Dan DiPietro is the chairman of Citi Private Bank’s Law Firm Group. DiPietro recently sat down with David B. Wilkins, faculty director of the Center on the Legal Profession, for a one-on-one conversation on the health of the current law firm marketplace.
David B. Wilkins: We have both seen a number of law firm failures in the past several years, some being quite large and spectacular. As chairman of the Law Firm Group at Citi Private Bank, you are in a unique position when it comes to these issues. What do you see as the most important drivers or causes of these failures?
Dan DiPietro: Looking back, there is a lot of insight to glean from the dozen or so firms—all of which were at one point in the Am Law 200—that Citi has been directly involved with and that ultimately failed. We went through and analyzed each case looking for common themes, and the most basic one we found was that there was some disconnect between leadership and the partners. That by itself may not seem particularly new or insightful, but what was interesting was that the disconnect took different forms at the various firms.
One example—or one form of disconnect—was a poorly conceived growth strategy. (I want to come back to that because it is worth noting that it was not always the same strategy that turned out to be problematic; it had more to do with conception and implementation.) Another example was a disconnect in the compensation range between top-paid partners and lower-echelon partners. Yet another disconnect was when firms allowed themselves to become overly concentrated—for example, with just one or two clients or a particular practice area or industry. That came back to bite them when macroevents affected their big client or their area or industry and it overwhelmed them whereas other, more-diversified firms were prepared to absorb the shock.
Wilkins: All these examples are worthy of exploration. Can you talk a bit more about the disconnect between management and the line partners? What types of things should lawyers look for as signals of potential problems?
There is a risk to overly aggressive action, but there is a risk that comes with inaction as well—a kind of opportunity cost.
DiPietro: I would start with the poorly conceived, poorly orchestrated growth strategies. This is an important one that cuts across a number of firms. One dynamic we saw in several firms was that their failures were the result of mergers from three to five years prior. The problem was that either they lacked an overall strategy or, if there was a strategy, it was too defensive or reactive.
Others may have been well-conceived on paper but lacked an integration plan for the two firms. I can remember one situation where a firm was starting to dissolve several years after a merger. We were talking to individual partners about collection efforts to bring money in to pay bank debt down, and these partners were still referring to themselves by their legacy names—an indicator that the new firm had not done a great job of creating a new culture and integrating!
A second example, one that cut across a number of the firms that we analyzed, was poorly conceived and implemented lateral hiring strategies. If I could contrast firms that do a good job with lateral hiring versus firms that do a poor job, one indicator would be the nature of the work that firms are doing when they hire. After they bring in X number of laterals, are they doing higher-end work at higher rates for more-sophisticated clients? Are they doing more work for clients they had before? If you were able to check those boxes, these would be good lateral hires.
Unfortunately, what we saw in a number of firms that failed is that they were hiring laterals who actually—when you really look at their impact on the firm—were reducing or at least diluting the brand of the firm. An example I would give is a firm that had established itself as a high-quality, almost boutique international firm. They had selected concentrations in a few key cities and had two or three practice areas where they were highly respected. And they were able to generate high rates and get good realization on those rates.
However, as they started to proliferate and grow with lateral hires, the reputation of the firm began to slide because those laterals came from practice areas outside the firm’s core. When you expand to new practice areas and you’re not able to quickly forge a reputation for excellence in those areas, this not only dilutes your brand in those specific practice areas but has a negative effect on the overall brand of the firm.
Wilkins: That reminds me of something you said earlier about firms failing because they had all their eggs either in one basket or in too few baskets. Another way firms fail is that although they concentrate in a small number of practice areas, those turn out not to be the right practice areas. In other words, they are overly weighted and cannot absorb a macroshock. Do you see firms, in order to avoid this danger, sometimes falling into the danger you just described?
DiPietro: I think you bring up a very good point. There is a risk to overly aggressive action, but there is a risk that comes with inaction as well—a kind of opportunity cost.
Let’s shift the lens a bit to the firms that had too high a concentration. Since these have been thoroughly reported and are far enough back in history, I can give you two distinct examples. A firm like Coudert Bros. is a good example of a firm that suffered by not maintaining their concentration.
