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[Linklaters Managing Partner Simon] Davies said the firm was focused on overall profitability rather than its revenue, which has suffered due to the deflated M&A market with about 40 per cent of income generated by the corporate department.

"Our objective has never been to maximise our revenue," he said [emphasis supplied]. "We're not focused on being the biggest firm by revenue but on being the leading firm as far as our clients are concerned."

--From The Lawyer story announcing Linklaters' 2009-2010 results, showing a decline of 8.8% in revenue to £1.18bn and also a decline of 6.88% in PEP to £1.21m.

This raises the question:  If not revenue, or if not PEP, what are the optimal metrics on which to judge law firm performance?

Orrick famously announced back in May that it would cease "using or reporting, internally or publicly, the metric of Profit Per Equity Partner."  And on the heels of that announcement I wrote about some alternatives I might endorse.  The list included:

• On the quantitative side:
  • Revenue Per Lawyer
  • Compound annual growth rate (CAGR) of revenue over a multi-year period
  • Realization rates (implying, I would argue, clients' perception of value-for-services-received)
  • Associate retention rates (or attrition rates, measured negatively)
  • Percentage of business from clients of long-standing duration (say, more than 3 or 5 years)
  • Percentage of all legal spend from top 10 (20/50/100) clients
    
    
• On the qualitative side:
  • Client satisfaction
  • Lawyer morale
  • Commitment to and investment in professional development
  • Commitment to and investment in such things as diversity and pro bono
  • The quality of firms the firm takes lateral talent from and the quality of firms they lose lateral talent to
  • The quality of firms the firm wins assignments from and the quality of firms they lose assignments to
  • Quality and morale of professional and support staff.

Most importantly, however, I believe we as a profession and as a management class need to stop genuflecting to the one-size-fits-all model of law firm performance.

What do I mean by that?

Simply that firms are increasingly segmenting themselves into different market positionings, and that applying one, or even a few, unitary  metrics across firms pursuing avowedly different strategies is guaranteed to produce misleading--and downright odd--results.

For example, much as I respect Simon Davis, I think being part of the Magic Circle means that you are, among other things, judged on overall size, that is to say, on annual revenue.  Who would claim that a firm with half, or one-quarter, of the revenue of Allen & Overy, Clifford Chance, Freshfields, or Linklaters would seriously be viewed as on a par with those?  In this league, size does matter.  (Which, among other things, is why Slaughter & May is not "really" a Magic Circle firm, or at best is one with an enormous bold asterisk after its name.)

Another set of firms--and yes, folks, we can name names--including Cravath, Slaughters, Wachtell, Weil Gothsal, and perhaps some relative newcomers such as Boies Schiller or Quinn Emanuel, positively invites us to compare them on the basis of PPEP.

Yet another set would like us to find them strong in global coverage:  Say, for example, Baker & McKenzie, DLA, Jones Day, Latham, Sidley, and White & Case, with a slightly newer orientation to the "global" value proposition represented by K&L/Gates, Orrick, and Reed Smith.  (Caveat, folks:  The trouble with naming names is you've named some people and you haven't named other people.  That's why letters to the editor are available; and I urge you all to exercise your right to add, subtract, and in general dissent.)

Another, separate, problem with cross-firm metrics has to do with averages.  Averages mislead.  Yes, seriously.  (In my original piece on this I used the familiar example of "Bill Gates walks into a bar....", and the average net worth in the place goes up to $5-billion.) 

Here's a fairly trivial example of how averages can mislead:  Imagine a firm with the vast majority of its lawyers in New York, or New York and London.  Now compare that firm's PPEP to another firm with relatively few lawyers in those high-margin markets.  Surprise!   Same would happen with Revenue per Lawyer, and, on the unflattering side (unflattering to the capital markets-centric firm, that is), with cost per lawyer.  The headline news would be if the capital markets firm had lower PPEP.

When stated baldly this way, none of us is the least surprised that "averages" across firms with completely different business models, strategies, and geographic footprints mislead at least as much as they reveal.  To abstract from our industry, what does the average fuel economy of Toyota's models tell you compared to the average fuel economy of Ferraris?  To say that Toyotas have "better" fuel economy is to focus on facts at the expense of the truth. (Focusing on facts at the expense of the truth is at the heart of many a cross-examination technique.)

Not to go metaphysical on you, but to do justice to the concept of what metrics are appropriate for measuring law firm performance, we need to delve for a moment into the difference between facts and truth.

Facts are convenient, tough, hard, unyielding little pebbles.  Not just facts like water freezes at 32°F or Oxygen is the 8th element in the periodic table, but facts like "during your deposition you said you'd seen this email and now you say you can't remember?"  Or, facts like today's announcement that "Clifford Chance boosted its average PPEP by 25% in the past fiscal year."  It's very hard to argue that facts don't stand for irreducible little nuggets of reality.  But facts can also tempt us into sloppy, lazy, and unreflective "analysis."   Such as:  "If CC boosted its PPEP by 25% and Linklaters and A&O didn't do as well, then that's bad news for Links and A&O."  Well, not so fast.

The difference between facts and truth brings to mind Oscar Wilde's famous definition of a cynic as someone who "knows the price of everything and the value of nothing."  As an economist, I'd be the last to tell you that price doesn't contain a lot of information.  But at times, as with the recent housing bubble, or the tech stock bubble of ca. 2000, prices can't really be trusted.  What you really need to know is what's the value of the asset?

And thus with law firm performance metrics. 

Before you conclude that any particular firm is doing well, doing poorly, or hanging out in the middle of the pack, you first need to figure out what that law firm is setting out to do.  What is their strategy?  Is it to be a "category killer" in employment law like Littler Mendelson or Jackson Lewis?  Then a high PPEP is probably not something they're striving for and it's unfair (and worse, irrelevant, and sloppy thinking, as noted above) to pretend that metric has much of anything to do with them.

Then what am I suggesting?

Not just that there is no "one size fits all" metric, which should be obvious if you're a student of almost any industry (autos, apparel retailing, wine and beer, cellphones), but that to gauge how any law firm is doing you first have to do the hard work of analyzing what they are trying to do.

Are they trying to be a global, but non-headquarters dependent, powerhouse?  Then you might want to know what percentage of their revenue comes from matters using substantial amounts of lawyers' time from multiple offices; or what percentage of revenue is "earned" by offices other than the originating one.  A little tougher to figure out than the Big Hard Rock of PPEP, isn't it?

Sorry to break this to you.

Whatever your views might be on the intrinsic validity or durability of the billable hour, timekeeping is still fundamental to most firms' accounting and compensation systems, so it remains a topic of "evergreen" interest.

Adam Smith, Esq. has posted a short survey--it will take a few minutes at most, if you dawdle--on timekeeping practices, which you can take here. To encourage you to do so, we will distribute the aggregated, anonymized results to all participants.

Orrick announced on May 12 that "it will no longer use or report, internally or publicly, the metric of Profit Per Equity Partner."

Please join me in prayer, dear congregants, that this will inaugurate a trend.

I'll explain in a moment, but first, Orrick deserves the floor (from their press release):

The firm believes the fundamental changes taking place in both the business of law and in the relationship between law firms and its clients have made the metric no longer constructive or informative for the firm or the industry.

"The legal profession is at a transformative moment, and now is the time to reconsider all of the metrics we have traditionally used to measure success," said Ralph Baxter, Orrick's Chairman and CEO. "Our partnership is engaging in a serious dialogue to identify more appropriate metrics to evaluate our firm, to strengthen our client relationships, and to make our lawyers' careers even more meaningful. Moving away from the Profit Per Equity Partner metric is a step toward greater accuracy and transparency about law firm economics, and it will focus us even more on how we deliver value and efficiency to our clients."

(Disclosure: Ralph and I have discussed alternative metrics for law firms in general, but I did not have any hand in Orrick's decision.)

Now, let me specify what I'm not going to talk about: Nothing logistical or prudential about this decision. I'm not interested in whether The American Lawyer can reverse-engineer the Orrick PPEP calculation (with or without willing sources); I'm not interested in whether competitors or even Orrick partners might conceivably wonder if the firm had something to hide; and I'm not interested in whether his will help, hinder, or be immaterial to Orrick's prospects in the lateral market. All those things I leave for others to speculate upon. So to the game.

Why do I "pray" (I exaggerate, but only to underline my belief in Orrick's move) that this become a trend? Let me count the ways:

• We all know, wink-wink, that PPEP is a consummately manipulable number. Even The American Lawyer has never mounted a resounding rebuttal to this widespread assumption. If it's a metric that can be gamed, how much weight does it deserve?
  
  
• PPEP is an average. As Cesar Alvarez of Greenberg Traurig famously said, the only PPEP that matters is "profits per me." I'm not being facetious. There are firms with (for example) a reported PPEP of $1.2-million and a band of equity partners' actual incomes from $500,000 to over $5-million. It's like the old joke about "Bill Gates walks into a bar...." (and the average net worth of those in the bar becomes $5-billion).
  
  
• Of far greater weight is the indictment of PPEP on the merits. Unfortunately, in the 30 or so years since it came to prominence under the fabulously talented Steve Brill, it has come to encapsulate Everything You Need to Know about a law firm. That of course is unadulterated pap, but we find ourselves drawn to it with an almost voyeuristic pull, much as we'd be drawn to salacious, compromising pictures of prominent politicians or Hollywood celebrities.
  
  
• And with the same effect: It tends to override the reasoning faculties of our frontal lobes.
  
  
• So what, if I'm proposing to dethrone PPEP, matters more in terms of evaluating a law firm's performance? Here are just a few candidates:
  
  
  • On the quantitative side:
    • Revenue Per Lawyer
    • Compound annual growth rate (CAGR) of revenue over a multi-year period
    • Realization rates (implying, I would argue, clients' perception of value-for-services-received)
    • Associate retention rates (or attrition rates, measured negatively)
    • Percentage of business from clients of long-standing duration (say, more than 3 or 5 years)
    • Percentage of all legal spend from top 10 (20/50/100) clients
      
      
  • On the qualitative side:
    • Client satisfaction
    • Lawyer morale
    • Commitment to and investment in professional development
    • Commitment to and investment in such things as diversity and pro bono
    • The quality of firms the firm takes lateral talent from and the quality of firms they lose lateral talent to
    • The quality of firms the firm wins assignments from and the quality of firms they lose assignments to
    • Quality and morale of professional and support staff.

And I could go on, but you get the point: PPEP is a remarkably crabbed, narrow, and, at this point, antiquated measure of law firm excellence. "Antiquated," in particular, because we've all learned long ago how to game it. It doesn't mean what it used to mean, at least if meaning consists in reliable comparability across firms.

You, there in the back, standing up and waving your hand?

Yes, I know, there's a case to be made that it's only fair that PPEP be "a part of the mix" of evaluating a firm, and that it tells the market something important about how a firm is able to distill the ineffably convoluted blend of clients, talent, markets, global platform, and infrastructure into a magic output.

I'm here to tell you the pendulum long ago swung preposterously far in your direction. And that we're long overdue for a big correction.

Far be it from me to aver that profits don't matter; they matter tremendously.  Baxter feels the same way, judging from his talk with Above The Law:

We're not saying that it doesn't matter to be profitable, it does. We're not saying that it's not important that our most senior partners are compensated in a way the matches the great law firms in the world. And they will be.

Whatever possessed us to rely on this shockingly narrow and unitary metric for so many years, I believe its time has passed. It served a salutary purpose in the beginning. That purpose was (a) transparency where opacity previously reigned; (b) objective comparability where impressions and reputations previously reigned; and (c) shining a light on quality of management where kitchen-table and seat-of-the-pants amateurs had always prevailed. That time is long past.

A final observation: Do you know what your clients' GC's make? (Unless they're public companies and the GC is one of the top five highest-remunerated officers, the answer is almost assuredly not.) Their AGC's, deputy GC's, or business head units?

