Ideoblog

The significance of the Cravath deferrals

The Law Blog and ATL, among others, are reporting deferrals at Cravath. The payment terms are generous. Cravath is supposedly saying its business is fine, it just has too many associates and summer clerks because of a high acceptance rate.

Yet Cravath is not only offering a deferral option to its current associate class of 09, but a mandatory deferral of its entire 2010 class with less generous terms. Moreover, these layoffs come as the economy is showing signs of life. This seems like more than a minor glitch in the acceptance rate.

Why is this big news, given how many other layoffs, etc, we’ve been seeing lately? Because Cravath has been touted as the epitome of the traditional high-reputation law firm, the type most likely to survive the current upheavals. See, e.g., this recent Henderson & Bierman paper.

This latest news supports my assertion that the problems with Big Law are fundamental to the business model and not just recession fallout.

The NYT on the White & Case meltdown

The NYT has a fairly mundane article on the Big Law meltdown, focusing on White & Case.

So why are big law firms suddenly shrinking? Partly, the Times says, because “in the first quarter of 2009, demand for legal services in New York decreased by nearly 10 percent over 2008, according to the Hildebrandt International Peer Monitor Index.”

Demand is down.  Duh.

We’re also told that

Big Law — especially in competitive New York — is facing a potential paradigm shift as fundamental as the one that has hit investment banks and the auto industry. Big, as a business model (let alone as an expression of the national mood), seems bound for obsolescence.

What is that “paradigm shift”? Partly it’s the bursting of the financial bubble, leaving firms with too many associates. Again, demand is down.  But that sounds like what’s hitting everybody, not a “paradigm shift” for big law.

The article also says:

But the natural order of this world has been set on end by the economic crisis and the possible disappearance of fixtures like the pyramid system (under which associates are thrown en masse at certain cases, fattening the fees), and the billable hour itself (increasingly replaced by flat rates or retainers in a client’s market). The tectonic plates have begun to shift in a nauseating manner, bringing fear, ambiguity and psychological scars.

Well, yes, but these are symptoms. What is the cause?

Philip K. Howard [the famous lawyer and author] says that market forces are taking over from “the emotional and professional commitment that goes along with being an adviser and a solver of problems.” This is the old saw about law suddenly being a business. But that's hardly a recent phenomenon.

How about this, from a W & C partner:

The loyalty of the institution to its people, and vice versa, isn’t really there anymore — it’s a different animal from what a lot of us were used to. It’s much more of a business now and less of a true partnership. The problem is we’re supposed to all be in this together. But at some point, you stop and think: ‘Well, maybe we’re not.’”

This starts to get at the problem. Where is the glue that is supposed to hold large firms together? Turns out maybe it was simply faith that the money would keep pouring in in large enough quantities to support the current business plan. Sounds a bit like a Ponzi scheme.

The real problem is that large firms don’t really own anything but faith, which is fine for religion, but not much of a glue for a business. Here’s my analysis of the meltdown of another big firm, Wolf Block, and some deeper explanations here and in this draft paper.  I’m hard at work on a longer elaboration.

Lawyer licensing: the elephant in the Bartlett bedroom

Judge Sotomayor is facing criticisms for her decisions (sitting by designation) in Bartlett v. New York State Bd. of Law Examiners, 2001 WL 930792 (S.D.N.Y. 2001), and 970 F.Supp. 1094 (S.D.N.Y. 1997), forcing NY to let a learning-impaired applicant sit for the bar exam. Judge Sotomayor said:

There is no insinuation, and I cannot find, that Dr. Bartlett is incapable of performing the functions of a practicing lawyer. * * * Therefore, while it is undoubtedly true that not every person is physically able to be a Yankees first baseman, it is likewise true that it would be grossly unfair to impede whole classes of individuals like plaintiff, with plaintiff's automaticity and reading rate disabilities, from participating in entire classes of customary professions such as the practice of law because they can not read a professional examination like average law school (or other professional school) graduates.

So Judge Sotomayor seemingly gave short-shrift to arguments that the need to read and understand quickly and accurately was an important test of bar admission.

