It's all over for Heller Ehrman.

One of the best single pieces of coverage comes from The San Francisco Chronicle.

Heller was founded in 1890, rode through the 1906 San Francisco earthquake (in the aftermath of which the nascent client Wells Fargo Bank set up a temporary headquarters at the home of founding partner Emanuel Heller), helped arrange financing for the Golden Gate Bridge, the Hoover Dam, and the Oakland Bay Bridge, and in more recent years took a pro bono case to the US Supreme Court that established the right of conscientious objection during the Vietnam War, took Levi Strauss public, and represented plaintiffs overturning California's same-sex marriage ban.

But it's over.

Here at "Adam Smith, Esq." we're not about sentimentality, not about pessimism, and not about optimism, but about realism. Heller's over. What can we learn?

We don't like to talk about it, none of us do, not me, not senior partners, not bankers or consultants to the industry, but the stark, glaring reality is that law firms are fragile institutions. Brobeck, Coudert, Heller, Shea & Gould, among the firms that didn't deserve it, and Finley Kumble and Myerson & Kuhn among the firms that did.  I could but won't go on. (Not to mention innumerable firms that were absorbed through merger in the nick of time to escape the guillotine.)

What went wrong?

Prefatory note: I don't have any inside information, but what follows is reading the tea leaves.

First of all, they should never have absorbed the Venture Law Group. It made no sense. Would it have made sense for VLG to be absorbed by another firm, perhaps Morrison & Foerster or Orrick? Perhaps, and of course we'll never know. But my instinct is that VLG was a sui generis creature that would never really fit within any law firm with a conventional legal industry business model. So Heller may have been ill-advised to take on the VLG group to begin with. Did this kill Heller? Of course not. Was it a strained fit from the beginning? Sure. And strained fits entail costs, economic and intangible.

Second, the Heller story should discredit, if more evidence or argumentation were needed, the notion of term limits for managing partners. Matthew Larrabee is of course the current, and final, managing partner, and Barry Levin was his immediate predecessor. What's wrong with term limits?,

Understand, as with the absorption of VLG, I'm not suggesting Barry could have saved the firm at this juncture any more than I'm suggesting Matt is responsible for its demise, but I'm strongly suggesting this:

• Your firm has a Chairman who is, by all accounts, widely respected inside and outside the firm;
• He has, as a matter of obligation to his Chairman responsibilities, let his practice go fallow, making him initially unproductive if he has to return to practice;
• The firm seems at the top of its game;
• There is no self-evident need to replace him;
• And you forcibly remove him anyway.

What sense does this make?  Why trade winning horses in mid-stream?

(Parenthetically, we are facing that same situation here in New York City as our term-limited Mayor Bloomberg will come to the end of his tenure on December 31, 2009, and everyone who is by self-anointment in line to stand for Mayor is, relatively speaking, a midget.)

Third, if you're in merger discussions at a moment of relative weakness, eschew hubris. Like to think that your firm is the firm that it was a decade ago or the firm that it could be a decade hence? Get over it. You're the firm you are today. So is your potential merger partner, and they might not be who you used to think they were.

I started this column by saying that I'm not an optimist and I'm not a pessimist, but that I'm a realist. I partly lied.

I am a realist, but I'm also an optimist, and I never have been and never will be a pessimist. You have the right to be optimistic about your firm, in merger talks or otherwise. More strongly: You have the obligation to be an optimist about your firm.

Fourth, fragility, again.

"Our assets go down in the elevator every night."

Take that bromide seriously.

You must give people a persuasive reason to come back "home" every Monday morning.

Make them believe in the ongoing vision of a vibrant institution, a living firm where they can make a contribution in their own way, where they have a voice, where they can matter, where they are part of a team, where there are new mountains to conquer and new clients to be won, new legal innovations to be created with your firm's imprimatur on them, new dimensions of professional development which you can create and with which you can inspire and energize your associates, new, heartfelt, admirable and groundbreaking commitments to pro bono, new, clear-eyed and profound commitments to client service and client relationships, new and innovative uses of technology to deliver cost-effective services clients increasingly will demand while at the same time sparing your associates scut-work. New, new, new.

Those are the things that will inspire people to come back on Monday.

Back to Heller.

What finally went wrong?

It's the same phenomenon, actually, that we've seen on Wall Street in the last few weeks: A failure of confidence. There doesn't need to be anything wrong with Heller, or Morgan Stanley, Goldman Sachs, or Merrill Lynch, for people and the market at large to perceive there's something wrong with any of those firms. It's the run on the bank mentality.

 JP Morgan put the bond between credit and character most memorably in the Congressional "Pujo Hearings" of 1912:

Samuel Untermeyer: Is not commercial credit based primarily upon money or property?
Morgan: No sir. The first thing is character.
Untermeyer: Before money or property?
Morgan: Before money or anything else. Money cannot buy character. A man I do not trust could not get money from me on all the bonds of Christendom.

In law firm land, this is how the breakdown of credibility (the "character" of the firm) goes:

• A few key partners leave
• Taking a few key clients with them
• Which makes other partners wonder
• And start looking around
• Finding, in this very liquid lateral partner market, ample opportunities
• Which some take advantage of
• Taking away more clients
• Making more partners, and associates connected to them, thinking about the door
• Leaving only the least mobile people with the smallest books of business at the firm
• And the vicious cycle has kicked in, with almost no meaningful chance of its being reversed.

The curtains come down and the lights go out when the abrupt exodus of partners, clients, and erosion of the revenue base, occasion breaches of bank lending covenants and a shut-off of credit.

Fragile institutions? More than a century old, and with north of $500-million in revenue?

Shhhhhh. We promise not to mention it again.

