Minding the Law's Business

LAW FIRM PUBLIC OWNERSHIP ETHICS ISSUES A RED HERRING

As the public offering of shares in the Australian plaintiffs’ law firm Slater & Gordon moved toward and then became a reality, the number of articles and blog postings discussing the possibility of public ownership of American law firms has increased.  The most recent RSS feed to hit my computer was the posting Everything You Wanted to Know About Owning a Law Firm, but Were Afraid to Ask published yesterday at the Law.com Blog Network.  Bruce MacEwen at Adam Smith, Esq., and Larry Ribstein at the University of Illinois College of Law are among those who have written about the issue.  Bill Gratsch at Blawg’s Blog noted the listing of Slater & Gordon’s shares.  And, the Georgetown Law Center for the Study of the Legal Profession will host a symposium next year that will discuss the issue.

The articles and postings I’ve read all have been good; and, generally they conclude that the U.S. ethical rules currently prohibit non-lawyer ownership of law firms.  In some states, ethical rules also prohibit the sharing of legal fees with non-lawyers.   As Bill Gratsch noted in his posting, “My mind's eye can already see the forces, for and against, lining up...”  When that great debate finally is joined in earnest, however, the ethical issues will prove to be nothing more than a giant red herring.

Nope – the real issue will be fear.  It’ll be fear of the type described by Franklin D. Roosevelt in his First Inaugural Address as being “nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance."  And who will be gripped by this paralyzing terror and what is it that they will fear?  Lawyers.  And they’ll be terrified by the prospect of just plain ole’ financial accountability - “transparent” financial statements, financial discipline, true cost control, public financial reporting, and quarterly earnings pressure, to name a few.

Let’s take a quick look at what some outsiders have said about financial practices within the “privately-held” legal industry.  Based on the results of his recently completed 2006 – 2007 survey of attorney billing practices, William G. Ross of the Cumberland School of Law noted:

•    Approximately two-thirds of the respondents to the 2006-07 survey stated they had specific knowledge of bill padding.
•    54.6 percent of the survey respondents admitted the prospect of billing additional time had at least sometimes influenced their decision to do work that they otherwise would not have performed.
•    34.7 percent of the respondents engaged in “double billing”, while only 51.8 of the respondents thought the practice was unethical.

According to The Wall Street Journal’s Law Blog, Bill Henderson - a law professor at Indiana University-Bloomington who studies law firms – suspects “many law-firm management committees may be minimizing the reported number of equity partners for the purpose of raising profits per partner in the Am Law 100. He feels that at some firms, the inner circles don’t share the actual (higher) number of equity partners with the rest of the firm’s partnership.”

In an interesting 2004 case study of eLawForum (a link to the study is in the margin under “Articles of Interest”), Harvard Law School Professor Clay Christensen and Scott Anthony summarized:

•    . . . But because corporations accept the sole-source market, law firms play a cat-and-mouse game with the billable hour and cost-plus pricing, hoarding productivity gains and saddling clients with both cost and outcome risks.
•    With one hand, law firms give discounts on hourly rates to their largest clients. With the other hand, they take back what they have given by raising the base hourly rates to which the discounts are applied and increase the number of hours they bill to do the same work. Law firms are masters of the cat-and-mouse game of the billable hour. As long as they respect the procedures mandated by the law department, law firms can circumvent any attempts at cost reduction by controlling the two key variables—the base rate and the number of hours spent.

Somehow, I don’t think the “industry” is going to want to subject that kind of behavior to the intense scrutiny that comes with being publicly held.

In any event, the debate should be fun to watch.  Soap boxes will be mounted, brows will furrow, obfuscation will abound, carnival barkers will be everywhere, and shouts about ethical concerns for clients will rain down – and no one should watch without putting on their waders because it’ll get deep.  And if you pay real close attention, you even may be able to smell the fear.

