Weil

In the 2008 financial crisis, there was a run on a money market fund called the Reserve Primary Fund. The fund owned some Lehman Brothers securities, and when Lehman filed for bankruptcy those securities lost value and Reserve concluded that its assets were worth only $0.97 per share. It had “broken the buck”; investors who had expected the fund to always be worth $1 per share were now disappointed. Investors demanded their money back, and Reserve had to close down, liquidate the fund, and give all of its investors back their money at a loss. Ultimately it paid them $0.991 per share. They lost 0.9% of their money. This was a huge scandal.

It doesn’t seem that huge? But this was all quite rational. You see, if Reserve had cashed out all of its investors at $1 when they asked for their money back, the first investors to get cashed out would all get back $1 and have no losses, but eventually the money would run out, and the last investors left in the fund would get back $0 and have 100% losses. That’s what a bank run is. The last 0.9% of investors would have had 100% losses. The other 99.1% of investors would have been perfectly fine. In some abstract sense, if you were an investor in the fund, you had a 99.1% chance of being fine, so there was really no need to rush to get your money out. But because everyone knows the dynamics of bank runs, by backward induction, everyone had to demand their money back at once. So they did: “In just two days, redemption requests surpassed $40 billion,” out of about $62.5 billion of asserts, and the fund had to shut down. The losses were not large. But tiny losses, combined with a very well-understood snowball effect, were fatal. Everyone could look several moves ahead, and what they saw, several moves ahead, was bad. Markets are efficient, so the bad thing immediately came true.

Here’s a well-known paper by John Morley at Yale Law School about “Why Law Firms Collapse.” He writes: 

It goes without saying that collapsing law firms suffer a degree of financial distress, but few people realize just how mild this distress actually is. …

The figures show that profits and revenues barely declined in the last year prior to collapse. The trends in the figures are consistent with impressions from news reports and litigation records. Many collapsed firms closed their doors when they were still quite profitable.

The financial distress is not bad. But there is a well-understood snowball effect, and the market is efficient, so it is fatal.

Here is a sketch of the mechanism. Law firms have a lot of operating leverage. If you are a partner at a law firm, you might go out and hustle to get clients to hire your firm to do work, and you might bring in, say, $5 million of revenue in a year. You might charge clients $4,000 per hour for your work, and $1,000 per hour for your associates’ work. The clients’ $5 million will buy, let’s say, 1,000 hours of your work and 1,000 hours of an associate’s work. You pay the associate $500,000 per year, and you have fixed costs — for rent, computers, etc. — of, say, $2 million per year. You are left with $2.5 million of profit for yourself.

Or you might bring in $50 million of revenue in a year. That $50 million will pay for, let’s say, 2,000 hours of your work — there are only so many hours in a year — and 42,000 hours of work from, say, 15 associates. (The associates have more hours in their years.) You pay the associates $7.5 million, you cover $2 million of fixed costs, and you are left with $41.5 million of profits for yourself. Profits increase faster than revenue.

But really you work at a firm, where some partners bring in $5 million a year and some partners bring in $50 million a year. And some partners bring in $0 a year: They are “service partners,” lawyers, who are paid for doing legal work but who do not themselves bring in clients. They get paid too, out of the revenue that other partners bring in.

The firm brings in revenue, pays for associates and paralegals and assistants and receptionists and rent and computers and so forth, and has some money left over, which is called “profits.” The partners get paid by dividing up these profits. Historically some firms used to divide the profits evenly among their partners, or on some lockstep seniority scale; a partner who brought in $0 of revenue would nonetheless collect millions of dollars of profits, while a partner who brought in $50 million of revenue would (1) subsidize other partners and (2) get paid much less than $41.5 million personally. This was considered to build esprit de corps and a collective sense of partnership identity. It is quite old-fashioned now, and most firms have moved closer to an “eat what you kill” system. But, only closer, not all the way. Law firm partners still get some cut of the profits for reasons — legal skill, hard work on deals other partners brought in, contribution to firm management, pro bono work, cultural contributions, seniority, etc. — other than bringing in revenue.

Let’s say your firm has 250 partners, 1,000 associates and $2 billion of revenue. The partners bring in an average of $8 million each, they pay the associates $500 million, they cover $100 million of fixed costs, and they have $1.4 billion left over as profits, for profits per partner of about $5.6 million.^[1] Of course some partners bring in $50 million of revenue, while others bring in zero. The ones who bring in $50 million get paid more than the ones who bring in zero, but not by that much. The ones who bring in zero still get paid millions of dollars for legal skill, etc.; the ones who bring in $50 million subsidize them and get paid, I don’t know, let’s say $15 million.

