Focus, Law firm management: A year of living dangerously

If last year was bad, the first three months of 2009 have been even worse. The weeks since 1 January have been extremely challenging for the world’s largest international law firms. Certainly, for the thousands of lawyers and staff laid off by their cost-cutting firms, the first quarter of 2009 is already infamous.

Those cost-cutting measures offer the starkest possible evidence that a growing number of firms are facing the greatest ever pressures in their history. The current financial crisis has been widely characterised as the most severe downturn since the Great Depression. Its severity is summed up neatly by K&L Gates chairman Peter Kalis.

“The global economy has been pushed to the brink and perhaps beyond,” he says.
“The financial system is largely in ruin. Great financial institutions are exposed; others have toppled. They will recover, but not in the same form.”

Expert opinion

The Lawyer asked dozens of the world’s highest-profile law firm leaders and legal market specialists for their thoughts on the severity of what they were currently facing. Is it a cyclical downturn or does it represent a paradigm shift?

“That to me is in many ways the most profound issue that the legal sector may be facing,” says Dewey & LeBoeuf chairman Steve Davis. “It’s one thing to say it’s a slow year, but by the end of 2009 or 2010 we’ll be back to business as usual, which means 150 first-year associates and 6:1 leverage and pay that starts at $160,000 [£109,800]. Because then you can say to yourself, ‘Alright, it’s going to be a bad year and the partners are going to have to grit their teeth, but by next year we can go back to the model that we’ve all become accustomed to’.”

However, Davis points out that if there is a major shift in the way law firms are going to operate, that model will not work.

“If it is a paradigm shift,” adds Davis, “that suggests there needs to be some pretty fundamental changes in the way law firms do business.”

All of the partners The Lawyer asked agreed that, at the very least, their clients are currently enduring an extremely severe cyclical downturn. But not all would go so far as to call it – or what the firms themselves are going through – a fundamental change in direction.

“I do see this as very different from other ‘cyclical’ downturns we’ve seen in the past 30 years,” says Clifford Chance managing partner David Childs. “However, overall I don’t believe that we’re seeing a paradigm shift for law firms like my own.”

For DLA Piper’s joint chief executive Sir Nigel Knowles, the answer is simple: there has been a fundamental change. Knowles’ belief was echoed by Ralph Baxter, his opposite number at Orrick Herrington & Sutcliffe.

According to Slaughter and May senior partner Chris Saul, the legal market is facing a hybrid of a cyclical downturn and a paradigm shift. As Saul argues, in the past decade many firms built up practice areas in leveraged finance, high-yield debt and asset-backed finance, which brought with it a level of activity not seen in the downturns of the 1970s and 1990s.

“The explosion of credit we’ve seen over the past 10 years or so and the deal activity that has helped to drive means that this downturn has a different quality of intensity about it compared with previous ones,” says Saul.

But while the debate over the severity and uniqueness of the downturn is interesting, the key question for the world’s top law firms is what impact it will have on them? How likely is it that the financial crisis, whatever you choose to call it, will lead to a paradigm shift in the established working practices of the world’s top firms? Here, there is a little more consensus that, at the very least, all major law firms will need to adapt.

“There are going to be many long-term implications arising out of  the current environment,” argues Knowles. “The magic circle and charmed circle will say there’s been a flight to quality. There has, but there’s also been a flight to value. There will be fewer clients, particularly in the financial services sector, and the clients will want to pay less. There’s going to be tremendous pressure on fee rates, particularly those rates often charged by the magic circle and charmed circle.”

As the head of a magic circle firm, and one that last week green-lit a major size and shape practice review (TheLawyer.com, 23 March), Clifford Chance’s Childs remains optimistic that when the current recessions in the US and western European markets eventually end, the overall demand for legal services will start to rise. But, until then, he agrees that the most pressing issue for firms is how they adapt to the current crisis.

“The challenge for law firms at the moment is reacting to the severe downturn in demand for our services as well as rebalancing our firms to have the right shape for when the world starts to get back to the new normal,” argues Childs. “Currently we’re embarked on an exercise to reshape our partnership so that, as the major economies come out of recession, the firm will be the right shape and scale to meet our clients’ future needs.”

Slaughters’ Saul also agrees that the current environment presents “significant challenges” for the top firms as the demand for their services in a number of areas dries up.

“Thus, we’re seeing various firms taking steps aimed at reshaping themselves,” he adds. “In some senses, this is a reflection of the fact that, over the past 10 years or so, many law firms have moved with some success more in the direction of the investment banking product-based model. Accordingly, with the contraction of products in the financial services and deal-doing market, law firms have had to follow the path previously trodden by investment banks of flexing the shape of the firm.”

That said, Saul believes the current downturn will not fundamentally change the structure or strategic direction of law firms. In a nutshell, he believes the global firms will remain global and those, like Slaughters, that follow a best-friends approach, will continue to do so.

