December 2008 Archives

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.

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.

Rockefeller Center, Christmas 2008
Photograph by Bruce MacEwen

A Merry Christmas, Happy Holidays story of the first order:

As noted this morning by The New York Times, Above The Law, and The WSJ Law Blog, Sonnenschein is acquiring about 100 lawyers, including 40 partners, from 160-year-old Thacher Proffitt & Wood—technically, not a merger of the firms but a large lateral group acquisition.  The lawyers come from Thacher's four main practice areas, including Structured Finance, Corporate and Financial Institutions, Real Estate, and Litigation, and include the chairs of each group.. 

The sad news is that this represents the end of the road for Thacher as a firm, but the reason to celebrate is that this extremely talented group of lawyers will have the opportunity to remain together, serving their clients from a broader, more diversified, and financially strengthened platform.

Are there larger lessons in this deal for our industry?  I believe so, but for now I'll leave those for another day.  (Hint:  They have to do with heavy concentration on specific practice areas.) 

For the moment, it's a much-needed vote of confidence in the ultimate recovery of the financial services sector:  Thacher's core clientele included all the biggest banks and investment banks and today a marquee client is the US Treasury Department itself, under the TARP program.  The sector will regain a pulse eventually, and this is a sign that I'm not alone in that faith.

Sad as it is to see a storied firm, bombed out of the World Trade Center twice and still resilient, reach the end of its road, what really matters is not the name of a brand, but the individual lawyers and professionals. No one at Thacher died during the two WTC attacks, and none will "die" professionally today. That's why it's a good news holiday story. They are living to fight another day, and (disclosure) from personal experience and acquaintance, I can testify that they're fighters.

"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.

A smart friend of mine, in a conversation apropos the financial meltdown, recently wondered if people "aren't reading too many newspapers and not enough history."  He has a point.

So forthwith, a little history.

According to McKinsey in "Financial crisis and reform: Looking back for clues to the future," the extent of regulatory changes in the wake of recession is roughly proportional to the severity and duration of the downturn.  Specifically:

History provides three clear lessons: first, reforms followed every major US financial crisis that led to an economic downturn. Second, the length and severity of the postcrisis recession have historically been approximately proportional to the degree of change that follows the recession. Finally, the resulting shifts commonly extend well beyond the financial-services sector.

Relatively mild and short-lived recessions (1990, 2001) lead to only piecemeal regulatory changes, while more severe downturns such as the Panic of 1857 can produce nearly cataclysmic repercussions including, by some accounts, exacerbating the regional tensions over states' rights and slavery and precipitating, if not exactly causing, the Civil War.  Another historically revisionist school of thought has posited that without the wholesale reforms of the New Deal, the Depression could have led to insurrections.

But it's worth putting this all in perspective.  Here is the GDP per capita, in real 2000 dollars, at the start of each of the following downturns, and the total GDP contraction, in percent:

• 1764:  £100, -50%
• 1837:  $1,681, -4%
• 1857:  $2,252, -2%
• 1893:  $4,559, -14%
• 1907:  $5,621, -12.5%
• 1929:  $7,099, -29%
• 1990:  $28,429, -1.5%
• 2001:  $34,759, -.03%
• 2007:  $38,148, -??%

In other words, we have a lot less to worry about than some of our forebears, by a far sight.  We could, for example, suffer a 20% drop in GDP per capita before we'd be back where we were in the dark old days of 1990.

Also helping put some perspective on matters is an interview with Richard Foster, a McKinsey director for over 20 years and coauthor of Creative Destruction: Why Companies That Are Built to Last Underperform the Market--and How to Successfully Transform Them.  Here are a few highlights condensing his views of the past 30 years of economic progress:

Q.:  How does your vision of creative destruction apply to today's situation?

A.: Let's start by looking back. In the 1970s, we had the "Nifty 50"--invulnerable companies that couldn't possibly lose, and of course they all did.

[...[  In the financial-services sector, the upheaval will create a new generation of leaders. Fifty years ago, we didn't have 8,000 hedge fund managers. Then somebody said, "We can go short as well as long; we have much better information than people did in the 1930s, and the information comes to us instantaneously rather than days after the event. We can make a lot of money modeling and leveraging that information." So the hedge funds were born. How many of those guys had been successful at mutual-fund management? I don't think any.

