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.

What We Know & What We Don't Know

Just as McKinsey's consulting practice centers on corporate America, certainly its core clientele and expertise, as opposed to law firms, where they have no domain expertise that anyone would notice, the McKinsey Quarterly surveys do not encompass law firm leaders, but global corporate executives. Nevertheless, these are widely traveled and well-informed people with their fingers on the pulse of the global economy, so it's worth reviewing what McKinsey learned in its most recent (March 10--March 16) series of interviews in its "Global Survey."

Here's what they found.

In summary, a "gloomy economic stasis has taken hold," and while the proportion of executives saying economic conditions have deteriorated has, at least, not increased this quarter, fewer than one-third expect an economic upturn this year.

As we've almost come to expect in these types of surveys, and amusingly, overall they remain confident about how their own companies are handling the crisis (still, over half expect profits to drop in the near term).

Some other interesting results of the study:

• There's no doubt whatsoever that trust in business has fallen: 85% have that view. And the culprit? The #1 response(56%) was: Financial firms' inability to comprehend risk and guard against its repercussions. For our purposes, what's more interesting is that after #2 (33%, "job losses," which is something of a non-response) was "executive compensation levels" (29%). Why do I mention this? Only because lawyers are seen as highly paid.
  
  
• Recovery will take time. 90% of these global executives say their own national economies "are in very poor shape" and "have declined since September 2008" but a similar number also agree conditions have not gotten worse since then.
  
  
• Some particularly revealing responses came in answer to questions about jobs and prices:
  • Compared to just three months ago, even more executives expect their workforces to shrink: 50% now vs. 42% in January, and only 38% expect them to stay the same size now vs. 45% in January.
  • The news on prices (can you say: Rates?) is equally telling: Projecting changes for the first half of 2009, only 12% see an increase, 25% see a decrease, and 54% see no change (9%, presumably in commodity businesses, don't know).
    
    
• There are very modest signs of a potential upturn in economic conditions. By and large, these executives are more hopeful than they were as recently as January:
  • When asked how they expect their country's economy to be in the first half of 2009, the results were:
    • January: 50% moderately worse, 7% moderately better
    • March: 41% moderately worse, 14% moderately better
      
      
• In terms of seeking new funds for new initiatives, while two-thirds of firms said they had sought no new funding, the change in the composition of what the other third that were seeking new funding planned to do with it was revealing:
  • Four months ago, 40% sought funding simply to increase available cash; now that's down to 30%
  • Four months ago, 32% sought it to pay for new initiatives; now that's up to 37%.
    
    
• A final, and suggestive, set of responses concerns differences between executives and managers who consider their firms to be "weathering the crisis well" (i.e., well-managed firms) and those at firms who say they have been hurt by the crisis because of poor management. What are firms deemed to be well-managed (by those who should know) doing differently than those poorly managed?
  • "Reducing operating costs:" Over three-quarters of well-managed firms but just more than half of poorly managed firms are doing this.
  • "Introducing new products/services to gain market share from weakened competitors:" Over one-third of good firms but just over one-quarter of bad firms.
  • "Increasing productivity:" Nearly 2 in 5 good firms, just over 1 in 4 bad firms.
  • "Leaving certain markets:" Only 8% of good firms, nearly one-quarter (23%) of bad firms.

What does this tell us, back here in LawFirm Land and out of McKinsey Land?

If trust in business at large has fallen, it perhaps cannot help but have spilled over into our world. Or, if as I do, you would prefer not to believe that, it nevertheless signals an opportunity to get closer than ever to your clients. Don't permit even a whiff of questioned trust to enter your relationships with your clients. Do you think (do they think?) that if there's nothing going on, there's nothing to talk about? Wrong, wrong, wrong. Reach out to them.

Second, if businesses are shedding jobs and prices are under pressure, surely we have known since at least September 2008 that the same is true of us. This is, at this point, very old news.

Third and most important, what is your firm actually doing in response to the crisis?

Here the McKinsey survey actually provides a bit of guidance, even if you're tempted to more realistically categorize it as confirmation of common sense. But the guidance would be:

• "Cut operating costs:" Engage in the dreadful substance, process, and experience of laying off lawyers and staff. And yes, associates today and partners tomorrow.
• "Increase productivity:" Partly by engaging in (a), above, but more creatively and more importantly by reallocating people to practice areas in greater relative demand. You object that it's hard to retrain people? I retort that it's only hard if those individuals who are about to be among the retrained find it hard themselves. And then you know who is onboard the train and who is not.
• "Leaving certain markets:" Here the message may be, if any of these are, more positive. Do not retrench. At least not if you're in markets you entered after due consideration, and not in a pell-mell rush to emulate a competitor or to plant a flag for ego's sake. If you are in a particular city for a fundamentally sound reason, aligned with your own internal firm strategy and your clients' long-term demands, do not retreat. We last saw this, may I remind you, in 2000 when everyone seemed to plunge into Northern California just about at the peak of the dot-com boom. Those who subsequently retreated were not there for the long haul, and should not have been there for the short.

Summing this up, I choose to put at least a skin-deep positive gloss on it.

We clearly don't know nearly as much as we'd like about what we're experiencing, but that doesn't mean we know nothing. We can take some obvious steps (costs, productivity, markets).

We can, also and imperatively, engage our partners, associates, and staff in the new firm-wide enterprise of shifting from a mindset of do-no-harm and steady-as-she-goes to one of:

• creativity,
• agility,
• flexibility,
• and suppleness.

Think different.

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.

"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.

Critical Thinking II

I recently wrote about the dearth of critical thinking abroad in the land.

Now I'd like to bookend that piece with a classic from The Harvard Business Review, "Why Don't Managers Think Deeply?"

The opening lines are priceless; I would ask you only to put yourself in the shoes of fellow HBS faculty members and try--honestly--to envision your reaction:

A since deceased, highly-regarded fellow faculty member, Anthony (Tony) Athos, occasionally sat on a bench on a nice day at the Harvard Business School, apparently staring off into space. When asked what he was doing, ever the iconoclast, he would say, "Nothing." His colleagues, trained to admire and teach action, would walk away shaking their heads and asking each other, "Is he alright?" It is perhaps no coincidence that Tony often came up with some of the most profound insights at faculty meetings and informal gatherings.

Another touch-point for this question comes from an announcement out of GE early last year:

Jeffrey Immelt, GE's CEO, has received a lot of publicity recently for fostering "imagination breakthroughs" by encouraging managers to think deeply about innovations that will ensure GE's longer-term success. He has vowed that he will protect those working on the breakthroughs from the "budget slashers" focused on short-term success. Questions that this effort raises include: (1) Why so much publicity? (2) Isn't "deep thinking" what leaders are paid to do? and (3) Why do these kinds of effort require so much protection?

Are you beginning to get the same creepy feeling I am, that large organizations discourage deep or creative thinking?

Well, in that case, shall we just pile on? Here are some HBS professors' comments on the initial piece:

"... what rises to the top levels are very productive and very diligent individuals who tend not to ... reflect and are extremely efficient at deploying other people's ideas," implying that this type of leader is not likely to understand, encourage, or recognize deep thinking in others.

"... managers are not trained for it."

"Time-for-thinking is a special moment which can be resource consuming and an unsafe activity ..."

"There's a name for managers who think deeply--entrepreneurs ... Big companies are no place for big thinkers."

Providing time to reflect, particularly in an era of multi-tasking and the tyranny of technology, was most frequently suggested as an antidote to the dearth of deep thinking. As Chris Shannon put it, "I think creatively better out of the office, say while out in the boat or at a conference, so that looks very much like not working!"

Also, we have the uncomfortable reality that deep thinking can produce uncomfortable collisions with accepted reality:

In the book, Marketing Metaphoria*, Gerald and Lindsay Zaltman suggest some answers to the question [why managers don't think deeply]. In decrying the lack of what they call "deep thinking" among managers and especially those responsible for marketing, they suggest some things that get in its way. Among them are: (1) reluctance to take risk, especially when short-term performance is at stake, (2) the fear of disruption resulting from "thinking differently and deeply," (3) the potential psychological cost of changing one's mind resulting from deep thinking, and (4) the lack of information providing deep insights on which to base deep thinking.

*Gerald Zaltman and Lindsay H. Zaltman, Marketing Metaphoria: What Deep Metaphors Reveal About the Minds of Consumers (Boston: Harvard Business Press, 2008)

Are there "deep thinkers" within your firm? Would you count yourself one?

If there's a shortfall on this score, why do you think that's the case?:

• People are task-oriented rather than business oriented?
  
  
• Reactive rather than patrolling the perimeter?
  
  
• Excessively focused on the short term?
  
  
• Allergic to change, in whatever form, so reluctant to engage in any mental activity that might suggest a need for it?
  
  
• So successful that "if it ain't broke,..."?
  
  
• Invested in the existing hierarchy, erego unwilling to even think of doing anything that could upset the apple cart?
  
  
• Simply and innocently in the dark, so they don't even have the base-level wherewithal to take the first step in any meaningful direction?
  
  
• Flat broke out of time?
  
  
• Prisoners of human nature (at some level aren't we all?) who are invested in going along to get along?

What do you think stands in the way of your firm deploying its immense intellectual assets better to understand your own capabilities and try to move in a purposeful, conscientious, and disciplined way towards a brighter future in these times of surpassing challenges?

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.

If You're So Smart, Why Aren't You Rich?

Actually, the formulation of that headline that I prefer these days is the famous inversion by the Nobel economist Paul Samuelson: "If you're so rich how come you're so dumb?"

And yes, that brings us promptly to the Bernard Madoff scandal.

Among the multitude of "we should have seen it coming" stories:

• the SEC was alerted to irregularities as early as 1994 [by putative competitors, to be sure, but where do you think "competitive intelligence" comes from?],
• the shockingly consistent monthly returns were suspicious on their face,
• Madoff in person was apparently something of a social misfit, whose primary technique for dealing with unwanted questions was to clam up and/or bluster,
• the investment strategy was a black box,
• and the auditing firm was a joke--a three-man firm operating out of a strip-mall office of about 125 square feet, whose principal and senior member was 80 years old and living in Florida.

Nevertheless, there have been surprisingly few first-person accounts of someone who encountered Madoff and said no.

But this week Barron's brings us one: "Living to Tell About Madoff," an interview with James Hedges (not, I assume, a stage name, although in the circumstances it ought to be), "president and founder of LJH Global Investments in Naples, Fla., who has invested billions in hedge funds and private equity since 1990 through relationships with numerous hedge funds."

Eleven years ago, Hedges spent two hours meeting with Madoff in his New York office planning to invest a few billion dollars of his clients' money. He walked out without a deal.

Here are some of the reasons why. If you read to the end, I promise I'll tell you why this is germane to what you do.

• "I was told it was unusual for him to meet with anyone for that length of time, and that he was perturbed with the process. His whole tone during the meeting was curt, truncated, and he volunteered nothing. It was an extraction process to get him to answer anything. He was distracted the whole time, looking at people out on the trading floor through the glass wall of his office. Mind you, I was coming in to potentially invest billions of dollars for prominent families and institutions, representing extraordinarily well-known clientele. I couldn't be more the type of person for whom you would open up the kimono. And what it told me was that it was a fraud, full-stop. It was wildly impressionable on me [I'm just the messenger--that's the word he used. Bruce]. I have said over the years to many people: Do not touch Madoff with a barge pole."
  
  
• "We have a due-diligence questionnaire that we use as a template for any investment. It's substantial, about 40 pages of factors we have to get comfortable with. It covers management's trading strategy, the back office, the pricing mechanism for the portfolio, how the manager is compensated, the checks and balances, and governance issues, and a whole host of other factors. We could barely get past page one with Madoff before alarm bells were going off. On the strategy itself, when I asked him to explain his investing strategy, it didn't line up. His strategy was like [defunct hedge fund] Long Term Capital Management, where you're saying you're going to sweep up pennies and nickels around the globe via arbitrage opportunities. His representation that he was going to get free money gains from the marketplace, without a principal risk, didn't make sense."
  
  
• "I literally remember waving my arms in the meeting and saying -- I'm going to guess -- there were, like, 50 to 75 guys trading [stuff] behind his glass wall, out on the trading floor.
  
  "So what do these guys do? I asked. Because when you're investing with anyone, you want to meet the chef, and the sous chef, see who's preparing the dish. That request was turned down.
  
  "We don't ever allow investors to meet our team, is what Madoff said. I said, Let's go into pricing. Who holds the securities?
  
  "He said, We hold the securities. There was no global custodian, no prime broker. That never happens in a real business.
  
  "I said that what we do is look at three to five years of audited financials on funds.
  
  "He said, We're not going to provide audits. I was there representing a billionaire family, and to be told I couldn't gain access to an absolutely correct and appropriate thing to ask for, was amazing to me.

And now, the "payoff question" from the interview. Hedges is asked how it was possible that "reputable" hedge fund consultants could have placed billions with Madoff? "What could Tremont and others have possibly been thinking?", the Barron's reporter asks (emphasis in what follows mine)

• "I was far from the only person to draw the conclusions that I drew about Madoff. Madoff was the fraud that happened in full view, with lots of complicit partners. This kind of thing requires complicit behavior. I believe the due diligence conducted by investors who were there was faulty, or possibly they were lied to, or it was not even done at all, perhaps put aside in deference to a relationship with a con man. Fairfield Greenwich allegedly derived some $300 million per year from their Madoff product -- that's the rumor. When someone is paying you or me or anybody that much per year to go to polo matches with high-net-worth investors and tell them about their portfolio, or on their boat in the south of France, it's hard to imagine [that] one's vision doesn't get skewed."

Here are the questions the Madoff saga should pose for you, managing your firm:

• What's going on that we're not asking enough questions about? Where are we following the herd because it's socially convenient, socially comfortable, and all of the "in crowd" is doing it (don't kid yourself that the "in crowd" phenomenon expires on high school graduation).
  
  
• Who are the 800# gorillas we're not scrutinizing as we should?
  
  
• Who is getting paid so much, or helping to get you paid so much, that "it's hard to imagine one's vision doesn't get skewed"?
  
  
• Is there a practice group that's throwing its weight around and trying to drive the firm's strategy? Are they getting away with it because they're the most profitable group going? Ask yourself how long that may last, and if you haven't read Clayton Christensen's The Innovator's Dilemma, about how companies at the top of their game can suffer fatal attacks from seemingly unworthy upstarts, it's high time you do. (Andy Grove said of it: "This book addresses a tough problem that most successful companies will face eventually. It's lucid, analytical-and scary.")

The real issue is this: How critical a thinker are you?