Then why should they know that (roughly, that is) about you?

This may be the key point.

Clients hate PPEP. All it can possibly accomplish is to inspire envy. "I work just as hard or harder as XYZ, and s/he makes $#.#-million!"

Is this a terribly smart thing for us to be doing to ourselves?

Let us close by joining in prayer....

A few days ago the juxtaposition of two articles, one in The Wall Street Journal and the other in The Times (UK), struck me as too rich not to point out.

The WSJ wrote, in "Gap Widens Between Tech Richest and the Rest," that:

A handful of cash-rich companies are consolidating power in the technology industry, using their wealth to expand into new businesses and making it harder for small and midsize competitors to break through.

In the past two years--in the teeth of the recession (think about it)--Apple, Google, Microsoft, Oracle, and six other large tech companies generated over $68-billion in new cash, compared with $13.5-billion, just 20% as much, for all of the other 65 tech companies in the S&P 500 combined.  The results are clear:

Because of their massive cash accumulation, these companies can afford to take risks that smaller companies can't at a time when the economy remains fragile. The result is a bifurcated tech landscape, says Erik Brynjolfsson, a professor at the Massachusetts Institute of Technology's Sloan School of Management. [...]

The repercussions from the cash discrepancy are being felt throughout the industry. Some midsize tech companies are giving up trying to compete with their larger rivals.

"I'm not going to fight" being a mid-tier company, says Enrique Salem, chief executive of security-software maker Symantec Corp., which has annual revenue of $6.1 billion and cash reserves of $2.6 billion. "It's a losing proposition for me to try to catch up with Oracle."

So what's a smaller or mid-size competitor to do?  Assuming that folding one's tent is not an option, the only answer is to take on more risk.  In plain English, you have to really stick your neck out:

Says Ciena CEO Gary Smith. "A large company can make a mistake in one of these acquisitions and it isn't going to be hugely impactful to them."

Ciena has no such luxury, he says. "Clearly, if we get this wrong, it will not have a good outcome."

Meanwhile, The Times (UK) wrote in "Law firms turn to banks, not partners, for cash," that:

Leading law firms increased borrowing by 40 per cent in response to the financial crisis, despite the sector's traditional aversion to taking on bank debt.

Debts among the 40 biggest legal practices whose accounts are publicly available rose to £591 million in 2008-09, according to data compiled by Grant Thornton, the accounting firm. The previous year the debts were £425 million.

Peter Gamson, head of the professional practices group at Grant Thornton, said that many firms had turned to their banks for funding rather than asking their partners to contribute more capital. The average partner now has £138,000 invested in his or her firm, compared with £128,000 before the crisis hit.

"It certainly looks like a lot of firms are going to a bank to get funding rather than sitting partners down and saying: 'Look, guys, we've got to put some more money in,' " Mr Gamson said.

Now, that may be lovely insofar as it helps partners sleep at night, but the clear message of our friend Mr. Gamson--as well, of course, as that of the entire tech industry as recounted in the WSJ--is that it leaves firms on very tenuous footing indeed.

The lack of working capital left many firms stretched when the downturn began, Mr Gamson said. "As a sector, [legal services] looks very undercapitalised. There's a huge reluctance to ask partners to contribute more capital. The question is how long you can play that game?"

Mr Gamson warned that the low ratio of capital to debt at many mid-tier firms could make it harder for them to grow when the market recovers. In addition it could deter funding from investors when new rules on outside ownership take effect next year. "Any investor is going to look at the business and think: 'Are the owners of this business being realistic about how much they're putting on the line?' " he said.

But we should not be surprised.  After all, the typical law firm (I'm hard-pressed to think of any exceptions, now that I think about it) "strip-mines" the firm of cash at the end of every year to pay partner compensation.  

Here's a parlor game for you next time you're feeling a bit churlish towards a colleague:  Challenge them to identify the balance sheet entry that appears on every corporation's statement but no law firm's.  The answer?  The line for "retained earnings."  I promise you no one guesses right.

Mr. Gamson puts it just about right:  "How long can you play that game?" 

And Ciena's Gary Smith completes the thought:  If you're playing with limited capital and make a mistake, "it will not have a good outcome."

You have been warned.2

Earnings Season is now in full throat, and we're beginning to see a remarkably consistent pattern emerge:

• Revenues essentially flat to down 10%
• Profits flat to slightly down-but PPP flat or even up a bit

I generalize, of course.

But here is some of the evidence (these are randomly selected from more recent releases):

I could go on, but you get the idea. And again, I emphasize that these are random names, selected, frankly, from the latest data I could readily put my hands on. I would like to think a random sample implies it might be statistically representative of a larger universe.

So what do we see?

The first column, revenue, ranges from essentially flat (certainly inflation-adjusted flat) to rather seriously down. This is of course the pole star that management must manage to. It's a rigid, unyielding number, particularly in cash-basis accounting businesses, from which there is no escape in terms of everything else you can try to manage on the expense side of the income statement. More on the implications of this in a moment.

"Net profits," the second column, are pretty much all over the place, but I'm not sure how much information that metric contains, so this doesn't particularly alarm or delight me.

When it comes to RPL, however, faithful readers will know that this is one of my favorite all-purpose law firm "performance" measures. Why? First of all, it's hard to fudge either the numerator or the denominator. (Sure, you can play games with FTE's and so forth, but frankly most firms aren't that focused on this metric to go to the bother.) So what's the RPL story?

To the extent it's disclosed, or calculable, I view RPL as something of a rough proxy for "quality of practice." By that I simply mean that the more clients are willing to pay you, on average, for a lawyer-year's worth of time from your firm, the higher the value clients place on what you do for them. At the margins and in the short run, this may be influenced by tweaking hourly rates or recognition percentages, but over the long run and in extremely revealing ways, the trend of your firm's RPL (vis-a-vis your peer group, as always--discipline, people!), be it up or down or sideways, tells an enormously important and almost incontrovertible story about the trajectory of your practice. You can be going up-market, down-market, or staying-market, but RPL, over time, won't lie.

So again, what does RPL reveal? Pretty simply this: It was a tough year. If you eliminate the highest and the lowest changes in RPL, the remaining cross-section looks like it's down in the middle single digit percentages. The sky is not falling, but people clearly aren't as busy, or aren't as busy on valuable matters, as the previous year. But the most important part of that sentence is the introductory clause: We're not in dire straits.

Finally, of course, column #4, the sexiest column of the all. Permit me to suggest that the PPP story is the second simplest story to tell, after the gross revenue story. Again, eliminating the highest and the lowest to normalize against outliers, the story is one of essentially flat year over year PPP.

The two key numbers come back to this: Revenue flat to seriously down, PPP flat to very mildly down.

Here's where I think law firm management deserves credit (again, generalizing).

Most of corporate America would be delighted to have emerged from 2009, or any difficult period, with revenue decidedly down but profits marginally up. It takes turning the ship quickly. And here's the good news from our industry: We did just that.

If you look at any of the charts tracking layoffs during 2009 (if you haven't, that's OK, I have so you don't have to), more than half the year's total layoffs took place in the first 3 months of the year. In other words, management reacted quickly.

Remember that September 2008 was the carpet-bombing month of damages to the financial system: Not just the Lehman bankruptcy, but the WaMu takeover, largest in history by the FDIC, the death of investment banks as we know them, the BofA/Merrill takeover, the $85-billion AIG investment, the Fannie Mae/Freddie Mac implosions, and even more-all in a single 19 days.

For firms' management, widely if not across the board, to have responded with historically drastic measures one short quarter later is, to me, nothing short of surprising. Management deserves more credit than it may have gotten.

As an industry, we did respond with alacrity. Kudos where kudos are due.

Now, two last thoughts.

First, the human toll of layoffs.

Putting aside partners who were overdue to be "spoken to," non-equity partners who were in place only because of a cowardly preference by their practice group leaders for avoiding awkward conversations, associates who long since "checked out" psychologically and in terms of commitment, and staff who might have come to view their jobs as sinecures--all of whom needed to be excused for the health of the firm overall, and overdue much of it was--there are still the legions of people who were collateral damage. People who were doing their best, even if it wasn't good enough. My heart goes out to them, and I've known more than a few.

But second, the Darwinian logic of the marketplace that compels firms to sustain PPP in the face of the most gruesome downturn in any of our careers is not cavalier and not selfish.

Why is PPP so important?

Because it is nothing less than the lifeblood, in today's currency, of firms' ability to compete for talent in the market. (Whether tomorrow could look different is a story for another day.)

If management allows PPP to take a serious hit in today's hyper-mobile environment, they may find that all of a sudden there are fewer partners and no profits. Lights out. And that, of course, is when the collateral damage to the secretaries with 20 years' service and a learning-disabled child at home hits you between the eyes.

Jack ("Neutron Jack") Welch famously said that his 20/70/10 forced-ranking of stars, the solid bench, and the ankle weights who had to be cut off, was not inhumane. It was the only way to provide a healthy and ever-renewing organizational environment going forward in which the stars and the solid citizens would not be tethered to the subpar and the serving-time.

So looking ahead to 2010, take heart. By and large we did what we had to do at the start of 2009, and the numbers, which overall and in the long run don't lie, are starting to report that story.

In the 1980's and 1990's, one often heard the only semi-facetious phrase that "investment bankers are short-term greedy, but lawyers are long-term greedy."  One of the few exceptions to "short term greedy" on the I-Bank side of the Street was always Goldman Sachs, which, under the leadership of people like John Weinberg, was the epitome of long-term greedy.

I was put in mind of this by a front page piece in today's New York Times, "As Goldman Thrives, Some Say an Ethos Has Faded."  Here's the gist.

Lloyd Blankfein has led Goldman Sachs since 2006, and "has surrounded himself with a tight circle of executives drawn from Goldman's trading operation."  The business model of Mega I-Banks has traditionally had two components, trading for the firm's own account, and counseling corporate clients on strategy, M&A, and so forth.  But if you believe the article (I do, fundamentally), this balance has shifted at Goldman:

Interviews with nearly 20 current and former Goldman partners paint a portrait of a bank driven by hard-charging traders like Mr. Blankfein, who wager vast sums in world markets in hopes of quick profits. Discreet bankers who give advice to corporate clients and help them raise capital -- once a major source of earnings for Goldman -- have been eclipsed, these people said.

To my way of thinking, the smoking gun is a 2006 change in compensation for measuring investment bankers' value to the firm.  That year, Goldman instituted banker "profiles," which are daily (yes, daily!) P&L's showing how much business its employees and clients are doing. As the article writes, this change--quelle surprise--had two effects.  First, Goldmanites focused on clients who might generate the most revenue in the very near term, and second, it "prompted bankers to fight more aggressively for credit for their deals." (Sound familiar?)

Regular readers know that I place great stock in compensation:  Read, incentives.  Econ 101, and Econ X01 through Y01, relentlessly teach the importance of incentives in molding behavior.  And the i-bankers at Goldman are surely smart enough that they don't need to be told twice how to bring home more of what they surely feel entitled to.

Here's another window on the change the firm may have undergone:

"Would John Weinberg ever be in this situation?" [offering vague apologies for "mistakes" leading up to the financial crisis], asked one former partner, referring to the legendary senior partner who ran Goldman for many years. "No way. He would have thought about the firm over 50, 100 years, not what people will get paid this year."

Since the modern Goldman emerged during the Depression, its executives have cultivated a ruthless professionalism tempered by what might best be described as Goldman Sachs Exceptionalism: a sense that Goldman stands apart from, if not above, Wall Street rivals.

This sense, strengthened by a tradition of government service among senior executives, runs deep inside the bank's headquarters at 85 Broad Street in Lower Manhattan. Indeed, from the day they arrive, employees are steeped in the firm's 14 principles. No. 1 is: "Our clients' interests always come first. Our experience shows that if we serve our clients well, our own success will follow."