[...]  In the book, Sarah Kaplan and I show that over the long term, the market performs better than companies do. There can be periods--5, 7, 10, even 15 years--when that isn't the case, but corporate performance always reverts to a lower level than the market because the economy is changing at a faster pace and on a larger scale than any individual company so far has been able to do without losing control.

[...]  The granddaddy of cycles in this economy is the equity premium, which is the difference between the longer-term total returns to shareholders and the supposedly risk-free debt rate. It is the premium the equity investor gets for taking the equity risk. Looking back, we can see seven great cycles. During the boom times, when the equity premium goes way too high, everybody hocks everything to get in on the game, and this creates the conditions for a crash. When the crash occurs, the politicians come in and say it was this or that person's fault. Then they create regulatory institutions, and virtually every one of those institutions--starting with the Federal Reserve, in 1913, as a result of the crash of 1907--has been quite productive for the nation in the longer term.

[...]  What do self-respecting entrepreneurs do when subjected to new regulations? They learn the regulations backward and forward and then vow never to start another business that falls within the scope of those regulations. And so off the entrepreneur goes to find a new way. That's one reason credit default swaps eventually took the form they did--the other options were regulated.

The new entrepreneur often seeks ways to innovate outside the scope of the newly established regulations. In the beginning, all that works out fine. We have innovations, we love the people who created them, they're great heroes, the returns are strong, everybody says, "I'm going to be one of those guys." Eventually, all the truly good guys who are going to get into that business have done so. The opportunity starts drawing less savory figures--charlatans who overmarket, cut corners, establish usurious contracts, and do other clever things to generate profit for themselves. They end up bringing the system down. Then guess what happens? At the end of that period, after the equity premium has soared and collapsed again, the government steps in and regulates the systems, this time focusing on the last wave of abuse. And then we start over.

But his conclusion is one with which I could not agree more resoundingly:

Q.:  Capitalism has just taken a beating. What will the future look like?

A:  The essence of capitalism is capitalizing--bringing forward the future value of cash to the present so that society can grow more quickly by taking risks. It goes back to the Dutchmen in the 16th century, sitting at their coffeehouses in Amsterdam and Leiden, loaning each other money for a guaranteed return. Someone said, "I'll give you a little higher return if you give me a piece of the action"--and equity was invented. That had the effect of bringing forward, into real cash today, the net present value of future earnings. That levered society and allowed it to grow at a much higher rate than it would otherwise have. Equity was a very clever invention, and we are not going to give it up. This is the way people are. This is the way commerce works and will continue to work unless capitalism ends. And that won't happen, regardless of what you read in the press.

As my friend said, fewer newspapers, more history.

Finally, some words about strategy in the midst of a structural dislocation.  Times like these—especially times like these—call for coherent responses on behalf of your firm to the challenges out there in the marketplace.  This, rather than any tepid or hypocritical "mission statement" or allegedly scientific market segmentation analysis that will be overtaken by events before it can be bound and distributed,, is the type of strategy that actually has traction today.

And the essence of such a strategy is a thoughtful and reflective view on the marketplace forces at work, and how they'll affect your firm, your talent pipeline, your geographic centers of gravity, and your client base.  To produce a coherent, nuanced, and dynamic view of what's happening, there's no substitute for the hard work of thinking about this multi-dimensional chessboard, with almost daily midcourse corrections based on new data points and new conversations, essentially incoming at you all the time. 

If we're truly in the midst of a structural dislocation—where the linear extrapolation of previous trend lines utterly breaks down—then it helps, even if briefly, to rehearse how we got here:

• The ratio of consumer debt to disposable income went from 40% in 1952 to 60% in 1982 to 80% in 1992 to nearly 140% in 2007;
• From 1990 to 2007, the financial services sector expanded 250% faster than GDP and its profits rose from the 1947--1996 average of 0.75% of GDP to 2.5% in 2007; and
• Financial leverage among Wall Street's five largest firms (Goldman Sachs, Merrill Lynch, Lehman Bros., Bear Stearns, and Morgan Stanley) went from the SEC-limited 12:1 in 2004 to 35:1 or 45:1 last year.

