False Sense Of Security Still Prevalent Among Law Firms

In spite of overwhelming evidence that the booming economy enjoyed practically uninterrupted for the past 20 years has ended, at least for the near term, many law firms are still optimistic of their 2009 prospects.  I beg to differ.  I believe 2009 will start a strong shift in the make-up of many law firms due to the lack of any planning for the economic conditions.

Who can blame attorneys for being optimistic?  Regardless of the economy since at least the early 1980′s, lawyers have enjoyed consistently increased business and profits.  This has led to a complacency and a denial of the economic conditions that are facing the country.

Law firms aren’t alone.  In fact, the “big three” auto makers (Ford perhaps excepted) are acting out of a similar denial as they attempt to scare Congress and the President into paying for their internal problems.  Who didn’t see the failure of GM coming?  Was no one noticing the extravagant pensions being offered to the employees?  Did anyone who dared notice believe the ever slimming margins would cover the ever growing benefits?   Not likely.  As the Legislative and Executive branches delve deeper into the phantom pockets of our tax base, a  nice summary of the fallacy of “avoiding acting like Herbert Hoover” has been inked in an opinion piece by Todd J. Zywicki in the Wall Street Journal.

Law firms, though not nearly in the long-term slide as the domestic auto industry, is more sensitive to this economic downturn than many attorneys would like to admit.  Many firms have been spoiled by margins that exceed 50% without spending more than a passing glance at the indicators that led them to such bounty.  The issue isn’t so much a drop-off in business, though some firms who specialize in areas that are in the midst of collapse will certainly feel the pain.  Rather, the issue is how firms will retain good talent, retain their expected incomes and avoid layoffs of associates.

These are regular issues for most industries but are foreign to the mid-size law firm.  Many firms pride themselves in their “family” atmosphere, which includes the bratty sibling rivalries that are tolerated when times are good.  Salary incongruousness may seem a bothersome itch when profits are high, but once the deadwood becomes heavy the scratching becomes intolerable.  Some may panic to find their balance sheet showing a loss without ever seeing it coming.  Drastic change is put into place – at a time no worse to prepare.  No more is it wise to visit a market when hungry than to suggest change while in the midst of a spiral.

Yet our economy has afforded all of us time to prepare.  It was suggested by many (myself included as far back as March) that our economy was in for some hard times.  Firms with the foresight and gumption to plan and hold timekeepers accountable for providing not only quality service to their clients but ensuring prompt billing and payment for the betterment of the long term financial health of the firm are in a position now to profit over the firms who were complacent.

It’s not too late, however.  Many firms are just now seeing the first bumps in the road.  It is my opinion that the economic downturn is just now really beginning to hit middle America.  The massive layoffs (over 533,000 in November) are an indicator that the many months of body blows caused by the collapse of the credit and housing markets (not so unlike what happened in the late 1920′s, speaking of Herbert Hoover) are finally taking its toll.  The question now is, where is the bottom?

No one knows.  That is a troubling concern that should make you want to hug every dollar your firm receives and not let go of it.  In times such as these, power goes to those who hold cash.  This may change if our government attempts to over-spend its way out of our economic downturn (thereby devaluing the dollar, leading possibly to hyperinflation combined with stagnant productivity – a prescription for the “d” word), but as of right now, many believe that the economy should rebound sometime in 2010.

In my opinion, firms need to pay more attention to the profitability of each fee earner and place more emphasis on marketing activities and their key profit drivers.  Please feel free to email me (by clicking here) if you would like some ideas on how to not only retain your current income, but increase profits during an economic downturn.

Is Suspension Of Mark-To-Market Rule Irrelevant?

Good counter-argument to what former FDIC chairman Isaac and Newt Gingrich have said regarding the role of mark-to-market accounting rule:

Even if mark-to-market rules are suspended immediately, it won’t change the makeup of a company’s balance sheet. Investors have decided that these assets are toxic and no matter how a bank accounts for them in its books, that sentiment isn’t likely to change unless investors see some proof that the instruments are actually undervalued.

Read more here.

On the other hand, there is the other argument:

“For almost every bank, especially the regionals, what they’ve taken the biggest hit on is mark-to-market securities,” said (Joshua Siegel, managing principal of Stone Castle Partners, a private equity group). “This is what they needed to do first – not cut a $700bn check. They first need to take the pressure off earnings.”

