By Roy Strom
The first lawsuit brought against Dewey & LeBoeuf's management by a former partner alleges trouble among the partnership from the very start of the firm's 2007 merger.
"Many of the merging partners were unhappy with the merger and threatened to leave the newly formed firm," Henry Bunsow, a former Dewey & LeBoeuf partner, said in his suit.
"In order to entice those partners to remain with Dewey & LeBoeuf," Bunsow's complaint alleges the firm's management "entered into long-term fixed amount compensation agreements with particular partners."
Bunsow said in the suit that these guaranteed payments strained the firm's financials and that management resorted to recruiting high-priced laterals — he got a $5 million a year guarantee himself — to boost revenue.
In the complaint, he called Dewey & LeBoeuf's series of lateral hires a Ponzi scheme.
If the allegations prove true, lawyers and law firm consultants said Dewey & LeBoeuf serves as an example of some of the extreme risks involved in certain types of lateral hire strategies.
The type of lateral hiring done at this failed firm sounds a warning to lawyers about some of the strategies law firm management may use that could cause long-term problems.
For instance, law firms short on cash can see a star recruit as a quick way to boost revenue, while the costs involved in landing and paying that recruit don't immediately appear in the firm's books, said Edwin Reeser, a business lawyer and a former office managing partner at then-Sonnenschein, Nath & Rosenthal.
"Some of the growth we're seeing at law firms isn't because they're healthy, it's because they're sick," said Reeser, now president of Edwin B. Reeser, A Professional Law Corporation.
Guaranteed pay packages like those allegedly given at Dewey & LeBoeuf for high-value partners can also destabilize firms — resulting in compensation disparities among partners that speed up the "rush to the exits" when a firm finds itself in financial distress, Reeser said.
But managing partners in Chicago offices said the lateral practices detailed in reports and Bunsow's complaint makes the Dewey & LeBoeuf case an extreme one. Law firms make lateral hires daily and for good reason. Partners, too, make well-informed decisions to move between firms.
For instance, Elizabeth Majers, administrative partner of Loeb & Loeb's Chicago office, came to her firm in 2008 from McDermott Will & Emery. She said she moved, in part, because she and the lawyers at Loeb & Loeb did a lot of similar work.
From the law firm side, Polsinelli Shughart grew from six lawyers when it opened an office in Chicago about seven years ago to employing 68 as of the start of July. Chicago Managing Partner Tony Nasharr said the steady growth came as a result of practice group needs.
Nasharr said his growing firm plans to become a "national powerhouse in certain areas," rather than an international super firm like Dewey & LeBoeuf.
"We don't think we're something we're not," Nasharr said. "And we're not a Dewey."
Bunsow's complaint alleges that Dewey & LeBoeuf recruited him and other big-money laterals knowing that the firm's financials didn't match up to what it told the public.
His complaint says Dewey & LeBoeuf listed gross revenues of $935 million in the 2011 Am Law 100 survey, when in reality the firm brought in $781.5 million that year. Profits came in at $252.5 million, $88 million less than reported. Profits per equity partner, listed at $1.7 million, were actually less than $1 million.
Why would a firm with falling financials look toward a costly lateral market to plug its money troubles?
"You can mask or hide the true costs for a period of time," Reeser said.
Reeser explained a kind of lateral feedback loop that Dewey & LeBoeuf found itself in: A failing firm can boost revenue in the short term by bringing in business through laterals. With the help of some creative accounting, it pays the costs associated with that lateral over a number of years.
In effect, it bolsters current earnings at the firm and makes laterals look profitable more quickly. But it also fails to account for the full cost of the lateral hire, and when paired with compensation guarantees, can lead to huge troubles down the road.
A version of accounting used at some law firms, known as modified cash basis accounting, enables that feedback loop, Reeser said.
For example, a lateral with $2 million in business can immediately add that number to the firm's annual revenue, but the costs to bring that lateral over — recruiter fees, for instance — show up in the books over a five-year period, Reeser said. The firm, in turn, appears more profitable.
