Why Law Firms Collapse

Law firms don’t just go bankrupt – they collapse. Dewey & LeBoeuf; Heller Ehrman; Howrey; Thelen. All of these firms and many others have disappeared with extraordinary swiftness and finality. Large law firms often go from apparent health to liquidation in just a few months – sometimes even weeks or days. And none has ever managed to reorganize its debts in Chapter 11 bankruptcy and survive. This pattern of swift and complete collapse is puzzling, because it is strangely out of proportion to law firms’ actual financial distress. Most collapsed firms have remained profitable up through the days they dissolved.

Why? We cannot just point to financial stresses like declining profits and rising debts, because financial stresses are not unique to law firms. Lots of businesses suffer financial stress and yet very few of them blow up like law firms. We have to account, therefore, for why law firms would be so unusually fragile in the face of problems that are often quite ordinary.

In a new paper, called Why Law Firms Collapse, I argue that the real weakness is partner ownership. Drawing on a review of every large law firm collapse in the last thirty years (of which I count 37), I show that partnership ownership exposes law firms to a cycle of decline that I call a partner run. Like a bank run, a partner run is a self-reinforcing spiral of withdrawal. When one partner leaves, she damages the firm. This causes other partners to leave, which further damages the firm, causing still more partners to leave, and so on.

The real driver of these spirals is partner ownership. Partner ownership is required by the Model Rules of Professional Ethics[1] and it speeds the spiral of partner runs in two ways. First, as owners, the partners get paid in profits, rather than in fixed salaries or cash bonuses. Their paychecks thus decline automatically whenever a firm’s profits go down. If one partner withdraws and damages a firm’s profits, therefore, his other partners will be tempted to withdraw as well. Second, as owners, partners face debilitating forms of personal liability. Perversely, these liabilities punish partners who stay more than partners who leave. The doctrine of fraudulent transfers, for example, forces the partners of a collapsed firm to give back the compensation they received in the months before bankruptcy. The doctrine only applies because partners’ compensation is paid in the form of profits, rather than wages. The doctrine encourages partners to hurry out the door, because it has a time limit: it does not apply to partners who get out early enough before a firm actually blows up. This and several other doctrines thus push partners into a race for the exits.

The spiral set in motion by partner ownership gains speed from another feature of law firm structure: free partner withdrawal. Under the Model Rules of Professional Conduct, law firms are forbidden from using covenants not to compete and other restrictions to keep their partners committed.[2] This makes law firms very different from large investor-owned companies, in which the owners cannot unilaterally withdraw. Free withdrawal makes partners more likely to leave because it lowers the costs of getting out.

This theory can tell us a lot about how and why law firms collapse. It tells us that law firms can begin to collapse even when it will make all of their partners worse off. This theory also tells us that debt, macroeconomic forces, and the recent decline in demand for legal services are all much less important than we might think. Governance failures and social factors, by contrast, are much more important. This theory also suggests that maybe we should change the rules of professional ethics. Lawyers often think that partner ownership helps to hold law firms together. Often, however, it is the very force that blows them apart.

ENDNOTES

[1] Model Rules of Prof’l Conduct R. 5.4 (2013).

[2] Model Rules of Prof’l Conduct R. 5.6 (2013).

The preceding post comes to us from John D. Morley, Associate Professor of Law at Yale Law School. The post is based on his recent article entitled “Why Law Firms Collapse”, which is available here.