If you perceive an analogy to Law Firm Land, the line forms to the left.

Surely, surely, your firm has stated core principles akin to Goldman's:  Put the interest of your clients first, and the firm will take care of itself.

But do you also have long-lasting origination credits?  And how important are they?

To what extent does your compensation model reflect a zero-sum game where one partner's hoarding gain is another's failure to collaborate loss?  Do you measure performance daily, weekly, monthly, quarterly, annually, or over three to five-year rolling cycles?

In other words, how short-term greedy are you and how long-term greedy are you?

I fear that too many firms became too short-term greedy in the past decade.

Were there reasons for this?

In hindsight, of course, we know that the reasons espoused at the time look more like pretexts or thoughtless obeisance to the common wisdom than they actually look like hard-boiled, unblinkingly analytical Reasons.  

• Why lend promiscuously to subprime borrowers?  Because housing prices only go up, never down.
• Why pinch clients for more immediate revenue with less regard to cultivating a long-term relationship?  (a) Because we're Goldman Sachs and we can; and (b) because we have eaten the fruit of the poisonous quarterly- and annual-results tree of knowledge.
• Why resort to financial acrobatics and structural contortions to boost your profits-per-partner figures for benefit of The American Lawyer?  Because no one wants to finish last in a beauty contest and because everyone else is doing it (and everyone else knows everyone else is doing it, so wink-wink).

Those that became short-term greedy are now faced with the consummate challenge of rebuilding their business model at the same time they need to re-educate their partners and their associates and re-invigorate a lost culture of client service first.  All while the "Great Reset" threatens to derail the entire train.

But if the design of your compensation system, evidently like that of Goldman's, encouraged short-term-itis, do not blame your partners.  Blame yourself.

Lloyd Blankfein

Update from a reader in the UK (December 22):

Fascinating and provocative as usual, Bruce. The question, though, is of course: is it possible for law firm management to be "long-term greedy" in the age of the lateral partner? Even public companies have institutional long-term shareholders who may exert some pressure to not throw the future out in the quest for quick returns. Law firms strike me as almost unique, in that the firm's talent are also the shareholders and can exert enormous pressure on management to do things their way; and, once you add a febrile talent market to the mix, you end up with partners able to effectively hold their firms to ransom: "short-term profit or I'm out of here". Of course, the Wall St law firms (ironically enough given what's happened to their clientèle) cling on to lockstep, relatively low levels of lateraling, etc. But any economist presumably knows "culture" is an inadequate bulwark against misaligned incentives

What's going on at Reed Smith?

Less than a week ago, they announced a roughly 20% cut in first-year associate salaries and hourly billing rates for the 50-odd lawyers joining the firm in January 2010. Here's what they had to say about it (emphasis supplied):

"In response to our clients' feedback and concerns about driving down the cost of legal services, we wanted to send a clear message that we are listening.  So, we have therefore reduced both the rates and the salaries of our incoming first year associates" said Gregory  B. Jordan, Reed Smith's Global Managing Partner.  "We have also launched a new competency based development program to better prepare our new lawyers to meet the needs of our clients."

Annual starting salaries for the new associates beginning in January 2010 will range from $130,000 in major markets such as New York City, Chicago, California, and Washington, D.C. (down from a high of $160,000 in 2008), to $110,000 in Pittsburgh, PA.  These actions solely involve the new associates entering the firm's U.S. offices.  Salary levels for 2010 newly qualifying lawyers in the firm's European, Middle Eastern and Asian offices will be determined in the normal course of business during 2010. 

"Our new U.S. starting salaries represent a reasonable and appropriate reset based on today's economic environment," said Eugene Tillman, the firm's Global Head of Legal Personnel. "We believe this will put Reed Smith in a stronger business position in a changing marketplace while still providing fair compensation to our new associates."

Billable hour expectations were also cut for 1st-years from 1,900 to 1,700/year (just over 10%), with the shaved time being devoted to training.

But the remarks I've highlighted go virtually all the way to explaining what's going on, I believe: The firm wants to try to get out in front of client expectations (and demands) for economies in legal expense, and they're targeting a hot button--the high salaries and low/nonexistent competency levels of junior associates. Will it work? Silly question: This is a buyer's market for junior associate talent the likes of which most of us still alive and breathing have never seen. Young associates have zero bargaining power (OK, Rhodes Scholars/Supreme Court clerks/NFL wide receivers excepted, as always).

Will it become universal? Don't hold your breath. As Jordan astutely notes elsewhere (at least I think it's astute since I happen to agree with him emphatically),

In the wake of the downturn, Jordan said law firms in general are making decisions independently and apart of industry trends.

"Law firms aren't copying each other," he said. "Everybody is trying to figure out how to run their business and how to get it as rightly-positioned as they can. We're seeing it every day. We're going to see sharper decision making by all the law firms, not mimicking each other on every little thing."

And now they have announced an even more radical move--well, at least one affecting about six times as many people, at a far more senior level--with the news that their 300 or so non-equity partners will be asked to contribute up to 15% of their compensation to the firm as capital. And if you would "prefer not to?" Then you can either forfeit your "partner" status, presumably achieving instant self-inflicted demotion to "associate," or leg into the contribution over a few years. What you cannot do is stay a non-equity partner and decline to make the contribution.

Whereas the first announcement was greeted, so far as I can discern, largely with silence if not a collective yawn, the latter has generated predictable second-guessing and skepticism about the firm's professed motives, most of it centered around what it does or does not imply about the firm's financial fortunes. Jordan (disclosure: I consider him a friend and one of the more innovative managing partners in the business) was at pains to head off this speculation:

Jordan stressed that the move is not simply meant to provide a quick-fix cash injection or as a way of culling the firm's non-equity partnership. "People could say, 'Oh, Reed Smith must need the money,' but the reality is we are having a very strong year," he says. "And if you wanted to just trim non-equity partners, there are much easier ways to do that."

Performing a very back of the envelope calculation, the move could bring Reed Smith $18-million or so (say somewhere between $15 and $20-million, to be safe), which is certainly a not-immaterial contribution to capital, and it's manifestly easier to raise it from your non-equity cohort than going back to the well with your equity partners or your even less forgiving bankers.

Alas, the coverage so far raises more questions than it answers:

• What type of animal exactly is the "contribution?"
  • A one-time payment, a sort of toll extracted for the privilege of continuing to carry the word "partner" on your business card?
  • An interest-free loan, repayable (presumably) upon your departure from the firm (and what if the departure is "for cause" as far as the firm is concerned?)
  • Is it secured or unsecured?
  • Oh, and again, does it earn interest?
  • Assuming it's not characterized as an equity investment--and both the language of the stories and the premise of "non-equity" partner strongly imply it's not--in what sense, then, are you a "partner?"
• The firm explains that part of the rationale is that some (but apparently not all) non-equity partners in European offices, primarily those in legacy merged offices, already have been required to contribute capital, so on that view it's only a way to level the famous playing field between the US and the rest of the world. (there are two ways to achieve that, of course, this being only one of them).
• How does the 15% number compare with the capital contributions expected/required of equity partners?
  • Are the other "terms" of the contribution identical or materially different?
  • When a non-equity's compensation goes up, or down, does their contribution rise or is a rebate expected?

One could go on, and I invite you to do so with your friends at home, but I have a larger issue to close with.

Assuming the Holy Grail of our world is the "one-firm firm," the institutionalized firm in which everyone, from Managing Partner to non-equity partner to paralegal to administrative assistant, feels invested, a firm with a vision they can buy into, what here is not to like?

This has to be what Jordan is driving at when he says "[Non-equity partners will] have a stake in the business and meaningful profit participation, not just carrying the title [of partner]. [and] "It's about not just saying you're a partner, but actually being one. It means something. It revolves around risk-sharing in the business."

We can take potshots from the sidelines to our heart's content (here's a sample), but who would seriously argue with the goals Jordan here articulates?

Or we may simply be overthinking this.

Econ101 teaches that if you want people to demand less of something, make it more expensive. Reed Smith has just made non-equity partner status more expensive.

Put that together with my belief that as an industry we let the entire non-equity tier grow out of control during the boom years, and you may be seeing the beginning of one approach to the problem. It's certainly easier than having all those awkward one-on-one conversations with underperformers.

My recent column, What Makes Laterals Run?, has generated a most rewarding level of reader feedback, worthy of an update to the original column.

Reactions have literally come from around the world, and, with the permission of my correspondents (all of whom expect anonymity, an expectation I most willingly grant), I wanted to share a sampling with you and then elaborate on what further thoughts of mine they prompt. 

First, from a former partner in a couple of name-brand firms, with 30+years of experience under his belt in roles such as executive committee member, founding partner of various offices, and co-chair of his firm:

"Bruce, you definitely have this right. When I set up our new London office in 1999, I was able to recruit top laterals not based on our money offer (strong and fair but not the ridiculous offers of firms like [name removed to protect the firm so charged--Bruce]) but rather based on our business plan and specific suggestions as to how they could cross sell to our existing client base and strong practices in new emerging markets. You are seeing the same thing here."

So what I'm suggesting has been going on for more than a decade--at least among the more discerning firms and lateral partner candidates.

Second, from another globe-trotting and astute observer of our wondrous profession:

Long time since I've emailed, but I was struck by something amusing, maybe even ironic, in your post today on lateral partner moves.  Basically, it seems like lateral partner moves have now "caught up" with lateral associate moves. 

Clearly, there were associates who used to move upstream (think bankruptcy associates during the last wave), who used to move downstream (the classic, maybe now defunct, "work/life" balance move), and who "serially divorced" (as in an associate I knew who was at 3 or 4 different firms in five years).  But for a long time, there were also strategic associate moves -- the associates who could not fully "read" how the firm planned for their future and moved to a firm where they believed their odds for making partner would be clearer and more transparent.  If a 40-50 year old partner moves because they cannot discern their firms' plans for the future and, indirectly, their future chances for increased fame, glory and compensation, is it really that different from those associates who used to move due to uncertainty over their own future?

Regards,
[xxxxxx]

P.S.  Yes, my use of the past tense for lateral associate moves was intentional.  Depending on how long this Great Reset lasts (great name for it, by the way), I wonder when discussion of lateral partner moves will also move in to the past tense?

Interesting perspective comparing lateral partners' strategies with lateral associates' strategies.  All I can add is that, yes, "work/life balance" is "so last August," and that the insight that one thing both associates and partners may be seeking in a lateral move is greater clarity vis-a-vis where they stand with their firm.  In my original column, I stressed partners motivated to look around because they perceived a lack of clarity in their firm's strategic vision, but an equally strong motivation could certainly be lack of clarity from the firm about the partner's own long-run prospects.

And as for using the past tense?  Given that voluntary associate attrition has fallen to barely above 0%, I agree that the past tense is justified, at least until a technical-but-jobless recovery from the Great Reset becomes robust enough to reach the stage of actually creating net new jobs.  (Don't hold your breath on this one, folks; my own armchair guess is 2012.)

Third, a partner with a Magic Circle firm in Asia writes:

Great piece on laterals - and, I think your hypothesis is spot on !!! [...]  It is also very relevant to a major shift going on in the [local] market at the moment.

Finally, a periodic correspondent offers extensive, and very thoughtful, observations:

Bruce --

        In response to your recent post on lateral recruiting, I drafted below a couple thoughts.    My general view is that extensive lateral recruiting is the sign of real trouble at a firm.  It typically is a sign that a firm has been unable to develop talent internally, and/or that a firm is trying to build a practice in an area that is not a core strength of the firm.  Only where firms use lateral hiring very selectively -- where they are able to specify the precise characteristics of the ideal candidate, and have targeted that person based on a unique firm strategy (rather than blind desire to replicate more profitable, NY-based firms), can lateral hiring have success.