No firm, however, is likely to escape unscathed. “Whatever the characterisation is, there’ll be changes in the legal profession,” says Bill Lee, co-managing partner of WilmerHale. “They’ll include structure issues and they’ll certainly include the manner in which our services are billed. Like any other institution, we need to adjust to the times.”

Major impact Up until 13 March this year there had been 7,092 layoffs (2,874 lawyers and 4,218 staff) among the largest US and UK firms (according to US legal market blog Lawshucks.com). If you are looking for evidence of firms adjusting to the times, there it is.

The accelerated layoffs underscore the changing world for law firms, where clients are increasingly demanding discounts, capped fees or frozen rates along with more partner attention and fewer junior lawyers on matters.

“The client base, which is feeling a lot of stress, is demanding that the suppliers of legal services react appropriately,” admits Dewey’s Davis.

Earlier this month, Davis invited the general counsel of around 10 clients to the firm’s offices in London’s Grays Inn so they could tell the assembled partners what they liked and did not like about law firms.

The session highlighted some of the most significant challenges a paradigm shift could create for law firms. They included the potential collapse of the traditional law firm pyramid structure, as clients become less willing to pay for junior lawyers, and the ending of the billable hour method of charging, as clients look for increased predictability in bills.

“Among the points they made,” says Davis, “was that they wanted to move away from the chargeable hour to agreed-upon fees, and that they wanted to see more senior lawyers.”

Another variable that could be added into that mix is the remuneration structure for junior lawyers. Last week in The Lawyer, one of the world’s best-known specialists on law firm finances, Dan DiPietro, urged New York’s top firms to take a lead in reshaping associate compensation.

DiPietro, head of Citi Private Bank’s law firm group, said there was “a real opportunity” for a top-tier firm to be innovative if it was prepared to take a lead on breaking associate lockstep.

“They could end up with a seriously competitive recruiting advantage,” he added.

DiPietro believes that if a top-tier firm was prepared to slash salaries and introduce a far greater merit-based approach to remuneration, it is inevitable other firms would follow.

“The current market provides an opportunity to look hard at the associate compensation paradigm,” DiPietro argued. “My definition of reconfiguring it includes a much heavier emphasis on variable as opposed to fixed remuneration.

I believe there should be a move to a more performance-based remuneration system.”

Tentative first steps

So far, that step has only been taken by a small handful of firms. “We’ve been thinking about it,” says Davis, speaking for the majority of law firm leaders. “We haven’t taken steps in that direction yet, but it’s certainly something that, in the current climate, has to be thought about and considered.”

In other words, Dewey is going to wait until another firm sticks its head above the parapet. There have long been unspoken financial benchmarks among the top firms to attract the best talent. In the US the $160,000 (£109,800) starting pay offered to first-years is the current measure in terms of fixed remuneration. But there are signs things are changing with both fixed and merit-based remuneration.

Last year, when Skadden Arps Slate Meagher & Flom unveiled its annual bonus, it was immediately followed by Cravath Swaine & Moore, which offered half. Most US firms matched Cravath’s reduced bonus.

“In a certain way that represented a market shift, a change in the market that then gives people some feeling of confidence,” says Davis.

Arguably, a similar pattern can be seen with the layoffs, where the growing number of redundancies at firms has given their competitors the confidence and cover to do it too.

Firms are already reshaping themselves to best confront the current challenges. And one of the key watchwords for global firms in this new world will be ‘diversity’. Indeed, a significant number of the managing partners The Lawyer quizzed were keen to stress just how diversified their firms were.

“Diversity is very important, both from a practice group point of view and from the point of view of geography,” says DLA Piper’s Knowles.

“Pillsbury is well-positioned in this new economy,” claims the firm’s chairman Jim Rishwain. “Why? Pillsbury has a diverse practice mix aligned with  issues that are most important in the world economy, particularly energy.”

Ditto Clifford Chance’s Childs. “Our strategy is to be strong across all six of our practice areas and to broaden our deep geographic coverage,” he states. “As a result we’re a very well-hedged firm and, as the world continues to look more to the East, our strong practices across the Middle East and Asia will stand us in good stead.”

The chairman of Paul Hastings Janofsky & Walker, Seth Zachary, amplifies the point. “If your firm’s well managed and your practice and client base are well diversified, you ought to be able to not only manage current market conditions, but unearth new opportunities,” he stresses.

In other words, look to the future as well as the present. Leave it to Taylor Wessing’s managing partner Michael Frawley to do what most lawyers prefer not to do, and offer his vision of what that future might be.

“The legal market will split into four distinct groups: the very large firms, a smaller mid-market group, boutiques and firms doing commoditised work such as personal injury and conveyancing,” he says. “The latter will be acquired by private equity houses under the Legal Services Act. Apart from the big boys, you’ll see a reduction or adjustment in lawyers’ remuneration. I don’t think we’ll see the heady days of 2007 and 2008 for some time, if at all.”

Simply put, buckle up for a rough ride.