Will Law Firms Be Ready When the Next Recession Hits?

Since the end of World War II, boom periods have lasted, on average, 4.9 years. The American economy has been growing steadily since the Great Recession bottomed out in June 2009.

Economists maintain that periods of growth don't die of old age; rather, they are killed by policy miscues by the Federal Reserve or asset bubbles that have been allowed to inflate.

“There's no clear evidence of a bubble in any part of the economy,” notes Ryan Sweet, director of real-time economics at Moody's Analytics. “This expansion has room to run for the next few years.”

But Malt, who is preparing to hand over the leadership of his 152-year-old firm after almost 15 years at the helm, says the prospect of a downturn always occupies his thoughts.

“It's less recession planning than thinking about contingencies — not because we're in a management transition, but because we always think about having a fundamentally sound investment strategy that fits with the stage of the economic cycle,” he says. “In some respect, you could say we're always planning for a recession. We're really not doing anything different, but what we always do serves us well in upturns and downturns alike.”

Observers of the legal industry suggest that the caution exhibited by Malt and his firm is the exception, not the rule.

“Our impression is that law firms are doing nothing to prepare for a recession,” says Janet Stanton, a partner with Adam Smith, Esq. “Law firms tend to think very short-term. At the end of the year, they strip the balance sheet, and all the profit gets distributed. There's no long-term investments in technology or any kind of advance planning. Many firms don't even have a long-term strategy.”

If firms are taking action, they are playing their cards close to the vest, suggests consultant Marcie Borgal Shunk of the Tilt Institute.

“There should be some level of discussion, but I haven't heard it,” she says.

That lack of preparation should sound alarms. But with the consensus among economists that the economy will continue growing for at least the next two years, leaders still have time to take bold measures — namely, trimming bloated layers of their firm — to ensure long-term stability. The immediate outlook may still be bright, but don't let the glare from the sunshine obscure one crucial fact: The ground that firms operate on has shifted substantially since the start of the Great Recession in 2008. The next downturn may not cut as deeply across so many sectors, but there are fewer levers left to pull to mask a recession's impact.

A New Normal

The cost-cutting by clients prompted by the recession has not let up, with general counsel increasing the amount of work they keep in-house, while also relying more on alternative legal service providers.

Firms' traditional beliefs about the limits of businesses' own legal departments are likely to be outmoded, according to ALM strategist Hugh Simons.

“Law firms like to think that the work that corporations bring in-house is the low-value-added or commodity work. Sometimes their thinking stops there,” he says. “But it makes sense for them to bring in anything they do frequently enough to justify the specialist resources required. What that means is that, as in-house lawyers come to recognize that more and more, they can go after anything that comes in at a high frequency.”

That could entail activities like licensing, moderate-sized mergers and acquisitions, and plenty of litigation that doesn't rise to the level of bet-the-company work.

“For bigger companies and bigger banks, there's mounds of stuff that can come in-house,” Simons adds.

The alternative legal service providers, including the Big Four accounting firms and players like Axiom and Thomson Reuters, also continue to expand their capabilities.

“In-house lawyers are behaving ambidextrously: they're pushing out to alternative legal service providers with one hand and bringing in to their own lawyers with the other hand,” Simons says.

These factors have created a trend of declining productivity within firms, as lawyers aren't handling the same quantity of work they once did. The 2018 Georgetown Law Report on the State of the Legal Market found that lawyers are billing an average of 156 hours a year fewer than they did 11 years ago.

The cushion for when the market shudders next is thinner than it was the last time.

Certainly, firms have responded by cutting their own costs. More have turned to contract lawyers for certain types of work and shed administrative staffers or moved them to lower-cost regions. Figures from the U.S. Bureau of Labor Statistics, tracking the overall legal services industry, show that employment still has not caught up with the pre-recession peak of 1.18 million jobs. Recent job growth is still less than half of a percentage point a year.

“As a share of total employment, it's shrinking,” Donald Grimes, a senior research specialist at the University of Michigan's Economic Growth Institute, says of the legal industry. “In some sense, it's acting more like a manufacturing industry than one of the other professional services, which are growing.”

Reflected at a firm-by-firm level, that new tendency may prove to be a benefit.

“I do think there is some level of being better equipped to deal with lower utilization,” Borgal Shunk says.

But stickiness, among law firm partners and clients alike, has also been in decline, with both groups proving increasingly mobile. That new reality, while dizzying in periods of growth, is more likely to be disastrous in a period of belt tightening.

“It's difficult to imagine a recession that would be as deep and protracted as the 2008 crisis. But the steady erosion of client loyalty and partner loyalty has created an accelerant in terms of law firm fragility,” says Paul, Weiss, Rifkind, Wharton & Garrison chairman Brad Karp. “In the past, partners at law firms that saw a sharp decline in profits would be inclined to ride out the decline. That, sadly, is no longer the case in many law firms. The relationship between law firms, on the one hand, and their partners and clients, on the other, has become much more transactional, which is an unfortunate development for the profession and poses a heightened risk for law firms.”