Now I realize that to some this will sound to some like the case of the one-legged Tarzan. But the missing issue here concerns the general usefulness of bar exam.

In my Lawyers as Lawmakers: A Theory of Lawyer Licensing, 69 Mo. L. Rev. 299 (2004) I criticized lawyer licensing in general, and bar examinations in particular, on the basis that they did not, in fact, protect the public from bad lawyers. The only function of lawyer licensing, I argued, was simply to reduce the supply of lawyers. (I then proposed a modest defense on those grounds – i.e., to encourage lawyers to assist in lawmaking by giving them property rights in their state laws.)

With respect to the bar exam, I said:

Perhaps the most important barrier to entry to law practice in a state is the requirement to take a bar exam. The bar exam usually requires months of study and the risk of embarrassing failure. That states pass a very high percentage of applicants if they take the exam enough times suggests that the bar exam is more a price of admission than an effective screen. On the other hand, the bar exam probably deters some people from attempting to obtain a license. Only four jurisdictions pass fewer than sixty percent of those taking a particular test. These include Louisiana, where the low rate may reflect the state’s idiosyncratic civil law system; the District of Columbia, which is unique in admitting lawyers on motion without prior experience elsewhere; and California, which uses its bar exam to screen graduates of unaccredited California schools. The fourth state is Delaware, whose low passage rate may be particularly significant for present purposes. Since Delaware is the most prominent example of a state where lawyers have played an important role in maintaining the state’s law, this provides some anecdotal evidence of the role of state licensing in encouraging lawyers’ participation in lawmaking.

For other criticisms of bar examinations as a licensing requirement, see Benjamin Hoorn Barton, Why Do We Regulate Lawyers?: An Economic Analysis of the Justifications for Entry and Conduct Regulation, 33 ARIZ. ST. L.J. 429, 434 n.16 (2001); Daniel R. Hansen, Note, Do We Need the Bar Examination? A Critical Evaluation of the Justifications for the Bar Examination and Proposed Alternatives, 45 CASE W. RES. L. REV. 1191 (1995); Andrea A. Curcio, A Better Bar: Why and How the Existing Bar Exam Should Change, 81 NEB. L. REV. 363 (2002); Kristin Booth Glen, When and Where We Enter: Rethinking Admission to the Legal Profession, 102 COLUM. L. REV. 1696 (2002).

I’m not an ADA expert so can’t generally critique Sotomayor’s opinions on this issue. But it’s worth noting that at least some of those criticizing her decisions in this case might be sympathetic with the implications of these decisions for lawyer licensing standards in general, and bar exams in particular, which I for one find indefensible as a means of determining fitness to practice law.

Additional point:  I am not arguing that Judge Sotomayor is taking a Friedmanian position on professional licensing.  As I said, this is only an "implication" of her decision.  Perhaps it would be more accurate to call it a possible effect of watering down the purported screening function of the bar exam.  

Are litigation hedge funds a problem?

The NYT discusses hedge fund litigation financing. The chief executive of a leader in the field, Juridica, crows that “[i]t’s always a good time to invest in litigation.” Juridica is up 24% since December 2007. Is this a bright spot in an otherwise murky investment environment.  If so, is it a problem?  

Walter Olson objects that “this innovation will, of course, encourage the filing of more litigation,” and squirms at a remark by Brooklyn’s Anthony Sebok that this financing will make "funding available for cases that are good cases, cases that from a God's-eye point of view, so to speak, should've been brought." Olson adds:

Don't you love that "God's-eye" wording, with its premise that God wants us to bring lawsuits when we have legal grounds to do so, and is disappointed when we instead decide to forgive, or shy away from the process for fear of hurting someone, or just want to get on with our lives?

So the basic question is whether funding litigation is like feeding pigeons.

The Times of London discussed this development when Juridica was launched in December 2007 and I discuss it in my draft paper on the evolution of law firms as an example of the move toward outside financing of law practice. I had also earlier discussed on this blog nonrecourse financing of litigators.

