Ex-Regulator Has Harsh Words for Bankers and Geithner

Sheila C. Bair, who tormented Wall Street and its Washington allies as a banking regulator, is taking a fresh swipe at her foes in retelling the dark days of the financial crisis.

In a book to be released on Tuesday, the former chairwoman of the Federal Deposit Insurance Corporation takes aim at the bankers she blamed for the crisis. She also criticized fellow regulators, including current Treasury Secretary Timothy F. Geithner, for their response to the problems.

Ms. Bair painted Mr. Geithner, the former head of the Federal Reserve Bank of New York, as an apologist for Wall Street, opposing some postcrisis reforms. She questioned whether his effort to inject billions of dollars into nine big banks masked a rescue intended solely for Citigroup, a theory that other government officials have rejected.

“Participating in these programs was the most distasteful thing I have ever done in public life,” said Ms. Bair, in the book, “Bull By the Horns: Fight ing to Save Main Street from Wall Street and Wall Street from Itself.”

People close to Mr. Geithner note that he issued early warnings about Wall Street risk-taking and championed a regulatory crackdown on big banks.

Lee Sachs, a former top Treasury Department official, said on Monday that Mr. Geithner never acted to protect Citigroup or any single institution, but rather the entire system. In 2004, the New York Fed ordered Citigroup to pay $70 million for consumer lending violations.

“If anything, he was quite focused on the pain the country was suffering,” Mr. Sachs said.

Another government official who attended some of the meetings with Ms. Bair and Mr. Geithner said she was overstating the animus. A Treasury Department spokeswoman declined to comment on Ms. Bair's attacks because officials had not read the book.

In a statement, a Citigroup spokeswoman defended the bank, whose bailout earned a profit for taxpayers. “Since Vikram Pandi t became C.E.O. during the financial crisis, Citi has executed a strategy based on returning to the basics of banking and building a culture of responsible finance. It is a simpler, smaller, safer and stronger institution than it was five years ago and this record speaks for itself.”

Drawn from personal e-mails and notes, Ms. Bair's book joins the growing collection of financial crisis histories. While the book contributes a few revelations to the annals of Wall Street, Ms. Bair mostly notably highlights the challenge of being the only woman in the room. At crucial times during the crisis, she said, Mr. Geithner and other top regulators kept her in the dark.

“Maybe the boys didn't want Sheila Bair playing in their sandbox,” she wrote.

A Kansas native, Ms. Bair portrayed herself as a lifelong Republican with a populist streak. She was among the first regulators to sound the alarms about the subprime mortgage bubble. When the crisis emerged, she pushed for banks to replenish their capital cushions.

Ms. Bair, who is now senior adviser to the Pew Charitable Trusts, spent much of the book criticizing the go-go attitude that fueled the crisis. She also delivered blistering assessments of several crisis-era chiefs. She said, for example, that the deal-making skills of Kenneth D. Lewis, then Bank of America's chief, “were clearly wanting.”

But she saved the sharpest critique for Mr. Geithner, calling him the “bailouter in chief.”

When the F.D.I.C. was negotiating the contours of a plan to guarantee bank debt, she said that Mr. Geithner pushed the agency to charge banks only a “minimal” fee in return for the government support. Mr. Geithner and other regulators argued that it was counterproductive to assign hefty costs at a time when the industry needed saving.

“Geithner just couldn't see things from my point of view,” Ms. Bair wrote.

Over her five-year tenure, Ms. Bair struggled to b reak into the clubby nature of high finance, detailing in the book how Mr. Geithner and others shut her out of major decisions. The F.D.I.C., for example, was not involved in picking which banks would receive the first round of bailout funds. One regulator circulated an e-mail questioning “the audacity of that woman.”

Much of the book is devoted to the regulators' dealings with just one company, Citigroup, which received more government support than any other bank. Ms. Bair fleshed out her frustrations with Mr. Geithner and his desire, in her eyes, to treat a dysfunctional bank with kid gloves.

She even suggested that the industrywide bailouts were meant mainly to help Citigroup. Other commercial banks were in considerably better shape, she noted, and beleaguered investment banks like Morgan Stanley had secured private investments.

“How much of the decision-making was being driven through the prism of the special needs of that one, politically connect ed institution?” Ms. Bair wrote.

Other players in the crisis will most likely criticize her concerns as reductive, especially in light of major problems at Bank of America, which required two bailouts. While other banks were healthier than Citi, regulators opted for an across-the-board plan to instill confidence in the industry and the economy.

Even so, Ms. Bair laid out new details in the book suggesting that regulators went further than previously thought to protect Citigroup.

Early on in the crisis, she said, Mr. Geithner wanted Ms. Bair's agency to financially support Citigroup's planned $1-a-share acquisition of Wachovia. In turn, the F.D.I.C. would receive $12 billion in preferred stock and warrants.

Mr. Geithner and Citigroup held private talks about the deal without telling Ms. Bair, according to her account. Regulators then planned to allow Citigroup to count the stock as capital, a boost to the bank's “sagging capital ratios.”

Wh en Wells Fargo swooped in with a higher offer that required no government backing, Ms. Bair indicated her support for the new deal. Mr. Geithner, she said, was “apoplectic” and wanted the F.D.I.C. to stand behind Citigroup, which then raised its bid. The Fed ultimately approved the Wells Fargo deal and Citigroup required two infusions of government capital.

As Citi continued to suffer in 2009, Ms. Bair pressed for the bank to put its troubled assets into a “bad bank” supported by private money. Ms. Bair said she received no support from other regulators, who feared it would unnerve the markets.

In the book, Ms. Bair also scrutinized Mr. Geithner's approach to reforming Wall Street. Detailing new elements of the debate over the Dodd-Frank act, she argued that Mr. Geithner worked with Republican lawmakers to “water down” new regulations like the so-called Volcker Rule. Other people close to the Dodd-Frank debate recall that Mr. Geithner supported the ru le but agreed to exemptions to secure Republican votes.

When Ms. Bair and other officials mentioned to lawmakers their concerns about a draft version of the legislation, she said Mr. Geithner summoned regulators to deliver an “expletive-laced tongue lashing.”

For her part, Ms. Bair acknowledged her own temper flare-ups. When preparing for Congressional testimony one night, she recalled having stomped out of the room in a fit of exhaustion. Ms. Bair, who received a security detail after threats on her safety, also lashed out at journalists who she felt were unfair, underscoring her sensitivity to the glare of the spotlight.

“I get cranky when sleep-deprived,” she wrote.

Bull by the Horns Chapter 1 (PDF)

Bull by the Horns Chapter 1 (Text)

About-Face for Bankers\' New Lobbyist

“I went to Wall Street and told them to get their snout out of the trough because they are some of the worst offenders when it comes to bailouts and carve-outs and special deals.”

That was Tim Pawlenty, the former Republican governor of Minnesota, just over a year ago while running for president, railing against big banks.

So what's he up to now?

On Friday, he was named president of the Financial Services Roundtable, one of Wall Street's most influential lobbying organizations. In his new job, in which his predecessor was paid $1.8 million annually, Mr. Pawlenty will spend his days shuttling around Washington, trying to convince lawmakers that those “carve-outs and special deals” really are beneficial for the nation's banking system, though presumably without putting his “snout in the trough.”

To say that the choice of Mr. Pawlenty to represent the banking industry is odd would be an understatement, but his appointment is the clearest s ign yet of the flexible ethic that makes the revolving door in Washington spin faster.

Consider many of Mr. Pawlenty's previously espoused views, which are likely to need to change when his new job begins in November:

Mr. Pawlenty has repeatedly said he was against the bank bailouts that some say helped save many of the member firms of the lobbying organization he just joined. “I don't think the government should bail out Wall Street or the mortgage industry or for that matter any other industry,” he told Fox News in January 2011 when questioned about his final position on the matter, which appeared to shift at times.

Last summer, when the banking industry - and the Financial Services Roundtable, specifically - was lobbying Washington to raise the debt ceiling to avert a default, Mr. Pawlenty was taking a different tack.

Jamie Dimon of JPMorgan Chase had called a potential default “catastrophic.” Mr. Pawlenty's view? “Well, we don't know tha t,” he said when asked on MSNBC about the many dire predictions of the fallout of a default. He suggested that Republicans play chicken with the Democrats, questioning the very premise that the country was on the verge of default. “I hope and pray and believe they should not raise the debt ceiling,” he told voters in Iowa.

And while Wall Street may like - some say love - the Federal Reserve chairman, Ben S. Bernanke, Mr. Pawlenty has a starkly different view.

“I opposed his appointment last time, so it wouldn't be hard for me to oppose his reappointment next time, and I don't think he should continue in that position,” he told CNBC in June 2011.

And then there is his public view of President Obama, who, depending on which poll you believe, has a chance of still being president and regulating the industry that Mr. Pawlenty now represents. “President Obama isn't as bad as people say, he's actually worse,” Mr. Pawlenty declared at the Republican National Convention as national co-chairman of Mitt Romney's presidential campaign. He is leaving that post to take the new job. Now, in his new role representing the banking industry, there are even odds, if not better, that Mr. Pawlenty will have to work with an Obama administration. Those will be some fun meetings.

So how exactly was it that Mr. Pawlenty, who has no financial industry background, got the job?

He declined to comment for this column.

Despite Mr. Pawlenty's thinking on certain Wall Street issues, he has become a banking favorite over the last two years, speaking out against government regulation, and in particular, President Obama. The top five donors to his presidential run, grouped by company, were Goldman Sachs, Moelis & Company, Wells Fargo, Capital Group Companies and Morgan Stanley. In total, he raised just over $5 million. His name recognition alone will most likely open doors in Congress, which, in the world of lobbying, is half the battle.

Steve Bartlett, the current president of the Financial Services Roundtable, who will be retiring and handing over the reins to Mr. Pawlenty, said he believed his successor was “a consensus builder,” with “integrity” and was “bipartisan.” He paused for a moment before acknowledging that “bipartisan certainly isn't the first word to come to mind” given the last two years ahead of the presidential election, but that Mr. Pawlenty is “bipartisan-minded.” He said that “this is not a selection about who is going to be in office in the next four years.”

