Santayana

Friday, April 6, 2012

Q:  What do these firms have in common?

  • Allen & Overy
  • Baker & McKenzie
  • Bryan Cave
  • Clifford Chance
  • Cooley
  • Dechert
  • Dewey
  • DLA Piper
  • Fitzpatrick Cella
  • King & Spalding
  • Kramer Levin
  • Kronish Lieb
  • Linklaters
  • Lowenstein Sandler
  • Morrison & Foerster
  • Orrick
  • Patterson Belknap
  • Paul Weiss
  • Ropes & Gray
  • SNR Denton
  • Sutherland
  • Venable
  • Vinson & Elkins
  • Wachtell
  • White & Case
  • Wilson Sonsini
  • (and there are probably a few more I’ve missed)

OK, I admit, trick question; I won’t torture you any further.

A:  Their New York offices are all on a short stretch of Sixth Avenue between 42nd and 54th Streets that you could walk in 7 minutes at a New York pace, if you make the lights.

There are other examples of extreme law firm propinquity in town:  Debevoise and Schulte Roth are both in 919 Third at 55th (where Skadden used to be before their move to Times Square), down two doors is Latham, across the avenue at 601 Lex is Freshfields, one door down at 599 Lex are K&L Gates, Reed Smith, and Shearman & Sterling; across the avenue from them at 399 Park are WilmerHale and Bingham, and a few blocks down Lex are Davis Polk and Simpson Thacher.

And the point would be?

It’s time to refresh the tired metaphor that all law firms have are “elevator assets” with a vivid reminder of just what teeth that trite observation has.

How easy is it for lawyers in any of these firms to decamp to a competitor?  Your commute may change by a few blocks, or it may change by a mere elevator bank.

I hasten to concede the blisteringly obvious objection that switching firms involves a bit more disruption and planning than that, but the point is what a stiffly competitive market we are in for lateral talent, and how many options there are in rich legal markets.

So what?

Imagine for a moment you are in charge of designing the balance sheet of one of these firms (or any sophisticated law firm regardless of location and absolute size).  As you examine what role debt should play, perhaps the first question that should come to mind is “what assets do we have on the other side of the ledger, against those hypothetical liabilities?”  And the answer is:  Elevator assets.  That’s it, folks.  Your firm’s primary and only meaningful asset is its talent:  Its human capital, a/k/a its people.

I won’t insult the intelligence of our hypothetical loan officer by offering up used desks, dusty library books, and obsolete computers as collateral.  What about accounts receivable, a pledgeable asset since the Peruzzi and Medici families in medieval Tuscany, if not before?  Normally, a law firm’s accounts receivable are a highly reliable credit—one with something approaching the creditworthiness of the firm’s clients themselves.  But consider:

      • Discounts and writeoffs are more widespread than at any time since I entered the practice;
      • Realization is systemically lower than at any time in memory (by “systemically” I mean industry-wide, not firm-specific);
      • And, most importantly, if a firm’s partners and/or clients begin to lose confidence in the firm, receivables decline in value abruptly and often irretrievably.

The reason for the last phenomenon is simple, and it’s a matter of both economics and psychology.  No client wants to pay money to a firm whose very viability is in doubt, for perfectly good rational and emotional reasons.  This is not the same as the famous financial markets observation that “Everyone has all the liquidity they want, until they need it,” but it’s a next-door neighbor.

Fundamentally, building long-term debt on to the balance sheet of an enterprise whose only material assets are readily marketable and freely mobile human beings is to repeat the classic mistake of the institutions at the core of virtually every post-World War II financial crisis in the United States:  It’s to create a timing mismatch.

That is to say, firms doing this are securing long duration liabilities with short duration assets.  Should anything imperil the value of the short-term assets, the roof can cave in before you can evacuate the building.