Litigation financing can be viewed as simply another way for the capital markets to help firms exploit productive assets. Of course there are special problems relating to outsiders stirring up claims by simply funding actions by others (maintenance), particularly where the investor gets some of the proceeds (champerty) or the claims are groundless (barratry).  Also, confidentiality and privilege rules may forbid disclosure of litigation information to outside funders, making these particularly difficult investments. The basic problem, as discussed in my earlier blog post, is that "it turns litigation into a business rather than the search for corrective justice."

With respect to the excessive litigation point, it's worth noting that the hedge funds aren't financing the most abusive types of strike suits. These aren’t consumer class actions, but b2b litigation. For example, the NY Times article discusses a case by isp WaKuL against Ericsson for breach of contract. WaKuL won $3 million in arbitration and was able to use outside financing to fight off a challenge by Ericsson. The article says that the hedge funds focus on readily valued claims, and avoid jury cases or novel issues.

On the other hand, the financing discussed in my earlier blog post and an AmLaw article did support tort class actions. Anthony Sebok, who was also quoted in the NYT article, told AmLaw the loans were a "a safety valve for tort reform."

For yet another approach to litigation funding, see the discussion in this article with Kobayashi of “dumping and suing,” where the lawyer in a securities or derivative suit in effect capitalizes the lawsuit by selling short the corporation that is the subject of the suit and then buying back after the suit is announced.

So what should we think of all this?  it’s important to keep in mind that, like it or not, litigation is a legitimate business. Like other basically legitimate businesses, it can turn bad. The question is whether the problems should be addressed directly by rules constraining improper litigation practices or indirectly by constraining firms’ ability to pursue the litigation.

I would opt for the former. Consider that, as discussed in my recent draft and earlier blog post, the current system clearly permits financing of litigation by lawyers via contingency fees. We have seen, e.g., with Milberg, how the reality of lawyer financing clashes with rules based on the pretense of client control of litigation to produce abuse (see my paper with Kobayashi on that).  I'm not sure outside litigation financing produces worse results.

The NYT article tells us that Juridica focuses on steady cash flows – that is, fairly solid claims whose results can be predicted – rather than novel theories or jury cases. Outside financing of cases like WaKuL's permits exploitation of claims the system has decided clearly should be brought (like Mr. Olson, I’m not sure about God, though). Indeed, financing this b2b litigation arguably helps the law deter socially inefficient opportunism.

Moreover, as discussed in my draft and blog post, there are other potential benefits of outside litigation financing.  Litigation funders could provide expertise and investigation that increases litigation's accuracy and deterrence value. This funding also helps eliminate the potential conflict of interest between a corporate client with diversified investors and a risk-averse lawyer who may have an incentive to settle cases that could be productively litigated.

To some extent, particularly outside the b2b context, outside litigation financing might increase the amount of socially inefficient litigation.  But even in those cases there is a question whether this financing increases the quality of such litigation as compared with a world without outside financing.

Given these many uncertainties about the costs and benefits of litigation financing, I would prefer to to go slow in regulating it, focusing instead on fixing abuses inherent in the underlying litigation.

The death of Wolf Block

Philly Mag reports on (HT Law Blog) what it calls the “wrongful death” of former powerhouse law firm Wolf Block. The article tries to make the point “that there was nothing inevitable about Wolf Block’s demise.” Other firms, seemingly no stronger, survived. WB’s most powerful partners tried to save it. So what happened?

The story begins with the usual lament about how law practice has turned into a “trade, akin to journalism or cooking” – and specifically about how Wolf Block changed from a “craftsman’s paradise” to a nasty business under the leadership of three hard-charging rainmakers. Then the firm’s culture was temporarily rescued by a gentler soul with wavy hair, Mark Alderman. Unfortunately, hair and avuncularity proved not to be enough. Alderman couldn’t execute a critical merger, profits sunk and the firm’s bank refused more credit without a personal guarantee, which the partners wouldn’t give. In other words, having become a business, the firm had not become a good enough business.

Ultimately the firm’s future came down to a key group of rainmaker partners, one of whom almost saved the firm by finding new bank loan that didn’t require a guarantee. But the rainmakers turned the loan down, and the firm was left with no option but to dissolve.

