With cracks appearing in Herbert Smith's venerable exterior, Suzanna Ring and Georgina Stanley ask if this proud City firm can renew itself for a rapidly changing global market

It comes as a shock when Herbert Smith senior partner Jonathan Scott slams his hand down hard on the table during a conversation about the firm's future. At this point in early November there have already been prolonged discussions between Herbert Smith and Legal Week regarding this article, and the veteran competition specialist is frustrated that during an unsettled period for a particularly private law firm, a number of partners have been discussing its affairs with outsiders. More than frustrated, Scott, by all accounts a leader who believes in the classic virtues of partnership, feels personally let down that confidences are being betrayed.

But understandable as this frustration is, many of the issues and tensions that have long been submerged at this proud City institution have been bubbling to the surface in recent months. Within weeks of this conversation, Herbert Smith will have received a negative response from its long-time European partners Gleiss Lutz in Germany and Benelux leader Stibbe to its efforts to secure a three-way merger, leading the City firm to dramatically pull out of the alliance within days.

That discussion did not come in isolation, with Herbert Smith since the spring having been engaged in a wide-ranging strategic review dubbed Project Blue Sky – a name perhaps tempting fate, given its resistance to bold structural shifts. Aside from accelerating the firm's international strategy, Herbert Smith has also been moving to wrestle with long-neglected performance and cultural issues.

Adding to the tension has been some setbacks in its business, with the firm this year losing a stream of well-regarded partners to rivals. Concerns have also been raised by a poor run of form at its corporate practice, which saw the team miss its 2010-11 budget by nearly £20m.

As such, the firm's financial performance is increasingly lagging the magic circle rivals it aspires to compete against, making some question if Herbert Smith faces being consigned to, in global terms, a second-tier player. There is also pressure for a major shift in the firm's international strategy and tougher management of the firm's notoriously individualistic partnership.

"Management seem sensible souls but there are definitely issues," reflects one senior partner within a magic circle rival. "They have just got to decide what kind of firm they want to be. It doesn't have the global feel and has ended up in a halfway house because of its alliance."

The consensus is that Herbert Smith can not simply rely on its culture and 129 years of history to see it through a crucial phase in its development. The firm must start making some proactive decisions about its future, at least if it is to fulfil its ambitions of being a leading player in the evolving global legal market.

"The firm is at a turning point and it has got some tough decisions to make," argues one former partner. "If they sort out the issue of the amount of contribution partners are making at the firm, then there is hope."

In many ways, these sentiments are reflected internally, with real estate chief Ian Cox commenting: "The current management regime has instilled a good deal of backbone in the last 12 months and the partnership has welcomed that; there is a real enthusiasm to show the outside world what we can now achieve."

Still, change will not be easy. Not for this firm.

The weight of history

It is in many ways impossible to assess Herbert Smith, the 265-partner giant of today, without briefly considering the firm's long history. Founded in London in 1882 by Norman Herbert Smith, the firm is one of the oldest major law firms in England and quickly established itself as part of a small club of prominent solicitor firms focusing on the City.

Acting on public offers and general corporate work, often for mining companies and financiers, Norman – still a sole practitioner – built a client base of famous corporate clients from the firm's launch. Riding the boom in the early 20th century, Norman in 1903 sealed the deal that truly made his firm a member of a select club of leading City firms after agreeing an ambitious deal to take on three partners. The firm's recently published official history wryly notes: "At a stroke it matched the strength of Ashurst and Slaughter and May. Linklater & Co then had six partners and Freshfields three. Overnight [Norman Herbert Smith] had distanced himself from the legion of sole practitioners. Herbert Smith had become a sizeable firm for its time."

But it was after World War II that Herbert Smith began to develop the dual litigation and corporate model, which came under disputes partners like John Barker and Francis Mann to define its modern reputation. Previously, partners at commercial law firms had focused on corporate matters, leaving clerks and outside counsel to manage litigation.

Herbert Smith was to pioneer using partners to actively – and often aggressively – run disputes. By the 1980s, the pre-eminent reputation of the firm's aggressive commercial litigators was such that it often overshadowed the firm's corporate practice.

As Herbert Smith senior litigation partner Ted Greeno notes accurately: "We were the first firm in the City really to start practising litigation in the way it is practised today."

