00:00:02 Speaker 1: Bloomberg Audio Studios. Podcasts. Radio. 00:00:06 Speaker 2: News. 00:00:18 Speaker 3: Hello and welcome to another episode of the OddLots Podcast. I'm Traci Allaway. 00:00:22 Speaker 1: And I'm Joe Weisenthal. 00:00:24 Speaker 3: Joe, we had some shocking news recently. 00:00:27 Speaker 1: Yeah, go on. 00:00:28 Speaker 2: I know. 00:00:30 Speaker 3: What could she possibly be about to say? No, we had the very sudden collapse of a law firm that's been in business for something like 95 years. 00:00:39 Speaker 1: A big Wall Street one. 00:00:40 Speaker 3: A big, you know, pretty elite law firm. 00:00:43 Speaker 1: One that I've heard of. 00:00:44 Speaker 2: Yeah. 00:00:44 Speaker 1: There's not a long list of law firms that I've heard of. Yeah. 00:00:47 Speaker 3: So while Gottschall collapsed, there's some irony here because it's. perhaps most famous for being a bankruptcy firm. It worked on stuff like the General Motors bankruptcy, Lehman Brothers as well, I think. And now itself has failed. And of course, this has prompted a lot of questions about the durability of the big law model. And I'm going to give my standard caveat whenever we do a legal episode, which is my husband was a lawyer. Neither of us enjoyed it very much. But one thing I learned from that entire experience is the law model is just so weird. 00:01:25 Speaker 2: It's weird. 00:01:26 Speaker 3: And no one seems to be particularly happy with it. Like, neither the partners. 00:01:30 Speaker 2: Yeah. 00:01:31 Speaker 3: Partners probably more so than some other people, but certainly not, like, junior associates. And law firms, they're always going through these efforts where they try to, like, fix things. You know, they start de-equitizing some of the partners or try to move out some of the older partners, try to make life better for some of the junior associates. And they never seem to quite get it right. 00:01:50 Speaker 2: No. 00:01:51 Speaker 1: And this seems totally true. I do not know much either about law firms, how they're structured from a corporate perspective, and also law firms, how they're structured from a corporate perspective in theory, as in what is the theory such that Maybe people don't like this system, but it seems to be the least worst system. It does not seem easily changeable. I know that law firms are basically like, they're never public. They never have like outside equity holders and so forth. There are some publicly traded law firms. 00:02:23 Speaker 3: I don't know if they're publicly traded, but they have outside investors. But you're right. You do know one thing about law firms, which is the standard model is the partnership model, right? 00:02:30 Speaker 1: Yeah, standard partnership is the partnership model. And you know what's funny is like, okay, we had this collapse of a pretty big law firm. Didn't seem to be a big deal in the sense like, Unlike, say, if there was an equivalent bank that had collapsed, you'd be like, oh, panic. What does it mean? Seems like it just sort of happened and life went on. But the other interesting thing, too, is I remember in 2008 when a lot of the banks literally did collapse. And people were like, oh, this wouldn't have happened if they hadn't abandoned the partnership model and stuff like that. But I guess partnerships aren't immune to collapse either. 00:03:03 Speaker 3: Well, this is exactly what I was going to say because I've been thinking about the partnership model because both of us read Lloyd Blankfein's biography earlier this year. And you can tell he is very wistful for the old partnership model that they had at Goldman Sachs until they IPO'd. 00:03:18 Speaker 2: Yeah. 00:03:19 Speaker 3: We should talk about how law firms ended up being partnerships, why they collapsed. Why does it seem like rainmakers are such a huge thing in the legal industry such that they can basically lead to the collapse of a single firm like basically overnight? And this does have broader importance beyond just the legal industry when you think about ownership problems. of firms, there is this like fundamental question of whether or not it's better for a firm to be owned by its workers directly or by outside investors. 00:03:51 Speaker 2: Totally. 00:03:51 Speaker 1: You know, like we go down every year, we go down to the future proof conference and there's a bunch of registered investment advisor, independent investment advisors, et cetera. And, you know, you always hear, I'm always interested in hearing how they, those small financial advisors structure their thing. And often there's like a founder or, And then they like sell their equity over time when they're ready to retire to the junior. People come up and maybe take out loans. I'm very interested in these different corporate structures and how they how people make them work and evidently how sometimes they don't work. 00:04:24 Speaker 2: Yeah. 00:04:25 Speaker 3: And how they don't work. Okay, so we do, in fact, have the perfect guest. We're going to be speaking with John Morley. He is a professor at Yale Law School. More importantly, perhaps, he published an academic paper that was very prescient in predicting, I guess, some of the pressures that can come to bear on a law firm through the partnership model. So, Professor Morley, thanks so much for coming on All Thoughts. 00:04:47 Speaker 2: Thanks for inviting me. It's a pleasure to be here. 00:04:49 Speaker 3: Why don't I start with a very basic question, but how did we end up in... a world where the vast majority of big law firms are partnerships. So I mentioned there are some exceptions, famous exceptions, particularly in the UK, but the vast majority of them are owned by the actual partners. How did this come to be a thing? 00:05:10 Speaker 2: It's not entirely clear, surprisingly. There's not an obvious answer to that question. I'll answer the question, though, on three levels. So the first is history. Law firms started out this way. And because it doesn't require a lot of capital to start a law firm, it really just requires the labor of the workers and the human capital of the workers, you can start one without having outside investors. And so large law firms didn't appear, and by large I mean even more than three or four lawyers, didn't appear until the mid-19th century in either the United States or the United Kingdom, but they've always been worker-owned. The second level in which I'll answer that question is regulation. Today... The model rules of professional conduct, which have been adopted in some form in almost every state, generally require that a law firm be owned by lawyers, which as a practical matter tends to mean the lawyers who work at the firm. Then there's a third level at which we could answer that question, which is economics. Big, big debate about whether this pattern of ownership is efficient or not. Should law firms instead be owned by their investors? The best answer to that question was given by a Yale Law School professor named Henry Hansman, who was my teacher and mentor. His argument was that in a law firm, the contributions of the workers are relatively easy to measure and perceive, which reduces the risk of conflict among the workers. Imagine if General Motors were owned by its workers, there would be huge conflict between the management and the people on the factory floor. There'd be lots of conflict about how much each of the executives pay because it'll be hard to measure their relative contributions. In a law firm, it's much easier to measure people's contributions because they bill by the hour. And you can often identify which clients they brought in. 00:06:50 Speaker 3: This is the eat what you kill model, right? 