He also pointed out that, with some important exceptions, “the fact is that the issues we deal with typically don't get up to the presidential level.” (That may be true of lobbying that goes on for small amendments, but the overhaul reforms of Wall Street that were recently passed and many of which still must be enacted are on the radar of the White House, if they are not indeed driven by it.)

Before getting too far into the conversation, Mr. Bartlett warned that he was not intimately involved in the hiring process. “I was N.I.F.O. - nose in, face out.” He described a rigorous hiring process, saying that more than 100 people had been considered for the job and at least 30 people were interviewed.

When I asked how he felt about Mr. Pawlenty's comments about the bailouts, which seem at odds with his organization, he said: “Our views are totally consistent. I don't find those views to be at odds.”

But then he said, “different time, different context.” He continued by describing Mr. Pawlenty as “a guy sitting outside the Beltway,” who had the luxury and freedom to say how he felt.

How about Mr. Pawlenty's views on Mr. Bernanke?

“I haven't heard Tim Pawlenty on that,” he said.

And what about Mr. Pawlenty's views of defaulting on the debt ceiling?

“In Washington there is an old saying, ‘Where you stand depends on where you sit.' ”

Sadly, no truer words have ever been said about the influence of money on our nation's capital.

A Key Witness in Rajaratnam Trial Receives Probation

A former Intel executive who leaked secret information about his employer to Raj Rajaratnam, the fallen hedge fund billionaire, avoided prison on Monday as a judge sentenced him to two years' probation.

The former executive, Rajiv Goel, provided prosecutors with extensive assistance in prosecuting Mr. Rajaratnam. During the hedge fund titan's trial in 2011, Mr. Goel was one of the three key government witnesses who testified against him.

The other two witnesses - Anil Kumar, a former McKinsey executive, and Adam Smith, a Harvard-educated former Galleon trader - also received probationary sentences. Mr. Rajaratnam is now serving an 11-year sentence at a federal prison in Massachusetts.

Judge Barbara S. Jones, who sentenced Mr. Goel in Federal District Court in Manhattan, said that she had given him probation because of his extraordinary help in building a case against Mr. Rajaratnam and his essential testimony during the trial. She also noted that he had already paid a price for his crimes.

“You showed good sense in deciding to cooperate,” the judge said. “You have already been punished in the sense of the shame you feel for your family and your having lost your career.”

The United States attorney's office in Manhattan has charged 70 people with insider trading crimes since 2009. Of those, 64 have either pleaded guilty or been convicted at trial.

Many of the defendants served as pawns in the sprawling insider trading conspiracy orchestrated by Mr. Rajaratnam, who ran the hedge fund Galleon Group. At the height of his powers, Mr. Rajaratnam managed more than $7 billion and was considered one of Wall Street's savviest stock pickers.

Mr. Goel and Mr. Rajaratnam had stayed in touch since their days as classmates at the Wharton School at the University of Pennsylvania.

Their paths subsequently diverged. While Mr. Rajaratnam had become a hedge fund titan, Mr. Goel was an unsatisfied middle man ager at Intel. Mr. Goel, a native of Mumbai, India, envied the success and power of his old business school pal.

Mr. Rajaratnam lured Mr. Goel into his insider trading conspiracy by bestowing favors upon Mr. Goel. They were friends with financial benefits. He loaned him about $600,000. He made about $750,000 trading - often illegally - in Mr. Goel's brokerage account. At the same time, he would press Mr. Goel for confidential information about Intel.

Eventually, Mr. Goel succumbed to Mr. Rajaratnam's cajoling, giving him advance word of Intel's financial results and a major investment that the chipmaker had planned to make, allowing his old friend to earn hundreds of thousands of dollars in illegal profits.

At Monday's sentencing, David Zornow, a lawyer for Mr. Goel, called Mr. Rajaratnam a “master seducer” and “clever seducer” who ”played his client like a fiddle.”

Federal authorities investigating Galleon had secretly recorded telephone calls between Mr. Rajaratnam and Mr. Goel. The conversations revealed not only a close friendship but also the swapping of secret information about Intel. The two were arrested on the same day in October 2009.

While Mr. Rajaratnam fought the charges, a number of his alleged tipsters, including Mr. Goel, pleaded guilty and helped the government prosecute the disgraced hedge fund manager.
The 54-year-old Mr. Goel, who resides in Palo Alto, Calif., has not worked since Intel fired him after his arrest. Appearing in federal court on Monday and accompanied by his wife, Mr. Goel pleaded for leniency in a brief statement that he read to Judge Jones.

“I had a serious lapse of judgment and good sense and I deeply apologize,” said Mr. Goel, speaking in a soft mumble. “I hope that I am given another chance to repair the harm that I have caused and am deeply ashamed for the mistakes that I have made.”

Graphic: Mergers and Acquisitions, Top Financial and Legal Advisers

In the third quarter of 2012, mergers and acquisition activity was $455 billion worldwide. The U.S. share was 43 percent, or $195 billion.

Goldman Sachs remained the top financial adviser. Freshfields Bruckhaus Deringer were the top legal advisers, up from number nine in the third quarter of 2011.

Graphic: White-Collar World

ARTHUR L. LIMAN, the renowned litigator, was once described as a “big trouble” lawyer because businessmen in hot water sought his counsel. Ubiquitous during the latter part of the 20th century, Mr. Liman appeared at the defense table alongside prominent clients like the Wall Street financier Michael Milken. The public knew him best, perhaps, as the chief counsel to the Senate committee investigating the Iran-contra affair.

Mr. Liman, who died in 1997, is a patron saint of an elite corps of lawyers in the white-collar bar. A small group of “big trouble” lawyers repeatedly show up on the dockets of major corporate scandals across the decades, both as government prosecutors and as defense counsel.

The lawyers, some of whom are featured below, share similar backgrounds. A few have clerked on the Supreme Court, including John F. Savarese, for Justice William Brennan Jr., or Mark F. Pomerantz, for Justice Potter Stewart. As with David M. Brodsky and Carey R. Dunne, many do stints as prosecutors. And they often become partners at top New York law firms, such as Simpson Thacher or Cleary Gottlieb.

Their success is not simply measured in “guilty” and “not guilty” verdicts. While many have made their names trying prominent cases, much of their work is done away from the public view.

Mr. Liman described that work in his memoir, explaining that the true value of his counsel was “that far less glamorous, behind-the-scenes effort to guide my clients not only through the mazes of what is legal and illegal but in the direction of what is right, and try to do so consistently with discretion, sound judgment, and common sense.”

Big Law Steps Into Uncertain Times

The legal profession sits at the nexus of dealmakers' worlds, from Wall Street to Silicon Valley to Washington. As regulations change and the threat of litigation rises, the importance of lawyers has never been greater.

Yet the legal industry itself has been confronting great pressures. The collapse of Dewey & LeBoeuf exposed the potentially fatal flaws in the bigger-is-better mantra that has swept through Big Law in recent decades. And business - throttled by the financial crisis - is still not booming.

Some big blue-chip firms, like Cravath, Swaine & Moore; Debevoise & Plimpton; and Cleary Gottlieb Steen & Hamilton have managed to navigate the industry's challenges successfully by sticking to their traditional ways, as Peter Lattman describes on Page 9. (My fellow New York Times columnist, James B. Stewart, has a poignant related essay on Page 8, reflecting upon his time as an associate at Cravath in the 1970s.)

So all is not bleak. Still, a more sweep ing transformation may be on the horizon. And it may look a lot like Axiom Law.

Axiom is a firm founded by Mark Harris, a former lawyer at the white-shoe firm Davis Polk & Wardwell. Mr. Harris is trying to rewrite the law firm business model. His firm, with some 900 lawyers, has no partners. The goal is to undercut the prices of the bigger firms on large cases and projects that require tens of thousands of hours. He hires lawyers of all stripes: some, from the biggest New York firms, do not have the drive or passion to become partners; others are lawyers who work from home.

Mr. Harris likens the difference between his firm and others to that between McKinsey & Company, the high-priced strategic consulting firm, and the consulting arm of PricewaterhouseCoopers. Cravath is like McKinsey, he says; Axiom is like PricewaterhouseCoopers. In the future, he imagines that companies will still hire the likes of Cravath for the biggest, most complicated work. But they will hire Axiom to trudge through projects that involve millions of pages of documentation and do not need to be done by an associate just out of law school billing $400 an hour. The law firms in the middle are likely to be squeezed.

“The legal industry is about to go through a transformational moment,” Mr. Harris says.

Perhaps change cannot come soon enough. Clients are unhappy, feeling overbilled and underserved. Lawyers are similarly miserable, feeling underpaid and overworked.

What happened to the legal industry?

The problem, many lawyers say, is “P.P.P.” (Some firms call it P.E.P.) P.P.P. stands for profit per partner. (P.E.P. is shorthand for profit per equity partner.) It has become the ultimate metric for measuring success among law firms. When American Lawyer magazine began publishing a ranking based on profit per partner in the early 1980s, it revolutionized the industry, but it also arguably led to a dangerous race among firms that left clients as a secondary priority.

Indeed, says Mr. Harris of Axiom, about three decades ago “the interests of law firms went from serving the clients to serving themselves.”

As Michael H. Trotter, a partner at Taylor English Duma in Atlanta, says in his book “Declining Prospects” that there are only a few ways to increase profit per partner. One way is for firms to “charge their clients more for what they do”; another is for them to “do more work for their clients by working more hours or using more lawyers”; a third is to acquire more clients; and the last option is for firms to “reduce their overhead by paying less rent, restraining the compensation of their lawyer-employees and other personnel.”

None of those options appear to be in the client's interest at all.

This is not a new lament.

A decade ago, Robert E. Hirshon, then president of the American Bar Association, declared that “the billable hour is fundamentally about quantity over quality, repetition over creativity.”

He explained that “because a lawyer's time is not an elastic variable, increased billable-hour requirements are squeezing out other aspects of what it means to be a lawyer.”

The focus on profits per partner is one reason so many companies have increasingly tried to move legal work away from big firms and have hired internal lawyers. And that means, Mr. Trotter says, that “the leverage that law firms have utilized to generate profits will go down and they aren't going to need as many associates.”

Depending on how the industry transforms its business model, an old joke may need to be rewritten.

A prospective client calls a lawyer, asking, “How much would you charge for answering three simple questions?”

The lawyer says, “A thousand dollars.”

