Surviving a Malpractice Fiasco: 10 Views

Part One of Two

Editor's Introduction

Recently I asked members of A&FP's Editorial Board and several new contributors for their thoughts on how a law firm might best deal with the financial blow of an unusually large settlement or penalty assessed against the firm.

Although a large financial hit could arise from many scenarios, including a client slipping on a banana peel near the firm's negligently wide-open elevator shaft, our 10 discussants immediately zoomed in on professional malpractice as the source of liability on which to focus. That was perhaps due to my noting what had prompted my query: a Dallas firm's Texas-size $81.6 million settlement of a class-action claim by 1,100 clients (in 41 states) in connection with tax-shelters rejected by the IRS. But my respondents might have focused on such professional trip-ups in any event, since lawyers routinely encounter a video game's abundance of regulatory banana peels and ethical elevator shafts.

This unexpectedly tight focus on malpractice deepened the discussion, yielding insightful perspectives on the financial aspects of legal malpractice with which firm management must contend: keeping the firm from crumbling immediately after a malpractice disaster and contingency planning for possible malpractice occurrences in the future.

A disclaimer regarding the first discussion thread: Allusions to various details of the specific malpractice settlement that prompted my query were plainly intended as illustrations of general themes. These particulars are not offered here as up-to-date factual reporting.

Finally, my thanks to all 10 discussants for sharing their insights: first-time contributors Sam Harris, John Niehoff and Douglas Thompson, and Board members Joe Altonji, Jim Davidson, Howard Mudrick, Pete Peterson, Ed Poll, Ron Seigneur and Lisa Smith. I've noted each person's affiliation with his or her comment.

' Joe Danowsky, Editor-in-Chief

Dealing with the Disaster

Pete Peterson (Managing Director, Law Firm Business Institute, Ridgway, CO, [email protected]): When J&G (the Dallas firm) tried to settle this same claim for $75 million, around 9 months ago, it was reported that the insurer would agree to cover $63 million, the firm would kick in $5-6 million, and the partners who rendered the tax opinions would pay the balance. That seemed a good kick in the teeth; and it seemed possible that the firm would see more claims down the road.

A recent update on these settlement figures in The American Lawyer (February 2005) states that the insurance carrier will pay about $70 million of the claim, JG will pay $5.25 million, and the remainder will be paid by the partners who rendered the tax opinions.

In addition, the article states that the settlement does not include 89 opt-outs from the class action. These opt-outs are trying to recover fees paid to J&G totaling some $25 million, plus the costs of setting up the tax shelters ' reportedly as high as $1 million per person. Of this additional $114 million of potential liability from the opt-out claims, the article states that insurance “could” cover another $50 million. Lawyers for the opt-outs are also making plans to go after individual partners if the firm should fold.

Separately, it was interesting to learn that $267 million in fees were generated from this activity between 1999 and 2003, according to a report issued by the New York Times. This was quite a boost to the firm's top line. The report also mentioned that the leader of J&G's tax shelter practice earned $93 million during this same period.

Ron Seigneur (Partner, Seigneur Gustafson Knight LLP CPAs, [email protected]): If I recall correctly, the consulting accounting firm was also implicated in these same schemes and has had similar (and possibly even larger) claims brought against it.

Joe Altonji (Director, Hildebrandt International, Chicago, [email protected]): A judgment significantly beyond insurance coverage ' what significant means depends on the size and wealth of the firm ' could easily result in the dissolution of many firms.

Under LLP status, uninvolved partners have relatively little exposure, so as a practical matter, any plaintiff's counsel is likely to settle a matter for only a “good kick in the teeth” but not a devastating blow. If Pete's right about the exposure, obviously the payment from the firm hurts, making for a weaker partner income for a year, but not a devastating blow. The firm would probably just pay from income at the level Pete suggests. The personal exposure, obviously, is a different issue.

Lisa Smith (Shareholder, Hildebrandt International, Washington, DC, [email protected]): Generally settlements are structured within the bounds of the firm's insurance coverage for the reasons that Joe Altonji describes. It doesn't take much of a hit to income for partners in mid-profit firms to start planning their exit strategy and ultimately destabilize the firm.

Howard Mudrick (President, HM Solutions, Inc., Dallas, [email protected]): While I have no specifics regarding the details of where the precise funding will come from, a few observations from an outsider (I have not consulted to this firm) may be helpful.

