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It’s the start of a new decade, and deal work is in the dumpster. In Washington, President Bush is sending troops abroad, while Wall Street struggles to cope with a recession and a stagnant stock market. The mergers and acquisitions machine that has driven law firm profits and growth for the last five years is sputtering, and one of Corporate America’s leading institutions — whose freewheeling style was symbolic of the boom years — has imploded amid allegations of fraud and malfeasance, leading Congress to call for reforms. That’s a fair summary of the events that converged to create the slump in deal work in 2001 — except that it’s actually a summary of the events that converged to create the slump in deal work in 1991. The parallels between the two downturns, separated by a decade of prosperity, are striking. Substitute Afghanistan for Iraq, Enron for Drexel Burnham Lambert, and a collapsing equities market for a cratering junk bond market, and it’s a virtual match. In the downturn 10 years ago, law firms suffered acutely, slashing costs and cutting personnel so vigorously that, in time, many came to believe they had overreacted. So far, the current slowdown hasn’t produced that kind of carnage, at least not outside of Silicon Valley. But no one’s predicting how long the current trough might last. Are we likely to see a repeat of the early ’90s? And which decade’s perfect storm was worse? Let’s compare the two eras and the forces that buffeted them. NASDAQ SWOON VERSUS JUNK BOND COLLAPSE The dealmaking booms of the late ’80s and late ’90s both had their roots in the emergence of new and innovative markets centered in California. In the ’90s it was the rise of the Silicon Valley�based IPO machine orchestrated by venture capitalists on Sand Hill Road. In the ’80s it was the explosion of the high-yield debt market orchestrated from Michael Milken’s X-shaped trading desk in Drexel’s Beverly Hills office. Both provided a torrent of ready cash for dealmakers and fat fees for their retinues of lawyers and bankers. And ultimately, both were unsustainable. When the tech bubble began to deflate in April 2000, Silicon Valley firms such as Brobeck, Phleger & Harrison; Cooley Godward; and Wilson Sonsini Goodrich & Rosati were slow to react. Even as the IPO drought stretched into 2001, fast-growth proponents like Tower Snow Jr., then Brobeck’s chairman, kept pumping optimism, predicting a rebound and pledging no associate layoffs. But by October 2001, Snow had resigned, and across the Valley the realization had sunk in that the wondrous money machine was not going to be fixed anytime soon — if ever. The resulting cuts, targeted at corporate finance associates, were deep and bloody. The collapse of the junk bond market just over 10 years earlier was more sudden than the Nasdaq’s long glide down, and it produced more immediate hardships for law firms. The impact also stretched on for years and was more generalized in the economy. During the takeover wars of the ’80s, corporations from a wide spectrum of businesses issued high-yield debt to fund takeovers and expansions. Servicing that debt straitjacketed them for years. The biggest holders of junk bonds were government-backed savings and loans institutions, and when billions of dollars in bonds were defaulted upon, taxpayers got stuck with the tab. The dot-com crash scorched the economy deeply, but was more contained, largely confined to the technology and telecom sectors. Bigger Impact: Junk Bond Collapse ENRON SCANDAL VERSUS DREXEL SCANDAL The collapse of the junk bond market was precipitated by the felony indictment and subsequent guilty plea of Drexel’s wunderkind financier Milken (Drexel also pleaded guilty to six felonies and was forced to file for bankruptcy). But the root of Milken and Drexel’s problems was not junk bonds, but insider trading and other fraud. The investigation of Milken and others by the Securities and Exchange Commission and the U.S. Department of Justice in the late ’80s and early ’90s turned up a rat’s nest of illegal trading that cast a pall over all of Wall Street. That was serious. But the scandal was largely limited to improprieties among financial professionals. The collapse of Enron Corp., by comparison, involves corporate accounting standards, something central to underlying market values. Put bluntly, the question is whether corporations routinely cook their books by using indecipherable accounting gimmicks. Lack of trust in the numbers translated quickly into a lack of investor confidence in the market. Suddenly, the financial statements of many of the stars of the late ’90s, such as Cisco Systems Inc.; WorldCom Inc.; Global Crossing Ltd.; and Tyco International Ltd. became suspect. Even General Electric Co. — whose now-retired CEO Jack Welch was the Pied Piper for corporate America’s acquisition-driven growth strategy during the past decade — came under scrutiny. “Enronitis” is