“A thousand dollars!” the prospective client shouts. “That's very expensive, isn't it?”

“It certainly is,” the law yer replied. “Now, what's your third question?”

Culture Keeps Firms Together in Trying Times

IN the year before it collapsed, Dewey & LeBoeuf went on a recruiting binge. The law firm poached 37 partners from rivals with multimillion-dollar, multiyear guarantees. Existing partners typically learned about new colleagues via e-mail.

Cravath, Swaine & Moore does things a bit differently.

When Christine A. Varney, the Obama administration's former top antitrust lawyer, joined Cravath last summer, she was just the fourth outside partner in a half century. But first, she had to meet all 83 partners - and any retired partners who wanted to sit down with her.

“I joked with Christine that it was like we were buying a horse,” said C. Allen Parker, who will soon take over as Cravath's presiding partner. “Everyone had to check her gums.”

Cravath parked her in a conference room. Partners streamed in and out. Five came in, two left. Four more came in, three lingered. Across two days, she was interviewed by the entire partnership.

“The big question was not whether she was a good lawyer, but whether she was a Cravath partner,” said Evan Chesler, the firm's outgoing presiding partner. “Would she be a good fit?”

A few weeks later, the Cravath lawyers assembled and unanimously voted her into the partnership. She received no signing bonus, no guarantee, no special deal. Instead, Cravath is paying her according to the firm's seniority-based, lock-step system, which sets the spread between the highest- and lowest-paid partners firmly at 3 to 1.

“We're not going to buy a lawyer with a big guarantee,” Mr. Chesler said. “That's not how we do things. That's not the Cravath way.”

The Cravath way? Really? One might dismiss such high-minded rhetoric as idealistic poppycock from a white-shoe lawyer hanging on to antiquated notions about the practice of law.

But the Cravath way, and Mr. Chesler's impassioned views about law firm partnerships, may be worth paying attention to at a challen ging moment for corporate law firms. The implosion of Dewey earlier this year - the largest law-firm bankruptcy in history - exposed the dark side of prevailing trends in Big Law. Four years after the financial crisis, the business climate remains challenging.

“At a difficult time in the legal industry, and at a time when the failure of Dewey illustrates how much can go wrong in the existing competitive environment, it makes good sense to look at the truly elite law firms that have done things right,” said Michael Trotter, a lawyer in Atlanta who has written books about the profession.

Cravath, along with Debevoise & Plimpton and Cleary Gottlieb Steen & Hamilton, are three remaining law firms that adhere to a strict lock-step compensation system, paying their partners in a narrow range according to seniority.

There are no stars or empire builders at these firms. No one gets paid extra for bringing in clients, so there aren't disputes over who gets credi t for new business. There is complete transparency: All the partners know, to the penny, what every other partner makes. (A few other prestigious firms, including Davis Polk & Wardwell and Wachtell Lipton Rosen & Katz, pay partners in a tight band and maintain similar cultures.)

These firms are sticking to their old-school ways amid profound changes in the legal industry. Driving this transformation has been a change in the lawyer-client dynamic. Law firms once had entrenched, enduring relationships with clients. Citibank worked with Shearman & Sterling. Chase used Milbank Tweed. I.B.M. employed Cravath.

But today, client loyalty has deteriorated and relationships are up for grabs. In-house legal departments have grown in size and influence. Under pressure to contain soaring legal costs, corporations now spread the work around. Also, many companies look to hire specific lawyers rather than an entire firm, creating a free-agent market for top producers.

“I t's a variant of too big to fail,” said William Henderson, a law professor at Indiana University. “Everybody's worried that if you don't pay your rainmakers they'll leave, and then the firm will blow up.”

Many of the country's largest law firms, a group that includes DLA Piper (4,200 lawyers) and K&L Gates (1,800 lawyers), are trying to meet the demands of their increasingly global client base with rapid growth through mergers and international expansion.

These firms are luring partners away from competitors by offering rich salary guarantees. And they promote an eat-what-you-kill compensation structure that has created a widening gulf between the pay - and the morale - of a firm's stars and its so-called service partners.

At Dewey, the ratio between the highest- and lowest-paid partners ballooned to more than 25 to 1. In 2011, Dewey's merger-and-acquisitions star, Morton A. Pierce, secured an eight-year contract paying him $8 million a year. Junior p artners made $300,000 annually.

“When a law firm grows too fast, it almost by definition loses its culture,” said Cameron F. MacRae III, a former Dewey lawyer now at Duane Morris. “And a star system weakens the bonds of a law firm partnership and destroys the shared sense of purpose.”

A shared sense of purpose is something you hear repeatedly when discussing the cultures of Cravath, Cleary and Debevoise. Listen to Michael W. Blair, the presiding partner at Debevoise, and one could think he presides over a utopian socialist community. He throws around phrases like “one for all and all for one” and “we're the one-firm firm.” He highlights Debevoise's genteel culture - its teamwork, camaraderie and decency.

The lock-step system, he said, reinforces that culture. The idea is to attract and motivate partners with a shared set of values who want to dedicate their life to the firm, and not just look for the next big thing themselves.

“The o nly way a partner does better is if the firm does better,” Mr. Blair said. “Individual success doesn't mean very much here; we're all incented for collective success.”

At Cleary, Mark Leddy, the firm's managing partner, said that the firm did not attract - and had no tolerance for - lawyers with huge egos and sharp elbows.

“People who want to be a star and make $10 million a year don't fit in here,” said Mr. Leddy. “Some of these lawyers are extremely talented and they go on to make $10 million a year. But breaking the lock step system for them would be an unacceptable cost to our culture.”

Several stars have left Cravath, for instance, most prominently David Boies, a trial lawyer who started his own firm. On the corporate side, Robert A. Kindler departed after 20 years for a career in investment banking and is now a vice chairman of Morgan Stanley.

Mr. Chesler said that those were rare exceptions. “Planets occasionally spin out,” he said.

Departures do not appear to have affected Cravath's profitability. The firm ranks as the fifth most profitable in the country, according to The American Lawyer magazine, with profits per partner of $3.1 million. Cleary's profits per partner are $2.7 million and Debevoise's are $2.1 million, the magazine says.

The firms' strong performances and blue-chip clients are, of course, a major reason they can maintain the lock-step system.

“Any of these three firms would change their compensation system overnight if they became unsuccessful,” said Bevis Longstreth, a retired Debevoise partner. “Let's face it, one thing that holds people together is success.”

Maintaining a partnership culture presents particular challenges for Cleary and Debevoise. While Cravath has nearly all of its 430 lawyers in New York (other than a small London office), Cleary, with 1,200 lawyers, and Debevoise, with 650, have vast international operations. Cleary will open its 16th office, in Seoul, later this year.

“International expansion puts a strain on our culture,” said Mr. Leddy of Cleary. “We're constantly asking ourselves as we grow how to sustain the glue holding us together.”

Maintaining those bonds is one reason the firms are so circumspect about lateral hiring, preferring homegrown talent instead.

And it is rare for partners at Cravath, Debevoise or Cleary to leave for competitors. But in 2005, Ralph C. Ferrara of Debevoise turned heads by moving to another firm. Mr. Ferrara, a securities litigator who brought in big, lucrative cases, frequently complained about the lock-step system. He bristled that some partners earned as much as he did yet had no clients of their own. He also was frustrated that he couldn't expand his business by hiring partners from other firms.

Realizing he would not change the ways of such a hidebound institution, Mr. Ferrara left Debevoise after 23 years to join LeBoeuf Lamb . After Dewey and LeBoeuf merged, he became one of Dewey's highest-paid partners, earning about $6 million annually. Mr. Ferrara recently agreed to return about $3.4 million of his compensation to help pay Dewey's creditors.

“As things have turned out, leaving Debevoise ended up being an imprudent decision,” said Mr. Ferrara, who now works at Proskauer Rose. “In my heart, I never left Debevoise; it is a place that I still love to this day.”

It is rare to hear a lawyer speak of a law firm with such affection, let alone one that he left years ago. Job satisfaction at corporate law firms is notoriously low, what with the long hours, demanding clients and sometimes mind-numbing work.

While the unhappy ones might be buried in a law library somewhere, partners at the lock-step firms proclaim love for their jobs.

“It might sound corny, but I really think our culture makes this a more relaxed and collegial and fun place to work,” said Mr. Leddy of Cleary.

A new compensation survey by the legal consultant Major, Lindsey & Africa backs up Mr. Leddy's sentiment. Seventy-nine percent of respondents from pure lock-step firms say they are satisfied with their work, with 55 percent describing themselves as very satisfied. That is more than double the percentage at other law firms.

Count Ms. Varney, who has been at Cravath for a year, as among the satisfied. She has provided antitrust advice on several deals since arriving, including Microsoft's investment in Barnes & Noble and Grupo Modelo's combination with Anheuser-Busch.

“When you take individual financial incentives off the table and focus on clients and collaborate,” Ms. Varney said, “the practice of law can be a rewarding profession first and a successful business second.”

A Law Firm Where Money Seemed Secondary

When I crossed the threshold of Cravath, Swaine & Moore 36 years ago next month, fresh from the bar exam and Harvard Law School, I entered a new world and began what turned into a life-changing experience.

Cravath's offices were at One Chase Manhattan Plaza, headquarters for the Rockefellers' Chase Manhattan Bank and a magnet for prominent law firms. I was just a short elevator ride away from lunch with my friends at Davis Polk & Wardwell; Milbank, Tweed, Hadley & McCloy; and Willkie Farr & Gallagher. All of Cravath's lawyers and support personnel fit into two floors - 57 and 58 - and everyone knew one another, except for a cadre dispatched to Armonk, N.Y., for an I.B.M. case and small offices in London and Paris. As a newcomer, I shared an office with a more senior associate, who got the coveted window seat.

Cravath did its best to keep the outside world at bay and minimize distractions. Among these was what other lawyers were being paid. I was told when I arr ived that my salary would be $16,500 and it was Cravath policy to always pay the highest rate. While my friends at other firms were speculating avidly about whether, say, Sullivan & Cromwell would raise starting salaries and others would follow, at Cravath we knew that if they did, our firm would top them. We were all paid the same based on seniority, and bonuses were unheard-of, so there were no jealousies or resentments.