00:06:53 Speaker 2: That's right. That's the eat what you kill model. But even before the eat what you kill model, there were even simpler ways of identifying lawyers' productivity and structuring their pay, which was that every lawyer of a given level of seniority got paid the same amount. So worker ownership is more tenable in a law firm than in other kinds of businesses because the workers tend to be more similar to one another. That's the idea. 00:07:17 Speaker 1: So let's say I'm a private equity guy and I look at a law firm, maybe a medium-scale law firm. And I look at it and I say, I bet they could do service just as well to their clients as they do just as well if they got rid of all their junior partners and replaced them with this AI solution that I developed. So I'm going to invest in them millions of dollars, tell them to stop hiring new juniors and use AI instead. Why doesn't that happen? Is there a legal thing? Why can't, let's talk about like, someone must have, people have this idea. People look at law firms and see opportunities for productivity gains. Are there legal reasons that this cannot be done? 00:07:57 Speaker 2: So first off, there are investor-backed, venture-backed businesses doing that now. Okay. It's harder to do that with a traditional law firm. In both types of businesses, the venture-backed businesses and traditional law firms, you have these rules that prohibit non-lawyer ownership. The way the venture-backed businesses get around those rules is by segregating the business into two chunks that each go into a different entity with a slightly different set of owners. On the one hand, you have the law firm, which provides legal services and employs lawyers and is owned exclusively by the lawyers. On the other hand, you have what's called a managed service organization or MSO. The MSO is owned by a mix of investors and the lawyers who work at the law firm. And the MSO does everything other than provide legal advice. Oh. It employs the word processing people, the administrative assistants, the finance, the accountants, the financial administrators. It holds the lease. It owns the computers. Oh, I see. And so basically what happens is the clients pay fees to the law firm, and then the law firm pays a price for administrative support to the MSO. 00:09:02 Speaker 1: So this makes a lot of sense. Just real quickly, when you say there are these rules about ownership from non-lawyers, are these state laws? Are they— Where do these rules come from? 00:09:15 Speaker 2: Yeah, they're essentially legal ethics rules adopted by state bar associations and sometimes by state legislatures. The American Bar Association has promulgated a model set of rules called the Model Rules of Professional Conduct. And every state has adopted them in some form. A couple of states, namely Arizona and Utah, have altered those model rules to permit non-lawyer ownership of law firms, but only those states. Okay. 00:09:41 Speaker 3: So the working narrative of what went wrong at Weill Gottschall is this idea of all the rainmakers departed. A bunch of senior partners who had really strong client relationships started walking away from the firm, and then it snowballed from there. And we'll get into the snowballing because this is basically the essence of a lot of your academic research on this topic. But just on the Rainmaker model itself, this is something that I have never understood about law firms because you think about the law firm as an organization that they should want clients to be sticky and loyal to the firm itself. But then in practice, the relationships that are sticky are between an individual lawyer and an individual client. So when a partner walks away, they walk away with, I don't know, like $ 300 million worth of business from a specific client. Why is that a thing? Why haven't law firms done more to, I guess, institutionalize some of these relationships? 00:10:40 Speaker 2: Because it's hard. is the answer. There's always a tension between law firm management on the one hand and individual partners on the other. The management wants to institutionalize all the clients and make sure that the client's loyalty is to the firm, not the partner. The partner wants to keep the clients individual to the partner so that the partner can leave. And also because under an eat what you kill system, the partner might get credit for bringing the business in, which means that the partner wants to make sure that the across other partners as well. And there's a way in which law firms are undermining their own objectives by adopting a what you kill system. If you pay partners for tethering their clients' loyalty personally to themselves, that is naturally what they will do. But on the other hand, if you don't pay them for doing that, well, then they'll sit back and wait for other people to generate business. It's what in economics we call an optimization problem. You're trading off two variables that are in tension with one another. 00:11:41 Speaker 1: We'll get back to the, maybe the original sin. It sounds like the original sin for a while, maybe it goes back to 2013 or something. But if we're in the sort of like the final few months of the firm this year, a big rainmaker walks out the door. I'm still in the door. Tell me why that's bad for me. Because we're describing, all right, there's this bank run like pressure, or I think you call it a partner run, but whatever. It's a bank run like pressure. What bad happens for the remaining partners when a rainmaker walks out the door? 00:12:12 Speaker 2: Okay, so let's break it into two pieces. One is how does that partner's departure damage the firm? Yeah. And second, how do the other partners get hurt as a result? 00:12:20 Speaker 3: Yeah. 00:12:20 Speaker 2: Okay, so the first piece is when that partner leaves, especially if that partner's a rainmaker and especially if that partner's clients are personally loyal to him or her, then that partner will take revenues with her, right? The clients will leave immediately. And the firm will have fewer revenues as a result. Now, that's not obviously bad for the firm because in addition to losing revenues, it also gets rid of some costs. You no longer have to pay that partner the partner's compensation. And indeed, sometimes law firms deliberately fire or de-equitize partners because the partners are bringing in less than they're taking out. But if the partner is bringing in more than they're taking out, then to lose the partner is a loss. Here's the bigger issue, though. You often can't cut costs as quickly as you lose revenues. So when the partner leaves, you still got to pay the lease on that partner's corner office. And you can lay off associates, but that's kind of a bad thing to do. You can lay off staff, but that's a bad thing to do. You might have debts to pensioners and retirees from the firm. You might have bank debts, none of which go away simply because that partner left. There might also be other partners who depend on that partner for work. If I'm an M & A partner, for example, I'm expected to bring in business. But if I'm a tax partner, all I really do is work on business brought in by the M & A partners. So if the M & A guy leaves, well, we