Pretty clearly, those trendlines cannot be linearly extrapolated.

Which brings us to the question:  What now?  What next?

Structural breaks of this sort take time to resolve themselves.  New business models need to be invented and fundamentally new flows of funds across the global economy need to settle into their grooves.  (Financing consumer consumption in the US via indirect borrowing from  China?  As they say in the schoolyard, "I don't think so!")  But it's also worth recalling that upon the ashes of previously impregnable industries have grown vibrant and utterly familiar new names:

• The 1893-1897 depression signaled the end of the railroad boom but thebeginning of the sophisticated consumer goods economy (Miton Hershey founded his iconic brand then).  GE was a product of the same period, capitalizing on the coming ubiquity of electrical power distribution.
• Similarly, in the Great Depression, while steel, rubber, glass, and coal were declining, yet another wave of mass market consumer brands was launching, including kellogg's.  With increasing automobile ownership penetration, motels and campgrounds took off.  Ultimately, airline passenger growth edged up from zero and radio and motion pictures became significant industries.
• Moving ahead to the birth of the internet, we can see in hindsight that at first it tried to mimic pre-existing industries.  Remember "brochure-ware," as the internet tried to mimic print?  For that matter, early radio mimicked vaudeville, and early TV mimicked the theater.  It took radio awhile to figure out that it excelled at sports, talk, music, and news; and TV awhile to figure out that it excelled at serial drama, game shows, movie re-runs, sports, and breaking and cable news.

What are the lessons, then, for us today?

To begin with,it can be dangerous to assume that more of the same old will light the way forward.  If a traditional pattern of commerce has been pushed to its breaking point, don't keep pushing. 

If this means a fundamental re-examination of the way your firm is organized—what its practice groups are, where your office are, what activities you take for granted—may I suggest there's no time like the present?

It's not about cutting costs, but about doing things differently, and smarter.  A decent rule of thumb is this:  Simplify. 

Just because you've "always" done something, do you need to?  Do you need that committee?  That organizational matrix layer?  That procedure?  That all-hands communication? 

Have you outsourced your cafeteria? (I hope so!)  Your mail room and your 401(k) administration? (Ditto.)  Your word-processing?  (On-deck circle.)  Your document review? (Time to think about it.)

Better yet:  If you were the founders of your law firm today, what would you do differently?  Even firms we think of as legendary (Allen & Overy, Latham, Skadden, Wachtell) essentially are within a couple of generations of their founders.  It's not that long ago. 

Put on the founders' eyeglasses.  What's now out of focus?

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.

I'm here in The City for the week, having arrived Sunday morning and going home to New York Thursday evening.  The purpose is essentially a series of meetings with various firms I'm having with my partners Ward Bower and Tony Williams, but that doesn't mean I haven't been able to enjoy a few sorties to The National Gallery and the British Museum. 

As I never tire of New York, I never tire of London.  And I'll be back, by the way, the third week of January, so let me know if you're here and might like to get together then.

Royal  Inns of Court

Last week I had a chance to catch up with Jeroen Plink, the CEO for the US operations of Practical Law Company. Jeroen has been with PLC for over 6 years and, in a previous life, worked as an attorney for Clifford Chance and Latham & Watkins.

Unfamiliar with Practical Law Company?

In the UK, PLC has been around for nearly 20 years, and they're just about to launch in the US (more about that anon). Perhaps the best way to think of them is as "knowledge management to the profession," or, a bit more precisely in economic terms, "content experts taking advantages of economies of scale to provide knowledge and efficiency to the profession." That's a mouthful, so I'll let them say it in their own words:

"PLC is the UK's pre-eminent provider of legal know-how, transactional analysis and market intelligence for business lawyers."

What do they cover? Practice areas in the UK include: Arbitration, Competition, Construction, Corporate, Cross-border, Dispute Resolution, Employment, Environment, Finance, Financial Services, IPIT & Communications, Pensions, Private Client, Property, Restructuring & Insolvency, Share Schemes & Incentives, and Tax.  

