currency that they are willing to give you for it -- equity partnership. 

As you noted, it is obvious these days that the life of an equity partner is no better than that of an associate - you just get paid more.  Eventually.  After you have paid off your buy in.  In my firm, new partners made considerably less than 8th or 9th year associates, yet had rainmaking responsibilities, etc.  Lousy deal, and increasingly, talented people noticed.  Indeed, because of all the additional time doing client development, etc. etc., the equity partners who really WORK, carrying the load for those old guys who don't, have a terrible deal these days.  You'll make a nice corpse in your expensive coffin.

So what do the talented people do?  The ones who would be offered partnership, but frankly aren't sure that they want it?  Believe it or not, those people do exist.  A lot of them are women.  And at least for a few key, biologically-driven years, they want and need to dial back on the soul-killing hours.  And if one is HONEST, billing 2500 hours is soul-killing because you worked so many more hours than that.

I was offered, and did not take, a non-equity position.  I would have been on reduced hours (work 40 rather than bill more than 40 was the deal), I could be paid on a 1/3 eat what you kill. 

I was a talented antitrust litigator capable of running cases and capable of very complex analysis.  The clients liked me.  There was a core cadre of women with this deal at my firm who were routinely offered equity partner status every few years.  Typically nobody took equity status because the extra money wasn't worth the price.  This is because we were in control of our own hours (because successful participants under this system have their own clients who are loyal and trust their work), our conversion rates billed/collected were spectacular, and we represented niche practices that were not easily replaced.  Why do you think that the firm was willing to make these deals with us in the first place? 

So yes: in a world where only the raw number of hours billed matters, these people are less profitable for the firm.  But if our conversion rate is extremely high, we're critical to the relationship with some long-term clients, your "diversity" numbers plummet and there is no one to mentor new female talent coming up, and we're a straight 1/3 pay with risk borne by the non-equity, I would argue that these people are one of the very best deals in law firms.  Indeed, the fact that the firm was willing to think outside the box to keep some of these folks tells you that there is profit there.

The bottom line of my little screed is that the raw hours worked numbers don't tell the story of a person's value to the firm.  A senior counsel (other non-equity) has a deal whereby they work fewer hours for less pay.  If the deal doesn't work for both sides, the senior counsel gets canned.  In litigation, senior counsels are sometimes called non-equity partners so that one's card will say what the client wants to see.  But really: this is a strategy for holding onto talent that has decided that working even more hours than one worked as an associate is not worth the price.

Hard to argue with.  So I won't try. 

I told you it was soulful--and deeply appreciated by me.  Next:

Bruce,

A very interesting post.  One comment to consider regarding the relative value of income partners to associates.  At least [in my non-US country], most income partners feed themselves, in the sense that they have direct client contacts that send them enough work that keeps their plates full. 

It is not enough work to keep a pyramid of associates busy beneath them, hence they are not equity partners.  Clients prefer experienced lawyers to inexperienced lawyers because they get more value from them, despite higher hourly rates.  Clients hate paying for 1st year lawyers who contribute relatively little to a file when compared with their hourly rates. 

In my experience, until associates have 2-3 years experience under their belts, they are rarely more useful than a good quality paralegal, whose hourly rates are much lower.  [Here's the same point our second commenter made, so you can mentally reprise the same reaction I had then.--Bruce]  We need junior associates only because we need a future stream of partners.  As you point out, not a very high percentage of those we bring in make it to even income partnership, let alone equity partnership. 

If you agree with Richard Susskind, as I do, that law has much work to do on refining legal work process, then there will be even less work for associates to do in the future, as, organized properly, more work can be done by paralegals, or outsourced to contract lawyers or lawyers in lower cost centers.  Yes, we will continue to need the future partners, but does it make economic sense to pay crazy wages when only one in ten or twenty will make partner. 

The cost of associates is not only in their wages, but also in the time, effort and money to recruit them, and then train them when they come on board.  The best case scenario is that when they leave, they go in-house to a client, and if you have treated them well and have a good alumni program, they may become your client. 

In the worst case scenario, you have to pay to off ramp them.  For a very large percentage, I doubt that their cost is ever re-covered by the firm.  That is why firms hold onto those with experience who can feed themselves, and give good advice to clients.  If they work fewer hours, they are compensated less.  The key is that they are generally good lawyers who are valued by clients.  I'll admit that if they can't feed themselves, then you have to ask, do you keep them on board for what they are paid relative to what associates are paid, who don't bring in any work.  When you add up the real cost of a 1-3 year associate in New York vs. an income partner who completely or largely feeds him or herself, then the economics becomes very different.

Thoughtful and, if I had to bet, penned by someone with a fair degree of exposure to economics in their background.

Next, we have an opinion about how non-equity partners' willingness to work for (relatively) less could threaten the position of equity partners in the longer run:

Your rant [Was it a rant?!?--I thought it was pretty reasonable.  Bruce] about Non-Equity partners could be dead on if you are an equity partner worrying about how to protect your $2 million draw. However, the prevalence of non-equity partners is indicative of another unpleasant reality.

There are many many lawyers who are perfectly competent to do the work and are happy or willing to do so for less money. As we all know, not everyone is a rainmaker. Most of the horned rim types engaged in the securitization mill are technical geniuses but clumsy back slappers. One way or another the redeployment of these people in the legal market place is going to put pressure on big firm economics. Particularly in world with bankers capped at $500,000.

Keep up the great blogging.
(former Big Firm equity partner happy to have left the law)

And finally, this piece from a BigLaw partner who's a regular reader (highlights, again, mine):

        Your last piece, the Great De-Leveraging Article -- is really one of your recent best analyses on the current law firm model.  Well done. 

        As you will recall, you and I corresponded a little over a year ago, when I said that I believed there was a "bubble" in law firm "stock prices" in the form of profits per partner.  The then-existing model could not continue to sustain its growth in profits per partner at the historic rate.  All the available revenue levers -- leverage, rates, utilization -- had all been taken close to their logical maximum points.  Moreover, the drive to continue increasing those profits was leading to poor business practices that would bite firms when they could no longer be increased.  For example, the increased reliance on leverage, in large part through parking associates in the income partner spot, would not be sustainable over the long term and leads to an underinvestment in new talent.  Similarly, the constant increase in rates, particularly for junior associates, was starting to alienate clients.

        As we now are starting to see, the bubble for law firms is popping.  They cannot maintain the profits per partner at the historic rates.  In an effort to prevent a free-fall in partner profits, law firms are now "de-leveraging."  And many firms who could not (or are currently not) doing this fast enough, are starting to fall apart (e.g. Heller, Thelen, etc.) because the collapse of the PPP sends the rain makers to other firms, leaving the firm to collapse of its own weight.

        I think you are right that this is the time that firms need to start afresh -- Andy Grove style -- to figure out their strategy.  But, I believe that the firm leadership in only a few firms actually understand the dramatic nature of the strategic decisions they should be contemplating.  Most firms will consider whether to downsize, and if so in which practice areas.  They'll take some actions, and those in the top quartile may even align those actions so that the resulting firm structure is aligned to those practice areas where the firm sees opportunity in the future.  But, I think the choice is much more fundamental, and most firms do not yet see it (or do not want to see it).  I think firms need to think through fundamentally what their competitive advantages are, what markets they are targeting, and as a result, they need to decide what their firm business model is going to look like. 

        A couple examples may suffice:  Some of the highly profitable, NY firms (who are listed in your article as having few, or no income partners), generally tend to generate work through the big deals and the big litigations.  Those deals are large enough that the clients become price insensitive, and they can be staffed with large teams of lawyers paying attention to every legal detail.  For those firms, the model of high fees and lots of leverage continues to work.  While they may also be able to get premium pricing structures, they don't typically have to take any risk to get those premiums.  Those firms can continue to use the "Cravath" model, where they churn through the best and brightest of law school graduates, and are left with the brightest (and most "durable") lawyers who become partners.  That model will probably continue to produce $2-$4 million PPP. And while the growth in those profits may be difficult, given the amount of those profits, the model will likely still be successful.

           A second model probably applies to many mid-tier firms  (AmLaw 20-60).  These firms will need to adopt what I would call the "production" model.  Their target markets tend to be Fortune 1000 clients.  In litigation, they may not get the "bet the company" cases, but they will get significant cases within the firm's areas of specialty.  In deal work, they may become specialists in certain types of deals (the equivalent of what securitizations work provided for much of the last 7 years).  In both categories, clients are increasingly fee sensitive.  And in both categories, the work, while not "commoditized" is certainly of a type where sophisticated firms could bid on the work on a fixed rate basis.  Those firms who can figure out how to do this -- and this requires an incredible control over internal information within the firm to ensure that projects are properly bid and managed -- will have a chance of keeping up with the NY firms in terms of profits (though I doubt they will maintain the same high level).   This "production" model requires an ingrained systematization of process controls, teams of lawyers who are deep experts, and leaders who are risk takers (for bidding purposes) and project managers (for execution purposes).  It may still be a leveraged model, but the leverage probably will not look the same as in current firms. There may still be a place for income partners, but those partners skills are now to bring deep expertise and extensive project management skills.  Think of this firm like large construction firms.  The principals take significant risk, have the potential for significant reward, but only if the team executes flawlessly.

        A third model is what I consider the "boutique" model.  These firms have very talented senior lawyers in practices that are often difficult to leverage (think of Regulatory work, Appellate practices, perhaps some IP litigation, Tax advisory work, etc.).  These firms will likely have difficulty maintaining significant leverage.  A 1:2 partner-associate leverage may be the most that can be maintained (if that).  To the extent these firms can command premium rates, they may support significant profits per partner, but probably never at the level of the large NY firms.  The question will be whether these firms can offer a culture that compensates partners in a non-financial manner that makes up for the lost profits they might earn at larger firms.  One could imagine a fairly idyllic life -- less pressure to generate business, more time engaging in the practice of law. 

        As you note in your article, most firms currently don't really know "who" they are or what their strategy is.  Strategies have focused on either "bigger, more revenue," or "focused, more profits," but I don't sense that most firms have really considered what makes the firms a cohesive entity, how the firm differentiates itself, what innovative services it might provide, or how the firm can leverage its strategic assets.  The result is behemoth firms that keep getting bigger, with shrinking equity partnership ranks in order to keep the PPP at acceptable levels, and layers of "associates," "income partners," "counsel" and "others" who largely become cogs in an indiscriminate entity.  Loyalty to those firms is at an all-time low, because all the firms basically look the same, so partners defect when they see a chance to increase income.  Clients have a hard time telling firms apart, so success in client marketing focuses mostly on the personal relationship because there are very few other differentiating factors (to be sure, personal relationships will always be important). 

        Most firms are following the crowd like lemmings, breathing a sigh of relief that now, given Latham's large layoffs, it is now "ok" to really cut into lawyer staffing levels.  When the markets return, the pecking order for law firms will probably stay the same, though mid-tier firms may be at even a greater competitive disadvantage, having lost even more of their rain-makers to higher-tier firms.  A few smart mid-tier firms might realize that downturns are opportunities.  In good times, it can be hard to rock the boat; In downturns, there is a burning platform where partners can be galvanized to take action, if a good roadmap is provided.  Firms with strong leaders will take the opportunity to "right-size" and "right-structure" their firms.  They'll adopt new business practices, invest in training on those skills critical to the firm's differentiated success (e.g., project management, or substantive expertise) (after all, their idle lawyers now have more time to attend these trainings), institute systems to track costs on the types of matters they want to focus on in the future, they will start partnering with clients now (when clients may be eager to take risks to reduce costs, and law firms may have excess capacity in their system) to find ways to take risks together to find a better long-term model. 

           The bubble has popped.  The market is in a downturn, and businesses are being reinvented.  Some law firms will keep doing the same old thing (and for some, like the NY firms, that's probably a good model).  A few well-managed firms will use this time to determine "who" they are, and how they want to compete; assess what sort of PPP they really need and want, develop a strategy that builds on their strengths to differentiate themselves from other firms, and develops a structure and set of expertise to execute that strategy. 

        But then again, for most firms, they'll just hunker down, cut costs, and hope their relative standing somehow improves when the market returns.  Good luck to them.

A fascinating roundup of responses--and all, Dear Readers, thanks to you.  As they used to say somewhere in the lost mists of collective media memory, "keep those cards and letters coming."

What, finally, then, do I think about the remarkable growth over the last decade of the non-equity tier, and of the advisability of same?

As Tolstoy famously wrote in the opening of Anna Karenina, "Happy families are all alike; every unhappy family is unhappy in its own way."  I would paraphrase, or mangle, that to observe that "single tier firms are all alike; every two-tier firm is two-tier in its own way."

By that I mean there is no template, no equivalent of the Cravath Model, for what being "two-tier" means.  We as an industry continue to experiment on this front (as we are experimenting, abruptly and unwillingly, on many other fronts, of a sudden in this environment).

But I continue to believe that the burden of proof is on those who would argue for the expansion and not the contraction of the non-equity tier.  Economic reasons, as I noted in my original piece, are the least of it--which, ironically, is at odds with the gravamen of most of my interlocutors above who argued for the non-equity tier on economic grounds.

The core of the debate, in my mind, is all about culture.  Many are the reasons to have a substantial  non-equity tier, and many are the reasons, as I have argued, to strictly limit it.  But do not, under any circumstances, pretend that you are not making a decision with vast cultural implications.

The Great De-Leveraging

Just as I was thinking it was about time to publish a column on the topic of "leverage" at law firms (roughly speaking, the associate to partner ratio, although there's more than one way to calculate something that people will call "leverage"), here comes a slew of pieces on the topic, including:

• Prof. Larry Ribstein on "the over-leveraging and over-regulation of the legal profession:"
  

  In the longer run, we now see very clearly that running law firms as thinly capitalized worker cooperatives is not an equilibrium solution in this market.

  The answer, as I've said many times before, is dropping regulatory restrictions on law firm structure and letting them be run like real businesses. This particularly includes permitting non-lawyer capitalization and perhaps even public ownership, as well as enabling firms to hold onto their intellectual property through non-competition agreements.

• A piece in, of all places, The Atlantic's blog called "There's leverage everywhere!" with this pregnant introduction to our system:
  

  But let's work the argument a little further. It surely is true that unlike their current incarnations, the old Wall Street partnerships did not destroy the world with excessive leverage. But in the pre-credit-boom era, no one else was incurring much leverage either. It might be worth considering whether there are entities that are structurally similar to the old Wall Street firms (i.e., partnerships in which a substantial portion of the partners' net worth was tied up in their employer, and could not easily be removed from same) and see whether they have taken on significant leverage in the modern age of easy credit.

  As it turns out, there are such entities. We call them "big law firms." And their example is instructive.

  and
  
  
• More than one of these new pieces has referenced something that ours truly wrote about "Leverage:  Friend or Foe? (Or Noncombatant?)" back in December 2005, where I said:
  
  Common sense would tell you that in a labor-intensive service industry, where revenue is driven primarily by sheer tonnage of hours worked, the higher the ratio of associates (and non-equity partners) to (full equity) partners, the higher the revenues and thus the profits per partner. Right? It turns out this is one of those cases where it's not as simple as it seems.
  
  [...]  Then there's the evil twin of high leverage: Low utilization. It doesn't help that your leverage ratio is through the roof if nobody's busy; indeed, welcome to the worst of both worlds.

What has changed?

For starters, the whole world is now aware of the perils of leverage.  Let me throw a few charts into the discussion for starters.  By and large, I would like to believe, they speak for themselves.

Finally, here's one that leaves you wondering whether to laugh or cry—and it's seriously out of date at this point.

It's a chart showing the large global banks' market capitalization as of the 2nd quarter of 2007 (large blue-grey circles) and then as of October 20, 2008 (small green circles). 

In order, left to right and top row to bottom, they are:  Morgan Stanley, RBS, Deutsche Bank, Credit Agricole, Societe Generale, Barclays, Unicredit, UBS, Credit Suisse, Goldman Sachs, BNP Paribas, Santander, Citigroup, JP Morgan, and HSBC:

Update (8 March 2009):  A very helpful reader, who chooses anonymity, pointed out within hours of my publishing this that the chart above is seriously misleading.  Why?  Because the circles, being two-dimensional, invite us to visually compare their areas rather than their diameters—and the latter is what the chart-drawer actually chose to represent. 

Take Citigroup:  Its market cap went from $255B to $82B in the period in question.  Now that you look at it closely, you can see that's how the chart was drawn.  But were the circles drawn to scale appropriately in terms of their area, it's clear that it would take only 3.11 of the small green circles to fill the large blue circle (since 255/82 = 3.11).  Your eyes tell you in a flash that the green circle as drawn is far too small, in fact.  (Full explanation here.)

While I apologize for this mental and visual hiccup, all I can offer in defense is that I'm not the only one:

Pretty scary, eh?  It's a chart showing the deterioration of major bank market caps since 2007.  Prepared by someone at JP Morgan based on data from Bloomberg, this chart flashed across Wall Street and the financial world a few days ago, filling thousands of e-mail in boxes.  Putting a face on the current banking crisis it really brought home to many people on Wall Street the critical position the financial industry finds itself in.

Too bad the chart is wrong.

[...] So it's a typo: no big deal, right?  Yeah, but what a typo!  It got past Bloomberg and JP Morgan and pretty much all of Wall Street before someone said, "Hey, this makes no sense!"

Here's a proper chart.  While the players are somewhat different, that's more than made up for by the fact that it's far more current:  Comparing the market cap as of March 30, 2007, with the market cap as of February 20, 2009—barely two weeks ago:

Still not great performance, to be sure, but if there are degrees of horrendous-ness, this is at least less so.  Plus truthfully representative.

Thank you, Dear Reader.  Thus concludes the update.

While there are many reasons for these breathtaking declines, surely a proximate cause was the sky-high assets to equity ratios of many of these institutions.  20 to 1, 35 to 1, and even 50 to 1 were not unheard of in the palmy days.  Suffice to say that business model is, as I heard someone remark recently here in New York, "so last August."

So other parts of the economy (shockingly large parts!) may have gone crazy.  What does this have to do with us, necessarily?

If there are analogies to be drawn across professional service sectors, leverage is out for the investment banks and leverage is out for us as well.  For the I-banks, as noted, it was (in retrospect and even, to some more astute observers at the time) outrageous ratios of assets to equity, and for us it may be the high ratio of lawyer leverage.

I said at the outset that there are different definitions of "leverage" in our world, and I want to take some time and spend a little bit of effort breaking them out, because I believe the subtle differences matter.

Courtesy of The American Lawyer, here are the top 25 most leveraged firms from the AmLaw 100 and the bottom 25 least leveraged firms.

Top:

And bottom:

These figures are calculated by dividing the total number of lawyers at the firm (full time equivalent) by the number of equity partners.  For example, using firm #100 here, Faegre & Benson has 424 total lawyers and 255 equity partners, so 424/255 = 1.89.

Again, we can debate whether this is the ideal measure of leverage or not; my own preference is to divide all lawyers who are not equity partners by equity partners, but the results would be directionally similar. (Using Faegre & Benson as an example, again, the number of "lawyers who are not equity partners" would be 424-255 = 169, and dividing that by the number of equity partners yields 169/255 = 0.66.)

Why does leverage matter? For starters, as I noted in my 2005 column I quoted at the outset, leverage is your best friend in good times and your worst enemy in bad times. While we've heard the drumbeat of client complaints about paying for useless junior associates for years, this is suddenly the kind of environment where it will grow sharp teeth and bite hard. Either: (a) massive litigations will not be pursued because they're too complicated, uncertain, protracted, and expensive; and/or (b) if they must be pursued, contract attorneys, staff attorneys, and outsourcers will provide the human throw-weight needed for massive document review; and/or (c) corporations will simply insist that document review be completed for flat fees of $X/unit [$1.00/page? $0.50/page?]. In any event, no one I talk to--absolutely no one--believes that the litigation "factory" model with one partner overseeing half a dozen or more associates who are billing 'til the cows come home will be a predominant source of revenue going forward.

All well and good, but I think a more interesting calculation compares the ratio of non-equity partners to equity partners.  The charts and calculations that follow are premised on The American Lawyer's conventions, which denote someone an equity partner if they receive a K-1 and a non-equity partner if more than half of their income is guaranteed.  This is not the place to debate that methodology; the point for present purposes is that all firms are hewing to the same metric. While the raw data is courtesy of The American Lawyer, the calculations and the sorting are my own.

Here are the firms where the non-equity to equity partner ratio is greater than 1.00:

And here are the firms where that ratio is less than 0.25:

Note that I've drawn lines segregating the 11 firms with a non-equity to equity ratio between 0.00 and 0.25, simply because—depending on what may be special circumstances unique to each firm—arguments could probably be made that they don't "really" have non-equity partners as they see it; they just have to report this way based on The American Lawyer definitions.   Also note that I alphabetized the listing, by firm name, of all those reporting 0.00 ratios.

Why does this matter?  Aren't all the firms reporting layoffs reporting exclusively layoffs of associates and staff, not partners.

Yes, but those reports reflect actions taken to date, and I want to essay a little vision into what we may be seeing in the future, and to set the stage I think the two charts above are most informative.

First, why have no firms announced partner layoffs?  Isn't this the worst kind of cronyism, safeguarding one's peers, taking it all out on the "little people," and demonstrating lousy business judgment to boot, when the cost savings realized by offing (say) 10 associates could probably be realized by tossing a single partner overboard.  (Such, to paraphrase, is how it has recently been expressed to me, in tones ranging from outrage to derision to glum resignation.)

The issue, as so often is the case, is more complex than that.

Simply put, it takes time to get rid of partners.  They are not employees at will, as associates and staff.  They must be cajoled, "spoken to," almost certainly offered incentives to walk gently towards the door.  Note, importantly, that this is almost universally true of non-equity as well as equity partners.  (Off the top of my head, essentially every partnership agreement I've seen that addresses the issue at all treats non-equity and equity partners alike on the topic of termination—that is to say, it's hard to accomplish without cause.)

And there's more.  More and more non-equity partners, that is.  This chart shows the percentage of all lawyers at AmLaw firms who are not equity partners, from 2000 through 2006.  The big red bars are of course associates, ranging from 82% of the total in 2000 to 75% in 2006.  The light grey slices are "income" partners, growing from 9% to 13%, and the darker grey slice at the very top, growing from 9% to 12%, are "other non-equity lawyer" (don't ask me about the terminology; I'm just the reporter here). The chart is courtesy of last year's Citibank/Hildebrandt Client Advisory.

Now—bear with me—one more data point. 

Here's the "productivity," measured by annual hours billed, of (a) equity partners; (b) income partners; (c) associates; and (d) other non-equity lawyers, at "higher profit" and at "lower profit" firms:

What it shows with conspicuous graphic clarity is that income partners and other non-equity lawyers are systematically the least productive lawyers in these firms.  Associates work the hardest, but equity partners work almost as hard.  (At higher profit firms, the associates record a negligible 2.5% more hours than equity partners.)

From both a human and an economic perspective, this is all perfectly logical. Non-equity lawyers don't have to beat their brains out.  So they don't.  Their deal—again, a perfectly rational one, to them—is that, premised on good behavior, they have a job essentially for life at, say, $350,000 to $450,000/year, adjusted for inflation.  If you think that's not an attractive deal, I suggest you immediately take the elevator down to the street and ask the first ten people you encounter if they'd like such a job.

What else do we know about non-equity lawyers?

They are the most expensive form of leverage.  They make more than associates, to state the obvious, and have also "maxed out" on any variable benefits one needs a certain period of tenure to earn, such as 401(k) matches, etc.

This, frankly, is the least of it. The real issue is cultural.

Go back and take a look at the firms with non-equity to equity partner ratios < 0.25. Better yet, focus on those where the non-equity tier is either nonexistent (0.00) or de minimis and probably only an artifact of The American Lawyer's reporting system.

What do they have in common?

Indeed: An unusually high combination of cultural cohesion and readily articulable strategy. Just a sampling proves the point:

• Cleary, Cravath, Davis Polk, Debevoise, Paul Weiss, Simpson Thacher, Skadden, Sullivan & Cromwell, Wachtell.

Like them or not, you can say of each of those firms that they stand for something, and that achieving partnership there is dependent on several dimensions beyond that of being a mighty rainmaker.

Vs. those with the non-equity to equity ratio > 1.00: Without (re-)naming names, it must be said of that group that their strategies are extremely diverse and, in some cases, as yet unproven. Additionally, many of the firms in that group have high proportions of relatively new lateral partners.

But back to culture. I submit that firms with high proportions of non-equity partners have changed their culture. They may not have intended to, they may not have foreseen it, but change it they have.

Thirty or twenty years ago and even pretty much today, at least in New York-based firms, the reality is truly up or out. This attracts a certain cohort of hard core Type A people who (as I felt at that time) have never been anywhere other than at the top of their classes and who don't intend to be anywhere else now. As a managing partner said to me last week, "We've all heard the statistics that only one in 25--or whatever--starting associates at Cravath will make partner. But you know what? All the Cravath on-campus interviews are hugely oversubscribed! Everybody thinks they're going to be the one in the 25."

He has a point.

So how does the introduction, and more importantly the perpetuation, of a material cohort of non-equity partners change the culture of a firm?

Let me editorialize about a few consequences:

• The culture shifts from "excellence or else" to "good enough."
  • I don't think that "good enough" is sustainable in this environment.
    
    
• In the palmy days of 2001--2007, having a flexibly extensible non-equity tier served as a crutch for firms that wanted to avoid making difficult decisions about people or having awkward conversations with them.
  • I don't think that those difficult decisions and awkward conversations can be postponed in this environment.
    
    
• One of the reasons we're seeing widespread associate layoffs--apart from the pure economic imperative to cut costs in order to match revenues to capacity--has to do with morale. It's dreadful to morale to walk the halls seeing a bunch of your colleagues with too little to do, who are then guiltily sneaking out at 5:30.
  • The non-equity tier, with nothing to aspire to and perhaps (psychological speculation on my part, which I am shockingly unqualified to offer) feeling themselves ever so slightly "damaged goods" only exacerbate this.
  • None of us, none of our firms, have room for morale-busting zombies in this environment.
    
    
• The ranks of the non-equities grew not by design but by happenstance and, frankly, inattentiveness. While it may be true, as Oliver Wendell Holmes famously remarked, that "the life of the law has not been logic, it has been experience," it's time to apply some analytic logic, some serious and rigorous strategic evaluation, to the weed on steroids that has been the growth of the non-equity tier in too many firms over the past palmy period.
  • And no, we cannot afford to do otherwise in this environment.

We read, finally, that firms are drastically cutting back their summer programs and dialing back first-year offers, postponing start dates, offering semi-paid sabbaticals, and so forth. All well and good and relatively innovative examples of rising to this dismal occasion.

The pipeline of new talent must be kept as full as anticipated demand warrants. Law firms live and die on their talent, and they cannot short-change their investment in it based on next quarter's or next year's depressing projections, although they can certainly try to size it to better approximate the new reality.

But the talent that may not be carrying its weight, that needs profound re-examination, is that of the non-equity tier.

If you were starting your law firm today, would it look as it does in terms of non-equity partners?

Better yet, or more realistically yet, perform Andy Grove's famous thought (and reality) experiment when Intel was a low-end maker of commodity DRAM chips, having their lunch eaten in the late 1970's by the voracious and talented Japanese, threatening Intel's very existence.