"The problem is businesses don't fail because they fail to make a profit, businesses fail because they run out of cash," Reeser said.
After a while, the high cost of paying those $5 million guaranteed contracts becomes real to a firm's cash position and it becomes tough to pay bills or partner compensation, Reeser said.
"Three years down the line you've built in a time bomb," he said. "And the only way to pay it back is to reduce current earnings, but if you're under pressure from your partners to make money, and you reduce current earnings, they leave."
Apart from masking financial weaknesses, pricey lateral hires can destabilize partnerships, said Steven Harper, a former partner at Kirkland & Ellis who runs a blog, "The Belly of the Beast," that comments on law firm management.
The more money top equity partners make compared to those at the lower end of the scale, the more precarious the threads that hold together the firm, Harper said.
Pay spreads, or ratios, at law firms historically registered around 3 to 1 or 4 to 1, said Harper, who wrote the upcoming book, "The Lawyer Bubble." That meant the highest paid equity partner made three or four times as much as the lowest paid.
In Dewey & LeBoeuf's case, some partners reportedly made up to $6 million annually while others received less than $500,000. That represents a pay ratio of 12 to 1. Other reports put that number closer to 20 to 1.
Low- and midlevel partners don't share as much of the profit in good times and get asked to take a pay cut when groups of lateral hires don't work out, Harper said. All the while, the same laterals whose costs contributed to the problem can simply leave a firm that tries to hold back compensation.
"You lose the middle class," Harper said. "You don't have the middle partners that offered some sort of check and balance.
"It's the rare person at the low end of the equity partner spectrum who will raise his hand at an equity partner meeting and ask the managing partner: 'Why is that a good idea?'"
Getting rid of pay spreads, "taking the top down," as Harper called it, can lead to a firm's dissolution, he said. Equity partners at the top end typically resist pay cuts.
"You have this related phenomenon, which is also driving all of this, which is partners thinking, 'Well, if I can't make it here, I'll just go somewhere else,'" Harper said.
Bryan Schwartz, chairman of Levenfeld Pearlstein, said he studies firm failures. He said he noticed pay spreads within large firms beginning to widen years ago.
"In firms like Levenfeld Pearlstein, (the pay spread is) probably closer to 4 or 5 to 1," he said. "And so, those people are still partners together. When somebody is making 16 or 30 to 1, calling them a partner is kind of insulting."
The impact that widening pay spreads can put on firm culture needs to be factored into the decision to pay a lateral hire more than the majority of existing partners, he said.
"And maybe when firms are in more difficulty they're factoring that in less," he said.
Making a move
Despite the possible pitfalls of seeking highly compensated attorneys to grow a firm, it continues to be a successful strategy for many law firms and a good career move for some partners.
Duane Quaini, former managing partner of then-Sonnenschein, Nath & Rosenthal who is now retired, said lateral moves typically occur for reasons other than what Bunsow's complaint says happened at Dewey & LeBoeuf.
"In most firms that I know of and in talking with colleagues of mine who are still running firms, or who ran firms in the past, I think all of them have expressed the same view I have, which is this story is pretty amazing," he said.
(From left to right) Theresa Davis, Elizabeth Majers, and Erik Chalut joined Loeb & Loeb's Chicago office as lateral partners between 2008 and 2011.
Photos by Ben Speckmann.
Majers, from Loeb & Loeb, represents what could be considered a more typical lateral move. Prior to her move to Loeb & Loeb, she worked at McDermott as the firm's global corporate finance group chairwoman and partner-in-charge of client relations.
While there, she said she became one of the more experienced attorneys at the firm, dealing in private placements of securities. In 2007, while representing Northwestern Mutual Life Insurance as it restructured its credit facility with a mortgage originator, she met a Loeb & Loeb attorney doing the same type of work for Merrill Lynch.