• "With the move, Wall Street as it has long been known -- a coterie of independent brokerage firms that buy and sell securities, advise clients and are less regulated than old-fashioned banks -- will cease to exist. Wall Street's two most prestigious institutions will come under the close supervision of national bank regulators, subjecting them to new capital requirements, additional oversight, and far less profitability than they have historically enjoyed." (WSJ)
• "A move that fundamentally reshapes an era of high finance that defined the modern Gilded Age." (NYT)
• "The investment banking era ends." (FT) 

Here are a few more data points to put this financial meltdown into some kind of perspective.

The Size of the Problem

Of the $3.13-trillion 2009 federal budget, here are the key components (courtesy The New York Times):

• National security: $738 billion
• Social Security: $651 billion
• Medicare/medicaid: $632 billion
• Everything else: $1.112 trillion
• Treasury rescue plan (estim.): $700 billion

What alternatives were there to this dramatic rescue?

According to Henry Paulson, were it not undertaken, "Heaven help us all." Alan Blinder, an economics professor at Princeton and former vice chairman of the board of governors of the Federal Reserve Board, said “It goes a long way; it ameliorates it very substantially,” but he immediately admits there's no certainty about what will work: “We’re deep into Alice in Wonderland’s rabbit hole.”

The need for the rescue, to my mind, is utterly unassailable. Why? Simply because the economy runs on credit, financing, and the ability to turn income streams into assets and assets into income streams. Without that, the entire economy seizes up like an engine deprived of oil.

“Wall Street isn’t this island to itself,” said Jared Bernstein, senior economist at the labor-oriented Economic Policy Institute. “Even people with good credit histories are having a very hard time getting loans at terms that make sense. If that gets worse, we’re going to be stuck in the doldrums for a very long time, because that directly blocks healthy economic activity.”

That's why the populist-sounding rhetoric coming from Washington about Wall Street "fat cat bailouts," "corruption," "golden parachutes," "pigs at the trough," etc., is, as the noted conservative commentator and New York Times op-ed columnist David Brooks wrote last week, "moronic."

Impact on the Financial Services Industry

As recently as 30 years ago, the financial services industry constituted well under 5% of the S&P 500's total market capitalization. By 2003 it had risen to over 20% and was the single largest industry segment. As The New York Times puts it:

As late as 2004, financial services firms earned 28.3 percent of corporate America’s total profits, according to Moody’s Economy.com. That was somewhat lower than it had been over the previous few years, but still almost double the financial sector’s average share of profits throughout the 1970s and ’80s. By 2007, the share had fallen only marginally, to 27.4 percent.

Meanwhile, the share of wages and salaries earned by employees of financial services firms continued to climb and reached a peak last year. Of every dollar paid to the American work force in 2008, almost 10 cents went to people working at investment banks and other finance companies, up from about 6 cents or 7 cents throughout the 1970s and ’80s.

Here's another way of looking at it:

If you want to look at the fortunes of financial services companies since the last market peak (October 9, 2007, for those of you keeping score at home), here are some representative numbers:

• IndyMac: -100%
• Lehman Brothers: -100%
• Fannie Mae, Freddie Mac: -99%
• AIG: -95%
• Bear Stearns: -93%
• Washington Mutual: -88%
• Countrywide: -78%
• Wachovia: -64%
• Morgan Stanley: -61%
• Merrill Lynch: -60%
• Citigroup: -57%
• Keycorp: -56%
• Goldman Sachs: -46%
• Bank of America: -29%
• Capital One: -22%
• JP Morgan Chase: -1%
• Northern Trust: +6%
• Wells Fargo: +7%
• PNC: +13%

New York, New York

The City is far more heavily dependent on financial services, of course, than the economy as a whole:

• Financial sector workers collected 35.9% of all income earned in the city, even though they accounted for only one job in eight.
• This is roughly double the level of 30 years ago.
• In the past 10 years, the number of jobs in New York City where people produce goods has fallen from 303,000 to 227,000 (down 25%).
• During the same time, people employed in "leisure and hospitality" (including waiters, bartenders, hotel clerks, actors, and even Yankee Stadium vendors) has grown from 232,000 to 307,000: But of course those pay relatively poorly.

Graphically, employment in financial services in New York City looks like this:

And of course, as only the WSJ can do, it featured a tongue-in-cheek article last week featuring how wealthy New Yorkers were economizing. With evidently thoughtless and rather amazing unintended irony, one high-end caterer described a client's change in plans:

On the party circuit, many New Yorkers aren't canceling events, but some are seeking to make them less ostentatious, says Bronson van Wyck, who runs New York event firm Van Wyck & Van Wyck LLC with his mother and sister. Earlier this week, the children of a Wall Street executive who are planning his 65th birthday party contacted the firm to change the menu. Out went the caviar and truffles and in came Wagyu beef instead. The new menu won't cost any less, Mr. van Wyck says, but "it's less overt."

Wagyu beef rather than truffles and caviar?

It will, of course, be far far worse than that.

Take the survey!

Thanks.

These are days of turmoil, chaos, a once-in-a-lifetime earthquake shaking our financial world to its foundations, and, frankly, days of insanity. Indeed, (according to The New York Times), last Wednesday, when share prices of Goldman Sachs and Morgan Stanley plunged even though the firms were still making money. Glenn Schorr, a UBS analyst, wrote an e-mail message to clients saying, “Stop the Insanity.” He was not wrong.

In your own world, you can stop the insanity. Step back, breathe deeply, and take a clear-eyed look at the fundamentals of your very own firm. It's a 30+ year old technique that has withstood the test of time. Sounds kind of reassuring right about now, doesn't it?