The article says the problem was “trust.” More precisely:

People who study human decision-making call this a “prisoner’s dilemma.” In a prisoner’s dilemma, cooperation is the choice that gets you the best outcome, but only if everyone cooperates. You don’t want to be the only one who decides to cooperate if everyone else is bolting, because then you’re screwed. Ultimately, in those final days, what Wolf Block needed to survive wasn’t a line of credit, or a merger. What it needed was some kind of larger glue to counteract the shearing logic of the prisoner’s dilemma. It needed, for lack of a better word, faith.* * *

A law firm is a strange, liquid thing. It doesn’t own anything. It’s just a group of people. It’s people and a lease and a collective sense of shared history. Nothing more. So if this is how a great and important law firm finally dies * * * there’s no reason to be shocked. It’s silly to see a law firm as a Promised Land when the true Promised Land is out there, diffuse and gleaming, beckoning to those with the courage to leave sentimental attachments behind.

A pretty good analysis, but the lesson is muddled. Although the article begins with the idea that WB didn’t have to die, in the end it says “there’s no reason to be shocked” by the death. That's correct. Because the firm “doesn’t own anything” there’s nothing to tie it together but mutual faith -- which might get you an afterlife, but not save a law firm.

Although the death of this particular firm may not have been inevitable, the death of many firms like WB may be. On the other hand, in a more general sense, it’s true that law firms don’t have to face such dismal prospects. Law practice should be a fantastic way for firms to make money in our increasingly law-saturated world.

The problem is, as the article says, that law firms don't own anything. Ownership of firm-specific property is critical to an ongoing business. Law firms theoretically could own property rights to legal products, reinforced by intellectual property laws, non-competition agreements and other contracts. Like other firms they could get outside financing based on these property rights. But as I've discussed, law firms are prohibited by ethical rules from, among other things, having non-lawyer owners and entering into strong non-competition agreements. And many legal products cannot legally exist because of rules against unlicensed practice of law.

These rules push law firms into a precarious hand-to-mouth existence. They need to squeeze profits out of their lawyers based on a failed time-based revenue model, with a significant markup purportedly based on an increasingly illusory promise of mentoring and supervision. Even worse, law firms face a mismatch between their revenues and fees and rely on bank financing to fill the gap. As the Philly Mag article says, “law firms tend to borrow at the beginning of the year, collect fees at the end of the year, and then pay the bank back.” When WB started sinking, the firm lost its bank credit and faith wasn’t enough to keep the bank or the partners in line.

As long as our absurd approach to regulating law firms persists, expect to see more "wrongful deaths" like Wolf Block’s.

Regulating the evolving law firm

I've been discussing (see my lawyers archive) some ideas about law firms and regulating the legal profession, particularly in the financial meltdown and its effect on law firms.

This week I had a chance to discuss my ideas and learn a lot about current regulatory developments at an ABA/Georgetown conference in Chicago on Globalization and the Regulation of the Legal Profession, which brought together practitioners, academics and state supreme court justices.  Very useful conference materials are collected here. 

My paper for the conference is a preliminary take on the issues that I plan to work more on this summer. Here's a quick overview of what I said:

1. It's a mistake for professional regulation to focus exclusively on the relationship between the individual lawyer and client.  Law firms perform significant client-protection functions, including through their incentive to protect their reputations from being diluted by their lawyers' misconduct.

2. Law firms' client-protection function is being eroded by a breakdown in their viability.  Among other things, law firms are finding it harder to motivate their members to do things like mentor associates rather than devoting all efforts to polishing their own resumes and clienteles. Certainly it is getting harder for both partners and clients to give their all for the firm when their tenure is more like a millisecond than a lifetime.

3. So we need better models for the delivery of legal services to enable lawyers and law firms to better serve their clients  Yet regulation of the profession has persistently failed to accommodate these models.  Instead, the rules, among other things, restrict non-competes, thereby constraining firms' ability to protect their property rights; forbid all capital structures except traditional worker ownership; and regulate national and global firms under the law of each state where lawyers are based.