I paraphrase: Grove said to his top management team, "If we don't turn things around in a very serious way, the Board will fire us. So why don't we 'fire' ourselves. Let's march out of this conference room and march back in assuming we're the new team the Board has hired. What would we do then?"

They performed the exercise, decided to abandon DRAM's and invest in microprocessors. The rest is history, and it's history residing under your desk or in your lap.

I'm suggesting you perform a "Grove Intervention" on your firm. And if you've read this far, you know where I think you might start.

The "Index Fund" of Law Firms?

The Latham news is of course all over the place: The WSJ Law Blog, Above The Law, The AmLaw Daily, LegalWeek, and etc.  The figures are, frankly, grim:

• 190 associates laid off, or about 12%;
• 250 paralegals and staff, or about 10%; but
• As of this writing, no partners (of whom there are 550).
• Finally, the start date for the class of 2009 is postponed to December, with an option to defer to October 2010, in which case the firm will pay those electing the year-long deferral $75,000 and encourage them to pursue volunteer work or community service.

One admirable and salutary part of the story is the severance policy associated with this:  Six months salary, capped at $100,000, as well as six months of health coverage.  As Bob Dell rightly says, this is "quite a bit above market."  Indeed, if you believe this table, it's double the approximate "going rate" of 3 months.  Classy.

So those are the facts.  What does it mean?

At the most prosaic level, it reflects the knock-on effects of the global economy hitting a brick wall.  (Actually, it hit the wall so hard that it bounced off backwards, as the just-revised 4Q2008 GDP numbers for the US showed, with a 6.2% contraction.)  When the economy experiences that, so do your clients, and then so does your firm.  It is as unfortunately predictable and seemingly inescapable as one billiard ball hitting another and then another.

This observation is simplistic only to the extent that it ignores how different firms will be hit in different ways—and how some, based on a delightful if sometimes random confluence of their practice mix, will dodge the gunfire altogether.  This is a period where "averages" will be particularly misleading. 

But that may be part of Latham's problem, in a suddenly-unfortunate way:  The simple fact that the firm is so global, and so diversified in its practice mix, makes it almost the law-land equivalent of an "index fund" representing the overall contraction in global legal spend.

Next, what absolutely positively must be said is how terribly sad and indeed frightening it will be for all those affected.  Now is not the time when you want to be abruptly looking for work.  "Adam Smith, Esq." is a tiny tiny enterprise, and for all of you who may be in this deeply unfortunate boat:  For the record, we're not hiring.  But for those of you reading this who might conceivably have an opportunity to offer, I urge you to act posthaste.  The people affected are not finding themselves on the street for "performance" issues, nor are they there through any fault of their own.  Throw what lifelines you may have.

Other observations from a management and strategic perspective:

• It is always and everywhere best to do these things in one big whack rather than through a thousand cuts, or—unforgivably—through "stealth" layoffs.  We can only fervently hope this one whack will be the last, but as we are learning on pretty much a daily basis, these days no one can make any promises.
  
  
• One must assume, although no details on this score have come out, that the review and cull are "strategically selective," as opposed to 10% across the board.  You will have noticed that all four of the Magic Circle firms who have announced "redundancies" have made a point of emphasizing that they were all in the context of re-sizing the firms to (we hope) better align with what they forecast to be market and client demand.  Again, while no one has a crystal ball, some things are clearer than others, and I would be shocked to hear that anyone in restructuring has been let go and equally shocked to hear that no one in securitization has been affected.  In other words, as nasty and "profoundly regret[table]" (Dell's words) as these decisions are, you can make them smartly or make them dumbly.  I have to imagine Latham is too well-managed to have done the latter.

Why were no partners affected?

I have a hunch, which Dell obliquely confirms when he remarks that "current and future client demand would likely require less leverage."

My theory—which I'll devote more ink to in future—is that, among many other things, we as an industry are going through our own "de-levering" period, and that on the other side of this interregnum firms will, by and large, have lower associate: partner ratios.   Many are the implications of that, presuming I'm right, but Latham seems to be acting as if they think it's accurate.

Finally, this morning's news out of Latham tells us something with all the emphatic insistence of a fire-truck air horn:  Firms are businesses.  I hope that by now that comes as news to no one.

Before firms can live to thrive again another day—which, trust me, they will—they first have to live. 

Call it what you will (carrying excess human capacity, being underutilized, supporting fallow and unproductive assets), it's simply not viable in a competitive marketplace to have a substantial proportion of the people on your payroll sitting around with too little to do.

That is also bad for morale, bad for professional development, unattractive to talented candidates you might want to recruit, and, finally, less than useless to clients.

At the moment, understandably and inevitably, we are all focused on the "destruction" inherent in Joseph Schumpeter's powerful insight about how capitalism repairs and reinvigorates itself.  It would be much more fun if we could focus on the "creative" dimension.  But not yet.  Not just yet.

Let's Just Pull the Covers Over Our Heads. Or NOT.

America has been through many crises and challenges before, far worse than what we're experiencing today. Need I mention (keeping it to economics and not including wars), the hardships and deprivations brought on by the Civil War, the long depression of 1873-1895, the Great Depression itself, the grinding stagflation of the 1970's. That we're facing a new challenge is not existentially threatening.

The problem is that many of us seem to feel it is, or at least that's the way the media is reporting it and, frankly, the way our political leaders seem to be responding to it--this is a crisis, they reiterate, and unless precipitate action is taken, disaster looms. Pass a three-quarter of a trillion dollar package this week, or else.

Robert Shiller, an economics professor at Yale, and co-author (with George Akerloff) of the just-released "Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism," has this to say in today's New York Times:

"People everywhere are talking about the Great Depression, which followed the October 1929 stock market crash and lasted until the United States entered World War II. It is a vivid story of year upon year of despair.

"This Depression narrative, however, is not merely a story about the past: It has started to inform our current expectations. [...]

"The attention paid to the Depression story may seem a logical consequence of our economic situation. But the retelling, in fact, is a cause of the current situation -- because the Great Depression serves as a model for our expectations, damping what John Maynard Keynes called our "animal spirits," reducing consumers' willingness to spend and businesses' willingness to hire and expand. The Depression narrative could easily end up as a self-fulfilling prophecy."

I recommend perspective. Perspective not that we deny the severity of this near-depression. To be sure, there are plenty of reasons to worry:

• It's global in nature;
  
  
• It has come upon us with shocking, whiplash-inducing speed;
  
  
• It seems inexorable, deserved, the Puritanical comeuppance for a decade or more of living extravagantly in "sand state" McMansions, furnished with super-large flat panel TV's and navigated by Hummers, consuming energy recklessly; and to the extent this narrative rings true we feel chastened, like children rightly sent back to our rooms after immature behavior, and the small voice in the back of our minds chants "we deserved this, and we brought it on ourselves, so we have no ground on which to resist or fight back;"
  
  
• It's striking at the heart of our 21st Century economy, the financial sector, as opposed to being a classic inventory hangover, consumer pullback, sustained oil price spike, or isolated tech bubble;
  
  
• Speaking parochially about our industry, we have been joined at the hip to the financial services sector for as long as the boom was going on, and even before that. The New York "white shoe" firms all made their reputations on core connections to bulge bracket investment banks, and to some extent those reputations lived on until the very recent past. I suspect they'll endure beyond this interregnum, in fact.

But let's get back to perspective.

I believe two characteristics will separate the strong from the weak firms coming out of this episode. They are: (a) cultural glue; and (b) the quality of leadership.

As for "cultural glue," you had it going into this episode or you didn't. If you didn't, I sincerely wish you the best of luck, and I hope you seize this opportunity to build some, ASAP. If you have it, on the other hand, now is the time to capitalize upon and reinforce that. Other than that, I don't have too much more to add about the strength of your culture. It takes years and years to build, as does trust, and (see: Spitzer, Eliot) can be destroyed in an instant.

This brings us to the quality of leadership.

I believe this will be the key differentiator in this period. We talk about "leadership" interminably, but we do so for a reason. It matters.

Jeffrey Sonnenfeld, President and CEO of the Chief Executive Leadership Institute at the Yale School of Management, was recently interviewed about what leadership entails in this environment, and here's what he had to say (emphasis supplied):

• "In times of genuine crisis, leaders do not have to use fear to alert people about the need to change from the status quo. When the place is on fire, it is counterproductive to frighten people. In battle, no one needs to be motivated.
  
  People want to know that their leaders are competent enough to see them through this crisis. They don't have to like you; they have to know that they can place their faith in you because you have thought it all through"
  
  
• Successful leadership in this era comes down to four critical points.
  
  The first is personal accessibility. We've seen CEOs in times of crises try to circle the wagons and stonewall the media and other stakeholders. That's not the way to go. It's critical to be out there.
  
  The second trait of an effective leader in crisis is empathy. Show some compassion for those hardest hit.
  
  A third quality has to do with authenticity and believability. [He proceeds to talk about how Wall Street executives performed, or didn't, on Capitol Hill recently, and excoriates those who dissembled and seemed to be unprepared.]
  
  The fourth great quality of leaders in crisis is that they don't let the stress of the present preclude the boldness, courageousness, and thoughtful prudent risk-taking that is still vital to success. These leaders understand that we still have to get out there and be in business. We're not running libraries and museums; we're running dynamic enterprises that can't be afraid to take calculated risks.
  
  It's really tough times that bring out the greatness in leadership. Disappointments, barriers, setbacks - they are all the punctuating moments that really define a heroic career. You don't know how good an executive is until times are tough. As such, this is the time when corporate leaders can really distinguish themselves and really punctuate successes as outstanding leaders.

Study after study, time after time, has shown that Americans are the most optimistic of all nations. It's time to invoke that.

There's no sin, hereabouts, in getting knocked down. The sin--and an unforgivable one--is in not getting back up.

It will soon be time to get back up. Wall Street may be dead for now, but it's Lazarus. It has reinvented itself every decade or so for as long as I've watched it. And our firms are the handmaidens to its serial reinventions. The notion of the "Wall Street law firm," or the international law firm with a Wall Street practice, should not yet be read its last rites.

Prepare to be optimistic. Prepare to be an American. Prepare to lead.

Layoffs: Substitutes & Complements

When non-lawyers ask what's happening in the world of law these days (i.e., what ATL is covering), our first response is usually one word: layoffs. It's been a dominant theme in our coverage since the fall.

—Above The Law (today)

While I might nominate that quote for Understatement Of The Season, I cite it for an entirely different purpose:  Are there any alternatives to layoffs?

Actually, I don't believe there are any "pure" alternatives to layoffs, at least not in the economic sense of "substitutes," for firms under serious financial stress.  But I'd like to suggest there are "complements" (economic sense) to layoffs. 

[Jargon digression:  In economics, "substitutes" are goods or services that people can trade off between without drastic disruption or deprivation, such as coffee and tea, bagels and muffins, or red and white wine.  As you can tell from these examples, there are rarely perfect substitutes—we all have our preferences—but if our favorite is unavailable or exorbitantly expensive, we will make do with the alternative and carry on.  "Complements," by contrast, are goods or services that tend to go together.  Think coffee and sugar, bagels and cream cheese, or red wine and bread.]

In the land of law firm layoffs, it's all too easy to understand why so many firms are resorting to them in this unprecedented environment. 

Forgive me if what follows strikes you as simplistic (good for you if it does!), but I find myself explaining this to people with a frequency that suggests it's not widely understood.  Consider hypothetical BigLaw firm in 2008 and 2009:

Obviously, these numbers are simplistic and you can quibble with the details and assumptions, but the message is powerful:  Law firm P&L's are highly leveraged. In the good times, this is your best friend:  Every additional dollar of revenue drops almost intact to the bottom line.  But in the bad times, this is your worst enemy.  A 1% drop in revenue can--all else equal--lead to a 3% drop in profits.

What, then, to do?  As the famous advice has it, "Follow the money."  The money, in this case, is associate and staff compensation.  Together they are to a law firm's expenses as Social Security and Medicare are to the federal government's budget:  Enormous.  If you need to cut a lot of expense at a law firm, you don't have many alternatives but to look there.  (I'm assuming all your office leases are long-term and not readily renegotiable, especially in this environment.)

The bad news, of course, is that cutting associates and staff used to be viewed as being as untouchable as trimming Social Security and Medicare would be. But not any more. If we've learned nothing else from the drumbeat of layoffs in the US and the UK, it is that there is no stigma attached to them today.

While we're at it, let's not limit the casualties to associates and staff. Everybody ought to share the pain, including equity and (if you have them) non-equity partners. It cannot be true that every single person in category X (say, partner) is irrebuttably indispensable while everyone in category Y (non-equity) is subject to scrutiny. Note to those keeping score at home: Cutting partner ranks will also distribute the diminished profits over a smaller pool, making the hit to your PPP less, percentage-wise, than the hit to your total P.

So if the base case for the inevitability of resorting to layoffs has been made, how can we do it more intelligently? How can we be more intelligent and less reactive, more scalpel and less meat-axe, more humane and less brutal?

Let's go back to "complements."

I suggest there are a variety of techniques you can employ, not as "substitutes" for layoffs, but to enhance their cost-saving impact and trigger other savings. Let me add that, with some degree of consternation, I don't see very many firms implementing these "complements." If this column has no other purpose, it's to change that myopic behavior.

• Reduced hours for reduced pay. Forgive me, but this strikes me as blisteringly obvious. We've heard bellyaching throughout the boom years about "work/life balance" and so forth, usually to imperceptible effect, but now we have an opportunity we can embrace with gusto. Of course, the reaction of associates invited to partake of this bonanza may suddenly be less than enthusiastic. "Be careful what you wish for?" Still, you should think about it.
  
  
• Sabbaticals. Whether paid, unpaid, or inbetween, consider granting (requiring?) people to take a period of time off. Don't permit them to do nothing, however; make sure the expectation is that they will do something related to broadening themselves, learning, professional or cultural or emotional or even artistic development. You might be surprised at the new imaginations they'll return with. And in the meantime you'll have economized while maintaining loyalty.
  
  
• Shared jobs. As with our first suggestion, this is one that was oft requested and rarely honored during the boom: "Impractical and unworkable." "Clients won't stand for it." "Shirking by another name." "How entitled do they think they are?" Permit me to suggest the world has changed. Think about this again.
  
  
• Salary freezes. Been there, done that, and how shocked are you that the reaction has been so placid? Which brings me to:
  
  
• Salary cuts. I don't know if you read it here first, but it matters not where you did. Economists famously and widely insist that wages are "sticky downwards," which is their awkward formulation of the highly common-sensical notion that people hate to see their pay (at the same employer) actually drop. But these are not ordinary times, and there are ample reasons to think that people would be surprisingly amenable to this revolutionary concept:
  • Today, a job--almost any job, much less a highly respectable one at BigLaw--beats no job. Enough said.
  • There's value in shared sacrifice. Taking a hit, collectively and communally, to preserve the firm's community, is not a hard stretch or leap of the imagination for people today.
  • Dollars go farther than they did 18 months ago. Have you noticed that housing has gotten cheaper? That cars can't be given away? That "70% off" is the minimum required to get people off the street and in the door? That everyone is suddenly very very negotiable on price?
    

I'm not suggesting my list is exhaustive; it's meant to be suggestive and (we can always hope) creative.

Now's the time to innovate. Given what a straight-line extrapolation of current reality would look like, somebody better.

Update:  23 February.  I received the following correspondence from a 1L at a top ten law school.

Greetings from Law Student Land.

What an intense time to be a 1L. Just thought I'd share a few thoughts and reflections, especially as they relate to your latest column.

First, never have any doubt about the attention paid to Above the Law at the student level. Personally I have serious misgivings about that site's position as the main conduit of information between associates and management. However, looking around my Crim class the other week on that famous thursday and watching everyone tick off the layoffs as they happened, I was struck again by the power of the instant press on firm recruiting and retention.

Secondly, and building on my first comment, note this story: ( http://abovethelaw.com/2009/02/nationwide_layoff_watch_mckee_1.php ) for an example of the sort of press that will make a difference in July, when my class at [*****] begins bidding for interview slots at firms. As I'm sure firms are aware, students aren't going to be able to exclude all of the firms that have made layoffs from our job search.

However, the process by which firms lay off their associates is a chance for us to "look under the hood" at the interaction between management and associates at different firms. I am certain that firms who conducted "stealth layoffs" or that swung the scythe heavily through the first-year ranks will be penalized come recruitment time. Which is not to even mention the debacle over at Pillsbury last week.

Lastly, I note with satisfaction your mention of work/life balances issues in your latest column as a way to trim firm expenses. Sadly, it seems that though firms have realized they will need to adapt to a changed business environment, they have so far acted with the lumbering (be-suited) herd mentality that so regularly characterizes their behavior.

Someone has told them that layoffs are ok, and so they are going to attempt to cut staff numbers until their profit margins return to normal. While wages are surely sticky, they are not stuck. I am lucky enough to have secured an associateship with a firm this summer. The firm I am headed to pays its associates below the "New York rate" but in a secondary city. I am told that associates work around 50 hours a week. This strikes me as a fair bargain, and one that many of my classmates would willingly make. It seems to me that even firms that are known as "sweatshops" could create a 75% work schedule in which pay is cut in relation to the chosen billable hour requirement. The idea of a sabbatical seems like an ingenious way to temporarily de-equitize partners until work picks back up.

All of which is just to say that I think your concept of where the general mood of the lowest rung of the ladder is these days is fairly accurate. Keep up the good work.

[After I asked my correspondent whether I could have permission to republish his thoughts:]

I have no problem with being anonymously quoted. I think this is clear from my comment, but just to be sure, the scheme I am advocating is less hours for less pay, as opposed to a straightforward pay cut. I don't think this would be too much of a problem, as I am under the impression that there aren't enough hours to go around at the moment. I'm also generally not in favor of having an across the board pay cut in exchange for a promise of no layoffs. Obviously, this would reward under-producers at the expense of the hardest working associates. I think generally we as students expect firms to approximate the level of attrition that they have in good times, and therefore be prepared for our class when we come aboard in 2011.

Thoughtful commentary indeed. 

Why would it not make sense for firms to offer a tradeoff between hours and pay or, perhaps more audaciously, a tradeoff between the investment made in professional development and training, and pay? 

What I'm suggesting in the latter thought experiment is simply this: If a firm is going to work you to death and skimp on training and professional development (they're non-billable), then shouldn't you expect to be paid handsomely for your pains? Conversely, if another firm is willing to devote significant resources in time and money to an intense training effort, shouldn't you rationally be willing to accept a lower salary, recognizing that you're investing for your future in a non-monetary way?

The remarkable thing is that it seems to work in other industries—witness the old joke about how the publishing industry is a wonderful place to get training "if your parents can afford to send you there."

What Did I Do Wrong?

Within the space of 15 minutes late this afternoon I got calls from both Bloomberg News and The American Lawyer asking me what was going on with all the layoff announcements hitting the wires today. So this was not your ordinary day, and even though "Adam Smith, Esq." has a firm policy against covering breaking events, this seems an outlier warranting an exception.

I used to be keeping a list of layoffs, but I've lost track; I decided to leave it to the statisticians, of whom we will have no shortage. Today alone we've had announcements from (random order) Epstein Becker, DLA Piper, Dechert, Holland & Knight, Cadwalader, Bryan Cave, Luce Forward, Cozen O'Connor, Faegre & Benson, Wolf Block (salary cut), and Goodwin Procter--over 600 jobs lost (lawyers and staff) announced in a single day.

Above The Law even has a poll asking what to call today: "Valentine's Day Massacre" appears to be in the lead, above "Black Thursday," at this reading. But I digress.

What's really going on out there?

Frankly, nothing alarming. In recessions, businesses cut jobs. Not to be dismissive, but this is what recessions mean. They are essentially defined by rising unemployment. Why should we be shocked that we are not immune?

When your clients are cutting jobs and truly putting the screws to legal spending, you know that your 2009 revenue will be down. And it's Management 101 to align costs with revenue.

Let's review some of the other salient dimensions of this:

• When Faegre & Benson announced its cuts, it provided one of the more articulate rationales: "We are practicing law in the same challenging economic environment in which our clients are doing business. Like many firms across the country, we are aligning our resources with the anticipated demand for our services."
  
  
• As Cravath's Evan Chesler announced when cutting associate bonuses compared to last year, and in a similar vein, the "principal driver is what's happening to our clients. Every day we're seeing them laying off people. Our conclusion was we needed to be as sensitive as we could be."
  
  
• So we can safely conclude that a large part of what law firms are doing right now is simply trying to match their capabilities (supply) to clients (demand).
  
  
• Last time I looked, total lawyer headcount in the AmLaw 200 was about 120,000. If we've lost 2,000 lawyer jobs, which I think is an exaggeration, at least in terms of public announcements, that's less than 2%.

But it remains an oddity why so many firms announced cuts today. I think it's just that--an oddity. Like tossing a coin and getting 4 heads in a row. Weird and unusual, to be sure, but indicative of precisely nothing.

On the other hand, there are good reasons we are seeing announcements of rounds of layoffs right about now:

• Financial results for 2008 are now in, and there can no longer be an argument in many firms that "we need to wait to see what the numbers actually are" before making any decisions. Lawyers are, among other things, believers in evidence, and the results of 2008 are now in evidence. I can imagine that many tentative decisions which were awaiting confirmation by the final numbers were pending, only to be announced this week.
  
  
• Similarly, no one wants to be so heartless and inhumane as to fire people during the holidays. This would explain the withholding of layoff announcements during December and early January.
  
  
• During end-of-year discussions with clients about collections and expectations for 2009, you have to believe that some reality checks were put in place about what level of revenue firms might expect gonig forward. If those expectations are now built in to the firms' 2009 financial models, adjustments in the cost base might be in order.

Finally, let us never underestimate the yin and the yang of the high degree of leverage on law firms' P&L's. That is to say, once you've covered your costs (which are, for the record, people @ ~60%, occupancy @ ~30%, and "everything else" @ ~10%), then essentially every additional dollar of revenue drops directly to the bottom line.

Also, if the average law firm's gross margin is, say, 35%, then--if you do nothing to change your cost base--a 17.5% drop in revenue (highly plausible in this environment) implies a 50% drop in profits.

Add to that the highly liquid market for lateral partners and you have the ingredients for immediate and severe problems.

So am I surprised by firms announcing layoffs? Not in the least. As I said at the outset, that's what happens to businesses in recessions. And finally, if there's any "good" news to be extracted from this, it may be along these lines:

• You did nothing wrong.
  
  
• That layoffs are so widespread indicates that firms with all types of different strategies, with all types of geographic footprints, are suffering along with their clients. This is not like the dot-com downturn of 2000/2001, where everyone who had piled into Northern California at the last minute was burned (predictably, in hindsight). No one predicted this.
  
  
• Hard as it is to reach the conclusion that layoffs must be decided upon, you owe it to your firm to make these hard calls. Not to be melodramatic about it, but you owe it to the people who will survive and thrive in your firm to make the firm the right size to match your clients' demand going forward. Overcapacity in law firms is extraordinarily expensive. Now is not the time that you can afford it.

So is this the "Valentine's Day Massacre?" Here at "Adam Smith, Esq.," we're not much into soundbites.

It may be the day when the stigma of layoffs went away--indeed, it is resoundlingly that, whatever else it may end up being.

My hope is more audacious: That it is one key day in the long series of days that will be needed to bring on the era when law firms' management is truly professional and clear-eyed. And when we can explain to our clients how we're managing as smartly as they are.

The "Cull" & Your Clients

So now the "cull" has come to partners in the Magic Circle.

As The Financial Times reports:

The cull of partners at Britain's leading law firms worsened on Wednesday as Clifford Chance unveiled plans for job cuts across its 21-country global office network.

The announcement came just over a week after Linklaters, its rival, revealed restructuring proposals that could lead to dozens of its 500 or more partners leaving.

The shake-ups at the world's largest and second largest law firms highlight how the financial crisis is now biting so hard that it threatens the partners who own and manage top legal businesses.

Clifford Chance said its changes were likely to lead to a reduction in its 633 partners, although it declined to say how many would be affected.

David Childs, managing partner, said the firm had decided to make cuts as part of wider moves to adapt to the impact of the credit crunch on clients' fortunes.

"What we are going to do now is work out what are likely to be the expected needs for legal services over the next three to five years. We are taking a much longer view and a much more forward view," he said.

Mr Childs added that the firm had launched its plan after conversations with clients led it to conclude that some areas of business - such as leveraged financing - were unlikely to recover quickly, while others, such as securitisation, might return in a different form.

The bad news is that layoffs are no longer limited to non-premier firms or those widely recognized to be under stress. The good news, if you care to interpret it so, is that there's no stigma attached to layoffs.

The question then becomes how to "do" layoffs more rather than less intelligently. I suggest there are some lessons inherent in the Clifford Chance experience.

• Don't limit it to associates and staff. This is taking out your anger, frustration, and anxiety on the defenseless. (Did I say anger and frustration?! Yes, on purpose; these are shockingly trying times, and it's not the worst thing to admit that you don't have all the answers. I do not, obviously, recommend indulging what may be a natural, if juvenile, temptation towards anger and frustration. We're all professionals here.)
  
  
• But to get back to the importance of culling partners as well: You must. Don't kid yourself that only associates are the ones with questionable performance and all partners are bulletproof. You know in your heart that's not true (partly because, rightly, partners are held to a higher standard) and now is the time you must act on it.
  
  
• Years ago in New York Con Edison, our local utility, would display a wonderfully pithy sign at worksites where it had to to barricade streets or sidewalks: "Dig We Must." I'm deeply sorry to report that with the decline in colorful English, or the corporatizing overlay suppressing what must have clearly been the inspiration of a single individual with a moment devoted to workplace pleasure and invention, those signs have long since disappeared in lieu of the ubiquitous, bureaucratic, depressing, and uninformative flurorescent orange and yellow tape and pylons with no informative signs.
  
  But today's motto for our industry might be: "Cull We Must."
  
  
• So if "cull we must," how best go about it? You might, for starters, as it sounds Clifford Chance has done, talk with your clients.
  • What do they see coming back sooner rather than later?
  • What do they not see coming back any time soon?
  • What are they willing to continue to pay premium rates for? (You can suss this out without asking directly, I trust.)
  • Where have they come absolutely positively under the gun to reduce outside legal expenses at all costs?
  • &c.
    
    
• Decide whether you view this financial crisis as a year or 18-month long "V" or as a multi-year "U" recession. This, if I may state the obvious, will help you determine how to re-align your firm for the duration.

Finally, I would argue for clarity of communication, internally to your firm and externally to your clients. (I know, it's hard to argue against clarity, but I have a different point to make.) The need for you to speak clearly now to your key constituencies has never been higher. Why?

Simply because people are confused, uncertain, and anxious. Layoffs and "redundancies" are ubiquitous. Revenues are down. Profits are down. Firms are, plain and simple, getting smaller. Now, of course you can't promise people things you can't deliver on, but you can tell them what you know, what you foresee, and what is, at least for the time being, not happening in terms of layoffs.

And it's interesting what Clifford Chance is not doing: They're not abandoning globalization. Childs "stressed that it was "very focused" on developing its work in the US east coast and in Asia. Globalisation of the industry remained the "right model" even in troubled economic times, he said, adding: "Indeed, I think more law firms will go down that route.""