the term coined for the virus of suspect accounting that weakened the stock prices of many leading corporations throughout the first quarter of 2002, and it has caused intense navel-gazing. “During the 10-K reporting season,” notes Faiza Saeed, a partner with New York’s Cravath, Swaine & Moore, “people were so heavily distracted going over their own disclosures that nothing else happened.” To understand how Enronitis infected the deal world, look no further than Tyco. For years, the Bermuda-based conglomerate was a darling of the M&A boom. Its high-multiple stock price gave it a ready currency to go after dozens of companies a year. Now Tyco’s acquisition strategy, and the accompanying accounting devices it used, are liabilities. Because growth by acquisition involves complex merger-related accounting, assessing a company’s true performance can be difficult. “Talk to bankers analyzing Tyco and they’ll tell you now they could never figure out whether it was generating organic growth or if it was just acquisition-driven,” says Cravath M&A partner Richard Hall. The issue has broad implications. In the last five years many respected corporations, led by Welch’s GE, have embraced acquisition-driven growth strategies. That has led to some saber-rattling by the SEC on accounting issues, but during the boom years of the late ’90s, scant attention was paid to such concerns. Analyzing accounting takes time, and time was a valuable commodity in that big-deal-a-day world. Says one New York deal lawyer: “I always said less diligence was done on a $20 billion merger of equals than on a $100 million acquisition.” A canary in the coal mine, accounting-wise, was Cendant Corp., an $11 billion conglomerate born of the 1997 merger of HFS Incorporated and CUC International Inc. In April 1998, about four months after the merger closed, Cendant announced it was restating earnings due to accounting irregularities uncovered in CUC divisions. Cendant’s stock dropped more than 75 percent and three years later has yet to recover fully. After Cendant blew up, lawyers took the position that they had little or no role in uncovering accounting irregularities in the deals they handle. Does the Enron mess change that philosophy? You bet. “Today the chance of doing a trust-me-I’m-OK deal is zero,” says a New York deal lawyer who is familiar with the Cendant scandal. “Until Enron wears off, you’re going to do a proctological exam on the other guys.” That means fewer acquisitions and much longer lead times until payday. “This is all about confidence,” says Latham & Watkins’ Charles Nathan. “Boards are saying, ‘Can you guarantee there is no Enron or Global Crossing problem?’ And the CEO says, ‘No, I can’t.’” Nor, according to many lawyers, is it possible for anyone to make that kind of blanket assurance without a forensic audit. “There are a thousand places to look for a problem,” says Sullivan & Cromwell’s James Morphy. “I’m not sure any amount of standard due diligence is going to give you a guarantee.” That’s what makes Enron so damaging to the deal world. The insider trading scandals were sexier, but in the end they involved clearly illegal activity by a small number of big-name players. The questions that Enron raises about sketchy accounting, illegal or not, are more systemic and fundamental than the trading scandals — and the impact on law firm revenue is potentially more drastic. Bigger Impact: Enron Scandal WAR ON TERRORISM VERSUS GULF WAR It’s easy to forget the wave of anxiety touched off by America’s entry into the Gulf War in 1990. The country was divided on the wisdom of the conflict. Many predicted massive casualties and worried about Iraqi chemical and biological weapons. The market also got a bad case of the shakes, with the Dow falling more than 15 percent in the two months after Iraq’s invasion of Kuwait. That said, the impact of last September’s terrorist attack on the heart of New York’s financial district was on a far greater order of magnitude. Beyond the horrific loss of life, the attack derailed a nascent economic recovery and suspended most transactional activity for weeks. Travel was especially disrupted by the attack, stalling globe-trekking deal lawyers and their international transactions. That had a much more direct impact on large law firms’ revenue than it would have had 10 years ago. At the time of the Gulf War, most firms were just starting to trace their global footprints. Today, about 60 Am Law 100 firms maintain at least one foreign office, and several top firms, such as New York-based Shearman & Sterling, Sullivan & Cromwell, and Willkie Farr & Gallagher have expanded aggressively overseas. The forces roiling the world economy since last September led to a dramatic slowdown in international transactional work in the fourth quarter of 2001, contributing to a 45 percent decline in cross-border M&A work and a 20 percent drop in project finance work. Not all of the drop-off can be attributed to global