Third, this is indeed a fundamental de-leveraging of financial institutions worldwide, as nicely captured today in a front-page WSJ article:

The U.S. financial system resembles a patient in intensive care. The body is trying to fight off a disease that is spreading, and as it does so, the body convulses, settles for a time and then convulses again. The illness seems to be overwhelming the self-healing tendencies of markets. The doctors in charge are resorting to ever-more invasive treatment, and are now experimenting with remedies that have never before been applied. Fed Chairman Bernanke and Treasury Secretary Henry Paulson, walking into a hastily arranged meeting with congressional leaders Tuesday night to brief them on the government's unprecedented rescue of AIG, looked like exhausted surgeons delivering grim news to the family.

Fed and Treasury officials have identified the disease. It's called deleveraging, or the unwinding of debt. [...]

At least three things need to happen to bring the deleveraging process to an end, and they're hard to do at once. Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money. They need to pay off debt. Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets.

But many of the distressed assets are hard to value and there are few if any buyers. Deleveraging also feeds on itself in a way that can create a downward spiral: Trying to sell assets pushes down the assets' prices, which makes them harder to sell and leads firms to try to sell more assets. That, in turn, suppresses these firms' share prices and makes it harder for them to sell new shares to raise capital. Mr. Bernanke, as an academic, dubbed this self-feeding loop a "financial accelerator."

Now that there appears to be a sort of "Resolution Trust II" on the horizon, we may be out of the immediate woods. But there's no question the financial services landscape is changing before our very eyes, in ways likely to last for the duration of many of our careers.

Fourth, it seems a virtual certainty, regardless of what happens in the US electorally in November, that we will be entering a more highly regulated world. And not just in the US, but in the EU as well.

You can applaud or decry this, ideologically, but everyone I speak to--unanimously--thinks it's a foregone conclusion.

Now, regulation per se is always a good thing for the business of lawyers. Whether it's a good thing for the economy and the vitality of our capital markets is something else altogether. On the whole, the consensus is that "new regulation is going to solve the problems that are already behind us. Just like Sarbox 'solved' the problem of Enron, retroactively, and just like the Transportation Security Department's airport screening procedures 'solve' the problem of 9/11, seven years too late." (This from an AmLaw 25 managing partner I spoke with today.)

His view, and mine, is that regulation is always backward-looking, and tends to be an encrustation on an already-existing structure, rather than a clean-slate, "zero-based budgeting" analysis of what we really need going forward. You read it here first.

Fifth, this type of economic environment will accelerate segmentation and consolidation in our industry.

Among law firms as among financial institutions, there will be winners and losers emerging from this downturn. Among the "losers" we may already count Heller (look for a post-mortem in these pages to come) and Thelen and perhaps one or two others that will outright cease to exist. Short of dissolving, other firms will find their competitive postures impaired, their attractiveness to laterals and law students compromised, and their viability as independent going concerns in question.

David Morley, new senior partner of Allen & Overy, announced last week in conjunction with release of their Annual Report:

I see us becoming the most successful of the emerging global elite of law firms. Those firms are beginning to set themselves apart when defined by scale, geographic reach, quality of people and concentration on high end, premium work for the largest clients. As each year passes the members of that emerging group, and what it takes to succeed in it, become clearer.

This throws down the gauntlet, does it not?

Yet I for one believe David has it precisely right. There may be six, there may be 12, but there will not be an AmLaw 100 or a UK 50 of firms that are truly viewed as the most global of players catering to the most global of financial institutions and corporations as we move on down the road into the second decade of the 21st Century.

If you believe that the tectonic shifts in our financial services industry going on this week mean that the world will be comprised of fewer and larger institutions, will they not indeed look to commensurately globally capable law firms? I believe they shall and must.

Sixth, what do you do now?

I believe you ramp up your competitive efforts. This is not the hour of the timid or the paralyzed.

If you haven't already figured out who you are and what you want to be, it is all but too late. Not "TOO late," but getting close. (And if you're on the fence about where you are, can we talk?)

If you have it figured out, but aren't there yet, this is the time to put your convictions to the test. Economic troughs like this don't cement the status quo, as I've said before, they tend to disrupt it. Now's the time for you to make your disruptive move. Incumbents may not like it, but there is no hereditary right of incumbency.

Above all, do not lose heart, be optimistic, believe in the value your firm and your partners can provide.

• Corporations' demand for financing, for credit, for leverage, and for capital is not going to diminish.
• Globalization is here to stay.
• Regulation is not shrinking, it's growing.
• Wall Street reinvents itself every decade or so; financial services are going to come back, securitization most prominently included.

Watch your costs.

Be opportunistic about the real estate landscape if you need to relocate or expand.

Hire and recruit prudently.

Ask probing questions about people and other assets who are on the street; it may be through no fault of their own, but then again.

Most of all:

Be bold. Fortunes are never made by buying at the top.

I've never seen so much opportunity as now.

Pete Peterson, former head of Lehman Brothers, co-founder of Blackstone, and secretary of commerce under Nixon, described this weekend's events on Wall Street with what almost amounts to understatement:  "My goodness. I’ve been in the business 35 years, and these are the most extraordinary events I’ve ever seen."

So "Adam Smith, Esq." has to ask you all:  What will this mean for your firm, and for our industry?

We'll report back on the results after a suitable sample of you have spoken.  (You may choose one or more than one response.)

This is how the cover story of the current issue of Fortune starts out:

It was the second week of October 2006. William King, then J.P. Morgan's chief of securitized products, was vacationing in Rwanda, visiting remote coffee plantations he was helping to finance. One evening CEO Jamie Dimon tracked him down to fire a red alert. "Billy, I really want you to watch out for subprime!" Dimon's voice crackled over King's hotel phone. "We need to sell a lot of our positions. I've seen it before. This stuff could go up in smoke!"

