Know your numbers

When former Dewey & LeBoeuf partners blamed Citibank for not telling them about the dire state of the firm’s finances, they got short shrift. In today’s legal market, there’s no excuse for not scrutinising the balance sheet. Here’s LB’s definitive guide to all you need to know

When law firms fail, the fallout can be spectacular. Take the case of DLA Piper’s Berge Setrakian, a one-time corporate partner in the New York office of Dewey & LeBoeuf, who now finds himself on the hook for $3.5m that he has agreed to pay in return for being released from liabilities in the largest law firm failure in US history. His former colleague, white-collar defence attorney Ralph Ferrara (now at Proskauer Rose), will stump up $3.7m; M&A supremo Morton Pierce (now at White & Case) is set to pay $1.02m. The lesson: when things go wrong, partners get hit where it hurts. 

To avoid any costly surprises, it pays to know your firm’s balance sheet inside out. But many don’t.

One former Dewey partner, Steven Otillar, has accused Citibank of covering up the state of the firm’s finances when it loaned him cash for his capital contribution on joining the firm in 2011. But the lender has hit back with gusto. In September filings before a New York federal court, the bank made clear that partners should have done their own research into the firm’s financial condition before joining; it was not the bank’s job to do so.

Citing a clause in Dewey’s partnership agreement giving any partner ‘the right to inspect books and records of the partnership’, Citibank said Otillar clearly ‘never availed himself of this opportunity at any time before signing on as a partner or before taking out his Citibank loan, or, indeed, ever’.

The Otillar case continues, but it’s clear that while ignorance may be bliss, it can lead to a nasty shock.

One thing’s for sure, partners need to do their due diligence before joining a new firm, and they need to keep on top of the numbers once they’re in the partnership.

‘Every lateral should have full disclosure of all matters affecting the finances of the firm they are joining.’

Colin Ives, a partner and head of professional services tax at BDO, says: ‘When you join a firm you’re asked to put in capital, which sounds reasonable. But actually you’re putting money into a business and if that business was to fail you wouldn’t get that money back.’

Yet lateral hires consistently fail to do their due diligence. According to Jeremy Small, director of legal recruitment firm JLegal, potential movers seldom ask for financial information. ‘I haven’t had many partner candidates who’ve been seeking financial assurances from firms or detailed information, because it’s so rare for law firms to get into trouble,’ he says.

One of Small’s colleagues in Singapore, Fred dos Santos, agrees: ‘I have never had one of my partner candidates asking to see books. It is debatable if they would be granted access before they actually signed on the dotted line, even if they did ask.’

But the Dewey debacle has caused partners the world over to worry. ‘We have had a few candidates that have been erring away from US firms a bit because of what happened with Dewey,’ says Small. ‘They are worried that there may be similar situations in the offing with other firms.’

The horror stories extend much further back than Dewey. Richard Eaton, a partner at Bird & Bird, has the rather unfortunate accolade of having been a partner at two spectacular law firm failures, Brobeck, Phleger & Harrison and Heller Ehrman. Eaton says that as Brobeck Hale and Dorr was a joint venture in the UK, partners in the City simply ‘weren’t in the loop on that one’. He says that he just heard rumours something was amiss on the West Coast.

But it is Eaton’s experience at Heller Ehrman that is more telling. ‘The first inkling we got that things weren’t well was just after I joined,’ he says. He adds that the problem was that the firm was ‘filtering’ the information given to partners, and they didn’t receive reports on the finances of the firm as a matter of course. Although Eaton says he was shocked when he heard the extent of the trouble the firm was in, he says: ‘It was not as much of a shock as to partners who came later.’ The firm was still recruiting partners two months before it went down.

‘You either trust what you’re being told or you don’t, and if you don’t trust what you’re being told, why on earth are you going there?’

He remains philosophical about the experience. ‘What can you do? You either trust what you’re being told or you don’t, and if you don’t trust what you’re being told, why on earth are you going there?’ he says.

In the current economic climate, partners are right to worry. Mark Husband, managing director of legal executive search company Cogence Search, says: ‘Every lateral should have full disclosure of all matters affecting the finances of the firm they are joining. Disclosure should include not only accounts but also overdraft facilities, loans and any significant professional indemnity claims that could affect profitability.’

It is time to wise up. Never has it been more critical to know your firm.

