Think Before You Leap into De-Equitization, April 2009 Options

[Editor]

Removing partners from equity status may seem like a good way to improve finances, but there are many things to take into consideration before taking such a step.

As the recession continues to take its toll on law firms, the media spotlight is primarily on the thousands of associates being terminated at the largest firms. In many firms this “culling process” is directly related to another phenomenon, less publicized but also on the rise: de-equitization and de-facto termination of older partners who may have higher billing rates but who bring in less business than their fellow partners. De-equitization is a financial strategy. Each of the laid-off partners was (presumably) added to the partnership because the firm had a strategic vision at some point for the clients that the partner could draw or serve. However, times of crises are leading firms to make changes. The objective of de-equitization is to improve the financial leverage of the firm.

Collecting Receivables

However, de-equitization is hardly a financial magic bullet because few firms look at the cash flow issues involved from the standpoint of cash coming into the firm. Accounts receivable may be the most fluid and important assets that a law firm has. Before a partner is de-equitized or fired, the firm should take care to understand what that partner’s amounts in receivable are, and to know how much they depend on the partner to bring in the receivables. Ensure that there are incentives in the interest of the partner to collect the receivable before he or she leaves and finds a home elsewhere. Here are some suggestions that might help you address this issue:

• Ensure that time sheets are current
• Send billings to client immediately even if the totals are off or need adjustments later
• Monitor payment history of the client and exert special effort on the partner to ensure that final invoices are sent out
• Do a peer review of the partner’s files to confirm that there can be no claim of negligence by the client
• Communicate with the client if payment is not received promptly.

Client Service

As lawyers age, they tend to slow down, but that doesn’t mean they always accept the de-equitization process. There was a recent lawsuit involving an older partner at a large firm who refused to accept a downgraded status. The law firm argued that the lawyer breached his employment agreement by failing to produce sufficient billable hours. The lawyer argued that he merely had to be available to do work, that he did not have rainmaking responsibilities. The issues revolved around interpreting an employment contract, and the arbitrator found that the lawyer did seek billable work and was available. The contract did not otherwise require that he reach the firm’s billables benchmark.

Neither the firm nor its clients benefit in such a scenario. The potential that it could happen makes essential the training of younger lawyers not only to service clients but to begin marketing and bring in clients of their own. Typically the next generation of lawyers has been accustomed to inheriting business and has no marketing skills. For partners at law firms where compensation is based on individual performance only (the so-called “eat what you kill” approach), the business development credo often leads them to refuse to share information about clients or prospects with the next-generation lawyer who might “steal” business before the first attorney is ready to leave active practice. De-equitization makes the decision for such a lawyer, but leaves open the issue of how the client is to be serviced.

It is essential that the client hear from the law firm. Retaining the goodwill of the partner is important. It may be appropriate to send a joint letter (firm and partner) to the client indicating the new relationships being created. If the partner is “taking the client with him,” it is important that the firm and the partner negotiate a methodology for collecting the outstanding fees. Whether the partner or the firm is responsible for doing this is subject to negotiation.

Client Transitioning

De-equitization concerns exist mainly in the context of larger firms. However, the issue of client transitioning is just as important in small firms and solo practices. Older lawyers in these contexts should plan for transitioning their practice well before the necessity is forced by age or ill health. Failure to plan for how clients will be taken care of as a lawyer approaches the age of retirement can, according to some authorities, be construed as reckless disregard for client welfare – a true ethical violation. Planning options can include simply closing or selling the practice, but other options are just as viable: for example, grooming a successor by hiring an associate to learn the practice, or merging with or hiring a lateral with the option to sell the practice to him or her. The succession plan can be structured to transition over a period of years, as client responsibilities gradually transition to the new lawyer.

Especially in a solo practice, aging lawyers or lawyers committed to closing their practices may emotionally leave their clients long before they close their doors. This can result in less effective representation, as well as less effective management of receivables, well before the lawyer retires, and it is a danger to guard against. Grooming and building a relationship of trust with a younger partner or associate can guard against such a problem, and build peace of mind for both the members of the firm and its clients.

Collections Policy

Collections are a bottom-line issue, and the bottom line is that lack of a firm-wide written collection policy which includes what to do with a departing partner’s outstanding accounts can lead a firm to financial disaster. The written policy must detail how to keep track of when clients are behind on their payments, and how to contact clients when they are late with payments. Such a collections policy should cover in usable electronic form everything from the beginning of the relationship with the client to the payment of the final bill. The policy should also include incentives for lawyers to have a high collection percentage on the fees they bill (realization rate) and enforcement actions against those who lag on collections (such as withholding compensation, or deducting collection expenses from it). Given that de-equitized partners often have been less than vigorous in their business development efforts, such ongoing pressure can keep overdue accounts from piling up to a dangerous point.

More than one firm has failed because of failure to collect receivables. More than one firm has survived by its ability to collect and commitment to do so. A firm that has reached the stage of de-equitizing partners may either be a firm in financial trouble, or a firm with a sharp eye on the bottom line that is taking tough corrective actions to ensure profitability. Either way, collections are an essential element in the financial survival strategy, and no client accounts – including those of terminated partners – should go uncollected.


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