"Our clients' interests were aligned and so we'd talk a lot," Majers said. "And I said, 'Wow, I didn't know Loeb did this work.' And (the Loeb & Loeb attorney) said, 'We do this work all the time.'"
When she interviewed with what would become her new firm, she spent six to eight hours at its New York and Los Angeles offices.
Scott Schneider, New York-based co-chair of Loeb & Loeb's lateral partner recruiting, said the firm begins to consider how a lateral's practice will fit into the firm from the first interview.
"We're meeting with that candidate and thinking, 'Who can this candidate work with?'" Schneider said. "And what we're trying to decide is whether this can be synergistic. If it doesn't add up to something more than one plus one equals two, it doesn't work for us."
Often times, synergy can be found by looking at a lateral's client base, Schneider said.
Analyzing how many clients a potential lateral can bring with them proves one of the most important ways to assess their value, Majers said. But because attorneys cannot round up clients before making a move, the analysis often comes down to a more subjective rationale, she said.
"I was the only one at my prior firm that did the private placement work at that high of a level," she said. "There were younger people that helped me, but I was really the one with that high of a skill set. So as a probability, did I know that (my clients) were going to stay with junior lawyers whom I knew were less developed than I was? It was less likely."
Schneider said Majers' skills, her experience as a manager and her practice area made her attractive to the firm.
"Attorneys are notoriously not the best managers, so finding someone who's got good management skills is a real bonus," Schneider said. "There was always a mindset of her advancement within the office, and not long after she joined us, she co-headed the commercial finance practice.
"In a firm our size it's much better when (laterals) come in and integrate with their partners, and once other lawyers know them and respect them, it's easier to say: 'This person now has this title.'"
But it didn't always look so rosy: Ten months into her move, Bear Stearns sold to JP Morgan Chase for $2 a share. Her move came just prior to the market dip that turned many lateral hires into losers for firms.
However, while the economy headed south, her practice stayed healthy, she said.
But success as a lateral also stems from integrating a practice into the work that other lawyers already do, she said.
For instance, when the firm brought on an energy practice in Washington, D.C., and in New York, the group initially phoned in to conference calls with Majers' finance practice.
The energy group told her team what kind of financing they often see in the deals they work on. When they realized some of their clients could use Majers' skill set, they invited her to a conference in Las Vegas to meet with their clients.
"I'm not a member of their group and they're not a member of my group, but because we met over one of our phone calls, and we found out we had synergies, we work together now," she said.
Laterals as a growth strategy
For Nasharr, managing partner of Polsinelli Shughart's Chicago office, lateral recruiting never really ends.
The firm nearly tripled in total size to 630 lawyers since he joined 6½ years ago. The Chicago office, at the same time, grew from six lawyers to 68.
He said he worked on at least 40 lateral partner hires and 20 lateral associate hires.
Despite the relatively rapid growth, Nasharr said the firm sticks to hiring only for practice group needs.
"We're not going to chase dollars," he said. "We don't pursue numbers. The numbers happen because we have needs. We get the right people, they generate work and, as they generate work, we find we need more people."
For instance, Spencer Wood joined the firm's intellectual property practice from Dewey & LeBoeuf in November.
"The IP practice here is very significant," he said. "It's a group that is a revenue generator itself and not just a service arm for other groups in the firm."
Wood said Dewey & LeBoeuf's Chicago office received little attention during the years after the merger. Eventually, this made him plan to leave.
Nasharr said Polsinelli Shughart tries to vet a person's intentions for moving — and their intentions of sticking around, he said. Nasharr said the firm values partners with a track record of 10, 15 or 20 years with the same firm.
If he gets a sense that a lateral wants to use the firm as a springboard, W. Russell Welsh, the firm's CEO and chairman, who ultimately sets compensation and makes offers for laterals, "will never make an offer. It just won't happen," Nasharr said.
But if a lateral partner makes it through the firm's six- to 12-week interview process, they will find themselves in Welsh's office, discussing compensation.