I never knew what partners made. I could only discern from the firm's directory - the Park and Fifth Avenue addresses of their apartments and Long Island and Connecticut country homes, some with names like “Brook Farm” - that they didn't have to worry much about it.

Considering that a cottage industry has since grown up around the notion of law as a business, there was surprisingly little talk of money, at least not with associates. One of my tasks was to organize the billing records for the senior partner I worked for. But all the client got was a simple statement, rendered in elegant script, “for professional services rendered,” followed by a large number. I once asked the partner if clients ever demanded a more detailed breakdown or questioned the sum. He paused as if that were a novel idea. “That's not the kind of client we'd want to have,” he replied.

Even then Cravath lawyers worked long hours. In my book “The Partners,” I told the story of a young partner who billed 26 hours in a single day by flying to the West Coast, gaining three hours thanks to the time-zone change while working on the plane. But the firm also said it encouraged civic and philanthropic activities.

I played in a quintet that gave chamber music performances at retirement and nursing homes. One evening I was on the subway examining my music when a partner materialized at my side. He saw the score, seemed interested, and asked where I was going. Soon after, the partner I was working for called me to his office a nd shared an experience from his life. He'd grown up in New York and gone into the military. Boot camp had been a challenging but rewarding experience. The only time he'd been unhappy was after a weekend visit to the lights and diversions of Manhattan. By staying at camp, he had avoided those distractions, and came to enjoy the tough discipline of the Army.

I pondered that message. He never mentioned the quintet, but soon after that I dropped out.

After several years I felt it was time to consider my future. I had wonderful assignments and congenial and stimulating colleagues. Still, I could see the winnowing process firsthand. Of the 20 or so associates hired each year, one or two might be chosen to be a partner. Some years there were none. I waited each year with keen interest to see who was tapped for the equivalent of lifetime tenure. What did they have in common?

They weren't necessarily the brightest. Everyone there had impressive test scores and acad emic credentials. They weren't, as I had expected, the hardest-working. Everyone aspiring for partner worked long hours and gave the appearance of hard work. They weren't the most personable. Cravath was refreshingly meritocratic, and gender, race, religion, sexual orientation, and social and academic pedigree all seemed irrelevant.

Finally it came to me: The one thing nearly all the partners had in common was they loved their work.

This came as a profound revelation. Of course they worked long hours, because it didn't feel like work to them. They took great satisfaction in the services they rendered their clients.

You couldn't fake this. The partners seemed to have some sixth sense. I enjoyed my work. But I had to admit I didn't love it the way they did.

At times I found this mystifying. How could anyone tackle a complex tax problem with such enthusiasm? Or proofread a lengthy indenture agreement? Why couldn't I love a prestigious, high-paying, secur e job like they did?

At the same time, it was liberating. It was obvious to me that someone who loves his or her work, whatever that might be, has a huge competitive advantage, not to mention a satisfying and enjoyable life. Somehow people who love what they do seem to make a living. So I started pondering what I might love as much as some of my Cravath colleagues loved practicing law.

When I announced my departure and took a big pay cut to become a reporter, I know some of my colleagues took it personally. They felt I was rejecting not just them, but their profession. I'm not sure I was ever able to explain my thinking, but to my mind I was paying them the highest compliment.

Over the ensuing decades. Cravath doesn't seem to have changed all that much (although I assume today it offers clients detailed billing records). But apart from Cravath and a few others like it, the world of big law firms has changed radically. Firms are huge, with thousands of lawye rs. They have branches all over the world, with partners who may see each other only at an annual retreat, if then. They buy up entire firms, merge and separate, and discard unproductive lawyers. Many so-called partners are little more than associates with bigger salaries. How much money other lawyers make has gone from a taboo to an obsession. And everywhere I go, lawyers at big firms - associates and partners alike - tell me they're unhappy.

I wonder how many lawyers at Dewey & LeBoeuf loved their work? I know some did because I've talked to them. Perhaps if there were more of them, their colleagues wouldn't have had the time or inclination for all the jockeying and infighting over financial guarantees and compensation that led to the firm's demise.

James B. Stewart, who was trained as a lawyer, writes the Common Sense column for The New York Times.

Groupon Moves Into Restaurant Reservations With Savored Deal

Over recent months, Groupon has sought to expand its core business of daily deals with a number of new business propositions, including with ventures like a mobile payment system.

Now, it appears that the online coupon purveyor is moving into restaurant reservations - and a little into OpenTable‘s domain.

Groupon said on Monday that it had bought Savored, an Internet start-up that offers customers ways to reserve tables at restaurants in 10 cities across the country. Terms weren't disclosed.

Unlike its more established competitor, OpenTable, however, Savored offers discounts for its customers. The business model is a bit like Hotwire.com's, in that Savored scans for openings at its partner restaurants and offers discounts - up to 40 percent, according to Groupon, though the company's own site describes the savings as “uncapped” - to customers.

The proposition is that both sides win: restaurants get patrons they otherwise wouldn't, and custome rs get both dining reservations and a discount.

Savored is meant to supplement the existing Groupon Now service, which is aimed at giving customers a list of discounts should they decide to indulge in impromptu shopping. The bigger goal is in turning Groupon into more than just a sender of daily deal e-mails: it's to transform the company into a broad platform for merchants, allowing them to provide discounts, book restaurant reservations and travel packages and track customer spending.

“Savored's platform nicely complements Groupon's efforts in yield management, an area we've pioneered with Groupon Now,” Dan Roarty, the vice president of Groupon Now, said in a statement. “We look forward to working together to achieve a common goal â€" making dining out even more fun and affordable for consumers while helping restaurateurs manage inventory and grow their businesses.”

So far, however, investors haven't really taken the pitch to heart. Shares of Grou pon were down 2.3 percent in late afternoon trading on Monday, at $5.15, and have plummeted more than 80 percent since the company began trading last fall.

Evolving Global Strategy Gives Law Firm an Edge

LONDON - EDWARD BRAHAM took over the corporate practice at the London-based law firm Freshfields Bruckhaus Deringer at a rough time for deal-making. In the midst of the global economic slump in early 2009, banks were reluctant to lend money and companies did not want to spend their cash.

So Mr. Braham, 51, and his colleagues went on the offensive.

After reaching out to partners in the firm's 28 offices spread across 16 countries, Mr. Braham decided to refocus the group's strategy, emphasizing its international reach. To increase ties between Europe, North America and Asia, Freshfields hosted its own version of speed-dating at partners meetings, where lawyers outlined their areas of expertise to colleagues until a bell signaled them to switch.

The firm also developed cross-border groups assembled around practices like capital markets and mergers and acquisitions. Each group, composed of roughly 15 senior lawyers from different countries, holds monthly con ference calls to discuss trends and developments in their respective regions.

“I was convinced we could stay at the front of the pack,” said Mr. Braham, an Oxford University graduate who started his legal career at Freshfields in 1985.

The global strategy has helped the firm to weather the financial turmoil.

Freshfields advised on almost a quarter of the European-related mergers and acquisitions announced during the first six months of the year, according to the data provider Thomson Reuters. It is working with the mining giant Xstrata on its proposed $90 billion merger with the commodities trader Glencore, as well as United Parcel Service on its planned $6.8 billion takeover of the Dutch shipping company TNT Express. Anheuser-Busch InBev also hired Freshfields as part of its $20.1 billion deal to buy the half of the Mexican brewer Grupo Modelo it did not already own.

With $162 billion of announced deals, Freshfields now ranks as the top law firm for the first half of 2012, up from eighth over the same period last year. Mr. Braham declined to comment on specific deals.

Still, the slump in acquisitions has forced Freshfields to adapt. The law firm has reorganized its teams, moving lawyers from depressed sectors, like private equity, to high-growth areas like restructuring.

Freshfields is also capitalizing on the European debt crisis. The firm is advising the Bank of England, the country's central bank, and the German Finance Ministry as they navigate the current financial problems. In debt-ridden countries like Spain and Italy, the law firm is helping struggling companies restructure their businesses and sell unwanted assets.

“Faced with the euro zone problems, there's a flight to quality by corporate clients across the markets where we operate,” Mr. Braham said. “If you are in the flow right now, it's amazing how much is actually going on.”

Freshfields has not been immune to broader pr oblems affecting the legal industry. Since 2008, the firm has laid off lawyers in weaker units, like real estate. Analysts also warn that a prolonged downturn in deal activity is likely to weigh on the firm's earnings. The law firm reported a 9 percent drop in its net profit, to £535 million, or $869 million, in the 12 months through April 5, 2012.

Freshfields has learned to evolve over its long history. Founded in 1743, the firm took advantage of the deregulation of the British financial services industry in 1986 to gain new clients, like the private equity firms Kohlberg Kravis Roberts and CVC Capital Partners.

In the 1990s, it expanded rapidly overseas, opening offices in Beijing, Moscow and Washington. In 2000, Freshfields merged with its German counterpart, Deringer Tessin Herrmann & Sedemund, and the Austrian-German firm Bruckhaus Westrick Heller Löber.

After the dot-com bubble burst, the firm was forced to reorganize, shedding more than 100 pa rtners. The move prompted an age discrimination lawsuit against the firm, which it eventually won.

By focusing on global deal-making, Freshfields says it has been able to better compete with the major American firms, like Sullivan & Cromwell and Simpson, Thacher & Bartlett. Matthew Herman, head of the firm's corporate practice in the United States, says the ability to call on partners from as far as China and Germany gives it an edge.

“For larger deals, it's essential for law firms to have a global reach,” said Edmund-Philipp Schuster, a law professor at the London School of Economics and former corporate lawyer at Baker & McKenzie. “Being able to work across borders is an important advantage.”

The firm's international brand also has helped it attract clients in the emerging markets looking to expand overseas. The deals, which often involve state-owned enterprises, can cause legal headaches, as Western regulators scrutinize takeovers from new global powers like China.

When Freshfields advised the Chinese automaker Geely on its $1.8 billion takeover of the luxury brand Volvo from Ford in 2010, the law firm had to deal with intellectual property issues that spanned three continents. To get the deal done, a team of lawyers in Hong Kong, London and New York devised a structure that allowed Ford to keep control of its closely guarded technology, but gave Geely access to certain patents to continue manufacturing Volvo cars. The cross-border deal also granted the Chinese company control of Volvo's manufacturing plants in Europe, while allowing Geely to extend manufacturing into China.