This is not a facetious, flip, or insulting question.

The fact is, none of us can rest on our laurels on this score. We can always improve.

I say this from personal experience.

Had you asked me, five years ago as I was about to start "Adam Smith, Esq.," whether I thought I was a critical thinker, I would surely and, resentfully and somewhat with hackles raised, have answered that of course I consider myself so. After all, I can imagine myself saying back then something embarrassing along the lines of, "I've gone to a college and law school you've heard of; I've worked in some fairly demanding environments, and so, yes, I consider myself a 'critical thinker,' thank you very much."

But that was before I started "Adam Smith, Esq."--the single most unexpected and salutary intellectual result of which is that it has made me a much more critical thinker. How so? Today, in a way that wasn't the case five years ago, I can scarcely read anything--from an article in The McKinsey Quarterly to a simple reportial story in The Economist, without asking myself questions like:

• What are the unspoken assumptions behind this piece?;
  
  
• If what the author is saying is correct, what happens next?;
  
  
• Does this align with most things we read in the past few months or is it squarely at odds with the consensus--and then who's right?;
  
  
• What are the author's presumed biases, predilections, and hobbyhorses?; and
  
  
• Last and most important--but hardest!--of all, does it spark any new ideas in your mind? What have you been taking for granted that might be due for a challenge or an update or a revisionist note?

This is all hard intellectual work. The reason most people who invested with Madoff did so is because they avoided the hard intellectual work. They, tragically, relied on friends at the country club, friends at the synagogue, friends in the boardroom, friends in the supposed insiders' group of insiders.

If you are an insider, or if you aspire to be one, don't fall prey to the seductive, salacious, and sleepy temptations of turning off your critical thinking.

Complete with serene, almost beatific smile

Update:  Fri 2 Jan 2009:

A regular reader wrote as follows and, with permission, I have reproduced the remarks verbatim, albeit without attribution.  While the point he makes is inarguable, I avoided it in my initial column both because I wanted to emphasize the "failure of critical thinking" angle to the exclusion of any other potentially distracting dimensions of the fraud and, at least as importantly, because I simply felt as a Scots Presbyterian it was far from my place to note this dimension.

Be that as it may, his remarks:

Bruce,

I love your site.  I've been a bit behind and just read your post of 12/27 about the Madoff scheme, which you attribute to lack of critical thinking.  While that is certainly true, one aspect that warrants further fleshing out (and, to my chagrin as an observant Jew, has been done in the mainstream press) is the fact that a good chunk of this was also a good, old-fashioned affinity fraud.  Too many victims relied on Madoff being a member of boards of Jewish philanthropies, or on the facilitation of Merkin, himself an Orthodox Jew. 

This vouching, almost mafia-like, of "he's a friend of ours" helps explain the lack of critical thinking.  It is simply a larger version of the fraud committed on Jews in Virginia Beach earlier this year.  While clearly many others also lost money, a large portion of the wealth lost (including an estimated $1.5 billion of philanthropic funds) is directly attributable to affinity fraud.

As I recently told a friend, this is a clear sign that we Jews have made it in this country when the biggest financial fraud has been committed by a Jew (Madoff), facilitated by an Orthodox Jew (Merkin), who preyed on wealthy Jews and Jewish philanthropies (Yeshiva U, Orthodox day schools, Jewish Federations, Hadassah, etc), and that the U.S. Attorney General, an observant Jew, had to recuse himself because his synagogue was a victim. 

Regards,

The bad news:  You're out $50-billion.  The good news:  You've made it in this country. 

2008 was indeed one for the record books.

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.

What's Your Attrition Rate Lately?

An unspoken, and certainly uncelebrated, aspect of the law firm associate personnel model is built-in attrition. "Built-in" can have two traditional meanings, and one new one:

• Traditional A: They wash out of their own accord, because of a variety of factors:
  • they've paid off their student loans, and so the music for the dance they signed up for in their own minds has ended;
  • ambitious as they thought they were for partnership, the hours are more than they bargained for (and partnership would only be more of the same--the famous "pie-eating contest where the reward is more pie");
  • they basically like it, but find they don't have true passion for it, and contrasted to those who do, they'll lose;
  • they realize that the years of key family formation coincide with the years to partnership and they choose the family track.
• Traditional B: They're not cutting it and they're excused.
• New Meaning: There has been zero attrition.

Welcome to the new reality of attrition. There isn't any. I was recently talking with the Chair of a firm that would normally experience the departures of 30 or 40 associates over a typical six months. For the past six months? Zero: Not one. The concept of "built-in" attrition is suddenly broken.

So: What to do?

First, one can simply acknowledge, from an economic and a human perspective, that this is entirely understandable.

Warren Buffett likes to say that Aesop was a poor economist because the question of whether a bird in the hand is worth two in the bush depends on when the two will be delivered and what one's discount rate is in the interim. But one thing we can say with certainty today is that a job in the hand is next to priceless. So much for starry-eyed visions of ditching the law firm to join the hedge fund or the private equity firm.

But the question remains: What are you going to do about it?

Logically, you can attack this with how you handle three pools of talent:

• Your investments in summer associate and first-year hiring;
• The level of your interest in the lateral associate market; and
• What you do about your incumbent (and non-attriting) associates.

Easiest is to alter your policy towards lateral associates: Go from choosy to hyper-picky. Only those with spectacular credentials in desperately needed practice areas get even a second look.

The intersection of summer and first-year hiring, and the ranks of your incumbents, is where it gets interesting. A rational view is that your 3rd through 6th years (say) are by and large known quantities, trained and raised in your firm to your standards and liking, and that excusing any of them in order to make room for fresh-faced question marks who are, not incidentally, very difficult to charge out to clients in this environment, is borderline lunatic behavior. You are demonstrating disloyalty to those who have survived at least the first few rounds of their 15-round bout, to make a largely uninformed bet on raw clay.

I beg to differ.

We've all read ad nauseum about the stunning virtues of just-in-time delivery in manufacturing supply-chain land. Our industry is the polar opposite.

Our "supply chain" (associate talent) is three to six to ten years long, depending on where you deem it reasonable to draw the start and finish lines. That is to say, it takes that span of years to take a human being from potential-lawyer-in-essence to actual, performing contributor to clients and the firm.

The relevance of this to today's personnel challenge, I submit, is that you cannot introduce a gap into that supply chain. You need to be in the business of continually recruiting new talent, in order to feed the continually moving production line of senior to mid-level to junior staff needed to manage cases and transactions. You cannot, in other words, inflict on your own firm the equivalent of a "lost generation."

So counter-intuitive as it may seem, I recommend continuing to feed the associate pipeline from the start, summer associates and first-year hires, even at the cost of some mid-year enforced "attrition." Aside from what I believe to be sound long-term reasons to continue investing in the firm's future in this way, there are as well both an abstract and a prudential argument for same.

The "abstract," or logical, reason to keep recruiting new talent is that some of it is bound to be better than your existing talent. It simply has to be the case. (If you think every single lawyer in your associate ranks is the best they could possibly be, stop reading now.) You may be satisfied with Bob 3rd-year or Emily 4th-year right now, but how do you know they're as good as Dave 1st-year or Melanie summer associate will be at their level?

When I spoke about your "supply chain," I wasn't speaking metaphorically. If clients are your demand, talent is your supply. Econ 101. Your "supply" (talent) is what you have to sell. You have few higher priorities than increasing the quality of that supply or, as a friend of mine likes to say, "enhancing the gene pool."

A prudential reason argues for the same continue-to-recruit policy: If your firm shuts down recruiting, be prepared for the market to have a long memory and for it to punish you when the good times return. (If you doubt this, recall that some firms were still suffering reputational dings for having laid off people after the dot-com meltdown half a dozen years later.)

Another reason to continue early-stage recruiting is the positive, optimistic, and confirming message it sends to your firm internally, to the marketplace, and to any other constituencies (potential clients?) whose opinion you value. Loud and clear, it says, "We are investing for the future, confident in the long-term value of our firm and what we provide to our clients."

Make no mistake about the power of this message in today's environment, when century-old firms are imploding and, as Jay Zimmerman, Chair of Bingham, recently put it: "We're starting to see a trend of people [changing] firms because they're not confident in the vision their current firm has of the future."

Now is not the time, in other words, to shut down the processes that feed your talent pool. Now is not the time to act as anything other than a vibrant, going concern. Now is in fact the chance to upgrade the "gene pool."

No voluntary attrition? I'm sorry to report that your business model depends on attrition, and attrition there must be.

Unless you'd prefer to reinvent the model entirely, in which case: We can talk.

In Search of Execution (And, Happy Thanksgiving)

Twenty-six years ago Tom Peters and Robert Waterman published In Search of Excellence, and to some extent the genre of writing for business managers hasn't been the same since.  If for no other reason, it's worth taking a moment to revisit Peters' thoughts on the current state of the art of management, as the FT recently did in its weekly "Lunch with the FT" feature. 

But first, if you haven't read "Search," you might yet give it thought:

"When people think about the great management blockbusters, this is the text they have in mind. Search made the business book news. It has sold more than 10m copies and is still the model to which many business authors – whether they realise it or not – aspire. It also launched Peters on the path to global, jet-setting guru-dom."

Peters himself, however, will have none of his elevation to "guru:"

Few, however, have criticised what he does for a living as ferociously as Peters himself. “I say to people, ‘You got a bad deal, paying money to see me,’” he tells me. “I have utterly nothing new to say. I am simply going to remind you of what you’ve known since the age of 22 and in the heat of battle you forgot. You’d have to be one of those television preachers to believe that you’re going to work with a group of 500 people and change their lives. First of all, most of them agree with you. You’re not going to pay £1,000 [a head] to go and see someone if you think the guy’s a jerk."

Self-effacing as he may be, Peters has some deeply contrarian opinions.  For starters, don't kid yourself that you have it harder than your predecessors or that 21st-Century life is markedly more complex than things were in the past:

Is management getting harder? “No,” he replies firmly – and in defiance of the conventional wisdom. But what about all that new technology, the end of deference, the increased pace of life, and the heightened expectations of employees? Doesn’t that all make management harder?

On the whole, Peters thinks not. We exaggerate the extent of change, he feels. It is the arrogance of modernity to believe that we face unique and unprecedented challenges.   [Putting it in perspective,] my mom died two years ago a month short of her 96th birthday, which means that she lived through the arrival of long-distance telephones, automobiles, airplanes, jet airplanes, a man on the Moon, the great Depression, world war one, world war two, the cold war, Vietnam, Iraq one, Iraq two, [so don't kid yourself].

I beg to differ.  I believe the complexities of the challenges facing law firms today actually are unprecedented.  Here's a very short bill of particulars:

• No longer are all your partners within one timezone, let alone one zipcode. 
• Clients are more sophisticated (read: more demanding). 
• The war for talent, both raw recruits and laterals, has never been more intense. 
• Technology, a major blessing but with a correlative curse, has pushed "work/life balance" to the breaking point for many individuals.
• Transparency of financial performance, and pressure for ever-escalating numbers, seems to reach new annual highs.
• And perhaps putting a nice exclamation point on our landscape, Gary Hamel, merely "the world's most influential business thinker" according to The Wall Street Journal, has pithily described the world today as "less benign" than ever.

But speaking of war, which we were a moment ago, Peters served two tours of duty in Vietnam as a combat engineer building bridges for the Marines, and in a revealing passage, he says that much of what he learned about management came from the diametrically opposed styles of his two commanding officers.

I’m not exaggerating but I really spent the next 40 years of my life writing about Dick Anderson. He was a guy who believed that young men aged 23 needed a chance to express themselves. He believed that [writing] reports was incidental but that building stuff for your customers, typically the Marine Corps, was what you were there for.

“On tour two I had a naval academy graduate who would rather have produced an excellent report about things we hadn’t built than a lousy report about things we had. One guy wanted you to do something, the other guy wanted you to write reports. It was the best management training that one could possibly have had. Do what Dick did and avoid what Dan did – there’s the book ... it’s a very short book!”

What strikes me as most revealing about this remark is that it has nothing to do with strategy, it has entirely to do with execution.  And this from a pair of McKinsey consultants (Waterman, his co-author, being the other).

Peters confirms which side of the strategy/execution chalkline  he's on:

[T]he book did not have an easy birth. Its breezy tone did not play well with earnest colleagues at The Firm, as its authors were to find out. “There’s no way to describe the viciousness with which Bob and I were attacked within McKinsey,” Peters says. “This was not the Holy Writ. It was the intellectual challenge to what McKinsey stood for at the time.

“To some extent what Waterman and I were looking at was the business of ‘execution’, and execution is fundamentally a management thing. We were saying, ‘If you can execute well, it doesn’t matter what the hell the strategy is. The doing is what counts.’ But this was when ‘strategy’ was at its apex. We were pushing back."

Peters subscribes with a vengeance to school of relentless execution, and also to the not-inconsequential  role of luck.  He ironically describes his own good fortune:  “I was born in 1942, in the US. I was protestant. I had relatively intelligent parents and I was white – that’s the first 99.9 per cent of it. Hard work may have done the rest."  And "Search" itself?  "A decent book with perfect timing."

In other words, try hard and then try some more.  Many many things may not be within your control—today seemingly more than ever, Peters' protestations to the contrary notwithstanding—but one thing is within your control:  How hard you work and how much you  get done. 

Having the energy, the imagination, and the sheer intellect to tackle today's escalating challenges—with, I should mention, impeccable integrity—is perhaps the single greatest thing we have to be thankful for today.

"Globalization of the Legal Profession" Conference at Harvard Law

I'll be attending the "Globalization of the Legal Profession" conference at Harvard Law School this Friday (21 November), put on by HLS' Program on the Legal Profession.  Here's the  agenda, with some notables on the program including a keynote by Ben Heineman, and commentary across four panels from many other recognizable names such as:

• Stephen Denyer, International Development Partner of Allen & Overy;
• Prof. Marc Galanter of Wisconsin;
• Dean Elena Kagan of HLS;
• Peter Kalis, Chairman and Global Managing Partner of K&L/Gates;
• Prof. Ashish Nanda of HLS;
• Prof. Carole Silver of Georgetown; and
• Prof. David Wilkins of HLS.

Here's a brief description of the program:

Legal practice historically has been a largely parochial endeavor.  One need look no further than the complex debate within the United States about multi-jurisdictional practice between states (let alone questions of foreign lawyers practicing within the US) to see that the inherent complexities of the emerging global bar extend far beyond fitness and character to practice law.

In an age of rapid globalization, this is no longer merely the academic issue it might have been even a decade ago.  The largest law firms now span the globe, with thousands of lawyers carrying the banner of a single firm, yet residing in geographically diverse offices and practicing law in numerous states. [...]