VIRTUALLY AN ADVANTAGE

Recently I spoke to a group of lawyers about a subject I mentioned in Toward a Brave New Business Model – the legal industry being just as susceptible as other industries to foundation-shaking and fracturing change - and that those changes make now the time for those in the industry to “reconceive existing business models” (to borrow Gary Hamel’s phrase) and to move toward a brave new one.

When discussing competitive advantage during the presentation I briefly mentioned, and then with a few members of the audience after the presentation I spoke at more length about, “virtual law firms.”  This is a topic a good friend (and former law partner) and I have talked about for years and is one he and I lately have talked about a great deal more with several other friends.  Yesterday’s on-line edition of The National Law Journal featured an article entitled “The rise of the model firm” that focused on “a handful of law firms, most launched within the last few years,” that have been “formed under varying business structures” and that “tout the advantages of offering drastically cheaper rates for corporate clients and a different work culture for highly credentialed attorneys put off by big-firm practice.”  According to the article, attorneys for these outfits work mostly on-site in corporate counsel offices and typically are free from the burden of billing huge numbers of hours to support high rents and leveraged partners.  And, at least with respect to one of the companies mentioned in the article, the attorneys also work from their own homes.

The firms mentioned in the NLJ article appear to have captured a number of the elements my friends and I over the years have attributed to virtual law firms, so I thought now a good time to talk briefly about virtual law firms, particularly as they relate to competitive advantage and new business models.  First, let me share with you some of the general elements that my friends and I believe represent the essence of a virtual law firm (VLF) as it’s evolved in our discussions - it is a law-based knowledge network that’s:

• Created by lawyers with a collaborative mind-set to manage, enhance, and distribute their legal knowledge for a fee.  (Since state disciplinary rules of professional conduct with respect to what constitutes the practice of law and what constitutes the permissible sharing of legal fees between lawyers and non-lawyers vary from state to state, I’m not going to incorporate into this discussion the idea of lawyers collaborating with non-lawyers in order to manage, enhance, and distribute their knowledge for a fee.)
• Based on collaboration, knowledge sharing, flexibility, and responsiveness.
• Linked not by physical facilities - but by technology, including the Internet, intranets, extranets, and other tools, not only among themselves but also with information and knowledge resources.
• Focused on sophisticated business clients whose work requires experience and/or expertise.
• Committed to creating the highest delivered value for clients.

Is a VLF a “brave new business model” and will it create a “competitive advantage” for those who choose to operate in such a manner?  Simply put, I do not think a VLF alone is the sort of “re-conception” of the business model that will be a rude surprise to competitors or that will give a VLF a competitive advantage.  I do believe, however, that if one accepts the definition of “virtually” to be “almost or nearly as described, but not completely or according to strict definition,” then the VLF will have virtually an advantage – albeit one that will not be sustainable or durable over a long period of time.  Let me explain.

In Sometimes Lawyers are Great Mimics . . . But Would Be Even Better Mimes, I noted that:

“Competitive advantage,” on the other hand, means being able to do something that your competitors cannot – and doing it over a long period of time.  It’s what Warren Buffett calls a “wide moat” – a sustainable, durable advantage that allows the business to earn profits greater than its cost of capital for long periods of time.

Then, in O Strategy, Where Art Thou? I discussed Michael Porter’s 1996 Harvard Business Review article “What is Strategy?” in which Porter said operational effectiveness and strategy both are essential to superior performance; and all the activities in which a business engages in order to create, produce, sell, and deliver its products or services are the basic units of competitive advantage – an overall advantage or disadvantage results from “all a company’s activities, not only a few.”  Porter also said the difference between operational effectiveness and strategy lies in these ever-important activities:  “operational effectiveness” meaning “performing similar activities better than rivals perform them”; and, “strategy” or “strategic positioning” meaning “performing different activities from rivals’ or performing similar activities in different ways.”   