I agree with your basic premise -- that strategy matters in attracting and keeping talent.  I also agree that we are seeing like firms and like partners starting to come together (e.g., securities specialists going to firms with substantial NY practices that earn higher PPP). 

I have two questions:

(1) When will firms stop chasing laterals and start building talent from within.  Most successful organizations develop talent internally, rather than through lateral acquisitions.  For example, GE historically grew all its management talent within GE.  Good professional football teams obtain most of their best talent from the draft, rather than frequent trades. In the legal world, certain firms (such as Latham) develop most of their talent internally, and rarely look for lateral acquisitions.  Conversely, growth through acquisitions is often the sign of a weak company without any compelling strategy or vision (e.g., WorldCom).  Talent grown from within is more loyal, and is often cheaper and less trouble than the lateral who is frequently bought and sold (think Terrell Owens).   Today's managing partners appear to believe either that there is some "silver bullet" to be had through lateral hiring, or that they do not have time to develop sufficient talent internally to meet their profit goals. 

(2) When will firms start matching their lateral recruiting strategy to a firm strategy that is based on the firm's (and the market's) reality, rather than a desire to replicate the successful strategies of the top-20 AmLaw firms (who are mostly all in NY).  If your hypothesis is  true(that there is a migration of partners to firms that better "fit" their practice), one would expect to see a fairly quick rationalization of the law firm industry structure.  Instead, that conversion is happening fairly slowly (though I agree it is happening).  It seems to me that this is because firms refuse to accept their position in the market, and believe (as all firms do) that they are a "premier firm" able to attract top rates and to generate the most sophisticated legal work. 

As a result, most firms still shop for the same, or similar, lateral candidates (such as high-end securities, white collar, IP, and M&A practices).  Even if mid-tier  firms are successful at attracting the lateral candidate, those firms often cannot create any "synergies" with that lateral candidate, because they don't have the clients that might need the service, or because the firm's reputation does not support such a high-end practice.  And, the mid-tier firm will often pay at least as much in compensation as the lateral generates in profits.  Thus, there is no net benefit to the firm of bringing in the lateral partner.  Eventually, either the firm becomes disillusioned with the partner, or the lateral partner becomes disillusioned with the firm and concludes that he can be more successful at a different platform.  The upshot for the firm is that it invested in talent that did not stay with the firm -- a lost investment to the firm.  Now, if the firm's lateral recruiting were targeted to those areas where the firm was distinctive, and different from others in the market, the firm might be better able to hold onto the talent, and create potential "synergies." 

In other words, firms need to stop recruiting just for the sake of "growth," or to increase profitability, and instead invest in lateral growth only in those areas that the firm has identified as being necessary for its unique strategy (and only when that strategy is rationally tied to the market reality of who the firm is, and not who the firm would like to become).  Now, if firms were sufficiently well-run that they identified their strategy several years in advance, and identified the areas in which they needed expertise, they might even be able to help senior associates and partners gain the experience and develop the skills needed, and thereby avoid lateral recruiting in the first place.  But, most firms do not appear to have reached that point. 

So, what more have we learned?

I'm tempted to reiterate where I began the original column, by pointing out (confessing?) that "perhaps I don't write as much as I should about lateral partners."  Certainly this piece seems to have unleashed some extremely thoughtful reaction.

The reason you rarely see me writing about laterals is blisteringly simple:  I have long believed that the vast majority of activity on the lateral-pursuit-seduction-&-wooing front is fundamentally misbegotten.  Yet, every day of the week you encounter firms and their managing partners (well, at least you did....) who act as if the single most valuable activity they can engage in to lift their firm's fortunes is to pound the pavement for desirable laterals.  And Lord knows the headhunting industry has made a living off it; never let me be the first to assume that entire sectors of the economy are premised on systemic, enduring, and irrational market failures.  Yet I continue to believe that all but the most assiduously and astutely targeted lateral recruitment is a fool's game.  (Here I invoke the widely recognized folk philosopher Bob Dylan to explain my reticence to write about this topic:  "And don't criticize what you can't understand....")

But now that the genie is out of the bottle, I'm compelled to offer, or elaborate upon, a few observations:

• I continue to believe that on an industry-wide, macro basis, we are seeing a systematic sorting-out of talent as lawyers seek to match their skills to the most appropriate firm platforms.  $1,000/hour rates are not for everyone, or for every firm, but they most assuredly are for some chosen elect and a similarly selective handful of firms.  Economically speaking, the logic is compelling that those blessed souls and those firms on whom fate has showered its beneficence should get together.
  
  
• Conversely, as I wrote in the original piece, there's room in this world for lower-margin, more routine work:  This is a respectable, indeed admirable, sector of any rationally organized marketplace, and firms and individuals who know themselves should rush to satisfy this demand.  And no, I'm not being condescending; au contraire. 
  
  I would tell you in all honesty that I think two of the finest cars for sale today are the Toyota Camry and the Honda Accord.  Neither one remotely breaks the bank and while, admittedly, neither will pin your ears back with acceleration or stun your date into a state of befuddled worship, they are very gentle on the wallet, they start, stop, and go as promised, and you can ignore and abuse them for tens of thousands of miles without complaint.  Try that with a BMW and see how long it takes you to cry uncle tow truck.  Toyota and Honda have achieved something truly outstanding here.
  
  
• There are other reasons to cast a jaundiced eye on excessive reliance on lateral recruitment as a core "strategy," some of which I alluded to in my first piece and some of which our enlightened commenters have pointed out:
  
  
  • There will never be a substitute for home-grown talent:  Not at GE, not for the Yankees, and not for your firm.  To cite a home-town (NYC) firm that has a long but not rigid tradition of emphasizing up-from-the-ranks talent, Paul Weiss seems to be thriving even in these currently challenging times.  Pure coincidence?
    
    
  • In MBA Land, professors delight in teaching about and management gurus delight in writing about "KPI's," or "key performance indicators."  What is a KPI?  Well, it depends on what your company does, but if you're a retailer (think Amazon, or Dell), a KPI might be the number of inventory "turns" you can generate annually.  Another might be how fast you can collect cash from your customers before you have to pay your suppliers (both those firms, amazingly, have that metric in negative territory, meaning they collect their customers' revenues well before they pay their suppliers--you might want to think of that trick next time you're tempted to indulge a client who's 90 days late and wants to be 150 days late).
    
    But my secret suspicion is that, for every KPI, there has to be an evil twin:  Call them "KRI's," or key risk indicators, which are dials on the dashboard indicating you might be headed for the guardrail, or over it.  For law firms, one big KRI, in my book, is excessive and promiscuous lateral recruitment.  Yes, "excessive" and "promiscuous" are both fudge phrases, but I think you know where I'm going and I think you know it when you see it.  As I said originally, the best predictor of getting divorced is having been divorced.  This is nothing, really, other than the flip side of home-grown talent's loyalty.
    
    
  • Finally, vast is the economic literature demonstrating and recounting the phenomenon of the "winner's curse," a/k/a "buyer's remorse."  It's quite simple:  The winner of an auction (a bidding war for lateral partner talent, for Alex Rodriguez, or for Madonna) will be the firm that is closest to paying The Talent every last red cent The Talent can expect to marginally contribute to the firm.  Which leaves the firm with....you guessed it:  Nothing.

Do I suspect our fascination with lateral hiring and recruitment will go away any time soon?  No, no more than corporate America's fascination with the search for CEO-as-Saviour will end and no more, for that matter, than the all too well-chronicled proclivity of the ambitious and the striving for seeking out mates other than those individuals to whom they're married.

But as a long-term strategy, I can't really bring myself to endorse either tactic.

Now, what exactly is your firm going to do about it?

Permit me to suggest you start with the intellectually challenging and culturally slippery project of defining precisely your strategic advantages and what distinguishes your firm from your competitive set in the eyes of clients.

And a last word.  If you intend to go about defining the Unique Value Proposition your firm offers clients, it has to meet each of these criteria:

• It must be credible.  We are not all Skadden, Wachtell, or Slaughters.
• It must be ownable.  It must connect, in other words, to a visceral understanding of who your firm is and where you fit in the great Value Chain of Law Land.
• And finally, it must offer a benefit to the client.  Without this final component, I invite you to beat your breastplates all you'd like; it will matter not.

Then again, if all this sounds too hard, why don't you just make a reservation at an elegant restaurant for dinner with a potential lateral?

Perhaps I don't write as much as I should about lateral partners.

I mean the economic phenomenon of lateral partner hiring, not gossip that much of the legal press seems to specialize in about specific "gotcha" movements of partners or small groups from Big Loser firm to Big Winner firm--stories whose half-life, in my experience, is measured by how long it takes for Big Winner firm to suffer a "shocking" loss of partners in its turn. Truth be told, much of it seems on the surface to be a revolving door.

Of course it's not really so simple.

If you stand back and look at the lateral partner migration phenomenon on a macro basis over the past two decades or so, what I think you see is a vast, and economically compelling, sorting-out. It's a sorting out of partners with high-margin, high-value practices migrating to firms where there are kindred souls and where the value of their practices can be maximized, and, on the other side of the coin (as it were), partners with low-margin, commoditizing, practices moving out of firms less willing to support those practice areas and into firms where they still feel welcome.

If you were to graph this in a conceptual way, I surmise you'd find something along these lines:

• People specializing in white collar crime, corporate governance investigations, tax litigation, high-end M&A (well, at least until last September 15), securities litigation, and other "high end" practices are by and large moving to firms with higher PPP's and greater prestige.
• Generalists in commercial litigation or corporate transactions are probably churning around a bit but not, on the whole, moving up or down the food chain as a cohort.
• And those in now-disfavored areas such as T&E, employment, or generic real estate are moving down-market to less prestigious firms with lower PPP.

This is a surmise, as I said, but I would like to believe an informed one.

Why, you may be asking, would anyone voluntarily move down-market? They wouldn't, and they don't. They have no choice. Firms that have decided they no longer care to be in the business of (say) T&E or employment simply make it clear there is no long-term home for them, and so they find a home where they can. Nobody guaranteed you a rose garden.

What else can we say about lateral partner movement?

The primary, most important, and most amazing thing to say about it is that it's both something many firms have obsessed about for the past many years (decades?) and that by and large we're terrible at making it work.

One managing partner recently told me that his firm's batting average was 1 in 3: One lateral in three succeeds. Another told me that they seem to have equal shares people who hit home runs and those who unceremoniously ground into double-plays--and that no matter how hard they analyze everything, they can't tell which will be which up front. They continue to be surprised both by who succeeds and who flames out.

Indeed, this mirrors my own experience.

For many firms, for the past many years, a core part of their strategy has simply been "lateral acquisition." And the primary reason I haven't written about it much, if at all, here on Adam Smith, Esq., is because I simply don't know what intelligent observations can be offered on that "strategy" in general. So much depends on the specifics of (a) clients; (b) cultural fit; (c) timing; (d) sexiness or sudden lack thereof of the practice area being sought [remember the firms who paid at the top of the market for private equity folks?--I do]; (e) receptivity or hostility by the incumbent partners; (f) emotional and intellectual flexibility of the incoming lateral; and (g) did I mention culture?

In other words, it's hard to discuss a "strategy" that is so hyper-dependent on intensely local and personal considerations of chemistry and nuance.

Two last observations before I move on to what I think is actually new and different and fascinating in today's lateral marketplace.

First, there's ample evidence from the worlds of celebrity entertainers and sports stars that marquee names tend to capture essentially the entire present discounted value of their economic contribution to the firm (the record label, the movie studio, the Yankees), leaving very little if any "surplus" for the acquiring firm. While the data in law-firm land to examine this question are, systemically, sorely lacking, it's worth thinking about. (I cite entertainment and sports only because they have a wealth of publicly available data which economists have glommed on to in order to analyze who "captures" the value of the Big Name.)