In response to your more immediate question, I think about a firm such as Thacher Proffitt & Wood—a good firm with a very strong culture. Partners were strongly woven together, and there were not a lot of laterals. However, their strong reputation was highly concentrated—in this case, in securitized transactions. So, when the 2007–2008 meltdown occurred and that business went away, they could not absorb the shock. That is an example of a firm where leadership allowed the firm to become overly weighted in a way that proved to be highly problematic and negative.
Another example of an industry concentration that turned out to be problematic was Brobeck, Phleger & Harrison. Brobeck was riding high during the tech boom—but then the tech bubble burst. That macroshock was certainly not the only reason for Brobeck’s failure, but it was a key aspect as it heavily factored in their long-term growth plans. In other words, they invested in real estate in anticipation of going from a 900-lawyer firm to a 1,200-lawyer firm on the back of their tech practice. So, when the tech bubble burst, they went from being a 900-laywer firm to a 600-lawyer firm, all while sitting on roughly double the amount of real estate they really needed. That cost created financial issues that the firm was not able to absorb.
Wilkins: Having watching this play out a number of times, is this changing the way people in your position—or just banks and lenders in general—are approaching their job? Are they looking at things to try to anticipate or ward off the risks of failure?
I have seen firms that are well able to manage high levels of debt. But a firm that is experiencing other problems and also has high levels of debt—now, that creates a complication.
DiPietro: I would say that Citi had its moment of epiphany about the time that I arrived, roughly 28 years ago. It had just absorbed what was at that time the largest loss it had ever taken, the failure of Finley, Kumble. It was a moment of epiphany not just because of the size of the loss but because we just missed so many of the red flags.
As we talked to our clients, they kept saying to us, “You know, you should have seen this. If you would have asked us, we would have told you these guys were destined to fail.” This is when we dramatically changed how we underwrite law firm credit and changed the kinds of covenants we want to see in deals. Since then, we have tweaked things in light of each succeeding failure, but the most significant change took place after the Finley, Kumble failure.
Wilkins: Turning that around a bit, what do you think law firms or regulators could do to prevent these failures from happening? For example, do you think law firms might revisit their approach to how and where they take on debt?
DiPietro: Let me start by giving you my take on how debt contributes to law firm failures—or rather, where having a high level of debt fits into the factors that might lead to a law firm failure. Personally, I view having high debt as a complicating factor and not necessarily a precipitating factor.
To take a step back, when law firm leadership enters into crisis mode, the firm leadership has to focus on a number of things: keeping the firm together and communicating to the partners, to the rest of the lawyers, and to the professional staff in a way that keeps them focused and calm (and, nowadays, to the media). When the legal press starts to pick up on the signs of trouble, this creates a cycle of news. Firms would be well advised to try to be out front of that in terms of crisis management. Firms that have failed have largely been too reactive rather than proactive in that regard.
I view having high debt as a complicating factor and not necessarily a precipitating factor.
Where debt comes into the equation is at a time when leadership is already being pulled in a number of directions. They are talking to their clients to keep them calm. They are talking to their partners and their other lawyers and their staff, trying to keep them calm. And the media is focusing its attention on everybody. So, if the firm has a relatively high level of debt, they have yet another constituent they have to keep calm and comfortable: their bank or banks.
At a minimum, having a high level of debt creates an extra burden on the leadership of the firm in that there is this whole separate constituency that now needs to be addressed. It creates huge anxiety around: What is the bank going to do?
I am not trying to minimize the impact of debt on these types of situations, but I do not see high levels of debt as being the core precipitating factor to a law firm failure. I have seen firms that are well able to manage high levels of debt. For instance, I have seen firms that decide to borrow rather than pay higher rent and get tenant improvement allowances from their landlord. A good number of those firms have managed that process extremely well and gotten their debt down over time. But a firm that is experiencing other problems and also has high levels of debt—now, that creates a complication.
Wilkins: Do you think that law firms changing their approach to investment would help them feel more stable? For example, as you know, in the United Kingdom there has been a move toward allowing different kinds of capital structures, from equity investment on up to public floating, as a substitute for the kind of debt and lines of credit law firms traditionally use here. Do you see any of that kind of either regulatory change or change in the management of law firms?
There will continue to be consolidation, but I also think that there will continue to be a place for more specialized firms.