Ironically, the firm is often now characterised as a litigation shop that subsequently built up a corporate practice – a reversal of the truth, and one explanation for bouts of institutional tension that flare up between its 'twin engine' practices.

But even if litigation was hogging the attention, Herbert Smith in the 80s took full advantage of the boom in corporate activity, notably working on a string of ground-breaking privatisations. With the firm rapidly outgrowing its mundane Watling House offices on Cannon Street by the end of the 1980s, it secured a deal to move to the flagship development in Broadgate's Exchange House in 1990, a much more attractive sell to young graduates with multiple job offers which would help the firm build up the lack of younger talent it had on the corporate side.

Despite suffering like all firms in the early 1990s recession – in the first half of the decade litigation generated more in revenues than any other practice – this period in many ways saw the firm come of age, with charismatic senior partner Edward Walker-Arnott, who led the firm from 1993 to 2000, overseeing a period in which the firm's corporate lawyers emerged from the shadow of litigation.

Walker-Arnott pushed through a programme of modernisation in which the firm invested in more sophisticated infrastructure and drastically updated its governance, human resources procedures and internal controls. The firm also began to ramp up its international expansion after a period of retrenchment during which it was acknowledged it was now lagging behind its rivals.

By the end of the 90s Herbert Smith seemed in an envious position. Despite the rapid international growth of its larger City rivals, the firm had an unparalleled reputation in litigation while having also built up an M&A team that was seen as nearly the equal of the traditional corporate elite of Slaughters, Freshfields Bruckhaus Deringer and Linklaters.

The end of the century also brought about a spate of international expansion for Herbert Smith. With offices in Paris, New York, Hong Kong and Brussels already opened in 1964, 1978, 1982 and 1989 respectively, the firm launched in Singapore, Bangkok, Moscow and Beijing across the following decade before entering into an alliance with Gleiss in 2000.

A harder decade

Herbert Smith's successes were famously recognised in Legal Business in 2002, when the title prominently made the case that the firm should be considered a part of the magic circle. Not everyone was convinced, but it did reflect the substantial progress the firm had made and put it in the company that it historically liked to see itself.

However, progress would become more challenging. In the more fluid market of the 1990s, Herbert Smith had been a stock on the rise. But with internationally consolidated law firms emerging in the shape of London's big four magic circle firms and a host of US law firms investing heavily in the Square Mile, it had become harder to make ground in the City. A smaller European practice at times also held back the firm's transactional practice.

Perhaps major progress would have required a greater willingness to take risks than the firm was ready to accept. In place of Walker-Arnott the firm had Richard Bond, a well-regarded corporate partner but arguably a  a little too steady on the tiller if the firm was intent on justifying its reputation as a practice in the global first tier.

Under Bond, the firm's performance seemed strong – unlike Linklaters, Clifford Chance (CC) and Freshfields, Herbert Smith did not have to wrestle with bedding down large European mergers – which sapped the larger firms' profits and morale. By 2004-05, judged purely on profits per equity partner (PEP), the firm was now outranking Freshfields, CC and Allen & Overy (A&O).

But this considerably overstated the firm's performance. It had avoided the kind of investment of its peers and its PEP was in part the result of an equity partner/fee earner leverage that was much higher than most leading City firms.

Though its alliance with Gleiss and Stibbe was viewed as a workable short-term measure, there were also clear limitations to the model and it remained unpopular with some partners. As global law firms began to improve the once-uneven service delivery across their European networks and magic circle profits revived during the credit boom, Herbert Smith began to look less well-positioned, strategically.

And for all the apparent confidence, scratch below the surface and there was always a streak of defensiveness about its status combined with an insecurity about whether the firm really was the equal of its larger rivals.

Against this backdrop, the firm in late 2004 held an election for its new senior partner – a break with its recent tradition of appointing by consensus. The process was billed in part as helping to define the key strategic issues that faced the firm, but in the end provided little resolution. Perhaps that is because the victor, the firm's heavyweight head of litigation David Gold, was not ideally suited to edge the firm into making more hard choices.

By consensus, the mercurial Gold was a difficult leader for some, making some partners feel under pressure without, critics argue, providing a constructive path to improve.