In the US, they'll be starting with Corporate & Securities (M&A, securities and capital markets, private equity, venture capital, JV's and cross-border transactions) and with Finance (general lending, acquisition and project finance, bankruptcy and restructuring).  

And in each area? They provide:

• Practice notes, which are explanatory how-to guides covering deal structure, process, and documentation;
• Standard documents and clauses: Model agreements and clauses each with drafting notes that provide detailed guidance on negotiating and other issues;
• Checklists;
• Flowcharts and timetables;
• "What's market", a database analyzing and summarizing current deals, securities filings, and market practice for various aspects of transactions;
• Legal updates (regular updates on developments in the law and the market, with practical implications);
• Cross-border analysis of particular areas of law; and
• “In Dispute”: Analysis of deals that are being disputed (currently focusing on deals affected by the financial crisis such as Clear Channel and United Rentals)

And how do they do this? With real live lawyers, formerly at name-brand law firms and in-house legal departments (for their US offering, including Davis Polk, Debevoise, Dewey LeBoeuf, Latham, Paul Weiss, Pfizer, Shearman & Sterling, and Skadden, among others) who develop and maintain the materials (meaning keeping constantly up to date with current law and market practice).

This invites some questions about the business model. First and foremost, there's a "chicken and egg" challenge, in that you can't expect serious law firms or in-house departments to subscribe to PLC services until they have substantial content prepared, and PLC has to commit to substantial investments in costly professional staff before they can claim to have that content. In the US, they've been investing in preparing US-specific content for about a year and a half, and currently have over 20 full-time lawyers drafting material.

But the second aspect of the business model follows on the heels of the first. While their fixed costs are high, their marginal costs (of signing up an additional law firm or in-house department as a subscriber) are virtually zero. This should enable them to scale up quickly once they gain critical mass here. And since 70% of AmLaw 100 firms that have UK offices and over 1, 700 law departments (many of which are in global companies with US parents or subsidiaries) are already subscribers to PLC in the UK, their marketing efforts here should find a relatively friendly reception.

PLC will launch its US services in December.

I asked Jeroen what PLC's competition was. "Well, in the UK, one could say it's law firms' own professional support lawyers and internal staff who build and maintain firm resources, but we actually find they're clients more than they're competitors. We're able to help them get their jobs done more efficiently, and they find us a valuable resource."

What about West or Lexis/Nexis, I ask? "They're very good at informing people about primary and secondary sources, but we think our niche is helping business lawyers actually get the deal done more efficiently.”

What do you view as barriers to entry to competitors?

"Obviously, setting up a service like PLC's requires significant initial and ongoing (to keep the materials up to date) investment.  In the UK, we have an advantage in that we have been around for a long time."

How is your market entry into the US going?

"Well, we've certainly been encouraged by US clients in the UK, who say it would be 'fantastic' if we had this in the US. Obviously we are concerned about the current economic climate but then again many of our resources are geared towards cost savings and with all of the new regulations expected to come into force I would say there is a place for a player who can make sense of it all from a practical perspective. When we launched our services in the UK, it was during an economic downturn as well and we think we helped our clients weather it then as we hope to do now.”

Is your entry to the US different than your experience in the UK?

“It's a challenge because there are 50 jurisdictions. Indeed, the main reason for starting in corporate, securities and finance is because most transactions in those areas are governed by New York, Delaware and federal law which makes it a bit more manageable from the outset. We are planning to cover California from early 2009. We are fine-tuning our offering in areas where the law is different for each state and have a short list of other areas to cover from 2009 onwards."

And as for the future?, I ask. What about the EU, the Mideast, Asia?

"The 'grand plan' for PLC," he says, "is definitely to look at other markets as well. But at the moment the US is our key focus."

PLC's business model is deeply intriguing. Think of it as outsourcing KM for the profession to one provider who benefits enormously from economies of scale. This requires deep investment on their part, and, more importantly, impeccable quality and credibility.

Those last two characteristics are attributes which, as we know all too well of late, can be forfeited in a heartbeat. It's a daring model for that, and a potentially chancy one. But based on their track record in the UK, their launch in the US is their next inevitable move. I for one will be watching PLC with great interest.