The must-haves

Understanding the financials is vital before joining a new firm, and critical once you’re in situ. For a partner looking to join a firm, the basics cannot be overlooked. According to Peter Zeughauser, the head of consultancy company Zeughauser Group, a partner should expect to see the firm’s balance sheet for the last three years and a list of its top 20 clients, with an indication of what percentage of the work those clients represent.

Aster Crawshaw, a partner in Addleshaw Goddard’s professional practices group, says a potential partner should see three years’ statutory accounts and partnership accounts. What’s more, monthly and quarterly partner reporting packages for each period since the date of the last audited accounts should also be checked.

‘Any draft or not-yet audited accounts for the period since the last audited accounts should be seen and ideally the same information for the office and the division the new partner will be joining,’ says Crawshaw.

Laterals would also do well to look into any onerous leases or property liabilities the firm may have before joining. Halliwells’ now infamous Spinningfields property in Manchester is the clearest recent example of the problems property can cause.

George Bull, head of the professional practice group at accountants Baker Tilly, provides services to lateral hires to help them examine their new firm’s accounts. For a partner joining an LLP, he thinks it is crucial to scrutinise the agreement they are signing.

‘I can’t imagine any partner signing an LLP agreement without reading all the words and weighing up what they mean for the individual,’ he says.

Things that are especially important to look out for include under what circumstances there might be a reduction of your fixed share if you join a firm as a fixed-share partner, for example if the profits aren’t sufficient to meet the obligations. This happened in the case of Halliwells and is rare, but it does happen.

While at a firm, partners need to know their billing target, their cash collection target and perhaps also the performance of the team against chargeable time. Bull thinks that partners should know the overdraft requirement and how close the firm is to that limit as a matter of course, as well as the funding plan and the cash flow.

‘The other thing people should be thinking about but rarely do is liabilities that might not be immediately obvious, like rent reviews and fit out costs, and staff pension fund deficits,’ says Tony Williams, principal of legal consultants Jomati Consultants.

A staff pension fund can have serious implications so it is important for a lateral hire to know about the type of scheme the firm has before joining. ‘It is a problem if you were to join a firm with a big defined-benefit scheme,’ says Ives. ‘If it folded tomorrow and someone put in a big claim against the firm then all the partners’ capital would be lost. All their drawings that they’ve not taken out would be lost as well.’ The problem arises because the defined-benefit scheme predates an LLP, which means it has unlimited liability. Fortunately this kind of arrangement is extremely rare nowadays.

‘As regards financial information, there is no reasonable basis for withholding this from partners.’

Joining a general partnership is fraught with danger, but even joining an LLP has its fair measure of financial risk. Aside from your capital being vulnerable, there are other potential pitfalls if the firm goes belly-up.

Firms tend to take part of a partner’s profit share drawings to use as a tax reserve, for example, as individual partners have a tax liability but not the firm itself. Although this rarely forms part of the due diligence a partner performs when joining a firm, ignoring it can have dire consequences. ‘Tax reserving is great unless the firm goes bust. The tax reserve goes but your liability is still there,’ says Crawshaw. ‘You still have to pay the tax but haven’t got the cash to pay it.’

Stay informed

Making the right decision on joining is one thing; being kept informed about how the firm is doing once you’re a partner is quite another. Crawshaw believes that information on work in progress should be available on a monthly basis to all partners for the year to date and the current month, as should debt. Other information that should be readily available includes recovery rates for the year to date; costs for the year to date; any major new commitments, for instance lateral hires with special remuneration deals; cash and debt position; and ‘some analysis from the managing partner explaining any particularly strong and weak statistics’, he adds.

Partners should also pay close attention to quarterly reports, which will ideally include all of the above information set out with more details.

On an annual basis, according to Bull, partners will be focused primarily on their own anticipated profit shares. ‘While overruns and underspends in respect of categories of overhead expenditure will usually be left to the finance team, partners need to be thinking about staff requirements for the forthcoming year, chargeable time and billing budgets,’ he says.

But when it comes to the financials, firms differ enormously in terms of the amount of information they allow their partners access to.

‘Partners are privy to as much information as they want,’ says Charles Martin, senior partner at Macfarlanes. His firm releases regular condensed information focusing on key performance indicators, but partners have access to any information that the system produces automatically, whenever they want it.