And finally, the last message from the Clifford Chance story: Talk to your clients. You have your pulse on the market, but your clients have their own different and significant and valuable pulse on the market. Listen to them. You might learn something. It could even help guide your internal decisions.

Are Profits The New Growth?

Find out my thoughts on the matter here.

The NYT's Obit for the Billable Hour

When The New York Times features it on the front page, it must be real, right?

I'm referring to Billable Hours Giving Ground at Law Firms, which features Evan Chesler flatly arguing that "This is the time to get rid of the billable hour." Unfortunately, if you're looking for real insight into the issues underlying the stress on the billable hour, this is not the article to read--unless, as I perhaps suspect, the article was pitched to an audience oblivious to the entire issue prior to picking up that day's Times.

Shall we review the bidding on this topic?

Pro the billable hour:

• It's familiar, both to lawyers in private practice and to their inhouse lawyer clients. It's been the dominant revenue model since the 1960's which, for all practical purposes, is the professional lifetime of anyone working today.
  
  
• It's measurable. David Wilkins of Harvard says:
  
  "Does this make any sense?" said David B. Wilkins, professor of legal ethics and director of the program on the legal profession at Harvard. "It makes as much sense as any other kind of effort to measure your value by some kind of objective, extrinsic measure. Which is not much."
  
  David (a friend) is of course right, but the alternative to an "objective, extrinsic measure" is some variant of subjective and judgmentally laden approximation, which requires trust.
  
  
• Clients--this is my theory, at least--have been largely bluffing this past decade or more when they've moaned and complained about the billable hour. After all, from their perspective, it has some indisputable virtues:
  • They can say to their financial green eye-shade types, "Well, look, they actually did the work. Says so right here."
  • And, for that matter, they can say that they negotiated the "most-favored nation" rate and, on top of that, got a 15% discount; so don't argue that we didn't get value for money.
    
    
• Again, clients might not be too comfortable with the alternatives. Why is $375,000 "for services rendered" the right number? How does one defend that internally against the purchasing agents and cost accountants? (And don't assume their instinct will be to ask why it's not a higher number.)

Con the billable hour:

• It provides, obviously and somewhat tendentiously, an incentive for firms to run the clock rather than solve problems. I say "tendentiously" because this assumes lawyers put their own very short-sighted self-interest ahead of professional responsibility, ahead of a satisfied client, and ahead of simple integrity in their professional dealings. In my experience, to the extent time-sheets did not reflect utter reality to the second decimal place, it was because lawyers engaged in self-administered haircuts on the time they'd actually spent, fearing they'd look inexperienced or simply making an on-the-spot judgment about what the activity they'd performed "was really worth."
  
  
• It starts from "cost of production" rather than "value to client." This, to me, is its core economic failing. To be sure, no firm can long sell its products or services at less than "cost of production," but unless you're in an absolutely commmoditized industry, that is the merest of starting points.
  
  
• It's dehumanizing, reducing talented and highly educated professionals to fungible units as factors of production. Worse, it contains no rewards for brilliance, insight, judgment, or even plain old efficiency. Lawyers have every incentive to work day and night, and no incentive to recharge their batteries, take in a performance of "Trovatore," read "The Merchant of Venice" or The Federalist Papers, or simply enjoy a moment outdoors in the sunshine. We can debate whether, in the long run, this will produce pale and narrow automatons or whether utter and uncompromised dedication to a profession, 24/7, is the only route to serious excellence, but the point is that decision should be made by each individual with free will unfettered by the hands of a stopwatch.
  
  
• Ultimately, it limits law firms' revenue. (Clients--you can skip this paragraph.) Each of the variables that goes into revenue under the billable hour model has intrinsic limits: Rates, hours, realization, and leverage. This is worth a separate column, or more, of its own, so I'll go no further here.
  
  

Are we, then, about to witness in some grandiose fashion the "death" of the billable hour, much less its dropping back into the shadows of small-beer practices or quaint and creaky backwaters?

As you can tell by how I phrased the question, I see no such incipient revolution. And the primary source of life-support I would cite is clients, not law firms. Indeed, if there's a single remark in the Times article that's wrong-headed at best and offensive at worst, this is it:

[There's a] risk to law firms experimenting with other payment arrangements: If lawyers set too low a price, they lose money. Many lawyers may not be good enough businessmen to pick the right price, said [Frederick] Krebs, [President] of the Association of Corporate Counsel.

"The difficulty is, we don't really know what it costs us to do something," he said.

Wrong on the count that we don't really know what things cost, and wrong on stilts that lawyers aren't good enough businessmen to set a fair price.

First, if you believe that actuarial science has continued to survive and thrive for centuries for a reason, and that statistics, while subject to abuse for rhetorical or polemical means, are fundamentally a powerful tool, then you subscribe to the notion that we can tell "what things cost."

Second, if you believe lawyers can't set a price that both profits their firms and continues to win loyal clients, I would ask you to explain how the share of GDP going to lawyers, as well as the total percentage of lawyers as a component of the workforce, have continued to grow essentially unabated (well, until the last six months...) throughout our lifetimes.

So where, then, do I think the future of the billable hour lies?

As the old political joke has it, "You can't beat somebody with nobody," and part of the billable hour's durability to date has been a failure of imagination in nominating "somebody" to run against it.

But for the first time in awhile, "somebody," in various guises, are appearing. Here are just a few suggestions:

• Flat fees for a large portfolio of litigation over time and space.
  • Imagine you could handle all of Wal-Mart's employment litigation west of the Mississippi for three years (a made-up example). With the help of some of our good friends the actuaries, you could put a reasonable, albeit approximate, price on that.
  • But beyond that, imagine how landing that contract would change our firm's behavior the day after signing: All of a sudden, your incentive would not be to let Wal-Mart slide carelessly into court, ramping up your billable hours, but precisely the contrary--to keep them out of court, because going to court costs you dearly against your fixed-price contract.
  • Wouldn't you, then, embark on a campaign of employment-law compliance counseling at Wal-Mart?
  • And did you notice how this aligns the client's and the firm's interests? All of a sudden there's genuine risk-sharing: The more the client is sued (unpleasant and expensive), the harder the law firm has to work and the less profitable it is (unpleasant and expensive).
    
    
• An 80/120 deal.
  • With a willing and innovation-friendly client, agree that such and such a matter should cost, say, $1-million, but ask them to pay your firm as progress fees just 80% of that as the matter proceeds.
  • When it's done, the client gets--in its sole discretion--to evaluate how successful the outcome was for them. If they don't like it very much, they've paid your firm 80% and the matter is closed.
  • But if they like the result a lot, they pay you 120%.
  • And of course, 99% of the time, they pay you more than 80% but less than 120%.
  • What do you wager that the average recovery your firm would make on deals like that would exceed 100%? I would happily take that bet, as everyone working on the matter at our firm will know that this is a client they have to please.

There are surely other models inventive minds can think of.

The billable hour is dead. Long live the billable hour.

"Animal Spirits," Anyone?

Robert Shiller, the Yale economics professor who has co-authored the forthcoming Animal Spirits: How Human Psychology Drives the Economy and Why it Matters for Global Capitalism, has an important op-ed in The Wall Street Journal.

Shiller's op-ed itself is an argument that the Obama Administration's proposed stimulus package isn't big enough, and while I'll preview that here as a minor exercise in public service (I personally won't vouchsafe a view on this, since I don't have one, believing it's still too soon to tell), this is really a column about "animal spirits:" Where the phrase came from, what they mean, and what you can do about them.

But first, Shiller's argument, condensed:

President Obama is urging Congress to pass an $825 billion stimulus package as soon as possible. But even that may not be enough to stabilize the economy, since it fails to take into account the downward spiral of animal spirits that is underway and may continue to worsen.

The term "animal spirits," popularized by John Maynard Keynes in his 1936 book "The General Theory of Employment, Interest and Money," is related to consumer or business confidence, but it means more than that. It refers also to the sense of trust we have in each other, our sense of fairness in economic dealings, and our sense of the extent of corruption and bad faith. When animal spirits are on ebb, consumers do not want to spend and businesses do not want to make capital expenditures or hire people.

...But lost in the economics textbooks, and all but lost in the thousands of pages of the technical economics literature, is this other message of Keynes regarding why the economy fluctuates as much as it does. Animal spirits offer an explanation for why we get into recessions in the first place -- for why the economy fluctuates as it does. It also gives some hints regarding what we need to do now to get out of the current crisis.

A critical aspect of animal spirits is trust, an emotional state that dismisses doubts about others. In talking about animal spirits, Keynes sought to convey the message that swings in confidence are not always logical. The business cycle is in good part driven by animal spirits. There are good times when people have substantial trust and associated feelings that contribute to an environment of confidence. They make decisions spontaneously. They believe instinctively that they will be successful, and they suspend their suspicions. As long as large groups of people remain trusting, people's somewhat rash, impulsive decision-making is not discovered.

Unfortunately, we have just passed through a period in which confidence was blind. It was not based on rational evidence. The trust in our mortgage and housing markets that drove real-estate prices to unsustainable heights is one of the most dramatic examples of unbridled animal spirits we have ever seen.

"Animal spirits" appears on pp. 161 et. seq of Keynes' seminal book (as noted above). It's important to step back a moment and put it in its original context (emphasis supplied):

"...a large proportion of our positive activities depend on spontaneous optimistm rather than on a mathematical expectation, whether moral or hedonistic or eonomic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits--of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

[...]

It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimat eloss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death.

This means, unfortunately, not only that slumps and depressions are exaggerated in degree, but that economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average business man."

The economy, in other words, is not a system of hydraulic pipes and valves, governed robotically by the laws of financial thermodynamics. It depends on confidence, trust, reciprocity, and the expectation of future rewards and growth. In other words, to some extent it's an exercise in faith.

(Small digression: A few years ago I was asked to speak to an elementary school class about "money"--clearly the result of an over-exercised grade school teacher's brain--and I decided to do show and tell. I took out a $20 bill and a blank sheet of paper and threw them both on the floor to open the presentation. After the predictable flurry of excitement surrounding the $20 and the curious looks surrounding the blank paper [accusing me perhaps of littering], I asked the students to explain their reactions. This was all an exercise in reminding them that "cash" is worth what it's worth because we all believe in it, and for no other reason. Intrinsically, it's merely paper. And yes, I did get my $20 back; they were well-behaved kids and had push come to shove I was bigger than they were. But I would like to believe they learned a small lesson about the role of trust in the modern economy.)

Now, what does "animal spirits" mean for you?

Three things.

First, many of you, as I, are surely asking yourselves what went wrong? How could the economy have fallen off a cliff so fast? After all, housing was overvalued for years, subprime mortgages were being issued for years, securitization and structured finance had been on a tear for years, and easy money had been around since the dawn of Greenspan for years.

The answer is not that economic fundamentals changed overnight; it's that psychology changed overnight. It has a way of doing this, particularly at the end of bubbles. (You do remember, of course, when the dot-com bubble was at its peak and no business model was too stupid to get funding, and no law firm was too smart not to get into Northern California?)

Shiller (and Keynes) rightly talk about confidence and trust, and I have my own pedestrian analogy: In normal times, you buy a 24-bottle case of Poland Spring water and trust without questioning that it's OK, just as you'd buy a triple A bond with no doubts. But in today's environment, buying a triple A securitized asset (if they even exist any more) is like buying that case of water worried that while 23 bottles are surely fine, one might be rotten. The upshot is you don't buy the case.

When there's no trust, there are no transactions.

Second, the good news about "animal spirits" is that they can and will reverse. Seemingly on a dime. As they recently did around Q3 2008. And, as hard as it might be to imagine right around now, the day will dawn when M&A will be back--not financially engineered M&A, but strategically driven corporate M&A. At some point clients will start looking around and realizing that that company they always coveted is now really really cheap.

Third, look to your own firm, internally.

Who in your firm is rolling with this punch we've all taken? Who seems to be paralyzed?

Who, in other words, is prepared and eager to re-invent themselves? ("We're all restructuring lawyers now.") Who is a deer in the headlights?

Who are you counting on to constitute the core of the firm going forward? Who's on the periphery, perhaps a recent lateral or someone who's a summer soldier and a sunshine patriot?

These are the times to segregate those truly on board with your firm for the long run from those who may have come for a brief guarantee or a short expectation of self-interested gain.

You have, I devoutly hope, a vision for your firm going into the future and for how it will look on the other side of this brutal interregnum. This is the time to assemble, or reassemble, the team you want for that other side. I would ask you one key question about who's on which side.

Whose animal spirits are still in the ascendancy?

Report From London

Back from a week in London. (Close readers may recall I was there six weeks ago, and while I may be imagining things slightly, I believe the tone in the City has changed perceptibly even in that short time.)

Herewith a concise report, albeit one consisting more of questions than answers: This period is like that.

One consensus is firm: That revenues and headcounts are going to shrink. That is to say, firms are going to get smaller before they again get larger. Here are some of the other topics that seemed to be widely on people's minds:

• Are clients finally going to get serious about reducing overall legal costs, no matter what?
  
  
  • Will that mean that alternative or "strategic" fee arrangements, at long last and after great, ineffective, and gassy fanfare, finally gain traction?
    
    
• How long is this recession going to last?
  
  
  • More importantly, will it be "V" shaped or "U" shaped?
    
    
  • If it's "V" shaped, we know how to deal with it: Cut back a bit, hunker down, and last it out.
    
    
  • If it's "U" shaped, on the other hand, we can't assume business as usual. Firms will have to shrink (see observation #1, above). How, then, precisely, does your firm shrink?
    
    
• What will the financial services industry look like on the other side of all this?
  
  
  • If large portions of the banking system are owned by either Her Royal Majesty or the United States Treasury, won't that imply a fundamentally different way of buying high-end legal services?
    
    
  • If Merrill Lynch is acquired by Bank of America (for example), won't it be BofA's and not Merrill's culture that prevails? (Note that this opinion was offered, or this speculation widely floated, before John Thain's abrupt eviction from his exquisite office [remodeled at a cost of $1-million+, it was conveniently revealed, on the occasion of his professional dismissal and embarrassment].)
    
    
  • Will the financial services industry, source of outsized revenues to BigLaw, itself become a smaller component of the economy?
    
    
• Associate attrition is now essentially zero. How do we maintain freshness in the talent pipeline with no room opening out in the mid-levels? Or do we create room by force, through layoffs and "redundancies?"
  
  
• Is there a similar demographic logjam developing at the other end of the age curve, as Baby Boomers postpone retirement based on the shocking and deplorable recent performance of their retirement portfolios?
  
  
• If your firm must engage in layoffs, the only questions that remain are whether to do it:
  
  
  • Quietly or publicly;
    
    
  • All at once or gradually.
    
    
• Are geographic areas outside the major global capital markets centers--to wit, the "BRIC" countries, the Middle East--going to be able to serve as counterweights to the First World?
  
  
• Are practice areas outside the mainstream--the mainstream being corporate, transactional, banking, and finance work, as well as litigation in the US--going to be able to serve as counterweights to the mainstream slowdown?
  
  
• Is this the time to take a perhaps overdue look, and a rigorous, even harsh look, at colleagues who may be failing to display the sense of urgency, energy, and resolute optimism this situation demands?

It is quite early to expect answers to these questions. But I for one am more determined than ever to ambitiously seek every indicator I can that may begin to give us the sketchiest shadow of answers.

Lessons From the Depression

Every day, these days, and more than once, I ask myself, what all this means for our profession and our industry.

By "all this" I refer, of course, to the economic environment. Here are some of the hypotheses I'm putting in front of people I talk with:

• Will this period embody a "flight to quality" whereby clients decide that if something needs legal attention it needs to be done absolutely positively right, whereas if something is marginally deserving of legal attention it can wait or the client can wing it?
  • Implication: The Magic Circle and the NYC Bulge Bracket firms win.
    
    
• Alternatively, if the overall demand for legal services remains essentially unchanged (admitting that the practice mix emphasis may change), will clients' demand for savings on legal costs drive them away from Super Tier firms?
  • Implication: Second tier firms, with lower rates to start with and perhaps greater "flexibility" on rates, will win.
    
    
• Corporate transactions, M&A, private equity, securitization, structured finance, and even garden-variety asset sales and purchases are, by and large, without a pulse at the moment. Yet we all know (and the original Adam Smith, not to mention John Maynard Keynes and Milton Friedman, would agree) that they will come back. Not, initially, we may surmise, driven by financial engineering, but certainly driven by stategic corporate decisions. At some point in the future, say, 18 months from now, people in corporate-land will begin looking around and saying, "Wow, that company that we've always had our eye on is really cheap."
  • Implication: Everybody hunkers down for the duration and re-emerges in positions essentially unchanged from where we are today.
    
    
• Clients finally get really, truly, serious about alternative and strategically-driven billing in lieu of the billable hour. (I know, obligatory caveat to follow, that we've been talking about this for 20 years, but I think the dirty little secret of that era is that the clients--not the law firms--were always bluffing. They were perfectly satisfied with the billable hour or it never would have maintained the market share it has.)
  • Implication: Any firm that's willing to be creative, agile, and--not least--self-protective in terms of maintaining revenue for services rendered, will thrive. Firms that still think clients are bluffing, that think "alternative fees" is a synonym for "reduced revenue," or that simply lack financial imagination, will suffer.
    
    
• Some firms will bet right and other firms will bet wrong on when demand will resume, in terms of maintaining or cutting staffing.
  • Implication: Firms with the financial wherewithal to carry under-utilized partners and associates for the (unknown) duration of the downturn will be in a stronger position to service demand when it returns. Firms forced by financial exigency or choosing as a strategic option to make deeper cuts will have to hope their bet on the timing of the recovery is right or else that the market for lateral talent will be open and forgiving when the time comes.
    
    
• Although this recession seems to be disproving the tiresome nostrum that law firms are a-cyclical, there's no question that some practice areas are doing better than others, and some types of clients (read: some client industries) are doing better than others. Firms that were already disproportionately engaged with and exposed to those relatively healthy industries and practices will, rather tautologically, perform better.
  • Implication #1, for those who are true agnostics: You can never know or anticipate on which clients or practice areas the sun will shine tomorrow, so a reasonable (not utterly promiscuous, or you lose your reason for being) diversification of practice areas may be a shield against adversity.
  • Implication #2, for those more willing to trust their judgment: Place astute and selective bets on (a) industries, and/or (b) geographies, and/or (c) practice areas, that you think may be up and coming. While this may seem intuitively more appealing and more rational, markets have a way of surprising us all.

I could go on. You get the gist.

Never in my career--or the careers of those I speak with continually--has there been a time of greater uncertainty. The future is as hard to visualize as it is to see the East Side of Manhattan from Central Park West on a deeply foggy morning, or New Jersey from Riverside Park. You know it's there, with definite shape, but you can't see it or draw it or write about it with clarity and conviction.

So let's try to step back and get a bit of perspective.

On that score, the reflections of Ian Davis, the Managing Director of McKinsey, are worth reading:

These are no ordinary times. The venerable independent investment banks Lehman Brothers and Bear Stearns no longer exist. Central bankers and finance ministers are working in concert but struggling to keep up with events. China's government is pumping hundreds of billions of dollars into the country's economy. Chief executives in the US financial-services and automotive sectors have gone to Washington hats in hand.

Along the way, many core assumptions about the merits of globalization, markets, risk, and debt, long taken for granted in business, government, and academia, have come into question. One big shift already under way involves a far larger role for government in the economy, whether through outright ownership of former private-sector assets or tighter regulation. Also inevitable: massive changes in industry structures. Consolidation, effected either by bankruptcies or mergers, is already transforming financial services and seems bound to take place elsewhere as the impact of the credit crisis ripples through the real economy.

[...]

Inspired leadership is urgently needed to renew the global financial system and avert a protectionist backlash or excessive regulation that could derail economic progress--especially in countries and regions emerging from poverty--or dampen the entrepreneurial spirit. Strong leadership is equally critical within organizations. Anxious employees, customers, suppliers, and shareholders are looking for a steady hand and clear, candid messages from corporate leaders, not for unrealistic pronouncements that may be overtaken by next week's events. The world is watching.

I would emphasize Mr. Davis' final point: This is a time for leadership. Leadership within your firms, to be sure, but also leadership on the public stage. If any group of managing executives is in a better position than law firm leaders to contribute to the debate on issues such as financial regulation; banking safety and soundness; the integration or severance of investment banking, brokerage, and classical-banking functions; the role of ratings agencies; the utility of global capital flows (just to suggest a few issues), I don't know who they are.

Are you prepared to speak out? If not, why not? If so, shall we try to enlist a leadership council of your peers to do so? If you're interested, "Adam Smith, Esq." is ready, willing, and able to help provide a platform and clearinghouse for ideas, position papers, and fora for discussion.

But back to the economic crisis.

We can also try to suss out some more concrete advice about what we should do now, for example in the popular parlor game of trying to take lessons from the Great Depression. But when it comes from McKinsey, I think there may actually be meat on the bones.

Recent turmoil in global financial markets and its spillover into the real economy have generated considerable interest in the Great Depression. There's much to be fascinated with, both in the parallels (banking failures, a large spike in real-estate foreclosures, and global uncertainty, for example) and the points of contrast (such as the speed and coordination of the response of central banks and finance ministries in 2008).

Can the business practices of the 1930s yield useful lessons for executives setting priorities in today's uncertain and evolving environment? For investments to promote innovation, the answer may be yes.

Using patents as a proxy for investment in the future, McKinsey found a fascinating pattern during the Great Depression: This chart shows change in GDP (green bars) and change in patent applications (yellow bars), lagged by one year, for the Depression era. Note the almost spooky correlation, as if companies could turn innovation on and off depending on which way the economic winds were blowing:

It couldn't be much more dramatically displayed how companies tied their investments in R&D to an almost yearly correlation with GDP growth.

Yet there were some companies that did not. Among them were:

• DuPont, which invented neoprene (synthetic rubber) in 1931 and nylon in 1934;
• Polaroid;
• Hewlett Packard; and
• RCA, which turned its research from radio to the new market, television, returning to profitability in 1934.

If these names sound like leaders in the WWII era and its aftermath, there's a reason. They leaned against the conventional wisdom and turned against the prevailing economic winds. A lesson for us?

Not only may your competitors be battening down the hatches, but investment assets (talent, primarily) may be cheaper than they have been for a long time.

As I've said before, perhaps a time for us all to read fewer newspapers and more history.

Happy 2009

This is actually a new-for-2009 Waterford crystal ball, approximately 10 feet in diameter, weighing over 12,000 pounds, covered with 2,668 crystal triangles, and illuminated by more than 32,000 LEDs.  Happy big bad bright New Year.

Actually, Dear Reader, I imagine many of you, as I, will be just as pleased to kiss 2008 goodbye:

• The Dow ended the year down 33.8%, its worst annual showing since 1931--and 28 of the 30 stocks (all but Wal-Mart and McDonalds) were down by more than 10%;
• The more representative S&P 500 was down 38.5%;
• The famously tech-centric NASDAQ was down 40.5%;
• The small-stock Russell 2000 was down 34.8%;
• The FTSE 100 declined 30.9% on the year, its worst annual drop since it was created nearly 25 years ago;
• Nearly $7-trillion in US wealth has been wiped out, erasing all the stock market gains of the past six years;
• There was no place to hide abroad either, with the "BRIC" stock markets down from 55% to 72%;
• Commodities such as oil and copper have crashed, and the Reuters-Jefferies CRB index, which first began tracking a basket of commodity prices in 1956, will be down nearly 40%, an all-time record annual decline, while the S&P FSCI index, another benchmark for commodity investors, was down over 50%;
• And of course the US housing market is in a famous and now nearly theatrical swoon, with median prices (there is of course no such thing as a "median" housing market) down by about 14%, by all accounts the largest decline nationwide since the Great Depression;
• Wall Street as we knew it (Bear Stearns, Lehman Brothers, Merrill Lynch, and Morgan Stanley and Goldman Sachs in their own ways) went away;
• Not to mention Heller Ehrman, Thacher Proffitt, and Thelen Reid, plus countless layoffs and pay and bonus freezes in our little corner of the world.

What, then, are my wishes for you for 2009?

As I've written fairly consistently this year, try to put these events all in perspective.  You are not your net worth or your income, and if both have returned to 2002 or 2003 levels, the world has not, actually, come to an end.

Nevertheless, an array of forces that have heretofore seemed rather randomly aligned, disconnected from one another, and more imaginary than real, may—emphasis on may—be assembling for the first time into something recognizable and coherent, although still, at the moment, of little real impact.  I don't know if this is, or will be, true, and I don't know of any way of thinking about it harder or looking for more data to tell if it will be true.

I can promise to you, however, Dear Reader, that in 2009 my fervent hope and commitment will be to continuing to make "Adam Smith, Esq." a place where everyone who cares so deeply about our industry and our profession can assemble to help figure these things out—and change them for the better.

Happy Big Bad Bright 2009.

Perspective

Perspective.

It's time for some.

A friend of mine who's the lead financial reporter for one of the original three networks prompts these thoughts. Not that he/she subscribes to the view that it's time for some "perspective"--au contraire. To paraphrase their view: "We're in a severe recession. This is not the time to be sanguine, it's the time to be alarmist. [And] In terms of investments, it's time to go to CD's; if you've already lost 40% in equities, you want to get out; you don't want the 40% to become 60%."

Now, we all react in our individual ways to once-in-a-career times like these, and if my job were to report on deadline every weeknight to a national television audience about the state of the economy and the financial system, I'd probably not be writing this piece. I'd be writing about how this time is different, and not for the better: That this time is more akin to the Great Depression than to the 70's staglation and OPEC oil price spike, the 80's Volcker-induced shock therapy to stamp out inflation, or the 90's dotcom meltdown. I would, in other words, be writing alarming things.

Since we're still in the middle (the beginning?) of this economic episode, we of course can't know. My call for "perspective" may be delusional and this may be one of those pieces ruefully quoted back to me months or years hence. But I'll go out on a limb.

This chart shows the US per capita GDP in 2000 dollars from 1870 to 2004 (ratio scale), and comes from the new textbook Macroeconomics by Charles Jones:

The trendline is 2%/year growth, and the only real deviation visible to the naked eye is the 1929-1933 Great Depression--and even after that, the trendline quickly returned to normal. Every other recession appears as little more than a blip or a rounding error.

What does this tell us?

It scarcely "proves" that this time is nothing to worry about, but it does suggest that, my friend the financial reporter's views to the contrary notwithstanding, the "animal spirits" of capitalism (John Maynard Keynes' felicitous phrase) will arise again. Assets will be bought and sold. Companies will be started, grow, and decline. Capital will flow from country to country and industry to industry. New financial instruments will be created. New regulatory structures will govern. Globalization will not cease.

In all of these activities, lawyers and law firms will be enablers, facilitators, innovators, brokers, handmaidens, and creators.

I'm not gainsaying the challenges, and for those of you in leadership positions in firms these days, this is surely the time you'll earn your keep. What I'm saying is:

• Be not apocalyptic.
  
  
• Manage your partners' expectations. If next year is tantamount to a return to 2003, we'll all live.
  
  
• Recruit carefully, prudently, assiduously, but keep recruiting. Talent is your lifeblood. Do not shut if off.
  
  
• Communicate, communicate, communicate, to your partners, associates, and staff, about how the firm is doing. (Yes, some of it will hit "Above The Law" in a nanosecond, but that's a topic for another day.)
  