This firm absorbed a number of former Johnson & Wortley partners when that firm disintegrated. Interestingly, a major catalyst for the demise of J&W was a projected decrease in per partner profits. My recollection is that the decrease was not significant, but that money was a major element of the glue that held that firm together (particularly after the death of firm leader Johnson).

Believing in the predicted demise of the midsize law firm, and that only a small number of major firms would prosper, J&G undertook an aggressive growth posture for many years; but their acquisitions were unremarkable. Growth was time-consuming and expensive. They did not attract very profitable groups, nor did they build profitable offices.

The Managing Partner and Executive Director who were the architects of much of their growth departed within the last couple of years.

The firm has experienced a high turnover percentage for many years, and turnover accelerated during the investigation of these tax issues.

A firm predominantly held together by little more than a wish to be a large firm and the desire to make money is an unlikely candidate to weather much of a storm. If data on the firm's revenue and profitability were reported correctly in Texas Lawyer, the partners seem to have benefited little financially from the firm's loss of lawyers; so there will likely continue to be pockets in the firm that are ripe for the pickin'.

Douglas Thompson (Managing Director, Thompson Flanagan & Company, Chicago, [email protected]): Retaining the firm's professionals is indeed the most important concern. The two most important aspects of this are the loss of productivity and the potential loss of partners' earnings.

Large losses can become very emotional within firms. The blame game and Monday-morning quarterbacking erode productivity, with professionals losing many hours of billable time discussing the claim. Then competitors start whispering around town that the firm is going through problems. They start to recruit rainmakers out of the firm, and the end of the firm becomes a self-fulfilling prophecy.

Firms that have successfully navigated around a large loss usually have taken the following steps:

• Internal handling of the claim is given to lawyers who had nothing to do with the work involved. Lawyers who were involved usually are too emotional to handle the claim.
• Day-to-day handling of the claim is closely held within the “claims team.” This ensures, to the extent possible, that the claim does not become water-cooler subject matter. This is not to say that the partnership is excluded from knowing how things are progressing, but it is best to restrict such updates to partnership meetings. This approach also reduces inappropriate information leaks to employees, clients and competitors.

Top-producing partners provide reassurance of their commitment to other firm members. The most successful outcomes we see in large losses are when the top producers in the firm step up and give the partnership their commitment that they will stand with the firm no matter what.

Conversely, it is a crushing blow when a top producer exits in a situation like this, as it destabilizes the partnership and threatens the fabric of the firm. If people think that their earnings are going to be impacted by a large loss ' from having to pay either a large retention or an excess-of-limits settlement/verdict ' they may elect to go to another firm to avoid the situation.

Of course, the grass will not necessary be greener at their new firm! It is hard for any law firm to never experience a tough claim situation.

John Niehoff (Partner and head of Law Firm Services Group, Beers & Cutler, Washington, DC, [email protected]): I agree with Douglas Thompson's comment that the most important concern is retaining the firm's professionals. With today's easy lateral movement of professionals to other firms, management must be able to communicate and present an effective vision of:

• How the firm will weather the storm financially;
• How the firm can quickly return to an adequate profitability level; and
• How management is adopting policies and procedures designed to minimize the likelihood of a similar issue recurring.

Management of a firm in crisis must adapt to thinking short term rather than long term with their business plans, since they cannot survive and prosper if short-term pain leads to significant departures. To maximize the short-term return to higher profitability, the firm will need to carefully manage all expenses, including hiring, and to achieve high billable utilization of all attorneys and professional staff.

Jim Davidson (Consultant, former CFO of Holland & Hart, [email protected]): If Joe Altonji is right about plaintiffs' lawyers being willing to settle for a kick in the teeth, then it could be covered from income, though maybe not all in one year. Settlements could be structured over a period of years. That would lower partner income during the period (possibly years) of settlement payments. Militating against this, however, is the possible or probable departure of productive partners whose income is diminished while the settlement is being paid out.

I have seen partnership agreements stipulate that if the number of partners falls below a certain number (well below the current number but not as low as half), then any partners who drop out for some period before the magic number is reached, and everyone who departs afterward, will remain on the hook to pony up their share of a capital call to cover the settlement. A few might get out early, but the door is soon blocked. What the partners think of each other, and of the firm and its reputation, will determine whether a provision like this is possible.

In part two, next month, the discussion turns to financial planning for future claims.