still got to pay the tax partners and now they don't have any business. So you can't cut costs as quickly as you can cut revenues. The answer to the second piece is a bit more complicated. Why does that hurt the partners who stay? Well, the answer is because the partners are owners of the firm and not merely employees. And that causes them to suffer for two reasons. The first is that as owners of the firm, they are paid in shares of the profits. And so if the revenues have gone down while the costs have stayed fixed, the profits have to go down as well. That's just simple math, which means that once that rainmaker has left, there are fewer profits left over to pay the partners who remain. Just as a matter of arithmetic, they can't all be paid the same. So their pay has to go down. The second reason they suffer is that if the firm eventually files for bankruptcy, and we'll talk about the snowball or the run that might propel it into a bankruptcy, but if it ever does wind down, the partners can face a bunch of forms of liability that are unique to their status as owners of the firm. The most important is a doctrine called fraudulent transfer liability. The basic intuition behind that doctrine is that We don't want a debtor to give away assets on the eve of bankruptcy. If I'm about to file for bankruptcy, we don't want me to give away my car and my house to my girlfriend and my uncle. So basic rules of bankruptcy say if you give away money between the period you become insolvent and the period you file for bankruptcy, all of those giveaways can be voided or clawed back by the creditors. And here's the catch. A distribution on profits is a giveaway under that doctrine because it doesn't actually have to be paid. Wages have to be paid because they're contractual debts. If your administrative assistants have worked for two weeks, they've accrued a debt that they have a right to claim against the firm. By contrast, all the partners are entitled to receive is a discretionary distribution of dividends, which the firm can choose not to pay. So, for example, Berkshire Hathaway is sitting on billions of dollars of profits, which it's never paid out as a dividend because it doesn't have to. So what happens in law firm bankruptcies is after the firm goes south, the creditors show up and say, look, there was a 10-month period during which we consider the firm to have been insolvent, but during which you were making payments to partners. We want to claw that all back. And the partners say, you can't do that. We were workers. Those were wages. And the courts say, uh-uh. You were not employees. You were owners of the firm, and those weren't wages. Those were discretionary distributions of profits, which standard law can be clawed back in bankruptcy. 00:16:38 Speaker 3: So the more a partner thinks that a firm might be heading for failure, the more risk there is that their compensation could be clawed back and that they could be liable for some parts of the business if it actually fails completely. But let's go like one step back and talk to us about what happens in a partner's mind when they see another high profile partner leave the firm. What are the sort of cost benefit calculations that they're doing in their heads to where they're thinking like, oh, this guy's getting a lot of money to go to a competitor. Maybe I should be thinking about doing the same thing. But on the other hand, maybe I really like my firm. Maybe I really enjoy working in the structured finance unit of Allen and Overear. I don't know what. What are the sort of thoughts going through their heads? 00:17:25 Speaker 2: So this is what I call the leave-stay decision. You might not wake up as a law firm partner on a Wednesday morning and think, should I stay or should I go? But implicitly, You face that decision every day. And so you're going to walk through three kinds of calculus. The first is to say, well, because that guy left and took revenues with him and the costs of the firm are going to stay the same, we in the aggregate, me and my other partners, have to be paid less as a result. So I'm going to get paid less. But the amount I can get paid by moving across the street to Cravath is going to stay the same. So whereas previously I was making 5 million a while and being offered 4 million in Cravath, if now I'm making 3.9 a while, suddenly I might begin to move. The second thing I'll ask myself is, well, what about my liabilities? And I'll be saying, hmm, if everybody follows the same logic I'm following, they might leave before me. And then one guy leaves and another guy leaves and all of a sudden we're in a run on the bank. And if the firm ultimately collapses, I'm going to have to give back all or a portion of the money I received from the firm between now and the date of collapse. So suppose that I'm a partner while Gottschall in this past September. And I think most of my compensation is going to be paid to me in January. This is a typical feature of law firm compensation. Partners get paid a little bit every month or every quarter, and then they get paid a big chunk, maybe 50% or more of their compensation in January after the books for the prior year have been saddled. And you say, okay, it's September. I think there's a 50% chance this firm is gone in February. If it is, every dollar of compensation I receive between now and February is going to get taken back from me. So if I'm expecting $ 2 million in compensation over that period, I have to apply a 50% discount. It's really only worth a million to me. So then if Gibson Dunn comes and offers me $ 1. 5 million, it looks on paper like a pay cut because Weil's offering me two. But in fact, it's a pay raise because the expected value of Compit Weil is $ 1 million. Whereas at Gibson, it's 1.5 and it's also less risky. The third calculus I'll be making is what about the viability of my practice? So most law firms now, including Weill, have eat what you kill compensation systems. You get paid according to your productivity. Well, if I'm a tax lawyer and I'm in the business of servicing M & A deals brought in by M & A lawyers, then if all the M & A lawyers have left, I'm not going to look even to my own firm's managing partners as if I'm very productive. In other words, my own practice might become unsustainable. So as each partner leaves, the predicament of the remaining partners gets worse and worse. in a spiraling cycle that becomes a kind of run on the bank. That was excellent. 00:20:12 Speaker 1: And I love this idea of like, even though the lawyer doesn't think so, actually in reality, every day they do wake up in the morning and make a decision whether they're going to leave or stay or Hard not to be reminded of the great 1882 essay, What is a Nation, by the French philosopher Ernest Renan, where he called a nation a daily referendum. And even though we don't vote every single day implicitly as citizens of a nation, we all decide every single day whether we want to continue on together as a nation. All right, let's try to talk more about Weil and the original sin here and why certain rainmakers perceived opportunities elsewhere is there an equivalent term like Wall Street for the legal magic circle is there like big law yeah what's is there like a term that's sort of like a what's like a anyway whatever elsewhere in the legal field listeners to the odd lots podcast know that a lot of money was made over the last several years and things like private credit, private equity, et cetera, all kinds of deal making. And everything I read seems to point to some like fateful early decisions in like 2013 coming out of the great financial crisis where while sort of like they sort of missed the boat on that. Do you agree with that characterization? 