For now, it appears the SEC is moving towards suspending the rule.  In the meantime, it was announced Tuesday that “managers could use their own judgment when valuing securities in illiquid markets, which means they can use measurements other than actual market prices.”  The revised rule can be read by clicking here.

I am not sure that sort of ambiguity is what is needed to help this crisis.  Perhaps a sane rule that doesn’t devalue assets based on immediate marketability would help investors better than leaving the valuation to the whim of the managers.  Further, taking the point of Phil Izzo from the Wall Street Journal’s “Real Time Economics” Blog, is it too late for the change to make a difference in the current crisis?  Can you really go back and increase the value of assets that you have already deemed toxic and worthless and expect anyone in the market to trust it?

Opinions on mark to market are strong and more and more people are speaking out on it:

• Jeff White, Financial Post; “Mark To Market Madness”
• The Motley Fool, “Mark-to-Market Accounting Basics”
• Andrew Willis, Globe And Mail, “Making the case for mark-to-market Rules”
• Joshua Boak, Chicago Tribune, “Critics Say Accounting Rule Off Mark”
• Floyd Norris, New York Times, “Mistakes Of Past Live Again”
• The Economist, “Fair Cop:  Fair Value Accounting Becomes A Political Issue”

How The “Market Meltdown” Affects Your Law Firm

This past week has been a scary time for the financial markets.  According to democrat Senator Chris Dodd last week, “we’re literally maybe days away from a complete meltdown of our financial system, with all the implications, here at home and globally.”  The New York Post reported that traders were “500 trades away from Armageddon on Thursday” with pre-open sell orders inundating the market and forcing the fed to pump $105 billion into the market to avoid a total collapse of the financial system.   There is little question that last week was historical.

I don’t believe that the end of this crisis is near.  The Executive Branch, along with the Federal Reserve, is planning a “bailout” (or what I would rather call a “clean out”) of the albatross of bad mortgage debt that is seriously deprecating the value of bank collateral and causing institutions to stop lending to each other.   Some are saying upwards of $1 trillion.  You can add another trillion to that (UPDATE:  Try $30 trillion).  And this is to just keep our financial system from collapsing.

The damage has already been done.  Our economy will be feeling the effects of the past week well into next year – and perhaps for several years to come (and I am not counting the effect of the massive printing of money to pay for the bailout).

What caused this to happen?  And how does it affect your law firm?  

In the Friday (September 19th) Wall Street Journal, William M. Isaac, chairman of the Federal Deposit Insurance Corporation from 1981-1985, wrote an opinion piece titled “How To Save The Financial System“.  Mr. Isaac compared the current crisis with the one he faced when chairman of the FDIC – at that time, the prime rate was 21%, the savings bank industry was insolvent more than $100 billion, “the S&L industry was in even worse shape, the economy plunged into a deep recession, and the agricultural sector was in a depression.”  3,000 banks and thrifts failed.  However, if the rules that are in place now were in place then, Isaac argues, it could have been much worse:

The country’s 10-largest banks were loaded up with Third World debt that was valued in the markets at cents on the dollar. If we had marked those loans to market prices, virtually every one of them would have been insolvent. Indeed, we developed contingency plans to nationalize them.

The economic conditions of the current crisis were nowhere near as bad as it was then.  What caused an estimated 20% loss to mortgage debt to institutions that held them to bring our financial system to the brink of collapse?  Isaac believes “[t]he biggest culprit is a change in our accounting rules that the Financial Accounting Standards Board and the SEC put into place over the past 15 years: Fair Value Accounting.”  

Fair Value Accounting dictates that financial institutions holding financial instruments available for sale (such as mortgage-backed securities) must mark those assets to market.

The rule can be a boon for an asset when times are good.  However, a company must also “mark the assets to market even though there is no meaningful market”.  Even though the value of the assets are depressed because of market conditions, not actual value of the asset, regulators have still required that accountants continue to mark down assets as the market tanks.  This has led to heretofore financially secure banks to go to the brink of bankruptcy within days of bad news.  Isaac argues that regulators must suspend such rules when the health of the industry is at risk.  

On November 15th, 2007, Fair Value Accounting was officially enacted by the FASB in rule FAS 157.

Isaac also argues that regulators should suspend the “naked selling” (or short selling a stock without possessing it).  Late last week it was announced a ban on short selling altogether.  This sweeping measure was met with opposition by options traders, who argued that the ban was “a draconian measure that will result in the sudden and severe removal of liquidity from the marketplace.”  The argument is that disallowing short selling altogether prevents investors from learning the real value of a company – in essence, taking away information from investors – and thus will discourage investment.  Isaac only argues for the ban of “naked selling”, not all short selling.