A classic Dimon manic moment, the call is significant for two reasons. First, it marked the beginning of a remarkable strategic shift that helped J.P. Morgan, virtually alone among the big diversified banks, sidestep the worst of a historic credit crisis. Second, it sheds light on Dimon's distinctive management style - a blend of Cartesian analysis and inspirational leadership that, despite some bad bets in the home mortgage market, has moved J.P. Morgan to the front of the pack in global banking.

But this isn't another story about sub-prime, securitization, and structured finance.  It's about building a leadership team:

Dimon relies on a trusted team of talented lieutenants who share his zeal for sifting piles of data to spot trouble before it happens and vigilantly control risk, even when that means sacrificing growth and losing market share to rivals. Says J.P. Morgan director Bob Lipp, the former Travelers chairman who's worked with Dimon for two decades: "This is the best team on Wall Street."

Dimon and his team are on top today because they took a daring stance at the height of the credit bubble. J.P. Morgan mostly exited the business of securitizing subprime mortgages when it was still booming, shunning now notorious instruments such as SIVs (structured investment vehicles) and CDOs (collateralized debt obligations). With the notable exception of Goldman Sachs, J.P. Morgan's main competitors - including Citigroup, UBS, and Merrill Lynch - ignored the danger signs and piled into those products in a feeding frenzy.

The stock price, while down 21%  from March 31, 2007, is down far less than Bank of America (-37%) or Citigroup (-59%), and JP Morgan Chase's market cap is now virtually equivalent to that of Bank of America and some 25% higher than Citi.  Meanwhile, they've enjoyed lower writedowns on the notorious CDO's.  For the period 1Q2007 through 2Q2008, here are the figures:

• JP Morgan:  $1.9-billion in CDO writedowns
• Bank of America:  $8.0-billion
• Citi:  $27.7-billion

And let's not even mention Bear Stearns, Lehman Brothers, or Merrill Lynch.  The beauty of having a relatively valuable currency (the stock) in this environment is the ability to do even more deals, beyond the Bear Stearns takeover.  "Sure, it's hard to make a deal when your stock has dropped," [Dimon] says. "But so have the stocks of the targets. We have the capital and the people to do a deal, if it makes sense."

Wasn't the Bear Stearns takeover a risk?

Not by the numbers: Bear had $11.5-billion in cash on its books, which should be enough to offset the costs of the acquisition, and JP Morgan also picked up Bears' headquarters building at 48th and Madison worth, conservatively $2-billion (with a mortgage of $670-million).

So who are these guys?

Here are some of the characteristics (emphasis supplied):

• "Dimon's all-stars who make up the 15-member operating committee are a mix of longtime loyalists, J.P. Morgan veterans, and outside hires. Dimon doesn't look for people who went to the right schools or have prestigious résumés. To make it on Dimon's team you must be able to withstand the boss's withering interrogations and defend your positions just as vigorously. And you have to live with a free-form management style in which Dimon often ignores the formal chain of command and calls managers up and down the line to gather information."
  
  
• The environment of being able to push back with your ideas is at the core of this culture.  A classic example, albeit in some ways a small but symbolic one, is this:  "When he first came from Bank One, Dimon vociferously defended using the Chase "octagon" symbol as a trademark across the company. [Jay] Mandelbaum [head of strategy and marketing]  convinced Dimon that the octagon was a symbol of retail banking that didn't match J.P. Morgan's exclusive image. His lieutenants joke that Dimon now claims dropping the octagon from the J.P. Morgan side of the business was his idea."
  
  
• But an atmosphere of free-wheeling ideas is not always without sharp elbows:  "If you get your feelings hurt, you can't work here," says [Steve] Black [co-head of the investment bank]. "Jamie will apologize, then do the same thing two weeks later. He can't help himself."
  
  
• Getting bad news to the surface is another component.  Says Todd Maclin:  "Jamie and I like to get the bad news out to where everybody can see it:  To get the dead cat on the table."
  
  
• At the team's monthly day-long management meetings, candor is the currency du jour: " Dimon will throw out a comment like "Who had that dumb idea?" and be greeted with a chorus of "That was your dumb idea, Jamie!" "At my first meeting, I was shocked," says Bill Daley, 60, the head of corporate responsibility and a former Secretary of Commerce. "People were challenging Jamie, debating him, telling him he was wrong. It was like nothing I'd seen in a Bill Clinton cabinet meeting, or anything I'd ever seen in business.""
  
  
• However, you need to be as detail-oriented as Dimon.  Says Jes Staley, head of investment management, who battled Dimon for a year and ultimately won (on the question of whether JP Morgan should sell other firms' investment products to their customers—Staley argued they should only sell in-house products):  "He understands the details completely, he loves to debate and disagree, yet he'll let you do it." Staley adds a caveat: "As long as you know what's in Appendix 3 of your report as well as he does."

What does all this add up to?

I would argue:  The shockingly free flow of information.

Remember the October 2006 "ditch subprime" call?  What set Dimon off?

Every month, recall, Dimon reviews every aspect of the business in great detail ("Appendix 3" is not a joke).  And in October 2006, during the regular monthly review of the retail bank's operations, the head of mortgage servicing said that late payments on subprime loans were rising at an alarming rate.  Moreover, data showed that loans originated by competitors like First Franklin and American Home were performing three times worse than J.P. Morgan's subprime mortgages. "We concluded that underwriting standards were deteriorating across the industry," says Dimon.

But what about the CDO's the bank still held?  Weren't they all AAA rated?

Yes, they were, but the price of credit default swaps on even AAA-rated CDO's told a different story: 

Winters and Black [investment bank co-heads] saw that once they bought credit default swaps to hedge the AAA CDO paper J.P. Morgan would have to hold, the fees from creating CDOs would vanish. "We saw no profit, and lots of risk, in holding subprime paper on our balance sheet," says Winters.