Wood said he "had a small client base" as counsel at his old firm, but one particular client "had been very good to me in the few years prior to my move."
"And with that as sort of my dowry, they were interested in bringing me in as a strategic fit, to help continue to grow the science and tech practice," he said.
In contrast with Dewey & LeBoeuf, Nasharr said pay among partners "is not a spread as much as a range."
Among equity partners, the firm uses 12 to 14 tiers of compensation. Six to eight tiers exist for income partners and some of the tiers overlap "meaning there are some income (partners) that make more than equity (partners)," Nasharr said.
He said wide pay disparities can roil a partnership, but the fact that Polsinelli Shughart keeps open compensation records among its about 300 partners makes the system inherently fair.
Nasharr also noted that his Kansas City, Mo.-based firm "is more Midwest conservative" and does not use modified cash basis accounting to make laterals look more successful more quickly.
"Compensation has to be fundamentally fair," he said. "But of the 300 partners that see what each other make, there are very few if any complaints. So, just by that fact alone, it's fair. I've seen it in practice for the last six-plus years."
The firm makes it clear to incoming laterals that it plans to continue growing, he said.
Wood said the firm's growth attracted him. After being at Dewey & LeBoeuf's neglected Chicago office, he wanted to come to a place with a group of like-minded attorneys seeking out a growing book of business.
"Before Dewey started to unfold, the decision had already been confirmed for me that it was the right one," he said. "I quickly identified the group of colleagues here who were likely to be my partners in growing the practice, and we meshed well together right away. … And then, of course, it was underscored how timely my decision had been by late spring."
Looking out laterally
Harper, the former Kirkland & Ellis partner, said firms looking to "grow for the sake of growth," which he said apparently happened at Dewey & LeBoeuf, should rethink their strategy.
He said competition in the lateral market for "star partners" contributed to pay spreads that "truly have exploded in the last five years, but certainly in the last 10 to 12."
"Does anybody really think that the current generation of so-called stars is the first generation of legal stars?" Harper said. "It's an absurd proposition if you give it any consideration. And so the question is: What was happening then that was different?"
Harper pointed to law firm management.
"You had people who really were committed, I think more so than people are committed now, to building a lasting institution rather than picking off talent and trying to just grow the (firm) for some short-term gain," he said.
Nasharr said his firm, Polsinelli Shughart, saves for lateral hires; it expects a bump of hires in the first six months of the fiscal year, he said. Because laterals typically take some time to bring over revenue, the firm "takes an appetite suppressant" after those early-year moves.
"Overall, we look at (our lateral hires) as a class, so to speak. Just as long as you're not making bad decisions on a regular basis, you're going to be fine," he said.
Schneider, Loeb & Loeb's co-chair of lateral partner hiring, declined to discuss the firm's pay ratios, but said: "We're a fairly profitable firm ... We're doing transactions or bringing in people on terms that are reasonable. Every once in a while, you have to extend yourself a little bit more and our partners expect that."
"Extending yourself" might mean paying a bit more for a top-tier lateral, he said.
"But that doesn't mean you guarantee someone exorbitant sums of money for two or three years whether they show up or not," he said.
Schwartz, from Levenfeld Pearlstein, said despite management's best efforts, it can be difficult to prevent a diaspora of lawyers once the firm's profitability dips.
"It's not easy to be a managing partner in a big firm … where everybody wants more and more money, and the only thing they understand is up, not flat and not down," he said. "And that's not where the economy is at."
The legal profession's rules that allow lawyers to move freely between firms "opened up the gate for this kind of conduct," Schwartz said, referring to partners fleeing a firm at the first sign of financial distress.
"You have a guy who's making $5 million that has no personal guarantees, he's not on a lease, and he can just get up and walk out the door, no consequence," Schwartz said.
"So, if you don't have the kind of courage to stand up to these kind of people … then you're going to get killed.
"And perhaps that's what happened (at Dewey & LeBoeuf), but no one ever knows the real story. That's the one thing I've learned from studying these failed situations."