Second, we have the unfortunate phenomenon of the serial killer mover. You know the type: They'll move for a 10-15-20% bump in pay (preferably with a guarantee, thank you very much), ply their trade for a few years until their new host gets tired of them or cottons to their game of large promises and underdelivering, and then they'll move on again. If clients ask me about folks like this, all I can say is that the best predictor of getting divorced is having been divorced.

This brings me to why I wanted to write about lateral partners now.

I detect a new reason for lateral partner movement, which I've never seen before.

I characterize it as laterals motivated to move because they're asking themselves, and implicitly their firms, "What's the plan here?" And not finding a persuasive answer.

Some context:

• I'm not talking about laterals tempted to move by a 10--15% bump in compensation. If somebody moves for that "reason," you can bet there's something else really going on.
• I'm also not talking about extremely senior (in years, that is) laterals who may be about to bump up against their firms' mandatory retirement age and are looking for an escape hatch; that's not the type of "what's the plan?" I mean.

Rather, I'm talking about youngish to middle-aged laterals who can realistically envision another 20 or 30 years of productive laboring in the vineyard, who look at their firm's reaction to the Great Reset we're living through and who do not perceive a credible response. Firms, in other words, without "a plan."

Now, if you're 55 or so and up, this scarcely matters. Momentum, if nothing else (market shares, and perceptions, lag reality by years), will carry you through safely to retirement.

But what if you're 35 or 40, or even 50 and are allergic to the concept of "retirement?" Then you have a serious problem if your firm appears to be clueless in responding to the seismic changes afoot.

I see this in laterals' resumes now coming out of firms they never used to come out of. And it's not about the money, and it is most assuredly not about the "prestige." Not that these people are going down-market; that's the last thing they need to do. They're simply going "sideways-market," which in and of itself makes little sense; thus my hypothesis that something else is going on.

The most important conclusion I can draw from this is that strategy matters. It matters if for no other reason than your partners now believe, perhaps for the first time in their careers, that it matters. People didn't used to shuffle between firms because they feared the ship they were on was rudderless, or captained by intellectually absentee management. This is what's new.

And here's my diagnostic suggestion for you: If your firm has recently lost a few people, ask yourself--really ask yourself--why they left. And if your firm is seeing great resumes, particularly resumes of a caliber you didn't typically used to see, ask those people what's motivating them. Dollars to doughnuts it's not the money. I bet it's the strategy.

According to the most recent fossil record discoveries, life on Earth dates back about 3,450-million years. But for about the first 85% of that time span, organisms were extremely simple, composed of individual cells, occasionally organized into colonies.  Pretty dull.

Then something striking happened, about 530-million years ago, which is now known as the "Cambrian explosion." For reasons not entirely understood--oxygen reaching critical levels in the atmosphere? more sophisticated predator/prey competition? an immediately preceding mass extinction? "co-evolution" of related species?--evolution came up with a brilliant invention: Mutli-cellular life.

Multicellular life, as expressed in the Cambrian explosion, is not just aggregate-cellular life.  It's organisms with structure, with layers, appendages, limbs conducing to mobility, eyes, ears, and dedicated noses, protective carapaces, offensive tools such as teeth and claws, and essentially the entire array of what we customarily think of as the Lego blocks that can go into making up modern-day and even prehistoric animals. (Something similar happened with an explosion in the diversity of land-based plants about 400-million years ago, in the Devonian period.)

This is a quantum leap.

A profusion of widely diverse body types and anatomical plans arose, some constituting direct predecessors to animal life as we recognize it today (for example, if it's mobility you're after, four limbs--not more, not less--turn out to be really useful). Many many other plans, almost certainly the majority, were less optimally adapted and now belong to extinct lineages--such as Opabinia, with five eyes and a nose like a fire hose, or Wiwaxia, an armored slug with two rows of protective upright scales.

Interestingly enough, the Cambrian explosion was sufficiently powerful, diverse, and creative that no design template for a modern animal post-dates it. In other words, structurally and conceptually, pretty much every animal we see had a recognizable predecessor dating to this period. To be sure, evolution can produce shockingly powerful advances given a few hundred million years, but the point is that it was the seminal moment in the creation of multi-cellular life, where "a thousand flowers bloomed." While many were proven more or less in short order to be false starts and dead ends, the point is that the intensity of experimentation led to some extremely durable and well-proven animal models.

Take a look (click to play the 25-second PBS video):

What has this to do with BigLaw?

My thesis is that since, say, around 1980, we've been living in an ecological mono-culture: We have all been one-celled creatures, in the sense that we have all had one and only one strategy: Growth.

Aside from our "mono-strategy" as an industry, we have had:

• Mono-associate career paths (8 years, plus or minus, of lockstep to partnership);
• Mono revenue models (the billable hour);
• Mono levers for increasing profitability (primarily, by increasing leverage);
• And mono techniques for gaining competitive advantage (primarily, lateral partner recruitment).

I believe we're on the cusp of our own "Cambrian explosion," where we may begin to see a wealth of experimentation with different business models.

If the Cambrian explosion of 540-million years ago is any guide, there will be a lot of false starts and dead ends, a/k/a extinct species and firms. But there will also be some far-seeing, fast-running, high-flying, incalculably intelligent designs.

Stay tuned for the next installment in this series.

Hogan & Hartson/Lovells?

As amply reported (Legal Week, The National Law Journal, The Lawyer), the firms are in merger talks and, since no one is remotely denying the reports, we can only assume it's all quite for real.

We'll get to what we think it means in a moment, but first, to the numbers:

*All figures in US$, using a conversion ratio of 1.594 $/£.

In addition, cities where both firms have offices are:

• New York
• London
• Hong Kong
• Beijing
• Paris
• Tokyo
• Munich
• Moscow

On a pro forma basis, the combined firm--assuming a complete merger--would have these characteristics:

• Revenue: $1.9-billion
• Number of lawyers: >2,500
• Global rank: Neck and neck with Latham & Watkins and Allen & Overy, all in a horse race for Global Firm #7:
  • DLA Piper: $2.26-billion
  • Linklaters: $2.23-billion
  • Freshfields: $2.21-billion
  • Skadden: $2.20-billion
  • Baker & McKenzie: $2.19-billion
  • Clifford Chance: $2.16-billion
  • Latham & Watkins ($1.92-billion), Hogan/Lovells (roughly $1.9-billion), Allen & Overy ($1.88-billion)

Finally, the practice mix would seem at first glance to be highly complementary. Hogan is known especially for its regulatory/government law practices, antitrust, litigation, intellectual property, real estate, and a substantial level of corporate work. Lovells, somewhat unusual for a UK-based firm, also has a relatively robust litigation practice and is less deal-driven than (say) the Magic Circle, as well as having strong real estate, antitrust, and regulatory law capabilities.

So: What does this really mean?

Already the naysayers, of course, are keening about the challenges and the obstacles.  To be fair, the commentary has not been uniformly negative, with (for example) Alex Novarese of Legal Week saying that "at first glance, there appears much to commend this union," but he is quite the exception.

A sampling:

• "Merger-averse Hogan" supposedly reversing field;
• "partner compensation is, of course, a tougher challenge;"
• "transatlantic deals are fiendishly difficult to pull off;" and "transcontinental mergers have a mixed [read: dubious] history;"
• "US/UK deals are notoriously difficult to secure given the challenge of marrying differing partner compensation and accounting models;"
• "it's not clear what a merger would do for the combined firms' profitability;" and, of course, the inevitable
• "there could also be conflict over whether control of the combined firm would reside in Washington or London."

I'm here to tell you that it's time for us all to just get over ourselves.

So far as I can tell (no insider knowledge here, folks, sorry to report), this deal makes superb sense.

For how many years/decades/centuries have major corporations been doing transatlantic business on a routine basis? And somehow they have been managing to smooth out the differences between the pound sterling and the dollar, the differences between compensation expectations in the US and the UK (not to mention New York and London specifically), the differences between driving on the right and on the left, and of course the grain of truth in the famous quip about being "divided by a common language."

As for the New York/London divide specifically, we are informed by a UK legal publication that the architects of this deal should be grateful Hogan doesn't have its roots here in the Empire State: "A conservatively-run practice like Hogan, with a centre of gravity outside the brittle egos of Manhattan, shouldn't be the hardest American firm to align with a UK practice." [Note to visitors to the home office of "Adam Smith, Esq.:" Please check your egos at the door; we do.]

Are there challenges? Of course; there are challenges to running each of the firms today, as they stand alone. Would the challenge of running the combination be twice as great? Perhaps, but I doubt it--at least it would decline over time, and in the meantime there would be double the resources to devote to the challenges. Combinations that have far more moving parts than this one (just to pick a current example, Kraft/Cadbury) are pulled off routinely in CorporateLand. Why do we presume market forces end where legal services begin?

More importantly, do you see what's going on here?

Each of the obligatory reservations stated to the deal--partner compensation, the putative transatlantic "challenge," whether Washington or London would "win"--is at bottom a rather shameless exercise in navel-gazing.

When I said it's time for us to "get over ourselves," this is precisely what I meant. So far, the tenor of discussion about this proposed merger has been--at least when it shifts from pure journalistic reporting to implied or overt opinion--about as sophisticated as sports bar debates. (I am compelled to note one outstanding exception, which I would like to believe serves to prove my rule, namely the thoughtful commentary by Aric Press, "What a Hogan/Lovells Merger Would Mean.")

This is potentially a transaction that will change a conspicuous portion of the BigLaw landscape globally. Prattle as we may about the "globalization" of the profession, the Global 100 law firms are still (for reasons that have understandable, if archaic, roots in history and regulation-by-jurisdiction) almost shockingly insular, domestically rooted institutions. Of those 100--pop quiz--how many have:

• Over 50% of their lawyers outside their home country? Only 10 (yes, including Lovells, and counting DLA worldwide and DLA international as one firm).
• And of those 10, how many are of US origin? Two, namely White & Case and Baker & McKenzie.
• Between 30 and 45% of their lawyers outside the home country? Again, only 10, with a somewhat more respectable 7 of US origin.
• And below the 30% bar, the pickings get slim indeed, including some heavyweight name brands with surprisingly low numbers. For example? I would argue that if at least 3 out of 4 of your lawyers are in your home country, you're not yet seriously international. Here are some candidates (not to single these out, just to make a point):
  • Sullivan & Cromwell: 22% of lawyers non-US based
  • Skadden: 16%
  • Sidley Austin: 16%
  • Davis Polk: 13%
  • Simpson Thacher: 11%
  • &c.

The point is simply this: As an industry, we are not nearly as "internationalized" as our clients, and certainly not remotely as global as the premier clients we all aspire to serve.

It sounds to me as though the leadership of Lovells and of Hogan & Hartson are focusing on genuine strategic objectives and not on "who's on first."

We all need to grow up, snap out of our self-referential and unappealingly self-regarding reveries, and seriously contemplate what this may portend. And from my perspective, it will all be good. Overdue, but good.

Pop quiz: Which of these would be worse:

• Learning that, based on economic performance, lawyers in your practice group (including yourself) would be getting year-end raises smaller than average across the firm; or
• Feeling that you, individually, are being systematically shunned by the head of your practice group.

If you answered (b), welcome to the Mammal population.

I'm not being facetious. Neuroscientific research described in Managing with the Brain in Mind, (Booz & Co., Strategy + Business, Issue 56, Autumn 2009, p. 59--not yet published online, but keep an eye on their site) demonstrates that mammals perceive the feeling of emotional exclusion (based on activity in the "suffering" region of the brain) as the neurological equivalent of the distress associated with physical pain.