The combined weight of that data triggered Dimon's call to King in Africa. "It was Jamie who saw all the pieces," says Winters.

Not only did Dimon instruct the bank to start selling its CDO's (including more than $12-billion subprime mortgages that JP Morgan had originated), he took action across the entire institution.  Trading desks were ordered to dump loans on their books, and to stop making markets in subprime loans for customers.  The private bank, that manages money for wealthy clients, started advising them to sell.  The corporate treasury department started hedging and placing bets that credit spreads would widen (profiting by hundreds of millions of dollars when that turned out to be precisely the case). 

Think there was no push-back?  Guess again:

Dimon's stance was radical: He was skirting the biggest growth business on Wall Street. "Our employees wanted to know why we were being so conservative," says Black. "We lost a lot of structured credit people to hedge funds." J.P. Morgan also lost ground to competitors. It sank from third to sixth in fixed-income underwriting from 2005 to 2007, and the main reason was its refusal to play in subprime CDOs, which its rivals were gorging on. "We'd get the quarterly reports from our competitors and see that they'd added $100 billion to their balance sheets," says Dimon.

So, to recap:

• Promote an environment of radical candor.
• Listen—truly listen—to those with other ideas.
• Assimilate information from every corner of the firm (unfiltered, need I add?).
• Synthesize it.
• And don't be afraid to take radically unpopular action, including walking away from seemingly lucrative business your competitors are milking.

Memories may be short, but financial services, let us never forget, are cyclical.  Just ask Jamie Dimon.

Take the survey.

Thanks!

Daniel Goleman, whose title is the business-card-filling Co-chairman of the Consortium for Research on Emotional Intelligence in Organizations (based at Rutgers University’s Graduate School of Applied and Professional Psychology), and who is the author of Social Intelligence: The New Science of Human Relationships (Bantam, 2006), has a new article out on Harvard Business Review about "Social Intelligence and the Biology of Leadership." Here's the kickoff:

In 1998 one of us, Daniel Goleman, published in these pages his first article on emotional intelligence and leadership. The response to “What Makes a Leader?” was enthusiastic. People throughout and beyond the business community started talking about the vital role that empathy and self-knowledge play in effective leadership. The concept of emotional intelligence continues to occupy a prominent space in the leadership literature and in everyday coaching practices. But in the past five years, research in the emerging field of social neuroscience—the study of what happens in the brain while people interact—is beginning to reveal subtle new truths about what makes a good leader.

The salient discovery is that certain things leaders do—specifically, exhibit empathy and become attuned to others’ moods—literally affect both their own brain chemistry and that of their followers.

What we have recently learned is that it's not just "leadership" in the abstract, but that there are neurological bases to what makes people respond:

Perhaps the most stunning recent discovery in behavioral neuroscience is the identification of mirror neurons in widely dispersed areas of the brain. Italian neuroscientists found them by accident while monitoring a particular cell in a monkey’s brain that fired only when the monkey raised its arm.

One day a lab assistant lifted an ice cream cone to his own mouth and triggered a reaction in the monkey’s cell. It was the first evidence that the brain is peppered with neurons that mimic, or mirror, what another being does.

This previously unknown class of brain cells operates as neural Wi-Fi, allowing us to navigate our social world. When we consciously or unconsciously detect someone else’s emotions through their actions, our mirror neurons reproduce those emotions. Collectively, these neurons create an instant sense of shared experience.

Mirror neurons have particular importance in organizations, because leaders’ emotions and actions prompt followers to mirror those feelings and deeds. The effects of activating neural circuitry in followers’ brains can be very powerful.

In a recent study, our colleague Marie Dasborough observed two groups: One received negative performance feedback accompanied by positive emotional signals—namely, nods and smiles; the other was given positive feedback that was delivered critically, with frowns and narrowed eyes.

In subsequent interviews conducted to compare the emotional states of the two groups, the people who had received positive feedback accompanied by negative emotional signals reported feeling worse about their performance than did the participants who had received good-natured negative feedback. In effect, the delivery was more important than the message itself. And everybody knows that when people feel better, they perform better.

Forgive me for repeating this finding, but it's striking: Positive performance reviews with negative body language are perceived as negative, while negative performance reviews with postive body language are perceived as reinforcing.

Here you have the key to something powerful indeed. You can lead, out of bad news, into improved performance and optimism on the part of your team, by evincing positive energy. Is this all smoke and mirrors? I think not.

Faced with a seemingly implacable challenge? Acknowledge it frankly, explore it thoroughly, discuss it openly, but proceed with optimism, candor, and energy.  This is where the sometimes misused and even more often simply confused notion of "emotional intelligence" comes in. 

If human beings were all about "IQ" and not about "EQ," the performance review tests would have had a different outcome:  You are evaluated in negative terms so you feel bad, positive terms and you feel good, period.  But that's not what happened.  This tells us that "EQ" is a powerful factor in human relations indeed—with the power, in fact, to override what our old-fashioned "IQ" should be picking up on. 

Given its power, the question is how to develop your "emotional intelligence"--and whether that's even possible.

Now, the bad news.

Lawyers are constitutionally predisposed, and through the law school and law firm selection process this predilection is reinforced and redistilled, to be analytic and rigorous, emotionally distant and frankly unfeeling. We are not, by and large, emotionally intelligent.

Here's a Cliff's Notes case study of a Fortune 500 exec seemingly suffering the same syndrome (emphasis supplied):

When Cavallo [the psychologist conducting the study] presented this performance feedback as a wake-up call to Janice [the executive under study], she was of course shaken to discover that her job might be in danger. What upset her more, though, was the realization that she was not having her desired impact on other people.