We will save for another day the possibility of compounding this financial mischief with aggressive assumptions about the timing and recognition of revenues and expenses, but suffice to say such dubious accounting practices have been at the heart of every significant financial fraud in recent memory. And you don’t have to take  my word for it:  Here are the key findings from Anatomy of a Financial Fraud: A Forensic Examination of  HealthSouth, published in the CPA Journal (emphasis mine):

On January 23, 2003, the SEC issued its “Report Pursuant to Section 704 of the Sarbanes-Oxley Act of 2002.” Section 704 directed the SEC “to study enforcement actions over the five years preceding its enactment in order to identify areas of issuer financial reporting that are most susceptible to fraud, inappropriate manipulation, or inappropriate earnings management.” The study period began July 31, 1997, and ended July 30, 2002.

Over the study period, the SEC filed 515 enforcement actions for financial reporting and disclosure violations arising out of 227 separate Division of Enforcement investigations. Those investigations fell into three categories:

  • Revenue recognition, including fraudulent reporting of fictitious sales, inaccurate timing of revenue recognition, and improper valuation of revenue.
  • Expense recognition, consisting
    of including improper capitalization or deferral of expenses, incorrect use of reserves, and other understatements of expenses.
  • Business combinations, relating to myriad improper accounting activities used to effect and report combined entities.

All but one of these investigations included revenue-related issues, and many investigations identified violations in two or all three of these categories.

So over this five-year period only 0.19% of the SEC’s financial reporting enforcement actions did not involve revenue recognition shenanigans. Stated differently, 99.81% did.

I will quote in full what the owner of a famous Scotch single malt distillery said at the end of a most gracious tour some years ago, when asked his opinion of blended Scotch:  “Best avoided.”

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Trackbacks For This Post

  1. [...] + Debt = Danger. As Bruce MacEwen recently reminded us : Fundamentally, building long-term debt on to the balance sheet of an enterprise whose only [...]

  2. [...] Note that this doesn’t address the fundamental timing mismatch between extremely short-term assets (lawyers and to some extent clients) and long-term liabilities.  Business models built on the expectation that short-term assets will always be available to satisfy long-term liabilities tend to end in tears (cf. Lehman, Bear Stearns, the entire 1980′s S&L debacle), as I’ve discussed previously. [...]

  3. [...] MacEwen. It is trite to point out that the supply side of law firm economics is notoriously fickle: Bruce links the problem to change on the demand side. Imagine for a moment you are in charge of designing the balance sheet of one of these firms (or [...]

4 Comments


  1. Ray Campbell, 2 years ago Reply

    Your point is spot on, but what’s equally interesting is that it does not absolutely have to be that way. That it is so reflects a weakness of the law firm capital structure, and also suggests why in the long run legal process outsourcers are poised to move up the value chain all the way to where big law is today.

    In phase one of the Industrial Revolution, investment in capital really didn’t apply to service industries. The productivity of factory line workers could be enhanced radically by capital investment. Scriveners and accountants, not so much.

    That changed a bit with the advent of word processing and hard drive information storage, but as you note, the cost and value of the hard assets is trivial when compared to the human assets.

    We are entering an era where that can and will change, but it will require a level of investment that law firms can’t and won’t make, for the most part. Software today can embed intelligence in a way that leverages a lawyer the way an industrial drill press – or even an industrial robot – leverages the human factor worker. The problems are, 1) the creation of that software requires capital, lots of it, all of which must be drawn from the annual distributions of partners already contemplating a move down the street in order to increase their take home, and 2) in a world where services are priced by the hour, the path to recovering that labor reducing investment is not clear.

    LPOs, which can and do access the capital markets and price by the job, are investing in exactly these kinds of systems as well as in more sophisticated business process systems that include efficiency monitoring, quality auditing, etc.. These are assets that, like the industrial drill press, enhance the productivity of the worker yet can only be used by the worker in that firm’s environment. They already are taking the lower end process part of the business away from big law firms. Aided by the investment in non-human capital, they will over time move into higher and higher value services, challenging for all but the very most complex problem solving work.


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