Making the Statue of Liberty Disappear

One of the interesting features of managing large professional partnerships in the United States is that, apart from the tax code, there are no standards for financial reporting.  This flexibility can be a powerful tool for law firm managing partners and I suspect 2009 was a banner year for the careful management of financial statistics by a lot of large law firms.

It’s fun to watch the media and various bloggers react as the 2009 revenue and profitability figures of large firms begin to trickle in.  I talked to one reporter recently who was attempting to do a sophisticated analysis of 2009 financial performance.  It apparently came as a shock to her that, aside from the IRS, law firms were under no obligation to report their numbers to anyone, much less report it accurately.

So, I pointed out three things she should remember in reviewing published law firm financial statistics:

1. Don’t accept the validity of numbers.  I recently asked a friend who is a professional stage magician how David Copperfield makes the Statue of Liberty disappear in front of a whole audience of people.  He responded, “Why do you assume the audience isn’t in on the illusion?”  There is no critical means of the media checking the validity of statistics presented by law firms.  They can call partners but most of them can’t reconcile their K-1 to the financial statements of the firm, never mind calculate profit per partner.  There is no motivation for telling the American Lawyer the truth and, often, lots of motivation for taking some liberties with the information.
2. Revenues and expenditures are manageable.  Many law firms receive a quarter of their annual revenues in the last month of the year.  Some see as much as 10 percent of annual revenues come in on the last couple of days of the year.  Law firm managers can affect the volume of revenues by the pressure they put on partners to collect receivables, without even resorting to keeping checks in drawers or leaving the books open until December 35th.
3. “There are…lies, damned lies and statistics.”  Whenever a statistic has the word “per” in it, you have two chances to fudge the numbers.  Law firms have been playing games with who is and who isn’t an equity partner for years and, in a year when law firms laid off thousands of lawyers, revenue per lawyer can change dramatically based on whether a firm uses “average lawyers,” “full-time equivalents” or “lawyers at year end” — all of which are valid and actively used.

“But why,” the reporter asked me, “would a managing partner want to play with the financial information?”   Here is where this all gets really interesting.  The basic report card that law firm leaders receive (indeed, about the only means by which partners can judge the effectiveness of firm management) is financial performance.  Partners can, of course, compare this year’s K-1 to last year’s but, after considering variances in phantom income, capital contributions and profit participation changes, most partners make judgments based as much on what the firm tells them as on the actual cash they receive.  So, there is an inherent desire by leaders both to retain their positions and, for their own ego, to want to report positive information.

This year, however, the motivations become more complex and strategic.  In some firms, managers don’t want performance in 2009 to appear too good.  After all, this was a year in which firms laid off associates and even some partners, froze salaries and deferred the starting dates of new lawyers.  Within the culture of many firms, having a significant growth in profits would seem like the partners were avariciously benefiting from the pain of their employees.

For other leaders the motive was more Machiavellian.   In many firms, cost-cutting measures had a greater impact than anticipated and resulted in a one time blip in profits.  Some leaders observed that their partners had already processed the bad news about the impact of the recession on profits and were bracing for a bad year.  It made more sense to take the already expected hit in 2009 and save the profits to show improvement in 2010.

On the other side of the ledger, some law firm strategists are anticipating that pent up demand supporting lateral movement and mergers will make the latter half of 2010 a boom period of lawyer growth for firms with stable finances and an aggressive outlook.  For these firms, having shown decent growth in a bad economic year provides a competitive advantage in making acquisitions.

Is everyone cooking the books?  Of course not.  But enough firms are actively managing the public face of their financial performance that law firm leaders need to understand this phenomenon, factor it into understanding legal markets and making decisions and, most importantly, explain it to their partners so they are “in on the illusion.”

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In addition…

1. The increasing importance of regional marketplaces has caused us to devote a lot of energy toward understanding how these markets function and where each law firm is positioned within its market(s).  As a result, we are preparing a series of reports analyzing various U.S. regional marketplaces.  The first of these reports for the Great Lakes Region is now available.  This is a 120 page analysis that discusses the region as a whole, the separate marketplaces in Chicago, Minneapolis, Milwaukee, Indianapolis, Detroit, Cleveland, Pittsburgh, Cincinnati, Columbus and Buffalo, as well as the interaction of smaller marketplaces in the region.  The law firms in each marketplace are evaluated for market position and competitiveness.  For details go to Marketplace Analyses.

2.  The second report on the Southeastern Regional Marketplace will be available at the end of this month and will cover Atlanta, Miami, Tampa, Orlando, Jacksonville, New Orleans, Birmingham, Mississippi, South Carolina, Memphis and Nashville.  For details go to Southeast Legal Marketplace.  We are currently working on additional reports covering the Mid-Atlantic, the Central U.S., the Northwest and the West. For details go to Marketplace Analyses.

3.  Last month I sent you an excellent article by my colleague, Melissa Hogan called Skinny Dipping: The Anatomy of Law Firm Demise. But I forgot to give you any information or contact information on Melissa.  Her consulting practice is heavily involved in strategy and business planning for law firms.  Her complete bio and contact information is available on my website www.edwesemann.com.