Lessons learned from law firm failures

August 1st, 2020

Much has been written about the impact that the COVID-19 pandemic and other geo-political and macro-economic events may have on legal practice. As legal practitioners analyse the economic impact of these events on their respective practices and reposition their practices in response thereto, some may be considering moving from their current practices and joining new law firms. In this article I hope to raise awareness of the risk associated with the departure of partners from a law firm and the impact on the firm they leave behind. The departure of partners is one of many reasons for the possible failure of the law firm.

In South Africa (SA), just like every other jurisdiction around the world, legal practitioners can recall many examples of once prominent law firms, which no longer exist. Underlying such anecdotes or ‘war stories’ (perhaps even urban legends in some quarters) are always lessons that can be learned from the failures of others. As can be gleaned from other jurisdictions, the current size and stature (real or perceived) of the firm does not mean that it is immune to failure. History has shown that even large firms with great commercial success can suffer unforeseen events that threaten their existence and even lead to their demise. As aptly put by Professor John Morley of Yale Law School, law firms ‘are made of unusually thin glass’ and ‘[l]aw firms don’t just go bankrupt – they collapse’ (John Morley ‘Why Law Firms Collapse’ (2020) 75 The Business Lawyer 1399).

Unlike some other jurisdictions, South African law firms are not legally obliged to publish their financial information. While some jurisdictions make the data on the movement of legal practitioners between firms freely available to the public, in SA the data is held by the regulator, the Legal Practice Council, and is not made readily available to the public. In some jurisdictions this information is publicly available. A number of studies have used the publicly available data to interrogate the reasons for the failure of law firms. In order to maintain the focus of this article – on the lessons learned rather than the personalities involved – I have deliberately avoided writing about the failure of firms in SA or repeating the names of the firms included in the international studies referred to below.

The impact of partners leaving

Multiple levels of relationships underlie all legal practices, whether these be the relationships of the people in the firm or those with external stakeholders, such as clients, competitors and possible suitors. The balancing of the various relationships is crucial to the success or failure of the firm. Legal practice is a business with legal practitioners at its core and when legal practitioners are of the view that their commercial and professional interests are not aligned with those of the firm, they are likely to move. A partner in a law firm may take some or all of their clients with them when they leave. A discussion with clients on the planned move may have preceded the announcement of the departure to the other partners. The decision to move may be as a result of an assurance of continued support by key clients to the partner intending to move. In some instances, entire teams and areas of practice are uprooted when there is movement of partners from the firm. Those left in the practice may then be left trying to salvage what – if anything – is left of the practice.

The nature of legal practice is that it is the clients who will have the final say on whether their matters remain with the original firm or are moved to the new firm with the legal practitioner concerned. The firm may have a lien over the existing files in respect of work already done, but this does not guarantee future fee income from a client who has decided to move with a particular legal practitioner with whom they have a preferred relationship. A firm cannot force a relationship with a client who no longer wishes to have a relationship with it. Other partners, staff and clients may see the departure of a partner as a symptom of serious underlying problems in the firm and also decide to leave. The legal practitioners who remain then need to spend a lot of time stabilising what remains of the firm in order to avoid an implosion. What happens to a legal practitioner who, for example, is close to retirement or has only practised in a limited area of law and thus does not have many options outside of the existing firm?

The failure of law firms

A number of authors have examined the reasons for the failure of law firms. Lee Rosen in ‘8 Reasons Law Firms Fail’ (https://roseninstitute.com, accessed 6-7-2020) for example, lists the eight reasons why law firms fail as –

  • fighting between partners;
  • failure to focus on clients;
  • internal orientation;
  • a refusal to learn;
  • a lack of focus;
  • no experiments;
  • no growth budgets; and
  • a failure to adapt and change.

In the article ‘The Decade’s Big Law Failures: Why Do Big Law Firms Fail?’ (www.lawfuel.com, accessed 6-7-2020), another study looked at the failure of large law firms in the last decade and listed the main causes of failure as –

  • lax management;
  • declining productivity;
  • mismanagement;
  • internal rifts and fading workflow;
  • slowing workflow;
  • over-extension; and
  • over-expansion.