To be sure, those VLFs on the scene first, especially those that focus on sophisticated business clients whose work requires experience and/or expertise and then match their assets (lawyers) with the demands of their clients’ business base, should be able to “perform similar activities better than rivals perform them” – thus gaining an initial operational effectiveness advantage.  This early VLF advantage likely would stem from:

• Lower infrastructure costs from little or no facilities costs and reduced administrative costs.
• Lower financial capital costs for, and greater speed in executing, geographic expansion.
• Reduced lawyer-related costs as (1) the business demand requirements (experience and/or expertise) would eliminate the need for “warehousing” and training young lawyers whose costs (particularly at today’s outrageous starting salaries) exceed their revenue generating capability, and (2) the network character of the firm would enable it to associate with lawyers outside the firm who have special expertise on a project-by-project basis and therefore avoid carrying the overhead expense for that expertise when it’s not needed.
• Greater pricing flexibility than firms carrying higher infrastructure and lawyer-related costs.
• Greater opportunity to deliver higher value to clients resulting from better positioning within the professional asset capability matrix combined with the improved cost structure.

But without more, VLFs likely will not gain a competitive advantage.  One can’t gain a competitive advantage by focusing on operational effectiveness alone, as Porter noted in an interview reported in the February 2001 issue of Fast Company that I also mentioned in O Strategy, Where Art Thou?:

If all you’re trying to do is essentially the same thing as your rivals, then it’s unlikely that you’ll be very successful.  It’s incredibly arrogant for a company to believe that it can deliver the same sort of product that its rivals do and actually do it better for very long.  That’s especially true today, when the flow of information and capital is incredibly fast.  It’s extremely dangerous to bet on the incompetence of your competitors – and that’s what you’re doing when you’re competing on operational effectiveness.

What's worse, a focus on operational effectiveness alone tends to create a mutually destructive form of competition. If everyone's trying to get to the same place, then, almost inevitably, that causes customers to choose on price. This is a bit of a metaphor for the past five years, when we've seen widespread cratering of prices.

Since rivals in all likelihood could replicate the essential VLF elements, the operating effectiveness advantage gained by early VLFs probably would last only until more and more firms became virtual and started siphoning away excess profits from those early movers, causing the initial advantage’s economic erosion – unless the operating effectiveness advantage were coupled by a VLF with something of strategic significance, perhaps such as better positioning in the information value chain.  Without that strategic something “extra” that would create a sustainable, durable advantage over a long period time, I think VLFs will achieve only virtually an advantage – but will not enjoy a competitive one.

YOU CAN CALL ME RAY . . . BUT YA DOESN’T HAFTA CALL ME JOHNSON

Yesterday morning, while rapidly scanning the far too numerous RSS feeds that I receive daily and for some reason can’t bring myself to limit, I was struck by the juxtaposition of one blog posting and two articles capsulized in the feeds.  The blog posting was written by Nathan Koppel at The Wall Street Journal’s Law Blog and was entitled “The Rise and Fall of Jenkens & Gilchrist.”  The first article also was from WSJ, also was written by Koppel, and was entitled “How a Bid to Boost Profits Led to a Law Firm’s Demise” - also about Jenkens. The second article was a “Viewpoint” article by Bill Syken at Sports Illustrated on-line under the tag “Don’t wash over athletes’ criminal acts by calling them off-the-field-problems.”

Immediately upon reading all three, comedian Bill Saluga’s refrain started dancing through my head:

Ahh, ya doesn't has to call me Johnson! You can call me Ray, or you can call me Jay, or you can call me Johnny or you can call me Sonny, or you can call me RayJay, or you can call me RJ... but ya doesn't hafta call me Johnson.

Why?  Because Koppel’s blog posting and WSJ article captured the legal industry’s version of the essence of Syken’s article.  Syken began his article with a classic exchange from Lewis Carroll’s Alice in Wonderland:

Humpty Dumpty:  When I use a word, it means just what I choose it to mean – neither more nor less.

Alice:  The question is, whether you can make words mean so many different things.

Humpty Dumpty:  The question is:  which is to be master – that’s all.

Syken goes on to explain that he referenced

[T]he above passage because there are a couple of phrases that sports fans and media figures need to become masters of again.  These phrases, through repeated usage, have acquired meanings they were never meant to have.

Those phrases would be:  “off-the-field problems” and “character issues.”

