To Stem Lateral Movement, Firms Are Adding Clawback Clauses in Partnership Agreements

As law firms face mounting pressure from the talent wars, many are attaching strings to their partnership agreements in order to protect their partnerships and forestall lateral departures in a high-demand market.

Since January, three Am Law 30 firms have incorporated clawback provisions into their partnership agreements that make it more difficult for a partner to leave, according to legal recruiter Larry Watanabe.

These agreements “will impact the complexion of the market, as firms try to retain laterals more aggressively than ever,” Watanabe says.

Such arrangements could allow firms to go after bonus payments in 2022, he says. For instance, a partner with a $1 million compensation plan could be entitled to a bonus of up to $5 million expressed in January, but paid in April or the summer.

Other firms are strengthening clawback provisions, which have proven difficult to enforce in the past, with other financial tools such as forgivable loans that allow for more incremental payments to partners and mitigate some of the risks of going after money that has already left a firm’s bank account.

As firms deploy these tools, law firm partners are increasingly leaving money on the table, according to one Am Law 100 partner, who agreed to speak on the condition of anonymity. Because of these newer models, “if you are not employed on the day your bonus pays out, you won’t ever get it,” the partner explains.

“The obvious difficulty there is that you’ve already worked for five to six months out of the year, and your bonus is based on work you’ve already performed. That puts you on a cycle where you’ll always walk away from something,” the partner says.

Mounting Risks

The strategy of using clawbacks reflects a bigger problem, as firm leaders desperately look to stave off lateral departures and hold onto business generators.

“Because of lateral movement in the past two decades, law firms are worried about golden handcuffs. It was much less of a problem 20 years ago, by a material margin, because firms simply didn’t have to worry about partners getting up and taking their practice elsewhere,” says Kristin Stark, a legal consultant at Fairfax Associates.

Just as associate attrition is on the rise, partner departures have also increased in recent years. About 40% to 50% of lateral hires ultimately depart before year five at their new firm, according to data analyzed by Decipher, an industry consultant on lateral hiring.

Factored into that is the success rate for lateral partners—based on how long the hire stays at their new firm, the amount of realized revenue they help bring in, their integration into the firm’s culture, and their impact on the firm’s profitability—which stands around 50%, according to data from Decipher.

While money isn’t everything, it is an important consideration among partners on the move. Since the beginning of the pandemic, Am Law 200 firms that cut their equity partnership compensation by one-third or more lost 36% more partners in 2021 than firms that did not make cuts, according to data from Decipher.

In all, 81 Am Law 200 firms publicly announced cuts to equity partner compensation in 2020. This number was likely much higher given that some firms did not announce compensation cuts publicly, according to Michael Ellenhorn, founder and CEO of Decipher.

Thus, firms need to focus on “hiring the right person,” according to Ellenhorn. He says that a successful strategy tends to include recruiting for a specific need, rather than simply being opportunistic. Firms should also know their candidates and ensure they are the right cultural fit.

Firms are performing more due diligence on lateral candidates, according to legal recruiters. Some are using lateral partner questionnaires (LPQs) more often, and requesting candidates fill them out sooner, to collect financial data and client information, as well as details on conflicts and professional and personal references.

But that process is not without its own faults.

For instance, a Decipher analysis of LPQs since March 2020 revealed a 75% increase in candidates claiming books of business. On average, candidates claimed a $2.1 million book of business in the period from March 2020 to October 2021, compared with an average of $1.2 million prior to the pandemic.That likely means candidates are inflating their books of business, according to Ellenhorn, who notes that since the start of the pandemic, Decipher has also seen a 40% rise in red flags related to financial irregularities.

Mitigation Measures

As a result, clawbacks and forgivable loans have come to the forefront as firms “use money as a retention tool to de-risk lateral transactions for the majority of partners within a partnership,” says Joe Macrae, the founder of legal recruitment firm Macrae.

Legal recruiters are fielding more questions from law firms interested in using clawbacks but unsure of how to apply them or whether or not the clauses are legal in the states where they operate.

In one recent encounter, Lauren Drake, a colleague of Macrae’s, says she received an unusual candidate offer with a one-year clawback provision on the candidate’s entire compensation package. After subsequent discussion, the firm revised the terms to create a more standard provision related to bonus payments.

In this instance, Drake explains, the firm hadn’t done a lot of lateral hiring, so there was room to clarify terms and ultimately come to a reasonable agreement.

The use and enforcement of clawbacks varies widely, and success is not certain.

Once the money has left the firm, it is difficult to secure a return. Furthermore, clawbacks often conflict with state noncompete laws aimed at protecting a client’s right to choose counsel, according to an employment lawyer who specializes in partnership agreements and disputes, who asked not to be named because of their representation of lawyers and firms in such disputes.

As more firms consider clawbacks and run into potential hiccups along the way, some are strengthening such clauses with forgivable loans that are considered “friendlier the longer a candidate stays,” according to Macrae.

If a partner reaches the end of their loan term, it is unlikely they’d walk away from money. However, if a partner leaves before the end of the term, the loan gives the firm the power to recover funds. In fact, firms can repay themselves through an equity partner’s capital contribution account and simply send the partner the remaining balance, according to the employment lawyer.