What can we do - as international scholars, educators, and practitioners - to adapt to the rapidly-changing economic, social and political environment and prepare the next generation of lawyers - domestic and international - to meet the challenges that globalization will continue to present?

I'll be staying Thursday night at the Inn at Harvard.  If any of you will be there and you want to look me up, don't be shy.

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."

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.

"Clients Are Extraordinarily Understanding"

Today's Wall Street Journal profiles H. Rodgin "Rodge" Cohen, Chairman of Sullivan & Cromwell. 

Here at "Adam Smith, Esq.," we're not into gossip and we're not into profiling celebrities (well, celebrities in our world, anyway) for the sake of same—unlike some sites doubtless familiar to you.

However, the roster of high-profile firms Cohen has represented just in the past few weeks is stunning, including AIG, Barclays, Fannie Mae, Goldman Sachs, Lehman Brothers, JP Morgan Chase, and Wachovia.  According to this creative graphic from the NYT's "DealBook," Cohen was tied to more rescues in the past couple of months than anyone else save Hank Paulson, Ben Bernanke, and Tim Geithner, President of the New York Fed.

If you're keeping score at home, Cohen scores connections to six deals; Richard Beattie at Simpson Thacher, Edward Herlihy at Wachtell, and Brad Karp at Paul Weiss tie for second (among lawyers) with three apiece; and Donald Bernstein at Davis Polk and Harvey Miller at Weil Gotshal tie for third with two apiece.

But that's not why I'm writing about Rodge Cohen.

I'm writing about him because of this observation:

Mr. Cohen's immersion in the banking system also has at times put him in a difficult position. As he jumps from one client to the next, it is sometimes hard to tell whom he may be representing at a given moment.

In mid-September, Mr. Cohen represented Wachovia in its preliminary merger talks with Morgan Stanley. Several days later, after those talks faltered, he advised Japanese bank Mitsubishi UFJ Financial Group as it negotiated a 21% stake in Morgan Stanley.

Mr. Cohen was counseling Lehman Brothers until it sought bankruptcy protection Sept. 15, and then pivoted to represent Barclays, which ended up buying the failed investment bank's U.S. operations. Late last month, as banks and private-equity firms rushed to examine WaMu's books, Mr. Cohen had to choose between four clients that wanted to hire him before settling on J.P. Morgan.

This foursquare raises the issue of conflicts, at a level of the game and an intensity of the stakes that we've rarely seen before. And Rodge Cohen's response is simple: While it's certainly true that "Sometimes you just have to pass" on assignments, he says, the far more telling remark is that most of his clients have "extraordinary understanding of the circumstances."

"Conflicts!" has often been raised as an objection to the increasing consolidation of the global legal marketplace. How could it be possible, this line of reasoning goes, that the Global 100 law firms could consolidate to (pick a number) the Global 5, the Global 10, or the Global 25, without running grossly afoul of conflicts?

Rodge Cohen has just given us our answer.

And the answer is slightly more nuanced than that "clients are extraordinarily understanding." It's what Jamie Dimon has to say elsewhere in the same article: "I don't think you can replace judgment and experience and he has both in great quantities."

Now we're getting closer to the issue. By all accounts, Rodge Cohen (and, yes, credit where due, his team at S&C) are the "go-to" people in banking crises like these. Why wouldn't the most sophisticated clients want to hire the most sophisticated team to go to bat for them?

This, by the way, is exactly the same phenomenon expressed with pellucid brevity in my favorite plaque of all of those dedicated to Central Park benches, which appears on one on the east side of the walk just north of the Zoo, donated by an anonymous but clearly once-needy client: "Stanley Arkin, 'The Man to Call.'"

So if Rodge Cohen is "the man to call" if you're AIG, Barclays, JP Morgan Chase, Lehman, etc., in these situations, where exactly is the "conflict?"

Clients don't perceive one, and I would like to ask what cramped, sclerotic, and antiquated view of what "professionalism" means could find one?

Let's go one better: In what other profession would going to the most qualified expert raise the hint of the shadow of the bizarre notion of "conflicts?"

If your firm needs a strategic management consultant, would you deem one who has dealt with similarly situated firms "conflicted?" If you need an orthopedic surgeon, would you go to anyone other than the most highly qualified and experienced in your metropolitan area? Rule out a banker who knows law firms inside out?

You get the point.

Clients are adults, and can by and large be trusted to know their self-interest best.

Are, then, the 19th-Century notions of "conflicts" a barrier to globalizing and consolidating law firms? If you want my view, it's that clients seek concentrated--not dispersed--expertise, and that deep and long-standing industry knowledge is precisely where competitive advantage comes from. This stands "conflicts" on its head, and says that clients seek depth, not shallowness.

Then again, if you don't want to take my word for it, ask AIG, Barclays, JP Morgan, et. al. Or just ask Rodge Cohen.

(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.

Heller Ehrman (1890-2008)

It's all over for Heller Ehrman.

One of the best single pieces of coverage comes from The San Francisco Chronicle.

Heller was founded in 1890, rode through the 1906 San Francisco earthquake (in the aftermath of which the nascent client Wells Fargo Bank set up a temporary headquarters at the home of founding partner Emanuel Heller), helped arrange financing for the Golden Gate Bridge, the Hoover Dam, and the Oakland Bay Bridge, and in more recent years took a pro bono case to the US Supreme Court that established the right of conscientious objection during the Vietnam War, took Levi Strauss public, and represented plaintiffs overturning California's same-sex marriage ban.

But it's over.

Here at "Adam Smith, Esq." we're not about sentimentality, not about pessimism, and not about optimism, but about realism. Heller's over. What can we learn?

We don't like to talk about it, none of us do, not me, not senior partners, not bankers or consultants to the industry, but the stark, glaring reality is that law firms are fragile institutions. Brobeck, Coudert, Heller, Shea & Gould, among the firms that didn't deserve it, and Finley Kumble and Myerson & Kuhn among the firms that did.  I could but won't go on. (Not to mention innumerable firms that were absorbed through merger in the nick of time to escape the guillotine.)

What went wrong?

Prefatory note: I don't have any inside information, but what follows is reading the tea leaves.

First of all, they should never have absorbed the Venture Law Group. It made no sense. Would it have made sense for VLG to be absorbed by another firm, perhaps Morrison & Foerster or Orrick? Perhaps, and of course we'll never know. But my instinct is that VLG was a sui generis creature that would never really fit within any law firm with a conventional legal industry business model. So Heller may have been ill-advised to take on the VLG group to begin with. Did this kill Heller? Of course not. Was it a strained fit from the beginning? Sure. And strained fits entail costs, economic and intangible.

Second, the Heller story should discredit, if more evidence or argumentation were needed, the notion of term limits for managing partners. Matthew Larrabee is of course the current, and final, managing partner, and Barry Levin was his immediate predecessor. What's wrong with term limits?,

Understand, as with the absorption of VLG, I'm not suggesting Barry could have saved the firm at this juncture any more than I'm suggesting Matt is responsible for its demise, but I'm strongly suggesting this:

• Your firm has a Chairman who is, by all accounts, widely respected inside and outside the firm;
• He has, as a matter of obligation to his Chairman responsibilities, let his practice go fallow, making him initially unproductive if he has to return to practice;
• The firm seems at the top of its game;
• There is no self-evident need to replace him;
• And you forcibly remove him anyway.

What sense does this make?  Why trade winning horses in mid-stream?

(Parenthetically, we are facing that same situation here in New York City as our term-limited Mayor Bloomberg will come to the end of his tenure on December 31, 2009, and everyone who is by self-anointment in line to stand for Mayor is, relatively speaking, a midget.)

Third, if you're in merger discussions at a moment of relative weakness, eschew hubris. Like to think that your firm is the firm that it was a decade ago or the firm that it could be a decade hence? Get over it. You're the firm you are today. So is your potential merger partner, and they might not be who you used to think they were.

I started this column by saying that I'm not an optimist and I'm not a pessimist, but that I'm a realist. I partly lied.

I am a realist, but I'm also an optimist, and I never have been and never will be a pessimist. You have the right to be optimistic about your firm, in merger talks or otherwise. More strongly: You have the obligation to be an optimist about your firm.

Fourth, fragility, again.

"Our assets go down in the elevator every night."

Take that bromide seriously.

You must give people a persuasive reason to come back "home" every Monday morning.

Make them believe in the ongoing vision of a vibrant institution, a living firm where they can make a contribution in their own way, where they have a voice, where they can matter, where they are part of a team, where there are new mountains to conquer and new clients to be won, new legal innovations to be created with your firm's imprimatur on them, new dimensions of professional development which you can create and with which you can inspire and energize your associates, new, heartfelt, admirable and groundbreaking commitments to pro bono, new, clear-eyed and profound commitments to client service and client relationships, new and innovative uses of technology to deliver cost-effective services clients increasingly will demand while at the same time sparing your associates scut-work. New, new, new.

Those are the things that will inspire people to come back on Monday.

Back to Heller.

What finally went wrong?

It's the same phenomenon, actually, that we've seen on Wall Street in the last few weeks: A failure of confidence. There doesn't need to be anything wrong with Heller, or Morgan Stanley, Goldman Sachs, or Merrill Lynch, for people and the market at large to perceive there's something wrong with any of those firms. It's the run on the bank mentality.

 JP Morgan put the bond between credit and character most memorably in the Congressional "Pujo Hearings" of 1912:

Samuel Untermeyer: Is not commercial credit based primarily upon money or property?
Morgan: No sir. The first thing is character.
Untermeyer: Before money or property?
Morgan: Before money or anything else. Money cannot buy character. A man I do not trust could not get money from me on all the bonds of Christendom.

In law firm land, this is how the breakdown of credibility (the "character" of the firm) goes:

• A few key partners leave
• Taking a few key clients with them
• Which makes other partners wonder
• And start looking around
• Finding, in this very liquid lateral partner market, ample opportunities
• Which some take advantage of
• Taking away more clients
• Making more partners, and associates connected to them, thinking about the door
• Leaving only the least mobile people with the smallest books of business at the firm
• And the vicious cycle has kicked in, with almost no meaningful chance of its being reversed.

The curtains come down and the lights go out when the abrupt exodus of partners, clients, and erosion of the revenue base, occasion breaches of bank lending covenants and a shut-off of credit.

Fragile institutions? More than a century old, and with north of $500-million in revenue?

Shhhhhh. We promise not to mention it again.

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.

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.

IQ Is A Commodity: Now What?

More futile ink has been spilled on the issue of "leadership" than, I would wager, any other topic in the managerial literature.

But the topic is irresistible.

Why?

Because deny it as you might, leadership matters. It consistently distinguishes the leading firms from the "chasing pack," it transforms firms over timeframes as short as a decade (yes, this is short), it destroys some firms in periods as short as a few years, and it leaves a gaping and almost unanswerable hole when an incumbent, powerful, visionary leader steps down.

Daniel Goleman, whose title is the business-card-filling Co-chairman of the Consortium for Research on Emotional Intelligence in Organizations (based at Rutgers University’s Graduate School of Applied and Professional Psychology), and who is the author of Social Intelligence: The New Science of Human Relationships (Bantam, 2006), has a new article out on Harvard Business Review about "Social Intelligence and the Biology of Leadership." Here's the kickoff:

In 1998 one of us, Daniel Goleman, published in these pages his first article on emotional intelligence and leadership. The response to “What Makes a Leader?” was enthusiastic. People throughout and beyond the business community started talking about the vital role that empathy and self-knowledge play in effective leadership. The concept of emotional intelligence continues to occupy a prominent space in the leadership literature and in everyday coaching practices. But in the past five years, research in the emerging field of social neuroscience—the study of what happens in the brain while people interact—is beginning to reveal subtle new truths about what makes a good leader.

The salient discovery is that certain things leaders do—specifically, exhibit empathy and become attuned to others’ moods—literally affect both their own brain chemistry and that of their followers.

What we have recently learned is that it's not just "leadership" in the abstract, but that there are neurological bases to what makes people respond:

Perhaps the most stunning recent discovery in behavioral neuroscience is the identification of mirror neurons in widely dispersed areas of the brain. Italian neuroscientists found them by accident while monitoring a particular cell in a monkey’s brain that fired only when the monkey raised its arm.

One day a lab assistant lifted an ice cream cone to his own mouth and triggered a reaction in the monkey’s cell. It was the first evidence that the brain is peppered with neurons that mimic, or mirror, what another being does.

This previously unknown class of brain cells operates as neural Wi-Fi, allowing us to navigate our social world. When we consciously or unconsciously detect someone else’s emotions through their actions, our mirror neurons reproduce those emotions. Collectively, these neurons create an instant sense of shared experience.

Mirror neurons have particular importance in organizations, because leaders’ emotions and actions prompt followers to mirror those feelings and deeds. The effects of activating neural circuitry in followers’ brains can be very powerful.

In a recent study, our colleague Marie Dasborough observed two groups: One received negative performance feedback accompanied by positive emotional signals—namely, nods and smiles; the other was given positive feedback that was delivered critically, with frowns and narrowed eyes.

In subsequent interviews conducted to compare the emotional states of the two groups, the people who had received positive feedback accompanied by negative emotional signals reported feeling worse about their performance than did the participants who had received good-natured negative feedback. In effect, the delivery was more important than the message itself. And everybody knows that when people feel better, they perform better.

Forgive me for repeating this finding, but it's striking: Positive performance reviews with negative body language are perceived as negative, while negative performance reviews with postive body language are perceived as reinforcing.

Here you have the key to something powerful indeed. You can lead, out of bad news, into improved performance and optimism on the part of your team, by evincing positive energy. Is this all smoke and mirrors? I think not.

Faced with a seemingly implacable challenge? Acknowledge it frankly, explore it thoroughly, discuss it openly, but proceed with optimism, candor, and energy.  This is where the sometimes misused and even more often simply confused notion of "emotional intelligence" comes in. 

If human beings were all about "IQ" and not about "EQ," the performance review tests would have had a different outcome:  You are evaluated in negative terms so you feel bad, positive terms and you feel good, period.  But that's not what happened.  This tells us that "EQ" is a powerful factor in human relations indeed—with the power, in fact, to override what our old-fashioned "IQ" should be picking up on. 

Given its power, the question is how to develop your "emotional intelligence"--and whether that's even possible.

Now, the bad news.

Lawyers are constitutionally predisposed, and through the law school and law firm selection process this predilection is reinforced and redistilled, to be analytic and rigorous, emotionally distant and frankly unfeeling. We are not, by and large, emotionally intelligent.

