Accounting Mismatch Spins Accrual Fate for Merger Deal

[Editor's note: Last month's edition featured a new book excerpt on resolving balance sheet issues in law firm mergers. This recent news report underscores the potentially extreme challenges of harmonizing disparate accounting systems.]

When the end finally came, Pennie & Edmonds' death certificate revealed few surprises. The IP firm had been bleeding key partners and was facing a serious real estate crunch, with its New York office lease nearing expiration and too few partners willing to be on the hook for another 15 years with personal guarantees. But the firm's funeral in December took an unexpected turn.

Rather than simply dismantle its practice or merge with a general practice firm, as many expected it would, the 120-year-old boutique did something in between: It ceased its operations and sent nearly 100 attorneys, including an estimated 29 partners, to Jones Day, a firm with which it had been in on-and-off discussions for years. Not all Pennie lawyers were asked to make the move, and some chose on their own to bail out. In all, at least 16 of Pennie's original lawyers will not end up at Jones Day.

Conflicts of interest with Jones Day clients were to blame in some cases, including part of the group that joined Morgan, Lewis & Bockius shortly before Pennie's dissolution. But a merger-repellent accounting system, among other potential liabilities, also shares the blame.

When Pennie and Jones Day started talking about joining forces in late 2000, a full merger was the presumptive strategy. But not long into this preliminary round of talks ' which stalled in early 2001 and then resumed toward the end of 2003 ' the strategy changed to a lateral move, says Brian Poissant, who had chaired Pennie's litigation department. The new plan called for Pennie to shut down and then export the bulk of its lawyers to Jones Day.

Why the backpedaling? It wasn't for a lack of a rapport between the firms. Lawyers at Pennie and Jones Day had worked together as co-counsel since the mid-1980s. Nor, according to top partners at both firms, did it reflect Jones Day's waning interest in taking the entirety of Pennie's practice ' litigation and patent prosecution alike. With profits per partner of $835,000 in the latest Am Law 100 compilation, Pennie partners say the firm's financial health was just fine.

The culprit, say several partners involved in the deal, was Jones Day's reluctance to inherit Pennie's liabilities. Most notably, there was Pennie's accrual accounting method. Unlike Jones Day's more typical cash-based accounting, which recognizes income when cash is actually collected, Pennie's method recognized income earlier in the billing cycle ' as soon as clients were charged for the firm's work.

That was fine for Pennie. But the liability arises when an accrual firm like Pennie tries to convert to a cash basis upon merging. A chunk of the resulting firm's receivables – the amount it has billed but not yet been paid ' will already have been counted as income under the defunct accrual system. To avoid double counting the same dollars, the cash-operated firm creates an unfunded obligation from the firm to its partners, an often-significant liability.

“Accrual to cash is a complication,” says Dennis LaBarre, who heads Jones Day's New York office. LaBarre and Pennie's managing partner, John Normile, both admit that the accounting issue was a factor in the decision not to merge.

Whatever combination of factors made Pennie's last days messier than they might have been, the lesson is clear for the few remaining giant IP boutiques: Take a closer look at your balance sheet before searching too hard for a merger partner

[Editor's note: Last month's edition featured a new book excerpt on resolving balance sheet issues in law firm mergers. This recent news report underscores the potentially extreme challenges of harmonizing disparate accounting systems.]

When the end finally came, Pennie & Edmonds' death certificate revealed few surprises. The IP firm had been bleeding key partners and was facing a serious real estate crunch, with its New York office lease nearing expiration and too few partners willing to be on the hook for another 15 years with personal guarantees. But the firm's funeral in December took an unexpected turn.

Rather than simply dismantle its practice or merge with a general practice firm, as many expected it would, the 120-year-old boutique did something in between: It ceased its operations and sent nearly 100 attorneys, including an estimated 29 partners, to Jones Day, a firm with which it had been in on-and-off discussions for years. Not all Pennie lawyers were asked to make the move, and some chose on their own to bail out. In all, at least 16 of Pennie's original lawyers will not end up at Jones Day.

Conflicts of interest with Jones Day clients were to blame in some cases, including part of the group that joined Morgan, Lewis & Bockius shortly before Pennie's dissolution. But a merger-repellent accounting system, among other potential liabilities, also shares the blame.

When Pennie and Jones Day started talking about joining forces in late 2000, a full merger was the presumptive strategy. But not long into this preliminary round of talks ' which stalled in early 2001 and then resumed toward the end of 2003 ' the strategy changed to a lateral move, says Brian Poissant, who had chaired Pennie's litigation department. The new plan called for Pennie to shut down and then export the bulk of its lawyers to Jones Day.

Why the backpedaling? It wasn't for a lack of a rapport between the firms. Lawyers at Pennie and Jones Day had worked together as co-counsel since the mid-1980s. Nor, according to top partners at both firms, did it reflect Jones Day's waning interest in taking the entirety of Pennie's practice ' litigation and patent prosecution alike. With profits per partner of $835,000 in the latest Am Law 100 compilation, Pennie partners say the firm's financial health was just fine.

The culprit, say several partners involved in the deal, was Jones Day's reluctance to inherit Pennie's liabilities. Most notably, there was Pennie's accrual accounting method. Unlike Jones Day's more typical cash-based accounting, which recognizes income when cash is actually collected, Pennie's method recognized income earlier in the billing cycle ' as soon as clients were charged for the firm's work.

That was fine for Pennie. But the liability arises when an accrual firm like Pennie tries to convert to a cash basis upon merging. A chunk of the resulting firm's receivables – the amount it has billed but not yet been paid ' will already have been counted as income under the defunct accrual system. To avoid double counting the same dollars, the cash-operated firm creates an unfunded obligation from the firm to its partners, an often-significant liability.

“Accrual to cash is a complication,” says Dennis LaBarre, who heads Jones Day's New York office. LaBarre and Pennie's managing partner, John Normile, both admit that the accounting issue was a factor in the decision not to merge.

Whatever combination of factors made Pennie's last days messier than they might have been, the lesson is clear for the few remaining giant IP boutiques: Take a closer look at your balance sheet before searching too hard for a merger partner