Part One of Two

Editor's Introduction

Recently I asked members of A&FP's Editorial Board and several new contributors for their thoughts on how a law firm might best deal with the financial blow of an unusually large settlement or penalty assessed against the firm.

Although a large financial hit could arise from many scenarios, including a client slipping on a banana peel near the firm's negligently wide-open elevator shaft, our 10 discussants immediately zoomed in on professional malpractice as the source of liability on which to focus. That was perhaps due to my noting what had prompted my query: a Dallas firm's Texas-size $81.6 million settlement of a class-action claim by 1,100 clients (in 41 states) in connection with tax-shelters rejected by the IRS. But my respondents might have focused on such professional trip-ups in any event, since lawyers routinely encounter a video game's abundance of regulatory banana peels and ethical elevator shafts.

This unexpectedly tight focus on malpractice deepened the discussion, yielding insightful perspectives on the financial aspects of legal malpractice with which firm management must contend: keeping the firm from crumbling immediately after a malpractice disaster and contingency planning for possible malpractice occurrences in the future.

A disclaimer regarding the first discussion thread: Allusions to various details of the specific malpractice settlement that prompted my query were plainly intended as illustrations of general themes. These particulars are not offered here as up-to-date factual reporting.

Finally, my thanks to all 10 discussants for sharing their insights: first-time contributors Sam Harris, John Niehoff and Douglas Thompson, and Board members Joe Altonji, Jim Davidson, Howard Mudrick, Pete Peterson, Ed Poll, Ron Seigneur and Lisa Smith. I've noted each person's affiliation with his or her comment.

' Joe Danowsky, Editor-in-Chief

Dealing with the Disaster

Pete Peterson (Managing Director, Law Firm Business Institute, Ridgway, CO, [email protected]): When J&G (the Dallas firm) tried to settle this same claim for $75 million, around 9 months ago, it was reported that the insurer would agree to cover $63 million, the firm would kick in $5-6 million, and the partners who rendered the tax opinions would pay the balance. That seemed a good kick in the teeth; and it seemed possible that the firm would see more claims down the road.

A recent update on these settlement figures in The American Lawyer (February 2005) states that the insurance carrier will pay about $70 million of the claim, JG will pay $5.25 million, and the remainder will be paid by the partners who rendered the tax opinions.

In addition, the article states that the settlement does not include 89 opt-outs from the class action. These opt-outs are trying to recover fees paid to J&G totaling some $25 million, plus the costs of setting up the tax shelters ' reportedly as high as $1 million per person. Of this additional $114 million of potential liability from the opt-out claims, the article states that insurance “could” cover another $50 million. Lawyers for the opt-outs are also making plans to go after individual partners if the firm should fold.

Separately, it was interesting to learn that $267 million in fees were generated from this activity between 1999 and 2003, according to a report issued by the New York Times. This was quite a boost to the firm's top line. The report also mentioned that the leader of J&G's tax shelter practice earned $93 million during this same period.

Ron Seigneur (Partner, Seigneur Gustafson Knight LLP CPAs, [email protected]): If I recall correctly, the consulting accounting firm was also implicated in these same schemes and has had similar (and possibly even larger) claims brought against it.

Joe Altonji (Director, Hildebrandt International, Chicago, [email protected]): A judgment significantly beyond insurance coverage ' what significant means depends on the size and wealth of the firm ' could easily result in the dissolution of many firms.

Under LLP status, uninvolved partners have relatively little exposure, so as a practical matter, any plaintiff's counsel is likely to settle a matter for only a “good kick in the teeth” but not a devastating blow. If Pete's right about the exposure, obviously the payment from the firm hurts, making for a weaker partner income for a year, but not a devastating blow. The firm would probably just pay from income at the level Pete suggests. The personal exposure, obviously, is a different issue.

Lisa Smith (Shareholder, Hildebrandt International, Washington, DC, [email protected]): Generally settlements are structured within the bounds of the firm's insurance coverage for the reasons that Joe Altonji describes. It doesn't take much of a hit to income for partners in mid-profit firms to start planning their exit strategy and ultimately destabilize the firm.

Howard Mudrick (President, HM Solutions, Inc., Dallas, [email protected]): While I have no specifics regarding the details of where the precise funding will come from, a few observations from an outsider (I have not consulted to this firm) may be helpful.