Here's a Cliff's Notes case study of a Fortune 500 exec seemingly suffering the same syndrome (emphasis supplied):

When Cavallo [the psychologist conducting the study] presented this performance feedback as a wake-up call to Janice [the executive under study], she was of course shaken to discover that her job might be in danger. What upset her more, though, was the realization that she was not having her desired impact on other people.

Cavallo initiated coaching sessions in which Janice would describe notable successes and failures from her day. The more time Janice spent reviewing these incidents, the better she became at recognizing the difference between expressing an idea with conviction and acting like a pit bull.

She began to anticipate how people might react to her in a meeting or during a negative performance review; she rehearsed more-astute ways to present her opinions; and she developed a personal vision for change. Such mental preparation activates the social circuitry of the brain, strengthening the neural connections you need to act effectively; that’s why Olympic athletes put hundreds of hours into mental review of their moves.

At one point, Cavallo asked Janice to name a leader in her organization who had excellent social intelligence skills. Janice identified a veteran senior manager who was masterly both in the art of the critique and at expressing disagreement in meetings without damaging relationships.

So this has been a longish detour into "emotional intelligence," but what again does it have to do with leadership?

Permit me to offer a brief excerpt from an interview with Allen & Overy's new senior partner, David Morley, from their just-published Annual Report:

Q: If that’s what it takes to be global, what else does it take to be part of the elite?

David Morley: It takes high levels of client trust and the most talented and motivated people, working together as one firm.

Q: No one would disagree with that, but how does Allen & Overy achieve that?

David Morley: For both our clients and our people it is the quality of Allen & Overy’s relationships with them, and the levels of trust we establish between us, which are critical.

A relationship is personal and unique. It cannot be replicated by a competitor.

Isn't this the distillation of "emotional intelligence?" A relationship which is personal and cannot be replicated?

Sorry that law school and your law firm's recruiting process didn't select you for this, but I have news for you:  Get over it.

As our industry becomes more competitive, more global, more client-centric, more focused on the war for talent, the winners will increasingly be those with charisma, drive, energy, and yes, those with "emotional intelligence." 

Face it:  Everybody in sight in your firm has nothing to apologize for on the IQ front.  That won't work as a distinction, either for you personally in your career or for your firm as a whole on the competitive landscape of the 21st Century.  But EQ, precisely because it's been so consistently selected-against in our profession, just might do the trick.

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.

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. 

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.

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 if he's familiar with the industry structure I call the "hollow middle," where consumers gravitate toward either the high-end, high-quality providers, or the mass market, value providers, but not in meaningful numbers to any middle-market providers. This industry structure is remarkably common and seems to be stable—an "equilibrium," as economists would put it. For example (think about whether these don't represent your own buying patterns):

• Apparel (you want Armani or Gap)
• Cars (BMW, Lexus, Mercedes, or Toyota and Honda)
• Alcoholic beverages: Beer, wine, and liquor (fill in the blank)
• Groceries (Roquefort or a dozen eggs)
• Financial services (free checking for life or Bessemer Trust)
• Etc.

Jay thinks it may hold lessons for the legal industry. And we know where he wants Bingham to be.

I realize that I don’t have a firm grasp on Bingham’s international strategy, so I pose the question bluntly: “Tell me what it is.”

Jay says he likes to use the phrase “global relevance.” By that he means Bingham attempts to offer a practice focused on one of their core strengths, which is global restructuring and financial regulatory work. They strive to offer this in London, in Tokyo, and increasingly in Hong Kong. “There are a lot of opportunities out there which are very real—they’re just not opportunities for us.” In other words, Bingham doesn’t need to have a dozen offices across the EU, or any offices in mainland China until the financial systems there mature a bit more.

“What makes this strategy work for you?”

“Well, first of all, there are spinoff benefits to other practice areas, including litigation, corporate, and finance work itself. But secondly, we’re benefitting—as we have in other areas—from changes and even relative turmoil in the markets. I’ll give you an example. Ten years ago in London everything having to do with restructuring distressed companies or distressed assets primarily involved banks: They had extended the credit, their covenants that were being violated, and they were in the driver’s seat. Since we didn’t have old-line relationships with those banks, we didn’t have the connections necessary to attract that kind of work.
“But today lenders are all over the lot: They’re hedge funds, maybe private equity, other sources of capital, and bondholders are no longer passive—they’re aggressive. This gives us many points of entry, and they’re not all the traditional institutional players. As I’ve said before, it’s a different world, and that creates opportunity for us.”

And what of the future?

“We believe that as globalization accelerates and the world becomes a more complex place, there will be increasing demand—both in absolute terms and across geographical regions—for sophisticated restructuring capabilities, again, with all the financial regulatory authority interfacing that goes with it. We don’t think this practice focus is at any risk of obsolescence.”

Regular readers will know that one of the “evergreen” topics here at "Adam Smith, Esq." is what can possibly explain the fact that for the past 30 years essentially 50% of law school graduates have been women and for almost the same period of time only about 15% of BigLaw partners have been women. Neither number is budging. Why, I ask Jay, is this?

“As a father of two grown daughters, I think about this often, so I’d like to take some time to share my thoughts on this. The unfortunate reality of today is that you can’t defy gravity, but I am optimistic things will change.   By ‘you can’t defy gravity’ I mean that graduates of our elite law schools, for the most part, marry people with equally promising career prospects. So you have all these couples composed of a pair of high-achieving people starting off.

"When it comes time to have a family, it often makes economic sense—putting aside any emotional issues—for one spouse -- and it is usually the woman -- to focus on raising the kids. If you assume that many of these couples are in a position to live on one income, it’s probably not so surprising what we see happening in the workplace.

"This scenario is not unique to law firms. We need to do a better job as a society to ensure that there are equal opportunities for women to pursue their career ambitions -- and not be automatically placed in a position of choosing between starting a family or building a successful career. Ultimately what we can do, and I do believe that we do this at Bingham, is to provide the opportunity for all our lawyers -- men and women -- to succeed.

"For women, we encourage flex- and part-time schedules. It is not uncommon for us to elect women partners who are or have been part-time. We provide an environment where women are encouraged and are given every opportunity to succeed. Our efforts have not gone unnoticed internally as well as externally. We’re consistently noted for our positive and supportive work environment by FORTUNE in its ‘100 Best Places to Work For’ issue (for five straight years), and by Working Mother and several regional publications where we have offices."

As we're preparing to adjourn, Jay recommends to me a Harvard Business Review article that has been influential in his thinking, "Strategy as Active Waiting" [only available for a fee, but I've bought it and look for a column about it here soon]. The concept is essentially:

• Keep your priorities clear, but your roadmap fuzzy;
• Test the future; examine your assumptions; keep an eye on the horizon;
• While you're watching, keep the pressure on your day to day competitiveness; don't let up; and
• When you see an opportunity opening up, focus on it with urgency.

As I’m about to get up, Jay asks abruptly if I think leaders can be made.

“No, I don’t,” I say. “You can ‘make’ managers, and you can expose people with leadership potential to career-broadening environments (say, sending them to Hong Kong for 3 years), but no, I don’t believe you can ‘make’ a leader out of whole cloth.”
“I agree; nope, you can’t.” (I’m relieved to have provided the right answer.)

There's little doubt Jay has managed Bingham with urgency and focus. The challenge—scarcely unique to Bingham—is now maintaining their strategic focus as they expand internationally. And besting the hollow middle.

Is Your Firm Innovative? As Innovative as Pixar?

Does it strike you (as it does me) that the noise level surrounding "innovation" in law firms is reaching crescendo proportions? Just in the last few months, I've written about Legal OnRamp, Allen & Overy's mini-conference on innovation here in New York, Eversheds' 21st Century Law Firm survey, Altman Weil's Legal Transformation Study, different ways of measuring lawyers' quality, the FT's expanding its "Innovative Law Firms" awards to the US next year, whether GC's really want change, how J+J innovates, NovusLaw, Axiom Legal, the potential impact of the Legal Services Act in the UK, etc., etc. It's enough to make one's head hurt--or to make you cry "uncle" and decide to stick with the tried and true model of business as usual unless and until the roof falls in.

Tempting, indeed.

But part of the genius of capitalism is that standing still means losing ground. So if "innovation" is here to stay, perhaps it's time to take a page from a firm that's almost by definition a genius at innovation: Pixar.

Our good friends at McKinsey provide the helpful background in "Innovation Lessons from Pixar Director Brad Bird."

Let's start with where innovation comes from: Unexpected places (they cite the Wright Brothers, "bicycle mechanics," as the fathers of heavier-than-air flight, and the muscle-bound Pentagon as the inventor of the Internet). Bird, whose name may not be household, has won Academy Awards for best animated feature for The Incredibles and Ratatouille. What are some of the ingredients of "innovation," as he sees it?

"Bird discussed the importance, in his work, of pushing teams beyond their comfort zones, encouraging dissent, and building morale. He also explained the value of “black sheep”—restless contributors with unconventional ideas. Although stimulating the creativity of animators might seem very different from developing new product ideas or technology breakthroughs, Bird’s anecdotes should stir the imagination of innovation-minded executives in any industry."

An initial insight of Bird's is the peril of complacency. When he arrived at Pixar, they had recently released three animation blockbusters: Toy Story, A Bug's Life, and Toy Story 2. And Steve Jobs said "the only thing we're afraid of is complacency." Given a mandate to change things, Bird proposed what was to become The Incredibles. Bear with the slightly technical background to get to the organizational point:

"The Incredibles was everything that computer-generated animation had trouble doing. It had human characters, it had hair, it had water, it had fire, it had a massive number of sets. The creative heads were excited about the idea of the film, but once I showed story reels of exactly what I wanted, the technical teams turned white. They took one look and thought, “This will take ten years and cost $500 million. How are we possibly going to do this?”

"So I said, “Give us the black sheep. I want artists who are frustrated. I want the ones who have another way of doing things that nobody’s listening to. Give us all the guys who are probably headed out the door.” A lot of them were malcontents because they saw different ways of doing things, but there was little opportunity to try them, since the established way was working very, very well.

"We gave the black sheep a chance to prove their theories, and we changed the way a number of things are done here. For less money per minute than was spent on the previous film, Finding Nemo, we did a movie that had three times the number of sets and had everything that was hard to do. All this because the heads of Pixar gave us leave to try crazy ideas."

Around this time you're doubtless thinking, "Black sheep? Crazy ideas? Guys headed out the door? Hand the car keys to them?"

Bear with me.

One of Bird's key insights is that innovation can result from not having to hold every single aspect of every single project to the same (unattainable) degree of superbness. It's unattainable, you understand, on the assumption that you want to get the project out the door before it's overtaken by events. Here's how Bird puts it in Animation Land:

"There are purists in computer graphics who are brilliant but don’t have the urgency about budgets and scheduling that responsible filmmakers do. [...] I’d say, “Look, I don’t have to do the water through a computer simulation program. If we can’t get a program to work, I’m perfectly content to film a splash in a swimming pool and just composite the water in.” This absolutely horrified them. Or I’d say, “You can build a flying saucer, or you can take a pie plate and fling it across the screen. If the audience only sees the pie plate very briefly and you throw it just right, they will buy it as a flying saucer.”

"I never did film the pool splash or throw the pie plate, but talking this way helped everyone understand that we didn’t have to make something that would work from every angle. Not all shots are created equal. Certain shots need to be perfect, others need to be very good, and there are some that only need to be good enough to not break the spell."

Admit it: Isn't it true that "not all shots are created equal" and that not all aspects of a deal's documentation are created equal? What if "good enough to not break the spell" were deemed an appropriate quality level for some types of documentation?

But let's pursue innovation a bit more deeply. Where, again, should you look for it? Let's back away from the notion that it's the crazy people and explore what Bird is really saying:

"Q: Do angry people—malcontents, in your words—make for better innovation? Can you be innovative and also happy?

"A: I would say that involved people make for better innovation. Passionate involvement can make you happy, sometimes, and miserable other times. You want people to be involved and engaged. Involved people can be quiet, loud, or anything in-between—what they have in common is a restless, probing nature: “I want to get to the problem. There’s something I want to do.” If you had thermal glasses, you could see heat coming off them."

And of course there's another angle to motivation and involvement, which is morale. To paraphrase the bumper sticker about education, if you think building morale is expensive, try the cost of dispirited professionals:

"In my experience, the thing that has the most significant impact on a movie’s budget—but never shows up in a budget—is morale. If you have low morale, for every $1 you spend, you get about 25 cents of value. If you have high morale, for every $1 you spend, you get about $3 of value. Companies should pay much more attention to morale."

How do you help make all this happen?

I'm not a fan of architecture as a cure-all (which runs the risk of letting management think the space will do their work for them), but there is surely something to be said for throwing people into situations where they're likely to run into colleagues they wouldn't ordinarily encounter. You may draw the line at the bathrooms, and the atrium isn't feasible in Class A Capital Markets office space, but consider what you could learn from this:

"Then there’s our building. Steve Jobs basically designed this building. In the center, he created this big atrium area, which seems initially like a waste of space. The reason he did it was that everybody goes off and works in their individual areas. People who work on software code are here, people who animate are there, and people who do designs are over there. Steve put the mailboxes, the meetings rooms, the cafeteria, and, most insidiously and brilliantly, the bathrooms in the center—which initially drove us crazy—so that you run into everybody during the course of a day. He realized that when people run into each other, when they make eye contact, things happen. So he made it impossible for you not to run into the rest of the company."

Do your litigators run into your transactional people? Do your M&A people run into your project finance people? For heaven's sake,do paralegals run into partners?

All is not necessarily rosy on the innovation campaign front, of course: You can have innovation destroyers, starting with passive-aggressive people "who don't show their colors in the group but then get behind the scenes and peck away; they're poisonous."

Most importantly, the greatest innovators are the perpetual students, the people for whom curiosity is a disease, who can never be satisfied simply by duplicating what they did last time around. Bird talks about meeting some of the legendary Disney animators when he was a teenager:

"I met a lot of the great old master animators. Their worst animation was 1,000 times better than this new director’s best, yet they would get to the end of a film and say, “I just started to feel like I was understanding the character, and I want to go back and do the whole thing over. Can’t wait for next time!” They were masters of the form, but they had the attitude of a student. This guy taking over the studio had only done a few pieces of pretty good animation, and he was totally satisfied. Could not have been less inspiring."

So the question for your firm might be: Are your lawyers inspired to perpetually learn? Do they wish they could go back and do the deal again, litigate the case again, knowing what they know now? Are they passionate about applying what they've learned to the next client and the next engagement? Are they, essentially, never satisfied?

