Yesterday Judge Martin Glenn of the U.S. Bankruptcy Court allowed Dewey to use cash collateral to fund its wind-down operations, even though this collateral should really be seen as belonging to the firm’s secured creditors. Judge Glenn initially denied this request, at least when it was coupled with giving the secured creditors a lien on recoveries from future litigation. In deciding to let Dewey tap into the cash, Judge Glenn did not decide what the lenders might get in exchange for letting the firm use their money. That will be decided later, at a June 13 hearing.
With things quieting down on the Dewey news front, let’s turn to analysis. Here are some insights into what brought Dewey down and what other firms can learn from its fall, from a former managing partner who now works as a consultant to the legal industry….
Back in January of this year, I served as a panelist at an excellent conference on entry-level recruiting that was put together by Bruce MacEwen (of Adam Smith, Esq. and JD Match fame). At the conference, I had the pleasure of meeting Edwin Reeser, a Biglaw managing partner turned law firm consultant who participated in another panel. I was very impressed by his insights, and we’ve stayed in touch since then.
Over the past few weeks, as the legal profession has watched Dewey implode, I’ve been impressed by Ed Reeser’s insights into the situation, which he has shared with me and others over email. I asked him if he might be interested in preparing a post-mortem of sorts on Dewey that we might be able to run on ATL. He kindly provided me with the following analysis, which I’m happy to share with you now.
The Dewey Disaster: Lessons Learned
By Edwin Reeser
The demise of Dewey & LeBoeuf has drawn much attention in the legal profession for the past three months, and commanded great attention in the business press as well. Now that the process of the firm coming apart as a viable enterprise has concluded, the wreckage of the firm has been turned over to the bankruptcy court for salvage. Like a train run full-speed off the trestle, thousands stand on the canyon walls peering down at the disaster below.
What happens next? Some people will express the view they do not care, or at least do not care to watch. They can stop reading now. But if you ride the train of Biglaw yourself, whether directly as a partner, employee, lender, creditor or landlord, or even as a client…. maybe you should care. Because while Dewey is the same as many of the failed law firms that have gone before it into bankruptcy in recent years, Dewey is also different, and not necessarily in ways that distinguish it from many firms still standing.
The salvage operation for this disaster is going to reach into new areas that have yet to be explored in law firm failures, and some of them could be game changers for the future. Let’s look at just a couple of them.
1. Dewey’s demise may have been predictable, and years in advance. To borrow a phrase from a former Dewey partner, “Anybody who says otherwise doesn’t know what they are talking about.” A careful, ongoing inspection and reassessment of the firm’s financial structure, governance, operations and compensation program would have shown that basic fundamentals at Dewey were trending terribly wrong, and for an extended period of time. A checklist of warning signals for large law firms approaching disaster, written three years ago without any thought of Dewey, can be found here.
Many of the components that are on this list will be examined closely in the context of the failure of Dewey. To the extent it is determined that such factors contributed to Dewey’s collapse, other law firms that have similar features should carefully re-evaluate whether they present a threat to their firm and should be significantly reformed or replaced.
2. Dewey’s demise may have been preventable, with partner participation and intervention. One of the questions to ask in the near future is: who was in charge? That question does not appear to have been much of an issue in other recent law firm failures, such as Coudert, Thelen, Heller, and Howrey — at least not yet. But it will be of intense interest in Dewey.
A law partnership is generally perceived as one in which each of the partners has a participatory role in the governance and decision-making of the firm, and thus while bearing a share of profit (and loss), also enjoys the privilege of informed voting and the burden of shared administrative duties and responsibilities. The scope of involvement of partners in decision-making and influence at Dewey, indeed in the distribution of information, appears to have been quite uneven. The prospect of a “partnership within a partnership,” of self-described “haves and have-nots,” has been raised. To what extent partners may have broadly delegated rights and powers voluntarily, and to what extent were those rights co-opted, and what does the partnership agreement provide — these factors could have relevance for allocation (or even the existence) of liability amongst partners, including determining who were or were not actually “partners.” It could also provide insights into the underlying rationale for decision-making that led to the firm’s collapse.
(Though not addressed to Dewey, some of the strategic logic of certain types of decisions in a failing law firm here could be worth reflection. See here.)
Whether and to what extent all or any of these motivations were present in Dewey will be determined in the future. But it will be important to the positioning of numerous partner interests as among each other, including core management members, executive committee members, practice group leaders and office managing partners, “insider partners” privy to information on guaranteed compensation and real financial information, junior partners, and perhaps other groupings. Dewey is likely to be the first major law firm collapse that will actively position groups of partners in conflict with each other over undisclosed programs and differential and preferred treatments by class.