Those phrases should only be used to refer to misdeeds that are not criminal.  For example:  being late for meetings, not showing up for mandatory autograph sessions, insulting teammates in the press, mouthing off to your coaches, and taking a coach’s assigned parking lot.

You could even include a few things Terrell Owens hasn’t done.

But the terms “off-the-field problems” and “character issues” should not be applied to, say, accusations of inciting a fight that leads to a triple shooting.  Nor should it apply to intimations that someone is supporting a large dog-fighting operation.

These are not “character problems.”  They are something worse.

. . . When you stop and take a moment and picture the crime being talked about, the phrases “off-the-field problems” and “character issues” are far too kind.  Their vagueness is a mask. . . .

Anytime we’re talking about a situation that involves a felony crime, use “criminal behavior” rather than “character issues” or “off-the-field problems.”  It’s simple, concise, and it means what we’re talking about.

In the legal industry, the phrase often used that is far too kind and whose vagueness is a mask is “profits per partner.”   Lawyers and media figures need to become masters of “profits per partner” again.  It is not a behavior, an action, or a disease – it simply is a performance metric.  “Profits per partner” is a measure of the amount of profit being paid to the owners of the firm – “neither more nor less.”

Unfortunately, profit per partners “through repeated usage has acquired meanings it never was meant to have.”  It typically is used today as a buzz-word that vaguely masks underlying behavior that people find offensive but are unwilling to talk about openly.  Koppel’s articles engaged in this “mis-speak” by laying the blame for Jenkens' conduct with regard to the tax opinions that led to its demise at the feet of “profits per partner” – a term he used three times when discussing the decision to hire the Chicago tax group and in discussing Durbin’s management tenure in the WSJ article.   In the Law Blog article, Koppel stated, “As it grew, firm leaders became increasingly focused on boosting its profits per partner, that all-important metric.”  Koppel’s articles about Jenkens aren’t unique in this regard – they’re just the most recent examples.  For example, my last posting came about indirectly as a result of a Law.com article, Is Shedding Partners the Right Way to Improve Profitability? where “profits per partner” was the focal point of an article about growing volatility in the partnership ranks.  And, in an earlier posting, Sometimes Lawyers are Great Mimics . . . But Would Be Even Better Mimes, I took lawyers to task for the incorrect use of business terms, particularly when they’re talking about the business of practicing law.  This is just a variation on that same theme:  when it comes to using “profits per partner,” its use often is a far too kind substitute for the real underlying behavior.

Let’s call the behavior what it is - pure, unadulterated, Gordon Gecko-like greed.  Use that term – greed – when talking about behavior influenced by an almost insatiable desire for the long-green.  “It’s simple, concise, and it means what we’re talking about.”  Greed has wrought bad behavior and brought out weak character and lack of integrity, poor management decisions, and idiotic public relations blunders long before Jenkens made its mistakes – and unfortunately greed likely will do so again in the future.  Jenkens made the bad decisions that led to its demise apparently because its lawyers were greedy.  The metric “didn’t make them do it” – it looks like the desire for more cash did.  Why won’t people talk about greedy behavior openly and candidly?  I guess it’s just an off-shoot of today’s obsession with political correctness – a phenomenon that I believe history will record as being the death-knell of common sense and logic.  But, regardless, let’s stop giving profits per partner – a simple performance metric – a bad name.  Ahh, ya doesn’t has to call me profits per partner!  You can call me greedy, or you can call me foolish, or you can call me Gordon, or you can call me Gecko. . . but ya doesn’t hafta call me profits per partner.

ASKING THE RIGHT QUESTION

Sometimes, asking the right question can be as important, if not more so, than the answer.  This was illustrated again this morning by Bruce MacEwen’s excellent posting “Where Have All The Partners Gone?” at Adam Smith, Esq.  Bruce’s posting, which reacts to an article in The American Lawyer that can be found at Law.com entitled “Is Shedding Partners the Right Way to Improve Profitability?”, uses the right question to direct properly the focus on the cause of equity partner changes to one of careful business analysis.