If so, you're on the road to having an innovative firm.

2011 Is Not Far Off

Richard Turnor, a partner in the Private Client Group at Allen & Overy, has penned for Managing Partner Magazine one of the more thoughtful pieces on the implications of the Legal Services Act in the UK.   In particular, he asks the same question I've been asking for some time: 

"After ‘Big Bang’, many, if not most, of the historic financial institutions in the City of London disappeared – replaced by the global giants that feature so prominently in today’s reports of turmoil in the financial markets. Will the Legal Services Act have a similar effect on the law firms of today?"

He begins by reviewing the reasons sophisticated firms might welcome outside investment—embracing the so-called "Alternative Business Structure" model—which include:

• Building their brand;
• Upgrading IT systems and infrastructure in order to compete more cost-effectively in existing markets;
• Financing the development of "know-how" (knowledge management to Yanks) systems and precedent banks;
• Covering investments in penetrating new markets, presumably either practice areas or geographies;
• Using the newly-created market for equity in the firm itself to incentivize non-lawyers in senior positions at the firm, or to buy out underperforming partners, or simply to let current partners monetize a portion of the discounted present value of their anticipated earnings stream.

Usefully, he provides a recap of the regulatory hurdles outside England and Wales.  They are numerous:

• At the moment, Australia is the only other jurisdiction that permits "ABS"'s.
• Scotland is beginning to consider amending its rules to conform them to those in England and Wales, "so as to enjoy a level playing field," but that process is far from complete.
• Spain permits up to 25% non-lawyer ownership since 2006.
• In France and the Netherlands, lawyers cannot share revenue with non-lawyers, making ABS's a non-starter there.
• Germany focuses more on regulation of individual lawyers than on firms' structures, so the jury may be out as to what's ultimately permissible there.
• And finally, of course:

"The US, in particular, would be a problem for international firms with branches in New York and New York lawyer partners. If non-lawyers were admitted as partners, every partner who was a New York lawyer would be in breach of the New York Code of Professional Responsibility and subject to disciplinary action."

Conflicts and client confidentiality, as well, will need to be seriously addressed.  At a bare minimum, there can be not the barest scintilla of a suggestion that outside investors could sway what matters a firm does or does accept, who it does or does not represent.  And client confidentiality must be maintained with the utmost punctilio.    In reality, I view thse problems as far more hypothetical (and even hallucinatory) than real:  What firm in its right mind would compromise on either of these counts one iota?  The damage to reputation would immediate and probably fatal.  Nor, I might add, do we see self-defeating debasing of standards in other industries where public companies are the norm:  Airlines have no interest in accidents and crashes for the same reason that pharmaceutical companies have no interest in adulterated drugs and Goldman Sachs has no interest in shading its advice post-IPO.

But Mr. Turnor rightly fingers a more telling consideration: 

"Firms will also need to convince their own lawyers, and the managers who may be partners from 2009, that an ABS can offer a career as rewarding as a career in a more traditional law firm – despite the fact that future profits will have to be shared with investors. Will the introduction of outside capital, and the opportunity to participate in the equity and make a market in shares, create value and earning power that counterbalances the diluted profit shares of the partners? Why not borrow from a bank instead?"

This, to me, is the heart of the economic debate that must be resolved before ABS's will be attractive to investors—and to existing partners and other stakeholders in conventional law firms. 

Put simply, if the outside capital cannot increase the total profits pie by more than the amount it will be withdrawing for a reasonable return on investment, then the entire exercise should be aborted before birth.  

Unfortunately, we have seen this in some professional service industries before.  Famously, in the 1980's, much of the New York-based advertising industry went public or was acquired by already-public firms.  The sad but typical experience was that senior executives and other favored insiders at the time of sale cashed out their interests to the tune of tens of millions of dollars, but the underlying economics of the ad agency business did not change. 

It still required virtuoso copywriters coming together with inspired art directors under the strategic direction of clear-eyed account management to identify and articulate each client's "unique selling proposition."  The fact that some who had the luck of fantastic timing and were able to exit at the top did not expand the agencies' war chest for recruiting top talent or wooing top accounts.  They were simply one-time monetizing events, with the vast majority of proceeds captured by exiting inside shareholders.

But fortunately, we know this model doesn't work and with luck we won't go down that path again.  (I hate to be the one to break the news to those of you in the audience who are 55—65 and at your career peaks in terms of "points" and so forth....)

Are we getting ahead of ourselves? Will the potential outside capital even be there? I have no doubt it will, and Turnor chimes in: "Lyceum Capital certainly thinks so, and has announced the appointment of a heavy weight team (Tony Williams, Richard Susskind and Paul Hewitt) to advise as it seeks to establish a position in the legal sector." [Disclosure: Tony Williams has been a friend for years and "Adam Smith, Esq." is in a strategic alliance with his consulting firm, Jomati, while I also Richard Susskind a friend.]

So let's assume the money is available, either from private equity or the public markets. What might we confidently predict will happen?

• Certainly, consolidation and potentially "roll-up's" of existing consumer and family-oriented legal services should take place, including practices such as:
  • Routine small scale real estate transactions;
  • Matrimonial law: Pre-nup's, divorces, child custody agreements, separation agreements;
  • Small business law: Incorporations, partnerships, shareholder resolutions, routine contracts, employment issues, general housekeeping;
  • Garden-variety employment disputes: Harassment, unfair terminations, discrimination;
  • Torts and negligence: Personal injury, car accidents, workmen's compensation, occupational hazards, slip and fall, etc.
  • Low-level criminal defense work: Misdemeanors, DWI, and so forth.
• Perhaps the introduction of legal services into the "product mix" of companies with large retail branch/distribution networks where legal advice is not too far afield from what they traditionally provide. Here, I doubt that "Tesco law" will be first (although Tesco is a consummately innovative organization so I could well be wrong). But what about banks or other financial services industry providers. Why wouldn't Bank of America (say) introduce BofA Law, or H&R Block, or Charles Schwab? They have trusted brand names and provide services inarguably relevant to legal advice, already.
• Essentially, any area of law where price, convenience, and baseline reliability are more important considerations than pedigree, impeccable quality, and bespoke services is a candidate for new entrants.

Beyond that?

I'm not an expert on corporate and partnership structures in the UK, but the good Mr. Turnor hypothesizes that outside investors could participate through more traditional law firms structured as LLP's permitting outside investors "in" in the form of a corporation which is a new member of the LLP. Assuming this is structurally correct (and it sounds eminently plausible to me), the next question is what dynamic influence their introduction into the LLP would cause.

Permit me to suggest a few:

• Pressure for more merit-based pay and performance evaluations.
• The expectation of senior non-lawyer staff that they'll be able to participate in the profits and growth of the firm.
• The inexorable introduction of more professional senior "C-suite" executives.
• Greater lateral mobility between firms (yes, I do mean even greater), especially for the newly empowered C-suite executives.
  • Meaning "the rich get richer"--this is part of capitalism's charm.

And overall, the changes will increase the tempo and decrease the cycle time of decisionmaking.

So what's to be done?

Most important of all, it's time to realize that we can't predict what will happen. The only failure that is inexcusable going forward is a failure of imagination. If law firms have never had meaningful access to capital on market terms (true), the challenge is not to think linearly from that world, but to think disruptively about what could happen--what business models could be invented--if capital access opened up. Will there be failures? To be sure. Successes? To be sure.

First, start thinking about these changes now. Once your competitors are not thinking about them but acting on them, the clock will have tolled midnight.

Second, take a hard, unblinking look at your firm's capabilities:

• Its internal strengths and weaknesses;
• Its external threats and opportunities;

and what your partners and partnership are capable of. (Let me add this counsel: Don't underestimate what people are capable of. "Stretch" goals often inspire inspiring behavior.)

But whatever you do, be hard-headed and realistic. Go it alone may not be an option, for example. That you should not take as a counsel of defeat. Rather, pursue that path (whatever path!) from a position of strength, not weakness.

One thing is certain: If "stay the course" seems a comfortable and time-tested strategic plan, that may be a complacent luxury you will soon be unable to afford.

How High Quality Are Your Lawyers? (How Can You Tell?)

This is a column about wringing our hands.

Our first text, from the Old Testament conventional debate, stems from today's WSJ story on "Axiom Legal," headlined Newcomer Law Firms Are Creating Niches with Blue-Chip Clients, discussing the business model of Axiom and other firms, which is to provide highly credentialed attorneys to corporate law departments on a contract or project basis, typically at savings of 25-50% vs. what an AmLaw 100 firm would charge.   Other components of the model are:

• The lawyers are recruited very very selectively—about 1 in 100 applicants to Axiom gets hired, according to its founder;
• Their pedigrees need to be gilt-edged, with backgrounds from places such as Cravath, Simpson Thacher, and Davis Polk;
• Work is typically performed directly at the client's, or the lawyer's home office, drastically cutting real estate overhead; and
• Axiom lawyers are provided benefits whether or not they're working on a particular engagement, but obviously only get paid for work performed.

Firms such as American Express, Cisco, Deutsche Bank, GE, Goldman Sachs, Morgan Stanley, Sun Microsystems, UBS, and others, have signed up and Axiom's revenue was $39-million 2007 and is "on pace" to be about $66-million this year.  So, yes, it's a real business, even if it will never be an existential threat to BigLaw in the complex deals or litigation.  Stuart Popham of Clifford Chance puts it nicely:  "Clifford Chance has always been at the forefront of developments in the legal world and welcomes innovation, but does not see it as a threat, nor as a challenge."

So what's the problem?  What's the conventional wisdom about this?

For that, we go to the source for the voices of the anonymously-empowered cranky observers who comment over at the WSJ Law Blog.  Herewith a sampling from the piece covering the Axiom story:

• For all the prancing and hot air, they’re still just another temp agency peddling flesh that didn’t cut it on the most grueling track. An unfortunate and painful fact of life is that excellence in the performance of legal services can’t be delivered by dilettantes. People with “other interests” — whether it’s playing with their kids or writing an opera — may very well be healthier and more interesting people than those who wed their souls to the inhuman demands of private law practice. But they are not going to be as good lawyers. There is always a market somewhere for less-than-excellence at a discount price. Temp firms like this one serve it. But please, enough about the “special” quality of their inventory.
  
  
• It is fascinating that, yet again, the perception is voiced that unless one is willing to work ridiculously long hours and bill exorbitant rates, (not to mention in expensive suits and behind mahogany desks) that the resulting work product is not good. Says who?
  
  
• This [article] highlights a mindset in the legal market which consistently causes larger corporations to pay exorbitant premiums for legal services of questionable quality. However, it ignores that “pedigree” and large firm experience are not reliable indicia of quality touches on a demonstrable fact that is largely ignored by the legal market…

  That salient fact being that at most large law firms, in the first several years of practice, the only experience that associates receive is doing work that could be handled by a competent paralegal or secretary. Moreover, in large firms, the billable hour and marketing requirements generally mean that the amount of quality mentorship conducted between senior attorneys and those highly compensated young lawyers who are mostly engaged in doing the work of a clerk typist is minimal.

  By contrast, in a small firm environment, the working relationship between partners and associates tends to be very close, with ample opportunity for supervision and mentoring. Further, opportunities for all manner of legal tasks come to associates much more quickly. The natural consequence is that after six years of practice, an attorney whose lack of pedigree limited her options to small firms is likely to be a much more polished professional with significant amounts of meaningful experience in the actual practice of law. By comparison, after six years in a megafirm, the associate is likely to be paranoid, jittery and harried from the toxic work environment, while having very little meaningful experience in the actual practice of law.

• There certainly are “bet the ranch” matters out there that warrant elite law firms. But 99.99% of what big law firms deliver is overpriced. These guys have identified a nitch [sic: niche] that is waiting to be filled.
  
  
• Axiom’s model works if you assume all Axiom projects will have plenty of lead time for staffing, have discrete start up and wind down dates, will keep the lawyer fully utilized during the project term, won’t morph into additional projects, won’t have intermediate deadlines that require late nights or weekends and won’t require supervision or input from other practice areas. If this was realistic, no one would ever leave big law. It’s the lack of control that causes stress, and once you have all of these variables in play, it’s going to be the same no matter what sign is on the door.

What exactly is problem these commenters—and the existence of Axiom to begin with—are highlighting?

I submit it's an inability, or at least a failure, of clients to measure quality of legal services.  With no real handle on what's extraordinary work, what's acceptable work, and what's unacceptable work, clients buy the "proxy" of prestige firm, law school pedigree, and, yes, high hourly billing rate. 

Axiom is attempting to perform arbitrage on that market by promising the gilt-edged pedigree (erego the 1 in 100 hiring number, which sounds impressive regardless of its statistical integrity), without the prestige firm name and without the eye-opening hourly rates.  As an admirer on general principles of firms that try to find localized market failures and capitalize upon them, I am glad to see Axiom evidently successful and growing. 

On the other hand, it strikes me they have not addressed the core market information failure, which is clients' consistent and nearly universal inability to assay quality of their lawyers.

Back in February, Steven Pearlstein wrote a column called Failure in Need of a Theory in The Washington Post (online version now only available for $$), positing the following:

"I'm wondering if we need a new theory of relativity for economics, where the standard models are unable to explain a growing number of situations where highly competitive markets are delivering less-than-optimal results.
The recent credit bubble is one example of a very big market failure for which we all will pay a serious price. But other, smaller failures also come to mind.
Think of skyrocketing tuitions among elite colleges and universities that spend lavishly on winning sports teams, rock-climbing walls and scholarships for those who don't even need them, all to attract top students.
Or the runaway compensation for chief executives who would be willing to take the job for half of what they are being paid.
Or the ridiculous prices paid for "it" handbags, fancy watches or houses in the Hamptons.
How do we explain why cities are still tripping over themselves to offer subsidies for baseball stadiums and convention centers in the face of overwhelming evidence that these diminish economic efficiency and welfare rather than enhance them?
And how is it rational that first-year associates at top law firms are paid more than federal judges? ...  And how many law firms have sacrificed the quality of their work and the collegiality of their culture to improve their profit-per-partner, the all-important metric in the annual American Lawyer rankings?" [Emphasis supplied]

Mr. Pearlstein fingers the culprit as "relative competition:"

"One thread that runs through all these "market failures" is that they involve a kind of competition in which "winning" is more a relative concept than an absolute one -- that the goal is not so much to maximize profits, income or welfare, as economic models assume, but to beat the competitors. In the process, perfectly rational investors, businesses or consumers wind up doing things that are irrational, leaving them no better off than before.  ...  The desire for ever-bigger homes, ever-fancier gas grilles, ever-more powerful SUVs is based not on some absolute notion of what is good or sufficient, but rather on the relative basis of what everyone else has.  ...  [As] Chuck Prince, the former Citigroup chairman, who famously gave this explanation last July for why Citi was continuing to lend aggressively into what everyone could see was a credit bubble: "As long as the music is playing, you've got to get up and dance.""