According to Naomi Eisenberger, the UCLA researcher who designed the study reaching this conclusion (involving fMRI's and a rigged computer game, since you asked), "Most proesses operating in the background when your brain is at rest are involved in thinking about other people and yourself."

What does this mean to you as a manager? Plenty.

As social animals, and as mammals animals extraordinarily dependent on the support of members of our community, work is not a financial transaction, not a quid pro quo of compensation in exchange for behavior. It's social interaction, where being given an assignment we feel unworthy of, being reprimanded (fairly or unfairly), or feeling excluded are far more devastatingly negative experiences than the differenceof a few dollars, or thousands of dollars, at the end of the month.

So what?

Don't think you can treat people--especially highly talented professionals--like a hydraulic system or internal combustion engine, where you adjust the richness of the incoming fuel/air ratio (compensation) and get corresponding horsepower out of the system.

Now, this is not news to anyone who's legitimately earned a role in management (and who has any memory whatsoever of the schoolyard playground), but what's shocking to me is how often this core human insight is honored in the breach in large and medium size firms.

Before, we might have thought that leaders who were empathetic enough to engage employees' strongest talents, support and encourage collaborative teams, and generally create an environment fostering productivity and creativity were "nice to have's."  But the reason I bring this new research to your attention is it argues strongly that such leadership is a lot more than that:  It's indispensable to high-performing organizations.

In an important sense this new research challenges Abraham Maslow's famous "hierarchy of needs," which posits that higher needs can only be met once lower-level needs are satisfied and which ranks the "hierarchy," from bottom to top, as follows:

• physiological survival, such as breathing, sleep, food, and clothing;
• safety, such as personal and financial security, and health;
• social, such as friendship, intimacy, and family
• esteem, both from others and self-esteem; and finally
• self-actualization.

But if being hungry, being physically threatened (by a snake, let's say, a vicious-looking dog, or a reckless driver), and being socially ostracized all trigger the same response in the brain--which this research confirms--then "merely social" needs start to appear more fundamental.

Coincidentally, we got unintentional but powerful confirmation of where "social" needs fit, in what otherwise would have seemed a small bit of news this weekend: The story was that three fishermen were rescued after spending 9 days 200 miles off the Gulf Coast on top of a capsized boat---one day after the Coast Guard called off the rescue efforts as in vain, and by sheer accident as a sharp-eyed guy on a passing boat spotted what he first thought was an innertube and went to investigate.

The story continued that the three had survived on a few gallons of fresh water serendipitously saved from the boat, a box of crackers, "and some bubble gum."  (The nutritional value of bubble gum being a topic that had hitherto not crossed our minds.)  But what's germane about the story?  When asked by the inevitable reporter looking for a "human reaction," "What was the hardest part of the 9 days?," the spokesman for the three replied:  "Right around the fifth day we just really all wanted somebody else to talk to."

Bingo.  You're hanging on for dear life to a useless boat in the middle of the Gulf with dwindling and palpably inadequate resources of food and water, hope for rescue diminishing by the day, and you report that "the hardest part" of the ordeal was being deprived of human companionship?  I did not make this story up.

Making this more important is what happens when the threat response is triggered, as hunger, danger, and ostracism all do:  Analytic thinking and creative insight go right out the window, and in a professional, performance-driven setting, just what people need most deserts them. 

Lest you think that this is all about avoiding dysfunctional human behavior, the good news from the new wave of neuroscientific research is "that the brain is highly plastic. Even the most entrenched behaviors can be modified." Neural connections are not static from adolescence (or thereabouts) onward, as once was thought:

Neural connections can be reformed, new behaviors can be learned, and even the most entrenched behaviors can be modified at any age. The brain will make these shifts only when it is engaged in mindful attention. This is the state of thought associated with observing one's own mental processes (or, in an organization, stepping back to observe the flow of a conversation as it is happening). Mindfulness requires both serenity and concentration; in a threatened state, people are much more likely to be "mindless." Their attention is diverted by the threat, and they cannot easily move to self-discovery.

What conditions, then, might conduce to "mindful attention," or at least to a disposition to collaborate instead of to clam up, to suggest imaginative or creative approaches instead of reproducing the last matter's approach by rote, or to truly engaged conversations instead of what we often get instead, punctuated monologues?

Again, the new research provides evidence that the predisposing conditions include:

• status
• certainty
• autonomy
• relatedness
• fairness.

Status is something we are constantly evaluating: Higher, lower, the same? In whose eyes? And high status is very important: It correlates with higher longevity and health (even adjusting for income, education, etc.). In a firm, the key point is that which indicators of status people value depend on the perceived values of the organization. If the firm is all about rewarding rainmakers, then the only "status" signal that matters is compensation. If the firm is committed to training and professional development, then recognition for increasing levels of professional competence and excellence will be at least as valuable in terms of morale-boosting and teamwork as serious raises.

Certainty is valued simply because its opposite, uncertainty, requires so much energy and attention, a/k/a distraction. Take this with a grain of salt: Moderate uncertainty (will we win the client? will we win the oral argument? will she go to bed with me the client approve our strategy?) can increase tension in very positive, creative, and energizing ways.

But too much uncertainty is simply exhausting. We have to pay so much attention to what seems like a series of unknown but potential threats (each one of which has to be assessed, discussed, and worried about) that we can't focus on what we're actually here to do. Particularly when change is on the agenda--especially if it's internally at the firm--all-hands efforts to reduce uncertainty are called for. Explain the rationale for change and then explain it again. Be reassuring not by assertion that everything will be fine but by explaining what is entailed and--one can hope--letting the logic of the change speak for itself.

Autonomy is an uber-value for lawyers. But it's important across the board, because the more autonomy one feels one has, the more capable one is of dealing with "the same" level of stress. The classic example is people who can control the hours they work vs. those who can't. A 40-, 50-, 60-, or even 70-hour week is relatively manageable if one feels in control of when one will be working and when not. But if quixotic and unpredictable forces from above dictate when you'll be working and when not, far fewer total hours can be worked productively before total burn-out sets in.

With lawyers in particular, be exquisitely sensitive to their perceived need for autonomy. Present options, not mandates; alternatives, not requirements; and offer independence wherever possible.

Relatedness goes right back to the old "friend or foe" distinction we all come hard-wired with. New people perceived as different may not be embraced in a spontaneous one-for-all hug. But if you lay the groundwork for new people to meet through social events (partner retreats, anyone?), the path will be smoothed towards accepting them as colleagues down the road.

Fairness may be the most critical ingredient of all. How many of you can sympathize with an executive who, when asked why he'd been at the same firm for 22 years, responded, "Because they always did the right thing."

Conversely, leaders perceived as having an "inner circle," whiffs of clubbiness, croniness, or old boys' networks, will destroy the perception of fairness in a heartbeat.

Particularly in times like these when cutbacks and pain are on the agenda, they must be perceived as fairly distributed, equitably arrived at, objectively parceled out, and explainable in common sense sentences containing words of few syllables.

What might all this mean for you as a leader?

Apply it to yourself, is the short answer.

Give people latitude to make their own mistakes (at least where it's not mission-critical). Buttress economic incentives with social reinforcement. If you're inclined to micromanage, try to wean yourself from the habit (it doesn't help your targets, and in the long run it doesn't help you).

The beauty of learning how to read your own reactions better, as a leader, is that once you're more comfortable in the zone of uncertainty, others will pick up on that cue and be able to relax into doing their real work rather than obsessively second-guessing your decisions. Don't be afraid to be spontaneous; it shows you're real and increases confidence.

The acid test may be this: Do you trust your colleagues in the firm to rise to the highest professional standards because that's what they believe in, because they feel confident their status entitles them to make autonomous decisions, and because they know they'll be treated fairly if they exercise their best judgment, regardless of the outcome?

As I said at the outset, you may think all this is obvious. I commend you if you know it all already. But the new research shows how profoundly grounded in our human and animal natures is the need for reinforcement of the social, not just the economic, context of our daily work.

Oh, and where do we fit in the Linnaean table?

Domain: Eukarya
Kingdom: Animalia
Phylum: Chordata
Subphylum: Vertebrata
Infraphylum: Gnathostomata
Superclass: Tetrapoda
(unranked) Amniota
Class: Mammalia
Linnaeus, 1758

Among the phrases, and phenomena, that now seem so hopelessly "last August" is that of the fabled Work-Life Balance.  ("So last August" has been a phrase around town for several months now, referring especially to examples of wretched indulgent excess, but by extension to almost anything dependent on an economy in overdrive.)  More on work-life balance (WLB) in a moment, but first consider what happened during a mere 19 days last September.  It wasn't just the fall of Lehman:

• 7th September 2008:  Fannie Mae & Freddie Mac nationalized
• 14th:  Bank of America buys Merrill Lynch
• 15th:  Lehman Brothers bankruptcy, one of the largest in American history
• 16th:  Reserve Primary money market fund "breaks the buck"
• 16th:  Fed gives AIG $85-billion in exchange for a 79.9% equity warrant
• 22nd:  Investment banks go extinct:  Goldman Sachs and Morgan Stanley become bank holding companies
• 25th:  Washington Mutual seized by FDIC--biggest bank failure in US history

Any single one of these headlines would have been eye-popping, but the concatenation of all of them in such a compressed period of time clearly signaled the world was changing.

And among the things that have changed is all of the talk about WLB.  First, let's simply try to understand what the loaded phrase "WLB" entails.  I think it's pretty simple:  It's merely the sense that the demands of the profession have gotten out of whack with the rewards.  You can solve for this inequality either by finding greater rewards in your professional pursuits--but there's no handy or obvious volume knob that adjusts your reward level, and it's usually a long and extended process of introspection and, more than anything, trial and error, to attain that blissful state--or you can decrease the demands so as to align them with the rewards.  WLB was, for better or worse, always assumed to mean the latter.  And in fairness we know how to achieve the latter:  Basically, work fewer hours and/or less intensely while you do.

There's just one problem with that, and it's an enormous one.  If you believe the thesis of books such as Talent is Overrated, you can never achieve professional excellence (and the satisfaction that flows from it) without something on the order of investing 10,000 hours in "deliberate practice," which is the demanding exercise of pushing the limits of what you're comfortable with in order to improve.

Two other aspects of WLB I will studiously not discuss here include whether it's primarily a women's issue, and whether it's a Gen Y/Millennial issue.  Why not?  The first craven and meanspirited assumption ghettoizes half the human race, and the second amounts to the feckless and self-indulgent attempt to "stand astride history, yelling 'stop!'."  The point is that neither engages WLB on the merits; both are nasty and somewhat immature ad hominem reflexes.

My theory about WLB is rather simpler:  It waxes and wanes in synch with demand and supply in the lawyer talent market:

• When the economy, deal-making, and firms are all booming, and when the greatest constraint on capacity is available talent, firms will worship at the shrine of WLB in order to try to make themselves attractive to a wider cohort of the (fixed number) of law school graduates.
  
  
• When, as now, voluntary attrition is nonexistent and law students are entering recruiting season with expectations ranging from "extremely confident law-reviewers to those expecting to receive zero offers" (as a top 10 school student reported to me in an email), or when students are offering to work for name-brand firms for free (also a true story), then the balance of negotiating power has shifted.

I offer as anecdote this January 2008 story from the NYT, "Who's Cuddly Now?  Law Firms," celebrating that:

"There are things happening everywhere, enough to call it a movement," said Deborah Epstein Henry, who founded Flex-Time Lawyers, a consulting firm that creates initiatives encouraging work-life balance for law firms, with an emphasis on the retention and promotion of women. "The firms don't think of it as a movement, because it is happening in isolation, one firm at a time. But if you step back and see the whole puzzle, there is definitely real change."

The article also noted the efforts of the suddenly-invisible "Law Students Building a Better Legal Profession" and their efforts to rank firms based on how well they treat associates.

Both seem certain signs of a "market top" in WLB.

