Winter's chill

Lawyers are in a dour mood this cold January. Their investment banking clients have experienced significant dislocation, and things aren't much better in the rest of corporate America. While law firms have traditionally been low-risk businesses far less vulnerable to downturns than most companies, the current crisis will challenge -- and at some firms overturn -- that historic security.

As dealmaking boomed from 2005 to 2007, law firms raked in fees from M&A and financing work that allowed many of them to expand aggressively by adding lawyers and offices.

With large numbers of associates leaving for opportunities in the financial services sector, firms increased the number of law students they hired in anticipation of expected attrition. Those dynamics have changed as banks, buyout firms and hedge funds are laying employees off rather than adding them, and deal work has slowed to a crawl. Capital markets work is at a standstill, with only one initial public offering since August, and debt markets aren't much more robust. M&A did hold up reasonably well in the first eight months of the year, with activity levels both here and Europe ahead of deal volume in 2005, a very strong year.

The dollar value of private equity M&A was off 75% from 2007 but still at a very healthy level compared with the early part of this decade.

And then Lehman Brothers Holdings Inc. went bankrupt, and M&A slowed to a crawl. In the fourth quarter, $115 billion worth of bids for U.S. companies were made, according to research firm Dealogic, which on an annualized basis would be the worst year since at least 1995. The last two months of the year featured only 11 U.S. deals worth more than $1 billion, according to The Deal's Corporate Control Alert, and only three above $3 billion.

Activity levels plummeted by more than 50% in November and December, and lawyers say they can't predict when things will pick up again. Almost everyone is writing off the first half of the year; one lawyer at a top firm says his partners consider him "a raving optimist" because he holds out some hope for the second half. Companies even seem to be reducing their spending on litigation, which lawyers have long seen as a recession-proof practice that protected firms against downturns in deal work.

Even the fall's few bright spots for transactional lawyers are muted.

The financial services sector has generated significant work as the government seized Fannie Mae, Freddie Mac and American International Group Inc. and pumped money into the banking system, but six law firms picked up the bulk of the work: Cleary Gottlieb Steen & Hamilton LLP; Davis Polk & Wardwell; Simpson Thacher & Bartlett LLP; Skadden, Arps, Slate, Meagher & Flom LLP; Sullivan & Cromwell LLP; and Wachtell, Lipton, Rosen & Katz.

Robust M&A activity in biotechnology and pharmaceuticals will help firms with strong relationships in the area, as Cravath, Swaine & Moore LLP does with Bristol-Myers Squibb Co. and Johnson & Johnson and Latham & Watkins LLP has with Eli Lilly and Co., but drug company deals won't begin to make up for the decline in overall deal volume.

Top M&A firms such as those six have thus far avoided wrenching change, but many of their rivals have not. Heller Ehrman LLP, Thelen LLP and Thacher Proffitt & Wood LLP all collapsed this fall. Cadwalader, Wickersham & Taft LLP and Clifford Chance LLP are two of the many firms to lay off significant numbers of associates. And several firms, among them Latham and Morgan, Lewis & Bockius LLP, have essentially rolled back the associate salary hikes of 2006 and 2007 by not granting the pay increase they usually receive at the start of a new year.

The effect of the technology market crash of 2000 and 2001 suggests worse is yet to come. As the Nasdaq fell by two-thirds from its height, Silicon Valley's leading law firms were severely squeezed. Wilson Sonsini Goodrich & Rosati PC and Cooley Godward Kronish LLP both shrank by about a third, while Brobeck Phleger & Harrison LLP, which expanded more aggressively than either Wilson or Cooley, dissolved. Many New York lawyers at the time saw their California counterparts' struggles as the reckoning for overexpansion during a bubble market. Now the reckoning has come home to roost.