00:21:32 Speaker 2: I do. And I want to be clear. I don't have any inside knowledge about what. No, sure. I'm just speaking based on what I've read in news reports. 00:21:39 Speaker 1: But in terms of the news reports in your framework. 00:21:41 Speaker 2: Yeah. I think one of the things that people found especially striking and prescient about my framework, if I can be a little bit immodest for a moment, I specifically predicted that a firm could collapse even when it had no meaningful debts and even when its profits were not just large but increasing. A firm can collapse basically whenever its profits are increasing. not increasing as quickly as its peers. In other words, what I call its relative profitability is decreasing. And that was unambiguously true of Weil. Weil's position in the profits per partner ranking fell from nine in 2020 to, I think, 20 in 2025. And I think that the fall was even starker if we go back further in history. So why did Weil fall relative to its peers? And I want to be clear, its profits were still increasing year over year. just not as quickly as Kirkland analysis. So why did Weill's profitability falter relative to its peers? I think the answer basically is that it didn't expand and it didn't shrink. Law is big law. That's the term that we'll use. Big law is in the midst of this sorting that actually resembles the sorting we've seen in many other industries, where the middle is getting hollowed out. And you're seeing this gravitation towards either becoming humongous or becoming really small. And Weil was uncomfortably in the middle. And that was a deliberate choice. My understanding is that there was a very powerful rainmaker there named Mike Aiello, whose departure in September was kind of the final straw that really, to mix metaphors here, pushed things over the edge. Aiello, understandably, in my opinion, wanted to work at a place that wasn't gigantic. He thought, you know, He was a little bit wistful, like Lloyd Blankfein, about the kind of smaller familial feel of the old Weill Gottschall, which is why, by the way, the firm he left for was Cravath, which still has that feel. But the problem was that Weill wasn't keeping pace with its competitors. And clients increasingly want firms that can offer a very large platform with a high degree of specialization. And that's something you can do if you're like Kirkland and Ellison, you're really gigantic. It's much harder to do on a smaller platform. There's only a couple of law firms that manage to stay small in the corporate transactional space and do really well. Basically, it's Wachtell and Cravath. But even those firms have been struggling. They've made it work by doing only very, very premium work on super-duper high-end stuff like public company M & A. But even those firms are experiencing a bunch of poaching. They are under profound pressure, and Weill just was not strong enough to withstand that. 00:24:33 Speaker 3: Yeah, we've seen a similar dynamic in banking as well, right, where clients want the treasury functions. They want corporate M & A and everything basically offered on a single platform online. A lot of people will be listening to this and thinking, well, if so much of the business depends on single individuals or personalities or rainmakers, why don't law firms have non-competes that prevent them from just automatically leaving the firm and taking all their clients with them? What's the answer to that question? 00:25:07 Speaker 2: The answer is rule 5.6 of the model rules of professional conduct, which prohibit a lawyer from signing any agreement that would restrict their right to practice. So that includes non-competes and similar kinds of agreements. Now, to be clear, other countries don't have these rules. In the United Kingdom, lawyers are free to sign non-compete agreements, and law firms generally require that they do. And my understanding is that they are frequently enforced. Those restrictions also don't appear in other industries. You can impose those kinds of restrictions in accounting, in engineering, in management consulting. I would say, by the way, Joe, so you'd asked earlier, what is preventing investors from owning law firms? Well, one answer and the most commonly given answer is the one that I gave a moment ago, which is the rules limiting investor ownership. But another and perhaps more important answer is these rules prohibiting non-competes. And the reason is this. If you're a private equity fund looking at investing in a law firm, you're going to pay all these partners a bunch of cash to buy out their equity interests. And then what are they going to do? They can leave the next day. 00:26:09 Speaker 1: They're going to leave, yeah. 00:26:10 Speaker 2: And you can't force them to sign an agreement committing not to leave. So the best solution you have is to give them equity in the MSO and require them to forfeit that if they leave, because that's not a restriction on the lawyer's right to practice. That's a forfeiture condition on an equity stake in an unrelated business, in like a distinct business. It works pretty well, but whether it works well enough is going to be one of the central questions. of the new private equity boom in law firms. Okay. 00:26:40 Speaker 1: While it didn't grow as fast, it wasn't aggressive enough, et cetera. Maybe it was a little bit too conservative going back a couple of decades. Couldn't that have been rational from the perspective of senior lawyers? at the time, some of these decisions, maybe some of whom have retired by now. So it's like, we go back to like 2010. They're like, you know what? We don't need to like go super crazy on the private equity, private credit deal-making stuff. We think, and you know what? We're going to like trim some of our ranks and so forth. And maybe that set the seeds for their destruction in 2026. But if I'm maybe they retired in 2021, that seems like a big, especially now, again, like thinking about future investment or AI, et cetera, this sort of like intertemporal relationship of the lawyers and how long they're going to actually stay there and how much they care about what the firm is going to look like in 20 years. 