Now we're getting somewhere.

AmLaw firms seeking to confirm their prestigious status (or aspiring thereto) cannot compromise on matching the "going rate" for associates, or on the pedigree of law schools they draw their partners and associates from, nor (once the overhead expenses associated with those decisions have been assumed) on their hourly rates.  They can't compromise not because it's purely rational homo economicus behavior:  No, the reason they can't compromise is because none of their peers is compromising.

But we still haven't broken the "quality" code.

Our second text, from The New Testament a Fortune 500 law department, tries to do just that.  In an email I received earlier this week from Jeff Carr, GC of FMC Technologies (granting me permission to share it, by the way), he writes:

"Bruce – interesting exchange on egos’s, capitalism and win ratios as opposed to P3 (profits per partner) data.  Here at FMC Technologies we maintain that the best and most effective way to approach this issue and to align divergent interests with performance and value is to use a performance based pay system.  Nearly 100% of our engagements are on one of two models.  The most simple, and the one that would in our view address your points as well as those of your interlocutor, is the “report card system.”  We directly tie compensation to evaluations – firms receive between 80% and 120% of the amount billed based on how they do on 6 criteria.  Our evaluation form and fee calculator is attached. 

We have over 1000 attorney evaluations in our own database and we are very disciplined in performing the evaluations and delivering the results to the firm – indeed we stack rank our firms with the other firms.  If you want to increase performance and customer satisfaction, all one needs to do is to unleash the competitive instinct of a bunch of smart, overachievers, tell them that they aren’t at the top of the heap compared to our other legal service providers!  Our experience with this system yields demonstrated results – firms are making more than 100% of their invoice (on average) and our total legal costs are static absolutely and down as a percentage of revenue.

If we in-house folks started to aggregate customer focused evaluation data, we would create a very powerful and very real assessment of attorney and firm capability, effectiveness and value."

Here's a screenshot of the evaluation form:

On a 1 to 5 score, from unacceptable through mediocre, good, and very good to excellent, the criteria are:

• Understood client's goals
• Expertise
• Efficiency
• Responsiveness
• Predictive accuracy (about budget and results); and
• Effectiveness.

Then there is the uber-question:  "Would you recommend that we use this attorney/firm for similar work in the future?"

But wait, there's more. 

In its one-page, plain English "Covenant with Counsel," FMC specifies additional conditions and expectations.  Among the more fascinating, FMC will:

• Organize and participate in “after-action” reviews at the conclusion of each matter to help us continuously improve performance
• Be flexible, accommodating and creative in dealing with potential conflict of interest issues that may arise
• Provide training opportunities for your associates through short term secondments or other creative arrangements
• Understand that this relationship is built on mutual trust and that by eschewing a “no stones unturned” approach, we accept some risk.

And the Firm will:

• Bill you fairly and understand that you seek neither education, elegance, new law, nor perfection unless these provide value consistent with your company’s objectives.
• We will always seek simple, effective solutions
• Seek to reduce our costs creatively and constantly and share those savings with  you while also increasing our profitability
• Not ask for blanket conflict waivers and be responsible to bring actual or potential direct, client or issue conflicts to your attention
• Exploit technology to our mutual benefit.

In other words, FMC establishes specific performance criteria for its outside firms, evaluates their adherence to those standards discipline, and rewards firms that excel (and punishes those that fall short) by specifying up front that the final fee may be from 80% to 120% of the estimate.  As Jeff summarizes (my emphasis):

"It's not rocket science, it just takes discipline.  If you pay for hours, you tend to buy hours regardless of quality and effectiveness.  If you reward performance, then your firms will perform."

Start thinking creatively (BigLaw and F500 firms, I'm talking to all of you) about what "quality" in legal services really means.

Enough with the hand-wringing already.

Lessons From Johnson + Johnson

Knowledge @ Wharton has an enlightening interview with William Weldon, CEO of Johnson + Johnson, on the challenges of leadership in a decentralized company.   You may think the scale of J&J (120,000 employees, $61-billion in revenue, operations in dozens upon dozens of countries) means there's no analog between what he does and what you do, but I think his insights into how you manage a fundamentally decentralized organization harbor valuable learning for law firms.  If you're inclined to agree, read on.

First, a word about the analogy between J&J and a large law firm—whether or not you're international.  Your offices, practice groups, and even individual client teams operate with a very high level of autonomy, certainly by the standards of corporate America.  That's why I think it instructive to listen to someone as thoughtful as Weldon talk about leadership in that context, where the sheer fact of J&J's over 200 operating companies means they'll be operating autonomously:  Even if he devoted a full day to each operating company, it would take him the entire year to cycle through all of them before starting over.  Is, then, running such an enormous organization fundamentally impossible or impracticable?  Not at all; he sees advantages to it.

"I think there are pluses and minuses to decentralized and centralized. I think J&J is probably the reference company for being decentralized. There are challenges to it, and that is you may not have as much control as you may have in a centralized company. But the good part of it is that you have wonderful leaders, you have great people that you have a lot of confidence and faith in and they run the businesses.

"If you look at Japan, for example, we have the local management running the companies. They understand the consumer, they understand the people they are dealing with and they understand the government and the needs in the marketplace. Whereas it's very hard to run it from the U.S. and to think that we would know enough to be able to do this. [...] But, with our credo and the value system that we work under, we feel very confident about our leadership and our management -- and you have to have trust and confidence in them.

"I think the other thing that decentralization does is that it gives you a tremendous opportunity to develop people. You give them a lot of opportunity to work in different areas, to work in smaller companies, to make mistakes and to ultimately move to larger companies."

There's much in here.  Listen again:

• You sacrifice control but you gain great people, who develop into leaders, assuming you have "a lot of confidence and faith in them."
• You get your operations closer to the ground, closer to the customer, and for that matter closer to the regulatory authorities.
• But—and this may be challenge #1 for law firm leaders—you have to be realistic about ceding control and realistic about people "making mistakes."  (Don't tell me you never made a mistake in all your career?)

And also listen to what he has to say about mistakes:

"The challenge really... I see it as a great benefit, rather than a challenge. This is because the problem with centralization is if one person makes one mistake, it can cripple the whole organization. This way, you've got wonderful people running businesses. You have to have confidence in them, but you let them run it -- and you don't have to worry about making that one big mistake."

In the current environment, haven't we seen firms that have made "one big mistake?"  Betting bigger and bigger on markets just as they were becoming frothy?   (Or, in the previous dot-com downturn, betting on Northern California at the top.)

Perhaps the supreme and ongoing challenge for J&J is maintaining the pace of innovation.  Law firms don't face this to the same degree, but I believe inventing new legal forms (new types of financing vehicles, for instance, or creative new covenants) is one of the few ways firms have to create an enduring impression in clients' minds that they are not only unlike their peer group but unlike their peer group in a most admirable and "unlawyerly" way:  They're legal entrepreneurs.

How does Weldon describe how J&J pursues innovation?

It starts with decentralization:  "Where decentralization helps in innovation is that it allows different people with different skills, different thoughts, to bring together different products and technologies to satisfy the unmet needs of patients or customers."  Not that it's without its challenges, and they are the familiar ones of expense (which is highly manageable if you believe in this), but more importantly the challenge of getting people to, even briefly, let go of the familiar (emphasis supplied):

"It's the ability to work across the boundaries that really brings true innovation, and is going to take some real breakthroughs and will bring real breakthroughs in the future. But, it also does take some coordination and some sacrifice from the individual. That is the toughest thing, getting people to get outside of the silos that they work in and work across the groups."

Yet isn't this precisely the way innovation works? The most famous legal innovation of the past couple of decades, Marty Lipton's poison pill, arose at the intersection of newfangled, gunslinging, hostile M&A and plain old Delaware corporate law.   Securitization (which will return—make no mistake) was initially a sort of weird child of banking regulatory law and bond indentures sprinkled with pixie dust.

What then might we do?

• Don't be afraid to set people free, even to the point of making mistakes. Even the most quality-obsessed companies in the world (Lexus, for example) recognize that defects are a fact of life.  "Zero defects" is a recipe for paralysis.  The question is not achieving zero but dealing constructively with defects that arise.
• Prod people to get out of their comfort zones and work—at least episodically—with other practice groups or other offices.  Barrels of ink have been spilled on how "Creative Companies" (IDEO, Apple, Google, et al.) ensure that employees run into people outside their group or function all the time—typically with something as simple as architectural design and layout of the offices.  Next time your firm is planning a move, you might interview a designer who has created spaces like these firms have.
• Finally, understand that letting people expand into their own leadership roles will only happen if they have a functioning ethical and professional autopilot.   Recall what Weldon said at the start of his conversation: 
  
  "[B]y being decentralized; what you do lose is control. But, with our credo and the value system that we work under, we feel very confident about our leadership and our management."

The key phrase is "with our credo and value system."  Is that something you can say with equal confidence about your firm?  The Johnson + Johnson Credo (crafted by Robert Wood Johnson in 1943 just before the firm went public) is a vibrant document today.   Whether or not your firm has anything similar written down, do your partners, associates, and staff live your firm's values?

Because if they don't, decentralization is not a workable option for you.

GC's May Be Complaining, But Do They Really Want Change?

Over at LegalOnRamp there's an interesting discussion underway about the extent to which GC's do—or don't—seek genuine innovation in the way BigLaw provides services.  I'm taking the liberty of republishing it here (with permission of Paul Lippe, the CEO of LegalOnRamp) because at the moment LegalOnRamp is invitation-only.

It was kicked off by Ron Friedmann:

General counsels complain about large law firms: too costly, bad service, and clueless about the clients’ businesses. After the failure of GC’s many attempts to fix the problem, regulation is surely the solution. 

This simple and easy idea struck me last week when I heard a panel of GCs address the Strategic Technology Forum in Lisbon, hosted by LegalWeek. Their anger at firms was palpable. CIOs have their own frustrations: few partners or clients use the innovative systems they create. The despair all around caused me to think about the market. Consider the many steps GCs have taken that have had no impact on outside counsel:

• Countless law departments have voted with their dollars, switching firms, and privately and publicly explaining their quest for better value. Yet large law firms refuse to budge.
• Rampant standardization has failed. The standard documents of ISDA (International Swaps and Derivatives Association, Inc.) is only one of hundreds of instances of clients coming together to simplify and standardize. Yet bills continue to mount.
• The Tyco arrangement with Eversheds, which introduces various metrics and carefully crafted payments to illicit [sic: elicit] particular law firm behavior (link to Legal Week article), is only one among many such agreements. No market impact.
• Law departments have invested heavily to create best practices, for example, how to manage outside counsel, checklists for transactions, empirical studies on reducing discovery costs, and regularly using risk analysis in litigation. Law firms ignore these well-document guidelines and every effort at enforcement.
• Law department frequent use of non-lawyers and lawyers in India has no affect.
• Large law firms have bid up the price of talent, shutting out the ability of law departments to hire.

Alarmed at large law firm recalcitrance, I consulted my economist friend Madam Smythe, who told me: “On first glance, the legal market looks competitive. The scores of large, global law firms with good reputations should not fool you. Once a company retains a firm, a mini-monopoly ensues; just one bite at the apple - then switching costs skyrocket. It’s diabolical. I’ve run the numbers: law firms are natural monopolies. They have too much market power, which they use artificially to raise rates and corner the market on talent.”

Out of my commiserations with the plight of the poor GC, suddenly, the solution emerged: regulation. Corporations should engage lobbyists to spur federal oversight of the monopolists. The lobbying cost is a small price to eliminate large law firm monopoly rents. Yes, GCs, who have tried every trick in the book, can finally rest - regulation will rescue them.

Now, Dear Reader, if you're inferring that the "modest proposal" title and Ron's reference to his mythical "economist friend Madam Smythe" mean the piece is tongue in cheek, I suggest you ask Ron.  But the substance of the GCs' anger, frustration, and resentment is something worth taking seriously, and the discussion that follows generally did just that.

David Johnson, a professor at New York Law School, chimed in next:

Ron Friedmann suggests in a recent blog post that large law firms should be regulated because they abuse some kind of "natural monopoly" power.

With all due respect to Ron, who often has interesting outside-the-box thoughts regarding the profession, and even though I'm not sure how serious he is, that's crazy talk.

It is not even good economics/antitrust analysis. Sure, switching costs may be high once a company gives a big chunk of business to a firm, but firms are always competing at the margins for new clients, so their practices are constrained by that competition. There is no way the government would be convinced that law firms gain whatever "power" they have other than through skill, foresight and industry. It is even unethical for a firm to leverage any power it has as a result of high switching costs into other markets.

Nonetheless, there may be a seed of an idea insofar as companies could come together to articulate some best practices compliance with which might be made a condition of entering into a new relationship with any firm. And there is no reason why every company has to bear the burden, alone, of "enforcing" such standards and monitoring compliance. So maybe there is a way for the client side of the market to collectively increase the costs to a law firm of "switching away" from adoption of some set of practices that companies generally agree should be followed.

That would be a different, and far more efficient, form of bringing some "regulation" to large law firm practices.

Paul Lippe then provides a schema around which to organize the discussion:

I understood Ron's post to be somewhat facetious in the spirit of Swift's essay http://en.wikipedia.org/wiki/A_Modest_Proposal, but it does raise an important point. I first became a GC in 1988, almost 20 years ago. There is little that was said in Portugal that is different from the critique offered in 1988. So, is it

A. The critique is invalid, the legal market works the way it should, and GCs should stop whining;
B. The critique is valid, things take a while, and now we'll see change;
C. The critique is valid, but the structure of the Legal market impedes change;
D. Regulation is the only answer; or
E Other.

Among others, I invite my friends Gillian Hadfield, Bruce MacEwan and Jordan Furlong to respond, and perhaps Gillian can share a little about her upcoming event(s)appropos of these issues.

Thanks Paul

Jordan Furlong, editor-in-chief of the Canadian Bar's chief publication, votes for Paul's option "C:"

Ron's Swiftian turn -- Bruce would appreciate the reference to "Madam Smythe" -- seems appropriate to the situation. Swift's satire was grounded in his very real outrage and frustration, and while the stakes aren't as high as in 18th-century London, I can appreciate that GCs must sometimes feel like giving up the fight in despair, powerless to make any progress towards more effective business relationships with their law firms.