“Around one-third of what we're doing now is connected to emerging markets,” Mr. Braham said. “That's where our clients want to be.”

The Economics of Law School

Law schools have come under fire during these tough economic times, with critics saying that they leave too many graduates in debt, chasing too few employment opportunities. But it could be worse. Consider the plight of veterinarians.

The average tuition and expenses for a veterinary degree at a private school has doubled in the last 10 years to over $200,000, well above the typical cost of law school. Yet their pay remains moribund at an average of $66,469 - much less than lawyers.

But unlike law schools, veterinary school is not regularly being called a scam or bubble. In fact, applications to veterinary schools were up about 2 percent last year.

Meanwhile, the number of applicants to law school is down 13.7 percent for this year's class after a 10 percent drop from 2011, according to the Law Students Admissions Council.

Perhaps today's youth are more eager to defend animals than people. Or maybe lawyers are better at voicing their dissatisfactio n.

Regardless, the trend away from law schools has prompted much discussion about what structural changes may be needed. Should law schools charge less? Should they strip down their programs? Should they abandon their collegiate ivory towers in favor of a trade-school approach by having “real world” lawyers teach practical skills?

None of these solutions, however, are likely to improve the economics of law school.

I believe that law students do need more training in practical skills, but a focus on that is probably only going to make law school more expensive.

A single law professor can easily teach 70 students in one contracts law class, but a clinical professor is limited to six to 10 people a class. If reducing costs is the goal, then more clinical education will only increase it.

A second alternative is to pay professors less, or replace them with practitioners who would also be paid less. The average senior law professor who is not at a top-ranked school makes $130,000 to $150,000 according to a survey by the Society of American Law Teachers. It's a nice salary, but certainly not comparable to what a law firm partner earns.

This year, the law school at Ohio State University, where I teach, hired a former editor in chief of The Michigan Law Review and a Supreme Court clerk. Both could be paid far more in the private sector, where the hiring bonus alone for a Supreme Court clerk can be $280,000. If the salaries for their positions are even further reduced to make Ohio State's law school cheaper, they are likely to be replaced by less qualified people.

For this reason, good practitioners are likely to be even more expensive than law professors. After all, the average partner at a big law firm can make well over a million dollars a year.

So what if universities hire less qualified, lower-paid practitioners instead, you may ask? Well, quality matters.

U.S. News & World Report lists 15 la w schools where tuition is currently less than $15,000 a year. CUNY School of Law, in New York City, has an in-state tuition of $12,090 and is ranked in the third tier by U.S. News. But there is not a flight of applications to these lower-cost schools from higher-paying ones. Instead, students still flock to top-tier schools with the highest-quality professors. In 2011, CUNY's applications were down from the year before.

Creating less expensive law schools with less-qualified staff may give graduates a degree, but that may not better qualify them for jobs. This points to another inherent problem with critiques of law schools - all are lumped together. This points to another inherent problem with critiques of law schools - all are lumped together.

There is, however, a qualitative difference between the top 15 law schools and the rest. These elite schools charge sky-high tuition that can exceed $50,000 a year. But graduates have a good chance of securing a covete d job with a starting salary of $165,000 a year - a salary that is likely to improve as the economy does. For a 26-year-old, that's certainly good money. Duke, for instance, which was No. 11 on the U.S. News rankings, said its graduates had a 95 percent employment rate last year, with an average private sector salary of $160,000.

There may be valid criticism about lower-ranked law schools, particularly those U.S. News places in the third and fourth tier. Such private schools often charge significant tuition but do not obtain the same employment outcomes. The question is whether changes can be made to lower their costs, and whether this will lead to better opportunities for their graduates.

The problem of law school is one that is ubiquitous to higher education - the current model is inherently expensive but even today, lower-priced alternatives don't seem to meet the standards or be desired by many students.

It is here where revolutionary technologies like online learning may come into play. If it becomes accepted that many basics like contracts law can be easily taught by one professor online to thousands of students, then a law school can charge a lot less. But this is still mostly a theoretical change embraced by those outside academia that has yet to sweep universities. Even with one online course, some local presence will be needed to facilitate learning, particularly if there is skills training involved.

It may not be simple enough to just pin the blame on the costs of law school education. For 2011 law school graduates, as of nine months after graduation, only 65.4 percent were employed in jobs requiring passage of the bar. And law schools should learn to be more innovative, as other types of graduate programs are doing.

Law schools have also hurt themselves badly by failing to fully disclose certain statistics, including their employment rates. It is clear that the number of lawyers in the United States wil l fall as fewer people apply to law school. But this trend will probably shrink enrollment, not decrease the number of schools over all.

In the longer term, the question is whether there will be a recovery in law jobs as the economy heals. There is hope that will be the case. One study has found that the average lawyer will earn about $4 million - or twice as much as someone with a bachelor's degree - over their lifetime of employment. In addition, law school provides a general education that is useful in other areas. Both presidential candidates have law degrees, as do the chief executives of a substantial number of companies in the Standard & Poor's 500-stock index.

A hard look at reform appears to be a worthy goal, but any changes should consider whether they will actually reduce costs, and provide something students want. The problem of law school is thus the problem that all schools of higher education, even veterinary school, face.

Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the world of mergers and acquisitions.

Under Investigation, and Doing the Investigation

Whenever there is a report of corporate misconduct, a predictable response is that the company in question says it has hired a reputable law firm to conduct a thorough investigation, and it pledges to cooperate with the authorities to resolve the situation quickly.

Prosecutors usually announce their own investigation, if they say anything at all. In reality, the government often uses reports provided by the companies to decide how to resolve the case.

Yet this raises significant questions about conflicts of interest. Is it a good thing that much of the effort to police corporate misconduct seems to have been shifted to lawyers retained by the companies under investigation?

A corporate investigation can easily cost a company millions of dollars, and sometimes much more. The German conglomerate Siemens paid over $1 billion in legal and accounting fees for its global inquiry into extensive bribery by employees.

Companies would prefer not to conduct an investigation at all. But having a law firm they hired overseeing the inquiry means they can maintain control over information, and minimize any surprises.

For the legal profession, conducting corporate investigations is a growth industry. Louis J. Freeh, the former F.B.I. director whose work includes an extensive report on the sex abuse scandal at Penn State, recently agreed to merge his firm into Pepper Hamilton - a sign that large firms want the cachet of a big name to attract more business.

For the government, waiting until the company's investigation is complete means there is no significant commitment of taxpayer resources on a case that may not result in prosecution. And there are good reasons to defer to the company's lawyers, at least at the early stages of a case.

If a company's overseas conduct is at issue, government investigators must slog through numerous bureaucratic steps to gather evidence. Private lawyers do not have to follow the same ru les, so they can often gather information more quickly.

Employees may be more forthcoming with the company's representatives, whether out of a sense of loyalty or the misconception that they are not at risk for prosecution. Even if employees are told that information may be turned over to the government, there can be a sense of comfort from being a team player, regardless of whether the details implicate them.

Lawyers from outside firms also often gain a better understanding of a company's culture and operations. In-house counsel can point out where to look for information and explain how decisions were made. That kind of inside knowledge usually would not be available to prosecutors because it could expose confidential information.

It may seem as if having a law firm oversee the investigation of corporate misconduct benefits both the prosecutors and the company in the inquiry. But there is a risk prosecutors may not be getting a picture of all wrongdoing, and the potential for the report to be slanted in a way to protect senior management.

The lawyers who conduct investigations are often former prosecutors or regulators themselves, sometimes coming back to negotiate with their old offices on behalf of new clients. This can create an interesting twist on the so-called revolving door, when lawyers leave private practice temporarily to take government jobs. Some have said that such lawyers may be more lenient on the companies they investigate in the hopes of getting a job later on.

Robert Khuzami, the enforcement director at the Securities and Exchange Commission, disputed that view, saying recently that staff lawyers “would not risk reputation and career and even jail by undermining an investigation for a possible future job prospect.”

The real problem, in my opinion, with the revolving door may be that former government lawyers are trusted because they developed reputations as tough prosecutors and regula tors. Companies can use that reputation to their benefit when the lawyers return to their former offices to represent them.

In practice, the lawyers employed to conduct corporate investigations must draw conclusions about conduct that falls into gray areas. Unlike murder and robbery, white-collar violations are difficult to identify and often call for nuanced judgments about intent and knowledge.

When lawyers report their conclusions, are they free from bias about the company that is also paying their bills?

Certainly, questions have been raised about the value of such reports. Since the financial crisis hit, few senior managers have been identified as among those responsible for a violation.

Prosecutors relying on law firms to do the legwork for an investigation and report on potential violations may not be in a position to challenge their conclusions by conducting an independent inquiry. The Justice Department simply does not have the resources to i nvestigate a company to the same degree as outside lawyers operating with seemingly unlimited resources.

One solution is to expand whistle-blower programs to reward those who report corporate violations directly to the government. The Internal Revenue Service recently awarded $104 million to a whistle-blower who provided information that helped bring down the wall of secrecy around Swiss banks.

Whistle-blowers offer a glimpse into a company that would not otherwise be available. The potential threat of a whistle-blower also can give prosecutors and regulators more leverage because information is no longer controlled by the lawyers who oversaw an investigation. As every investigator knows, it is far better to keep the target guessing about exactly what you know.

Companies do not care for whistle-blowing programs because they divert information from their internal compliance systems and instead give it directly to the government, meaning it is not filtered fi rst by outside counsel. Maybe that is not such a bad idea.

Peter J. Henning, who writes White Collar Watch for DealBook, is a professor at Wayne State University Law School.

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Wall Street Scandals Fill Lawyers\' Pockets

AS Wall Street has faced a string of scandals, bank executives, investors and customers have suffered. But one group is thriving: lawyers.

Called upon to navigate crisis after crisis, the white-collar bar is having a banner year with cases like the collapse of the futures brokerage firm MF Global, a multibillion-dollar trading blunder at JPMorgan Chase and suspicions of money laundering at HSBC.

The global investigation into the manipulation of a crucial benchmark interest rate known as the London interbank offered rate has emerged as the most profitable for the legal profession.