But I believe there's something else even more important here.

As Jack Welch put it last month with his trademark directness, "There's no such thing as work-life balance.  There are work-life choices, and you make them, and they have consequences."  He added that you shouldn't be surprised if you're passed over for promotions if "you're not there in the clutch."

I would only refine what he has to say slightly, to adapt it to the context of law land:   There are elite, high-performance firms, playing at the top of the global game, and they are not "lifestyle" firms.  They never will be.  Don't kid yourself.  Or, as the New York vernacular puts it, "Fugghedaboutit!"

These firms, I hasten to add, are not for everyone.  Neither are "lifestyle" firms for everyone.

My point is simpler:  One and the same firm cannot be both. 

If you doubt me, the people (or at least readers of LegalWeek) have voted:

But the fun is that you get to vote as well.  We'll keep track of the results and have a followup piece in the near future.

Last week I had a chance to sit down with Tomasz Wardynski, founding partner of Wardynski & Partners, based in Warsaw, which is now a firm of close to 250 people including 137 lawyers with 22 partners, of whom 9 are equity and 13 are salaried or limited partners.

I was looking for perspective on the Eastern and Central European markets, and Tomasz was more than prepared to oblige.

"2010 will be very very tough," he began.  "There is no more inertia" remaining in the system from the end of the boom.  Therefore, he opined, the challenge for senior management is to "change the partners' attitudes."   Tomasz was pellucidly clear that it was not optional for partners to decide whether to go along.

"For the first time in my firm, the equity partners will need to make substantial investments of capital."  And if someone resists making the capital contribution?  "Well, then, they won't be an equity partner, will they?  That is always their choice."  And:  "It's really very simple:  You need to make sure you have fewer people than there is work to do."

Recently the firm has shifted to pure lockstep compensation of partners.  Previously, there had been a small retention, which was then distributed in the discretion of management, but they decided to end it because "it involved too much emotion: not worth it."  Progress through the lockstep is based on a subjective evaluation of performance plus an expectation of 2,000 hours/year, "which is not very demanding, after all."

"How do you train people?"

"Well, this is an issue because the universities are not very good at it.  It's a combination of watching, lectures, and the firm's own 'development center.'" Training clearly represents a substantial investment by, and commitment on behalf of, the firm.

The path to partnership is 8 to 10 years, during which associates are paid based on merit:  "Some of them make more than limited partners."

How does he feel about media coverage of the legal industry?

"Rankings are put together by smart media outlets to play to the vanity of lawyers."  And, he added in emphatic words, those rankings are extremely detrimental to the profession.  "Perhaps the only media phenomenon that's more destructive than rankings is the American Lawyer profits-per-partner numbers.  This is simply awful; they have transformed the profession, and they claim innocence.  Preposterous."

Clearly, Tomasz believes the AmLaw PPP numbers are not only a caustic influence on behavior, but borderline fraudulent.  The problem with the PPP numbers' accuracy?  "Running a law firm is a cash business.  But if I want to inflate profits by accruing some expenses and some revenues, I can come up with any numbers you like."

Tomasz expressed a strong belief in highly professional management of his firm.  "Five years ago we started introducing professional management systems into the business--human resources, information technology, knowledge management, and coaching for all lawyers."  Surely not all lawyers, I interjected?  "Well, yes, all.  And we have a very strong CFO who manages our finances extremely closely."

What's your biggest management challenge in this environment?

"The hardest problem to deal with is people who are very talented but who don't have enough work to do.  That's the hardest by far."

What else are you dealing with that's new?

"Last year we decided not to pay out profits from the firm above the level of partners' standard draw.  This is a protective measure."  And how long will you keep this in place?  "I foresee a downturn in the shape of an 'L,' not a 'V.'"

Let's step back, I suggest:  Why did you decide to start the firm?

"I had no choice but to start the firm.  I had clients needing to get deals done." 

And did you envision its growing so large?

Without missing a beat:  "Yes.  We were clearly in the right place at the right time."

What other issues are you facing today that are new?

"The next issue will be whether clients can pay.  The challenge of course is that you can't really protect yourself because you can't demand payment up-front, and you can't sue clients."

What else?  How about keeping the talent pipeline flowing?

"Yes, absolutely!  You cannot stop recruiting, so all you can do is to share the risk with people, to the extent they can bear it.  This recession may last a long time."

Other worries?

"That state intervention--not just in Eastern Europe, but in the US, the UK, conceivably even Asia--may suppress investment and entrepreneurship.  The very notion that some institutions are 'too big to fail' is monstrous.  Failure is what some of these banks richly deserve; they have it coming to them.  The namesake of your site would be apoplectic."

How's the regional CEE environment?

"Poland actually has +0.8% growth this year; it's not great, but it's greater than zero.

"Hungary has been suffering for two years.

"Latvia is very bad.

"Ukraine:  Disaster!"

But overall Tomasz remains an optimist: 

"Life is strong, and it will continue.  The economy will be boiling again in places where it seems unimaginable today. 

"What really counts at this moment is discipline.  People have to be mobilized.  You cannot lose...[he appears to be momentarily, and uncharacteristically, searching for a word].  You cannot lose speed!

"Even the strong-willed, independent, and autonomous partners have to believe in central management in this environment.  It's too dangerous not to.   Not only our livelihoods, but the welfare of our families and our children are at stake.

"Life is not a fairy-tale."

Doubtless over the weekend many of you read the NYT's longish story, "A Study in Why Major Law Firms Are Shrinking."  Truth in labeling would have changed the headline to "A Profile of White & Case So Far This Year," but perhaps that might not have drawn so many readers (according to the Times' website, the story was the second-most emailed of the day).  In journalism, I suppose you have to do what you have to do to corral readers--not that there's anything wrong with that.

Many of you probably read, as well, "The Economy Is Still at the Brink," on the op-ed page, by Sandy Lewis and William Cohan (fourth-most emailed of the day).  I'd like to suggest how these two stories intersect.

I.  White & Case

The White & Case story, it pains and annoys me to say, is fundamentally incoherent--at least if you're looking for a consistent through-line theory of how "major law firms [should address] shrinking"--or even whether White & Case itself has done the right or smart thing.  My irritation at the story is simple:  If the august Times is to devote this much prominent ink to the number one issue challenging our industry, you wish they could have at least come up with a plausible diagnosis and a debatable prognosis.  

There are even credibility-puncturing copy-editing errors.  I won't dwell on relative minutiae, but in this one phrase alone I detect two bloopers: "The firm, which is sixth on the Hildebrandt list, reported a 7.7 percent increase in profits last year, to $1.4 billion,..."  The "Hildebrandt list" referred to is the "Peer Monitor Economic Index," which is a composite of law firm market performance intended, roughly speaking, to be an analogue to the S&P 500 for law firms.  As best I know (and I'm quite familiar with the PMI), it's an aggregate index and not a ranking.  Suspiciously, however, White & Case was #6 in the AmLaw 100 in 2009 and in 2008, so that's probably what the Times is inartfully and inaccurately trying to refer to.  Second, of course, the firm's "profits" were not $1.4-billion, although its revenue was $1.467-billion, which was up 6.8% year on year.

Here, by the way, is the 1st Quarter 2009 PMI (I've added the arrow to make the "smoothed" results more conspicuous:

But to more substantive matters.

The most frustrating aspect of the article is its promiscuous mixture of the certainly-true with the scarcely-plausible.  For example?

At the root of the law-firm crisis, legal experts say, is the credit crisis, which has pulverized the need for traditional practice areas like structured finance, mergers and acquisitions and private-equity transactions -- the very things that have always kept a high gleam of polish on the city's whitest shoes. The downward trend has been unrelenting: fewer Wall Street deals mean fewer Wall Street lawyers.

While the legal industry is hardly battling the existential threat that is facing, say, the newspaper trade, Big Law -- especially in competitive New York -- is facing a potential paradigm shift as fundamental as the one that has hit investment banks and the auto industry. Big, as a business model (let alone as an expression of the national mood), seems bound for obsolescence.

Mr. Verrier ... suggested there was still "a vital role for the global law firm," even while acknowledging an increased tendency among clients to seek out regional firms for certain work. "Is there a paradigm shift?" he asked, seated in a 40th-floor conference room with a privileged view of Times Square. "I don't think anyone has a monopoly on what the future's going to bring."

Isn't this precisely the case?  Aren't we likely to see a relative profusion of law firm business models in the very near future?  And yes, very much including global firms as a "vital" part of that mix?

The mantra of BigLaw from about 2001 (or, arguably, 1991) through the third quarter September 15 of 2008 was:  Growth.  Growth was thought to be the universal solvent, the only strategy one needed, and we lived to some extent in a mono-culture.

That is most assuredly no longer the case.  Among other things, this means the challenge to senior management is to take a hard look at their strategy in light of today's new reality.  I've written before that what worked yesterday has zero assurance of working tomorrow.  (Not zero probability--you might be splendidly positioned for the new landscape, and I could quickly name several firms that are.  But zero "assurance," meaning you cannot take yesterday's conventional wisdom as still settled today.)

One aspect of the new reality that the Times piece gets right is how emotionally tough this is--even for those fortunate enough to still be at their firms.  Senior management underestimates this at their peril.  As I say, the Times deserves credit for identifying this very real phenomenon, the profound, even identity-undermining, changes that have already taken place, with more to come.  An unnamed "longtime partner at a big New York litigation firm" describes it:

"For the first time in their lives, people feel sort of useless. All of a sudden, you can go to lunch for two and a half hours and really not be missed. It's a blow to the ego. You're talking about people who have never really failed."

A "top partner" at White & Case expresses similar thoughts, but with the additional fillip (and a common one) that the marketplace reality of having to make tough business decisions has sapped the blood of what it means to be a partnership:

"When you finally make the partnership, you can walk into a room and certain assumptions travel with you: This is someone who knows what they are doing, who has intelligence and authority," the partner said.

"While that's still basically the case, it was a much more collegial place when I first got to the firm. Now it's colder. "The loyalty of the institution to its people, and vice versa, isn't really there anymore -- it's a different animal from what a lot of us were used to. It's much more of a business now and less of a true partnership. The problem is we're supposed to all be in this together. But at some point, you stop and think: 'Well, maybe we're not.' "

Covington's Philip Howard, famous for his clarion calls for "common sense" in the law, is also brought into the mix to opine that "as the bottom line increases in importance, the traditional role of the lawyer as a trusted counselor slips away," although he would seem to disqualify himself as an expert on the issue by frankly and commendably admitting that "I'm not really interested in the business of the law."

I've written earlier about what I view as the preposterously false dichotomy between running firms as businesses and maintaining impeccable standards of professionalism, so I won't rehash that debate here.    But my take on the supposed inconsistency in a nutshell is that nothing provides a firmer foundation from which to exercise rigorously objective professional judgment than rock solid underlying firm financials, and that in turn clients pay top dollar only to "trusted counselors" whose judgment comes with a backbone of steel.

II.  The Economy is Still at the Brink

The theme of this column is aptly summarized in the title:  Despite every effort of the Obama Administration and the Fed to restore confidence in the economy, it takes a lot more than mere confidence to restore the foundation of a healthy economy (inserted subheads and emphasis mine). 

Forgive the extended excerpt, but not only is this one of the better analyses I've read lately, it also happens to coincide with my profound skepticism that there are "green shoots" of recovery in evidence.  I will grant, more precisely, that there may be such green shoots, but I also predict they could be covered over again with snow; I do not believe, in other words, that winter is over.

Confidence Alone Is Not Enough:  We Need Fundamentally Sound Foundations

If the mood is right, the capital will flow. But this belief is dangerously misguided. We are sympathetic to the extraordinary challenge the president faces, but if we've learned anything at all two years into the worst financial crisis of our lifetimes, it is that a capital-markets system this dependent on public confidence is a shockingly inadequate foundation upon which to rest our economy.