3. Follow the money. If there is anything on this earth that moves for a reason and in accordance with a plan, it is money. Law firms are no different than any other businesses in this regard. The footprints of plans are to be found in the steps and decisions that facilitate the movement of money, for those can reflect an awareness and understanding of the financial condition of the business at the time the decisions were made. This will impact a key future decision, the determination of when Dewey reached a point of insolvency. This is a critical challenge in the Dewey bankruptcy because the amount of the creditor claims will likely be quite large relative to the realizable assets of the firm. There is a real prospect that the secured creditors will have significant unsatisfied balances due them after exhaustion of the collection efforts on their security interest in the accounts receivable and cash. Thus the unsecured creditors, and the secured creditors to the extent of their shortfall on collections, will look to the clawbacks of distributions to partners as a potential source of recovery. The farther the reach-back into time on those distributions, the more they may recover.
Where are the footprints? One set will be found in the accounting methodologies applied by the firm (for example, capitalization of lateral partner recruitment expense). Any management-directed changes in accounting methods that might have occurred — for example, changes in modified cash basis treatment of expenses to capitalize them, thus overstating income and understating current expense — will be but one immediate focus. So will all manner of techniques to shift items of income and expense, defer contributions to pension plans to future years while commingling monies withheld from partners to pay expenses or make distributions, defer returns of capital to withdrawn partners, reallocate income in the partnership, use borrowed funds to make distributions to partners in excess of earnings, etc. If none of these things happened, then there is nothing to see. If some or all of them did happen, then why these steps were taken, and what they enabled, will become important to know. It may be solidly grounded, but we have to find out.
Thus Dewey will quite possibly involve more forensic accounting attention than previous big law firm failures, and the conclusions could have an impact on the potential claims by many tens of millions of dollars. Think about it this way, just for illustration. If net distributable partner income was $240 million per year for the last two years, on a straight-line basis, every month clawed back is $20 million more for the creditors. If the partners were equal and there were 200 of them, that is $100k per partner in potential personal liability for each month clawed back.
(An explanation of the significance of modified cash basis accounting in large law firms is available here.)
4. Watch what is done, not what is said. Another one of the important questions likely to be asked shall be directed to firm culture, e.g., “Was there one?” And if so, “What was it?” This is important because, as Professor Bill Henderson and others have pointed out recently, “money is weak glue.” It takes a resource more powerful than money to pull a partnership together and change direction away from disaster while there is still time to do so. In that situation, the firm must have confidence in its leadership based on a history of its action, not just its words. An interesting element of the Dewey scenario is the embracing of a public relations crisis manager, and the apparent long-term disconnect between what was said, and what was done, right up to the filing of the bankruptcy itself. What was the culture of the firm and how did that translate into firm governance and operations, and are there lessons there to be learned for the rest of us that we can apply to our own situation? (For more on the subject, see here.)
There is no fortune telling here — at best, just a grasp of the intuitively obvious, mixed with some common sense. The references to published pieces from three years ago is simply to prove that there isn’t anything special or unknown at work. It is “Course 101” in management and leadership. Maybe it was just ignored. The hard news is that in the case of Dewey, as with most large law firm failures, the consequences of ignoring these fundamentals are going to be harsh on a lot of good people.
The possible good news is that perhaps this final observation will lead to productive change. That observation is that this may be the first instance in a large law firm failure that leadership will be held accountable for the consequences of actions taken that led to the firm’s failure. The mere spectre of that possibility should energize all law firm leaderships to work ever more responsibly to protect and preserve their firms and their people, and limit the number of Deweys in the future. It is certainly going to energize more than a few partners at Dewey to protest they knew nothing about what transpired within their own firm, even at the highest levels. For a lot of the world’s self-professed smartest lawyers, that is a hard admission if true, and a harder argument if not.
Edwin Reeser is a lawyer in Pasadena specializing in structuring, negotiating and documenting complex real estate and business transactions. He also consults with law firms, lenders and businesses on law firm operations and finance, partnership agreements, and ethics issues. He has served on the executive committees and as office managing partner in firms ranging in size from 25 to 800 lawyers.
The Big Law Firm Demise – It Happens Like This [JD Supra]
Do Partners Really Want to Save Their Law Firms? [JD Supra]
Super Fuel for the Profits Per Partner Drag Race – Modified Cash Basis Accounting [JD Supra]
Spin, Truth, and Law Firms [JD Supra]
Dewey’s bankruptcy: Let the rumble begin [Thomson Reuters News & Insight via Morning Docket]
Bankruptcy Judge: Dewey Can Use Lenders’ Cash Collateral [WSJ Law Blog]
In Dewey Bankruptcy, A Second Day Scramble [Am Law Daily (reg. req.)]
Dewey Bankruptcy Judge Releases Collateral for Wind-down [ABA Journal]