Law firms don’t just go bankrupt – they collapse. Dewey & LeBoeuf; Bingham McCutchen; Heller Ehrman; Howrey; Thelen. All of these firms and many others have disappeared with extraordinary swiftness and finality. Large law firms often go from apparent health to liquidation in just a few months – sometimes even weeks or days. And none has ever managed to reorganize its debts in Chapter 11 bankruptcy and survive. This pattern of swift and complete collapse is puzzling, because it has no parallel among ordinary companies. Delta, Chrysler, and countless other companies have gone bankrupt over the years, and many more, such as Uber, consistently lose money. And yet many of these companies are still in business. By contrast, almost no large law firm has ever survived a money-losing year, let alone insolvency or bankruptcy. Why?
In Why Law Firms Collapse, I argue a law firm is fragile partly because it is owned by its partners, rather than by investors. Drawing on a review of every large law firm collapse in the last thirty years, I show that partnership ownership exposes a law firm to a self-reinforcing spiral of withdrawal that I call a partner run. When one partner leaves, she damages the firm. This causes other partners to leave, which further damages the firm, causing still more partners to leave, and so on.
Partner ownership drives these spirals by forcing a firm’s remaining partners to suffer when other partners depart. First, partner ownership forces a firm’s remaining partners to suffer the decline in profits caused by another partner’s withdrawal. As owners of a firm, the partners get paid in profits, rather than in fixed salaries or cash bonuses. So if one partner withdraws and damages a firm’s profits, the remaining partners necessarily have to eat the loss in the form of reduced profits. Second, as owners of a firm, partners face devastating forms of personal liability that reward partners for leaving early. The doctrine of fraudulent transfers, for example, forces the partners of a collapsed firm to give back the compensation they receive in the months before bankruptcy. Because partners get paid in distributions of profits, rather than wages, their compensation might be recoverable as a fraudulent transfer in bankruptcy. Leaving early can protect a partner by reducing the amount of compensation she receives from a dying firm in the days before bankruptcy. Other doctrines similarly push partners to race for the exits.
The importance of partner ownership in law firm collapses is evident in the experience of Slater & Gordon, a firm based in Australia and the United Kingdom that was owned by investors. Slater & Gordon recently became insolvent and had to negotiate a workout, eventually wiping out its equity holders and giving ownership to its creditors. In contrast to conventional partner-owned law firms, Slater & Gordon did not collapse. Like Delta Airlines, Chrysler and many other investor-owned businesses, Slater & Gordon continued to pay its attorneys during the firm’s insolvency and the attorneys stayed on, because they faced little risk of declining pay and no risk of liability.
This theory can tell us a lot about how and why law firms collapse. It tells us that law firms can begin to collapse even when a collapse will make their partners worse off. This theory also tells us that debt, macroeconomic forces, and the recent decline in demand for legal services are all much less important in driving collapse than we might think. Governance failures and social factors, by contrast, turn out to be more important. This theory also suggests that a struggling law firm could resist collapse if it was owned by investors or if it could impose significant restrictions on its partners’ withdrawals.
Lawyers often think that partner ownership helps to hold a law firm together. But sometimes it can become the force that blows the firm apart.
John Morley is Professor of Law at Yale Law School.