  
• Communicate with your clients. They're anxious as well; let them know you're in the same boat. A little bit of sympathy about cost-cutting pressures wouldn't hurt as well.

It all depends, perhaps, on your perspective. If it's the nightly news, it's one thing. If it's the arc of a career, it's another. Stay true to which is yours.

Beyond continuing to hypothesize duelling views of future realities, let's look at the historical record (with help from McKinsey).

Financial crises, to begin with, are not that rare:  On average, they occur every decade to one major economy or another.  And while this promises to be among the more severe, a lesson from the 20th Century is that how bad things will get depends largely on the governmental response. 

At this point (December 2008), according to Bloomberg, US financial instiutions have taken total credit-crisis related write-offs of almost $1-trillion.  McKinsey estimates the total required amount of writeoffs will be between $1.4 and $2.2 trillion, or 10—15% of US GDP.  Historically, in the past century that level of writeoffs was exceeded only three times:

• During the early 1990's banking crisis in Japan that initiated its "lost decade;"
• In the Asian financial crisis of the late 1990's;
• And of course in the Great Depression.

In the first two, writeoffs in the affected banking sectors were 15 and 35% of GDP respectively; in the Great Depression, about 20%.

But from the perspective of the functioning economy, the real question for companies is not what's happening in the banking sector but what's happening to the availability of credit:

How long it takes an economy to emerge from a downturn depends heavily on what kind of cleanup and stimulus package governments employ--especially in repairing the banking system's ability to provide credit efficiently and restoring confidence among companies and consumers. On average, countries have needed two years to emerge from past recessions after major banking crises and up to twice as long to return to trend growth. Only in two cases did a downturn last substantially longer: in Japan during the lost decade, as a result of counterproductive government policies, and in the Great Depression, when the government was far less able to mount a coordinated response than it is today.

And with respect to stock markets—the high-profile indicator that everyone including our financial reporter friend pays attention to—we are also, apparently, in a quite well-precedented downturn:

Equity markets are the most visible and dramatic indicators as crises unfold. At the end of October 2008, the S&P 500 index had fallen by 46 percent from its peak a year before (October 9, 2007, to October 27, 2008). By late November 2008, the US equity market had given up almost all of its gains since the 2001-02 dot-com bust. Although nobody knows if the market has reached bottom, the fall so far isn't unusual by historical standards. Japan's Nikkei 225 fell by 48 percent from peak to trough (December 29, 1989, to October 1, 1990) during the banking crisis, though the market has subsequently fallen still further; at the end of October 2008, it retained less than 20 percent of the peak value reached in 1999. During the Asian financial crisis, the equity markets of Indonesia, South Korea, and Thailand fell by 65, 72, and 85 percent, respectively, in local-currency terms. In the United States, the S&P 500 index fell by 49 percent from March 24, 2000, to October 9, 2002, after the tech bubble burst.

Here, as well, are some fascinating and troubling statistics on the housing market.

But reasons for hope still remain, and they're all tied to how the underlying economy is—or isn't—isolated from the financial services sector blow-up.  For example, in the early 1980's S&L crisis, 258 US banks failed or required FDIC assistance and during the entire decade of the 1980's 750 failed and more than 1,500 required assistance (vs. 35 during the entire decade of the 1970's), yet corporate investment continued to increase at an annual rate of 4.5% in the 1980's. How well prepared are we today?  Surprisingly well:  US industrial companies have higher interest coverage and lower leverage than they did going into the dot-com bust or the S&L crisis.

By contrast, one reason the Depression was Great was that business investment fell by more than 75% from 1929 to 1933 because capital had almost nonexistent cross-border mobility and even the soundest of corporate credits couldn't obtain long-term debt financing.  That happening again today appears exceedingly unlikely.

So where does this leave us? 

As we've just all learned, the famous PG Wodehouse character had it right when he said, "never confuse the unlikely with the impossible."  Now that we've all seen shockingly unlikely events unfold, including the end of Wall Street as we knew it, what should we actually be doing?

Your answer depends on how uncertain you feel about the future.

If you feel that what we're going through is a "normal," albeit severe and protracted, recession, we know how to deal with that. Pull in your horns, sit tight, control costs rigorously, and wait for the legal industry (a lagging industry) to pull out after the real economy does.

If on the other hand you feel that we're experiencing a generational or once-in-a-career change in the way high-end legal services are bought and sold, then you need to stand on tiptoes, rather like a sprinter entering the blocks at the starting line of a race, prepared to bolt forward as soon as there's clarity enough (in your mind) to think the starter's pistol has fired. This does not mean you need to be inattentive to costs, any more than sprinters are inattentive to weight, or complacent about your current exalted standings. At the starting line, you have no standing; all are equal, at 0:00.

This is where I actually think we are. We are all about to begin running a new race, one where incumbency will count for far less than it used to, and where a premium will be put on agility, speed, and foresight. Because this race, once the starter's pistol fires, will be run in heavy fog, with visibility just yards down the track and the positions of your competitors, be they ahead of or behind you, difficult to discern moment to moment. But the time to start training, to make your firm more agile and alert and responsive, is now.

Thacher, Proffitt & Wood LLP: 1848 - 2008

A Merry Christmas, Happy Holidays story of the first order:

As noted this morning by The New York Times, Above The Law, and The WSJ Law Blog, Sonnenschein is acquiring about 100 lawyers, including 40 partners, from 160-year-old Thacher Proffitt & Wood—technically, not a merger of the firms but a large lateral group acquisition.  The lawyers come from Thacher's four main practice areas, including Structured Finance, Corporate and Financial Institutions, Real Estate, and Litigation, and include the chairs of each group.. 

The sad news is that this represents the end of the road for Thacher as a firm, but the reason to celebrate is that this extremely talented group of lawyers will have the opportunity to remain together, serving their clients from a broader, more diversified, and financially strengthened platform.

Are there larger lessons in this deal for our industry?  I believe so, but for now I'll leave those for another day.  (Hint:  They have to do with heavy concentration on specific practice areas.) 

For the moment, it's a much-needed vote of confidence in the ultimate recovery of the financial services sector:  Thacher's core clientele included all the biggest banks and investment banks and today a marquee client is the US Treasury Department itself, under the TARP program.  The sector will regain a pulse eventually, and this is a sign that I'm not alone in that faith.

Sad as it is to see a storied firm, bombed out of the World Trade Center twice and still resilient, reach the end of its road, what really matters is not the name of a brand, but the individual lawyers and professionals. No one at Thacher died during the two WTC attacks, and none will "die" professionally today. That's why it's a good news holiday story. They are living to fight another day, and (disclosure) from personal experience and acquaintance, I can testify that they're fighters.

Rumors of Its Demise

"Reports of my death have been greatly exaggerated."
—Mark Twain, in a cable from London to US publishers, who had mistakenly printed his obituary.

And so, for the entirety of my career, has it been the case with predictions of the demise of the billable hour.  If the best predictor of what will happen is what just has happened, then the billable hour is here for keeps.  But I wonder.

If you can say nothing else about what's going on now, you can say that the volume of the dialogue about alternatives to the billable hour has never been higher.

Last month the Association of Corporate Counsel announced their "Value Challenge," through, among other venues, an interview with Susan Hackett, their GC. Some of her comments included:

Value from the corporate perspective means receiving a solution that addresses the client's problem-for an appropriate cost. [...] Take a look at the cost of legal services and the fact that they've been rising 6, 7, 8 percent a year, for as long as anyone can remember. But the services remain pretty much the same. And at the same time that outside firms' costs are rising, the in-house law departments are getting better at their efficiencies and at lowering their costs. [...]

We also want to measure whether people are starting to do more of their work on a non-hourly basis. It¹s one metric. I¹m not saying billable hours is the entire project, but it¹s one good way to look at this. [...] You would see a lot less work done on the billable-hour basis, but I don¹t know what alternative billing will look like.

I don't know about you, but it sounds like "billable hours is the entire project."

Consider another perspective: The dehumanization that comes with the billable hour. And dehumanization it is, is it not? Doesn't it tell people that they're fungible commodities? To be sure, their hourly rates vary, but they're all and every reducible to cogs in the machine. No rewards for specific insight, no discounts for slogging through it, no premiums for remarkable efficiencies. You are your watch.

Or consider the perspective of the intersection of the core years to partnership tournament with the key family formation and child-bearing years. At the moment, these two critical life trajectories tend to overlap in people's lives. Both are intensely time-consuming. Their intersection is, for many people, unsustainable; they are forced to choose one or the other.

Don't misunderstand; I'm not suggesting that the pressures of the path to partnership years--and the partnership years themselves--can be substantially ameliorated, minimized, or underestimated. There is no substitute for hard work if one wants to achieve professional performance at the level partnership entails. But what I am suggesting is that the billable hour model exacerbates the tension between familly and work precisely at the time it matters most. Without it, contributions could be more readily recognized "on the merits," without the quota of hours in the office or on the BlackBerry.

Two other perspectives are, I believe, more important and will be more consequential. One results from the tsunami of changes in the complexion of the financial services industry in the last year and the other results from an inherent structural problem with the billable hour model for firms themselves.

Financial Services

The industry is unrecognizable from its form a year ago. Bear Stearns, Lehman, Merrill Lynch, gone, and Morgan Stanley and Goldman Sachs essentially far different from what they were. Balance sheet leverage ratios of 30:1 or 40:1 are ancient history. New regulations, of forms we can't yet predict, are certain. Old forms of regulation may go by the wayside, but the net result, to be sure, will be an overall increase in oversight.

Which brings me back to the billable hour: If financial services comprise a substantial part of your clientele, look forward to their being more heavily regulated than before. With congressional oversight. Care to explain to, say, Barney Frank, why $1,000/hour is a fair and economically justified rate? Wouldn't you far prefer to explain why (say) $750,000 as a flat fee on a $50-million transaction is reasonable?

Also, Bank of America buys legal services very differently than did Merrill Lynch. RFP's, beauty contests, bakeoffs, diversity quotas, expectations about first and second year associates (don't bother putting them on the bill), and so forth: It will be a new world.

Structural Issues

I have long predicted that the demise of the billable hour will only come about when law firms find it in their own self-interest to call a halt, and perhaps at last the stars are beginning to align. Consider the four variables that determine your firm's revenue and profitability under the billable hour model:

• Rates;
• Hours;
• Realization; and
• Leverage

Faithful readers will know that I've pointed out that all four of these variables have intrinsic limits:

• Rates: $1,000/hour? £1,000/hour? At some point there is a limit to clients' stomach for it.
• Hours: 2,200/year, 2,600. 3,000? At some point the body rebels, and the talent pool capable of sustaining these super-human schedules thins out.
• Realization: >100%? I think not.
• Leverage: At what point do associatesl look at the odds and simply check out?

But on the profitability side of the ledger, there are no intrinsic limits.  How high is "too high" for PPP?  Sarah Palin Joe Six-pack probably thinks $2-4-million/year would do just nicely, but when you're a partner at BigLaw regularly rubbing shoulders with hedge fund managers and private equity folks—or plain old Fortune 500 CEOs—you're a piker by comparison. Consider also the baffling silence over the fact that corporate execs get equity in the form of stock, restricted stock, or options.  Lawyers, even the best of them, toil for ordinary income.  Yes, you can make a very respectable income and if you sock it away prudently (we Scotch Presbyterians can give you advice on this if you'd like), you'll end up with a very comfortable nest egg.  But it will have been gained by the sweat of your brow and not the true alchemy of returns on capital.  So we have, under the billable hour model, inherent constraints on revenue but no inherent constraints on the desire for ever-increasing profits.

This brings me to the point: Won't firms find it in their own self-interest to get beyond the billable hour in the pretty darned near future?

Do not, I hasten to add, be afraid. "Alternative billing" is not code for "reduced revenue."

Indeed, we have every reason to expect that getting away from the billable hour will lead to less micro-management of billing, fewer he-said/she-said spats about whether this, that, or the other micro-activity was justified, and less general embarrassment over tiny charges for faxes, messengers, and other costs of doing business.

I'll suggest another reason more potent than "embarrassment" for ditching the billable hour:  Doesn't it fundamentally reflect a lack of trust between your firm and your clients?  Rather than being able to say "For professional services rendered...." and have confidence that hte client will trust you to have put a fair price on things, the billable hour reflects a green eye-shade mentality, notoriously subject to auditing (now, even by bespoke software programs designed to ferret out inconsistencies and discrepancies of the most minute and trivial nature).  The billable hour, I believe, starts from a relationship of mistrust:  "See, we can prove we actually did the work!"  And the GC or other inhouse counsel can, in turn, tell their finance department, "Yes, see, they really did the work." 

This is not the premise from which mature relationships of trust and confidence arise. 

At the risk of piling on, I'll suggest yet another reason the billable hour disserves our profession:  Economically, it begins life with "cost of production" rather than "value to client."  Except for the rawest and most basic of commodities, "cost of production" should have virtually nothing to do with price.  (OK, before the microeconomists in the audience start piling on, permit me to issue the immediate caveat that, in a  perfectly competitive marketplace, price will equal marginal cost of production, but I stoutly question the assumption that the marketplace for services of BigLaw is remotely "perfectly competitive.")

To be sure, firms need to meet their costs and then some to make a profit, permit reinvestment in their businesses, and appropriately reward their owners and investors.  In this technical sense, then, "cost of production" is clearly a relevant variable when determining price.  Price best exceed cost of production by a reasonable margin if the firm is to survive as a going economic entity.  But for price to be mathematically determined to the second decimal place by "cost of production" is flatly irrational.  Worse, it ignores (again) what the perceived value of the services is to the client.

Now, don't pretend you can't put a value on those services.  We value complex baskets of goods and services all the time, and markets for those goods are highly liquid.  Why is a haircut at "Frederic Fekkai" on East 57th Street worth hundreds and hundreds of dollars while one with Sal the barber on Upper Broadway is worth $30 including a hefty tip? 

Finally, a failure to bill "for professional services rendered" represents, I must believe in my heart of hearts, a failure of courage.  Do you mistrust what your services are worth?  Do you mistrust whether your client agrees with your perception of their value?

If that is the root cause of the continued dominance of the billable hour, then we have far more work to do than turning off "timeslips elite."  But for the health of our profession, for our self-respect, and for the benefit of clients, turn it off we ultimately must.

Lessons From Citi

Consider a nonrandom selection of headlines from The New York Times, The Financial Times, andThe Wall Street Journal:

• Citigroup Pays for a Rush to Risk
• Citigroup Tries to Steady Stock
• Turmoil Continues in Banking Sector
• Citigroup: You Can't Step Into the Same Crisis Twice, Right?
• Citi crisis deepens as shares fall further
• Pandit denies break-up as Citi tumbles

Aside from the obvious, that these articles all revolve around Citi, they have, I suggest, one core theme in common: An erosion of trust in Citi. Theobvious question is whether this skepticism is warranted. Some think not:

"The earnings power is there," said Charles Peabody, a financial services analyst at Portales Partners. "It's a question of getting through the credit issues."

But is that the right question? Trust may be intangible, but it's an intangible with extraordinarily powerful repercussions. Trust is granted by grace, not demanded or usurped by fiat, can only be cultivated over an extended period of time, and can be forfeited in a heartbeat (Exhibit A: Eliot Spitzer).

Now,this may seen an exercise in rehearsing the obvious, but at times a return to first principles is in order.

We sit astride or at least within firms which may have hundreds of thousands of dollars of debt per partner, and extensive long-term lease obligations, often in far-flung networks of offices, yet whose assets voluntarilly choose each morning which building to enter and which elevator bank to go to.

As Citi's recent experience deonstrates, these are not abstract issues.

How, then, can you reinforce the cultural glue that brings people back to your offices every day?

I submit you have two tools at your disposal: (1) Communication; and (2) Behavioral Incentives.

Communication means constantly telllingpeople how the firm is doing and reinforcing that message at every opportunity you have.

Be candid, or don't bother. People have shockingly acute sensitivity to insincerity, and an incomplete or half-hearted effort will do more harm than good.

If there are challenges facing the firm, explan them. Call for collaborative action and, if necessary, shared sacrifice. You'd be amazed at people's ability and willingness to rise to the occasion when hard times are at hand.

How will you know if your message is getting through? Ask them. Ask your partners, associages, and staff if they feel they understand the firm's situation, meaning the external threats and opportunities, and the internal strengths and weaknesses. And, of course, your plans for addressing those threats and weaknesses.

Afraid that if you communicate it will appear on Above The Law in no time?

Get over it.

We live in the YouTube/Above The Law era, but that does not relieve you of your obligation and your duty to lead. It makes it more challenging and more risky, but if anything even more necessary. I've written that information abhors a vacuum, and the unprecedented availability of channels for near-instantaneous distribution of rumors or innuendo increases, not decreases, the burden on you to tell the firm's story. If you're clear, consistent, candid, and direct, Above The Law won't be able to lay a glove on you. (If you disagree, permit me to ask you whether your time-frame is that of months and years, appropriate to managing a firm, or that of Above The Law itself, which is hours or minutes.)

Second, Behavioral Incentives: Reward (read: pay for) the behavior you want.

As an economist, I can't help but reflect the reality that I'm ingrained with the power of incentives. This brings us back to Citigroup:

To some, the misery at Citigroup is no surprise. Lynn Turner, a former chief accountant with the Securities and Exchange Commission, said the bank's balkanized culture and pell-mell management made problems inevitable.

"If you're an entity of this size," he said, "if you don't have controls, if you don't have the right culture and you don't have people accountable for the risks that they are taking, you're Citigroup."

A more serious problem was whether the bank, assembled from a potpourri of financial services firms by Sandy Weill, ever came together as one coherent entity:

Even as Citigroup's C.D.O. stake was expanding, its top executives wanted more profits from that business. Yet they were not running a bank that was up to all the challenges it faced, including properly overseeing billions of dollars' worth of exotic products, according to Citigroup insiders and regulators who later criticized the bank.

When Mr. Prince was put in charge in 2003, he presided over a mess of warring business units and operational holes, particularly in critical areas like risk-management and controls.

"He inherited a gobbledygook of companies that were never integrated, and it was never a priority of the company to invest," said Meredith A. Whitney, a banking analyst who was one of the company's early critics. "The businesses didn't communicate with each other. There were dozens of technology systems and dozens of financial ledgers."

As an example of how "Citi" never integrated, it's been reported that in China the mortgage unit and the credit card unit couldn't even agree on a common consumer-fronting language: One used Mandarin and the other Cantonese.

This brings us back to law firms.

Are your firm's incentives aligned to encourage people to collaborate, or to give them reason to hoard business? Do you keep track of partners who "give away" business they've originated to other partners/offices/practice areas to handle? Do you reward them for doing so? Or, contrariwise, to you have perpetual origination credits, rewarding partners or heirs of partners in perpetuity for entrepreneurial achievements now lost in the sands of time?

I suggest now is not the time to indulge in such hereditary droits du seigneur. If the unfolding lesson of Citi is anything, it's that unclear and blinkered management, perverse incentives, and a failure to enforce and communicate a firm-wide vision can catch up with you in sour times.

Care to guess how fast the sour times are going to end?

BigLaw & The Big Three

Consider Detroit's Big Three.

Having made what  turned  out to be bad bets on  over-investing in now shunned product lines, they've been  conspicuously laying people off, downsizing, attempting to  renegotiate credit lines, and furiously trying to revamp their product offerings to align to and conform with the world's new reality. 

Sound familiar?

It should because the same description, with variants in emphasis, could apply to our industry.

So I have a modest proposal:  Let's put all our lawyer  brethren in Congress—surely we should at least get some good out of the vast over-representation our colleagues enjoy in poliitics—working on a bailout bill for BigLaw.

I owe the genesis of this insight to a faithful reader, Brent Jeffcoat, of McGuire Woods' Charlotte office.  He frames the key argument nicely:

When do law firms start seeking federal assistance?  After all, think of all the people we affect: our young associates marry and live in condominiums in urban centers.  We probably support Starbucks.  Allen Edmonds is toast.  Many high-end automobile dealerships will suffer mightily without the patronage of lawyers.  I mean, the list goes on.  Think of all those poor guys in Scotland who will not be able to sell their single malt whiskeys.  It would be a global crisis of unimaginable proportions if one or two of the AmLaw 100 were to fail.  The Federal government has got to step in and lend a hand.  Before year-end or else the distributions will be hit.  Heck, many people in the medical industry are dependent upon elective cosmetic procedures scheduled just after year-end distributions.  America needs us to survive.  Who will keep the kept women?

This is firmly in keeping with the evident economic philosophy of our times.  Who needs Microsoft, Intel, Starbucks, or, for that matter, Target?  Wouldn't we all be  better off in a world dominated by Wang, DEC, Howard Johnson's, and Nash Rambler?  And isn't your dream  for your kids that they can grow up and join the UAW?  Don't you wish you could, to paraphrase William F. Bucklkey, stand astride the tide of history and cry, "Stop!"?

Joseph Schumpeter (Mr. "Creative Destruction"), and Adam Smith himself, would be outraged and appalled.  And  rightly so. 

Permit  me  to remind our colleagues in Congress what happens when a company declares the dreaded "bankruptcy:"  Its workers are not taken out and shot, its factories and offices are not incinerated, and its customers' demand does  not evaporate.  Rather, all those assets  and market forces are  reallocated elsewhere.  If the Big Three have demonstrated anything  over the past 30 years, it is their unrivalled  managerial genius at misallocating productive  assets and falling ever further behind their rivals.  Time, one might  think, to give someone else a chance to deploy those assets.

Sympathetic as I am to law firms struggling with yesterday'spractice areas, and to lawyers rudely discovering the urgency of reinventing themselves, the dynamism of the  market will not abate. 

That is something devoutly to be celebrated.

New York Today and Tomorrow

Our texts for today come from (in inappropriate order) the New Testament, as it were, and Peter Kalis, the chairman of K&L Gates:

"The metaphysical question is whether you can have bulge-bracket Wall Street firms without Wall Street," says Kalis. "The capital markets, when they rebound, will no longer have the margins they once did. Like night follows day, they won't be willing to pay premium rates."

And from the Old Testament, Simpson Thacher's Chairman Richard Beattie:

"I strongly suspect we've got a rough period of time ahead". He sees the markets turning around within a year or two, and doesn't expect big changes ahead for his firm and its closest competitors. "I don't think [the market changes] will impact fees," he says. "The M&A work will come back, and Goldman Sachs and Morgan Stanley will be advising the companies doing M&A, and I don't see the fees being different. . . . The private equity firms will be back. They're sitting there with huge piles of money."

In my conversations with managing partners in New York and elsewhere, they segregate their worries into the (relatively) pedestrian and the existential. The low-level worry is one of duration: How long will this recession last? If it's of "ordinary" duration, say about a year, and of "ordinary" depth, with unemployment staying below 8%, we know how to deal with that: Be prudent about costs, manage your partners' expectations, and stay the course.

But there's another possibility, the one Pete Kalis fingers: Are we facing an existential challenge?

If the US Treasury is a major stockholder in major financial institutions, how will that change the dynamic of how premium-level legal services are bought and sold? Not to be facetious about it, but how would you feel to be called before Barney Frank to justify your $950/hour rates?

Short of being hauled before the television cameras of Congressional hearings, contemplate the implications of the changes in ownership of major financial institutions simply on the private side. If you think that Bank of America hires lawyers as Merrill Lynch hired lawyers, guess again. Here are a few examples from their website (warning: they run 69 pages):

• Extraordinarily explicit diversity requirements;
• Refusal to pay for first year and junior associates;
• No payment for time spent on conflict checks;
• Automatic "most favored nation" status on rates;
• Staffing demands enforced at a task-level basis;
• Highly stylized and formatted billing submission requirements, failure to adhere to which spurs immediate rejection of the entire bill; and
• You get the picture.

But back to the issue of New York. To what extent will it remain a financial powerhouse for investment banks and, by analogy, law firms?

At the risk of offending both Pete Kalis and Richard Beattie, I don't think New York will become Just Another Big City, nor do I think its pride of place at the pinnacle of the food chain is guaranteed. Instead, I want to offer an analogy between law-firm land and corporate land.

The common perception is that Fortune 500 companies have been abandoning New York for their headquarters in a steadily departing stream for the past 40 years or so. The reality is quite different. (Not so incidentally, there are a multitude of studies showing that firms that relocated outside New York have underperformed the S&P 500 whereas those that stayed here have outperformed--but that's a debate for another day).

Here are the numbers on Fortune 500 headquarters in New York over time; the exodus  actually ceased over 20 years ago:

• 1965:  128 of the F500
• 1976:   84
• 1986:   53
• 2007:   53

And just for reference, here are the top five states by Fortune 500 headquarters as of 2007:

• New York:  57
• Texas:  56
• California:  52
• Illinois:  33
• Ohio:  28

Even companies that have formally relocated their headquarters, with all the ancillary staff that usually implies, more often than not keep a core group of finance, design, marketing, and other professionals in New York, and you can be sure their key executives fly through regularly. (Even the Sage of Omaha almost invariably announces his big deals in New York.)

Similarly, as recently as 10 years ago, New York was where essentially all new significant company listings occurred. Since then, for a variety of reasons including Sarbanes-Oxley, the "Spitzer Effect," and even (I say this speculatively) America's relative fall from international grace, new listings on London's AIM, in Hong Kong, and even in Beijing are now substantial.

But New York remains the financial capital of the Americas and, I will confidently wager, will remain so as far as the eye can see.

Is its international importance diminished? To be sure. Is it at threat of becoming marginalized? Not a chance.

To some extent, the  erosion in New York's pre-eminence is an ironic reflection on how all-important it had become—and on how that importance can only decline, in a relative fashion, as Brazil,  Russia, India, China, and the Mideast grow in global importance.  But surely Orrick's Ralph Baxter has it right when he says:

"There will be some adjustment.  But there's really no way to be an American-origin firm that has anything to do with capital markets and finance without being in New York in a serious way."

On this view, New York will remain one of a handful of global financial centers, along with London, Hong Kong (or its possible Asian successor, such as Shanghai), and perhaps Dubai or another Mideast center of gravity. 

Recent months have brought a surfeit of announcements by firms of expanding finance practices in the Middle East and Asia.

Even before the financial crisis, Jay  Zimmerman, CEO of Bingham, said his firm had broadened its approach, continuing to seeek opportunity in New York but also expanding abroad, especially in Asia.

"There have been shifts in the global economy," he said. "Demographics are clearly pointing to a shift ininfluence and financial strength to Asia."

But Mr. Zimmerman added that it would be quite some time before such new markets could supplant New York, either as a financial center or a source of firm revenue.  He said that New York would remain Bingham's number-one priority for growth.

Let's not be seduced into thinking this is an all or nothing, Manichean proposition:  "New York will forever be King of the Hill or it will become irrelevant."

Consider that New York has so many established assets which are all part of the lush and verdant ecosystem sophisticated law firms needing to attract world-class talent have to have, and it's not all about stock exchanges, banks, and capital markets.  Hubs of top-end global commerce need to provide the environment to attract, please, and win the affection and allegiance of the Type A, discriminating, demanding professionals from all walks of life who together produce the pulse, the vibrancy, and yes, the romance, of a global capital:  Museums, theater, opera, restaurants, sports, universities, stores and boutiques,  a reasonably salubrious climate, great housing stock, and abundant international  air connections. These aren't built in a day.

And unless you really know New York, it may be hard to appreciate how profoundly woven into the City's warp they are.