Cavallo initiated coaching sessions in which Janice would describe notable successes and failures from her day. The more time Janice spent reviewing these incidents, the better she became at recognizing the difference between expressing an idea with conviction and acting like a pit bull.

She began to anticipate how people might react to her in a meeting or during a negative performance review; she rehearsed more-astute ways to present her opinions; and she developed a personal vision for change. Such mental preparation activates the social circuitry of the brain, strengthening the neural connections you need to act effectively; that’s why Olympic athletes put hundreds of hours into mental review of their moves.

At one point, Cavallo asked Janice to name a leader in her organization who had excellent social intelligence skills. Janice identified a veteran senior manager who was masterly both in the art of the critique and at expressing disagreement in meetings without damaging relationships.

So this has been a longish detour into "emotional intelligence," but what again does it have to do with leadership?

Permit me to offer a brief excerpt from an interview with Allen & Overy's new senior partner, David Morley, from their just-published Annual Report:

Q: If that’s what it takes to be global, what else does it take to be part of the elite?

David Morley: It takes high levels of client trust and the most talented and motivated people, working together as one firm.

Q: No one would disagree with that, but how does Allen & Overy achieve that?

David Morley: For both our clients and our people it is the quality of Allen & Overy’s relationships with them, and the levels of trust we establish between us, which are critical.

A relationship is personal and unique. It cannot be replicated by a competitor.

Isn't this the distillation of "emotional intelligence?" A relationship which is personal and cannot be replicated?

Sorry that law school and your law firm's recruiting process didn't select you for this, but I have news for you:  Get over it.

As our industry becomes more competitive, more global, more client-centric, more focused on the war for talent, the winners will increasingly be those with charisma, drive, energy, and yes, those with "emotional intelligence." 

Face it:  Everybody in sight in your firm has nothing to apologize for on the IQ front.  That won't work as a distinction, either for you personally in your career or for your firm as a whole on the competitive landscape of the 21st Century.  But EQ, precisely because it's been so consistently selected-against in our profession, just might do the trick.

Here's how McKinsey poses the dilemma:

"As the credit crunch threatens to become a global downturn, corporate leaders have a choice: pull in their horns and ride out the storm or look for opportunities to pick up bargain-basement assets that will help them grow and create future value for shareholders. If past is prologue, more will follow the first course—which is a mistake."

The head/heart opposition is simple to understand:  While your head tells you that one of the best times to invest is in a downturn, that's precisely when your heart quails.  "Buy low, sell high" is advice so impeccable as to achieve the truly advanced state of tautological, but "buy high, sell low" is more descriptive of the way people actually behave across economic cycles. 

I may not be able to change your heart—only you in league with your spouse or your shrink can do that—but I can at least hope to arm you with the intellectual fortitude to mount a stalwart case for exploring some acquisitions now, in the teeth of the fretful and querulous naysayers.

Based on a survey of over 200 global companies, the authors (who also collaborated on the May 2008 book The Granularity of Growth), derive two pivotal conclusions:  The most powerful way to position one's firm for growth coming out of a downturn is through selective acquisitions during that downturn, and, conversely and with wonderfully rewarding and symmetric logic, during an upturn selective divestitures create slightly more value than acquisitions.

If only people behaved that way:

This shows the actual behavior across a sample of 537 product/service lines (from 187 companies) between 2001 and 2004, in reaction to a "major" (> 10%) upturn (top blue bars) or downturn (bottom green bars).  Essentially, the lessons are:

• Companies are more likely to divest during a downturn;
• And more likely to acquire during an upturn;
• While the reality remains that during both upturns and downturns the most likely course of action of all is simply to do nothing.

Again, this is understandable.  But that, I would argue, is less an excuse than an indictment of conventional wisdom. 

Do you want to "protect your balance sheet" during a downturn?  Sounds logical.  (And, to be sure, some firms simply aren't in a position to do otherwise.)  And as revenues flag and margins are compressed, you may focus on cutting costs and trying to at least match previous periods' earnings levels.

But the savviest growth companies do otherwise.  Famously (as even the usually somnolent business coverage of The New York Times realized in 1999), GE Capital immediately went on a capital spending binge following the Asian financial meltdown in 1997:

The last two years alone, [GE Capital] has made at least eight major investments in four Asian countries, expanding its assets to about $20 billion in the region. Acquisitions included two consumer-credit businesses, a life insurance company and a $5 billion leasing company in Japan, a consumer-credit business and a portfolio of car loans in Thailand and a life insurance unit in the Philippines. It also has its sights on a stake in a South Korean bank.

[...]

[T]he 1997 Asian financial meltdown and resulting recession turned the area into a vast bargain basement. Here was GE Capital's chance to buy up distressed companies and establish itself in the one part of the world where it lacked a strong presence.

''There's no question that financial turmoil has resulted in an environment that facilitates deal creation,'' Denis J. Nayden, president of GE Capital, said in a telephone interview from the company's headquarters in Stamford, Conn. ''Yes, we have moved into that opportunity.''

In other words, countercyclical growth works. 

If you're in a position to do so, think about trying some for yourself.  You may like where you'll end up on the other side of this credit markets lockdown.

Here's a primer from McKinsey, admittedly addressed to investment banks, but utterly applicable to you.

They start from the analytical premise of segmenting investment banks into quartiles based on noncompensation costs per head count. That strikes me as a strong indicator since it abstracts from the absolute value of growth in noncompensation costs (you can expect headcount and noncompensation costs to grow as the firm grows) as well as from the impact of one-time investments such as opening new offices.