The desire to look into the firm’s finances varies greatly among the partners, says Martin. ‘Some have an almost indecent appetite for detail, others are happier leaving it to management,’ he says. ‘As regards financial information, there is no reasonable basis for withholding this from partners.’

Where there are sensitivities about the performance of certain practice areas, however, he says context may need to be provided, but even then the issue is about how the information is communicated rather than whether it is communicated at all.

And a word of caution: Martin says that while on one hand he is happy to encourage an appreciation of the importance of the financial aspects of the firm, including the impact that partner performance can have on it, he does not want partners focusing on it at the expense of keeping their clients happy.

Trust but verify

At the other end of the spectrum, New York giant Jones Day is known for its opaque compensation system. ‘We have a confidential compensation system, and we don’t share information with partners about the financial performance of other partners,’ says John Phillips, managing partner of the firm’s London office.

But Phillips says it is an unfair assumption that because the compensation system is confidential, partners don’t receive financial information.

Instead, partners get a monthly update on the performance of the firm as well as a quarterly detailed analysis of the firm’s performance that goes to an advisory committee and is then summarised to all the partners. The firm has partnership meetings every one or two years where there is a great deal of financial information broken down by office, by practice area and includes revenues, expenses and net income.

‘The broad performance metrics on the firm and London are available to all the partners once a month,’ says Phillips. The more detailed financial information goes out to the 37 partners-in-charge, who use the information to identify trends. Mary Ellen Powers, partner-in-charge of Europe at the firm, says: ‘The head of the office is free to put up whatever financial information they want about the firm and the office.’

She adds that there are good reasons for the confidential compensation system. ‘In too many firms the compensation system becomes a source of enormous internal tension,’ she says. ‘People are competing against other partners. We want them competing externally, putting the firm and the clients first.’

Edwin Reeser, former managing partner of SNR Denton’s office in Los Angeles, thinks that the ability of management to pick and choose what information they present can lead to problems. ‘The disadvantage of this approach is that it leads to the ability of management to not provide the key information that would let you understand how the business is really doing,’ he says.

Ronald Reagan, while president of the US, once described his relationship with the USSR’s leadership as one based on the principle of ‘trust but verify’. It’s a quote law firm partners would be wise to keep in mind.

Full transparency

One firm that has a reputation for being completely transparent with its finances is Latham & Watkins. The managing partner of its London office, Nick Cline, believes that transparency is core to the firm’s culture. ‘We feel that it is essential for the firm’s lawyers to have good access to the firm’s financial data so that there is a broad understanding of what makes good business,’ he says.

The type of information the firm’s partners have access to is wide ranging and includes data for daily cash collections, monthly financial reports, annual accounts and compensation information.

‘Having access to financial information encourages lawyers and all our staff to become financially literate’

‘Latham’s remuneration system is about as far away from a “black box” as you can get. All of our partners’ compensation and financial performance data is made available to each partner,’ says Cline. ‘This transparency [around partner remuneration], combined with a very detailed and thorough review of partner contribution by our executive committee and firm management, contributes to high levels of trust in the partnership,’ he says.

DAC Beachcroft is another firm that advocates financial transparency. Lawyers at the firm can access the accounting system through the firm’s intranet, and management accounts are available monthly, including profit and loss accounts, utilisation and realisation. Time recording, cash collection and billing information is available daily.

‘Having access to financial information encourages lawyers and all our staff to become financially literate,’ says Simon Hodson, senior partner at the firm. ‘The reason we provide it is to have a better educated workforce, which is more commercially aware.’

The only thing that the firm doesn’t release to all lawyers is the profit share of the equity partners, which is only available to the equity partners once a year. ‘Associates don’t need to know profit-sharing information,’ says Hodson.

Latham also keeps partner compensation information away from associates. But Cline says: ‘As part of the fifth-year academy that the firm runs, the associates get a detailed introduction to what it means to be a Latham partner, and as part of this introduction, they are taken through the Latham partner compensation model.’

Hodson says he can’t think of a good reason for withholding information from partners, and what’s more: ‘Once you’ve gone for full transparency, you can’t go back.’

Run like a business

Given the trend for law firms to be run more like listed businesses, Russell Jones & Walker (RJW), which was taken over by publicly listed Australian firm Slater & Gordon at the start of the year, makes for an interesting case study.