Gold's first two years saw him push the idea of a 'partnership charter' that would spell out the expectations of partners. But, however many pains the firm took to style the move in the context of a collegiate renewal of its partnership vows, the underlying rationale was clear: a firmer line on central management and less tolerance of poor performance. Though the firm has historically avoided exiting partners and has few tools to force departures, it is apparent that some veterans were encouraged to leave during this period.

Midway into Gold's term tensions were rising with little apparent progress, but the decision to re-introduce the managing partner role in 2008, which was handed to corporate partner David Willis, improved the situation, bringing in more operational polish and more consistent communication. Willis also quickly established himself as a popular leader who was able to be tough when needed.

Still, even if the mood was less fractious in the latter half of Gold's term, progress on the key issues was slow in coming, with a 2007 review of the alliance with Gleiss and Stibbe going nowhere. The firm had new office launches in Spain and the Middle East under Gold's term, but remained uncertain in its global footprint or outlook.

There were even tensions over whether Gold would stand again for another term, amid indications that he wanted to see the projects he had started through to fruition.

In December 2009 the firm went through elections to replace Gold which saw Jonathan Scott victorious in a contest against Commonwealth of Independent States (CIS) managing partner Allen Hanen (pictured) and disputes partner Tim Parkes. Nothing much had yet been resolved.

Quite apart from leadership issues, Herbert Smith in recent years has faced questions over the development of its key corporate and litigation practices. While litigation is regarded as a top-tier player, it no longer maintains the dominance it once had on high-end disputes work, with firms like Freshfields and Hogan Lovells closing ground in recent years.

Meanwhile, while the firm's corporate practice maintains an enviable client base and continues to secure a strong run of big-ticket mandates, it is acknowledged to be held back by poor cross-selling, less sophisticated client management than some rivals and an uneven volume of mid-market work.

While claims of tension between litigation and corporate are sometimes exaggerated, the corporate team's performance in coming nearly £20m under budget in the last full financial year did provoke some disquiet internally. Global head of corporate James Palmer comments: "This year's performance for corporate in London won't be where I'm happy with, but it will be materially better than last year."

One area where the firm has made progress in recent years is in its international expansion in Asia and the Middle East, with new offices in Tokyo, Indonesia, Shanghai, Dubai, Abu Dhabi, Saudi Arabia and Qatar. Its Asia revenues (not including the Middle East) now make up 18% of its total turnover, higher than magic circle peers. In total the firm now generates 35% of its revenues outside the UK.

Collegiality versus 
contribution

While it was quickly apparent that Scott intended to take a less confrontational approach to the issues facing Herbert Smith than his predecessor when he assumed his role in May 2010, the fundamental issues had not changed: international strategy and how the partnership should work.

In the spring of 2011, the management team of Scott and Willis gave the clearest indication yet that it was finally ready to address such matters with the launch of a wide-ranging review Project Blue Sky, a process led by a committee under Hanen. In addition, PricewaterhouseCoopers (PwC) was called in to aid a review of the firm's business, including measuring the utilisation of associates and partners.

Some of the messages put to the firm's partners were blunt. "Collegiality appears to be an excuse to mask widely different levels of contribution", stated a report presented to the firm in May this year by Scott.

One presentation to partners under the heading 'The need for cultural change: attitude' expressed other home truths including:

• The difference between [Herbert Smith] and its peer group is the level of commitment
• We are at risk of being amateurs in a world of professionals
• There is no soft/nice Norton Rose/Lovells option.

The same presentation warns that the firm risks losing its best people if it does not address performance concerns.

PwC's findings on utilisation also showed some cause for concern, with the average number of fee earner chargeable hours standing at 1,240 in 2010 compared with an average of 1,412 for the rest of the UK top 10.

Further breakdowns show that utilisation among equity partners came in at an average of 1,019 hours, 151 hours below the average for equity partners in the rest of the top 10, while the firm's paralegal performance was 33.6% lower in 2010 than 2009 and 507 hours behind its peers. Mid-level associates also lag the firm's peer group in terms of utilisation, a major issue for any large law firm.

The firm is also moving to improve financial discipline, with its limited liability partnership (LLP) council recently deferring a decision on cash distributions to partners in response to a deterioration in cash collection this year.

