Drew Combs reports on the bad decisions that sealed the fate of a US institution

When Heller Ehrman partners gathered at Santa Barbara, California's Bacara Resort & Spa in March 2007, there was already reason to be concerned about the firm's future. Several practice areas were slow. The firm's national and global ambitions were in disarray. And partners were increasingly skeptical about management's ability to address the problems. But that weekend they were determined to laugh at this worrisome predicament. The final night of the retreat featured a $300,000 (£186,000) skit. Performers from the Los Angeles Opera, accompanied by a professional orchestra, portrayed chairman Matthew Larrabee (pictured) and other firm leaders frantically searching for a merger partner. "Some people were laughing, but I thought it was surreal," says one former partner.

Eighteen months later, no-one was laughing. Partners were flooding out the door and management couldn't put together a merger. With no hope of rescue, the once 650-lawyer firm announced on 26 September that it was shutting down.

The demise of the 118-year-old Heller – which had little to do with larger economic events – has left questions about what went wrong. Firm management had blamed the crisis on a decline in the firm's marquee litigation practice that stemmed from the settlement of several large cases in a short timeframe. But Heller partners and outside observers have debunked that analysis. "I completely object to the reasoning that it fell apart because three cases settled," says Stephen Ferruolo, who was one of the first partners to depart the firm in 2007.

Instead, Heller died because its partners lost confidence in their leaders. More than 80 partners left the San Francisco-based firm in 2007 and 2008, some embittered, some merely frustrated, by a roller coaster of changing strategies, faltering financials, and less-than-candid communication. Those who remained to the end shared the frustration. "I thought I would finish my career at Heller Ehrman," says Nancy Cohen, who served as the last managing shareholder of the Los Angeles office. "I went from thinking that, to realising I might have to leave if we did a merger that would not include the insurance recovery group, to accepting that we are dissolving."

What went wrong? "It was as avoidable as it is regrettable that this happened," says one former member of the policy committee. Three critical decisions, according to the more than a dozen one-time Heller partners interviewed for this story, proved to be turning points on the road to Heller's death. They are specific to this firm, but they also provide broader lessons.

Decision one, December 2004: The policy committee denies Barry Levin a third term. Heller tradition dictated that the firm's chairman serve no more than two three-year terms. That policy was never much of an issue when Heller was a respected but fundamentally local firm. As it became a half-billion-dollar business toward the end of Levin's term in 2004, at least three members of the firm policy committee suggested that Levin continue as chairman. Levin was a well-liked leader. He had pushed Heller to expand and become a national player, bringing in expensive laterals in New York and Washington DC. The firm had prospered under Levin, but the success of his strategy was far from clear. Levin was of two minds about staying on. He asked a Seattle partner to measure the attitude of the firm. The Seattle partner's report: Levin should step down. Larrabee, a successful litigator with a dry but barbed sense of humour, would take his place.

It was a typical Heller decision in that it was based at least in part on maintaining good relations among the partners. "We were concerned if we changed things, Larrabee's feelings would be hurt," says one partner of the 2004 decision.

Partners say it would be unfair to blame Larrabee's ascension for the firm's demise. He inherited a flawed strategy. And the fabled Heller 'glue' proved less durable than many would have predicted. But in hindsight, several partners argue that Levin might have been better suited to keeping partners in the fold. "Levin certainly listened to a lot more people," says one. "He was good at bringing partners along and forming consensus."

Decision two, spring 2005: Heller botches its downsizing. A flash report for the first two months of 2005, which was distributed days before Larrabee's election as chairman in March, projected an annual utilisation rate of 1,600 hours per lawyer – 300 hours less than Heller's target. Management responded with a preliminary plan to chop head count. Heller was never an up-or-out shop, so the firm had a thick layer of 'special counsel' and partners with little business – lawyers Heller could not afford to keep.

But the reduction plan was hobbled by months of politicking by partners anxious to protect their favourites. In the end, about 60 lawyers, mostly special counsel, were shown the door. It wasn't a deep enough cut: according to one former partner, the total should have reached 100 and should have included more service partners. "We didn't do enough," says one former partner. "You only get one chance to do something like that." There was still too little work to go around, and Heller's profits continued to lag behind those of other Bay Area firms, such as Orrick Herrington & Sutcliffe and Morrison & Foerster. Even worse, the cuts began transforming a firm known for its collegiality into one with lots of sharp elbows.

Decision three, summer 2006: Heller reverses course and plans a major expansion. In the summer and autumn of 2006, Heller had two options. It could severely curtail its ambitions, or it could continue the growth strategy that foresaw the firm as a 1,000-lawyer national operation. At the time, that plan did not appear to be succeeding: Heller had unfilled space for 450 lawyers in offices around the country and was losing money in Asia. Nevertheless, instead of retrenching and addressing the unrest, Larrabee and the policy committee announced a plan to increase Heller's head count to 1,500 lawyers. The following year, the firm opened offices in London and Shanghai and made a few lateral additions in domestic offices. But management never articulated how it would execute the new growth plan when it had failed with the old one.

In the months that followed, partners – including office leaders, Heller careerists and rainmakers – would vote on Heller's future with their feet. By the end of 2007, Patricia Gillette, co-head of the employment practice; Jerry Marks, Los Angeles managing partner; and Margaret Mann, head of bankruptcy, would all be gone.

With Heller's leadership committed to growth, even as it laid off staff and lost partners, rumours of merger talks began circulating. Many later turned out to be true, but few were discussed openly by leadership. "It went from being an overly democratic firm to one in which no information was given out," says a former New York partner. "The chairman would say, 'I am going to start telling you more things,' but it never happened." Office managing partners complained that Larrabee, increasingly occupied in merger talks, didn't even return their calls. And in a sign of desperation, firm management began denigrating departing partners. Some of them, leaders said, "didn't play well with others".

In the summer of 2008, merger was the only option for the crippled firm that Heller had become. Would-be suitors such as Baker & McKenzie and Winston & Strawn came and went. By mid-August, Mayer Brown was Heller's last hope.

A few years earlier it was Heller that broke off merger talks with Mayer Brown. Now Heller couldn't afford hubris. By early September the two firms had a tentative agreement that would give Heller some much-needed stability and Mayer Brown heft on the West Coast. Leaders of both firms were scheduled to make a presentation to Mayer Brown's policy committee on 15 September, with partnership votes at both firms to follow within days. But on 10 September Heller leaders learned that 14 intellectual property (IP) litigators – with at least $80m (£49m) in business – would resign from the firm and move their practices to Covington & Burling.

It was the final blow – the inevitable result, in retrospect, of mistakes dating back to 2004. Firm leaders had known some IP lawyers would be leaving, but they were surprised at how many, and at how much business they were taking. The size of the departure triggered a notice requirement in the firm's lending agreement. Mayer Brown walked away. Citigroup and Bank of America Securities called in Heller's loans. Within days, Heller conceded the inevitable, laying off staff, and telling its lawyers to find new jobs.

What is to be learned from Heller's sad ending? To paraphrase Tolstoy, every unhappy firm is unhappy in its own way. But in turbulent times, firms have to make hard decisions – even at the cost of hurt feelings and lost jobs. And they have to be realistic about their prospects. Heller was undone by a simultaneous lack of focus and lack of resolve, which led rainmakers to lose confidence. Few firms will be able to survive similar mistakes in the next couple of years.

A version of this article also appeared in the November edition of The American Lawyer, Legal Week's US sister title.

See Editor's Blog: Heller's familiar fate for more analysis.