While many of the recent scandals have been relatively isolated, the scope of the rate-rigging scandal has been vast, encompassing 16 banks. More than 10 government authorities around the world are looking into whether the banks conspired to fix crucial interest rates, potentially affecting trillions of dollars of financial products like mortgages and student loans.

The in vestigation is still in its early days, but experts say it is likely to drag on for years. Authorities could arrest traders this year, and more cases against big banks are expected. Earlier this year, Barclays agreed to pay $450 million to settle accusations that it had reported false rates.

Every major bank under investigation has hired a major law firm to represent it. An army of white-collar defense lawyers has been assembled to defend individuals. Plaintiffs' lawyers have filed more than a dozen lawsuits against the big banks, claiming damages on behalf of institutions, pensions and municipalities like the City of Baltimore.

“This is looking like a full employment act for the corporate bar,” said Samuel W. Buell, a professor at Duke Law School. “It's very hard to see how you draw a tight circle around this issue.”

Over the last few decades, white-collar law has transformed from a boutique business into a major focus for the biggest law firms. As firms expand globally and the federal government makes corporate prosecutions a higher priority, the practice has become a profit center.

Companies do not like to scrimp with civil and criminal cases. The stakes are too high.

In the last decade, a number of major cases have engulfed corporate America - and by extension, white-collar lawyers. The stock options backdating scandal, which emerged in 2006, swept up more than 100 companies and many executives. The cases provided much work for lawyers, including internal investigations at major companies and notable criminal defense efforts. A few years earlier, accounting scandals at companies like Enron and WorldCom generated similarly handsome legal fees.

Not all white-collar crackdowns are the same. Consider the federal government's insider-trading cases. The charges affect a handful of people and do not require the machinery of an entire legal institution. One former prosecutor in the Southern District of Ne w York who spoke on the condition of anonymity because the conversations had been private said that defense lawyers jokingly complained that the hedge funds and other traders affected by the investigation tended to be low-margin clients.

With the interest-rate-fixing case, law firms started seeing the dividends in 2008. When the investigation got under way, the Commodity Futures Trading Commission, the American regulator, asked a handful of major banks to conduct internal inquiries. The goal was to figure out the extent of potential manipulation, focusing on a crucial benchmark known as the London interbank offered rate, or Libor.

At the time, the banks hired outside counsel to review the e-mails and documents as well as to conduct interviews. Barclays, the hardest-hit institution to date, hired Sullivan & Cromwell, which is led by H. Rodgin Cohen. Paul, Weiss, Rifkind, Wharton & Garrison is leading the defense for Deutsche Bank.

The firms put dozens of top lawyers to work unearthing the worst of what had transpired, then gave their findings to regulators. Those reports form the backbone of the cases against the banks.

In the midst of the internal investigations, banks began identifying individuals who may have improperly tried to influence interest rates. Those employees are entitled to counsel, paid for by the banks. The bank's law firm will usually refer the individuals to other white-collar lawyers, since the interests of the banks and the employees may differ. Despite the effort to reduce conflicts, the referrals can be problematic because the banks are paying the bills.

“Sometimes you may be best served by going with a lawyer who has established relationships with the people who represent the company,” said Charles D. Weisselberg, a professor at the University of California, Berkeley School of Law and co-author of a recent study examining white-collar practices at major law firms. “Or sometimes you may want someone more independent of the company lawyers who may not be looking to them for a referral in the future.”

The referral system has been big business in the Libor case.

Dozens of individuals have hired lawyers, according to interviews with lawyers. Andrew J. Levander, the Dechert lawyer who represents former Gov. Jon S. Corzine of New Jersey in the MF Global matter, has been retained by Robert E. Diamond Jr., a former Barclays chief executive. Ira Lee Sorkin, who represented the Ponzi scheme mastermind Bernard L. Madoff, has been retained by a former trader at Barclays.

The most damaging aspects of the case could be traders' efforts to manipulate the index to squeeze more money from clients. After one exchange, a rate submitter at Barclays told a trader, “Always happy to help. Leave it with me, sir,” according to regulatory documents. Another responded, “Done … for you big boy.”

“The tenor of the exchanges reflects a relentless in difference to the rights and interests of their clients,” said Michael Hausfeld, a plaintiff's lawyer in the Libor case. He said it could take a long time to sift through the evidence. “There are a lot of nuances here that still have to be studied, but it's clear there was widespread disruption caused in the market.”

As Wall Street Fights Regulation, It Has Backup on the Bench

Deep in enemy territory, Wall Street has found a powerful ally.

An appeals court in Washington has become ground zero for legal challenges to financial reform. Over the years, judges have rejected several major rules, saving financial firms millions of dollars in compliance costs and exposing government regulators to further litigation.

As regulators once again take aim at Wall Street with the Dodd-Frank regulatory overhaul, the financial industry is racing to fill the docket of its favorite court.

The latest legal attacks are largely aimed at the Securities and Exchange Commission. The United States Court of Appeals for the District of Columbia last year struck down the agency's so-called proxy access rule, a Dodd-Frank plan that would have empowered shareholders to oust company directors. The court is also expected to hear lawsuits over the S.E.C.'s new corporate whistle-blower program and the so-called Volcker Rule.

The flurry of litigation will play out on friendly political turf for Wall Street. Noted for its conservative credentials and harmonious culture, the appeals court is stacked with judges who enjoy rock-star status in Republican circles.

But Wall Street's winning streak reflects more than partisan ideology, lawyers say. The rulings, which often hinge on whether a regulator fully studied the costs of a rule, are also rooted in the court's philosophy to keep government watchdogs on a short leash.

“I think it's a court that sees one of its responsibilities as regulating how agencies discharge their duties,” said Eugene Scalia, a prominent corporate lawyer who has defeated the S.E.C. four times before the Washington court.

Dodd-Frank is under attack from multiple directions. Congressional Republicans and banking lobbyists are picking apart the overhaul with some success, but the lawsuits present a greater threat.

Lobbyists can create the occasional loophole, but courts can halt ne w regulations and reshape the financial industry with one swing of the gavel.

Bracing for the worst, the S.E.C. and other regulators are scrambling to safeguard their rules. The cautious approach, which has delayed new regulation, raises questions about the government's ability to rein in banks four years after the financial crisis.

“The court has given tremendous power to business groups, causing the agencies to operate out of fear,” said Harvey Goldschmid, a law professor at Columbia and a former S.E.C. commissioner. By virtue of its perch in Washington, the circuit court is seen as the second most important court in the country. It is akin to a farm system for the Supreme Court, producing four current justices, including the chief, John Roberts.

Though corporate groups routinely file lawsuits in the Washington circuit, this court was not always so business friendly. Under a landmark Supreme Court ruling, judges must defer to a government agency when its authority is ambiguous - so long as its approach is reasonable. But the Washington circuit court in recent years reversed nearly 23 percent of the rules it reviewed, up from 14 percent in the early 1980s. This year, the court overturned an air pollution rule and a crackdown on cigarette advertising.

The lawsuits against Wall Street regulation enjoy special advantages. For one, financial regulators are often facing off against Mr. Scalia, a seasoned litigator at Gibson Dunn and the son of Justice Antonin Scalia.

Gibson Dunn often represents the United States Chamber of Commerce, which defeated the S.E.C.'s proxy access plan and twice persuaded the court to knock down a mutual fund rule.

The rulings also coincided with a conservative makeover of the court. Of the court's 13 members, nine are Republican presidential appointees. George W. Bush selected four judges, including Brett Kavanaugh, who advised Mr. Bush on the 2000 election recount in Florida. The court has three vacancies, but none of President Obama's picks have received Congressional approval.

“There's very little true resistance to the conservative power of the court,” said Thomas C. Goldstein, a partner at Goldstein & Russell and the founder of Scotusblog, a Web site dedicated to the Supreme Court.

But the court's decisions, Mr. Goldstein said, stem only in part from partisan ideology. The circuit has overturned the S.E.C. six times in seven years, including in the proxy access case. In all but one instance, the court was tossing aside a Bush administration rule. The cases were unanimous decisions, with the court's liberal bloc siding with conservatives each time.

The decisions reflect the collegial dynamic among the judges. The court became deeply polarized in the 1980s, but under Harry T. Edwards, a Democratic appointee who became chief judge in 1994, peace became a priority.

It began with Judge Edwards sending handmade birthday card s to fellow jurists. The good will then spilled into their work. The court rarely reconsiders cases en banc anymore, a somewhat contentious procedure in which the entire court will gather to second-guess a ruling of a three-judge panel.

“I felt we were becoming a broken court, and I wanted to bring us together on a professional and personal level,” Judge Edwards, who now sits as a senior judge, said in an interview. “It became a matter of great pride.”

The court also regards itself as an expert check on regulatory power. While Washington circuit receives a smaller number of cases than most appeals courts, its complex workload requires judges to review the minutiae of administrative rules.

“You don't want to deny the agency the right to be wrong on occasion,” Judge Edwards said. “But when it goes too far, we're supposed to tell them to do it right.”

Dodd-Frank is particularly vulnerable. After the success of the proxy case, Wall Street groups twice sued the Commodity Futures Trading Commission in cases likely destined for the appellate court's docket. The industry is now weighing another potential lawsuit against the Volcker Rule, a still-uncompleted plan to stop banks from trading with their own money.

“It's common-sense litigation 101,” said Paul Clement, the former solicitor general under President Bush who is now a partner at Bancroft P.L.L.C. “If you keep winning, you keep going back.”

Rather than attack a rule on the merits or constitutionality, Wall Street is building lawsuits around the costs a rule will impose on the economy.

The challenges are largely rooted in a 1996 law that requires the S.E.C. to examine the effect of a new rule upon “efficiency, competition and capital formation.” The S.E.C. is merely required to “consider” the costs, not write a formal study.

The strategy has worked. In the proxy case, the court ruled that the S.E.C.'s policy “failed adequately to consider” its economic effects, even though the agency drafted a roughly 60-page cost-benefit analysis.

Proponents of regulation fear that the court created an impossible standard. In a 2012 report, the advocacy group Better Markets noted that the S.E.C.'s “pre-eminent duty” is to “protect investors.” The group also argued that the S.E.C.'s cost-benefit analyses should account for the cost of government bailouts that might result from lax regulation.