Let’s say you’re one of the partners bringing in $50 million. You collect $15 million of that. Another law firm approaches you and says: “We see that you bring in $50 million of revenue. If you just showed up here and brought in $50 million of revenue, that would generate, like, $42 million of incremental profits for us: We’d have to buy you a computer and stuff, and we might have to hire a few more associates to do the work you bring in, but mostly we’d just make everyone work a bit harder and keep virtually all of that revenue as profit. If we gave you $30 million of that, you’d be better off than you are now, and we’d have an extra $12 million to share among our existing partners, so we’d be better off.”

So you do it. You’re better off: You have added revenue to a firm with a lot of operating leverage, and you’ve collected most of the incremental profits. Meanwhile your original firm is worse off: You have subtracted revenue from a firm with a lot of operating leverage. Now the firm brings in $1.95 billion of revenue, covers the same $600 million of fixed-ish costs and has $1.35 billion left over as profits for its 249 remaining partners, for profits per partner of about $5.4 million. There is a bit less money go to around. Maybe another $50 million partner is still collecting $15 million a year, but she notices that her less lucrative partners are grumbling about their pay cuts. Another law firm approaches her with the same pitch you got: “Bring your $50 million here and we’ll give you $30 million of it.” This pitch is now slightly better than it was the first time: The original firm is doing worse, and has less money to pay her, than it did when you left. The third rainmaker to get this pitch will find it even more compelling.

If twenty $50-million-a-year partners leave, the firm will be down to $1 billion of revenue, $600 million of fixed costs and only $400 million of profits to share among its 230 remaining partners, or just $1.7 million per partner, which will barely cover their kids’ private school tuitions. That is a disaster case for any partner still left at the firm. Morley writes:

Partner withdrawals exhibit a selection bias. In general, the partners who leave first tend to be the ones for whom the leave/stay calculus is most nearly in equipoise. Unfortunately, it just so happens that these partners also tend to be the ones whose departures do the most damage. One reason a partner’s leave/stay decision might be in equipoise is that the partner brings in more in revenues than she takes out in costs. The partner, in other words, is a net contributor. When a net contributor leaves, the rest of the partners suffer, because the firm loses more in revenues than it recovers in saved costs. The leave/stay calculus of a net contributor is more likely to be in equipoise for a net contributor than for a partner who is a net taker, because the net contributor’s compensation, by definition, is low in comparison to her productivity. This will make the contributor more likely to get a better deal by moving to another firm. Indeed, the cycle of a partner run works by converting successive waves of partners into net contributors: As a firm’s profits decline, the compensation of the remaining partners progressively declines until finally even the partners who were originally net takers end up getting paid less than the value of their contributions.

If you’re a partner bringing in $5 million a year — not a giant rainmaker, but more or less earning your keep — then right now you are doing well by working at this firm, but if 20 rainmakers left you’d be left holding the bag. (“Finally even the partners who were originally net takers end up getting paid less than the value of their contributions.“) If you think 20 rainmakers might leave, you will be sending out your resume, because:

1. You see this dynamic starting and know that, the more rainmakers who leave, the more rainmakers will leave.
2. You don’t want to be left at the firm after the rainmakers leave, because it will no longer be profitable enough for your kids’ tuitions. 
3. You don’t want to be left at the firm after the rainmakers leave, because whoever’s left will be stuck with all of the firm’s various fixed costs: At some point, you won’t be able to walk away from the office rents, etc., and your own capital will be used to wind up the firm.
4. Other law firms only need so many mid-tier lawyers, and if you don’t get hired elsewhere quick, someone else will take the spot and you’ll be stuck.

So everyone sends out their resumes at the first sign of trouble, the end.

Bloomberg’s Roy Strom reports:

Weil Gotshal & Manges plans to wind down its operations, a staggering collapse for a nearly century-old law firm that was once a New York corporate powerhouse.

The end for the firm whose lawyers advised Microsoft, General Motors and Lehman Brothers follows a raft of prominent partner exits and failed merger talks with New York’s Willkie Farr & Gallagher that triggered a scramble to keep partners on board and find a path forward.

Weil was among the country’s 30 largest firms last year, bringing in nearly $2.1 billion in revenue. The run on the partnership occurred as its longtime leader Barry Wolf was set to relinquish control after a protracted process that raised questions about the firm’s direction. …

It is not yet clear what Weil’s plans will mean for the hundreds of partners, associates or staff at the firm. Law firm failures lead to losses of jobs for staff and associates and often impose a financial hit on partners who invest capital in their firms. Remaining at a law firm through a wind-down is personally challenging and can carry financial liabilities, part of the reason the most in-demand partners often leave struggling firms first.