Finally, Isaac argues that the new Base II regulations, though perhaps too new to have caused this crisis, must be suspended before they make matters worse:

Basel II requires the use of very complex mathematical models to set capital levels in banks. The models use historical data to project future losses. If banks have a period of low losses (such as in the mid-1990s to the mid-2000s), the models require relatively little capital and encourage even more heated growth. When we go into a period like today where losses are enormous (on paper, at least), the models require more capital when none is available, forcing banks to cut back lending.

Contrary to the rhetoric coming from both Presidential campaigns, the problem hasn’t been lack of regulation – but the regulations (and regulators) themselves.  At this point it is academic, and any remedy will not undue the damage done.  What firms need to do is prepare for cash flow problems in the near and long term.

As with any economic slowdown, transactional practices will suffer and litigation will do well.  However, if lending dries up, firms need to confront the possibility of losing significant numbers of corporate clients.  They also need to confront the high probability of clients having difficulty paying their bills.

As law firms are typically the bottom of every client’s stack of invoices (due to the lack of late fees and interest – unless you are one of those who actually charge for lack of payment), it may be a good idea to consider retainer billing your corporate clients.  Retainer billing simply requires a certain amount to be paid up front and set off against work performed.  When the retainer goes below a certain amount, a letter is sent to replenish the funds.  This ensures cash flow and, in coordination with setting budgets for services, can provide clients with some cost certainty – something corporate clients will be requiring with more and more frequency.

If your firm hasn’t addressed receivables that are over 90 days and don’t have a coherent, consistent, and reliable collections process, the time is now to develop and implement one.  It may be the difference between your firm managing a difficult economy and becoming a victim of it.

Amlaw Daily: Profit Down in 2008

AmLaw Daily reports that during the first two quarters of 2008, “profit margin compression–that is, expenses increasing faster than revenue–was the greatest it’s been in the last eight years.”  The Wall Street Journal Law Blog takes a look at the highlights of the report:

• Too many lawyers:“Because law firms continued to add lawyers to their ranks despite the drop-off in demand,” writes [Citi Private Bank’s Dan] DiPietro, “firms experienced a slowdown in productivity comparable to the second quarter of 2001 and lower than every other second quarter between then and now.”
• Unproductive lawyers, beware: Among other things, DiPietro advises firms to “consider sending a tough message to unproductive lawyers at every level,” and to “conduct a systematic expense review to eliminate redundant or nonessential support staff and functions.” As for hiring in a soft economy, he writes: “[I]t’s particularly important to vet candidates to differentiate between laterals who are looking to move because they’re not happy and those who are looking to move because their firms are not happy.”
• Associate bonuses (a/k/a “The elephant in the room”):DiPietro is paring back earlier estimates for 2008 profits-per-equity-partner. “[W]e now believe PPEP will be flat, or even down by as much as 10%, in 2008,” he writes. “The top-tier firms will have an even tougher year, with profits down by 5-15%. Our reason for providing a range is that there is an elephant in the room: How will firms, particularly the top-tier firms, handle associate bonuses this year? The rational approach would be to pare them back, but, while lawyers display rationality and dispassion in the practice of law, they have exhibited ‘irrational exuberance’ on this issue in the past.”
• Most profitable firms hit hardest:Demand drop-off and expenses were accelerated at a more rapid pace at the top firms, writes DiPietro. He explains that top-tier firms tend to rely on high-end private equity deals, securitization, and structured finance, and have more financial service clients. Now, with those markets in decline, top-tier firms “are paying the price,” and the practices that firms typically rely on in a downturn, such as restructuring, bankruptcy, and litigation, haven’t helped “cushion the drop-off in transactional work.”
• A silver lining?“A bad year (and the numbers suggest 2008 will be even more trying than 2001, when partner profits were down slightly),” writes DiPietro, “will enable firms to take steps that partners would resist in a good year-winnowing out unproductive lawyers and applying greater discipline to expense control.”

 What can law firms take from this report?  Measure performance.   Of Counsel Consulting was created to help firms perform better.  Whether you need help in determining your profit drivers, need help in measuring them, or need help in implementing technology to make you more efficient, Of Counsel Consulting can help.  For more information, call (205) 588-4OCC (4622).