But while hardly anyone would really endorse government intervention, that unlikely outcome might still prevail if firms don't watch themselves. Law firms are nowhere near as wealthy and influential as their biggest clients, and provoking or prolonging a fight with entities way above your weight class is foolish. Populist lawmakers + corporate campaign contributions + widespread anti-lawyer animus = a lethal combination. Lawyers receive a lot of protection from their status as unique, independent professionals who constitute a significant pillar of a free and democratic society. But if they operate less as professionals and more as complacent businesspeople in a rarefied marketplace, they court serious danger.

I think we're closest to position C on Paul's list, and fundamental structural obstacles invite equally fundamental intervention. But the legal profession still possesses, for now, the ability to reform itself and dictate more attractive terms for a new relationship with clients. I'm not terribly optimistic, though -- there's not much leadership on this point evident in the organized bar right now.

Gillian Hadfield, a professor of law and economics at USC, brings to bear the heavy artillery of competitive market analysis to argue that it's the very complexity of law—a condition created and maintained by lawyers—that is responsible for the "low level of competition:"

Several years ago I wrote an article that argued that the underlying structural feature that generates a low level of competition in law (both over price and product) is complexity. (This is in a Stanford law review article called The Price of Law available at my website https://works.bepress.com/ghadfield) Complexity creates specialization, ambiguity, difficulty judging and comparing legal quality etc. So the question becomes why does law stay so complex, indeed become increasingly complex over time?

Here I think the problem is the regulatory structure of legal markets--which are among the most heavily regulated in the economy. It's just that the regulation is supplied by lawyers themselves through bar associations and the judiciary. The complexity of law is attributable, I think, to the closed nature of the markets here: without the ability to form corporations, seek venture capital, attract innovators who have not been through the training process of lawyers, it is very hard for the market to spur the only real type of change that can reduce complexity and cost and that is innovation in the underlying dimensions of legal inputs.

Why do we need a rule to determine a contract dispute that takes 100 pages of appellate opinion to explain, for example? Why do we need millions of documents to resolve a patent dispute? Why do we need 400 page agreements to effect a transaction (to respond to the complexity of legal rulings real and anticipated?) These are the underlying dimensions of demand. The smart innovator in law, if they could exist, would figure out how to meet legal needs -- for assurance in a contract relationship or protection against risk re-allocation or assessment of liability exposure or ownership of a patent--with a more streamlined product. Until there's a return for innovation and pressure to innovate--because of the risk to established firms that their modus operandi is about to become obsolete--little is likely to change.

Next up is yours truly.  In an attempt to be even-handed, I decided to take a swipe both at the GCs (questioning the sincerity of their desire for innovation) and at the organized bar (which is such a target-rich environment that it was hardly any fun):

Taking Ron's "modest proposal" at face value, my reaction is that it's precisely regulation that's contributing to the problem: Regulation of lawyers by lawyers and for lawyers. What might shake things up is not Congress second-guessing how to protect the Fortune 500 and FTSE 100 corporations from themselves--with Congress' congenital and exquisite obliviousness to the law of unintended consequences--but removing the stranglehold of 51 state bar associations, bar examining authorities, and the ABA itself. Can anyone still say with a straight face that there is any remotely beneficial purpose to such requirements as ABA accreditation for law schools, transparent restraints on trade masquerading as "ethical" proscriptions (no sharing of profits with non-lawyers), and the medieval practice of determining which regulatory authority has jurisdiction over lawyers and firms based on brute force physical presence? Why can't law firms choose, as corporations can, to submit to Delaware or New York or California law and be done with it? What is the economic justification for the need to engage "local counsel?" Why aren't the ABA's Model Rules a per se antitrust violation? I could go on...

But I actually have a more subversive suggestion, which falls under "E. Other" in Paul's schema: I don't believe GC's really want things to change, for all their trashmouth game talk. GC's want their backsides protected by the imprimatur of the Magic Circle, the New York Elite, or the Skadden/Latham brand name. GC's don't want "good enough" quality; they want top-drawer quality.

And I submit this is not irrational. Legal fees as a percent of deal value (unless you're smaller than the attendees at the Portugal event) are typically not material compared to the i-bankers' fees or the opportunity and other costs of corporate personnel assigned to the deal. Do I think Gillian is wrong that 100 pages of appellate opinion interpreting a garden variety contract clause is idiotic? No, of course it is. But the answer is to eliminate regulation of the bar by the bar and watch a thousand flowers bloom.

Paul rejoins the conversation and introduces the new, and entirely pertinent and fitting, concepts of "quality" and "value:"

My learned friend Bruce makes some very compelling points about the consequences of lawyer self-regulation.

His argument about why GCs don't insist on change, while in many respects descriptively accurate, is rooted in a common fallacy: that spending more on legal services is the same as getting better quality.

Dollars spent on legal work is to quality as LSATs are to intelligence - a somewhat self-referential indicator, but largely of a limited type of the feature measured, and problematic in that it crowds out other definitions and metrics. So for sure if the primary good purchased from a law firm if the firm's reputation to shift accountability, then Bruce's argument is correct. But I'd be curious if anyone can come forth with any data to show that in fact (as opposed to in repute) more expensive law firms produce better results, e.g. can it be shown that the investment banks who had the largest losses on their mortgage portfolios were served by lower reputation law firms?

Once this conversation settles down, I will start a separate string (and perhaps a wiki to really pull something together)on what I consider the core issue: how can we develop a definition of VALUE in legal services that is meaningful and useful, and not simply measuring inputs like hours spent, diligence of lawyers, law school attended or reputation of the firm. With such a definition of value, I think we could expect that some lawyers' reputation and income would go up, but some would not.

b/t/w, I think Bruce's point about regulation is 100% correct, but his point about marginal pricing theory is not - no one pays the price for electricity or medical care or food or seatbelts or anything else equal to what the detriment would be if they didn't have it.

Barend Blonde, a legal consultant from Belgium, introduces the European perspective and casts a vote for "B" in Paul's schema::

From my purely European perspective, I find that you a are a bit quick in abandoning option B from Paul's list: Yes, things take a while.

The arguments I read are valid and exciting, but I think we shouldn't be blinded by the seminars we attend and the forums we visit. The GCs that visit the Lisbon Technology Forum are not your average GCs or and the GCs 'cruising the Ramp' are not 'standard'.

I admire GC of companies like Tyco and Cisco for what they are doing and their value can hardly be underestimated. But the truth is they are the scouts of a Mexican army that is still figuring out what to do. The average GC is still a conservative guardian of the hourly rate. The average GC is not thinking about how to use technology to put pressure on law firm services. The average GC is struggling with the implementation of a decent matter management system.

We just finished a poll among European inhouse counsel. We asked them to rank 10 priorities. 'Improving efficiency in outsourcing work to law firms' came out 7th, 'reducing costs' came out 8th. What keeps them awake? The professionalisation of their departments (internal brand, role, skills, IT) and compliance.

The legal market is a free market. Markets change when there is an urge to change. If the legal market doesn't change rapidly, it just means the sense of urgency is not there yet. Tyco, Cisco and you guys are slowly building it up. Keep up the good work!

Finally, I elaborate a bit on the thinking behind my suspicion that "GC's don't really want to change," by analogy to shopping at Tiffany's:

Paul's thoughts about quality and value are, as usual with Paul, intriguing, as well as a bit of a departure from where I was headed, so a small dose of clarification may be in order.

I violently agree that we lack sensible or compelling measures of the "quality" and the "value" of high-end legal services today. If the shocking durability of the billable hour teaches nothing else, it teaches that we are by and large at a loss to determine value (a/k/a price), since we are throwing up our hands at valuing the output and resorting to the blunt instrument of summing the costs of the inputs (with a profit margin built in, to be sure).

My point about the imprimatur of a brand name, or "quality," as Paul nicely puts it, may be a bit more subtle or at least a bit different than the implication that GC's will pay a price equal to the "detriment...if they didn't have it." My point was that having a Magic Circle or a New York Elite firm's name on your acquisition agreement or your IPO registration or your massive IP licensing deal has an in terrorem effect against challengers. It's like buying your diamond engagement ring at Tiffany's instead of on 47th Street. It may not actually be better quality, but it's perceived that way, and at some (I would suggest fairly self-aware) level that's precisely the bargain the buyer is striking.

That's what I meant by "GC's don't really want things to change." They want Tiffany to stay in business, and more importantly, to stay in business on the Tiffany business model--not the 47th Street business model.

Finally, although no one asked me, as an erstwhile student of industry structure and antitrust law, the high-end legal industry doesn't remotely resemble an industry susceptible to oligopolistic or cartel-like behavior. Even the Chambers league tables show pretty consistent turnover in who's up and who's down in M&A, debt and equity offerings, etc. Sure, many or all of the players are the usual suspects, but their individual market shares change rapidly and continually.

The floor is now yours:  Email me (bruce at adamsmithesq.com) with your observations.  And, if there are any GC's in the audience, it's high time to stop lurking and start speaking up. 

• law firm competency
• client satisfaction, and
• alignment of the firm's performance with the client's culture.

A Conversation with Allen Fagin

Last week I had the opportunity to sit down with Allen Fagin, Chairman of Proskauer Rose. Allen is Columbia BA summa cum laude, and Harvard Law JD cum laude at the same time he earned an MPP from Harvard's JFK School of Government. He's worked at Proskauer for his entire career, and comes from the Labor and Employment Law Department where he was co-Chair.

With Allen, I wanted to hear about the state of Proskauer, his views on the recent past and potential near-term future of the industry, and to explore what he thinks are important changes in our industry.

I started by noting that both he and his immediate predecessor as Chairman, Alan Jaffe, came from the employment department and that to many people Proskauer has a reputation first and foremost as an outstanding labor law firm.

"Our labor and employment practice is extraordinary," he responded, "with a truly world-class brand.  But that practice accounts for less than 20% of our lawyers and revenues.  What the market is now recognizing is all the other things we do equally well."

Allen made clear that a strategic priority for the firm is the growth of its corporate practice, which has seen its revenues increase by $100-million over the past three years. He also reminded me that only three firms in the recently released AmLaw 100 increased their Revenue per Lawyer (a favorite statistic of Allen's, as it is of mine) by more than 15%: Wachtell, Debevoise, and Proskauer (+16%). That increase was almost entirely accounted for by the corporate practice.

Allen said it point-blank: "The whole thrust of our growth has been to build out the corporate practice."

Does that explain your recent opening of a London office?

Yes, that was "following our clients." It's following the practice areas we have in some measure of strength here in New York that can be bolstered by a presence in London:

• private equity, hedge funds, and alternative investments in general;
• finance; and
• mid-market M&A.

What, I asked, was "mid-market" M&A? He replied with bemused candor that it's whatever people say it is, but roughly from deals valued at $100-million to $1-billion or more. Very much in the eye of the beholder.

Is M&A being driven more "strategically," by corporations interested in acquiring capability and integrating, today, as opposed to six months to a year ago when it was more about financial engineering? "Absolutely; and those who can pay cash are the ones where you know the deals will happen."

Proskauer recently opened an office in Sao Paolo, Brazil, I observe; what's that about?

"It's about our Latin America corporate practice; it's almost exclusively outbound work. We don't practice Brazilian law. At the moment it's a small office, and it will remain small, but we find it valuable to have boots on the ground down there." So there's money in Latin America? "Absolutely."

Switching gears a bit, I ask Allen to describe in his own words the "State of the Firm."

"It's healthy, strong, and growing. But don't take my word for it: We just reported our 16th year in a row of higher PPP, and last year [2007] our year-over-year increase in total revenue was +22% and our increase in PPP was +18%: RPL was +16%" [as noted].

Without prompting, Allen continued: "The real question is the same question that any firm that intends to stay in the serious group of 20 to 40 firms (maybe 40 is too high) that will be left standing when the dust settles: How do we ensure we're one of that group?"

And here's where Allen really began to warm to the topic of our conversation.

"There's a critical tension between balancing growth and development, on the one hand, as against stability and the maintenance of values, on the other. That might be my single biggest challenge as Chairman."

What are you proudest of, then, in your tenure as Chairman to date?

"I'm most proud of being able to see the firm grow without sacrificing our values." How do you do that? "It's a constant effort to communicate, of course, talking to everyone in the firm about what we're trying to accomplish in terms of marrying the past and the future."

"You know, you can read any number of articles in the legal press about law firms adopting a more corporate business model. But I'm old-fashioned. I believe law firms need to be partnerships. We need to be partnerships, but we need to do so without sacrificing efficiency, nimbleness, competitiveness, and a sense of collective destiny. This is part of the challenge."

I ask about a topic on which an enormous amount of ink has been spilled: The intertwined issues of associate attrition, the "war for talent," and the much bruited new expectations of Gen Y. "Is this really different," I ask, "than when you were an associate?"

"Yes, it's different; Gen Y is different. It's real." Allen observes that the number of law school graduates have increased perhaps 8% over the past decade, and that the number of top students from the top schools who want to go to the top firms has decreased. This double whammy explains, to him, in Econ 101 supply and demand terms, why associate salaries are as high as they are. [Editor's note: I thoroughly concur.]

Compounding this problem is that the cost of attrition--whatever it actually is, he says, implying healthy skepticism about the often quoted and glib numbers of two years worth of salary, $500,000, etc.--has most assuredly gone up. The only way to deal with it, he said, is through scrupulous attention: "It's a much more difficult retention problem, the issues are more nuanced, and it has made us all think more critically about this."

I ask if he thinks the classic recruiting model of hiring the top X% of students from the top Y law schools still makes sense, and he proceeds to outline Proskauer's and his own vision of what I have called "Associate Moneyball," wherein firms would attempt to determine what characteristics of law students, aside from class rank and name-brand of school, actually correlate with successful and enduring careers. He related the experiment of attempting to always hire the student who was first in the graduating class at Brooklyn Law School's night program: "Now that person, I have to believe, has fire in the belly. And after all, it's all to do with:

• intensity of effort;
• dedication to the quality of the work product;
• and caring for the client."

I cannot disagree.

Proskauer, I note, has a long history of contributing leaders to New York bar associations, and of pro bono work. Where, I ask, did that come from? (Here, Allen became especially animated and fervent.)

"History; it's imbued in our culture." The firm has a long tradition of public service, and it tends in a way to feed on itself. Someone who's chairman of a committee will recommend a colleague to be a member, and soon that colleague will become a more senior member, and so on and so on. But in terms of our pro bono program, we've really tried to formalize and institutionalize it in important ways:

• We have more meaningful partnerships with designated organizations in the community that we therefore get to know better.
• We've coordinated our firm-wide charitable giving program with the pro bono commitments we've made and with the targeted organizations; and
• We've expanded beyond the traditional bastion of pro bono work--litigation--to more transactional and corporate type work including, specifically, counseling on corporate governance.