DiPietro: It is interesting that we have the United Kingdom to observe as a major center of lawyers and the legal profession in a variety of forms. By now, the United Kingdom has a five-year track record of these types of regulatory changes. Now, I do not have hard data on this, but I believe that the folks who have availed themselves of outside investment in law firms have been the disrupters who have been picking around the edges of what might be called “the traditional law firm environment.” I do not think we have seen any of the Magic Circle firms avail themselves of the new regulatory options. Nor have we seen the next level down avail themselves either. It has been more the peripheral players who have a business model that might actually be more appealing to a hedge fund or a private equity investor. They are essentially saying: “Hey, we have identified a level or an area of legal work that we can do better than traditional law firms and are going to exploit this if you invest and allow us to build a greater technology solution.” Maybe I am just being shortsighted in not seeing how traditional law firms will avail themselves of this, but we just have not seen it yet. And, as I talk to law firms, they are not all that excited about giving away equity in exchange for some kind of cash infusion.
Wilkins: As somebody who watches a lot of law firms, where do you see this going? We have people predicting that we are going to see a lot more failures over the next few years. And we have others predicting the “death of big law.” What do you see?
DiPietro: We are now encountering a new form of law firm dissolution that I term “de facto dissolutions.” The lessons and the ripple effects of law firm failures such as Dewey have created an environment where firms that begin to experience early signs of weakness or fragility, usually in the form of partners leaving or the loss of a large client, are more willing to come to the merger table much earlier in the process. The most spectacular example, which has been thoroughly reported, so, again, there is no issue with confidentiality, is the Morgan Lewis–Bingham deal. Was it a combination? Was it a lateral lift-out on steroids? I would argue it is probably somewhere in between. But what you have is a case where Bingham still had a lot of positives to bring to the table as they started to experience some financial difficulties—again, well-documented in the press. And they got to the negotiation table early enough that there were enough attractive elements that probably two-thirds of the firm was combined into Morgan Lewis. That’s just the largest example.
You could also go back to smaller firms like Dow Lohnes, Patton Boggs, and Dickstein Shapiro as examples of high-quality firms with very good brands that began to experience financial issues, often for different reasons. But these firms got to the negotiation table early enough that larger, stronger firms saw that they could enhance their own brand by bring them into the fold. I think you will see more of these de facto dissolutions.
I am not convinced that we are going to see a huge spike in formal dissolutions or law firm failures in the traditional sense of a bankruptcy (though I do think there will be the occasional large firm where that will happen). I think this de facto dissolution model, in which a firm in trouble gets to the negotiating table early enough to combine, will become more and more the norm.
Wilkins: What are the implications of all this for the legal services market? Will this type of consolidation continue or even pick up as these weaker firms run into hard times? Do you see that kind of reshaping the marketplace at the top end of the corporate legal market in the United States?
DiPietro: Without question there will continue to be consolidation, but I also think that there will continue to be a place for more specialized firms. We could be looking at more boutique firms and more midsize firms. I know some in the legal industry feel like the midsize firm is a dinosaur and cannot succeed, but it is not so much about your size as what your value proposition is. Can you offer an effective value proposition for the clients you are serving? Value is not solely a function of size.
A de facto dissolution model, in which a firm in trouble gets to the negotiating table early enough to combine, will become more and more the norm.
All that being said, there will be consolidation. Looking at the demand metric, in a typical year between 2010 and now, we are seeing only half-percent growth (in our data we define growth as the total hours logged by all the firms in our sample). That half percent a year is contrasted with about 4 percent a year in the pre-2008 world. Put differently, firms that are experiencing 2 or 3 or 4 percent demand growth are getting that not because of organic growth in the market but because they are gaining market share at somebody else’s expense. This is why we continue to believe that there will be firms that will become weaker and that they will see incentive to come to the table early. And when they get to the table, they will find a stronger firm there to meet them. That is why we will continue to see that dynamic of smaller, weakened firms merging into larger, stronger firms.
Dan DiPietro is the chairman of Citi Private Bank’s Law Firm Group.
David B. Wilkins is the Lester Kissel Professor of Law, vice dean for Global Initiatives on the Legal Profession, and faculty director of the Center on the Legal Profession at Harvard Law School.