It's not that you can find a dozen great restaurants or a spectacular concert or a wonderful theater troupe or the "nowhere else" boutique, because you can find those in a hundred or more cities worldwide.  No:  It's the depth of New York's "bench."  By which I mean:  Not only are the top 10 [pick your favorite category] institutions great, but so are the 50th, the 250th, and the 500th. I would pit a "neighborhood" New York restaurant against a top restaurant in many other cities, the chorus line at an off-Broadway show against lead dancers in other shows, and so forth.  You are welcome to call  this chauvinism or provincialism, and I'm an increasingly appreciative consumer of culture and the "urban experience" around the globe, but it's a difficult base of expertise  to replicate in short order.

Think this is a bit touchy-feely?  Think again. Studies of why corporations tend to favor large metropolitan areas for headquarters reach a common conclusion: 

"What exactly are the competitive advantages of large cities?  The central function of corporate headquarters is the acquiring and disssemination of information.  [...More specifically,] concentrations of business service firms in large cities, such as medial, law, accounting, and consulting, may enable firms to achieve cost and price advantages."

If acquiring and  disseminating information doesn't sound to you like what law firms do, what would?

But don't just take my word for it. 

Professor Bill Henderson of Indiana University School of  Law—Bloomington just published "The Changing Economic Geography of  Large US Law Firms," which analyzes the geographic  migration of lawyers in the AmLaw 200 over the past 20 years and concludes (emphasis supplied):

Our preliminary findings suggest that over the last twenty years, New York City has supplanted Washington, DC as the more interconnected market, particularly for law firms with international offices in Europe and Asia. Although profitability and revenues per lawyer appear intimately tied to presence in large global cities, particularly New York City and London, the network analysis reveals several firms that are following successful niche strategies.

Bill also produced this fabulous graphic showing the change in headcount of lawyers in AmLaw 50 firms from 1984 to 2006, by region of the US:

This shows how uneven lawyer  headcount growth has been.  In absolute numbers the growth occurred:

• Abroad: +8,012 lawyers
• New York: 7,315
• Washington, DC:  4,908
• Los Angeles:  2,453
• San Francisco:  2,430
• Chicago: 2,130
• Everywhere else (domestic): 7,372

The short story this tells is that, if you're a lawyer in BigLaw, being in a major metropolitan center is more important than ever, not less.

If you're asking yourself right about now whether this distribution mirrors that of corporate America,  the answer is not in the least. 

To dimensionalize that asymmetry, Bill undertook an ingenious analysis,  namely comparing  the percentage of Fortune 500 revenue attributable to each city to the percentage of AmLaw 200 lawyers in each city.  (Actually, it's next to impossible to determine the percentage of Fortune 500 revenue actually  "attributable" to each city, so as a proxy Bill assigned all revenue to the headquarters city.  I'm not a statistician but this  strikes me as a fair approximation.)

At one extreme, take the Midwest region (ex-Chicago), which accounts for 25.2% of Fortune 500 revenue (2004) but only 10.1% of AmLaw 200 lawyers.  The ratio of lawyers to revenue is then 0.40.  At the other extreme we have Washington, DC, with 14.7% of lawyers but only 3.4% of Fortune 500 revenue, for a ratio of 4.33.  Here are the other figures:

In macroeconomic terms, this means that New York is a net exporter of legal services (and,with more AmLaw 200 lawyers than LA, San Francisco, and Chicago combined, a huge exporter). 

The question remains—and a fair one it is—whether New York's past pride of place is prologue to future pride of place.  The answer will emerge from whether New York can continue to generate innovations—in finance, in transactions, and in capitalizing  upon changes in the regulatory environment.  And the answer to that, in turn, depends on continuing to attract the premier, take-no-prisoners, absolute best of breed talent.  So far as I can see, nothing that has happened in the last year has changed that dynamic.  Nothing.

The challenge is famously laid down in the sappy but still resonant chorus to "New York, New York:"  "If I can make it there, I can make it anywhere."  Those of us who have lived through this City's re-inventing itself roughly every decade for the past 40 years will give the last word to Jay Zimmerman: 

"I wouldn't want to bet  against New York."

New Industry Economic Indicator

I am happy to re-publish the press release issued this morning by ThomsonReuters reporting on a new alliance we have struck.

For my purposes, the value of this will be being able to offer you, my readers, an additional perspective on legal industry market conditions at a time when they might be of particular interest.

Manic-Depressive? Take a Deep Breath

We are surely living in times of manic-depressive equity and fixed-income markets ("We've made the future safe for Western financial institutions!"  "No, we haven't!). New York City itself can seem to be suffering from one gigantic case of whiplash:

Even last month, those of us who don't work in finance took wishful comfort in our Econ 101 understanding of the distinction between the financial crisis--that is, all the accumulated bad debt causing panicky global credit pipelines to tighten all at once, like so many sphincters--and an economic crisis, when people in general stop buying things and companies lay off workers or go out of business. The problem for New Yorkers, however, is that a financial crisis is an economic crisis, since more than a quarter of the wages in the city are paid by the stocks-and-bonds industry. For us, Wall Street is Main Street.

The other night, as I drove down one of New York's more conventional and lovable Main Streets--Bleecker, west of Sixth--looking at the glowing shopfronts and bustling restaurants and strolling pedestrians, I had a sudden elegiac impulse to register the scene and its details. Because, I thought, once a Depression descended, these same blocks would look and feel very different; in 2010 or 2011, I might think back to this particular evening--autumn! Twilight!--and remember how sweet and jolly the city had felt and looked not so long ago.

Alarmist?  Certainly.   A mildly embarrassing and gushy, jejune, home-town lament?  Probably that as well. 

But the insight that the financial crisis is not severable from the potential economic crisis is where attention now focused, and that concerns us all.

So where do we stand?

2008 is to some extent the devil we know.  At least for most firms, the year will be flat to down in the low double digit percentages in revenues and profitability.  But this is also a time when averages may be deceiving.  A small but  nontrivial minority of firms  will actually perform just fine,  thanks to a serendipitous practice mix.   But across all firms people should have a realistic sense at this point of where  they'll end up.  There should be "no surprises" at year-end. 

2009, by contrast, is the devil we  don't know.  From the perspective of today, to imagine it being a strong year risks professional humiliation,  and the key question for most  people is whether  it will be worse than 2008 and, if so,  in precisely what  way will it be worse?

Much as US automakers have found their model  lineups—featuring pickups, SUV's, and large, gas-guzzling  "crossover" models—suddenly and  brutally out of step with market demand, the question for law firms will be whether their practice mix is congruent with the new economic order or orthogonal to it.  Lacking the ability to travel forward in time and report back to you, I can only advise  nimbleness and celerity in adjusting to client demand.

Within reason,  professionals can retool themselves into adjacent practice areas to follow demand.  And to the extent people are under-utilized during a trough, but still  have valuable capabilities to contribute in the future, redeploy them in support of professional development, writing and speaking opportunities (business development), and getting  closer to your clients

What if it's worse, even,  than that?

The 55% unknown in the room  is whether  litigation will rebound to offset the drought  in corporate, transactional, and finance work.   ("55%" because that's approximately litigation's share of all revenue across the AmLaw 200; your firm's mileage may vary.)  What  do the tea leaves say?

Managing partners and senior  partners I talk with say that there is no evidence that litigation is  rebounding as of yet,  and a surprising number of them  doubt that it will.  This dour and gloomy assessment (we know who  we're rooting  for, after all) typically rests on a rather granular analysis of plausible causes  of action stemming from the financial meltdown,  and the view that since it was a systemic crisis, there is no liability for fraud, misrepresentation, or inadequate or misleading disclosure.

Analytically, they may be right. But my faith is unshaken in the creative ability of our plaintiff brethren to point  accusatory fingers  (sufficient so survive motions to  dismiss) when hundreds of billions of dollars  have gone up in smoke.

On another issue, there seems near-universal agreement: We are in for more regulation.  From helping  craft that regulation to explaining and guiding compliance with it, lawyers will be at the fore.

The real V-8 engine of recovery will kick in once the credit crisis has receded into the vanishing point of our rear-view  mirrors,and corporations and institutional investors  have recovered their appetites for risk-taking and deal-making.  At the moment, that  seems a distant day indeed, but our perspective may be warped by the deafening roar of  today's locked-up  markets.  Warren Buffett, after all, is already stirring.

And we know there is no more salubrious time to buy than when all around you think you're  daft to do so.  "Be fearful when others are greedy, and greedy when others  are fearful," spoke the Sage of Omaha on the New York Times's op-ed page last week. 

But back to law-firm land.

Here, the writings and the articles are dire.  Various prognostications promise us that corporations are going to "slash spending on outside counsel," and  that's just for starters.   There are far more apocalyptic predictions afoot, including that:

• As goes executive compensation (down), so goes law firm compensation.
• The recession will throttle demand across all sectors, particularly M&A.
• Financial institutions experiencing the gruesome task of reducing headcounts and budgets "20 to 25% across the board" will grant no immunity to legal spending.

Even worse, did you know that:

• "The key assumptions that underlie the whole legal market" are being undermined?
• We are experiencing the "Wile E. Coyote Effect," running off the cliff into space, powered by sheer inertia, but about to discover that, as the old joke has it, jumping out of a 50-story building is fine for the first 49 stories.
• London will eat New York's lunch, without so much as a "prithee, may I?"
• And lastly that we will be so desperate and delusional that we will engage in fictitious and unsustainable "financial engineering" to keep the numbers looking good for a few more hair-raising quarters before the roof comes inevitably crashing in?

Well, then, that makes two of us.  I wasn't aware of these scenarios of doom, either.

It's time, Dear Reader, to take a deep breath. 

Here are four very concrete things you can do to weather this storm.

Time for a Strategic Re-Think

Why are your practice groups arrayed as they are?  Is it time to invest, or disinvest, in some of them?  What sense does the geographic array of your offices make?  Ought you to be in (just to pick a random place) London in a bigger way than you are?  Does Frankfurt/Miami/Seattle (pick one or three) still make sense?

If you had to reorganize your firm from a clean sheet of paper, would it look the way it looks today?  Well, then, what's stopping you?

Do you have the right people on the bus?  It's entirely possible that some highly talented people might find themselves on the street through no fault of their own.  Even if some of your professionals and staff are "just fine," might now be the time for a little quality upgrade?

Now, in other words, is the ideal time to get back to re-examining some of those "key assumptions that underlie the whole [firm]."  Why now?  Because people's appetite for change, never great, is at a local maximum in the midst of disarray and uncertainty. 

When clients and fees are rolling in, there's no sense of urgency about actually changing anything and, a fortiori, no reason to re-examine whether anything might be suboptimal.  But now is the time when everyone is tempted to ask, "What's wrong?!" and when you can engage them in actually trying to position your firm more soundly.

Go Into 2009 with a Zero-Based Budgeting Mindset

Don't take sacred cows for granted.  Are there things the firm is doing just because..., well, because we always have?

Again, if given a clean sheet of paper, would you recruit the way you do?  Would you spend your marketing dollars the same way?  Your IT investments?  How do you manage cash?

More aggressively, consider bargaining harder with suppliers and vendors, starting, perhaps, with your landlord.  Is the commercial real estate market suddenly softer in your key locations?  Nothing is more deadly to a landlord than vacant space—it's like an empty seat on an airplane leaving the gate.  Perhaps you should have a talk.  Similarly, need new computers?  BlackBerry's?  Servers?  Office suite software?  "Let's Make a Deal."

Get Close To Your Banks

"Keep your friends close, but your enemies closer."  And your banks may not be your best friends at the moment.  (Last week I was at a large gathering where the speaker asked if anyone knew a generous banker these days, to a healthy round of laughter.)

Get out a sharp pencil and take another look at your bank debt covenants.  Are you going to be marching close to the chalk line on any of them any time soon?  Get out in front of it.  Talk to your bankers; let them know your plans.  Let them know what concrete steps you're taking to navigate in this new environment.  Enlist their support and counsel (well, you can at least try).

At the very least, know their  intentions. 

Many many things cause firms to fail, including weak leadership, ill-timed or misguided strategic choices, undiversified practices, extravagant investments in real estate, and weak cultural glue (this one is huge, but that's a topic for another day),  but the proximate cause of failure, if the horrible  horrible  day arrives when the lights  go out and everyone is loosed to the street, is running out  of cash.  Your bank  is your  ultimate cash lifeline.

Communicate, Communicate,  Communicate

You thought nature  abhorred a vacuum?  Well, facts really abhor a vacuum; and in their absence, rumor will rush in to occupy the void.

How is the firm  doing?  Tell people.  And after you tell them, remind them.  Regularly.

What's your debt situation?  Your cash situation?  Your reliance on a few key clients or a few  key practice areas or a few key offices?  If you have good  news to deliver on these  counts, deliver it.  If you don't have good news to deliver, be candid.  Remember, it's not the offense that will get you  (that will sap morale, that will cause people to look at the exits), it's the  cover-up. 

Are we all in this together?  Explain why.  What's  the professional challenge in front of us all, partners, associates, and staff  alike?  Lay it out.  Why should people care about  the place? It's not about how much it  can pay you (best not be, at least), it's about why it matters.

What's the vision for the firm?  Reiterate it—crisply.  At the risk of borrowing language from a no-fly zone in intelligent and sophisticated discourse, don't just reiterate it, preach  it.

After all, you do believe, don't you?

Sand Hill Road Brings You The Head of a Pig

Making the rounds is a  presentation by Sequoia Capital on "startups and the economic downturn," which constitutes a sort of come-to-Jesus meeting for that storied VC firm's portfolio companies.  It tells a tale of radical gloom, with "multiple problems" in the world economy including:

• over-leveraged financials
• falling  asset prices
• frozen credit markets
• weak household balance sheets; and
• global synchronization exacerbating all of the above.

And it gets worse. They point out that bull and bear market cycles are long, and predict we're in a (long) bear market.  They note that consumers have driven the US economy for a decade and more but that they're utterly and completely tapped out.   Assets have become grossly overpriced, while balance sheets have become grossly over-leveraged.  This means massive deleveraging is called for at the same time that asset prices will (so they predict) be plunging, creating a vicious race between the need for increased asset ownership in the midst of decreased asset values.

For housing, the bill of particulars is particularly severe:

• In 2002, less than 5% of mortgages were either subprime or Alt-A (10% in total);
• By 2006, each of those categories accounted for nearly 20% of originations  (40% together);
• Home price inflation was -1.2% annualized from1900--1929, +0.7% annualized from 1930--1997, and +8.0%  annualized  from 1998--2006.

Not done yet, either:

• The notional value of derivatives outstanding is approximately $525-trillion, or 35x US GDP;
• The world has significant excess capacity;
• Consumer spending has gone from 66% of GDP (1987) to 70% (1997) to 73% (2007);
• In the same period, consumer spending as a % of disposable personal income has gone from 88% to 97% to 98+%;
• Consumer savings is, conversely, at an all-time low;
• Real wage growth is stagnant, eroding living standards;
• And not surprisingly, consumer confidence is at a cyclical low, flashing the red light of sustained recession.

They conclude that this will not be a "V" or even a "U" shaped recession, but more like an "L" tilted slightly to the left at the top, with a long  slow slog off the bottom.

Now, for Sequoia portfolio companies, this has implications expressed in VC-speak (such as "$15M raise @ $100M post is gone," which even those of you who can't explain exactly what it means will understand is not whoop-de-do news).  And their diamond-hard-headed advice is to (a) preserve capital; (b) deal only with customers you know can pay; (c) treat cash as king; and (d) avoid the "death spiral" by cutting costs drastically and immediately.  In short:

"Get REAL or Go HOME."

OK, so what about the rest of us?  Is it that bleak?

Your answer to that may depend on whether you think "it's different this time."

Yes, I know, we have all been indoctrinated to instinctively disbelieve (or be skeptical of) that oft delusional mantra. 

The longer answer is that it both is and is not "different this time."  On the down side we have the notable, inarguable, and extraordinary negative differences which Sequoia has just so ably enumerated (not, one might note, without potential ulterior benefit to themselves, at least if they have scared the bejeesus out of one or two of their portfolio companies sufficiently to make the difference between survival and capitulation).

On the positive side we have a number of other considerations, however:

• We have never before witnessed as massive, as coordinated, and, all things considered, as thoughtful and promising a government intervention--wordlwide--as we are now witnessing.
• It is again true that "the only thing we have to fear is fear itself."  The good news embedded within that is that the underlying, functioning economy is not flat on its back and, if credit markets unlock fast enough, need not go there.
• There are signs that the bottom may be in sight, as some savvy and opportunistic investors emerge (Warren Buffett, to name a name).

What then do I counsel for your firm? 

Cash is, indeed, king. 

Bill your work in progress; collect your receivables; don't be shy about client reminders.  And more:  Cut off work for rocky clients who aren't paying.  On the reverse side, hoard the cash you have.  Partner payouts may need to be extended; bonuses delayed; all discretionary spending canceled or deferred.  Watch your net cash like a hawk.

Firms don't fail for metaphysical reasons such as "weak leadership," although defects such as that are not to be gainsaid, and are always telling in the long run.

But when it comes to the hard reality of telling everyone they're out of a job and turning out  the lights, the proximate cause is almost always running out of cash.  And now is not the hour to rely on the kindness of your banker.  Even if your banker is not Sequoia Capital.

Yes, But What Does It Mean for Us?

A few weeks ago I posed the question to you all:  Will the realignment of the top financial services institutions fundamentally alter the long-term demand for legal services?

Here's how you voted:

A couple of aspects of these seem worth commentary: 

• There seems near unanimity that, regardless of what happens on Presidential election day in the US this November, we are in for a more regulated world.
• And there is near equal consensus in the short run that it will require more lawyers to sort things out.
• Likewise, the era of 20:1, 30:1, or 40:1 investment bank balance sheets (in terms of assets:equity ratios) seems at an end, perhaps for a long long time.
• And securitization—at least in terms of standard "assembly line" deals—is over.

What can you read between the lines, as it were?

I read massive uncertainty and doubt.

Partly that's from the popularity of the rather cheeky "What do I care?  I'm a litigator!"  After all, when one is nervous, flippancy is a familiar mask to don.

But also I infer it from the lowest-single ranking selection, seeing no fundamental change in demand "because the 'primary' demand" comes from the underlying corporate economy, not Wall Street.  That this option was uniquely unpopular—only 12 votes out of 272, or a mere 4.4%.  In other words, it sure sounds as though the financial services industry is the lifeblood of much of what we've been doing recently.

Which brings to the fore the only question that really matters in terms of getting our financial system back on its feet:  When will "credit" return?  The English word "credit" traces its etymology to the Latin credere, meaning "to believe," and has cognate forms in, among other things, creed, crediblity, credence, and credulity.  Note that neither "assets" nor "liabilities" is a cognate for credit.  Credit is all about belief.

Until fundamental belief in the "credit-worthiness" (for which one could almost substitute "worthiness" without loss of meaning) of financial institutions returns, we will not be able to count ourselves out of the woods. 

At this point the only question is how much more massive the federal government's intervention will have to be.  That, at least, is the question for Presidential candidates, policy-makers, bankers, Wall Street and Main Street, not to mention any corporation that goes to the commercial paper marketplace and any family that's in the market for a mortgage, a car or student loan, or a new credit card.

For you, the question is when your firm can emerge from this, and how best to position it to do so:

• In strategically important and solid relationships with your clients
• With practice groups best aligned to how you see the new emerging landscape
• With expenses under tight control and the opportunity to prune deadwood fully exploited
• And to do all the above with alacrity.

(New York) City's End?

With all the body blows the New York City financial services industry and its attendant handmaidens (BigLaw, that would be you) have taken in the past couple of months, it may be time to remind ourselves that for the past two centuries or so, ever since New York's emergence as the pre-eminent American city, there has been a vibrant tradition of imagining the Apocalypse descending upon Sin City.

Indeed, one of the earliest published screeds railing against New York came in 1812 when Nicodemus Havens warned (hoped?) that the city would be "consumed by the 'devouring tide' of God's wrath. 'Whole families were enclosed within its horrid grasp,' Havens wrote, 'and whole streets in this flourishing city, swallowed together.'" We learn this through the WSJ's review of Max Page's The City's End.

Just in the past week we have been reminded of how virulent, deep-rooted, and widespread is animus towards Wall Street, which, judging by the rhetorical lightning-bolts flung in its direction from precincts ranging from Alaska to Washington, DC, Paris and Berlin, would be well-advised to dispatch all its inhabitants forthwith to the Trinity Church graveyard which anchors the top end of the Street. Or, as some wits would have it, perhaps Mayor Bloomberg should just rename it "Main Street."  

Many Washington politicians have evidently decided that a ringing denunciation of "Wall Street greed and corruption" (Google results for a search on that phrase:  1,620,000) is an ample substitute for thinking hard and seriously about how to help repair the credit system's meltdown, while Angela Merkel of Germany and Nicolas Sarkozy of France have called for severe retribution against the "excesses" of global capitalism, with, one imagines, no small dose of schadenfreude at the travails of Anglo-American capitalism.

But we digress.

The ways in which New York City has been fictitiously destroyed constitute a tour of the human imagination's ability to contemplate destruction, but underlying them all seems to be a sense of righteous--or at least self-satisfied--indignation that we benighted residents of Gotham are only getting what we have coming to us. Among the animate and inanimate tools of our destruction have been "onslaughts of flood, famine, zombies, plague, conflagration, meteors, earthquakes, cyclones, hostile aliens, thermonuclear bombs, giant insects and King Kong himself." Here's one high point:

In 1886, Joaquin Miller published "Destruction of Gotham," in which the decadent city is consumed by flames: "The very earth was on fire. The oil, the gas, the rum, the thousands of filthy things which man in his drunken greed had allowed to accumulate on the face of the island appealed to heaven for purification."

Ilustrators also got in on the act. Here's one from 1917 advertising Liberty Bonds:

I think the biplanes circling Lady Liberty are a particularly sympathetic touch.

In the 1960's, 1970's, and in the 1980's (as I can personally testify), "Fun City" was anything but. Homelessness and murder rates peaked, police and transit and sanitation workers went on strike, blackouts provoked looting and chaos, Midnight Cowboy symbolized the triumph of grit, lowlifes, and disorder, the City was famously viewed as ungovernable, it went de facto bankrupt and its appeal to the federal government for help fell on deaf ears (the only redeeming value of which was the Daily News' all-time great headline, "Ford to City: Drop Dead"), and "white flight" reached an ugly apogee.

Fast forward to, say, 18 months ago, and we were on top of the world. Times Square had (like it or not) been transformed from XXX Porno Central to DisneyLand East, commercial rents were world-class, foreigners couldn't pay enough for condos in the renovated Plaza Hotel, our murder rate fell to small Midwestern town levels, and, of course, Wall Street revenue and profits were, as they often are, in the stratosphere.

Clearly, we had over-reached.

Thank goodness we don't have that to worry about any more. Our comeuppance is at hand. And about time, say I.

A final word. There's a reason people from all over the world are tempted to pursue their dreams here. And to those who wonder how we'll fare? I say:

We've been here before. We don't, actually, like it. We know how to be innovative, how to re-imagine ourselves, how to re-create for the umpteenth time world-class industries on this slip of an island, and how to fight our way out of a tight fix.

Don't take your eyes off us just because you think we're down.

Pretend Your Firm Is an Investment Bank

Analogies are imperfect (that's why they're called analogies), but here's an interesting thought experiment tying together the wild rides investment banks have had on Wall Street during the past few weeks and the potential impact of the Legal Services Act in the UK, permitting law firms to go public and to take on public investors.

James Surowiecki, writing in the current New Yorker, talks knowingly about the repercussions of being a public company.

And he was writing before the most recent downward acrobatics occasioned by Congress' incomprehensible, profoundly irresponsible, self-serving, and altogether shocking rejection of the Treasury's rescue plan. Here at Adam Smith, Esq., we don't editorialize, but numerous analyses of the votes have shown that those congressional representatives facing contested elections voted overwhelmingly against while those with safe seats voted overwhelmingly in favor. You are at liberty to draw your own conclusions, but the word "courage" ought to be a part of your reflections.

Back to the repercussions of being public. Here's the intro:

Before the government stepped in last week, the bodies of financial institutions--Lehman Brothers, Merrill Lynch, and A.I.G., with Washington Mutual and even Morgan Stanley threatening to be next--were piling up so fast it seemed possible that Wall Street might simply cease to exist. The list of blunders that led to the carnage is by now familiar: firms succumbed to the frenzy of the housing bubble; relied on dubious mathematical models to manage risk; and leveraged bad bets with suicidal amounts of borrowed money. But the impact of these mistakes was made worse by a seemingly harmless decision that these companies made many years ago: the decision to go public. Doing so put the firms at the mercy of the stock market, and last week that mercy evaporated.

Once upon a time, investment banks were private firms, structured as partnerships, and relying on the capital provided by the partners in order to run their operations.

Sound familiar?

It only gets more so (interpolated text mine):

For Wall Street firms, going public was a deal with the devil, because it meant exposing themselves to what was, in effect, a minute-by-minute referendum, in the form of the stock price, on the health of their operations. This was fine as long as things were going well--the higher the stock price, the richer everyone got--but, once things started to go bad, that market referendum started to look like a vote of no confidence. And that made the problems that the companies were already facing much, much worse.

That's because the entire edifice of Wall Street is built on confidence. Investment banks [law firms] rely on short-term debt [people] to run their businesses, and their businesses consist of activities--trading, dealmaking, money management--that depend on people's faith in their ability to honor their obligations [continue to perform at impeccable levels]. As soon as the customers and creditors of a company like Lehman start to wonder whether it might collapse [the firm will lose top talent], they become less willing to lend or to trade, and more likely to demand their money back [take business away]. The perception of weakness exacerbates the reality of weakness. And although there are myriad measures of a company's health, nothing looks scarier than a stock price that's heading toward zero.

About now you may be arguing that the "stock price" of a law firm should reflect more than the inchoate and indefinable notion of "confidence" in its ongoing power as a magnet for talent, that, after all, the firm has serious clients and a genuine accomplishments and a powerful partnership and a strong pipeline of associates and robust and reinforcing systems of professional development, recruitment, knowledge management, business development, and so forth.

Nice try.

The problem is that if the "stock price" of a law firm drops, it might well signal a drop in confidence in the firm's ongoing viability, whereas the drop in the stock price of most corporations which aren't entirely dependent on confidence per se signals only a drop in expectations for their near-term performance, not an existential questioning of their reason for being.

Thus concludes the article:

The downward spiral can be stunningly fast and near-impossible to escape. Lehman's assets were not significantly more toxic last Monday, when the company filed for bankruptcy protection, than they had been a week earlier. And, technically speaking, the bank may not even have run out of money, since it had access to an emergency liquidity line from the Federal Reserve. What Lehman did run out of was credibility. It couldn't remain a going concern because creditors and customers no longer trusted it. Why would they, when its stock price had fallen nearly eighty per cent in the previous week? The less faith the market had in the possibility of Lehman's survival, the more remote that possibility became.

This doesn't mean that stock prices don't reflect reality--Lehman's business really was in bad shape--or that Lehman would have survived had it been private. But being publicly traded makes it harder to take the long view and survive market storms. [...]