What all this adds up to is that we get more associates involved, and involved at a higher level of intensity. We can, as it were, "adopt" community organizations and this gives lawyers across all our practice groups the opportunity to serve.

Finally, at an organizational/executional level, we have converted "pro bono" into a practice group in its own right, just like any other, which means that it comes with all the operational and institutional procedures of any other practice group--things like the assignments system, looking to fill holes in experience, and so forth.

As I said, Allen is fervent on this topic.

Also noteworthy is that prominently displayed on their reception area coffee tables are copies of their report on pro bono work, "Break/Through: 2007 Pro Bono Review," a handsome and high-quality brochure with a foreword by Allen that opens with the words, "For many people who face complex legal challenges, it's difficult even to get a break..." Interestingly, the typical self-congratulatory firm annual reports were nowhere to be seen.

Have you policed your reception area lately?

But I digress.

What would your advice be to new associates, I asked.

"It's too late!" (laughing out loud).

Well, then, to college grads contemplating law school?

"Obviously, friends ask me to talk to their kids all the time, and what I say is to talk to as many young associates as you can, so that you really, deeply, understand what you're getting into."

My final question has to do with the unexpected.

What, looking back over the past 10 or 15 years, has been the biggest surprise to you?

Allen thinks, visibly, and there is a long silence. Finally he says:

"The resilience of the billable hour. Ten years ago I would have told you it would be dead, today I will tell you it should be dead, and ten years from now I imagine I'll be telling you it should be dead. It's inexplicable."

"But second [and this is entirely unprompted], equating the compensation of attorneys with their year of graduation from law school." Do you mean '"associate lockstep?" Hasn't Howrey experimented with changing that? "Yes, I do mean 'associate lockstep,' but it's so hard to get away from it." He elaborates that it makes no sense to clients, it doesn't resemble what's done in any other remotely modern industry, and it's intrinsically at odds with the meritocracy that elite law firms hold themselves out to be.

And with that we adjourned.

Broadly speaking (gross generalization coming up), managing partners are selected for the force of their personality or the force of their intellect. True, there are the extraordinarily gifted few who combine both, but they're as rare as Lincolns among American Presidents.

Allen is understated, low-key, speaks very softly, and is one of the most truly thoughtful people I've recently met. Lawyers, we of all people, should appreciate the supreme value of analytic rigor and acuity. In fact, the intensity of his thoughtfulness borders on the shocking. We long ago got used to not expecting thoughtfulness in public discourse, and that expectation may, alas, be infiltrating our expectations in private discourse. A few minutes with Allen would disabuse you of your cynicism.

"Innovation in Legal Services" Sponsored by Allen & Overy

I was invited to attend a presentation on "Innovation in Legal Service Delivery" last Wednesday at Allen & Overy's New York offices, where the conversation was kicked off by four speakers:

• Ward Bower of Altman-Weil discussing their Legal Transformation Study;
• Rosemary Martin, newly minted General Counsel of the Practical Law Company and as of two weeks ago General Counsel of Reuters;
• Paul Lippe, CEO of Legal OnRamp; and
• Michael Will, partner, Derivative Services LLP.

Unfortunately, the only public coverage the event has gotten to date focused on the common wisdom that law firms are allergic to innovation ("Innovate or Die Still the Message to Law Firms" is the headline of the piece), that they're "conservative to a fault," and "slow to embrace change."

What's wrong with that?  Simply that it misconstrued not only the creative and diverse approaches of the four panelists on the program, but most importantly did not comment upon or reveal the tonality and purpose of the event, which were exploratory, open-minded, inquiring, and refreshingly prepared to admit the speakers (and the questioners) didn't have all the answers.

Where to start? 

I suppose as good a place as any is to go right back to the mainstream media, where, it bears reminding, Allen & Overy won the Financial Times annual award last year as "The law's best and boldest innovator."  (I understand this FT competition will be broadening its reach to include a separate US category this year; that should be interesting....)

Another starting place might be to reflect on the conversation about the billable hour, regular scourge of those evangelizing for innovation.  What struck me about this part of the conversation was that the law firms seemed weirdly less wed to it than the clients.  After all, how is a GC necessarily to defend a bill to the CFO for $850,000 "for services rendered."  One imagines the conversation if it went well:  "Why not $750,000?!"  And if it went badly:  "You were trying to save money?!  This was a million-dollar-plus case!"  But on the billable hour model, with activities itemized down to the 1/10th of an hour for the paralegals at the document warehouse, the GC is bulletproof.  "Well, yes, you see, but the work was actually done, to the tune of $902,347.25"

Yet another might be to look at the actual framework of the Altman-Weil sponsored Legal Transformation Study, which looks out to the year 2020 and projects four potential scenarios, based on your view of whether legal service delivery will become more aggregated or more disaggregated, and on whether regulation will become heavier and more intense or looser and more laissez-faire.  This produces the following 2 x 2 matrix:

The dimensions are "aggregated/disaggregated" across the horizontal axis from left to right, and "highly regulated/laissez faire" down the vertical axis from top to bottom. 

None of these four scenarios is meant to represent an exclusive view of the truth, as combinations and permutations may be (according to your view) the most realistic.  Similarly, none is meant as a "prediction."  Rather, scenarios are tools for critical thinking about how your firm (your practice group, your office, your own book of business) may fare in the future depending on what you think is plausible as the industry evolves.  Here are the four quadrants in summary form:

• Mega Mania
  • Consolidation
  • A conflicts-prone world
  • A traditional model dominated by giants
  • Client loyalty is low, frustration high
• Expertopia
  • Rise in litigation
  • Expertise at a premium
  • Numerous niche players driven by regulatory breakup of large providers
• E-Marketplace
  • Major economic downturn leads to deregulation and harmonization to spur growth
  • Flurry of new providers
  • Commoditzation
• Techno-Law
  • Peaceful world dominated by desire to enhance trade relations
  • Harmonious regulatory systems offering "lawyers in a box"
  • Clients demanding interoperable technology to pare costs
  • Global sourcing

Again, none of these, nor all of them together, is meant to be a blueprint for the future; they are meant to spur reflection, analysis, and strategic agility and nimbleness.  Take issue with them as you will, but do not take issue with the reality that the status quo is not an option.

Meanwhile, Rosemary of the Practical Law Company talked about her background of a dozen years at Rowe & Mawe followed by nearly a dozen more at Reuters, and her conviction that outfits such as the Practical Law Company are preparing the way for how law will be practiced in the 21st Century.  Hers was not a message of "innovate or die," it was more a message of, "look around and see how the other departments of corporations have been transformed.  And dare to think you might take a page from their books."

Rarely recently have I sat in a room with as many senior, high-caliber inhouse and law firm practitioners discussing openly their thoughts, their suggestions, their speculations, their doubts, their hopes and their fears for how our industry may evolve.  That leads me to my own devout hope, which is how to continue to advance this conversation.

One of more insightful remarks came from Paul Lippe of Legal OnRamp, who said that he believed there were "immensely strong pockets of innovation" in law firms, driven by individuals with vision and a commitment to their idea of a different future, but that "law firms have no way of institutionalizing those visions," and thus they tend to wither away after the spearheading individual departs.  Corporate America, you may have observed—at least the best of it, places like Google and Intel and the new HP—have ways of nurturing and spreading these individual pockets of innovative excellence.  But I fear our colleague's remark was true, that we have no such practices.

About this time you may be saying to yourself, "Sure, and I've heard all this innovation stuff discussed for the last 10 and 20 years and I'll hear it for the next 10 or 20."  That, permit me to suggest, is the problem.  That's the problem our faithful American Lawyer reporter succumbed to in trying to cover the event, and I admit it can be all too appealing to fall prey to a type of intellectual exhaustion, a feeling that all the energy has been drained out of the issue of "innovation" in legal services.

But I have news for you:  No one in this room on this evening believed that.  To those of us there, innovation is a vital, demanding, pressing challenge.  On the demand side, clients are increasingly seeking alternatives to the billable hour and annual 6—8% increases in fees, while on the supply side, associates are increasingly unwilling to stomach annual increases in billable hour expectations for episodic starting salary bumps. 

Actually, I believe the attitude of "I've heard this already" is just fine.  For 90% of firms. 

But 10% will change, and that 10% will explore alternatives, some successful and some failures.  The failures we can chalk up to Darwinism (and failures need not be fatal), and the successes we can chalk up to Darwinism.   If there are tremendous successes, however, the logic of the competitive marketplace tells us something else: Best be a fast follower.

So I ask you, dear reader:  How shall we continue these discussions? Are they best conducted in law firm-sponsored colloquies such as this?   Under the auspices of a legal publication such as The American Lawyer?  At dispassionate fora and conferences put together by and hosted at a law school?  What are your thoughts?  Let me know.

Or else, adopt the tone of the press coverage and decide it's ten years on and "still the [same old same old] message."

"CSO's?"

Does your firm have a "Chief Strategy Officer?" Thinking about it? Tried it and didn't like it?

Well, apropos the news a couple of weeks ago that Cravath has a first ever director of strategic planning, we thought it would be timely to review what's known about "CSO's." But first, a word to the wise: Do not assume that Cravath's move is one to emulate in all respects. When Legal Week got in touch with Cravath to learn more, this was their report:

"We figured the firm would be happy to talk about the new hire and share some details on Johnston's charge going forward. When we reached presiding partner Evan Chesler by phone, he dismissed our interest in the comings and goings of what he calls “administrative people”. Johnston is "a very nice guy", says Chesler, though he didn't recall his new strategist's title.

"This is just a support job to help us out in our work," says Chesler, who explained that a group of nine Cravath partners, which he chairs, will continue to formulate firm strategy. "The strategy is entirely set by the partners of the firm," he insists."

And there's more:

"[Johnston will be] gathering information, doing the staff work, the kind of stuff that any committee would have a person doing the staff work for," says Chesler. "We have a very busy administrative staff [and] people were simply overburdened by trying to do that in their spare time."

Despite the addition, Chesler says Cravath's strategy is the same as it has always been: to remain the country's best law firm.

"That was the strategy, by the way, when I got here 33 years ago," Chesler adds. "So I don’t want to see a headline that says that we just came up with that idea."

But this is actually a piece about firms that are serious about CSO's, so let's pick up where we left off. [Full disclosure: I suspect Cravath is a lot more serious about Bill Johnston's position than they're letting on to the mainstream press, and I'm meeting Bill later this week to check my intuition.]

Let's start with the fact that the position of CSO is new, and therefore undefined. To be more precise, it has various definitions. Trust McKinsey to assemble a roundtable of high-profile CSO's to give their views on what the job entails, how to do it right, and what the payoff might be. The panel included:

• Edward C. Arditte, senior vice president of strategy and investor relations at the multi-industry company Tyco International;
• Marius A. Haas, senior vice president of strategy and corporate development at the technology company HP;
• Dan Simpson, vice president, office of the chairman, at the cleaning-products group Clorox;
• Annabel Spring, managing director in charge of strategy and execution at the investment bank Morgan Stanley; and
• J. F. Van Kerckhove, vice president of corporate strategy at the e-commerce company eBay.

While all CSO's agree that the real chief strategy officer is the CEO, from there the consensus seems to dissolve. But given the centrality of the CEO to setting strategy, a close CEO/CSO relationship is a job requirement. You might have an alienated or disaffected CFO or CIO and be able to function, if suboptimally, for awhile, but not so with the CSO role.

Part of the CSO's challenge is to develop strategy in an iterative way between bottom-up and top-down. The goal of this is to build on the collective wisdom, marketplace knowledge, and client savvy of the partners themselves (bottom up) while trying at the same time to attune that wisdom to the competitive realities of the firm's evolving position in the marketplace and where it aspires to be. This quote from the CSO at Morgan Stanley nicely articulates the challenge, and comes from someone in an environment not dissimilar to today's sophisticated global law firms:

"Our role is to get feedback from the business units, overlay the global trends, and make sure that everybody has identified the right issues. We then prioritize the opportunities across the business units and provide a strategic element for that prioritization. Feedback from the business units is also critical for maintaining that entrepreneurial edge. Morgan Stanley is so specialized and yet complex and global, which is hard to balance."

Another aspect of the CSO's role is that it's intrinsically dependent on the state of the market. In plum times, one has the luxury of thinking long-term, being visionary and planning investments. In times like these when the market is tough, it may be more about restructuring and retooling your people and refocusing your practice areas.

How do you ensure that "strategy" has bite, that it actually has an impact?

Probably the most straightforward way is to integrate it with individual evaluations, to make people see how their performance is (or isn't ) aligned with strategy. At numbers-driven companies like HP, this can take on forms that would seem extreme in a law firm, but they exemplify how concretely expectations for implementation of strategy can be tied to a business unit's planning:

"An implementation plan that has clear milestones and owners is a must. Execution sits in the business units. At HP, we won’t make the hand-off until the business owner understands, accepts ownership, and acknowledges the need to deliver. As to the strategic plan as a whole, we’ve gotten a lot more disciplined. Now we can say, “Here are the levers within our plan that we need to execute in order to deliver. We know the plan, the capacity, and what we can do incrementally. If you’re going to show me a number, you’ve got to tell me how you’re going to get there.” Management has changed how people’s performance was going to be measured at a granular level."

Lest all this seem too abstract, think about actively and consciously segregating your practices into three primary business areas each with its own composition of clientele and economic goals:

• Emerging opportunities and markets;
• Mature but healthy and constant practices; and
• Marginally declining areas that nevertheless help generate cash flow.

Invest in each--investments in people, geographies, and managerial talent--appropriately.

Many people confuse strategy with financial planning. Don't be a victim of this. Planning has to do with internal budgeting and resource allocation, but it has little if anything to do with your market, your clients, and why corporations come to your firm vs. another. (At Clorox, they are so disciplined about this segregation of strategy from finance that they don't permit financial perspectives or exhibits in the first rounds of strategy meetings, in order to enforce the disciplined focus on market positioning rather than internal resource allocation.)

What, then, is the value of strategic planning? If your firm is struggling "operationally," the real problem more likely than not can be laid at the door of strategy, as explained by Dan Simpson of Clorox:

"Execution problems are often symptoms of trouble upstream in the strategy-development process—the strategy process has failed to realistically assess current reality, to honestly understand organizational capabilities, to align key players with those who do real work, or, at the end of the day, to create a compelling, externally dr