This firm absorbed a number of former Johnson & Wortley partners when that firm disintegrated. Interestingly, a major catalyst for the demise of J&W was a projected decrease in per partner profits. My recollection is that the decrease was not significant, but that money was a major element of the glue that held that firm together (particularly after the death of firm leader Johnson).

Believing in the predicted demise of the midsize law firm, and that only a small number of major firms would prosper, J&G undertook an aggressive growth posture for many years; but their acquisitions were unremarkable. Growth was time-consuming and expensive. They did not attract very profitable groups, nor did they build profitable offices.

The Managing Partner and Executive Director who were the architects of much of their growth departed within the last couple of years.

The firm has experienced a high turnover percentage for many years, and turnover accelerated during the investigation of these tax issues.

A firm predominantly held together by little more than a wish to be a large firm and the desire to make money is an unlikely candidate to weather much of a storm. If data on the firm's revenue and profitability were reported correctly in Texas Lawyer, the partners seem to have benefited little financially from the firm's loss of lawyers; so there will likely continue to be pockets in the firm that are ripe for the pickin'.

Douglas Thompson (Managing Director, Thompson Flanagan & Company, Chicago, [email protected]): Retaining the firm's professionals is indeed the most important concern. The two most important aspects of this are the loss of productivity and the potential loss of partners' earnings.

Large losses can become very emotional within firms. The blame game and Monday-morning quarterbacking erode productivity, with professionals losing many hours of billable time discussing the claim. Then competitors start whispering around town that the firm is going through problems. They start to recruit rainmakers out of the firm, and the end of the firm becomes a self-fulfilling prophecy.

Firms that have successfully navigated around a large loss usually have taken the following steps:

• Internal handling of the claim is given to lawyers who had nothing to do with the work involved. Lawyers who were involved usually are too emotional to handle the claim.
• Day-to-day handling of the claim is closely held within the “claims team.” This ensures, to the extent possible, that the claim does not become water-cooler subject matter. This is not to say that the partnership is excluded from knowing how things are progressing, but it is best to restrict such updates to partnership meetings. This approach also reduces inappropriate information leaks to employees, clients and competitors.

Top-producing partners provide reassurance of their commitment to other firm members. The most successful outcomes we see in large losses are when the top producers in the firm step up and give the partnership their commitment that they will stand with the firm no matter what.

Conversely, it is a crushing blow when a top producer exits in a situation like this, as it destabilizes the partnership and threatens the fabric of the firm. If people think that their earnings are going to be impacted by a large loss ' from having to pay either a large retention or an excess-of-limits settlement/verdict ' they may elect to go to another firm to avoid the situation.

Of course, the grass will not necessary be greener at their new firm! It is hard for any law firm to never experience a tough claim situation.

John Niehoff (Partner and head of Law Firm Services Group, Beers & Cutler, Washington, DC, [email protected]): I agree with Douglas Thompson's comment that the most important concern is retaining the firm's professionals. With today's easy lateral movement of professionals to other firms, management must be able to communicate and present an effective vision of:

• How the firm will weather the storm financially;
• How the firm can quickly return to an adequate profitability level; and
• How management is adopting policies and procedures designed to minimize the likelihood of a similar issue recurring.

Management of a firm in crisis must adapt to thinking short term rather than long term with their business plans, since they cannot survive and prosper if short-term pain leads to significant departures. To maximize the short-term return to higher profitability, the firm will need to carefully manage all expenses, including hiring, and to achieve high billable utilization of all attorneys and professional staff.

Jim Davidson (Consultant, former CFO of Holland & Hart, [email protected]): If Joe Altonji is right about plaintiffs' lawyers being willing to settle for a kick in the teeth, then it could be covered from income, though maybe not all in one year. Settlements could be structured over a period of years. That would lower partner income during the period (possibly years) of settlement payments. Militating against this, however, is the possible or probable departure of productive partners whose income is diminished while the settlement is being paid out.

I have seen partnership agreements stipulate that if the number of partners falls below a certain number (well below the current number but not as low as half), then any partners who drop out for some period before the magic number is reached, and everyone who departs afterward, will remain on the hook to pony up their share of a capital call to cover the settlement. A few might get out early, but the door is soon blocked. What the partners think of each other, and of the firm and its reputation, will determine whether a provision like this is possible.

In part two, next month, the discussion turns to financial planning for future claims.