The firm has reporting obligations that most LLPs do not. ‘We now provide key financial performance information, actual against budget, on a daily basis to key management groups in the UK business and to our parent company in Australia,’ says Geoff Drake, the UK chief financial officer.

The firm gives partners monthly reports with information, including performance against budget for billing, cash collections, utilisation, realisation, debtor targets, 90-day debtor targets, case intake numbers and average fees for different types of work.

That’s considerably more than the average partner sees. One partner at another LB100 firm says: ‘We get a monthly report from our senior finance officer, which says “at this stage in the budget we were supposed to be here in terms of income and here in terms of costs”. We are run through what the capital position is looking like and what the debt position is.’

Given the structure of RJW, transparency of individual partner billing comes with a corporate twist. ‘We have former partners who are now shareholders in the business who have responsibility for key divisions within the group,’ says Drake. ‘They have full access to their group’s financial indicators at their desktop and via standard reports that are available at various intervals, at least monthly,’ he adds.

The firm now has a corporate structure, meaning that financial information for the business is consolidated through tiers within the firm, so that relevant groups have access to information appropriate to their level and needs.

‘At each level of information it is always possible to drill into the detail further and our aim is always to be able to make this access available directly online, wherever possible,’ says Drake.

How much is too much?

RJW is in a unique position in the UK market in that it operates under even stricter guidelines than an LLP when it comes to financial reporting. But whatever the firm, there can be a problem if management provides too much financial information and the partners get overwhelmed.

‘You could provide to the majority of senior partners at a law firm the most detailed information – which if they knew what they were doing and read it carefully would tell them, “this firm is about to die” – and they wouldn’t understand it,’ says Reeser.

This is hyperbole but certainly the presentation of the information is as important as the information itself. Crawshaw says that the key to law firm finances is that the information given to partners is presented in a way that they can understand, admitting that lawyers ‘aren’t generally numbers people’. Peter Zeughauser says that historically the data that firms presented to partners was not user-friendly, but things are changing.

‘In recent years firms have created much more friendly financial reports, using lots of graphics, allowing partners to get a quick impression on how the firm is doing,’ he says.

Ronnie Fox, principal of specialist employment and partnership law firm Fox, says it is management’s responsibility to present financial information in a way that partners can understand. ‘Most partners don’t understand how to read a balance sheet or understand a profit and loss account,’ he says. So finances need to be presented in a way that shows a firm’s turnover and profit compared to costs, which is much easier to digest.

Not only is the way that the information is presented important for partners’ understanding of it, so too is the sheer amount of data a firm shares with its partners. Bull says that some firms provide huge amounts of information that are simply overwhelming. ‘The challenge for the finance team is to provide all the information that is necessary but no more than is helpful,’ he says.

Taking responsibility

Who would envy a law firm managing partner: if they give partners too much information, the partners complain that they’re overloaded and ignore it; too little and they say that management is holding back or deceiving them, as was the case with Dewey.

‘In 2012, the attitude “trust me and don’t worry” is no longer acceptable. Some partners at US firms say, “Well we trust the man in charge”. That to me is an abdication of responsibility,’ says Ronnie Fox. The partners are the owners of the business, after all, with all the responsibilities to stakeholders that that entails. They have a huge vested interest in the success of the firm, and in return need to keep a close eye on those profits and losses.

Firms may vary considerably over how much information they routinely distribute to partners, but rare is the partnership agreement that does not allow full access to gory details for those that seek it out. Dewey partners learnt to their cost that burying your head in the sand doesn’t pay.

If you’re worried that your firm is in trouble, Fox has some tips for finding out the state of affairs. ‘Group together to avoid victimisation or being labelled as a trouble-maker,’ he says. ‘At a minimum you should ask for quarterly accounts and comparison with budgets, and finally ask for details of deals offered to lateral hires.’

No one forces a partner to join a firm; if you join up knowing that you might not be privy to all the financial information, you are taking a risk. Likewise if you don’t seek out the details you’re entitled to know. Given that the average equity partner at a City law firm has between one and three million pounds at stake if a firm fails, it’s time to wise up on the financials.

Otherwise, when things go wrong, you really will only have yourself to blame. 

david.stevenson@legalease.co.uk