Obviously, in some instances improving profit per partner (the performance metric functional equivalent of return on equity as I’ve noted before) can be or is the result of “simple” denominator management.  Gary Hamel and C.K. Prahalad noted as much in Competing for the Future when in discussing return on investment they said:

[R]aising net income is likely to be a harder slog than cutting assets and headcount.  To grow the numerator, top management must have a point of view about where the new opportunities lie, must be able to anticipate changing customer needs, must have invested preemptively in building new competencies, and so on.  So under intense pressure for a quick ROI improvement, executives reach for the lever that will bring the quickest, surest improvement in ROI – the denominator.  To cut the denominator, top management doesn’t need much more than a red pencil.  Thus the obsession with denominators. . . . Denominator management is an accountant’s shortcut to asset productivity.

But, if you understand LawBall, you also understand that denominator management is not the way to long-term financial health nor is profit per partner - which simply tells you what the equity in the firm is receiving as profit - a measure of that health.  Rather, profit per lawyer (the functional equivalent of return on assets) is a better measure of a firm’s financial health since it measures the efficiency with which a business allocates its resources and eliminates the effect of leverage on operating results – and, as I’ve noted in prior postings, it not only mathematically is (profit ÷ lawyers), it also is (margin x asset turnover), which for those of you who might not have read the earlier postings about metrics is [(profit ÷ revenue) x (revenue ÷ lawyers)].  By understanding that return on assets is the mathematical product of margin times asset turnover, one can “drill down” into the components of this relationship to gain an understanding as to why his or her firm’s financial health has changed over time or that it may be one way while the financial health of a competitor may be another way.

Robert G. Hagstrom, who has written several books about Warren Buffett, notes that, “The driving force of Warren Buffett’s investment strategy is the rational allocation of capital.”  Hagstrom further notes with respect to Buffett, when discussing a company’s earnings (which become part of a company’s capital), “Determining how to allocate a company’s earnings is the most important decision a manager will make . . . Rationality – displaying rational thinking when making that choice – is the quality that Buffett most admires.”

As businesses, law firms are knowledge businesses – they sell legal information and legal knowledge.  As such, their biggest and most important assets are intellectual capital; and, in particular, human capital – their lawyers.  In discussing business models, Gary Hamel has noted with respect to “configuration” – which is what he calls the intermediating between a company’s core strategy and its strategic resources – “The notion of configuration recognizes that great strategies (and great business models) rest on a unique blending of competencies, assets, and processes.”  The strategic resources or assets must support the strategy – in Peter Drucker’s “theory of the business” that I’ve previously mentioned – the assets must “fit” with the other assumptions.  In an intellectually capital intensive business like a law firm, that configuration requires aligning or matching the capabilities of the firm’s assets (its lawyers) with the demands of the firm’s business.  That is nothing more and nothing less than the rational allocation of capital that Warren Buffett believes to be the most important decision a manager can make.  Such critical managerial tasks and decision-making are hard work and take a great deal of time – and when done in this manner, partner changes are the natural result of intelligent and thoughtful business practices.  Partner changes that occur from simple denominator management more likely are the result of “an accountant’s shortcut to asset productivity” practiced by a firm’s senior manager playing with a red pencil while he or she manages the firm in his or her “spare time.”

In my last posting, I included a matrix I developed that facilitates aligning the demands of a firm’s business with the capabilities of its assets.  I suggested that as you look at the matrix, think about where some of the firms that I mentioned in my prior discussions about metrics might fall – like “Firm B”; Wachtell, Lipton, Rosen & Katz; and, Gordon & Rees.  Sitting here “wasting away again in Margaritaville, searching for my lost shaker of salt,” it looks to me that, based on the operating performance levers chart that I introduced in “What’s Good for the Goose is Good for the Gander . . . And Maybe Even Better” and is included under “Posting Attachments” in the right-hand margin of this blog, Wachtell has aligned it’s assets with the demands of its business in the upper left-hand square of the matrix, while Gordon & Rees has aligned its assets with the demands of its business in the lower right-hand square of the matrix.  Firm B?  It looks misaligned, and I’m guessing it doesn’t have a clue – looks like it may have overestimated the demands of its business and aligned its assets accordingly, resulting in a loss of business and issues over pricing and costs per lawyer.