Using only publicly available sources, they benchmarked eight major financial institutions over the past three years and found, perhaps not surprisingly, that "the difference in noncompensation costs per head count between the top- and bottom-quartile banks is significant:"  Banks in the top quartile had average costs by this measure of $148,000 and across the bottom three quarters, $212,000, or a 43% difference.  When you look at it from the perspective of potential savings (assuming, that is, that banks in the bottom three quartiles could duplicate the cost structure of banks in the top quartile), the numbers are striking indeed:

What accounts for these sizable differences in the cost base?

Simply put, during the good years (2005—2007), some banks permitted themselves to bloat up.  Here are the "CAGR" (compound annual growth rate) figures for noncompensation costs (light blue bars on top) and revenue (dark green bars on bottom) for the eight banks:

Only three of the eight had sufficient discipline to keep cost growth below revenue growth.  (The "N/A" for the last two listed is a result of their revenue "growth" in 2007 being negative vis-a-vis 2006, which vitiates the CAGR calculation.)

So much for the background:  Now for the interesting part.

How precisely do you cut costs without sabotaging morale?

First, let's assume you've done any staff and attorney headcount "right-sizing" that may be called for.  If you're going to do it:

• Do it surgically;
• Do it once and only once;
• Tell people it will be once and only once;
• Tell the people who have been saved that they've been saved and that it's for keeps;
• Even if you think in hindsight you might have made some mistakes, do not go back to the well; and above all
• Do it once and only once.

Now that you're past that, the good news is that "80% of fixed costs have minimal or no impact on a bank's employees or culture."  In other words, you can draw blood from the 80% of your noncompensation cost base that is relatively invisible to people on a day-to-day basis.  You can go, in the famous phrase, "where the money is."

Here's the breakdown (understanding it won't be identical for law firms as for investment banks, but the comparable notional amounts are worth thinking about):

Obviously, some of these don't map one-to-one to law firm land.  You probably don't spend nearly as much on "data," for example (or you charge it through to clients if you do), and your sum total of spending on "other professional services" and legal is probably de minimis (if it's not, we should talk).  

But the point is not how your noncompensation costs break down vis-a-vis investment banks.  Rather, the point is how relatively small a component of that goes to activities that are highly visible and have a direct impact on morale:  Travel, entertainment, and firm events.

Times like these give you the opportunity to cut out the deadwood and to re-examine unspoken assumptions about what customary activities would really justify themselves all over again in a "zero-based budgeting" world.  In some ways, these are the best of times to cut costs; everyone understands the imperative.

When things turn up again, however, I have a word of advice:  Keep in mind that CAGR chart comparing cost growth to revenue growth.  And make your firm one of the three, not one of the five.

Relying on the results of the McKinsey "Global Capital Markets Survey," which purports to forecast estimates of investment banking revenue for the years 2007 to 2010, the message is that:

• Emerging Asia,
• Emerging Europe,
• The Middle East, and
• Latin America

will probably show absolute revenue growth over the next three years and under what they call "all likely outcomes," emerging markets' share of global revenues will "jump sharply."  Here's the soundbite:

Collectively, indeed, revenues from investment-banking and capital market activities in these regions are projected to match those in North America by 2010; in 2006, before the credit crunch, they amounted to less than half. A case, perhaps, for referring to “emerged” rather than emerging markets in the future?

Uncertainties, to be sure, abound.  Primary factors determining when the credit crunch may ease include the overall macroeconomic prospects for growth in the US and developed economies; investors' behavior--simply put, when and to what extent confidence comes back; regulators' behavior (do they over-react and clamp down in market-suppressing ways); and of course the grand-daddy unknowable of them all, namely when the credit and liquidity lockup will start melting as the lending institutions in the economy begin to see clarity about the future and are able to restore their balance sheets to health.

But back to the emerging markets.

Why are they so attractive at this juncture in the economic cycle? For one thing, as McKinsey alluded to above ("emerged" vs. "emerging"), they're already getting sophisticated (emphasis supplied):

First, their macroeconomic environment remains comparatively benign, even if talk of a complete “decoupling” of their economies from those of the United States and Western Europe was premature. Although, if trade flows with the West do suffer, regional demand for oil and commodities, growing intra- and interregional trade flows (especially within Asia and between it and the Middle East), and huge infrastructure-investment programs will continue to underpin growth.

Second, a new breed of global corporate players, notably in countries such as China, India, and the United Arab Emirates (UAE), now demands the sort of sophisticated investment-banking services [and concomitant legal services] previously reserved for large Western multinationals. This new group thus represents an increasingly attractive fee pool.

Add to that that they're less exposed to the infamous credit crunch. For example, if writedowns is your blunt-instrument measure of exposure, investment banks have written down only about 7% of their revenues from emerging markets as opposed to three times that--21%--on a global basis.

Two other reinforcing trends are in play. First, certainly in Asia, economies are growing, pure and simple, on their own. That just increases the stock of financial instruments and their tradability. But second, as Asia becomes increasingly integrated with the global economy, inbound and outbound investment will increase, and it will take increasingly sophisticated forms. For "sophistication," substitute "lawyer-heavy," and you have a reason to take this region more seriously.

Do you have to be there?

I believe you do. But let McKinsey speak to this:

Asian markets are fast becoming as demanding and sophisticated as markets in Europe and the United States. Clients have developed a taste for complex financial products and demand good local service; domestic competitors are ramping up their skills and opening their checkbooks to attract international talent.

An onshore presence in emerging Asian markets, meanwhile, is becoming critical. The old model of the suitcase banker operating from hubs such as Singapore and Hong Kong will fail to satisfy clients and regulators seeking a true commitment to the local market.

I've observed before that in America the first "real" question people ask a new acquaintance is, "What do you do?" In the UK it's "Where did you go to school?" And in China it's "Where are you from?"