For its part, the S.E.C. has hired additional economists to scrutinize rules and published guidelines for evaluating regulations. “The S.E.C. is finally starting to figure it out,” said Michael Livermore, executive director of the Institute for Policy Integrity at New York University Law School. “The new approach just might save Dodd-Frank.”

With Smartphone Deals, Patents Become a New Asset Class

David Berten has spent his legal career as a mercenary student of technological change. He has educated himself in one field after another: chemical coatings, genetics, navigation systems, semiconductors and digital communications software.

Keeping up is a constant challenge. This month, the 48-year-old lawyer was in his Chicago office, discussing past cases while scanning news Web sites and technology blogs for details on Apple's iPhone 5, which was being introduced in San Francisco that day.

“We have to know what's in it,” Mr. Berten said. “In patent law, you're at the cutting edge of everything, and that's shifting all the time.”

His firm, the Global IP Law Group, is a sign of the fast-emerging patent marketplace. Global IP, founded in 2009, is one of several boutique firms specializing in patent legal and advisory work that have cropped up recently. Silicon Valley is home to a cluster of them, including Inflexion Point Strategy, Epicenter IP Group and 3LP Advisors.

Though created by lawyers, these companies are hybrids: more merchant banks than law firms. They have legal expertise, but focus on valuing and selling patents and giving strategic advice.

Global IP made its name as an adviser to Nortel Networks, a bankrupt Canadian telecommunications maker that sold its 6,000 patents for $4.5 billion to a group of six companies led by Apple.

The high price paid for the Nortel portfolio set off a bull market in patents that can claim some snippet of smartphone technology. By one estimate, as many as 250,000 patents may touch a modern smartphone. So patents have become defensive and offensive weapons in the smartphone wars, with the major companies suing one another in courtrooms around the world.

A few months after the sale, the big loser in the Nortel auction made its move. Google agreed to buy Motorola Mobility for $12.5 billion, and about $5.5 billion of that was the value of Motorola's pate nts, Google said in a government filing this year. Smartphones made by Samsung and other companies are powered by Google's Android software, making Google and Apple archrivals in smartphone technology.

The smartphone patent megadeals may be over now that the two main adversaries have armed themselves. An attempt by the bankrupt Eastman Kodak to sell 1,000 digital imaging patents stumbled recently, as bids from potential buyers like Apple and Google came in far below the $2.2 billion to $2.6 billion Kodak had said the patents were worth.

But the huge deals, while exceptional, were made possible by a broader trend: patents have become a new asset class.

Traditionally, patents sat on corporate shelves and were occasionally used as bargaining chips in cross-licensing deals with competitors. But that began to change in the 1990s, when technology companies like Texas Instruments and I.B.M. started to regard their patent portfolios as sources of revenue, licensing their intellectual property for fees.

Today, companies routinely buy and sell patents, mostly in deals that draw little attention, for millions of dollars instead of billions. The question, experts say, is how big the market will become.

“Patents are a tricky asset to trade,” said Josh Lerner, an economist at the Harvard Business School. “But there is clearly a huge amount of value in intellectual property. And I think what we're seeing is the beginning of a lot more monetization and trading of intellectual property rights.”

A sizable specialist industry has developed to build the marketplace for trading ideas. The players include patent aggregators like Intellectual Ventures and RPX, patent brokers like Ocean Tomo and ICAP, hedge funds, investment banks and law firms.

Yet boutique firms like Global IP play an important role, offering specialized expertise and an entrepreneurial approach. “We take patents and try to make money from them in all ways known to man - sales, licensing and litigating, if necessary,” Mr. Berten said.

Global IP opened in 2009 with two lawyers, Mr. Berten and Steven Steger. The firm now has 10 lawyers. About two-thirds of its business is selling patents, and it is working on more than two dozen portfolios. Most work is done on a contingency basis, with a sliding scale of fees that can reach 40 percent on projects that involve litigation, Mr. Steger said.

In the Nortel project, Mr. Berten and his team built a vast database of the Nortel patents, tracking the history of each through the government patent office, citations in other patent applications, uses in license agreements and filings in other countries. “It was a boatload of work,” said George Riedel, former chief strategy officer at Nortel.

Mr. Berten and Mr. Riedel, along with Nortel's bankers from Lazard, made presentations to companies in Silicon Valley and Europe. Mr. Riedel said Mr. Berten showed an im pressive grasp of detail, down to individual patents and claims, when challenged by lawyers at the major technology companies.

His job, Mr. Berten said, was to “identify the value of patents and then demonstrate that value to potential buyers.”

The auction was run by Nortel's bankruptcy lawyers at Cleary Gottlieb Steen & Hamilton. The winning bid of $4.5 billion was well above the $2 billion to $3 billion projected. “Sure, I was surprised,” Mr. Riedel said. “We were fortunate to be in the midst of an ecosystem battle in smartphones.”

In the Kodak bankruptcy, Global IP was brought on in a very different role: as an outside adviser to the unsecured creditors, including Wal-Mart Stores and Sony Pictures Entertainment. Its job was to determine if the proposed auction was undervaluing the patents, and to advise the creditors if they might be better off taking another approach, like licensing the patents.

The very different experiences of Nortel and Kodak point to the many factors that go into pricing patents. Timing, competitive forces, regulation and court rulings all have an effect, said Ronald S. Laurie, managing director of Inflexion Point Strategy.

“Patents are a volatile, spot market,” he said. “This is a market, but a market that is more like art than stocks or oil.”

Ron Epstein, chief executive of Epicenter IP Group, agreed that pricing patents, especially large portfolios, was difficult. But he said he thought corporate trading in patents would become more commonplace, and pricing more routine. Someday, he predicted, patent acquisition costs may be a standard line item in corporate earnings statements.

“By fits and starts, we are moving to a more efficient marketplace for innovation,” Mr. Epstein said.

Calling patents an asset class is shortsighted, said Kevin Rivette, a founder of 3LP Advisors. The larger value of a portfolio, he said, can be as a strategic tool to neg otiate lower costs from a supplier or to alter a rival's product plans.

“You can use patents to change the competitive landscape,” he said.

Gensler Calls for Overhaul of Libor

A senior regulator called for an overhaul of a key interest rate on Monday, telling the European Parliament that the integrity of consumer borrowing is at stake.

Gary Gensler, chairman of the Commodity Futures Trading Commission, suggested that authorities retool or replace the London interbank offered rate, which affects the cost of borrowing for consumers and corporations. Libor, a measure of how much banks charge each other for loans, underpins the cost of trillions of dollars in mortgages and other loans.

“It is time for a new or revised benchmark â€" a healthy benchmark anchored in actual, observable market transactions â€" to restore the confidence of people around the globe that the rates at which they borrow and lend money and hedge interest rates are set honestly and transparently,” Mr. Gensler said in prepared remarks that he delivered via video from Washington. “People around the world saving for the future, using credit cards or borrowing mone y for tuition, cars and homes have a real stake in the integrity of Libor” and other rates like the Euro Interbank Offered Rate, or Euribor.

(Mr. Gensler cancelled his trip to Brussels after a recent “clumsy” fall caused him to break four ribs and puncture a lung.)

In June, Mr. Gensler's agency leveled a $200 million fine against Barclays, accusing the British bank of attempting to manipulate Libor. The settlement was the first of several cases the C.F.T.C. is building against big banks suspected of lowballing rates to protect their image during the financial crisis.

“Naturally, people are wondering if the Barclays situation was isolated,” Mr. Gensler said.

Citing reams of data, Mr. Gensler argued that the problem persists today.

With banks no longer lending to one another, he noted, Libor is not rooted in actual transactions. The United States Dollar denominated Libor rate is also significantly different from the comparable Euribor ra te. The discrepancy, he said, underscores that the rate remains vulnerable to tampering.

“When market participants submit for a benchmark rate lacking observable underlying transactions, even if operating in good faith, they may stray from what real transactions would reflect,” he said.

Some regulators have called for alternative benchmarks, including the overnight index swaps rate, that are based on real transactions. Other options include using short-term bank financing, where banks pledge collateral with other financial institutions.

While Mr. Gensler did not insist on ending Libor, he argued that it might be the safest route.

“Despite a long and painful recovery, sometimes replacement is the better choice when a hip or a knee or even a benchmark rate has worn out,” he said, a nod to his recent medical mishap.

Dave & Buster\'s Sets Range for I.P.O.

Dave & Buster's Entertainment, the restaurant and arcade chain, announced on Monday that it was seeking to sell 7.7 million shares at $12 to $14 a share during its initial public offering.

At the mid-point of that range, the private equity-backed company is set to raise $100 million at a market value of $351.9 million. Its underwriters also have the option to sell an additional 1,153,846 shares, according to a revised prospectus filed on Monday.

Dave & Buster's return to the public market comes after six years of private equity management. In 2006, Wellspring Capital Management took it private for $257 million. Oak Hill Capital Partners later bought the company in 2010 for $570 million.

After the I.P.O., the private equity firm will retain a 68 percent stake, while the company's management team and directors will own roughly 3 percent.

Founded in 1982, the Dallas-based company has 59 restaurants in the United States and one franchised location in C anada. The locations generate considerable revenue, roughly half of which come from food and drinks.

But the business has recently struggled to turn a profit. It has posted net losses every year for the last three years. In 2011, it recorded a loss of $7.3 million on sales of $521.1 million.

The company company said in its prospectus that it wants to ultimately expand its footprint to more than 150 stores. It plans to open four locations this year and about four to six in 2013.

The company, which is backed by Oak Hill Capital, will trade on the Nasdaq stock exchange, under the symbol “PLAY.” Dave & Buster's hired Goldman Sachs, Jefferies and Piper Jaffray to be the lead underwriters of the I.P.O.

What\'s Facebook Worth?

Facebook's 40% plunge from its initial-public-offering price of $38 in May has millions of investors asking a single question: Is the stock a buy? The short answer is "No." After a recent rally, to $23 from a low of $17.55, the stock trades at high multiples of both sales and earnings, even as uncertainty about the outlook for its business grows.

The rapid shift in Facebook's user base to mobile platforms-more than half of users now access the site on smartphones and tablets-appears to have caught the company by surprise. Facebook (ticker: FB) founder and CEO Mark Zuckerberg must find a way to monetize its mobile traffic because usage on traditional PCs, where the company makes virtually all of its money, is declining in its large and established markets. That trend isn't likely to change.