“SEARCHING FOR MY LOST SHAKER OF SALT”

“The best laid plans of mice and men oft go astray,” as both John Steinbeck and Robert Burns have written in one form or another, so please accept my apologies for the inordinate delay between postings.  About the time that I normally would’ve been writing this posting, I had an opportunity to go to the Jimmy Buffett Bama Breeze Tour 2007.  What a choice – write the posting or rub shoulders with Parrotheads!  Obviously, rubbing shoulders with Parrotheads won; and “a good time was had by all”!

But, the posting benefited, too.  While sipping on margaritas and listening to Jimmy Buffett, I was reminded of the truth inherent in the K.I.S.S. philosophy – keep it simple stupid.  Or, as that “other” Buffett, Warren Buffett, has said, “The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective”; and, “There seems to be some perverse human characteristic that likes to make easy things difficult.”  Charles Munger (or “Charlie” as he is referred to), Buffett’s long-time friend and partner, combats complexity with a “latticework of models.”  Says Charlie, “You’ve got to have models in your head, and you’ve got to array your experience – both vicarious and direct – on this latticework of models.”  As an example, Munger views stock picking “as a subdivision of the art of worldly wisdom,” which incorporates the market, finance, general economics, psychology, engineering, mathematics, physics, and the humanities.  According to author Robert G. Hagstrom, acquiring this worldly wisdom “is an ongoing process of, first, acquiring the significant concepts--the models--from many areas of knowledge and then, second, learning to recognize patterns of similarity among them. The first is a matter of educating yourself; the second is a matter of learning to think and see differently.”

I started thinking about some of the “mental models” I’ve filed away over the years with respect to strategy and its development.  I thought I’d share some of them with you, hoping it might facilitate your thinking about creating the “strategic architecture” (from Gary Hamel and C.K. Prahalad) I mentioned recently that is necessary to develop the “different activities from rivals’ or performing similar activities in different ways” that are at the core of competitive advantage according to Michael Porter.

The first such model is a graphic illustration of the strategic management process that I came across a number of years ago in a textbook, Management:  Function and Strategy by Thomas S. Bateman and Carl P. Zeithaml.  It should have a ring of familiarity to it – it’s similar to what I imagine is the way most lawyers (and others) go about decision-making:  first, identify or diagnose the problem; then develop alternative solutions; next, evaluate the alternatives; then choose the best alternative; next implement the decision; and finally evaluate the decision.

In the case of developing strategy by using the strategic management process model, the first step is to conduct an internal assessment.  That assessment would include both a review of the current strategy (if there is one) and an analysis of the firm’s internal resources and, in keeping with Porter’s view, all of the firm’s activities.  As I’ve mentioned before, I think it’s critical for a firm to “match” the capabilities of its “assets” (lawyers) with the demands of its business, and the internal assessment is a good place to start doing that.  Here’s the second mental model – a matrix I developed that facilitates looking at the demands of a firm’s business and capabilities of its assets.

I know it’s hard to read the model in the body of this posting; but, if you’ll click on it, another larger version should open.  I’ve also put a copy of it in Adobe *.pdf format in the right-hand margin in the “Posting Attachments” section.  As you look at this matrix, think about where some of the firms that I mentioned in my discussions about metrics might fall – like “Firm B”; Wachtell, Lipton, Rosen & Katz; and, Gordon & Rees.

I hope these 2 mental models help get you on your way to develop a strategy or as Hamel so eloquently put it to “reconceive existing business models in ways that create new value.”   I’m afraid that, without new business models that incorporate new strategies, a lot of the “players” in the legal industry will be, as I joined with the Parrotheads and Jimmy Buffett singing recently, “wasting away again in Margaritaville, searching for my lost shaker of salt.”