4.  Permitting non-lawyer financing, multidisciplinary practice, unlicensed sale of legal products and allowing firms to choose the jurisdiction that regulates their structure (as can other business associations), would facilitate evolution rapid of more efficient laws. 

5. This does not mean deregulation, but rather regulation that takes account of the significant evolution of the law business.  I emphasized that regulators' failure to recognize these defelopments threatens to make the regulation irrelevant and not simply unresponsive to law firms' rpoblems.

Comments are welcome!

The Drinker model: sugar-coating the bitter pill

Bill Henderson likes the Drinker Biddle model (see ATL) of paying new associates $105k instead of 145 or 160 and giving them more training. The WSJ Law Blog also thinks this is intriguing.

I don’t get it.

Let’s look at this from three perspectives.

1. The associates. Would they accept $105k instead of $145 when the alternative is unemployment or a public interest subsidy? Even without training?

2. The clients. So Drinker is telling them that these associates who were working for them before and billing out at rates that could sustain $145-160k are now finally getting the training that they need? What are the clients to think about the deal they were getting before?

3.  The firm.  Are its labor costs increasing or decreasing, given the training expense? That's not clear.  Assuming its overall expenses are rising, can the firm recoup the training costs over the long run?  That depends partly on what it can charge the clients over the long run. See 2. Beyond that, as some comments to Bill’s post noted, what’s to stop these associates from leaving when the market improves? Keep in mind that the ethical rules limit the firm’s ability to contract to penalize departure.

This seems to me to be lipstick on the pig of the collapse of the big firm model. In the end, law firms have to find a way to pay high-powered rainmakers with the difference between associates' billing rates and their pay. As the revenue rock approaches the expense hard place, the delivery of legal services is going to have to be drastically restructured. The Drinker model seems more a way to make the poison taste better than a cure.

The coming big law partner bloodbath

ATL reports about possible big problems with cutting and deequitizing partners at Jenner & Block:

One tipster quips: At this pace Jenner and Block will soon be populated by top level experienced partners (billing clients hundreds of dollars per hour) and nobody else. Service partners are gone. Yet another tipster describes the situation as a "partner blood bath." Our sources explain that high-end rainmakers are demanding a larger share of the profits, at the direct expense of junior partners who do not bring in business.* * *

Is this really an issue that is localized to Jenner & Block? Fundamentally, there is only so much money you can save by laying off associates and cutting salaries (just like there is only so much money you can save by firing staff). Some firms will undoubtedly start taking a hard look at the people who are supposed to be generating business.

I have no information about J & B specifically, and this may or may not be happening there. But I think it’s clear it will be happening eventually at a large number of big law firms.

The basic problem is that the current large law firm model is breaking down. Under this model of associate leveraging, senior partners are supported by the profits generated by a large number of associates. But for various reasons, including but not limited to current market conditions, clients are not continuing to support those profits by paying the billing premium the firm tacks onto to what they pay associates.  They will pay high prices only for the high-end rainmakers that attracted them to the firm. Unfortunately, this means in the near term that associates and lower-end partners in large law firms may be out of luck.

In the long term there will be high demand for law-trained people in an increasingly regulated environment.  The problem, as I've discussed, e.g., here, is that we have an unsatisfactory structure for delivering those services, frozen into place by ethical and licensing rules.  These rules, among other things, restrict law firm capital structure by requiring owners to be lawyers. The rules need to change before we can reach a more satisfactory equilibrium. 

Licensing history

You need a license to talk about history for money in Philly (also NYC and Washington).  The WSJ has the story.  The Institute for Justice is suing to free the Philly tour guides from having to get a license, which requires them to take a test on Philadelphia's version of history.

Not too surprisingly, the law was a tour guide's idea.  No doubt he is sincere, but it's worth noting that this is one way to reduce the competition. Philadelphia agreed because it wants to preserve its "branding, messaging and identity." Sounds like a business talking, but with a government stick. 