Vulnerabilities

Karp is confident in his own firm's preparedness for the next downturn. He says that during the last recession, Paul Weiss identified five particular practice areas for investment — litigation, white-collar regulatory work, restructuring and workouts, private equity transactions, and public company M&A — and those efforts paid off.

“We emerged from the financial crisis far stronger than we were in going into it,” he says. “We were very fortunate that we had the right client base, the right practice mix, and the right talent in the right geographies, given prevailing market conditions.”

But certain underlying factors, ranging from recent strategic moves to deeper structural realities, will undoubtedly place a range of other firms at added risk when the downturn inevitably arrives.

Recent geographical expansion, particularly overseas, is one cause for concern, according to Simons, who points at Fried, Frank, Harris, Shriver & Jacobson's 2015 retreat from Asia after nine years of operations as a likely harbinger for others.

“When a downturn comes, it will probably hit international firms harder,” Simons says. “More firms will make the same kind of assessment that Fried Frank must have done that the payback time on Asia investment is too far off to be attractive.”

Simons flags Australia as another problem spot, pointing to UK firms Herbert Smith Freehills and Ashurst, which recently made investments down under to take advantage of the economic boom there prompted by China's thirst for natural resources. If a global economic downturn serves to quench that thirst, those investments could be at risk.

“I wouldn't be surprised to see firms like Ashurst and Herbert Smith retract their Australian footprint, because a lot of that business can't be that profitable,” he says.

Ashurst global managing partner Paul Jenkins, based in Sydney, refutes that point, contending that his firm's work on infrastructure, energy and resources, and on behalf of banks and funds, is at least as profitable as other parts of the firm.

“In our experience in Australia, it is a profitable market,” he says, highlighting the connections between the practice and the rest of the firm and its overall client base.

A Herbert Smith representative shares a similar sentiment, noting that in Australia the firm's “market-leading operations are fully integrated across practices, sectors and regions.”

And Stanton says that, for the most part, global, UK-based firms are more likely to be run like businesses than their American counterparts, and therefore in a better position to ride out a destabilizing period.

“I have been gobsmacked by how little real information firms use to make business decisions, which would be a felony in the practice of law,” she says.

But UK firms, owing to the geographical reality of being in a market with only one major city, faced a higher bar when they sought to expand.

“In the U.S., you can expand and grow and stay within the same language [and] legal system,” Stanton argues. “To expand, the UK firms had to be better run.”

Feeling Bloated

Overcapacity within firms is also a real worry, especially among those with swollen ranks of non-equity partners. The 2018 Georgetown Report indicates that while associates — whose ranks were slashed during the last recession — have seen their hours return to pre-2009 levels, partner hours have not, and non-equity partner hours have suffered most dramatically.

Those non-equity partners are at the biggest risk of layoffs, depending on the severity of the next recession. And smart-thinking firms might even want to think about acting sooner, consultants say.

“Associate ranks have been cut back to the new normal, but non-equity ranks haven't been,” Simons notes.

“Pretty much every non-equity partner will have an equity partner who thinks they're the non-equity partner who needs to be retained,” he adds. “The strife in the non-equity partner ranks will cause all kinds of tension in the equity ranks.”

But cost-cutting there may be key to a firm's long-term survival, especially compared with sacrificing associates.

“If you do strip out a lot of the business professionals and associates, you run the risk of not being able to staff matters appropriately for the clients' needs,” Stanton says. “You're, in a sense, potentially over-servicing the client.”

While the best-performing firms have managed to take steps to deal with the issue, many more have not.

“Some firms have acknowledged that they need to have difficult conversations and make difficult decisions to meet what the current reality looks like and where it's going to remain, but the vast majority are still avoiding those conversations and those decisions,” Borgal Shunk says.

They might as well start soon, because measured reductions earlier would be wiser than panicked personnel cuts later.

“You have to keep enough meat on the bone to operate. You can't just wander the hallways with a chainsaw. Talent isn't just available anywhere,” legal consultant Edwin Reeser says. “Lawyers are not fungible. I can't get rid of five real estate lawyers, and when the market turns up, move five litigators over to replace them.”

Practices at Risk

In the 2001 recession, the tech industry took the biggest hit. In 2008, real estate got pummeled. In hindsight, both had been the beneficiaries of bubbles.

“We have to look around and see what areas are being overly serviced right now; what areas are being 'irrationally exuberant,' to use Alan Greenspan's phrase,” Fordham University economist Giacomo Santangelo says of the next potential trouble spots. Based on that logic, he thinks lawyers and firms servicing players in the gig economy may see work dry up in the next downturn.