Considering that Wall Street firms spend all day dealing with the market, they have been slow to understand just how vulnerable they were to it. Companies like Lehman and, earlier, Bear Stearns saw going public as an excuse to take on more risk and act more recklessly, when in fact becoming a public company makes caution more important, since the margin for error is smaller, and the punishment for failure swifter. Now that the government has acted, Wall Street (or what remains of it) may yet be able to regain investors' confidence. But long-term survival really depends on remembering the fundamental truth about playing with other people's money: it's a lot of fun until they suddenly decide to ask for it back.

Am I counseling, then, against considering the possibility of going public or taking on material amounts of outside investment? No, I'm only counseling against doing so without considering the long-run repercussions of having to deal with (a) transparency and disclosure that outside investors will demand; and (b) the possibility--and the repercussions--of their yanking their money.

You have tools to fight the reality that being publicly traded makes you "vulnerable" and that it punishes reckless behavior more swiftly. For example?

One thing investors always favor is a stable revenue stream over a variable one. They prefer subscriptions to events, wealth management programs to brokerage commissions, leases to sales, and, in general, ongoing relationships to opportunistic and expedient windfalls.

Let's assume that going public is not within your sights at the moment: What do the preferences of investors have to tell you? Here are a few thoughts:

• Lateral partner acquisitions for revenue bumps are a losing game. This is buying market share, and what you buy is for sale to the highest bidder.
• Lateral partner acquisitions for increasing your firm's capabilities hold, to the contrary, potential promise. Skadden, for example, doesn't even ask lateral partners about their books of business; they only care about what potential partners can add to the firm's capability.
• Thinking of merging? Same analytics apply. Would it add capability or merely revenue?
• Or, approach it from the perspective of client relations: It's amply proven that the more practice groups within your firm a client utilizes, the more loyal that client is. Loyal clients provide more stable revenue streams than one-off clients. So cross-marketing is not just a nice thing, it could be vital to your long-run stability.
• Finally, don't permit partners (senior or otherwise) to hoard clients. Insist that they expose the clients broadly to other members of the team, making the client a client of the firm rather than the individual.

The vast majority of large, profitable, and growing US and global corporations are, of course, publicly held. So there must be something to that model.

But investment banks, and law firms, may be different. Pay attention.

How Big & How Bad Is It?

Now that Morgan Stanley and Goldman Sachs will be converting into traditional bank holding companies, the landscape has changed for keeps:

• "With the move, Wall Street as it has long been known -- a coterie of independent brokerage firms that buy and sell securities, advise clients and are less regulated than old-fashioned banks -- will cease to exist. Wall Street's two most prestigious institutions will come under the close supervision of national bank regulators, subjecting them to new capital requirements, additional oversight, and far less profitability than they have historically enjoyed." (WSJ)
• "A move that fundamentally reshapes an era of high finance that defined the modern Gilded Age." (NYT)
• "The investment banking era ends." (FT) 

Here are a few more data points to put this financial meltdown into some kind of perspective.

The Size of the Problem

Of the $3.13-trillion 2009 federal budget, here are the key components (courtesy The New York Times):

• National security: $738 billion
• Social Security: $651 billion
• Medicare/medicaid: $632 billion
• Everything else: $1.112 trillion
• Treasury rescue plan (estim.): $700 billion

What alternatives were there to this dramatic rescue?

According to Henry Paulson, were it not undertaken, "Heaven help us all." Alan Blinder, an economics professor at Princeton and former vice chairman of the board of governors of the Federal Reserve Board, said “It goes a long way; it ameliorates it very substantially,” but he immediately admits there's no certainty about what will work: “We’re deep into Alice in Wonderland’s rabbit hole.”

The need for the rescue, to my mind, is utterly unassailable. Why? Simply because the economy runs on credit, financing, and the ability to turn income streams into assets and assets into income streams. Without that, the entire economy seizes up like an engine deprived of oil.

“Wall Street isn’t this island to itself,” said Jared Bernstein, senior economist at the labor-oriented Economic Policy Institute. “Even people with good credit histories are having a very hard time getting loans at terms that make sense. If that gets worse, we’re going to be stuck in the doldrums for a very long time, because that directly blocks healthy economic activity.”

That's why the populist-sounding rhetoric coming from Washington about Wall Street "fat cat bailouts," "corruption," "golden parachutes," "pigs at the trough," etc., is, as the noted conservative commentator and New York Times op-ed columnist David Brooks wrote last week, "moronic."

Impact on the Financial Services Industry

As recently as 30 years ago, the financial services industry constituted well under 5% of the S&P 500's total market capitalization. By 2003 it had risen to over 20% and was the single largest industry segment. As The New York Times puts it:

As late as 2004, financial services firms earned 28.3 percent of corporate America’s total profits, according to Moody’s Economy.com. That was somewhat lower than it had been over the previous few years, but still almost double the financial sector’s average share of profits throughout the 1970s and ’80s. By 2007, the share had fallen only marginally, to 27.4 percent.

Meanwhile, the share of wages and salaries earned by employees of financial services firms continued to climb and reached a peak last year. Of every dollar paid to the American work force in 2008, almost 10 cents went to people working at investment banks and other finance companies, up from about 6 cents or 7 cents throughout the 1970s and ’80s.

Here's another way of looking at it:

If you want to look at the fortunes of financial services companies since the last market peak (October 9, 2007, for those of you keeping score at home), here are some representative numbers:

• IndyMac: -100%
• Lehman Brothers: -100%
• Fannie Mae, Freddie Mac: -99%
• AIG: -95%
• Bear Stearns: -93%
• Washington Mutual: -88%
• Countrywide: -78%
• Wachovia: -64%
• Morgan Stanley: -61%
• Merrill Lynch: -60%
• Citigroup: -57%
• Keycorp: -56%
• Goldman Sachs: -46%
• Bank of America: -29%
• Capital One: -22%
• JP Morgan Chase: -1%
• Northern Trust: +6%
• Wells Fargo: +7%
• PNC: +13%

New York, New York

The City is far more heavily dependent on financial services, of course, than the economy as a whole:

• Financial sector workers collected 35.9% of all income earned in the city, even though they accounted for only one job in eight.
• This is roughly double the level of 30 years ago.
• In the past 10 years, the number of jobs in New York City where people produce goods has fallen from 303,000 to 227,000 (down 25%).
• During the same time, people employed in "leisure and hospitality" (including waiters, bartenders, hotel clerks, actors, and even Yankee Stadium vendors) has grown from 232,000 to 307,000: But of course those pay relatively poorly.

Graphically, employment in financial services in New York City looks like this:

And of course, as only the WSJ can do, it featured a tongue-in-cheek article last week featuring how wealthy New Yorkers were economizing. With evidently thoughtless and rather amazing unintended irony, one high-end caterer described a client's change in plans:

On the party circuit, many New Yorkers aren't canceling events, but some are seeking to make them less ostentatious, says Bronson van Wyck, who runs New York event firm Van Wyck & Van Wyck LLC with his mother and sister. Earlier this week, the children of a Wall Street executive who are planning his 65th birthday party contacted the firm to change the menu. Out went the caviar and truffles and in came Wagyu beef instead. The new menu won't cost any less, Mr. van Wyck says, but "it's less overt."

Wagyu beef rather than truffles and caviar?

It will, of course, be far far worse than that.

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Stop the Insanity

Sometimes in the midst of turmoil all around us, with the landscape of the financial services industry--for many of us, our lifeblood--reforming under our very eyes, it's worthwhile to take a step back and reflect upon some enduring business verities.

For today, I nominate the GE-McKinsey "nine-box framework" that dates to the early 1970s. For those of us whose memory does not date to that time, a brief primer: Draw on one axis the attractiveness of the relevant practice group ("industry," in the original parlance) and on the other axis that group's competitive strength in the marketplace vis-a-vis your peers. And then just map your existing practice groups into this 9-sector grid--high, medium, low, on each axis, giving you the most informative tic-tac-toe board you've ever seen.

Above the diagonal, you want to think about, in general terms, investment and growth, while below the diagonal, you may want to consider backing out of those practice areas, milking them for cash, or even (what a concept for a law firm) marketing them to other firms as intact practice groups available for a price.

Don't mistake this for a cookie-cutter approach: Being above the diagonal does not mean that you're the fair-haired child, without giving it any further thought, and being below the diagonal does not mean you're cursed. A strong practice group in an out of favor area is very different from a weak practice group in a hot and sexy area. They require different strategies.

When McKinsey developed the GE "nine-box framework," GE had about 150 business units and the challenge was to segregate those that were generating cash from those that were worthy of cash infusions.

You can't, of course, answer that question by depending on answers from the business units themselves, or the practice group leaders. If you try that game, you invite people to essentially engage in "Liar's Poker," as the most optimistic scenarios will lay claim to most of your firm's resources. This is of course an unpoliced arms race. Something more objective is required.

The insight behind developing the 9-box matrix was to abstract from what the business/practice group leaders would tell you to, instead, look in a very objective way at what that practice group's actual marketplace strength is vis-a-vis your competitors; and then of course to map it against what the ongoing attractiveness of that practice area is.

Simple? Sometimes the best ideas are.

These are days of turmoil, chaos, a once-in-a-lifetime earthquake shaking our financial world to its foundations, and, frankly, days of insanity. Indeed, (according to The New York Times), last Wednesday, when share prices of Goldman Sachs and Morgan Stanley plunged even though the firms were still making money. Glenn Schorr, a UBS analyst, wrote an e-mail message to clients saying, “Stop the Insanity.” He was not wrong.

In your own world, you can stop the insanity. Step back, breathe deeply, and take a clear-eyed look at the fundamentals of your very own firm. It's a 30+ year old technique that has withstood the test of time. Sounds kind of reassuring right about now, doesn't it?

What's Going On?

Nothing less than a generational transformation of investment banking and the financial services industry at large.  Its implications for, among other things, the economies of New York City and London, the structure of global capital markets, and our own dearly beloved industry, are impossible to predict with any high degree of confidence, but I think we already know a few things.

First, as an AmLaw 50 Chairman I know well put it to me yesterday, "the business model of 35 times assets:equity ratios is over."  That works great in flush times but it kills you (literally) in times like these.

"Lend long and borrow short" was always a game that threatened to turn the tables on you at the worst times in the nastiest of fashions, and it turns out that "invest long and borrow short" is no less so.

Does this mean that the "Masters of the Universe" investment banks will more closely come to resemble--or pair up with--conventional deposit-taking banks? Of course, that's already happening, and we can envision a world where financial services institutions break down into:

• Truly global mega-banks (Bank of America, Candidate A) which take deposits, issue credit cards, offer mortgages, cater to every customer from retail walk-in checking account folks to small businesses, luxury private wealth management, and Fortune 500 underwritings;
• Boutiques offering investment advisory services, M&A counsel, and the like (think Greenhill or Evercore);
• Hedge funds, private equity, and venture capital (Blackstone, SAC, KKR, Kleiner Perkins); and
• Unknown and undefined institutions yet to be invented and unfurled.

The last point is the most important. Investment banking reinvents itself (by opportunity and necessity) every decade or so, and there's no reason to imagine this time will be any different. Where does this innovation come from? At the risk of contradicting my next point, historically it has come from New York. And who does it? Creative and, yes, greedy, investment bankers, but also lawyers at the premiere firms, working hand in glove to imagine, craft, and define the products and services the industry will offer in its new incarnation.

Depressed and demoralized? The sin, we know, in America, is not being knocked down. It's failing to jump right back up. We may have seen the end of investment banking as we've known it for the latter half of the first decade of this century, but we have not seen the end of creative financial engineering.

Second, this cannot be good news for the economy of New York City.

This pains me, as a Manhattan native born and bred, but I value realism over sentiment.

London already has the unspeakable advantage of time zone: If you want to do business with North America and Asia (not to mention the Mid East) in one day, London is a terrific place to be. It also happens to be a very civilized place to live, and it's possible to do so in fine style provided one's pay is denominated in pounds Sterling.

As for New York (the numbers vary), something on the order of 10% of all jobs in the City are/were in financial services, but they account for 25% of total payroll and a "multiplier effect" of 3 jobs per financial services sector job--which produce average annual salaries of $280,000. If you cut substantially into that employment, purchasing power, and tax base, as we're in the process of doing, everything from demand for caterers to jewelry to BMW's and co-op apartments is going to decline. Stemming the pain, we can only hope, will be the "America on sale" psychology, and reality, of the weak dollar, bringing foreigners here to drive demand for everything from, again, iPhones at the Apple Stores to Fifth Avenue apparel to Central Park West co-ops.

In the long run, New York will always be the financial capital of North America, and in some symbolic, enduring, and romantic, gritty, black & white night-time rain-soaked pavement sense, the port of entry to the American dream. But it will have substantial, and ever-stiffening, competition on the global stage.

Third, this is indeed a fundamental de-leveraging of financial institutions worldwide, as nicely captured today in a front-page WSJ article:

The U.S. financial system resembles a patient in intensive care. The body is trying to fight off a disease that is spreading, and as it does so, the body convulses, settles for a time and then convulses again. The illness seems to be overwhelming the self-healing tendencies of markets. The doctors in charge are resorting to ever-more invasive treatment, and are now experimenting with remedies that have never before been applied. Fed Chairman Bernanke and Treasury Secretary Henry Paulson, walking into a hastily arranged meeting with congressional leaders Tuesday night to brief them on the government's unprecedented rescue of AIG, looked like exhausted surgeons delivering grim news to the family.

Fed and Treasury officials have identified the disease. It's called deleveraging, or the unwinding of debt. [...]

At least three things need to happen to bring the deleveraging process to an end, and they're hard to do at once. Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money. They need to pay off debt. Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets.

But many of the distressed assets are hard to value and there are few if any buyers. Deleveraging also feeds on itself in a way that can create a downward spiral: Trying to sell assets pushes down the assets' prices, which makes them harder to sell and leads firms to try to sell more assets. That, in turn, suppresses these firms' share prices and makes it harder for them to sell new shares to raise capital. Mr. Bernanke, as an academic, dubbed this self-feeding loop a "financial accelerator."

Now that there appears to be a sort of "Resolution Trust II" on the horizon, we may be out of the immediate woods. But there's no question the financial services landscape is changing before our very eyes, in ways likely to last for the duration of many of our careers.

Fourth, it seems a virtual certainty, regardless of what happens in the US electorally in November, that we will be entering a more highly regulated world. And not just in the US, but in the EU as well.

You can applaud or decry this, ideologically, but everyone I speak to--unanimously--thinks it's a foregone conclusion.

Now, regulation per se is always a good thing for the business of lawyers. Whether it's a good thing for the economy and the vitality of our capital markets is something else altogether. On the whole, the consensus is that "new regulation is going to solve the problems that are already behind us. Just like Sarbox 'solved' the problem of Enron, retroactively, and just like the Transportation Security Department's airport screening procedures 'solve' the problem of 9/11, seven years too late." (This from an AmLaw 25 managing partner I spoke with today.)

His view, and mine, is that regulation is always backward-looking, and tends to be an encrustation on an already-existing structure, rather than a clean-slate, "zero-based budgeting" analysis of what we really need going forward. You read it here first.

Fifth, this type of economic environment will accelerate segmentation and consolidation in our industry.

Among law firms as among financial institutions, there will be winners and losers emerging from this downturn. Among the "losers" we may already count Heller (look for a post-mortem in these pages to come) and Thelen and perhaps one or two others that will outright cease to exist. Short of dissolving, other firms will find their competitive postures impaired, their attractiveness to laterals and law students compromised, and their viability as independent going concerns in question.

David Morley, new senior partner of Allen & Overy, announced last week in conjunction with release of their Annual Report:

I see us becoming the most successful of the emerging global elite of law firms. Those firms are beginning to set themselves apart when defined by scale, geographic reach, quality of people and concentration on high end, premium work for the largest clients. As each year passes the members of that emerging group, and what it takes to succeed in it, become clearer.

This throws down the gauntlet, does it not?

Yet I for one believe David has it precisely right. There may be six, there may be 12, but there will not be an AmLaw 100 or a UK 50 of firms that are truly viewed as the most global of players catering to the most global of financial institutions and corporations as we move on down the road into the second decade of the 21st Century.

If you believe that the tectonic shifts in our financial services industry going on this week mean that the world will be comprised of fewer and larger institutions, will they not indeed look to commensurately globally capable law firms? I believe they shall and must.

Sixth, what do you do now?

I believe you ramp up your competitive efforts. This is not the hour of the timid or the paralyzed.

If you haven't already figured out who you are and what you want to be, it is all but too late. Not "TOO late," but getting close. (And if you're on the fence about where you are, can we talk?)

If you have it figured out, but aren't there yet, this is the time to put your convictions to the test. Economic troughs like this don't cement the status quo, as I've said before, they tend to disrupt it. Now's the time for you to make your disruptive move. Incumbents may not like it, but there is no hereditary right of incumbency.

Above all, do not lose heart, be optimistic, believe in the value your firm and your partners can provide.

• Corporations' demand for financing, for credit, for leverage, and for capital is not going to diminish.
• Globalization is here to stay.
• Regulation is not shrinking, it's growing.
• Wall Street reinvents itself every decade or so; financial services are going to come back, securitization most prominently included.

Watch your costs.

Be opportunistic about the real estate landscape if you need to relocate or expand.

Hire and recruit prudently.

Ask probing questions about people and other assets who are on the street; it may be through no fault of their own, but then again.

Most of all:

Be bold. Fortunes are never made by buying at the top.

I've never seen so much opportunity as now.

Lehman Bros. RIP; Merrill, Meet BofA; ??AIG??

Pete Peterson, former head of Lehman Brothers, co-founder of Blackstone, and secretary of commerce under Nixon, described this weekend's events on Wall Street with what almost amounts to understatement:  "My goodness. I’ve been in the business 35 years, and these are the most extraordinary events I’ve ever seen."

So "Adam Smith, Esq." has to ask you all:  What will this mean for your firm, and for our industry?

We'll report back on the results after a suitable sample of you have spoken.  (You may choose one or more than one response.)

Lessons from JP Morgan Chase

This is how the cover story of the current issue of Fortune starts out:

It was the second week of October 2006. William King, then J.P. Morgan's chief of securitized products, was vacationing in Rwanda, visiting remote coffee plantations he was helping to finance. One evening CEO Jamie Dimon tracked him down to fire a red alert. "Billy, I really want you to watch out for subprime!" Dimon's voice crackled over King's hotel phone. "We need to sell a lot of our positions. I've seen it before. This stuff could go up in smoke!"

A classic Dimon manic moment, the call is significant for two reasons. First, it marked the beginning of a remarkable strategic shift that helped J.P. Morgan, virtually alone among the big diversified banks, sidestep the worst of a historic credit crisis. Second, it sheds light on Dimon's distinctive management style - a blend of Cartesian analysis and inspirational leadership that, despite some bad bets in the home mortgage market, has moved J.P. Morgan to the front of the pack in global banking.

But this isn't another story about sub-prime, securitization, and structured finance.  It's about building a leadership team:

Dimon relies on a trusted team of talented lieutenants who share his zeal for sifting piles of data to spot trouble before it happens and vigilantly control risk, even when that means sacrificing growth and losing market share to rivals. Says J.P. Morgan director Bob Lipp, the former Travelers chairman who's worked with Dimon for two decades: "This is the best team on Wall Street."

Dimon and his team are on top today because they took a daring stance at the height of the credit bubble. J.P. Morgan mostly exited the business of securitizing subprime mortgages when it was still booming, shunning now notorious instruments such as SIVs (structured investment vehicles) and CDOs (collateralized debt obligations). With the notable exception of Goldman Sachs, J.P. Morgan's main competitors - including Citigroup, UBS, and Merrill Lynch - ignored the danger signs and piled into those products in a feeding frenzy.

The stock price, while down 21%  from March 31, 2007, is down far less than Bank of America (-37%) or Citigroup (-59%), and JP Morgan Chase's market cap is now virtually equivalent to that of Bank of America and some 25% higher than Citi.  Meanwhile, they've enjoyed lower writedowns on the notorious CDO's.  For the period 1Q2007 through 2Q2008, here are the figures:

• JP Morgan:  $1.9-billion in CDO writedowns
• Bank of America:  $8.0-billion
• Citi:  $27.7-billion

And let's not even mention Bear Stearns, Lehman Brothers, or Merrill Lynch.  The beauty of having a relatively valuable currency (the stock) in this environment is the ability to do even more deals, beyond the Bear Stearns takeover.  "Sure, it's hard to make a deal when your stock has dropped," [Dimon] says. "But so have the stocks of the targets. We have the capital and the people to do a deal, if it makes sense."

Wasn't the Bear Stearns takeover a risk?

Not by the numbers: Bear had $11.5-billion in cash on its books, which should be enough to offset the costs of the acquisition, and JP Morgan also picked up Bears' headquarters building at 48th and Madison worth, conservatively $2-billion (with a mortgage of $670-million).

So who are these guys?

Here are some of the characteristics (emphasis supplied):

• "Dimon's all-stars who make up the 15-member operating committee are a mix of longtime loyalists, J.P. Morgan veterans, and outside hires. Dimon doesn't look for people who went to the right schools or have prestigious résumés. To make it on Dimon's team you must be able to withstand the boss's withering interrogations and defend your positions just as vigorously. And you have to live with a free-form management style in which Dimon often ignores the formal chain of command and calls managers up and down the line to gather information."
  
  
• The environment of being able to push back with your ideas is at the core of this culture.  A classic example, albeit in some ways a small but symbolic one, is this:  "When he first came from Bank One, Dimon vociferously defended using the Chase "octagon" symbol as a trademark across the company. [Jay] Mandelbaum [head of strategy and marketing]  convinced Dimon that the octagon was a symbol of retail banking that didn't match J.P. Morgan's exclusive image. His lieutenants joke that Dimon now claims dropping the octagon from the J.P. Morgan side of the business was his idea."
  
  
• But an atmosphere of free-wheeling ideas is not always without sharp elbows:  "If you get your feelings hurt, you can't work here," says [Steve] Black [co-head of the investment bank]. "Jamie will apologize, then do the same thing two weeks later. He can't help himself."
  
  
• Getting bad news to the surface is another component.  Says Todd Maclin:  "Jamie and I like to get the bad news out to where everybody can see it:  To get the dead cat on the table."
  
  
• At the team's monthly day-long management meetings, candor is the currency du jour: " Dimon will throw out a comment like "Who had that dumb idea?" and be greeted with a chorus of "That was your dumb idea, Jamie!" "At my first meeting, I was shocked," says Bill Daley, 60, the head of corporate responsibility and a former Secretary of Commerce. "People were challenging Jamie, debating him, telling him he was wrong. It was like nothing I'd seen in a Bill Clinton cabinet meeting, or anything I'd ever seen in business.""
  
  
• However, you need to be as detail-oriented as Dimon.  Says Jes Staley, head of investment management, who battled Dimon for a year and ultimately won (on the question of whether JP Morgan should sell other firms' investment products to their customers—Staley argued they should only sell in-house products):  "He understands the details completely, he loves to debate and disagree, yet he'll let you do it." Staley adds a caveat: "As long as you know what's in Appendix 3 of your report as well as he does."

What does all this add up to?

I would argue:  The shockingly free flow of information.

Remember the October 2006 "ditch subprime" call?  What set Dimon off?

Every month, recall, Dimon reviews every aspect of the business in great detail ("Appendix 3" is not a joke).  And in October 2006, during the regular monthly review of the retail bank's operations, the head of mortgage servicing said that late payments on subprime loans were rising at an alarming rate.  Moreover, data showed that loans originated by competitors like First Franklin and American Home were performing three times worse than J.P. Morgan's subprime mortgages. "We concluded that underwriting standards were deteriorating across the industry," says Dimon.

But what about the CDO's the bank still held?  Weren't they all AAA rated?

Yes, they were, but the price of credit default swaps on even AAA-rated CDO's told a different story: 

Winters and Black [investment bank co-heads] saw that once they bought credit default swaps to hedge the AAA CDO paper J.P. Morgan would have to hold, the fees from creating CDOs would vanish. "We saw no profit, and lots of risk, in holding subprime paper on our balance sheet," says Winters.

The combined weight of that data triggered Dimon's call to King in Africa. "It was Jamie who saw all the pieces," says Winters.

Not only did Dimon instruct the bank to start selling its CDO's (including more than $12-billion subprime mortgages that JP Morgan had originated), he took action across the entire institution.  Trading desks were ordered to dump loans on their books, and to stop making markets in subprime loans for customers.  The private bank, that manages money for wealthy clients, started advising them to sell.  The corporate treasury department started hedging and placing bets that credit spreads would widen (profiting by hundreds of millions of dollars when that turned out to be precisely the case). 

Think there was no push-back?  Guess again:

Dimon's stance was radical: He was skirting the biggest growth business on Wall Street. "Our employees wanted to know why we were being so conservative," says Black. "We lost a lot of structured credit people to hedge funds." J.P. Morgan also lost ground to competitors. It sank from third to sixth in fixed-income underwriting from 2005 to 2007, and the main reason was its refusal to play in subprime CDOs, which its rivals were gorging on. "We'd get the quarterly reports from our competitors and see that they'd added $100 billion to their balance sheets," says Dimon.

So, to recap:

• Promote an environment of radical candor.
• Listen—truly listen—to those with other ideas.
• Assimilate information from every corner of the firm (unfiltered, need I add?).
• Synthesize it.
• And don't be afraid to take radically unpopular action, including walking away from seemingly lucrative business your competitors are milking.

Memories may be short, but financial services, let us never forget, are cyclical.  Just ask Jamie Dimon.

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Buy High, Sell Low

Best of times or worst of times to make some acquisitions?

This is one area where the head/heart divergence may be more radical than usual—and where it could really cost you.

Here's how McKinsey poses the dilemma:

"As the credit crunch threatens to become a global downturn, corporate leaders have a choice: pull in their horns and ride out the storm or look for opportunities to pick up bargain-basement assets that will help them grow and create future value for shareholders. If past is prologue, more will follow the first course—which is a mistake."

The head/heart opposition is simple to understand:  While your head tells you that one of the best times to invest is in a downturn, that's precisely when your heart quails.  "Buy low, sell high" is advice so impeccable as to achieve the truly advanced state of tautological, but "buy high, sell low" is more descriptive of the way people actually behave across economic cycles. 

I may not be able to change your heart—only you in league with your spouse or your shrink can do that—but I can at least hope to arm you with the intellectual fortitude to mount a stalwart case for exploring some acquisitions now, in the teeth of the fretful and querulous naysayers.

Based on a survey of over 200 global companies, the authors (who also collaborated on the May 2008 book The Granularity of Growth), derive two pivotal conclusions:  The most powerful way to position one's firm for growth coming out of a downturn is through selective acquisitions during that downturn, and, conversely and with wonderfully rewarding and symmetric logic, during an upturn selective divestitures create slightly more value than acquisitions.

If only people behaved that way:

This shows the actual behavior across a sample of 537 product/service lines (from 187 companies) between 2001 and 2004, in reaction to a "major" (> 10%) upturn (top blue bars) or downturn (bottom green bars).  Essentially, the lessons are:

• Companies are more likely to divest during a downturn;
• And more likely to acquire during an upturn;
• While the reality remains that during both upturns and downturns the most likely course of action of all is simply to do nothing.

Again, this is understandable.  But that, I would argue, is less an excuse than an indictment of conventional wisdom. 