“The forgivable loan is better because it represents the other side of the coin. Now, the departing partner has to sue the firm to recover funds,” the employment lawyer explains, noting that their firm generally advises clients to incorporate both clawbacks and forgivable loans into their arrangements to serve as a “deterrent.”

Weighing the Benefits

Some consultants and firm leaders remain skeptical of using such financial tools, because the benefits could fall short of the consequences.

The upside of such provisions are fairly obvious: protect the overall partnership from loss of funds by ensuring partners stick around. Additionally, these provisions can provide operational benefits, because many firms incur one-time expenses at the beginning of the year and do not reach profitability until months later.

However, such clauses necessitate partners getting used to their new firm and the system they use.

“Once you are used to how the firm pays out profits, you can live your life accordingly. But if you’re used to getting paid at the end or beginning of the year, and suddenly you’re waiting three months, it can be a big adjustment,” legal recruiter Frank D’Amore says.

When it comes to enforcement, some firms have likely used clawbacks to send a message to other partners.

For instance, Kirkland & Ellis refused to let an M&A partner leave for Latham & Watkins in 2016 until the lawyer returned a $120,000 bonus, Law.com reported. The lawyer received the bonus in 2014 in the form of a loan that was to be repaid if he left the firm within two years. Latham was aware of the bonus condition ahead of the hire, but thought that Kirkland would waive the obligation. Latham ended up reimbursing the lawyer.

“The firm may not have cared about getting their money back,” the employment lawyer suggests. “But firms are very mindful of the precedent of what happens when someone leaves. If you have a clawback provision but you never enforce it, it is likely someone could point that out and use it against you in a dispute.”

Similarly, another benefit in the short term is stemming the flow of departures for a period of time, so that subsequent departures “do not contribute to market perception of losses or instability at a particular firm,” Stark says.

Considering the Cons

Others note that firms using clawbacks could be perceived as using an extreme version of “golden handcuffs” on their partners.

Mary K. Young, a legal consultant with Zeughauser Group, questions the ability of law firms to attract lateral partners if their partnership agreements come with “shackles” aimed at preventing departures. Others agree.

“If you put in an onerous clause, maybe it’ll help prevent people from departing, but it will also deter people on the recruiting side,” says Bob Brigham, a legal recruiter at Major, Lindsey & Africa. “It can send a message of weakness and raise a red flag in people’s minds. And in my experience, those provisions don’t keep people from leaving.”

One Am Law 100 leader says firms that are known to enforce clawbacks or other financial handcuffs are likely “a tough sell” and are “trying to play in a league they don’t belong in.”

Furthermore, firms that enforce such provisions will bring onto themselves questions of who was the bad actor, he says. “If you hire a partner and they leave right away because of conflicts with your system or, say, none of their business ported, is it really fair of the firm to enforce that?”

He continues, “I think it’s rare when you’re dealing with a lateral who misses their targets and numbers that they’re going to say it was their fault. And I think human nature is such that people will lean into the story that it was more the firm’s fault than the partner.”

For instance, when 10 partners left Quinn Emanuel Urquhart & Sullivan to form litigation boutique Selendy Gay Elsberg in 2018, a subsequent dispute revealed that the firm was particularly displeased with Selendy Gay’s moves to take associates out of the firm, according to an email between John Quinn and Faith Gay that was published on Above the Law.

In an interview shortly before the launch of Selendy Gay, the attorneys who spun off said their departure wasn’t a matter of dissatisfaction with Quinn Emanuel. Yet, onlookers suggested the public nature of the disagreement did not reflect positively on Quinn Emanuel, and that other firms should consider their options carefully.

“It is bad enough that someone is leaving,” one Am Law 100 partner says. “When a firm makes a big deal out of a departure, it becomes obvious that the departure really hurts you. It tends to reflect negatively on the firm, and people will question what the firm was doing to prompt those partners to leave in the first place.”

The firm leader offers this advice instead: “In this tight market, I think it is better to lead with love, lead with compassion, and lead with why things will work.”

The Other Side

In the spirit of making things work, firms are taking steps on the other side of the playing field to make it easier for partners to join them.

In the last two to three years, firms have incorporated indemnity clauses amid the rise of clawbacks and forgivable loans, which in effect make the hiring firm responsible for any claims the former firm brings.

“The new firm is essentially defending the partner, so it is harder to intimidate a partner into not leaving,” the employment lawyer explains. “The new firm is saying, ‘If you have a problem, give us a call.”

Firms are also offering to make partners whole through one-time payments or additional bonuses to mitigate the sting of leaving money behind. Furthermore, many partners are able to move upstream and secure a better compensation package in the current environment.

“While it is painful to leave money behind, the expectation might be you’ll make it up many times over if you continue to perform at the new firm,” D’Amore says, noting that this, too, can take some adjusting, but many partners will be ahead by year two at their new firm.

Ultimately, firms must constantly weigh the pros and cons of following through on financial safeguard provisions. While such provisions are a display of discipline for the firm and its remaining partners, firms must present an attractive partnership agreement in order to win talent and grow in a competitive marketplace.

“This is a people business. Those are your assets—your people,” Young says. “Firms need to be looking at balancing the needs of current partners and what you need to do to attract laterals all the time.”

Email: [email protected]

https://www.law.com/americanlawyer/2022/03/22/to-stem-lateral-movement-firms-are-adding-clawback-clauses-in-partnership-agreements/

Zubair Q Britania

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