Another issue for Herbert Smith is whether its cherished collegiality is compatible with its partnership structure. While the firm maintains a lockstep for its full equity partner – dubbed A partners – it has a large rank of B partners with fixed-share status. Partners were generally expected to serve three years before making the A rank, though this is now typically stretched to four years.

As such, the firm maintains a very high leverage for a practice focused on the high-end legal market – a structure which seems at odds with delivering a partner-led service. At the close of the 2010-11 financial year, Herbert Smith's leverage came in at 1:7.3, while the average across the magic circle stood at 1:4.18.

Critics argue that the firm's partnership model is a recipe for underperformance, making it too easy to park plodding senior lawyers on fixed-share status on one hand and having neither the culture or governance tools to manage performance within its equity ranks on the other. And as any managing partner will tell you, lockstep only delivers in a culture intolerant of indifferent performance. The firm's profitability is also far behind the elite five, with a PEP figure of £892,000 for 2010-11 compared with an average PEP across the magic circle of around £1.27m.

One ex-partner comments: "They have to de-equitise some people because there's a contingent of the firm that has been there for a long time and I don't think that they have the practice or the desire to build their practice to bring the levels up to the levels of the firm. Either they do that or they do away with lockstep entirely, or at least modify it. The trouble is the culture is so wedded to the lockstep."

Scott says: "I have no doubt that the lockstep will change in some ways in due course, but at the moment the focus is not on how we share the pot, but making sure the pot is bigger."

Some argue that performance concerns have contributed to a rash of senior losses.

The most notable departures in recent months have been the three-partner Paris litigation trio consisting of Denis Chemla, Michael Young and Erwan Poisson who resigned from the firm in May to join A&O. Shortly before their resignation, Chemla had been appointed as head of disputes for Continental Europe, the Middle East and Africa. (The number of departures to A&O has seen some partners mutter darkly about the magic circle firm trying to 'destabilise' Herbert Smith.)

Meanwhile, the resignation of investigations and corporate crime head Peter Burrell for Willkie Farr & Gallagher in the spring this year was known to be a real blow.

In addition, the firm has recently experienced a haemorrhaging of its capital markets practice with the loss of five partners globally since the summer, including well established partners Jim Wickenden and John Moore, respectively global head of capital markets and Asia head of US capital markets.

"One thing you can say for the people that have left is that they have gone to absolutely fantastic law firms, which speaks to the quality of our lawyers," says Hanen.

Still, one quote in a presentation to partners this year leaves little doubt about the cultural challenge facing the firm. Cited as a need for fundamental change in mindset at the firm, an anonymous Herbert Smith partner is quoted as saying: "The good thing about being an A partner at Herbert Smith is that you can ignore directions from the 'central brain' with which you disagree or think silly."

Reality bites

Whatever problems the firm has faced, 2011 has at least shown evidence of Herbert Smith grappling with them. Findings from the Blue Sky review were discussed with the partnership at the end of September. The firm decided that it needed to be more committed internationally. This decision ultimately led to the attempt to merge with its alliance – and the end of that alliance.

The alliance's break-up leaves Herbert Smith planning a major programme of international expansion under its own steam. A key aim will be an office in New York to focus on international arbitration, investigations and cross-border disputes – a move long supported by litigation but resisted by corporate.

Herbert Smith is also planning to re-establish its presence in Germany with an office as soon as the alliance agreement permits.

The firm had previously discussed relocating Asia head of US securities Kevin Roy to the region to open an office in Frankfurt to exist alongside the alliance. Whether this option will be revisited is unknown, but the firm has confirmed that its aim will be to have an office servicing capital markets along with M&A, disputes, energy and finance.

The firm has also outlined intentions to open in Francophone Africa and South Korea, with a Korea launch believed to be scheduled for 2012. One area the firm is still delaying making a decision on is South America. Plans to launch in the region were floated last autumn with no conclusion reached, and the firm has now said that it intends to revisit the possibility of opening in Brazil in the second half of next year.

There will also be much interest in whether the firm is prepared to make a major move in the Asia-Pacific region, where it already has a highly-regarded network. The firm held merger discussions with Australian leader Blake Dawson before the firm agreed a tie-up with Ashurst and has also been connected with Clayton Utz and Freehills. A number of rivals have argued it would seek to join the union of King & Wood and Mallesons Stephen Jaques, though no such step has yet apparently been taken. Nevertheless, Scott declares the firm is ready to consider a largescale union if the right deal presents itself.