Do you want to "protect your balance sheet" during a downturn?  Sounds logical.  (And, to be sure, some firms simply aren't in a position to do otherwise.)  And as revenues flag and margins are compressed, you may focus on cutting costs and trying to at least match previous periods' earnings levels.

But the savviest growth companies do otherwise.  Famously (as even the usually somnolent business coverage of The New York Times realized in 1999), GE Capital immediately went on a capital spending binge following the Asian financial meltdown in 1997:

The last two years alone, [GE Capital] has made at least eight major investments in four Asian countries, expanding its assets to about $20 billion in the region. Acquisitions included two consumer-credit businesses, a life insurance company and a $5 billion leasing company in Japan, a consumer-credit business and a portfolio of car loans in Thailand and a life insurance unit in the Philippines. It also has its sights on a stake in a South Korean bank.

[...]

[T]he 1997 Asian financial meltdown and resulting recession turned the area into a vast bargain basement. Here was GE Capital's chance to buy up distressed companies and establish itself in the one part of the world where it lacked a strong presence.

''There's no question that financial turmoil has resulted in an environment that facilitates deal creation,'' Denis J. Nayden, president of GE Capital, said in a telephone interview from the company's headquarters in Stamford, Conn. ''Yes, we have moved into that opportunity.''

In other words, countercyclical growth works. 

If you're in a position to do so, think about trying some for yourself.  You may like where you'll end up on the other side of this credit markets lockdown.

Costs & Revenues: Health Check Time

So maybe you can't save your way into profitability, but you can save money more and less intelligently.

And I'll give you a hint: It's not about how many meetings are held at times when food should be served. (Think I'm making this up? Firms have sent out memo's to encourage non-food-appropriate meeting times.)

Here's a primer from McKinsey, admittedly addressed to investment banks, but utterly applicable to you.

They start from the analytical premise of segmenting investment banks into quartiles based on noncompensation costs per head count. That strikes me as a strong indicator since it abstracts from the absolute value of growth in noncompensation costs (you can expect headcount and noncompensation costs to grow as the firm grows) as well as from the impact of one-time investments such as opening new offices.

Using only publicly available sources, they benchmarked eight major financial institutions over the past three years and found, perhaps not surprisingly, that "the difference in noncompensation costs per head count between the top- and bottom-quartile banks is significant:"  Banks in the top quartile had average costs by this measure of $148,000 and across the bottom three quarters, $212,000, or a 43% difference.  When you look at it from the perspective of potential savings (assuming, that is, that banks in the bottom three quartiles could duplicate the cost structure of banks in the top quartile), the numbers are striking indeed:

What accounts for these sizable differences in the cost base?

Simply put, during the good years (2005—2007), some banks permitted themselves to bloat up.  Here are the "CAGR" (compound annual growth rate) figures for noncompensation costs (light blue bars on top) and revenue (dark green bars on bottom) for the eight banks:

Only three of the eight had sufficient discipline to keep cost growth below revenue growth.  (The "N/A" for the last two listed is a result of their revenue "growth" in 2007 being negative vis-a-vis 2006, which vitiates the CAGR calculation.)

So much for the background:  Now for the interesting part.

How precisely do you cut costs without sabotaging morale?

First, let's assume you've done any staff and attorney headcount "right-sizing" that may be called for.  If you're going to do it:

• Do it surgically;
• Do it once and only once;
• Tell people it will be once and only once;
• Tell the people who have been saved that they've been saved and that it's for keeps;
• Even if you think in hindsight you might have made some mistakes, do not go back to the well; and above all
• Do it once and only once.

Now that you're past that, the good news is that "80% of fixed costs have minimal or no impact on a bank's employees or culture."  In other words, you can draw blood from the 80% of your noncompensation cost base that is relatively invisible to people on a day-to-day basis.  You can go, in the famous phrase, "where the money is."

Here's the breakdown (understanding it won't be identical for law firms as for investment banks, but the comparable notional amounts are worth thinking about):

Obviously, some of these don't map one-to-one to law firm land.  You probably don't spend nearly as much on "data," for example (or you charge it through to clients if you do), and your sum total of spending on "other professional services" and legal is probably de minimis (if it's not, we should talk).  

But the point is not how your noncompensation costs break down vis-a-vis investment banks.  Rather, the point is how relatively small a component of that goes to activities that are highly visible and have a direct impact on morale:  Travel, entertainment, and firm events.

Times like these give you the opportunity to cut out the deadwood and to re-examine unspoken assumptions about what customary activities would really justify themselves all over again in a "zero-based budgeting" world.  In some ways, these are the best of times to cut costs; everyone understands the imperative.

When things turn up again, however, I have a word of advice:  Keep in mind that CAGR chart comparing cost growth to revenue growth.  And make your firm one of the three, not one of the five.

What's Your Time Horizon?

Time to take stock.  This dratted credit crunch has now celebrated, if that's the word, its first birthday, and there is no clarity about when it may end.  What's a law firm to do?

If you believe McKinsey, and if you believe that where investment bankers go, law firms will follow, the answer is:   Look to the emerging markets.

Relying on the results of the McKinsey "Global Capital Markets Survey," which purports to forecast estimates of investment banking revenue for the years 2007 to 2010, the message is that:

• Emerging Asia,
• Emerging Europe,
• The Middle East, and
• Latin America

will probably show absolute revenue growth over the next three years and under what they call "all likely outcomes," emerging markets' share of global revenues will "jump sharply."  Here's the soundbite:

Collectively, indeed, revenues from investment-banking and capital market activities in these regions are projected to match those in North America by 2010; in 2006, before the credit crunch, they amounted to less than half. A case, perhaps, for referring to “emerged” rather than emerging markets in the future?

Uncertainties, to be sure, abound.  Primary factors determining when the credit crunch may ease include the overall macroeconomic prospects for growth in the US and developed economies; investors' behavior--simply put, when and to what extent confidence comes back; regulators' behavior (do they over-react and clamp down in market-suppressing ways); and of course the grand-daddy unknowable of them all, namely when the credit and liquidity lockup will start melting as the lending institutions in the economy begin to see clarity about the future and are able to restore their balance sheets to health.

But back to the emerging markets.

Why are they so attractive at this juncture in the economic cycle? For one thing, as McKinsey alluded to above ("emerged" vs. "emerging"), they're already getting sophisticated (emphasis supplied):

First, their macroeconomic environment remains comparatively benign, even if talk of a complete “decoupling” of their economies from those of the United States and Western Europe was premature. Although, if trade flows with the West do suffer, regional demand for oil and commodities, growing intra- and interregional trade flows (especially within Asia and between it and the Middle East), and huge infrastructure-investment programs will continue to underpin growth.

Second, a new breed of global corporate players, notably in countries such as China, India, and the United Arab Emirates (UAE), now demands the sort of sophisticated investment-banking services [and concomitant legal services] previously reserved for large Western multinationals. This new group thus represents an increasingly attractive fee pool.

Add to that that they're less exposed to the infamous credit crunch. For example, if writedowns is your blunt-instrument measure of exposure, investment banks have written down only about 7% of their revenues from emerging markets as opposed to three times that--21%--on a global basis.

Two other reinforcing trends are in play. First, certainly in Asia, economies are growing, pure and simple, on their own. That just increases the stock of financial instruments and their tradability. But second, as Asia becomes increasingly integrated with the global economy, inbound and outbound investment will increase, and it will take increasingly sophisticated forms. For "sophistication," substitute "lawyer-heavy," and you have a reason to take this region more seriously.

Do you have to be there?

I believe you do. But let McKinsey speak to this:

Asian markets are fast becoming as demanding and sophisticated as markets in Europe and the United States. Clients have developed a taste for complex financial products and demand good local service; domestic competitors are ramping up their skills and opening their checkbooks to attract international talent.

An onshore presence in emerging Asian markets, meanwhile, is becoming critical. The old model of the suitcase banker operating from hubs such as Singapore and Hong Kong will fail to satisfy clients and regulators seeking a true commitment to the local market.

I've observed before that in America the first "real" question people ask a new acquaintance is, "What do you do?" In the UK it's "Where did you go to school?" And in China it's "Where are you from?"

Not to be cute, but if this is remotely correct (and I've reality-tested it with numerous people in all three areas), you really need to be on the ground in Asia to manage inbound or outbound investments more than you need to be on the ground in (say) Silicon Valley to manage a high-tech IPO or Brussels to handle an EU regulatory matter.

So much for Asia. What about Eastern Europe?

In a nutshell, McKinsey sees overall annual GDP growth from 7% (in their "darker" scenario) to an astonishing 19% in their "more benign" scenario. I'll take some of that, thank you very much.

The only trouble with this area, for law firm land (as opposed to investment banking land), is that the primary source of increased fee revenue McKinsey foresees has almost all to do with sales and trading: "In the future, we believe, growth will probably shift from foreign exchange to interest- and equity-based derivatives, among other products."

And the Mideast?

No surprises here: Investment banks are redeploying more and more professionals from New York and London to the region:

The oil-rich states of the Gulf Cooperation Council (GCC)—Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the UAE—are generating wealth at levels not seen since the 1980s. High oil prices have triggered an unprecedented wave of investment, including a huge pipeline of industrial and large-scale infrastructure projects, such as Saudi Arabia’s new “economic cities.” By some accounts, the GCC will have invested around $3 trillion in the region by 2020.

Can you afford to miss this?

That is for your firm to call, including your partners' appetite for risk and their willingness to endure a period of potentially protracted investment, but the historic shift of momentum seems clear:

Emerging markets now have a rare window of opportunity to catch up with the rest of the world, not least because they don’t have to mitigate the mess created by current market dislocation in the West.

Here we have, in other words, the flip-side of the credit market and liquidity freeze.

Stung (perhaps severely?) by that meltdown? Here (the good news) is an enormous, far more durable, opportunity. But (the bad news) if you are still bleeding from overexposure to the frozen credit markets, you may not be in a position to make the requisite investments half a world away.

Don't ever again think that managing a law firm is an exercise in quarter to quarter or year to year performance.

The transition from "emerging" to "emerged" will take a few decades. You need to have the same time horizon.

Update:  Mon 1 Sept.

The September issue of The American Lawyer (published online today) has a lead story, "No More Pure Plays," attempting to apply lessons learned by law firms sideswiped (or worse:  see Brobeck) by the dot-com meltdown in 2000—2001 to today's market where securitization and structured finance have experienced a similar sickening sensation of the trap door opening beneath them.

The first thing to be said about these types of market tops is simply this:  "In hindsight, the folly of it all seems obvious. But here we are again."

And, as Stephen Neal, managing partner of Cooley Godward Kronish from early 2001 through today puts it with commendable clarity:  "In retrospect you might say [the growth] was a mistake, but we didn't know at the time how long this market would last. At the time it was almost irresistible."

The "almost irresistible" comment brings to mind the business classic, The Innovator's Dilemma, where Prof. Clayton Christensen of Harvard Business School set out a coherent, compelling, and historically astute view of just how the most powerful incumbents in any given industry are precisely the firms most vulnerable to maverick upstarts with what appear at first glance to be second- or third-tier offerings of no conceivable utility to the incumbents' core customers.  While it might seem intuitive that the most knowledgeable, most strongly capitalized, most sophisticated firms in an industry would be theones most capable of exploiting innovations "in their own backyard," as it were, Christensen demonstrates precisely the opposite is more common.  Incumbents suffer from:

• Being excessively loyal to their core, established clients (yes, even client loyalty can be pushed too far, when it becomes a limitation rather than a strength);
• Focusing on continuous incremental improvements to their existing product or service offerings, while being blind to "disruptive" innovations; and finally and most tellingly of all
• Being unable to abandon extremely profitable existing lines of business to take a chance on an unproven innovation whose value will only be known in some indeterminate future time.

It's the final point that Mr. Neal is echoing, and it's the seductive power of any boom:  When the getting is good, the getting is very good indeed.  (Or, as The Onion recently facetiously headlined, "Americans Reeling from Housing Meltdown Seek Next Bubble to Invest In.")  Some of the key Silicon Valley firms grew as follows—and this doesn't include all the firms from elsewhere in the country that starting piling willy-nilly into Northern California just as the window was about to slam shut on their fingers:

• Cooley added 300 lawyers in a 12 to 18 month period;
• Wilson Sonsini went from 550 to 812; and
• Brobeck from 540 to 724.

Even at that torrid pace (let's not even think about quality control, shall we not?), "'We turned away nine out of ten pieces of business--maybe more,' said Mark Tanoury, who then headed Cooley's business group, in 2000."

Still, the article finds reason for optimism this time around, at least as compared to the carnage at the start of this decade.  Why?  Primarily because the NY-centric firms that doubled down on securitization have been far quicker to wield the "scythe" with associates.  To this day, Wilson Sonsini has never publicly admitted that it laid off associates, although, mirabile dictu, its headcount shrank from 812 in 2000 to 540 in 2004, and the beginning of the end of Brobeck, at least as the received wisdom has it, came when Tower Snow refused to lay off associates. 

The article gives, indeed, the last word to Mr. Snow:  "History shows that those who are overconfident or arrogant tend not to do well when the environment changes." Ironic, and prescient, words indeed.

But I choose to give the last word to Chris White, chairman of Cadwalader, who told The Wall Street Journal last month: 

"There was a bubble, we rode that bubble, it contracted, and we adjusted. Even knowing what I know now, I wouldn't have changed a thing,"

The cynics in the audience may judge that chutzpah of the highest order.  But I for one see it differently, and give Mr. White great credit for a shockingly salubrious spasm of candor. 

Now the only question will be whether their "adjustments" have been rapid and strong enough. 

ILTA 2008

Apologies for a dearth of columns this week, but I was at ILTA/2008 at the Gaylord Texan outside Dallas.  Two comments about the Gaylord, Dallas, and August.  First, the Gaylord comes as close as any place I've ever been to meriting the word "indescribable."  If you start by envisioning what is essentially a circular hotel built around an enormous, enclosed atrium roughly the size of a domed football stadium, you begin to get the idea.  Now furnish that atrium with lifesize replicas of part of The Alamo, fountains, streams, and brooks, model trains running hither and yon, facsimiles of Conestoga wagons, an oil derrick, and other totemic Texas artifacts, put it adjacent to the largest conference center in Texas (which is actually saying something, unlike perhaps "the largest conference center in Rhode Island"), and you begin to have a prayer of envisioning this place.  Don't you love America?

Comment #2:  Dallas in August is an extremely hostile environment if you're a runner, or, indeed, if you like to spend any part of your day outside hermetically sealed environments.

Be that as it may, on Wednesday I presented on "Web 2.0 & Law Firms," and on Thursday, with my friend John Alber, Strategic Technology Partner at Bryan Cave, on "Law Firm Economics 103."  (If you don't know John, he is perhaps the single most insightful and creative thinker in our industry about how to measure performance internally at law firms. He comes up with stuff you've never dreamed of, and passes it off as all in a day's work.)

Here are the presentations (click each to view):

This particular presentation concludes with Information R/evolution by Michael Wesch:

And just to add some interactivity to your visit, I was also videotaped by Thomson West who posted it on YouTube.

See you at ILTA next year! (But please, dear organizers, not Dallas.)

How's Your 2008 Shaping Up?

We have our first comprehensive report on how 2008 is shaping up financially, courtesy of The American Lawyer, and Dan DiPietro of Citi's Private Bank, and it paints a picture of what are soon going to be, if they aren't already, vastly diminished expectations.

Let's set the scene.

Since 2001, we've enjoyed overall consecutive year over year growth rates at almost double digit levels in practically every metric that counts. Here are the CAGR (compound annual growth rate) figures for the 2001 to 2007 time span:

• Revenue: 10.6%
  • YTD 2008: 4.8%
• Gross billable hour demand: 3.9%
  • YTD 2008: -0.3%
• PEP: 9.3%
  • YTD 2008: -9.1%
• Growth in the ranks of equity partners: 2.9%
  • YTD 2008: 1.7%
• Associate compensation (roughly 23% of total firm revenues): 10.1%
  • YTD 2008: 15.2%

Now all of these trends have turned negative:

• Revenue growth has reversed, with demand the weakest since 2001
• Since firms have continued to add lawyers, there's "profit margin compression"--lower revenues hit higher expenses

And, fascinatingly:

The slowdown is hitting the most profitable firms the hardest. In the first half of 2008, demand dropped off even more dramatically and expenses increased at a more rapid pace at the top firms, resulting in even greater margin compression and a steeper drop in productivity than experienced by their less profitable rivals. The practice areas that normally provide a lift in a downturn -- restructuring, bankruptcy and litigation -- have not helped cushion the drop-off in transactional work.

It's not just a failure of the classic countercyclical practice areas to kick in; there appears to be a structural component involved as well.

When firms are broken out by profitability, our data produced an interesting finding. The firms that soared in 2002 through 2007 were harder hit in the first half of 2008 than their less profitable peers. From our sample of 165 firms, we broke out 63 top-tier firms (defined as those with profits per equity partner above $650,000 in the year 2000). Over the past six years, this group has consistently produced higher growth in revenues and PPEP than other firms.

That changed dramatically in the first half of 2008. Growth in PPEP for 51 of the 63 top-tier firms that reported their results to us plummeted from an 11.7 percent increase in 2007 to an 11.8 percent drop in the first six months of 2008. In contrast, their less profitable rivals experienced a 5.3 percent drop in PPEP in the first half of 2008. After reaching a seven-year peak of 7.4 percent growth in 2007, demand at top-tier firms actually dropped 1.6 percent in the first half of 2008. Again, this decline compares unfavorably with the 1.1 percent rise in gross billable hours at the other firms in our sample.

Top-tier firms experienced even greater profit margin compression than their peers, with revenue growth of 4.3 percent and an increase in expenses of 10.9 percent. In contrast, the other firms we surveyed had revenue growth of 5.5 percent and a rise in expenses of 9.1 percent. Demand at top-tier firms declined in both the first and second quarters of 2008, in contrast to their less profitable competitors, for whom demand dipped in the first three months but increased in the second three months.

The posited explanation is that since firms with the highest profitability tend to concentrate on serving the financial services industry's demand for transactional work, they are suffering disproportionately from the freeze gripping that sector. This rings convincingly true to me. And the data support it: Hours per lawyer have dropped 8% at these top-tier firms compared to a decline of 2.9% elsewhere.

One last observation from the report and then some commentary.

What Citi defines as "international" firms, with between 10 and 25% of their lawyers abroad, "experienced greater profit margin compression than any other group of firms." By contrast, "global" firms, with more than 25% of their lawyers abroad, have experienced the least profit margin compression.

If you assume that firms just beginning, or in the early stages, of international expansion are focused on the UK and the EU, this makes some sense: Those geographies are experiencing a similar, though not as sharp, a slowdown as we here in the US. So their geographic diversity hasn't helped much. By contrast, if you think Citi's definition of "global" firm identifies firms farther down the globalization path, they're likely to have substantial presences in Asia and the MidEast--areas anything but suffering from the Western economies' downturn.

More importantly, this speaks to the power of a diversified portfolio of practices--both by specialty and by geography.

So: What's to be done?

Since you can't create a truly compelling international platform by yourself overnight, you have one aggressive and one passive option. The aggressive one is to carefully, thoughtfully, and thoroughly explore a potential merger with a firm that, together with yours, would provide that international platform.

Globalization is here to stay, and the notion of a powerhouse firm based primarily in one country--no matter how large the domestic economy--will increasingly become a mark of irrelevance.

The more passive, or perhaps I should say more cautious, response is simply to do what you can to cut costs.

There's just one problem with cutting costs: Your biggest costs are (a) people and (b) office space.

You can't cut corners on either one. And, as many firms learned to their lasting chagrin after the dot-com bust, if you cut associate ranks drastically to improve short-term results, you have no mid-level bench strength when the good times return. Neither your clients nor people in your recruiting pipeline--nor partners who have to turn down work or over-stress their colleagues--forget this soon.

Which brings me to the real point.

Firms that are "suffering" (down 10% in profits?--let's get a grip, people) are probably in that situation because they made bets--hopefully calculated--to concentrate on practice areas that were hot. That's all well and good, if they were consciously chosen bets placed with an understanding of the odds of their coming up snake-eyes.

Managing a sophisticated law firm is not remotely a quarter by quarter exercise, and it's also not a year by year one. It requires explicit, considered, hard thought through choices about what your firm is, what it's capable of, and what it can credibly and realistically aspire to given your client base, your recruiting pipeline, and a clear-eyed view of your partners' and associates' appetite for change.

And then it requires a consistent communications effort, forceful, undeviating, adapted to different audiences at different times but indistinguishable in thrust. You need to be shockingly clear about the vision, able to crisply articulate it, relentless in communicating, and prepared to reinforce it all with carrots and sticks.

Come to think of it, maybe it's easier just to cut costs.

The Balanced Scorecard, Version 5.0

One of the most famous management books in recent history is The Balanced Scorecard, published in 1996 by two Harvard Business School professors, Robert Kaplan and David Norton. If you've never heard of it, you should at the very least become familiar with its core precepts, which can be roughly summarized as recognizing that purely financial measures of performance are inadequate and that a multidimensional analysis is required to effectively evaluate your firm's organizational effectiveness.

There are basically four sections to the "balanced scorecard:" articulating your firm's strategy; communicating that strategy and linking it to relatively objective measures which clearly reflect your progress (or lack thereof) towards achieving the strategy; setting targets for individuals to inspire them to reach higher on those measures; and finally enhancing feedback and learning.

Now Kaplan and Norton are back with their fifth book as coauthors, The Execution Premium: Linking Strategy to Operations for Competitive Advantage. If you think this is a franchise they're milking, all I would say is give them a moment's credit for inventing the franchise--after which I agree with you utterly.

But in the land of business literature, where the average half-life of a concept can be measured in terms of one or at most two quarterly earnings releases, the "balanced scorecard" has legitimate legs, and so it's worth seeing what new they have to say.

As implied by the title, the new book takes leadership in crafting a credible, distinctive, and powerful strategic vision as almost a given (or at least as a prerequisite): "There are two key issues. First is leadership. Without strong visionary leadership, no strategy will be executed effectively." That's about all they have to say on the topic. The rest of the discussion focuses on how to actually imbue operations with the strategic vision or, in other words, how to get it done:

The normal course of events is for companies to focus on day-to-day operations and short-term problem solving. Management meetings focus on fighting fires and fixing problems. Often little time and few resources get committed to strategic issues.

We don't advocate abandoning an intense focus on operations and their improvement. But we do advocate planning strategy, not just describing it as important. The senior management team needs to have regular, probably monthly, meetings that focus only on strategy.

To emphasize the importance of marrying strategy to execution, they offer this quote perhaps apocryphally attributed to Sun Tzu: "Strategy without tactics is the long road to victory; tactics without strategy is the noise before defeat."

What's wrong with being strong on tactical execution? Obviously, nothing per se. In corporate America, tactics are often addressed through initiatives such as Total Quality Management, Six Sigma, and other "continuous improvement" and business process re-engineering efforts. All well and good. But they are typically pursued without regard to whether the processes that are being optimized are actually things the company should be doing. As the authors put it, "quality and process improvement programs are like teaching people how to fish. Strategy maps and scorecards teach people where to fish."

Here's a simplistic example from law firm land: A "zero-based budgeting" examination of your office space requirements--for partners, for associates, for staff, for the library, for conference rooms, etc.--might yield incremental improvements in how you allocate those expensive downtown Class AA building square feet. But they will not address the question of whether all the activities you perform in that premium space need to be performed there.

A stronger example might be in how you pursue development of your lawyers' client relations skills. If you are sufficiently progressive as to have a dedicated client relations or client focus program, good for you. But does it discriminate in favor of your best clients or is it scattershot across the board? Even more strategically, are the clients (and prospective clients) it focuses on informed by the types of work the firm aspires to get and the industries and practice areas you want to emphasize going forward? Not all dollars of revenue are created equal.

Don't assume a focus on strategy happens automatically.

Indeed, the authors recommend monthly meetings explicitly focused on strategy:

"[M]ost management meetings get consumed with discussions about short-term operational and tactical issues. It is important to meet to discuss and solve operational problems. But companies err when they devote all their time together for fire-fighting and coping with near-term issues. The formal strategy execution system schedules strategy review meetings at a different time from operational review meetings. In that way, each meeting has its own frequency, agenda, information system, and participation, as best meets the goals for that meeting."

Beyond monthly meetings, they recommend creation of what they call (they are business school professors, alas) an "Office of Strategy Management." Stop rolling your eyes and stay with me.

Think of the "OSM" as the managing partner's or executive committee's "chief of staff:" Not the person who sets the strategy, but the person who tries to ensure that (a) the right meetings are held (b) attended by the right people (c) with appropriate follow-up and follow-through.

Essentially, the OSM is responsible for making sure that nothing important falls between the stools, and that you have the right stools in the right places. Finally, they can reach out to less central but still important functions such as finance, recruiting, marketing, and IT, to make sure those departments' activities are closely aligned with the firm's espoused strategy.

Is your leadership team, then, delegating responsibility for day to day oversight of strategy execution? Not on your life:

"[E]executive leadership pervades every stage of the management system. Throughout The Execution Premium, we describe organizations that have successfully implemented their strategies. They operate in varied regions and industries ... Their strategies differ ... About the only common element all these diverse successful strategy implementers have in common is exceptional and visionary leadership. In every example, the unit's CEO led the case for change and understood the importance of communicating the vision and strategy to every employee. Without such strong leadership at the top, even the comprehensive management system we introduce in this book cannot deliver breakthrough performance.

"In fact, leadership is so important to the strategy management system that we make a rather bold claim that leadership is both necessary and sufficient for successful strategy execution. The necessary condition comes from our experience with the more than one hundred enterprises around the world who have become members of the Balanced Scorecard Hall of Fame. In every instance, the CEO of the organizational unit implementing the new strategy management system led the processes to develop the strategy and oversee its implementation. No organization reporting success with the strategy management system had an unengaged or passive leader."

At every stage, then, senior leadership is doing exactly what it's being paid to do: Leading.

You:

• set the ambitious agenda and "stretch" goals;
• explain and relentlessly communicate how each professional will have to adapt their behavior to pursue those goals;
• modify the firm's organizational units as need be to suit them to pursuing the goals;
• run the on-going strategy review meetings and determine what mid-course corrections are called for; and finally
• allow the strategy to be challenged as circumstances change, performance is evaluated, and professionals respond more and less favorably to the new mandates.

In many ways, the Holy Grail of leadership is to identify and articulate a compelling strategy tightly suited to the firm's capabilities and market opportunities, and then to assure that everyone starts rowing strongly in that direction.

The fact that it's relatively easy to state makes it no less daunting to achieve. How hard is it to state "I want to lose weight." "I want to stop smoking." "I want to get more exercise."

Or, "I want to align everyone in the firm with our carefully crafted and potent strategy."

Good luck. Seriously.

The Thirty Years' Associates Salaries War

Put these trends together, as reported by this month's issue of The American Lawyer, and what do you get?

• Midlevel associates, despite their pay jump since 2006, aren't satisfied with with their compensation;
• New York City salary levels have penetrated every major market across the country;
• The annual midlevel associate survey "shows associates eyeing the door;" and
• Howrey is continuing its revolutionary efforts to end associate lockstep.

I suggest you get what could be the beginning of cataclysmic cracks in the associate compensation/promotion/professional development model.

Shall we start with the easy stuff?