Success in mobile is no sure thing. The small screens on these devices don't give Facebook much room to configure ads without alienating users. And the way that mobile users access Facebook, through applications on iPhones, iPads, and Android devices, may diminish the time users spend at the Website while handing greater power to Apple (AAPL) and Google (GOOG), which dominate the apps business.

AT ITS CURRENT QUOTE, Facebook trades at 47 times projected 2012 profit of 48 cents a share and 36 times estimated 2013 earnings of 63 cents. Compare that with Google and Apple, two proven technology growth stories, which both trade for about 16 times estimated 2012 earnings. Facebook is valued at $61 billion, or $53 billion excluding its estimated $8 billion in cash. That's more than 10 times estimated 2012 revenue of $5 billion. Google trades for half that valuation.

What are the shares worth? Perhaps only $15. That would be roughly 24 times projected 2013 profit and six times estimated 2013 revenue of $6 billion, still no bargain price. Wall Street's consensus estimate for 2013 shows earnings rising 31%, to 63 cents a share.

That pro forma number is generous because it ignores Facebook's very significant stock-based compensation. The company has been issuing gobs of restricted stock to engineers and other key employees in the hot Silicon Valley job market to prevent them from being lured away to the next hot tech start-up-the next Facebook.

Facebook issued $1.4 billion of restricted stock in 2011, or nearly $500,000 per employee. So far this year, the company has doled out $1 billion of restricted stock. Facebook's reported stock-based compensation expense-based on the amortization of several years of stock grants-could total 20 cents a share next year. Subtract that from the 2013 consensus earnings number, and the shares trade at 50 times earnings. At $15 they would still be valued at a rich 35 times earnings.

TECHNOLOGY IS THE ONLY MAJOR industry where companies routinely encourage analysts to ignore stock-based compensation expense-and most comply. This dubious approach to calculating profits is based on the idea that only cash expenses matter. That's a fiction, pure and simple. As Warren Buffett has said, companies could take this to the extreme, pay all their expenses in stock and claim to have no costs.

Facebook's restricted-stock grant was so large last year that it may have exceeded its cash compensation costs. CEO Mark Zuckerberg seems to have a cavalier attitude, saying in a recent interview that "the way we do compensation is that we translate the amount of cash that we want to give you into shares" and give more stock to employees as the price declines.

Ours is admittedly an outlying view on the stock. Only one of the almost 40 Wall Street analysts covering Facebook, Dan Salmon of BMO Capital Markets, has a price target of $15. Most are in the high $20s or $30s. Many of these firms initiated coverage of Facebook with price targets in the $40s.

Barron's, it bears noting, never bought into the pre-IPO hype. We published two skeptical stories on Facebook, first when it filed for its IPO in February, and again right before it went public in May ("Mad About Facebook!" May 14). Our take was that the stock looked very richly priced at $35 to $40 and that investors should consider Apple and Google instead. (Both are up about 25% since then.) "Connect with your friends on Facebook. Stay away from the stock," is how we concluded the article.

THE BULL CASE FOR Facebook is that Zuckerberg & Co. will find creative ways to generate huge revenue from its 955 million monthly active users, be it from mobile and desktop advertising, e-commerce, search, online-game payments, or sources that have yet to emerge. Pay no attention to depressed current earnings, the argument goes. Facebook is just getting started.

Facebook now gets $5 annually in revenue per user. That could easily double or triple in the next five years, bulls say. In a recent interview at the TechCrunch Disrupt conference, Zuckerberg said, "It's easy to underestimate how fundamentally good mobile is for us." His argument, coming after Facebook's brand-damaging IPO fiasco and a halving of the stock, was something only a mother, or a true believer, could love. This year Facebook is expected to get 5% of its revenue from mobile. "Literally six months ago we didn't run a single ad on mobile," Zuckerberg said. Facebook executives declined to speak with Barron's.

"Anyone who owns Facebook should be exceptionally troubled that they're still trying to 'figure out' mobile monetization and had to lay out $1 billion for Instagram because some start-up had figured out mobile pictures better than Facebook," says one institutional investor, referring to Facebook's April deal for two-year-old Instagram, whose smartphone app for mobile photo-sharing became a big hit (and at the time had yet to generate a nickel in revenue).

Facebook's initial profit report in July didn't cheer Wall Street, as second-quarter revenue rose 32% to $1.18 billion while expenses, excluding stock-based compensation, were up 60%. The company projected similarly large expense gains in the final two quarters of the year, as it ramps up infrastructure and other undisclosed spending.

That surprised many investors who figured Facebook's business model was so powerful that it would generate operating leverage, meaning revenue growth would outpace expense growth. The Street now projects that Facebook may not hit $1 a share in profit until 2015. And that doesn't reflect heavy stock-based compensation. And who knows if that $1 a share estimate, which may require a doubling of revenue, is even achievable.

"I don't understand management teams that don't explain how they are going to spend shareholder money," says Michael Pachter, an analyst at Wedbush and a Facebook bull. "Facebook is saying, 'Trust us.' Investors don't need to know about every pencil, but they want to know the strategy." So far, Facebook has said little, and the company lacks the credibility and track record of Google, Apple and Amazon.com (AMZN).

FACEBOOK GENERATES almost 85% of its revenue from advertisements, much of it from ads on the right side of the screen when users visit the site on PCs. Ads are likely to remain its mainstay for some time to come. But in a troubling sign, last week online research firm eMarketer, after cutting its estimate of Facebook's revenue, projected that Google would top Facebook in online display-ad revenue this year.

Facebook conceivably could charge modest subscription fees to its users of, say, $1 a month and generate $5 billion or more of annual revenue, even with significant user attrition, but the company has ruled that out. "It's free and always will be," the Facebook log-in page says.

Facebook's chief operating officer, Sheryl Sandberg, has acknowledged the company's ad "challenge." On the July earnings conference call, she said, "That's mainly because we're a completely new kind of marketing. We're not TV. We're not search. We're a third medium."

It's not easy to measure the effectiveness of this third medium because its ads are often more about brand building than transactional. "Facebook's jumble of activity centers on communications with a roster of friends, a core activity where commercial intervention may be less welcome," writes Paul Sagawa of Sector & Sovereign Research.

As Facebook was trying to win over sometimes skeptical advertisers with desktop ads, its users were moving to mobile devices. Facebook's response has been advertisements that it euphemistically calls "sponsored stories" based on products or services recommended by a user's Facebook friends. Yet these ads, which appear in the user's "news feed"-comments, pictures, and videos from friends-may be alienating users and driving them away from the Website. Some appear again and again, stating that a particular friend "likes" Wal-Mart or Target. A recent lawsuit actually challenges this practice, arguing users ought to be compensated as paid spokesmen or allowed to opt out and not have their names attached to sponsored stories.

"If the mobile ads were well targeted and creative, that would be a good thing, or at least not an annoying thing. But the ads seem untargeted and not very creative," says Rich Greenfield, an analyst at BTIG in New York. "Facebook seems to be proud to have the biggest and most disruptive ads on mobile devices. I struggle with the idea that bigger is better. It's not a great user experience. If consumers are upset with this, it could result in a reverse spiral down."

Greenfield, who now has a Neutral rating on the stock after urging investors to avoid it at the IPO, says Facebook's mobile strategy has him "getting more concerned, not less" about its outlook. He points out that 11% of Facebook users accessed the site only through their mobile devices in June, up from 9% in March. That percentage is likely to grow.

Most of those mobile-only users probably are under 25, and it's within that group that Facebook is seeing reduced usage on PCs. Evercore Partners analyst Ken Sena estimates that domestic PC users spent 12% less time in August on Facebook than they did in the same month a year earlier. His estimate is based on data from comScore, which measures U.S. Internet traffic. Sena's analysis shows that the declines were sharpest among users aged 12 to 17 and 18 to 24, which saw drops of 42% and 25%, respectively. Time spent on Facebook by PC users aged 55 and older was up sharply.

An aging demographic isn't good with a youth-focused ad industry. Will young people continue to be attracted to a social networking site frequented by their mothers and grandmothers? Some of the decline in desktop usage is being offset by mobile access, but it's not easy to assess the combined impact.

Paul Sagawa says Facebook's mobile problems go beyond the small screen size. "The paradigm shift to the app model is unequivocally bad for Facebook," he wrote in a recent report. "Facebook is designed to be open all the time, to be visited in the gaps of the day or as a platform in its own right, bridging to a variety of activities related to the social network." The app model, he says, disrupts this approach. Users open a mobile app for a reason and close it as soon as they are finished. "Why use Facebook to play a game, read an article, manage your photos, stream music, or shop," he wrote, "when you can select a specialized app directly." Moreover, Apple and Google, which control most mobile operating systems, siphon away some of the revenue from Facebook apps.

The app model may favor more specialized sites like Twitter, Pinterest, Yelp (YELP), LinkedIn (LNKD), and Trulia (TRLA), the real-estate Website that had a hot IPO last week. Facebook, Sagawa says, ought to create more specialized apps, like Instagram by Facebook, Facebook chat, or Facebook messaging tied together by a common user name and password.

IN COMING MONTHS, FACEBOOK'S share price could be depressed by significant sales by holders subject to expiring lock-up restrictions established at the time of the IPO. Already, co-founder Dustin Moskovitz has sold 7.5 million shares, or 5% of his stake, and early investor and director Peter Thiel has sold 20.1 million shares, or 80% of his holding (see table, Major Insider Sales Since IPO).

Some 234 million shares (including options and restricted stock) become available for sale on Oct. 29, followed by another 777 million on Nov. 14. That's a lot relative to the current float of as much as 692 million shares, representing the 421 million sold at the IPO and another 271 million shares on which lock-up restrictions already have expired. The total share count is 2.65 billion.

Zuckerberg's recent decision not to sell any of his 504 million shares for at least a year reduced the potential flood of shares, but his decision shouldn't have been seen as a surprise. As CEO and controlling shareholder, Zuckerberg would have had a hard time selling any stock without a serious negative market reaction.

Even with the sharp drop in its share price, Facebook remains a richly valued bet on the company's ability to wring a lot of revenue from a huge and potentially fickle user base. Facebook's mobile woes aren't likely to go away. Stay away from the stock. It could be heading to the mid-teens. 

E-mail: editors@barrons.com