Outside Weil’s New York offices, near the southeast corner of Central Park, the mood was somber. One first-year associate, who started at the firm last week, said Wolf and the board were together on Zoom, with its longtime leader doing all the talking and offering no opportunity for employees who joined from their desks to ask questions.

Two points here. First, one reaction that I have seen to Weil’s collapse on social media is that it is “all about AI.” We talked last month about artificial intelligence and the billable-hour model of law-firm revenue. I wrote:

The basic point is that law firms are tied to the billable hour, and the senior partners’ time is underpriced, both in the sense that clients would (and do!) pay more for it than their hourly rates, and in the sense that the senior partners take home a lot more than their hourly rates times the number of hours they work. Whereas the associates’ time is overpriced, both in the sense that the clients wouldn’t pay the associates’ hourly rates just for the associates’ work, and in the sense that the associates take home a lot less than their hourly rates times the number of hours they work. Billing out the associates’ time is a way to capture more value for the partners.

The general model is that clients are paying star rainmaking partners $50 million a year for their stardom, rainmaking, judgment, etc., but for a variety of reasons (tradition, needing someone to do legal work), the partners do not keep all of that money. Some of it goes to associates who do some of the legal work that the rainmaking partners generate. 

AI will, probably, change that calculation, somehow. There are various possibilities, of which one is of course “clients will just ask AI for legal advice and stop using law firms altogether.” But another possibility is that law firms will use AI to increase their operating leverage. Some big law firms will invest a lot of money in AI systems to, like, do all the work of associates; at those law firms, a partner who brings in $50 million of revenue can keep $49 million for herself, because her only costs will be some tokens. Other firms will keep doing things the old-fashioned way and lose their rainmakers to the more AI-forward firms. And other firms will invest a lot of money in AI systems but then lose their rainmaking partners anyway to firms that do it better, leaving them with huge fixed costs and even worse partner runs. I’m not sure that Weil is exactly an example of any of this, but that may be the future.

Second: Isn’t this all stupid? Lots of businesses are kind of like this; hedge funds and investment banks also have rainmaking senior employees who collect less than 100% of the revenue they bring in and are vulnerable to poaching by other firms. Why doesn’t every business collapse all the time?

I think the basic answer is “lawyers are a guild with a lot of power to make legally binding rules (because they are lawyers), and the guild makes rules in ways that are good for the short-term financial interests of lawyers but also lead to occasional runs on law firms.” Broadly speaking, the way investment banks and hedge funds prevent this sort of run is:

1. They have non-competes and gardening leave, so rainmakers can’t instantly leave for a competitor, and a competitor can’t instantly capture 100% of the value of luring them away.
2. They have deferred compensation and restricted stock, so rainmakers face a real cost from leaving for a competitor.^[2]

But law firms can’t do that! “Under the Model Rules of Professional Conduct,” notes Morley, “law firms are generally forbidden from using covenants not to compete and other restrictions to keep their partners from leaving. ... The rule prohibits, among other things, covenants not to compete and the excessively long retention of a partner’s capital contribution after she leaves.” It is unethical for a lawyer to prevent another lawyer from practicing law elsewhere, whereas it’s totally normal for an investment banker or a hedge fund manager.

You can see why the lawyers who write these rules would write them that way: They want to be able to quit in a huff, or for a better offer, and take their business elsewhere.^[3] It is good for each individual lawyer to be able to maximize her personal profitability. I’m not sure that it’s good for lawyers collectively. It’s certainly bad for Weil.

Elsewhere in law firm economics

At the Financial Times, Sujeet Indap reports:

Sidley Austin has hired an investment banker to lead its practice handling out-of-court corporate restructurings, an unusual move by a major law firm to tap a non-lawyer which highlights the escalating war for talent in hot areas of dealmaking.

William Evarts, partner at New York-based financial advisory firm PJT Partners, will join Sidley Austin and is expected to lead its “liability management” group, a team of lawyers who help design refinancing transactions for companies seeking to avoid formal US Chapter 11 bankruptcy reorganisations. …

Evarts, who has a law degree and an MBA from the University of Pennsylvania, has been with PJT since 2015.  ...

Some lawyers have left legal practice to become financial advisers, only to return to law later in their careers. Industry participants told the FT that a banker who has never practised law becoming a top law partner is almost unprecedented.

But in recent years the most in-demand lawyers have seen their annual pay soar above $20mn, and financing and restructuring lawyers have become critical to law firms’ pitch to large private equity groups that need legal guidance on multiple issues.