According to The Paycheck Report,

"Finally, everyone's being paid like a New York lawyer. Thanks to an informal wage freeze in the country's largest market, midlevels in other major cities caught up to the salaries of their New York counterparts this year, although they still lag behind in bonuses.[...]

"Even though New York salaries were flat, the data shows healthy pay increases elsewhere, as non-New York medians caught up with those in New York--$185,000 for third-years, $210,000 for fourth-years, and $230,000 for fifth-years. For midlevels outside of New York, those are one-year increases of 9 percent, 11 percent, and 10 percent, respectively. Nationally, median bonuses increased 17 percent for third-years, 21 percent for fourth-years, and 14 percent for fifth-years."

Next, we have the report from the front lines that even associates in firms receiving "going rate" salaries aren't satisfied if they don't receive going rate bonuses. You may be asking yourself whether the notion of a "going rate bonus" isn't an oxymoron, and I would be the first to agree with you.

At risk of revealing how far back my memory goes, and worse, at risk of appearing a curmudgeon, I do recall the days when bonuses were individually determined based on--quelle horreur--individual performance. But that was then and this is now. This says it all: "'Compensation is too low for the New York office' notes one Blank Rome associate. 'The bonus is not a market bonus, even if the salary is a market salary,' says another." As they say hereabouts: "Deal!" (Not as in, "you're on," but as in, "deal with it.")

The issue is not one of pay for performance, but one of comparative envy. And, to a large extent, of shocking law student ignorance about the differences between firms in training, culture, professional development, opportunities for partnership, strength of the alumni network, value of the firm's "pedigree" for future options, chances to spend some time in an overseas office, and so many other things that are critically important to one's future career.

So it comes down to money: "Students can’t easily differentiate between prospective employers, so they rely too much on pay as an indicator of prestige. Competitive and clueless, students are "the most uneducated consumers of law firm life and what it really means to practice," says a Simpson Thacher & Bartlett midlevel."

But associates may actually be the most brutally honest realists about what's going on. If their careers in BigLaw are destined to be "nasty, brutish, and short," they may be being perfectly rational. We all know that the odds of equity partnership are asymptotically approaching zero:

“We’re like pro athletes,” says a Jenner & Block midlevel. “Only a few will make equity partner, and [most] will have a limited amount of time at a big firm.” In that scenario, the growing paycheck becomes a substitute for an enduring career with a single firm."

In other words, you can buy allegiance--temporarily, and I hate to call it loyalty--by paying salaries that are arbitrarily and capriciously set by a "going rate" market that changes in unpredictable and unforeseeable epileptic seizures, but don't kid your associates that they're anything other than hired brain meat, the vast majority of whom will burn out from career-ending morale injuries. This is the problem:

"[T]he message from management was, 'We're just doing [the raise] because the market is doing it,'" recalls another Jenner [& Block] associate. "They're not raising because they value us. We're just the collective beneficiary because the firm needs to keep up in the market. It’s a back-handed compliment."

OK, I put it harshly, but is this any way to sustain and grow a superb, world-class professional services firm?

And what ever happened to the old dream of making partner after serving your years at Parris Island boot camp?

Maybe that doesn't hold the delayed-gratification appeal it used to, either. Start with the twin facts that: (a) partnership is not the tenured position it used to be, with de-equitizations rampant; and (b) partners work only marginally lower hours than associates, and have more non-billable hour responsibilities, so, in the famous joke, the achievement is seen as "a pie-eating contest where the reward is more pie."

This sums up the change in the mindset:

When Arnold & Porter's director of professional development, Caren Ulrich Stacy, started working in law firm recruiting in the mid-'90s, she says there was one question that she could count on hearing from every incoming associate, be it a new law school recruit or a potential lateral hire: How long does it take to make partner here? But today, Ulrich Stacy says, it goes largely unasked. "I've maybe had that question once in the past five years," she says.

It seems not to be a mask for insecurity. Associates still report (70+%) that they're "on partnership track," and even in today's straitened economy fewer than a quarter say their hours are lower, while fully a third say their hours have increased.

So if it's not insecurity, it's what?

Lack of desire: They may not want partnership.

For one thing, they see some junior partners working even more ferocious hours than their own. "There have been times when I have been watching a movie late at night that I've gotten an e-mail from a partner," says a Latham and Watkins third-year ... Adds a midlevel [at another firm]l: "When you see how many hours [junior partners] put in, you realize there really is no end to it."

Yet isn't there more to life as an associate, and as a partner, than grinding out the hours? The happy news is yes. And there may be hope that those firms willing to work on what that "more" is may be able to put together career paths that make financial, emotional, and professional sense for associates and financial and client-service sense for the firms.

Here are some clues:

"The professional development programs are all well and good," says one Arnold & Porter midlevel. "But in terms of learning the craft, you can't beat learning through a real-life experience and working on client matters."

And this:

"I wanted a place that would treat me like an adult, as opposed to a place that would hold my hand for three or four years before letting me do anything of substance," says one Gibson Dunn midlevel.

And this:

Howrey chief professional development officer Heather Bock adds that the pitch to this generation of associates has to include more than just a prospect of partnership. The question Bock asks herself: "What is it that we can offer these high achievers that will appeal to them?" One of Howrey's answers is to offer a two-to-three-day intensive academy each year of an associate's career. (The firm ranks in the top third of the survey overall, and in the top 10 in terms of training.) "We try to make it a very high-impact experience," Bock says. "It's very rare for them to come and listen to hours of PowerPoint presentations."

Arnold & Porter even employs two career counselors--former lawyers both--who help associates navigate internally within the firm or even help them plot an exit strategy; and it's all confidential. What do these efforts have in common?

• Treating associates as autonomous adults, not fungible factors of production.
• Giving them the rope to hang themselves, if hang themselves they will.
• Taking "professional development" seriously. It's not about videotapes and PowerPoints.

Take this thought experiment a step further, and broaden it out from one firm to BigLaw in general.

What do associates want?

Essentially, they want two things, in varying mixtures: Money and training.

We're actually very strong, and extraordinarily undifferentiated, at the first, and wildly variable on the second, from firm to firm, department to department, and even partner to partner.

Here's the thought: What if firms chose to position themselves along a two-dimensionally differentiated spectrum from exceptional pay and minimal training to exceptional training and below-market pay?

Wouldn't associates be able to make informed choices about where they wanted to begin their careers, based on their own needs, goals, and aspirations?

Now imagine adding other dimensions to these two simplistic ones:

• Higher or lower partner:associate leverage.
• More or less pro bono work.
• Clarity (this is a challenge to communicate to law students) about whether your firm is focused on corporate, finance, and transactional work, or on litigation and dispute resolution.
• Clarity (again, a challenge) over whether your firm is regional, national, or truly international, and the opportunities (or lack thereof) for, say, spending three years in Hong Kong or moving to the EU for an extended tour.

Associates are complaining that high salaries don't equate to career satisfaction. Is this any surprise? Recall the "back-handed compliment" remark?

Imagine differentiating your firm on dimensions that truly matter, and which you can communicate as:

• credible;
• distinctive to your firm; and
• beneficial to potential associates.

And start thinking about what those dimensions might be pretty soon. Because when the next jump in first-year salaries comes--and it will be to $200,000, I predict--you may want to have other, truly meaningful, differentiators in mind. Other than going to $210,000, that is.

Bubbles

This is about the Cadwalader layoffs.

But I won't be piling on. I really won't.

Instead, I'd rather examine how the firm got to this unhappy pass and what managerial lessons it might hold in store for us. To understand what brought it to cutting fully 20% of its lawyer headcount vs. late 2007, we have to begin, not at the beginning, but at what the firm has just done. Here are the highlights key decisions:

In a statement Wednesday the firm said: "From 2003-2007, when [commercial mortgage-backed securities] issuance tripled, the firm grew rapidly to meet client needs. With CMBS issuance now at a small fraction of previous levels, we are making these personnel adjustments in response to this change in demand. In September 2008, the firm will have 580 lawyers, the same number we were in January 2006."

At the end of 2007, the firm had around 720 lawyers.

Adding to Cadwalader's woes are that Bear Stearns (RIP) and Lehman Brothers, now under siege, were key clients. One unnamed "chairman of another leading New York firm" said that he was not only "stunned" by the scale of Cadwalader's layoffs but added that this economic downturn feels "fundamentally" different than the post-9/11 and post-dot-com falloffs.

"Those were lulls in activity," he said. "This is a fundamental change. A whole segment of capital markets has disappeared and we're not sure when it will come back, in what form or if it will ever come back."

The real challenge to Cadwalader may yet lie ahead. Reportedly, all of the 96 lawyers let go this week (and the 35 let go earlier in the year) were associates or "of counsel." The question this immediately poses is: And not a single partner? Not one? It's possible, of course, that some partners have been "spoken to," and since Cadwalader is not responding to requests for comment, we don't really know.

Yet I promised this would not be about this week and more about how a firm could get into this fix. For that we have to go back to a strikingly revealing interview a year and a half ago profiling Bob Link, then Chairman. The first insight into Link (the article starts in the context of "bowling night out" at Cadwalader) is "'Don't let him fool you,' someone says as Link, 52, takes down another frame. 'He's the most competitive person you'll ever meet.'" Profits per partner were on a tear, at more than $2.5-million in 2005 and $2.9-million 2006. Link had set out to make the firm almost obsessive about profitability. This from the February 2007 profile:

The oldest law firm in America and once one of the most genteel, Cadwalader under Link went through a wrenching and controversial 1990s turnaround during which it transformed itself into perhaps the nation's most aggressively profit-focused law firm. Today's Cadwalader, at which big producers are lavishly rewarded and underperformers are shown the door, presents a stark alternative to the more conservative ways of New York's traditional top-tier firms.

"They are definitely the firm to watch," said the managing partner of one leading New York firm recently overtaken by Cadwalader in the profit charts. "Even though they recognize the business realities, most law firms still hold on to certain ways of doing things. Cadwalader is run like a corporation."

But whether a law firm should be run that way is a question Cadwalader is far from definitively answering. The departure last week of antitrust chief Steven Sunshine, lured to the firm just two years before from Shearman & Sterling and now heading to Skadden, Arps, Slate, Meagher & Flom, underscores persistent criticisms that the firm, while able to attract star laterals with high pay, is unable to build sustainable practices around them.

And Cadwalader's approach has won it a reputation for ruthlessness that suits some but turns off others.

"It's exactly the shark tank that everybody says it is," said former partner Robert Vitale, "If you're a shark, it's great."

Now, of course, Link is no longer Chairman, but the seeds of this week's news were well and firmly planted at least a few years ago. In February 2007, he readily proclaimed the firm's success in concentrating on structured finance:

"Are we going to have difficulty sustaining this?" he asked. "No, short of some cataclysmic event that hits everyone else too."

This puts me in mind of nothing so much as the infamous quote by Chuck Prince, late of Citibank:

"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,” (he said in an interview with the FT in July 2007).

Unfortunately, Chuck Prince didn't foresee just how "complicated" things could be. Including forfeiting his job in short order. (Link, as noted, is no longer head of Cadwalader, either.)

Other elements of Cadwalader's pursuit of profits included:

• Very high leverage. Roughly the same size as Davis Polk in total lawyer headcount, Cadwalader had only half as many partners. Link's observation on this: "Why would I have any more partners than I need?"
• The abrupt closing of the firm's 15-lawyer Palm Beach office led to a lawsuit by a former partner (who was awarded $2.4-million) and led to these remarks by the judge overseeing the case: "Such activity cannot be said to be honorable," Palm Beach County Circuit Judge Jack Cook wrote in his 1996 decision. "While life in the marketplace may well be made up of fear, greed and money ... life in a partnership is not so composed."
• Partners with less than $5-million in business were "eased out."

But the question of deepest interest is whether Cadwalader had embarked on a new business model that we all should attend to, and which was unfortunately waylaid by the vagaries of the financial services industry's cyclicality, or whether the model was fundamentally flawed. Eighteen months ago the former partner, Vitale, posed the question thus:

But the difference between Cadwalader and other firms he has been with is still striking to Vitale. Though he said there was no question that Cadwalader had achieved tremendous financial success, he said the firm still seemed to be trying out a "new model."

"It'll be interesting to see whether they've really built something that lasts," he said, "or if it's Finley Kumble in richer clothing."

Getting closer to the point, Link staunchly defended the firm's concentrating its practice on asset-backed and structured finance, and Vitale underscored the difficulty the firm had in accommodating to the investments required to build practices that would diversify its exposure to the markets.

First, Link:

The engine of the firm is its asset-backed structured finance practice. Link made his name in the area and still serves as the firm's practice leader. It is a specialized area ...

It is not generally regarded as a premium practice area like M&A or high-yield bond offerings, and some have questioned how Cadwalader could have achieved such impressive results from that foundation. For the most part, the other major firms in the area are not Sullivan & Cromwell or Simpson Thacher but non-New York firms like Sidley Austin or Orrick, Herrington & Sutcliffe.

The head of another New York law firm described securitization as a high-volume "commodity" practice, an area top firms avoided because of their inability to command premium rates in it.

"Somehow they've managed to make a success of it," he said of Cadwalader.

[...]

According to Link, the firm only wants to be in those areas where it can achieve a similar level of profitability, primarily those revolving around financial institutions. This discipline also explains why the firm has avoided most overseas expansion apart from London and a small office in China. In the United States, Cadwalader also only has offices in Washington, D.C., and banking center Charlotte, N.C., aside from New York.

"All other offices are dilutive," said Link.

And, Vitale:

Cadwalader's tight focus can clash with its attempts to expand into new practice areas. Vitale said it was frustrating trying to push the firm in a direction that required investment but guaranteed no immediate return. The firm did not yield.

"The firm decided that what it needed to do to expand its project finance practice, it wasn't willing to do," said Vitale.

In his case, he said, what the firm needed to do was swallow the pill and open some overseas offices, particularly in Latin America. The firm's unwillingness to do so meant its project finance group had a hard time competing for business with more global firms. Cadwalader could be a lonely place for those outside the humming core practices, he recalled.

And there you have the stark contrast: Link stands for reinvesting and doubling down in highly profitable areas--given the extant market conditions--while Vitale stands for the school of thought that investing in different practice areas could yield dividends down the road.

Today the choice facing Cadwalader is far more stark than the quasi-intellectual debate between Link and Vitale 18 months ago would have you imagine.

But consider this ineluctable responsibility of management: The task of management is to choose. The task of management is to decide. And the task of management is to do so with an eye towards likely future scenarios. Expecting a bubble to continue growing linearly to the sky is a mug's game. "Everyone thought it would grow to the sky," you retort? Goldman Sachs didn't; the vast majority of the AmLaw 200 didn't, and (we learn through recently released emails), even S&P, one of the great enablers of the bubble through their promiscuous granting of investment-grade ratings to toxic CDO's, knew it was a mug's game: "We can't rate this thing, it's a joke." "Don't you know we rate everything? We'd rate this thing if it were put together by cows."

Is it possible Cadwalader's management was thoroughly in the dark about the nature of the structured finance bubble? Were they in touch with their clients? Did they read the WSJ? Did they think strategically beyond what it would take to create a strong and sustainable law firm for the future, other than showing up for work every morning and answering the phone?

In a way, you can compare the Link/Vitale schools of thought to the grasshopper/ant fable that you recall: The ant spent the six months of summer storing up provisions for the winter while the grasshopper lived off the seemingly endless fat of the land. And we know what happens when autumn arrives.

This brings us to Cadwalader today. While it's scurrying to develop new practices, such as private equity, one has to wonder if its cultural DNA is capable of the long-term investments needed.

In the last year, the firm has established a private equity practice led by former Latham & Watkins star R. Ronald Hopkinson, as well as an intellectual property litigation practice comprising several former Morgan & Finnegan partners. The firm also substantially boosted its bankruptcy practice with the recruitment of four partners from Weil, Gotshal & Manges.

But it is unusual for new practices and partners to immediately boost a firm's bottom line, and some question whether Cadwalader acted wisely in investing heavily in private equity, another practice severely impacted by the tightened credit environment.

"You can't just buy some PE guys and present yourself as an alternative to Simpson Thacher to [Kohlberg Kravis Roberts & Co.]," said the [unnamed] firm chairman.

The question, of course, is whether the firm's reputation in the recruiting market will suffer long-term damage from laying off 20% of its lawyers (albeit, as noted, no partners). But the other question is whether those partners reflecting the figurative grasshopper mentality are willing to stick around through what could be, relatively speaking, winter.

The New Whipping Boy?

Earlier this month, I wrote a column "about wringing our hands" (its actual title was How High Quality Are Your Lawyers?  And How Can You Tell?) and I've just received a most thoughtful email from Alec Guettel, one of the co-founders of Axiom Legal, which is extensively discussed in the earlier piece. 

I want to share it with you, but first permit me a few observations. 

Essentially, Alec recaps Axiom's experience in measuring the quality of lawyers--at least as perceived by clients--and provides some refreshingly concrete suggestions, based on hard-earned experience, about how to secure meaningful client feedback.  These valuable observations speak for themselves.

But Alec also takes a roundhouse swing at the famous profits per partner "success metric," which he says "continues to amaze and entertain us.  Increasingly, it seems to be the only metric that matters to firms [even though it] is almost perfectly cross-aligned with the clients' interests." 

Is this actually correct? 

Hasn't PPP become, in some ways, everyone's favorite new whipping boy?  Alec argues that PPP can "basically" be increased by raising rates, raising hours billed per attorney, raising leverage, or cutting costs (which, he says, "we have yet to witness in a meaningful way from top firms").  Are those the only, or the "basic," ways to raise PPP? 

More to the point, what's so bad about PPP, anyway?  The poliltically correct gang is warring with the economic gang, and I wonder whose side you come out on.  Whichever side it is, thanks to Alec for lobbing in the question.

Dear Bruce –

Thanks for what you’re doing with "Adam Smith, Esq." – really interesting and really necessary. 

I was pleased to see your recent post on the failure among clients to measure the quality of legal work they are receiving and the failure among law firms to measure client satisfaction.  You could not be more right that this is a. lacking and b. critical to the improved function of the legal services market.

This is a topic we’ve invested a lot of time and energy thinking about at Axiom so, for what it’s worth, I thought I’d share some of our views.  We’d love to help you catalyze a broader discussion in this area.

After trying some less structured approaches with mixed results (read: abject failure), we began to insist at the outset of our relationships with new clients on a highly structured series of feedback sessions at specified points in each engagement.  These meetings are always in person (otherwise they get cancelled) and after some experimenting, we’ve begun to schedule them for only 10-15 minutes.  This has increased our clients’ enthusiasm for the meetings and forced all the parties into having very focused, prepared, surprisingly productive conversations.  In specified meetings during the process, we have a quantitative review where we walk the client through a survey about technical legal skills, business counsel, responsiveness etc.  We don’t send these quantitative questionnaires to the clients – again, because they’d never get around to filling them out – we walk them through the questions and record the answers.

This process yields superb feedback for our individual attorneys and for Axiom as a firm, and provides a relatively objective measure for performance evaluation and compensation of our people.  As a next step, we’re looking at ways to provide transparency to future clients about the performance of individual Axiom attorneys on prior engagements and about the firm as a whole. 

These lines of thinking have also generated a separate internal discussion about the whole notion of “profits per partner” as a success metric.  The level of importance and pride assigned to the P3 metric by traditional law firms continues to amaze and entertain us.  Increasingly, it seems to be the only metric that matters to firms - a very  public, highly scrutinized measure of success of firm management and overall status.  Even where individual partners care about more than the size of their paycheck, they have to manage toward that number because it’s become shorthand for the quality of the firm.

The problem, of course, is that P3 is almost perfectly cross-aligned with the clients’ interests.

There are four basic ways to increase profits per partner. Three of them put the firm in direct conflict with their clients’ goals and the fourth has been neglected:

• Firms can increase rates, which we have seen plenty of in recent years and is self-evidently a negative for clients.
• Firms can increase hours billed per person, which is bad for associates and bad for clients as they result in lawyers who are unhappy, overworked and moving between firms at an alarming rate.
• Firms can increase their leverage (number of associates per partner). This is destructive in countless ways, including deterioration of work quality and the quality of life of the partners themselves, which exacerbates rising attrition among associates (who wants to be a partner these days?).
• The fourth solution is to cut costs, which is a solution we have yet to witness in a meaningful way from top firms. In fact, costs have increased as lawyer salaries have escalated. Ironically, this is the only one of the four approaches that is, on balance, good for clients.

 

In contrast to profits per partner, we’ve been developing an alternative metric based on the percentage of the client’s overall legal spend that Axiom constitutes year-over-year.  This provides client-favorable motivation in both the numerator and the denominator.  In the numerator, we are motivated to win “market share” within existing clients.  In our view, this is the most reliable expression of a client’s level of satisfaction (though we also ask them to rate us, as outlined above).  In the denominator, we are motivated to reduce our clients’ overall legal spend, which has resulted in our doing free consulting on best practices and recommending a range of solutions that have nothing to do with Axiom.   (Note: one could argue that the numerator provides an incentive for us to raise rates, but we think that’s outweighed by the primary focus on winning “market share” within the client.)

Finally, I wanted to draw readers’ attention to the comments you quoted from Jeff Carr, GC of EMC.  The system he reports combining performance feedback and performance compensation is in our view close to ideal.  We’ve proposed a similar approach to a few clients but have never succeeded in getting a performance compensation system adopted.  Carr’s comments are inspiration to try again, and I encourage other legal service providers to do the same.

We all appreciate the work you’re doing to highlight this issue via your publication and look forward to continuing the discussion. Thanks for being a catalyst for these conversations!

Best regards,
Alec
_____________________________
axiom
law redefined

alec guettel
23 austin friars
london EC2N 2QP UK

A Conversation with Jay Zimmerman

I recently had the chance to sit down with Jay Zimmerman, Chairman of Bingham, to discuss the changes he's seen over his career, and to talk about the future of the legal industry and Bingham. Herewith a synopsis.

Jay (Harvard, Harvard Law) started his career in New York at Debevoise, but within a couple of years moved to Boston and joined what was then Bingham, Dana, and Gould. Making partner in 1986, he relocated with his family the following year to London to manage what was just about then the tiniest office imaginable for Bingham--one partner and one associate--and ended up staying seven years. (Since Jay’s transatlantic stint, the London office has grown to 45 lawyers, focused on financial restructuring and financial regulatory practices.) Enjoying the quintessential ex-pat experience, Jay got to the point where he never expected to return. But of course he did, to lasting effect.

"Are you sorry in any way that you left London? Obviously there's a school of thought that London has or will overtake New York as a financial capital."

"Well, I wouldn't write New York's obituary quite yet!" Nor, he volunteers, would he worry about the "New York elite" firms who haven't yet invaded London to a material degree. They have the resources and the will to do so when they see fit, he opines. "It's a problem lots of firms would like to have."

The firm he returned to relied on Bank of Boston (founded in 1784) for fully one-third of its business, and the comfortable relationship engendered complacency (my reading, although Jay would probably be more politic). Sure enough, in the recession of the early 1990's the Bank was challenged: Its share price hit a low of $3. In 1996 (we now know) it was to merge with BayBanks, then to be acquired in short order by Fleet (1999) and finally by Bank of America (2005).

Although Jay and his partners had no inkling of that subsequent history, it was clear that with such extraordinary over-reliance on one key client, and with essentially all of its 200 lawyers based in Boston, Bingham had what was not exactly a business model for durability in a world of change.

In 1994, Jay was elected Chairman and embarked on nothing less than a concerted transformation of Bingham, with no fewer than nine mergers since 1997, and the following results:

Increasing the number of offices from one with three small satellites to 13, across the globe;

• Quadrupling its size and then some to nearly 1,000 lawyers;
• Growing revenue eight-fold; and
• Increasing revenue per lawyer from about a third of a million dollars per year to nearly $1-million.

Last year was Bingham’s best on the financial front. As for 2008, Jay reports that the firm is experiencing an even stronger first half compared to last.

How did Jay do this? As he observed drily, "fear is a great motivator."

Other firms have tried to move from a metropolitan or regional base to a national and even international platform, with varying degrees of success. How has Bingham done it?

"Well, for starters, Boston was, second to New York, perhaps the most sophisticated and highest-rate legal market in the domestic US. If you want to try to build a global firm, it helps to begin in what's a relatively high-end home market.

"LA has produced some absolutely terrific firms, Latham, Gibson Dunn, etc., but when you think about it the LA market itself is an uncommon place for very high-end law firms to come from: It's not a powerful financial capital, it doesn't have a lot of Fortune 500 headquarters, and its industries are widely dispersed. But then again, when you look at where other nationally prominent firms have come from (the Midwest, for example, and I say that as a St. Louis native), Boston wasn't the worst place to start."

It's clear to me, I observe, that Jay personally has been a large part of the driving force behind Bingham's decade of expansion. "How do you deal with the challenge of leading notoriously autonomous and independent-minded lawyers? Obviously this is a challenge for any managing partner or Chairman, but when you embark on a course of, essentially, transformation of the firm—not a 'steady as she goes' strategy—you've really upped the ante."

"It's probably a cliché, but it's communicate, communicate, communicate. I'm constantly traveling—in fact I just got back from London and Tokyo—and I meet and talk with as many partners, associates, and staff as I possibly can. I do videotapes. [There's a nice sampling on the firm's website—Bruce] In fact I just did a videotape for the summer associates, who are just starting. But there's no question it's a challenge. You need to be out in front of your partners, but not too far out in front."

And the message is?

"The message is two-fold:

"Number one, this firm is ambitious, and our lawyers need to be ambitious. They need to understand that. When I talk to people we're thinking of recruiting, I try to get a sense of their level of ambition. People want to fit in, and we as a firm want them to fit in. So ambition is part of what we're all about.

"Number two, we love change. You don't hear that often from a law firm, but the fact is that the status quo is good for incumbents, and we're not an incumbent. In change we have opportunity; in stasis we don't. So people here need to be prepared to embrace change."

I observe that law firms can be fragile institutions. Is that something he worries about?

"Of course. We're all here voluntarily. And when you're in the business of assembling a bunch of highly talented people, one of the consequences is that those people have options. The only reason they come back up in the elevator in the morning is because you've presented them with, and continue to present them with, an attractive career proposition. But yes, I pay a huge amount of attention to that. It goes back to communication, and to having people here who fit in and want to fit in."

Is "work-life balance" part of that equation? Part of the task of retaining talent? And how different is "Gen Y?"

"Well, they're really hugely different. The original IBM PC was introduced in 1981 and our new associates were born after that. They've grown up digital; it's not news. But I don't think the term ‘work-life balance’ is helpful, descriptive, or informative. If you're going to make it here, you need to be committed. What has changed is that commitment takes a different form. When I started at Debevoise, it was all about 'face time.' You needed to be seen in your office at 7 or 8 or 10 pm, and the same on Saturday mornings. But today of course you can work from pretty much anywhere—so long as you do the work.

"But again, the commitment hasn't changed. Look at young investment bankers starting out. They get told, 'Look, you're going to make a lot of money, but you need to be on call 24/7. We're not going to need you 24/7, but you need to be on call.' For our associates, what I tell them is that it's all about realism. If they're realistic about the commitment this profession demands—as well as the rewards, intellectual, professional, and otherwise, that it can provide—then they'll be fine. If they're not realistic, they're in for a rude awakening."

I ask