When ‘Run’ on Partners Starts, So Does Race to Save the Law Firm

In the year prior to its bankruptcy filing in September, more than 70 partners left struggling law firm LeClairRyan.

Sedgwick, a now-defunct firm that preceded LeClairRyan into Chapter 11 nearly a year ago, lost more than 30 partners ahead of its decision to dissolve in January 2018. In the massive “run” on partners leading up to Dewey & LeBoeuf’s catastrophic collapse in May 2012, 200 of 300 fled the imploding firm.

Law firms are structured so it’s inherently tough to stem partner departures and the financial death spiral that ensues. But there are some legal and business tactics firms can use to stop the bleeding or minimize damage, including one that may have worked at LeClairRyan if its founder’s apparent vision of the future had come to pass.

“[Partner ownership] might simultaneously be a source of community and bonding and even profit and also the cause of law firm collapses,” said Yale Law School Professor John Morley, author of “Why Law Firms Collapse.” “Those two things can both be true at the same time.”

How the Ship Goes Down

Law firm collapses generally start the same way, according to Morley. One or more senior partners head for the door. After the initial partner leaves, another departs and then another, as confidence and firm funds wane.

At some point in the process of partner departures, law firms will breach covenants in loans and leases, triggering the dissolution of the firm.

“If they weren’t owned by partners they would not blow up in this way,” Morley said.

As owners of law firms, partners’ compensation is directly tied to the firm’s profitability. As partners leave, the remaining partners will be paid less, but their lateral marketability remains the same, he said.

And U.S. law firms are prohibited by the American Bar Association’s Model Rule of Professional Conduct 5.6 from asking a partner to sign an agreement not to leave, which limits a firm’s options for retention.

Law firms usually don’t have any assets other than the clients of their lawyers, said Robert Hillman, a professor at the University of California at Davis and author of “Law Firm Breakups: The Law and Ethics of Grabbing and Leaving.”

Over the last 20 to 30 years, the legal industry has developed a culture of mobility, so lawyers can move from firm to firm with their books of business and clients in tow, he pointed out.

He contends that it’s not so much the structure of the function of partner ownership, but more a function of the nature of the assets owned by a firm, essentially its clients, which causes a law firm to fail.

“It’s really hard to lock those assets in,” he said.

Back From the Brink

Avoiding insolvency can seem like an almost impossible task for a struggling firm, but Australia-founded firm Slater & Gordon — which became the world’s first publicly-traded law firm in 2007— managed to pull off that feat last year.

In early 2015, Slater & Gordon acquired the legal services branch of U.K.-based insurance claims processor Quindell, an ill-fated deal that resulted in a loss of $700 million and saw its stock price plummet nearly 40 percent.

But the firm reorganized, and its shareholders approved, a recapitalization plan in December 2017 saving it from insolvency. Slater & Gordon was able to stay afloat because its lawyers stayed put even though the firm had become massively unprofitable, according to Morley.

“The lawyers kept getting paid the same salary, so why would they leave?” he said.

But in a partner-owned law firm like LeClairRyan, as the firm becomes less profitable, it’s a “mathematical necessity” that the partners will earn less, Morley said.

In a twist of irony for LeClairRyan, co-founder Gary LeClair apparently envisioned that his firm would eventually be structured like Slater & Gordon and other overseas firms, to leverage outside investment. This included LeClair’s idea of a preferred stock option offered to LeClairRyan’s partners to raise additional capital.

The trouble is, non-lawyer investment in law practices is allowed in other jurisdictions, but it’s still illegal stateside.

And even if outside investment became a possibility, whether there’d be a lot of Slater & Gordon-like success stories is debatable.

“In order to secure that financing, you have to convince the investor that your business model makes sense and that business model is key to the revenues coming into the firm,” said Hillman, who believes there would be only a minority of firms able to prevent dissolution this way.

An ailing firm would have lost a chunk of those revenues due to partner departures, which it could possibly address by downsizing to make it more profitable and attractive to outside investors, Hillman said.

“But that’s really the dream case, because when firms start to lose lawyers, those departures tend to feed on themselves,” he added.

Hillman said outside investors need to have some assurance the revenue stream isn’t going to be compromised in the future and that the firm is able to address its problems.

“For some firms that face temporary liquidity crises, outside investment can get them over that hump,” he said. But in the long-term, Hillman noted that such firms are going to have a tough case to make with outside investors.

To Stop the Bleeding

Often times when facing partner losses, firms look elsewhere for salvation.

“Every collapsing law firm tries to merge with somebody on their deathbed,” Morley said.

After layoffs, partner exits, and drops in revenue the struggling Washington-based Patton Boggs merged with Squire Sanders in 2014 to create Squire Patton Boggs, ultimately saving the firm.

Firms also have tried to bring aboard other new partners to replace the departing ones to stem a firm collapse, which could become more common in a projected recession. But internally there are other moves they can make to slow departures and improve their situation.

They can buy time if they write a retroactive dissolution clause into partnership agreements. That way, if a major partner group leaves, the firm has a 60-to-90-day period to determine if it can make it on its own without that group or various partners, said Leslie Corwin, managing partner of Eisner LLP, who has advised on several major law firm bankruptcies.

Just because you’re the first one to leave, you’re not leaving the burden of the firm on the last person to “turn out the lights,” he added.

If a troubled law firm doesn’t have such a clause, it can then ask certain key partners to enter into standstill agreements—delaying but not preventing their departure— and try to get partners to agree to that even if they leave they are in no better or worse position, Corwin said.

By slowing the down partner exits, partners’ capital and business can stay in the firm long enough to allow it to pay lenders and hopefully head off a Chapter 11 scenario.

Corwin said firms can “read [partners] the riot act” and try to convince them to stay for a certain period of time with the understanding that a proper and orderly dissolution can keep a law firm out of bankruptcy, which should always be the goal.

Firms can also try to make leaving costlier but they can’t make it prohibitively costly, Morley said.

In certain circumstances in some states law firms can require a partner to reimburse the firm for certain losses as a result of clients taken from the firm. Firms can also delay the repayment of capital to departed partners and could withhold a partner’s retirement if it is unfunded or a not a part of a qualified plan.