There is also an expectation that the firm will begin managing its partnership more robustly, with talk of as many as 15 partners being exited, in part in response to performance concerns in the firm's corporate and banking practices.

The question for Herbert Smith now is over how much ground it has lost as the global legal market rapidly evolves and what its prospects of regaining its competitive position are.

There is no doubt that Herbert Smith has for too long put off difficult decisions, relying on superficial fixes to cover such problems, whether it is high leverage to give an exaggerated measure of profitability or an alliance to inflate its global standing.

However, its position remains in many respects enviable. The firm still has a top-tier litigation practice and strong corporate team, a good practice mix more generally and a strong network across Asia. It can also take comfort from a more than respectable performance in expanding its revenues during a difficult climate, with income growing 57% over the last five years to £465.1m.

Senior partners also argue robustly that the mood has been galvanised in recent months. Litigation head Sonya Leydecker (pictured) expresses common sentiments: "I'm very confident that we're doing the right things and heading in the right direction, and partners are rallying together to get us where we need to be. The next few years are going to be good."

With revenues approaching £500m, the firm has considerable scale to fund targeted expansion. While it overall cannot match the magic circle above it, neither does it yet face many potent rivals below it, though this could change over time as emerging giants like DLA Piper and Hogan Lovells consolidate their position.

Indeed, if the firm can break from its obsession with its magic circle status, it has considerable scope to carve out a distinctive position in the market on the back of its core litigation and corporate practices.

But in the end, the firm's fate will likely be defined by how credible the claims are from its senior partners that Herbert Smith is finally ready to address tough decisions. And here, at least, a new realist tone is being struck in which the firm accepts that it needs to proactively renew itself if it wants to stay relevant.

"Every moment in an institution's life is a crossroads and if there's any moment where you think that's not the case, then wake up," reflects Hanen. "If you want to survive then you better be alive to what's going on around you. You're always going to have problems. What you want to have is a better set of problems than before."

See legalweek.com for additional coverage of Herbert Smith's litigation and corporate practices.

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Herbert Smith's alliance – Be careful what you wish for

There wasn't much surprise when it happened, yet the end still stung. After more than a decade of courtship, Herbert Smith's hopes of securing a full union with allies Gleiss Lutz and Stibbe were dashed last month (19-20 November) when its German and Benelux partners formally declined a proposal to merge.

Their decision ended not just the notion of the three-way tie-up proposed by Herbert Smith to its longstanding partners in 
late September, but the 11-year alliance itself, with Herbert Smith formally withdrawing from the grouping on 23 November.

An internal memo regarding the split advised Herbert Smith partners: "Your response should be that we were not surprised that they decided not to proceed but we would have been delighted to merge if it had been possible to achieve a merger on terms acceptable to us." Despite the clipped corporate-speak, the memo – which also stresses the importance of conveying "a consistent and positive message" – accurately sums up the context in which the City firm was pressing for a deal despite knowing the reluctance of its allies was unlikely to be overcome.

Of course, the alliance was created in a very different market. Against the backdrop of an aggressive push into Germany from its larger City rivals, Herbert Smith first entered into an alliance with Gleiss in 2000. The strategically crucial German market had been quickly swept through by larger, more profitable foreign law firms – risking leaving Herbert Smith as the odd man out. With many senior lawyers expecting a post-euro Frankfurt to challenge London as Europe's financial centre, there didn't appear to be much time to waste.

And the initial attractions of the alliance for Herbert Smith were obvious. Being less than half the size of the big four magic circle firms, the alliance allowed Herbert Smith to concentrate its limited investment in its network of offices including Paris, Hong Kong, Beijing, Brussels, Singapore and Moscow. So while the firm was way behind, say, Linklaters in terms of an integrated European presence, it was able to build a formidable presence in key emerging economies (though surprisingly, given its historic tilt towards energy and infrastructure, the firm was a late entrant to the Middle East – not launching locally until 2007 with a Dubai outpost).