00:27:35 Speaker 2: Yeah, so look, it's hard to know the future. Law firms face the same uncertainty in business decision making that every other kind of business does. And let me say, there's lots of firms that took the path that Weill took, but most of them have since changed course. A good example is Cadwallader. The full name of Cadwallader was Cadwallader, Wickersham, and Taft. Haft being the former president and chief justice of the United States. It was a very, very prestigious, and Yale law professor, I might add. Very, very prestigious firm that was for a time extremely profitable. But like Weil, it didn't grow. And it eventually, very recently, had to find refuge in a merger with a much less prestigious firm. Hogan loves that. Apologies to all the people at Cadwallader and Hogan. But Hogan doesn't have the history that Cadwallader had. And so the point is to say Weil was not crazy. in pursuing the strategy. However, it was crazy and hanging onto it for a little too long. But you asked a deeper question, Joe, also, which was, are the partners of the present or past willing to invest for the future? Yeah. And the answer is, well, not necessarily. So I'm working on a new project that I recently put online about a concept that I call generational conflict. Generational conflict is a problem in many kinds of businesses that don't have what I call permanent equity. So let's imagine General Motors or Microsoft. When you buy a share of stock in General Motors or Microsoft, it lasts forever. It lasts as long as the firm does. And so even if I'm going to sell my shares in Microsoft next week, I'm still happy for Microsoft to incur costs today in order to build technology that will yield profits 10 years from now because the price at which I sell next week will reflect the buyer's expectations about what will happen 10 years from now. The share lasts indefinitely, and therefore prices paid in a market for those shares will reflect the value of the indefinite future. Well, not so in a law firm. When I retire from a law firm, whether that's Cravath or Covington and Burling, my shares simply disappear. They're extinguished. Nobody buys them back from me. They're just gone. And so if I'm a 31-year-old partner and you're a 61-year-old partner, I'm going to be a lot more interested in the future of the Because when you retire two years from now, the value of any investment you made in the firm is going to be gone. 00:30:07 Speaker 3: This also goes back to partner incentives, right? Where if all of their compensation is based on bringing in clients and none of it is based on nurturing the next generation of talent, like no one is actually going to be paying attention to that. Like there are some great senior lawyers out there who will mentor junior associates, but they seem to be few and far between. 00:30:29 Speaker 2: That's right. So this problem of generational conflict, it's not just between the old and the young. It's also between the people who are here now and will also be here tomorrow and the people who are here now but might leave tomorrow. And, you know, as the pace of lateral movement has picked up, the generational conflict between present and future has become much more intense. And it feeds back into everything that happens at a firm, including compensations. If I can leave at any time, it's hard to pay me anything other than my market value. So again, turning to Wachtell and Cravath, they both had lockstep compensation periods for a long time. And under a lockstep system, lawyers get paid the same based on their seniority rather than their productivity. Well, a system like that creates winners and losers. And the losers, the people who are getting underpaid, are likely to leave. And so the pressure of lateral movement basically forces the firm into an eat-what-you-kill system. An even broader way to think about it, to return to your analogy about nations, Joe, is to say it really is like nations where people can come in and out as well. If you overtax billionaires in California, for example, they will leave. And if you pay really generous healthcare subsidies and poverty-related transfers, a lot of people who are in need of that assistance will come in. And you get the same thing in law firms, right? If you make transfers from the successful partners to the less successful ones, you'll get fewer successful partners and more unsuccessful ones. 00:32:10 Speaker 1: We've talked about this briefly on a couple of episodes in the past, but since we're talking about it again now, this whole thing of big star lateral hires, where one firm spends a lot of money to poach a ringmaker. This is a fairly new thing. In the history of big law, this is a relatively recent phenomenon. 00:32:29 Speaker 2: It is. 00:32:30 Speaker 1: I mean, it's really- Is this a norms thing? Was it just not the norm that this was done, and then someone broke the norm, or- Like, what is it now such that this has become a more prevalent phenomenon than. 00:32:43 Speaker 2: It used to be? It's a hard question to answer convincingly because I think ultimately it was a norms thing. There was no hard obstacle to it. There was nothing in 1975 preventing a partner from leaving Cravath and moving to Kirkland and Ellis. There's nothing preventing that. And yet they just didn't do it. They just didn't do it until really the last 20 years. And with every passing year, the volume of lateral partner movement increases. I mean, the firm that really started the action was Kirkland and Ellis. They were the first ones to do this kind of poaching at a really large scale, and they did it very well. I should say there are substantial business risks to doing that kind of poaching. When you interview a lawyer to move to your firm, you ask the lawyer how much business she has, and she's going to say, oh, I generate a gazillion dollars a year. But both professional ethics rules and that lawyer's fiduciary duties to their current firm prevent them from actually talking to their clients and asking if they'll be willing to move. Also, if the lawyer's current firm found out that they were shopping around, that lawyer might get fired. So you basically don't know. The lawyer says, I'm bringing in X amount, but you don't really know. And I think for a long time, people were just skittish about hiring under those conditions. But people have overcome their fears and they're now willing to make big bets. On the norms question, let me just say one other thing, which is that I really feel like law firms are kind of a microcosm of modernity. They really are like nations in the sense that they have one person, one vote rules. They have systems of redistribution. People relate to them in a variety of ways. They want not just money, but also satisfying social lives, a nice working space. They have multiplicitous demands of this organization they relate to. People are conflicted in how they vote to it. They're voting on their own compensation, in a sense, in the same way that we vote on our own tax rates implicitly by electing the people who will establish them. So a lot of the problems of public governance also creep into law firm governance and replicate themselves in weird ways. And so what I would say about norms is just that in the same way, all of human life has become more calculated, more self-interest seeking, more formal and more commercial, less familial, less communal, less traditional. That's happened at law firms. And so like, you know, at Cravat, there used to be, I don't know if there still is this tradition where in the partners of Cravath would be the pallbearers at a partner's future funeral. You know, like an illustrative example of like the tradition that attached to these organizations. But like that's all fading away. And when it does, people act on the basis of self-interest seeking and money. There's nothing wrong with that. It's just a very modern way of thinking about human relations. 00:35:36 Speaker 3: Joe doesn't like the term peak capitalism, but it's very peak capitalism. 00:35:41 Speaker 2: Come on. The peak could get higher still. 00:35:44 Speaker 1: That's right. 00:35:45 Speaker 3: It's true. It's true. I just want to go back to the sort of classic theory of ownership stuff. And I mentioned in the beginning, we do have some investor owned law firms. And there's a famous example that you talk about in your paper, an investor owned law firm that came very, very close to collapse. But because they didn't have the partnership model, they ended up being able to restructure and sort of emerge from the bankruptcy process more or less in one piece. Can you talk about how that difference in ownership structure actually played in that example? 