As will be noted from Prof Morley’s extensive study (op cit), it is normally the rainmakers in the firm who are first to leave. The departure of the rainmaker may be followed by a departure of other partners who view the departure of the former as a sign of impending trouble in the firm. Senior partners will have access to the financial information of the firm and make their decisions armed with that information. Prof Morley conducted an extensive study on the collapse of law firms using the publicly available information on the collapse of 37 large law firms over a 30-year period. He opines that one of the problems with law firms is their ownership structure. The fact that the equity in the firm is owned by the partners rather than investors makes law firms fragile and susceptible to ‘partner run’ with similar consequences to a run on deposits by investors in a bank when they fear that the bank may be facing the risk of failure. This model of ownership requires that the partners be paid in profits rather than salaries and bonuses. According to Prof Morley, the personal liability of partners for debts of the practice is another reason that law firms fail. He writes at p 1402 that:

‘Debt, macroeconomic forces, and declines in demand for legal services all are much less important than we might think. Governance failures and social factors, by contrast, are much more important.

This theory can also tell us how to stop law firms from going up in flames. The solution is not just for law firms to make more profits and borrow less money. We could also stop law firms from collapsing by changing professional ethics rules to allow them to be owned by investors or permit them to restrict their partners from withdrawing. …

This theory also reveals a deep connection between partner ownership and the values of friendship, loyalty, and trust. By undermining the formal bonds of money and creating powerful financial incentives to withdraw in times of decline, partner ownership forces firms to rely on informal forces like friendship and loyalty to hold themselves together. Partner ownership cuts the metal nails of contract and replaces them with leather cords of loyalty. Law firms are thus uniquely reliant on informal forms of bonding capital in place of more formal forms of financial capital. The trouble is that if the leather cords of friendship and loyalty cease to bind – if all partners care about is money – then partner ownership has a hard time creating financial incentives that can hold a law firm together. Indeed, … partner ownership can become the very force that blows a law firm apart.’

In SA, the partner ownership of law firms is entrenched in s 34(5)(a) and (b) and s 34(7)(a) in the Legal Practice Act 28 of 2014 (the LPA).

What firms can do?

Melissa Hogan in ‘Skinny Dipping: The Anatomy of Law Firm Demise’ (http://edwesemann.com, accessed 6-7-2020) suggests the following steps for firms:

  • Establishing a culture, compensation system, and other systemic safeguards to help prevent important partner (or partner group) defections.
  • Despite best efforts to prevent partner defections, if they do occur, develop strategies to address the implications of such defections.
  • Consider strategic decisions that address the current market conditions in practice areas central to your firm.
  • If you are thinking about a potential merger, carefully analyse the possible candidates in an objective manner and create the best business case to bring the merger to fruition.

Firms can also consider addressing the consequences of partnership departure in their partnership agreements. What will happen if the firm is notified of a claim after the departure of the partner concerned and the allegations are that the cause of action relates to something that the latter has either done or omitted to do? Firms can also consider including the debts and liabilities of an incorporated practice (s 34(7)(c)(i) of the LPA) and the liability in respect of any theft committed during their term of office
(s 34(7)(c)(ii) of the LPA) in the partnership agreement so that partners who depart do not leave those who remain to face the consequences of any liability on their own.

When the pre-occupation of the partners is on salvaging the firm and preventing the practice from haemorrhaging further, risk and practice management measures may be put on the back burner. That creates a potential fertile environment for something to fall between the proverbial cracks and for errors or omissions to occur which give rise to claims against the firm.

Learn from the reasons listed above for the failure of the firms concerned and avoid following the same route.

Thomas Harban BA LLB (Wits) is the General Manager of the Legal Practitioners’ Indemnity Insurance Fund NPC in Centurion.

This article was first published in De Rebus in 2020 (Aug) DR 5.

South African COVID-19 Coronavirus. Access the latest information on: www.sacoronavirus.co.za