security concerns. Aggressive anti-competition enforcement in Europe and continuing banking problems in Japan and Argentina have also slowed international deal-making. But the psychological trauma of the attack was undeniable. As Latham’s Nathan noted, deals work depends on confidence — and almost seven months after Sept. 11, many remain uncertain about the future. By contrast, the Gulf War was seen as a quick triumph with few American lives lost, and its conclusion caused great optimism — for a time. But the euphoria was short-lived. A recession hit the legal industry in late 1991, and 1992 was a bad to flat year for the Am Law 100. Bigger Impact: War on Terrorism LAW FIRMS NOW VERSUS LAW FIRMS THEN Despite the multiple blows deal-makers have sustained during the past two years, many feel that the current downturn is unlikely to be as bad or last as long as the one a decade ago. “It’s not nearly as severe as the early ’90s,” says Dennis Hersch of Davis Polk & Wardwell, who estimates that his firm’s transactional practice is off about 15 percent. Hersch says it would take a much steeper downturn for Davis Polk to take significant action, such as cutting way back on hiring of first-year associates. “We learned our lesson after the ’92 recession,” he says. “You can never catch up [after a severe cutback]. You’ve just got to chart a course and stay that course.” (Davis Polk did, however, announce that it would not pay associate bonuses last year, a decision it reversed when other New York firms declined to follow suit.) Many lawyers echo Hersch’s assessment. They argue that firms learned a lot from the last recession in legal services and are better prepared for the current one because of it. They’ve hedged risk through increased diversification of their practices, they say, beefing up areas like litigation and bankruptcy and shuttling younger lawyers from corporate finance to those practice areas when necessary. But most also acknowledge that there are limits to those countercyclical strategies. “You can’t turn M&A lawyers into bankruptcy lawyers, though you can use them on some bankruptcy transactions,” notes Skadden, Arps, Slate, Meagher & Flom’s Blaine “Fin” Fogg. Some take a gloomier view, arguing that large law firms are in a more precarious position today than they were 10 years ago. For example, even though New York firms did not come close to matching the hockey-stick-shaped growth pattern of Silicon Valley firms in the late ’90s, top New York outfits have added, on average, 15� percent to 20 percent more lawyers during the last five years. Moreover, associate salaries and bonuses rose almost 100 percent during the same period. Add to that domestic and overseas expansion, a spate of lateral hiring and major commitments to office space and technological upgrades, and you get a sense of the huge expenses that firms have to meet. “People are locked into a much higher cost structure [than they were 10 years ago], real bull-market cost structures,” says Cravath’s Lewis Steinberg. “There are far more lawyers, in far more offices, with far more expensive talent.” A strong economic recovery, of course, would lessen those vulnerabilities. But even if the markets rebound and Enronitis abates, it is far from certain that deal work will return to the level of the last few years. The technology and telecommunications sectors, among the most active acquirers during the last five years, seem moribund. And even before Enron, heavy-industry M&A had stalled over asbestos concerns. For example, when Halliburton Co. bought Dresser Industries Inc. in 1998, it also acquired about 100,000 asbestos claims. The resulting liabilities are punishing Halliburton’s stock price. “Really, it’s hard to imagine any industrial deal you could get comfortable with on the buy side,” says a top New York deal lawyer. A soft market would seem like catnip for financial buyers like Kohlberg Kravis Roberts & Co. and Blackstone Group L.P., who were priced out of major deals by strategic acquirers during the last five years. But for now, financial buyers still see companies as overpriced, and lenders are keeping the purse strings pulled tight. “There’s just not financing available for big deals or deals with lots of leverage,” says Toby Myerson of Paul, Weiss, Rifkind, Wharton & Garrison. Still, most firm managers are confident that they won’t get caught in the kind of downdraft that rocked the Silicon Valley firms. Of course, at this time last year lawyers in Silicon Valley were singing the same tune. And despite their sunny facades, you get the feeling many transactional lawyers are privately echoing the words of one of their comrades: Asked about his firm’s strategy for making it through the downturn, he paused and said, “To tell you the truth, we’re doing a lot of praying.” Navigating past this perfect storm may take an appeal to the highest court. Related chart: How Bad Was 2001?

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