00:36:35 Speaker 2: Yeah. So the firm was called Slater & Gordon. It was a conventional partner-owned law firm in Australia that went public and listed on a stock exchange when Australia changed its rules about lawyer ownership back in the 90s. And after going public in Australia, it used the capital it raised to acquire other firms in both Australia and the UK, and it eventually listed in the UK as well. So it was basically just an investor-owned business. And it had so much capital and so much ability to raise it that it eventually did kind of add-on acquisitions of related businesses that weren't law firms and acquired a business called, if I remember correctly, Quindel, which was... a medical services firm as well as a legal services firm for people who'd been in car accidents. The idea was somebody gets in a car accident, we'll represent you as a lawyer and treat your whiplash. Well, Quindel, it turned out, was just a fraud. The accounting, the books had been cooked. 00:37:32 Speaker 1: I'm shocked. 00:37:32 Speaker 2: I'm shocked. So Slater and Gordon realizes that it's massively overpaid for this asset that now turns out to be worth a fraction of its accounting value. So it was just insolvent in the same way An auto parts manufacturer would be insolvent if it made a bad acquisition. All right. So what happened was the firm went to the hedge funds that had lent it money. It went to the banks that lent it money and said, we got to do a workout. They wiped away the equity. They turned the junior debt into equity. They split the business between its Australian and UK pieces, and they kept operating. And the question is, and they're both still in business today. Why didn't that collapse in the way the Weill Gottschall collapsed? Well, the answer is because the lawyers weren't owners of the firm. Their pay did not decline when the business became less profitable. They didn't face any risk of liability. They were like the pilots at Delta Airlines or the factory workers at General Motors, both of whom continued working for those businesses when they went bankrupt because they continued to get paid. The key difference in an investor-owned firm is that investors can't pull back their money Right. In an investor owned firm, you can sell your shares, but you can't take back the chunk of the company's assets that correspond to your interest. So Slater and Gordon was able to say to its equity holders, you're wiped out, go away. And they just did. But the money stayed inside the firm. Now, imagine if Weill Gottschall tried that. Imagine if it said to the equity holders, you're wiped out. The creditors of the firm now own the firm. What would those equity holders do? They would go to Cravath because they're partners of the firm. They could just walk away. 00:39:11 Speaker 1: So what happened? So actually, just for including me, like in the last several weeks, so the company collapses. Is there something called while still? What is the wind down look like? Is there a last lawyer who leaves like someone who has to turn? You know, someone's got to be the last lawyer to like find a job somewhere else. How does it actually, what's the actual good night process? 00:39:33 Speaker 2: It's going to be fascinating to watch this all unfold. So let me first of all say, I think that not surprisingly for a firm that does bankruptcy for a living, Wiles actually handled the wind down remarkably well. The best decision they made was to wind the thing down quickly. Remember fraudulent transfer liabilities. Fraudulent transfer liability commences the moment the firm becomes insolvent, and it ends the moment the firm winds up. And it's really hard to say when a law firm becomes insolvent, not least because they have very few debts. But in many other collapsed firms, that period has lasted six months, eight months. At Dewey and LaBeouf, it was something like eight or nine months. And so by calling an end quickly, Weil basically avoided a bunch of fraudulent transfer liability for its partners. So what they're doing now is winding up the firm. There's a few lawyers still left at the firm. They need a place to continue representing their clients. Their clients have ongoing needs that need to be serviced. And to the extent people still at Weil are continuing to represent clients, the fees for those representations are all going to go into Weil. But all of the cash, including the fees that are brought in over the next few months, all of that's going to get eaten up by creditors. Now, Weill didn't have a lot of financial debts. That is to say, they didn't have bank borrowings. But it still has lots of creditors who have claims on the firm. The biggest category by far is going to be the landlords. Now, people often say, well, you know, landlords, rent doesn't account for that big of a chunk of law firm's revenues. That's true month to month. But if there's 10 years outstanding on that lease on the General Motors building on Fifth Avenue and 59th Street, the landlord can probably make a claim for all 10 years of it today. Well, that's going to be more than enough to eat up whatever cash is left inside that firm. So even though the partners at Weill are not going to face a bunch of liability, things are not going to be happy for them. Law firm partner compensation is ordinarily spread out unevenly across the year. Every month or every quarter, they'll get paid a little bit of money. But then they'll get a big chunk amounting to like 50 or 60 percent of their total annual compensation around mid-January when the books for the prior year have been settled. What this means in effect is that the partners at Weill Godshall worked for 10 months out of the year and they're never going to see the 50 percent of their compensation for that period that would have been paid to them in January. That's all going to get eaten up by creditors. So Kind of sad for the partners at Weill Godshaw. 00:42:10 Speaker 1: Yeah, it's a rough year. 00:42:11 Speaker 2: I genuinely feel bad for them. A big question is whether the firm's going to file for bankruptcy. They've said they don't intend to, and I think they probably won't have to. The reason is that bankruptcy is fundamentally a solution to a collective action problem. You have a lot of creditors who need to work together to recover on the debts, and you need one person who can represent them. The collective action problem at Weill Gottschall is not going to be as acute as it was at many other law firms, such as Dewey and LaBeouf, for example. Because first off, there aren't going to be many creditors. There'll be a few landlords, basically. And there aren't going to be that many debts for it to collect upon because the partners aren't likely to be liable. Like in Dewey, you needed a bankruptcy to trustee to go out and sue each one of the partners. And famously, there were a few partners at Dewey who declared personal bankruptcy as a result of those liabilities. But we don't need anyone to do that process of collection at Wild Gottschalk because the partners aren't going to be liable. 