Santangelo questions the sustainability of businesses like Uber, Lyft and Airbnb, which he says rely on workers eschewing higher education and traditional benefits to deliver services that barely qualify as innovations.

“The gig economy is an illusion,” he says.

Even if he's right, this emerging sector doesn't have the same central place in the economy as real estate, and any recession is unlikely to be as severe as 2008, when work in real estate and M&A vanished, replaced by a bankruptcy surge.

“The next downturn is highly unlikely to be a duplicate of the last recession,” says Sweet, of Moody's. “It will be painful, but it won't be what we saw the last time.”

The stock market is an area of some concern, according to Michigan's Grimes, and a correction that starts there would likely put the brakes on new IPOs and other work in the securities realm. But he's not forecasting a downturn at any point through 2020.

Conversely, the expectation that the next recession may not be as severe as the last means there's no reason to expect historically countercyclical practices — namely bankruptcy and restructuring — to see another surge.

The Litigation Question Mark

Prior to 2008, firm leaders had great faith that litigation was recession-proof. Even when work in real estate development and M&A dried up, business disputes were perennial. The shrinking pie had a way of sending companies to the courthouse looking for relief.

But that expected hedge against declining transactional work was absent during the Great Recession.

“Businesses became much more aware of the costs of litigation and what they can really achieve,” Reeser says. “In some instances, they wouldn't sue, even if they had a heck of a case, because the defendant was a failing company, and even if you win, you can't collect.”

Malt says Ropes & Gray observed the same trend.

“To the extent that litigation is company-versus-company, though that probably rose in [the 2001 recession], in 2008, industry was broadly affected,” he says. “Everyone was looking to cut costs. They cut the legal budget along with everything else, and that was indeed our experience.”

But bankruptcy and government investigations prompted no shortage of opportunities for litigators. “We expect to see the same sorts of exceptions,” Malt says.

Paul Weiss' Karp notes that the litigation tie-ups that emerged from the last financial crisis, alongside reduced regulatory enforcement activity under the Trump administration, are together pushing an industrywide decline in litigation.

“That said, I have never seen a market without high-stakes litigation and today is no exception. The key is to be in a position — through talent, experience and expertise — to secure a meaningful share of that activity,” he says. “We've been fortunate that our litigation practice has remained extraordinarily busy, though our mix of matters has changed somewhat over the past decade.”

Proactive Measures

Even if firms can't count on litigation as an unshakeable bulwark against decline elsewhere, they can still embrace the larger principle of having a broad array of practices.

“Diversification is a great hedge; for example, events that slow down deal flow may also bring an uptick in bankruptcy work,” Reed Smith global managing partner and executive committee chair Sandy Thomas says in an email.

Thomas adds that Reed Smith has embraced diversification through shoring up work in five key industry sectors — financial services, health care and life sciences, entertainment and media, energy, and shipping — along with pursuing geographic breadth and a large and varied client base. He also highlights the firm's “Enterprise Risk Management” process, in which Reed Smith's senior management team regularly works with the firm's audit committee — a sub-unit of the executive committee — and annually reports on the principal risks facing the firm's business and what it is doing to mitigate them.

His snapshot matches up with what consultant Stanton describes as the more “businesslike approach to running a firm” shared by the 5% to 10% of firms that are pulling away from the pack in each segment of the market: “having plans, using metrics and being accountable.”

That's not to say that all high-performing firms respond uniformly to times of crisis. Reeser singles out Latham & Watkins for its unprecedented move to lay off 190 associates and 250 staffers in 2009.

“They were one of the first to operate in the manner of a rational, calculating, capable entity. And they're at the very pinnacle,” he says.

But Malt says Ropes & Gray tacked in the opposite direction: the firm did not lay off a single associate and instead hired actively in 2008 and 2009 when other firms were “pulling in their horns.”

“You have to think about investment strategy. Our strategy is invest when others think the world is coming to an end,” he says. “Right now, the lateral market is stunningly overheated, and we're being restrained. Starting new practices with 30 new laterals — that would probably be too many for this stage of an expansion.”

Likewise, lawyers who have the trust of clients can push a similar message with regard to their own business decisions, especially when it comes to transactional opportunities.

“There are a lot of cash-rich corporations that have a lot of money, and they will look for bargains in a recession,” Borgal Shunk says. “I'd be generally encouraging them to have those conversations about bargains and where they might occur.”

That's just one of many conversations that should be taking place — between leaders and attorneys, and between attorneys and clients — both now and when the economy invariably takes a turn for the worse.

“Good managers are going to be dealing with practice group leaders, who should be in close touch with the clientele and figuring out what client plans are,” Reeser says.

Because we all know a downturn awaits at some unknown point in the future, and there's no good excuse for being a lawyer — or law firm leader — without an umbrella when storm clouds start massing.

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Dan Packel covers law firms' global strategy and economics for ALM. Based in Philadelphia, he can be reached at [email protected], and on Twitter at @packeld.