Not to be cute, but if this is remotely correct (and I've reality-tested it with numerous people in all three areas), you really need to be on the ground in Asia to manage inbound or outbound investments more than you need to be on the ground in (say) Silicon Valley to manage a high-tech IPO or Brussels to handle an EU regulatory matter.

So much for Asia. What about Eastern Europe?

In a nutshell, McKinsey sees overall annual GDP growth from 7% (in their "darker" scenario) to an astonishing 19% in their "more benign" scenario. I'll take some of that, thank you very much.

The only trouble with this area, for law firm land (as opposed to investment banking land), is that the primary source of increased fee revenue McKinsey foresees has almost all to do with sales and trading: "In the future, we believe, growth will probably shift from foreign exchange to interest- and equity-based derivatives, among other products."

And the Mideast?

No surprises here: Investment banks are redeploying more and more professionals from New York and London to the region:

The oil-rich states of the Gulf Cooperation Council (GCC)—Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the UAE—are generating wealth at levels not seen since the 1980s. High oil prices have triggered an unprecedented wave of investment, including a huge pipeline of industrial and large-scale infrastructure projects, such as Saudi Arabia’s new “economic cities.” By some accounts, the GCC will have invested around $3 trillion in the region by 2020.

Can you afford to miss this?

That is for your firm to call, including your partners' appetite for risk and their willingness to endure a period of potentially protracted investment, but the historic shift of momentum seems clear:

Emerging markets now have a rare window of opportunity to catch up with the rest of the world, not least because they don’t have to mitigate the mess created by current market dislocation in the West.

Here we have, in other words, the flip-side of the credit market and liquidity freeze.

Stung (perhaps severely?) by that meltdown? Here (the good news) is an enormous, far more durable, opportunity. But (the bad news) if you are still bleeding from overexposure to the frozen credit markets, you may not be in a position to make the requisite investments half a world away.

Don't ever again think that managing a law firm is an exercise in quarter to quarter or year to year performance.

The transition from "emerging" to "emerged" will take a few decades. You need to have the same time horizon.

Update:  Mon 1 Sept.

The September issue of The American Lawyer (published online today) has a lead story, "No More Pure Plays," attempting to apply lessons learned by law firms sideswiped (or worse:  see Brobeck) by the dot-com meltdown in 2000—2001 to today's market where securitization and structured finance have experienced a similar sickening sensation of the trap door opening beneath them.

The first thing to be said about these types of market tops is simply this:  "In hindsight, the folly of it all seems obvious. But here we are again."

And, as Stephen Neal, managing partner of Cooley Godward Kronish from early 2001 through today puts it with commendable clarity:  "In retrospect you might say [the growth] was a mistake, but we didn't know at the time how long this market would last. At the time it was almost irresistible."

The "almost irresistible" comment brings to mind the business classic, The Innovator's Dilemma, where Prof. Clayton Christensen of Harvard Business School set out a coherent, compelling, and historically astute view of just how the most powerful incumbents in any given industry are precisely the firms most vulnerable to maverick upstarts with what appear at first glance to be second- or third-tier offerings of no conceivable utility to the incumbents' core customers.  While it might seem intuitive that the most knowledgeable, most strongly capitalized, most sophisticated firms in an industry would be theones most capable of exploiting innovations "in their own backyard," as it were, Christensen demonstrates precisely the opposite is more common.  Incumbents suffer from:

• Being excessively loyal to their core, established clients (yes, even client loyalty can be pushed too far, when it becomes a limitation rather than a strength);
• Focusing on continuous incremental improvements to their existing product or service offerings, while being blind to "disruptive" innovations; and finally and most tellingly of all
• Being unable to abandon extremely profitable existing lines of business to take a chance on an unproven innovation whose value will only be known in some indeterminate future time.

It's the final point that Mr. Neal is echoing, and it's the seductive power of any boom:  When the getting is good, the getting is very good indeed.  (Or, as The Onion recently facetiously headlined, "Americans Reeling from Housing Meltdown Seek Next Bubble to Invest In.")  Some of the key Silicon Valley firms grew as follows—and this doesn't include all the firms from elsewhere in the country that starting piling willy-nilly into Northern California just as the window was about to slam shut on their fingers:

• Cooley added 300 lawyers in a 12 to 18 month period;
• Wilson Sonsini went from 550 to 812; and
• Brobeck from 540 to 724.

Even at that torrid pace (let's not even think about quality control, shall we not?), "'We turned away nine out of ten pieces of business--maybe more,' said Mark Tanoury, who then headed Cooley's business group, in 2000."

Still, the article finds reason for optimism this time around, at least as compared to the carnage at the start of this decade.  Why?  Primarily because the NY-centric firms that doubled down on securitization have been far quicker to wield the "scythe" with associates.  To this day, Wilson Sonsini has never publicly admitted that it laid off associates, although, mirabile dictu, its headcount shrank from 812 in 2000 to 540 in 2004, and the beginning of the end of Brobeck, at least as the received wisdom has it, came when Tower Snow refused to lay off associates. 

The article gives, indeed, the last word to Mr. Snow:  "History shows that those who are overconfident or arrogant tend not to do well when the environment changes." Ironic, and prescient, words indeed.

But I choose to give the last word to Chris White, chairman of Cadwalader, who told The Wall Street Journal last month: 

"There was a bubble, we rode that bubble, it contracted, and we adjusted. Even knowing what I know now, I wouldn't have changed a thing,"

The cynics in the audience may judge that chutzpah of the highest order.  But I for one see it differently, and give Mr. White great credit for a shockingly salubrious spasm of candor. 

Now the only question will be whether their "adjustments" have been rapid and strong enough.