The Anatomy of Law Firm Failures

The recent failures of Heller Ehrman and Thelen Reid & Priest – coming, as they did, at a
time of serious economic downturn for the country and the legal market – have led a
number of our clients to ask us about the root causes of law firm failure and whether it is
possible to identify early warning signs of firms in distress. In fact, we believe that it is
possible to point to certain commonalities in the law firm dissolutions that we have
observed over the past several years.

At the outset, we should note that, while the current economic downturn may have
exacerbated the distress of Heller, Thelen, and other troubled firms, it would be inaccurate
to conclude that the downturn actually caused their problems. It is important to remember
that Heller and Thelen are only the latest in a series of high profile law firm failures that
stretches back at least two decades. The list includes (to name but a few):
• Altheimer & Gray
• Arter & Hadden
• Bogle & Gates
• Brobeck Phleger & Harrison
• Butler & Binion
• Coudert Brothers
• Donovan Leisure Newtown & Irvine
• Hill & Barlow
• Jenkins & Gilchrist
• Johnson & Wortley
• Keck, Mahin & Cate
• Lyon & Lyon
• Pennie & Edmonds
• Shea & Gould
• Testa, Hurwitz & Thibeault
• Troop Steuber Pasich

To a significant extent, law firm dissolutions – as well as the continuing large number of law
firm mergers – are the products of a rapidly consolidating and segmenting market place.
As competition within the legal market becomes more intense, as clients become more
demanding and discriminating in their choice of firms, and as firms become more
aggressive in positioning themselves in their selected markets, it is inevitable that there will
be winners and losers. As weaker firms become less competitive, their partners will
invariably look to relocate their practices to firms that are better positioned for success in
their relevant markets. Recognizing that the legal market is continuing to segment, we
expect that we will continue to see a steady number of both mergers and dissolutions, even
after the recovery from the current economic downturn.

Four years ago, Hildebrandt conducted a study of 80 law firm failures occurring in the
United States from 1998 to 2004, in an effort to identify the fundamental causes of the
dissolutions. Looking back on that study – and extending it forward to the firms that have
dissolved since 2004 – we believe that the conclusions we reached in our earlier study
remain valid and offer helpful guidance for today’s law firm leaders.

In our experience, failed firms typically exhibit one or more major fundamental flaws, and
the flaws usually fall into three primary categories:
• Below average financial performance – often including excessive financial
leverage, significant deferred obligations, low productivity, and poor realization;
• Internal dynamics – primarily involving leadership issues, partners with
incompatible goals, differences over compensation philosophy, and lack of
succession planning; and
• External dynamics – primarily involving competitive pressures related to the firm’s
historical client base, access to new clients and desirable work, and inability to
recruit key talent.
All of these issues, of course, can be viewed as involving some sort of strategic failing.
And, in fact, in troubled firms there is rarely a well-articulated and implemented strategy.

It is also often the case that a failed firm may exhibit multiple flaws, and this too is really not
surprising. A leaderless firm, for example, that is faced with significant competitive
pressures will often produce poor economic performance. In many failed firms that we
have reviewed, the fundamental flaws were well recognized long before the firm voted to
dissolve, but the partners chose not to act on the flaws until it was too late to fix them.

Typically, the underlying problems created by the fundamental flaws in the firms we studied
were brought to a head by a triggering event that set in motion a rapid downward slide.
Four types of triggering events were the most common: (i) overexpansion that weakened
the firm over an extended period of time, (ii) the unexpected rapid or gradual defection of
significant partners to one or more other firms, (iii) a breakdown in merger efforts for a firm
that was already in serious financial distress and barely surviving, or (iv) the impending
expiration/renewal of the firm’s primary office lease. In many cases, there were multiple
triggering events – for example, a breakdown in merger discussions followed by the rapid
exodus of key partners. While the seeds of collapse are generally sown long in advance of
the actual dissolution of a law firm, the downward slide following one or more triggering
events can be very rapid – usually a matter of weeks not months.

With these considerations in mind, and recognizing that circumstances will differ from firm
to firm, it is possible to identify a number of factors that should be warning signs to law firm
leaders. These factors are described below, using the three broad categories identified in
our previous dissolution study.