And the Stuttgart-based Gleiss brought undoubted credibility to the table, being established as just behind Hengeler Mueller as one of only two remaining heavyweight German independents with a brand that opened doors on Wall Street. The alliance solved some problems immediately, and hopes remained that the relationship could later evolve towards a full merger (though Herbert Smith always unconvincingly downplayed its merger intentions).

Benelux leader Stibbe joined the relationship in 2002, with the trio subsequently pitching together for projects, using joint engagement letters and single marketing initiatives as well as lawyer secondments. The alliance moved to establish referral partners in major markets, initially focusing its links in the US on Simpson Thacher & Bartlett and Cravath Swaine & Moore in New York and O'Melveny & Myers.

To the resentment of many of its rivals – in particular Slaughter and May – the trio also managed to get data providers such as Mergermarket to combine deal tallies across all three firms to produce a single ranking. Indeed, a persistent criticism of the grouping was that the alliance was maintained partly for how it played in deal rankings – a flimsy foundation to sustain any major business structure.

In essence, the birth of the alliance was a sound if opportunistic strategic shuffle. But Herbert Smith ultimately continued with the alliance well past the point where not only was it beginning to outlive its usefulness – which many would have said was five years ago – but also when it was becoming increasingly plain that Gleiss was not going to budge.

Meanwhile, an increasingly large gap had opened up between the official pitch regarding the alliance and what partners at the coalface described. While generally supported in corporate, a good number of partners at Herbert Smith reported having little to do with their allies. And it was never an elegant concept come pitch-time. As one ex-partner comments: "I don't think the alliance has ever worked – people don't buy it. It was set up to help capture US investment into Europe, but it is a hybrid of two models– best friends and own offices – which doesn't work."

Herbert Smith carried out reviews of the alliance model in both 2002 and 2007, both of which only served to preserve the status quo. By the time of the launch this spring of a major strategic review, dubbed Project Blue Sky, the mood had belatedly turned towards finally bringing the matter to a clear resolution – one way or another. Gleiss rejected the merger proposal in a vote over the weekend of 19 November, the same time as Stibbe took more informal soundings before coming to the same conclusion.

Even a sustained push over the last 12 months to convince Gleiss of the merits was not enough – though it does appear that there was considerable support for a merger among sections of the 280-lawyer German firm. The rise in profitability at Gleiss in recent years – which now exceeds Herbert Smith's profit per equity partner – is cited externally as a factor for the failure, though credible internal sources at both firms argue profitability was very much a secondary factor.

Herbert Smith senior partner Jonathan Scott (pictured) reflects on the firm's handling of the alliance: "Both David [Willis] and I would have wished to have had this discussion sooner. We clearly wanted it to be a stepping stone to a merger, but the Germans do value their independence. I will never know if suggesting it earlier would have been better. It was just time to bring the alliance to a head."

The alliance will now wind up over the next 12 months, with the firms continuing to work on existing mandates. Meanwhile, non-compete clauses in the alliance agreement mean Herbert Smith will also be unable to hire anyone from Gleiss for a further 12 months after the alliance formally ends.

If the handling of the alliance is a strategic misfire for the City firm, how badly it damages Herbert Smith in business terms is open to debate. While the Benelux region is not a priority, Herbert Smith is now committed to building up its own practice in Germany. Launching so late after its international rivals, the firm will either need to acquire a large established team or office or commit to slow and expensive expansion amid what will almost certainly be a challenging commercial market.

But while the saga has been an embarrassment for Herbert Smith, the fallout from the end of the relationship could ultimately be damaging for Gleiss. With some support for the Herbert Smith deal among Gleiss partners, it remains possible a team could jump ship, while other City rivals have begun targeting the German firm in the hope of attracting disgruntled partners.

Gleiss managing partner Rainer Loges argues, however, that his firm is on the right track. "Each partner has their own reasons for not wanting to merge, but I think the two main reasons as a firm are that we felt the alliance model was working well and we didnt see the benefit of a merger at this point. Second, we have been very successful as an independent firm and are convinced that we will be in the future. There is a strong feeling among all partners that the firm is worth keeping as it is and to preserve its independence."

For more, see Two tribes – the co-existence of corporate and litigation at Herbert Smith.

• Related: The history boys – Herbert Smith needs to escape its past