00:43:13 Speaker 3: Yeah, we're recording this on November 10th. And there's a new story just across the Bloomberg now saying that the Weil partners have voted to dissolve the firm and they've named their wind down committee. So I guess they'll be making some decisions soon. But I hadn't realized this, but like the ultimate injury added to insult the woman who was going to lead the firm as executive partner, Ramona Nee. I didn't realize she's been hired by Kirkland Ellis. Yeah. So she said she didn't want to take on the executive partnership and things kind of spiraled from there. 00:43:47 Speaker 2: You know, I have to say the moment that I thought, wow, the end is near for Weill Gottschall, I knew that they were in trouble for since midsummer, basically. But the moment when I thought it's inevitable, it was when I found out that Ramona Nee was not going to be the chair of the firm and that there was a debate about whether she had known that for several months before disclosing it to the rest of the partners. You know, A law firm collapse is kind of like a bank run. It's a crisis of confidence. Franklin Delano Roosevelt said, we have nothing to fear but fear itself. And what he meant was the fear that propels bank runs is itself a thing to fear. And I think a big part of Weill's problems, which I didn't describe earlier, is that in addition to having unfavorable economics, it had by all accounts a pretty toxic governance culture. And when Ramona Nee, when that news about her came out, I thought, whatever faith was left in the management of this firm is going to be gone. And people are not going to have any reason to stay other than money. 00:44:43 Speaker 3: Well, can you talk a little bit more about that? Because when I think about law firms, again, much like banks, all of these companies or partnerships, they like to talk about the importance of culture and putting the client first and we're all one big family. But then when you look at what's been going on recently with some of these lateral hires, with the way some partners treat junior associates and stuff like that, is there culture left at a lot of these firms? 00:45:11 Speaker 2: Less and less, less and less. I mean, again, law firms are microcosms of modernity, right? There's a loneliness crisis for a reason. We all love to talk about how much we value our families, and yet we so often move away from them. We have fewer children. We have less close relationships with our siblings and our parents. And yeah, I think law firms are finding it harder and harder and harder to sustain. The way I think about it is that families are places of what my Yale University sociology colleague, Nick Christakis calls mild hierarchy. He describes mild hierarchy as the default mode of organization in every small to medium-sized group of human beings. Well, that's what feels like a family. Like dad and mom are sort of in charge, but like, you know, eventually the kids will take care of them and they sort of have obligations to the kids. Law firms could feel like that in the days of lockstep compensation. But like now that you can fire brother, And now that sister can leave, it feels less like a family. Or maybe in some weird way, it feels more like a family now that there's all these news stories about children cutting off their parents, right? 00:46:20 Speaker 3: It's a dysfunctional family. 00:46:22 Speaker 2: It's a modern family is what it is, which is a very disconnected one. 00:46:27 Speaker 1: This is a very deep conversation. As you mentioned, and I've heard about, and maybe we'll do an episode at some point about some of these like AI native law firms. And I know there are some efforts- Like you mentioned Arizona, where there may be like an investor bag. People are trying different models and so forth. And actually, speaking of Kirk O'Neillis and AI, there was a story earlier this year, like they're going to build their own AI model, et cetera, and have their own fine-tuned model and house. I'm just curious from your perspective, from this sort of the generational warfare framework that you characterize AI, et cetera, like can you give us some thoughts on like whether you think that for some of these big legacy firms, they're going to successfully, A, make investments that will just like sort of kind of come out of the senior partner's pocket in a way they might never, they might not be around long enough to see the fruits and actually like sort of like navigate a transition to some meaningfully different type of economics. 00:47:31 Speaker 2: And so if you believe my story about general conflict, you would predict as I do that, Although AI will transform the practice of law, very little AI technology will be developed by law firms because it's really hard for the partners of today to incur a big expense for the benefit of the partners of five years from now because the partners of today and the partners of five years from now will be different. People will enter, people will exit. Okay, but that doesn't mean that law firms never invest at all. They invest in branding. They invest in the training of associates. They invest in the renovation of office space. They've always made investments, just not really big ones. And I predict that's how investment in AI will unfold. They will make investments, just not really big ones. A nice illustration is law firms renovate office space. They don't buy office space. Law firms will renovate AI. They won't buy or develop AI. They will rent it. They'll pay licensing fees to third-party providers. Now, Let's talk about Kirkland and Latham, both of which have announced large investments in AI technology. Why are they able to do this? First off, the investments aren't that big in the scheme of those firms' revenues. I'm shooting from the hip here a little bit, but it's no accident that those two firms are the largest law firms by revenue in the world because they're the ones that can handle a big investment. So Kirkland's revenues are something like $ 10 billion a year. And they've announced that they're going to make a $ 500 million investment over a period of five years. Well, if we assume Kirkland continues the same growth trajectory of revenue growth that it's been on, over those five years, it'll probably earn something like $ 80 million. Well, $ 500 million in the context of $ 80 billion is not that. much. Like the partners might just shrug and say, yeah, okay, fine. You're taking 1% of my compensation to benefit the partners at five years from now. That's okay. Especially because a lot of those partners will be partners five years from now. The other thing is they're pacing it over five years so that they can align the incurring of an expense with the earning of the revenue, right? As they develop this technology, it will bring in more revenue and they will pace the development of the technology to coincide with the earning of the revenue. The other thing I would say about it is, and apologies to the Kirkland and Ellis people listening to this podcast, they say it's going to be $ 500 million. Who's keeping track? Like, what is the AI investment? I don't really know. they have an incentive to expansively characterize a lot of what they do as an AI investment. So the bottom line is it's a relatively modest investment spread out over a long period of time that will coincide with the earning of revenues. 