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"Why Law Firms Collapse"

Excerpt from article "Why law firms collapse"

“The answer lies in the unusual way that law firms are owned. Unlike Amazon and Chrysler, law firms tend to be owned by their partners rather than by investors. And this makes the partners unusually sensitive to decline. As a firm’s profits drop, the decline can feed on itself and turn into a self-reinforcing spiral of partner withdrawals.

Law firms die with extreme ease and astonishing speed. Partner ownership encourages a cascade of partner withdrawals for two reasons. The first is that, as owners of their firms, partners get paid in profit shares rather than fixed salaries or wages. This makes partners acutely sensitive to problems in a firm because it links their individual compensation to the fortunes of the firm as a whole. For some partners, at least, a decline in profits means a decline in pay. As profits drop, some of a firm’s partners will inevitably start to leave for better-paying opportunities elsewhere. But this causes profits to drop even more, which drives even more partners to leave. Profits then decline still further, causing even more partners to leave, and so on, until the firm finally collapses. If partners were paid in fixed salaries, they would not care about the declining profits. But because they are paid in profits, departures become self-reinforcing. As each partner leaves, the benefits of staying decline for all those who remain.

The second problem is that because partners are owners of their firms, they face crushing personal liability when a firm finally dissolves. All the compensation partners receive in the months leading up to bankruptcy can be clawed back as a fraudulent transfer, for example, and the partners’ capital investments in a firm can be taken away as well. Partners who stay too long may even have to give up billings they generate after the firm dissolves. All these liabilities flow directly from partners’ status as owners. The staff and associates face none of these liabilities. And unfortunately, these liabilities encourage partners to leave, because the only way to avoid them is to be among the first to withdraw.

Therefore, the net effect of partner ownership is to make law firms remarkably fragile. As we pick through the burnout ruins of firms like Dewey & LeBoeuf, it becomes obvious that partner ownership exposes law firms to the same horrifying logic of withdrawal that animates bank runs. A law firm can collapse, in other words, because partner ownership can drive a run on the partnership.”


Article: https://thepractice.law.harvard.edu/article/why-law-firms-collapse/ 

Original report: https://www.law.columbia.edu/sites/default/files/microsites/law-economics-studies/why_law_firms_collapse_11.0.pdf