The key points here are:

1. Law firms are not hiring senior partners to do legal work, per se; the job is to (1) bring in business and (2) be a trusted adviser to companies. Investment banking — particularly in restructuring — prepares you for both of those jobs, probably at least as well as being an associate at a law firm, so actual experience in legal practice is kind of optional.^[4]
2. That said, those pesky legal ethics rules require law firms to be owned and run by lawyers, so having a law degree is actually mandatory. 
3. Traditionally lawyers went to investment banks because the pay was better,^[5] but now investment bankers are going to law firms because the pay is better.

Back in my day, lawyers wanted to be investment bankers and investment bankers wanted to be in private equity. But these things are cyclical. We talked last month about how private equity is stagnating, carry is down and “banking has become an increasingly attractive alternative.” And law is even better, at least at the top. 

The onion guys

I mean, if I were a University of Chicago student doing a performance-art bit in which I pretended to care so much about libertarian free-market economics that I was marching to protest the US ban on trading onion futures, and a reporter came up to me and asked “so are you doing a bit or what,” of course I would say “no, not a bit, I just really care about the freedom to trade onions.” Like that is an important part of the bit? It’s only funny if you’re completely deadpan about it? Anyway I can’t peer into the soul of this guy, but Bloomberg’s Erin Ailworth reports:

Outside the Chicago Mercantile Exchange last week, a small group of university students staged an irreverent rally that sparked a serious debate among some of America’s financial elite about what can and can’t be traded.

At first glance, the target of the protest group, called For Our Futures, appeared to be obscure: a 68-year-old ban on trading onion futures, a prohibition the students want to overturn. ...

While some passersby questioned whether the effort was a PR stunt or an elaborate joke referencing the satirical news publication The Onion, organizers insisted their mission is genuine. They think the prohibition is antiquated given the stronger market manipulation regulations the US has in place today.

“This is not the most important law in America, but this is precisely why it matters to us,” said For Our Futures founder Adam Ash, an economics major at the University of Chicago, as peers chanted and handed out onions. “We want to bring attention to the fact that there are many outdated laws on the books.”

Ash said the idea came from talking with fellow students disenchanted with the political discourse, and who wanted to show they could successfully campaign to change a specific law.

You know who else wants to get rid of outdated laws limiting gambling? Obviously Kalshi is in on this:

Kalshi Chief Executive Officer Tarek Mansour had already commented on For Our Futures earlier in the year, sharing a post in May that highlighted the group’s campaign. Last week, he lauded the students as “patriots” when reposting a video of their rally outside the CME.

I mentioned last week that the protest was sponsored by Kalshi, but Ailworth notes that “For Our Futures organizers said they first thought of holding a rally outside the CME over the summer, following other protests elsewhere earlier this year, and Kalshi only got involved after the group had already planned and announced the event.” It’s not strictly Kalshi sponcon. Just kind of.

Elsewhere in outdated laws

I mentioned yesterday that the state of Utah has banned sports gambling for 130 years, and Kalshi thinks it’s high time that Utah got with the times and started allowing sports gambling. Utah still disagrees:

Utah filed criminal charges against Kalshi Inc. on Wednesday, alleging the company illegally promoted online gambling in the state amid an escalating fight over prediction markets.

In the complaint, officials said Kalshi continued to offer online gambling to individuals in Utah after a federal judge ruled the state can apply its anti-gambling laws to trades on the platform. The complaint named Kalshi co-founders Tarek Mansour and Luana Lopes Lara as defendants, in what appears to be the first time during a nationwide fight that the company’s top executives have been targeted with criminal prosecution. 

“This is a crazy overreach; Utah is clearly playing politics,” Kalshi said in a statement. “We look forward to putting a stop to this in court, just like we did in Arizona.”

“A federal court has already ruled that Utah’s gambling laws apply to Kalshi. Kalshi kept taking bets from Utahns anyway,” Utah Attorney General Derek Brown said in a statement. “That is illegal, and we’re putting a stop to it.”

I will say that it’s an absolute legal mess. On the one hand, Kalshi (1) is clearly violating Utah law, (2) went to court to get a ruling that Utah law doesn’t apply, (3) lost and (4) is still offering bets in Utah. On the other hand, Kalshi really is regulated by the US Commodity Futures Trading Commission, which has not only brought its own lawsuit trying to overturn Utah law, but has also repeatedly used its “statutory emergency powers” to order Kalshi to ignore state law and court orders and keep offering gambling nationwide. It really is kind of true that:

1. It’s illegal, based on Utah law and court orders, for Kalshi to offer sports bets in Utah, and
2. It’s illegal, based on the orders of its federal regulator, for Kalshi not to offer sports bets in Utah.

I don’t want to be too sympathetic — this is definitely a problem Kalshi created for itself — but it is a problem. Presumably the Supreme Court will sort it out eventually one way or the other. 

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