00:50:24 Speaker 3: Yeah, it's not like their outside shareholders are going to call them up on it and be like, you said $ 500 million. Okay, so just to wrap all of this up, a lot of people will hear us talking about the sudden collapse of a large law firm and think, okay... So what? Poor lawyers, right? Like the last thing the world needs is another law firm. Why should people care about this particular topic, the frailties of the big law business model? 00:50:51 Speaker 2: Well, let me first explain why people do care. It's the wreck on the side of the road. You can't look away. Okay. 00:50:57 Speaker 3: True. 00:50:57 Speaker 2: True. 00:50:58 Speaker 3: Other than schadenfreude. 00:51:00 Speaker 1: Or just rubbernecking. 00:51:02 Speaker 3: Yeah, okay, fine. 00:51:03 Speaker 1: I don't schadenfreude. No, that's true. That's true. 00:51:06 Speaker 3: But for lawyers, there's a lot of schadenfreude. 00:51:10 Speaker 2: Let's ask why people should care. Okay, I think there's a few reasons. One is it has happened to many other firms. We haven't talked about this, but This has happened to dozens of firms. In my paper, I studied three dozen firms. In the years since I published the paper, there's been more. Bingham, McCutcheon, Strzok and Strzok and Levin. There will be more. I promise you there will be more. The other is that what's happening at law firms is diagnostic of what's happening in the legal industry generally. It's tremendous pressure on profitability such that if you don't keep up, you're in the doghouse. Huge amounts of lateral partner movement. Also, law firms as microcosms of modernity. I also think that what happens in law firms is consistent with what happens in other kinds of what I call impermanent equity businesses. So there's lots of businesses where equity interests don't last forever. Mutual funds and hedge funds, when you redeem, your interest terminates. Mutual insurance companies, which are sort of owned by their policyholders, if you stop renewing your policy, you're no longer an equity holder. They experience some of the same problems as law firms. Hedge funds, for example, are famously vulnerable to runs. just like Wild God Shaw. So I study organizations broadly. I write about investment funds, about law firms, about marriage even. And I find law firms an interesting laboratory in which to study themes in organization. Maybe here's the biggest one of all. The central ideological struggle of the Cold War between the United States and Soviet Union was whether the means of production would be owned by investors, that is to say capitalists, or by workers. And what law firms illustrate is some of the perils and promise of worker ownership. It's the path not taken by industry more generally. 00:52:57 Speaker 3: All right, John Morley, thank you so much for coming on Our Thoughts. Really appreciate it. 00:53:02 Speaker 2: Truly a pleasure. 00:53:15 Speaker 3: So, Joe, I thought that was an absolutely fascinating conversation. And I do feel like I need to emphasize just how prescient John's paper actually was. If you read it now, it's sort of line by line what seems to have happened at Weill Gottschall. I do think the question of how to institutionalize some of those client relationships at law firms. is a fascinating one. And we like to say on the show that incentives. 00:53:42 Speaker 2: Matter, right? 00:53:42 Speaker 3: And it just seems really hard to get partners to sort of release their death grip on the big clients if the thing they're paid for is bringing that relationship in. 00:53:53 Speaker 1: These are definitely some of my favorite conversations that we have, like corporate structure conversations, because again, it's, you know, there are versions of this that we could have talking about multi-strategy hedge funds, et cetera, and the degree to which they're, and, you know, I'm thinking also back to some of our conversations with Scott Bach at Greenhill about investment banking and the degree to which There is such thing as franchise value beyond what the Rainmaker brings in and so forth. But as you say, the prescience of his paper is that. 00:54:28 Speaker 1: You could have a company that is growing, that is not spiraling in any business sense whatsoever, that is actually improving profit every single year, but because they're not improving as fast as their neighbor, that is still enough. 00:54:42 Speaker 3: This is also peak capitalism stuff, right? Where the only thing that matters is the relative gains, not the absolute gains. 00:54:49 Speaker 2: Yeah. 00:54:49 Speaker 1: I really am a sucker for all of that. This is the crisis of modernity. Stuff, you know, like the idea that like, OK, you go back like 100 years or 100 years, 50 years, whatever. And maybe there was such a thing as like a law firm culture or a family or whatever. And these things like, you know, when maybe it gives me some perspective, like. When someone like Lloyd Blankfein is sad about the– Yeah. No, like when he's sad about the end of the partnership model, is he really sad about the end of the partnership model or is he really sad about just like when it was a smaller organization that felt more like a family and a club than a big company? Because that's like– you know what I'm saying? It's like you get sad. It's like, oh, I miss when we were a partnership. 00:55:38 Speaker 2: Yeah. 00:55:39 Speaker 1: Or are you just sad that you missed when it was like small and clunky and had idiosyncratic culture and now just a sort of like a big corporation? 00:55:48 Speaker 3: No, the problem is you can't slap a compensation number on like how well someone fits into a culture or how much they like. boost the culture, right? It's much easier to do it by the amount of revenue they bring in. 00:56:01 Speaker 1: If any one of us dies, I think the other Outlaws people should be the pallbearers. I think we should even, thank God, let's knock on wood, nothing happens to anyone on the team for a long time. 00:56:11 Speaker 3: Are we making a promise? 00:56:12 Speaker 1: Yeah, we should institute that. 00:56:14 Speaker 3: Can we do a tontine too? Just while we're talking about funeral arrangements, I want to do a tontine. 00:56:19 Speaker 1: Yeah, the last one of us to survive gets... $ 600. 00:56:22 Speaker 3: We're going to bury some treasure in the Bloomberg offices and the last one alive gets it. 00:56:28 Speaker 2: All right. 00:56:29 Speaker 3: On that happy note, shall we leave it there? 00:56:31 Speaker 1: Let's leave it there. 00:56:32 Speaker 3: Okay, this has been another episode of the Odd Lots podcast. I'm Tracy Allaway. You can follow me at Tracy Allaway. 00:56:37 Speaker 1: And I'm Joe Weisenthal. You can follow me at the stalwart. Follow our producers, Kermen Rodriguez at Kermen Arman, Dash O'Bennett at Dashbot, Kale Brooks at Kale Brooks, and Kevin Lozano at Kevin Lloyd Lozano. And you can chat about all of these topics 24-7 in our Discord, discord.gg slash oddlots. And for more Odd Lots content, you can check out our daily newsletter, which you can find at bloomberg.com slash oddlots. 00:57:01 Speaker 3: And if you enjoyed this conversation, if you like it when we talk about law firms as dysfunctional modern families, then please leave us a positive review on your favorite podcast platform. And if you're watching on video and you enjoyed the conversation, then please like or leave a comment or better yet, subscribe. 00:57:17 Speaker 1: And remember, if you're a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free. All you need to do is find the Bloomberg channel on Apple Podcasts and follow the instructions there. 00:57:28 Speaker 3: Thanks for joining. Thank you.