This would seem to be an easy case of pure speech rather than protecting citizens from economic harm.  But as the IJ points out:

The United States is in the midst of an explosion of occupational licensing. * * * Roughly 20 percent of American workers are now forced to meet government-imposed licensing requirements to work in their chosen field, up from only 4.5 percent in the early 1950s. * * * [I]n occupation after occupation—from floristry to interior design—the meteoric growth of arbitrary and unreasonable barriers to entry is making it more difficult for entrepreneurs to break into the career of their choice.* * *

The plight of Philadelphia’s tour guides is not unique. It is easy to single out this new regulation as unjust because the government’s goal—protecting people from hearing things that the government does not want them to hear—is patently illegitimate. But individuals have a right to be free from unreasonable restrictions on their choice of occupation no matter what that occupation is—be it braiding hair, arranging furniture or giving tours.

So, now let's talk about legal services.  What kind of talking about law should the government regulate?  Glad you asked.  See Lawyers as Lawmakers:  A Theory of Lawyer Licensing, 69 Mo. L. Rev. 299 (2004), online version.   

Law firm leverage and non-equity partners

Bruce MacEwen has a superb post about law firm leverage that is must reading for anybody who is practicing law or at all concerned about the market for legal services. 

Bruce was kind enough to start with a link to my Friday post arguing that “we now see very clearly that running law firms as thinly capitalized worker cooperatives is not an equilibrium solution in this market.” The basic problem, as Bruce and I argue (though Bruce got there way before me), is that law firm associates with high fixed salaries act like debt in non-law firms. Associates are great when the firm is raking in profits because you don’t have to share those profits with them. But not so great in times like these when the profits are gone but the associates are still there. This is a simple explanation for all the layoffs.

But Bruce takes it a step further. He notes that law firms’ real leverage problem isn’t partners/associates, but equity/non-equity partners. That's partly because associates are more productive than non-equity partners. Those striving for full partnership have stronger performance incentives than those who have accepted a permanent fixed-wage deal.

The more general point here that is sometimes ignored in the “leverage” analogy is that, unlike conventional debt, which can be used to buy anything, human leverage bundles the asset with the liability. Moreover, the bundle is tightened by the fact that the debt aspect, by affecting incentives, also helps determine the value of the asset.

So why are firms firing associates but not non-equity partners? Bruce points out that associates are simply easier to fire – non-equity partners usually have contracts that bar termination at will. Indeed, from this perspective, it’s not clear that associates even are debt. You have to pay back debt. Technically, you can fire associates at any time.

The usual problem with firing associates is that it sends a very bad signal about the firm – to clients, the hiring market, etc. But as I pointed out last month, the current market reached a “tipping point” where the equilibrium shifted and the reputational penalty for firing associates dropped precipitously. In this market, associates are no longer the leverage that they used to be.

The good news is that the long-term market for big law associates may not be quite as bad as it looks. Law firms do need associates in the long run. 

The bad news is that the trend toward non-equity partners may sharply reverse. Law firms won’t want to be saddled with the big-time debt represented by non-equity partners. Especially when you consider, as Bruce does, the morale problem of having bunches of disincentivized workers hanging around.  Law firms went to non-equity partners because in flush times firms had more work than they had senior associates to do it. Not so anymore, and probably not for a long time.  The even worse news is that non-equity partners may be the next to get laid off, contract or no (might be a good time to be an expert on partnership law).

Bruce thinks that law firms now are going to need a serious “intervention” to get on track. However, as I pointed out in my last post, this is going to necessitate "dropping regulatory restrictions on law firm structure and letting them be run like real businesses." As discussed above, lawyers are leverage if you can’t easily get rid of them. Yet at will employment (to the extent this category still exists) is not a panacea. You want your workers to care about whether the firm succeeds, not always looking around the corner for the next job. An answer might be unbundling the incentives from the job – something like stock options, where the compensation reflects the long-term value of the firm and not just how you did last year. Employees with options care about how the firm as a whole is doing even if they know they don't have tenure.

But stock option type compensation requires a market for the firm’s stock – something that is illegal today for law firms in the US. (Bruce has proposed a workaround through derivatives, but that was always a regulatory minefield, particularly so now.) In other words, the space for “intervention” Bruce suggests is currently limited by regulation. That’s unfortunate, because law firms today need all the space for change they can get.