by Peter Frankl.

Why does any business go bust? Here are some typical reasons: deficient products, loss of clients, declining demand for its products or services and management errors. This looks like a generic list and could apply to law firms as much as any other type of business.

So the interesting question to ask is whether law firms go bust any differently?

The “loose” ties of a partnership structure appears to be a key point of difference between law firms and other types of businesses in the way they go bust. The ownership structure of a typical law firm, especially a traditional partnership, enables law firms to go bust in their own financial and emotional style.

When an important rainmaker in a law firm leaves, clients will follow. Just like any other business, bankruptcy occurs when sales decline too rapidly. Unlike most other businesses, “sales” in a law firm will decline rapidly because partners walk out the door to join the competition or start a new firm.

It is therefore the ownership structure of law firms that create their own unique style of going bust.

Of course, this leads to the question, what causes a key rainmaker to leave a firm? There would be a long list of potential reasons. Some of the more obvious ones are: poor management of the firm, excessive overheads, internal competition for clients, personality clashes, remuneration arrangements, etc etc etc.

Someone who has done empirical research on why law firms collapse is Yale Law Professor, John Morley. He has noticed that “law firms die with extreme ease and astonishing speed”.

The ownership structure factor is John Morley’s insight: “Drawing on a review of every large law firm collapse in the past 30 years, I argue that the answer lies in the unusual way that law firms are owned. Unlike Amazon and Chrysler, law firms tend to be owned by their partners rather than by investors. And this makes the partners unusually sensitive to decline. As a firm’s profits drop, the decline can feed on itself and turn into a self-reinforcing spiral of partner withdrawals.”

Another insight from John Morley is that law firm collapses share a resemblance to bank runs. When deposit holders lose confidence in a bank, they will naturally consider withdrawing their funds to avoid losing them. In Australia, the Reserve Bank provides protections against this phenomenon.

At first, there may be a few early withdrawers. These are people “in the know.” As others notice what the savvy few are doing, more follow until it causes a run on the bank.

In a law firm setting, there might be a departure of one key fee earner. Then a second leaves, maybe with some associates and staff. Eventually a tipping point of confidence-loss in the firm arises; there is a rush for the door and all of a sudden, the firm collapses.

Professor John Morley has even produced a graphical representation of this “bank run effect” in law firms. There is a relatively flat line while all is well, then a little bump here and there when a rainmaker leaves and then a fast rising exponential curve representing the increasing rate of partner exits.

It seems that the flexibility and fluidity of a law firm partnership not only gives it the ability to grow in size and expand geographically but to also go bust at a rapid rate when the rush for the door starts.

Link to John Morley article

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