Wishing Won't Make It So

We have both spent large chunks of our lives working on Wall Street, absorbing its ethic and mores. We're concerned that nothing has really been fixed. We're doubly concerned that people appear to feel the worst of the storm is over -- and in this, they are aided and abetted by a hugely popular and charismatic president and by the fact that the Dow has increased by 35 percent or so since Mr. Obama started to lay out his economic plans in March. But wishing for improvement and managing by the Dow's swings are a fool's game. [...]

Why Are We Propping Up the Institutions That Got Us Into This?

Six months ago, nobody believed that our banking system was well designed, functioning smoothly or properly regulated -- so why then are we so desperately anxious to restore that model as the status quo? Nearly every new program emanating these days from the Treasury Department -- the Term Asset-Backed Securities Loan Facility, the Public Private Investment Program, the "stress tests" of major banks -- appears to have been designed to either paper over or to prop up a system that has clearly failed.

Instead of hauling out the new drywall to cover up the existing studs, let's seriously consider ripping down the entire structure, dynamiting the foundation and building a new system that rewards taking prudent risks, allocates capital where it is needed, allows all investors to get accurate and timely financial information and increases value to shareholders and creditors.

We Need to Fundamentally Rethink How We've Been Living

Instead of promising the imminent return of good times, why isn't Mr. Obama talking more about the importance of living within our means and not spending money we don't have on things we don't need? We used to be a frugal nation. The president should be talking about kicking our addictions to easy credit, to quick fixes and to a culture of more is better [...]

Gas-guzzling S.U.V.'s, cigarette boats, no-income mortgages and private jets should be relegated to the junk heaps of history, or better yet, put in a museum dedicated to never forgetting the greed and avarice that led us so far astray.

"Feelgood" Medicine is the Last Thing We Need Right Now

Why is the morphine drip still in the veins of the financial system? These trillions in profligate federal spending are intended to make us feel better again even though feeling pain, and dealing with it responsibly, would be healthier in the long run. It is time to stop rescuing the banks that got us into this mess. If that means more bank failures on a grander scale or the dismemberment of Citigroup, so be it. Depositors will be protected -- up to $250,000 per account -- but shareholders, creditors and, sadly, many employees will, for the long-term health of the system, need to feel the market's wrath.

Beware Government Second-Guessing the Markets And (Inevitably) Playing Political Favorites

Is there to be any limit on bailouts? We have now thrown money at the big banks, any number of regional ones, insurance companies, General Motors, Chrysler and state and local governments. Will we soon be bailing out Dartmouth, which just lost its AAA bond rating? Is there no room left for what the Austrian economist Joseph Schumpeter termed "creative destruction"? And what is the plan to get the American people out of all these equity stakes we now own and don't want?

Furthermore, for government leaders to decide who shall live and who shall die in an economic sense opens them up to legitimate charges of crony capitalism and favoritism. We will benefit in the long run from a return to market discipline. [...]

Time for Some Creative Destruction

We are in one of those "generational revolutions" that Jefferson said were as important as anything else to the proper functioning of our democracy. We can no longer pretend that our collective behavior as a nation for the past 25 years has been worthy of us as a people. Many of us hoped that Barack Obama's election would redress the dire decline in our collective ethic. We are 139 days into his presidency, and while there is still plenty of hope that Mr. Obama will fulfill his mandate, his record on searching out the causes of the financial crisis has not been reassuring. He must do what is necessary to restore the American people's -- and the world's -- faith in American capitalism and in our nation. But time is wasting.

By now you must be wondering what on earth I think this has to do with Law Firm Land, much less White & Case.

The relevance is this: I'm asking you to think that BigLaw is like the financial system, and it's not fixed yet.

We had 20+ years of living off the fat of the land, with 5-10%/year rate increases, 5-15%/year revenue growth, and 5-15%/year growth in profit, until we began to think of them as God-given rights. A generation of us has experienced nothing else.

I'm here to suggest that those days were abnormal. It's time to meet the new normal.

But, as Melville's Bartleby the Scrivener famously said, "we'd prefer not to."

We're at risk of wasting the opportunity this crisis presents, of being 139 or 180 or 270 days into "The Great Reset," as I have come to call it, and deciding that the green shoots represent true spring, spring just like any other spring of the past 20 years, and not a January thaw with hard freezes yet to come. No need to fundamentally worry; it will be back to business as usual if we just can sit tight long enough.

The real intersection of the White & Case article and the still-on-the-brink article is this: We must have the intellectual and emotional courage to first imagine, and then to begin to build, business models that will carry forward our professional traditions and the highest standards of impeccable client service into the 21st Century, knowing that the strategic business mantra of growth for growth's sake is no longer the answer.

This will take from us no less courage and imagination than it will take to re-imagine and reconceive our financial system, and it will require that many of the same components of what was settled wisdom be re-examined root and branch:

• Compensation and incentives;
• Training and professional development;
• Billing methodologies;
• And not least, the purposes and structure of our firms.

Hugh Verrier is right to insist that there will remain a vital role for global law firms. But there will also, I intuit, be a vital role for boutiques, for regional firms, for industry-specific firms, for commodity-work highly efficient firms, and for prestigious high-end bespoke firms, and for new varieties undreamed of by us today. Some firms (White & Case?--perhaps, but don't look to The New York Times for guidance) will occupy a spot in that future firmament, and some will not.

The only prediction I can make with utter confidence about that future is that if you think all is now right with the world and it's time to relax again, it bodes ill for your firm's future stature. Even though, like Obama on the economy, I really am the optimist at heart.

From the famous annual meeting of Berkshire Hathaway, "Woodstock for capitalists," comes news a couple of days ago from the WSJ that Warren Buffett, long an investor in newspapers, sees "unending losses" for the industry. He then makes even more pessimistic remarks:

The current environment is accentuating the problem in newspapers -but it's not the basic cause. Charlie [Munger, his long-time business associate] and I read five a day. We'll never give them up. But we would not buy these companies at any price. They have the possibility of going to unending losses. They were essential to the public 20 years ago. Their pricing power was based on the fact that they were essential to the customer. They lost that essential nature. The erosion has accelerated dramatically. They were only essential to advertisers as long as they were essential to readers. No one liked buying ads in the paper - it's just that they worked. I don't see anything on the horizon that causes that erosion to end.

For some inexplicable reason (sunspots?), there's a sudden confluence of articles about how e-book readers might come to the rescue of newspapers, including this strainingly optimistic piece from the NYT (leading with "the iPod stemmed losses in the music industry") to this piece in the WSJ quoting Rob Grimshaw, managing director for the Financial Times's Web site, weirdly echoing what sound like the self-protective incantations of the doomed: "This channel potentially could revolutionize the consumption of content in much the same way the Internet did." Finally, and for good measure, we have an entire story, "Newspapers' Essential Strengths," in today's NYT business section pegged on the hook of Mary Schapiro, chairwoman of the SEC, speechifying:

"Financial journalists have in many cases been the sources of some really important enforcement cases and really important discovery of practices and products that regulators should be profoundly concerned about. But for journalists having been dogged and determined and really pursuing some of these things, they might not be known to the regulators or they might not be known for a long time."

But before we let our prurient gaze rest too much longer on the admittedly engrossing spectacle of the newspaper industry contemplating the prospect of its own demise, let me reassure you that's not why we're here today.

I come not to praise or damn the financial press, the political press, or the arts and culture or sports press, for that matter.

I come to call the roll of industries whose fundamental business models are changing.

With help from Jeff Jarvis, and his column "The Great Restructuring," we can almost run down the litany of industries challenged at their core:

• Newspapers: These we know about.
• Magazines: I would think have brighter prospects, because there's no substitute for their glossy sexy inky tangible regularly scheduled appearance in your mailbox, but given the recent shuttering of Portfolio, a bright light in the increasingly dim firmament of business magazines, I am less optimistic today than I was last week.
• Books: The e-book model will, in time, inhabit the earth. This will up-end the publishing industry, and libraries, and bookstores, and yes, your and my own favorite dens to which we retire, walls lined with shelves of books we've read and others we have ambitions to read.
• Speaking of bookstores, retail will change and, yes, downsize, as online commerce grows. When I can comparison-shop by opening a new tab in a browser--and if it's not merchandise that requires touch and feel, a big if--then who needs the store?
• Residential and commercial real estate. As a dyed-in-the-wool city dweller, I would like to believe that development will become more concentrated, but I'm also a realist. The sprawl of McMansions may have seemed folly to me, and perhaps now folly to some who bought and invested in them, but they clearly struck a chord. Suffice to say their run seems to be up for the moment.
• Computers, where netbooks are the new new thing, and operating systems are commoditized or open source, face drastically shrunken margins.

But this is a publication about the economics of law firms.

So let's talk about that, and let's try imagining what our industry would look like if all bets were off. That's what's happening, after all, to all of the industries I just listed.

What type of service do we provide and what do you think clients are willing to pay for it?

I think we provide three primary categories of service:

• Commodity, repetitive, predictable work. Call this "C" work.
• Particularized services for clients, which, while specific, customized, and to some extent without precedent, are not frankly of transcendental importance. Call this "B" work.
• Unique, intrinsically valuable, high-stakes engagements. Call this "A" work.

The problem is that we bill for all three the same way, on the billable hour, without differentiation between either what they're worth to the client or what resources they call for from our firms and what demands they place upon our firms--demands ranging from the caliber of staff and professionals we assign to them to how that affects our long-run strategic plans including where we locate our offices, what practice areas we focus on, and where we recruit our lawyers and what level of excellence we expect from them.

Permit me to opine that billing for A and for B and for C the same way is insanity, and that we have only ourselves to blame.

The current crisis environment may give us a chance to change that. Such, at least, is my hope.

So what might that new future look like?

Starting with C work, this strikes me as supremely amenable to predictable, fixed fee arrangements.

Let me hasten to add that we can't quote a fixed fee for a single piece of litigation or a single corporate transaction, because nobody can predict how any individual matter will turn out, but we can nevertheless realistically predict what specific pieces of work during the course of those matters will cost or, at the other end of the distribution, what a large-ish portfolio of those matters would cost over a sufficient span of time and geography.

Getting specific, couldn't you put a price on taking or defending a deposition? Making or opposing a motion to dismiss? Marking up a simple acquisition agreement? Reviewing 10,000 or 100,000 or 1,000,000 pages of documents for privilege?

At the other extreme, how about taking on a major company's employment litigation east of the Mississippi for 3 years? All its EPA regulatory compliance matters for the same time and geography?

How would you go about this? (A) Examine your historic costs. (B) Hire some smart actuaries. (C) Think about pricing things at 60% or 70% of your median costs for that particular "unit" exercise. You can please clients with predictable fees and ensure that, over time, you will cover your costs and then some.

Prepare to make money.

B work is what you want to continue to price on the billable hour model.

For everything else you read and for everything else I say here, the billable hour is alive and well--exceedingly so. It has the advantages of being familiar, objective, quantifiable, itemizable, defensible, and familiar (oops--did we already say that?).

These are not idle benefits. When an in-house lawyer is challenged by an in-house finance type about a legal bill, the first and best line of defense the lawyer can offer is that (a) they really did the work--see, it says so right here; and that (b) we got a 10% discount. Defending a bill "for professional services rendered, $XXX,000" is a lot tougher, and immediately puts the in-house lawyer on the defensive.  (Finance types are convinced the value of legal services is always negotiable downwards, for starters.)

This is the bread and butter for many firms, the meat and potatoes that pays the rent, covers the fixed costs of staff and associate salaries and benefits, and buys you everything from online access and your IT infrastructure to malpractice insurance. It is, without doubt, the comfort zone for most of your lawyers, but don't kid yourself that it's a diffferentiator.

It is not a criterion on which clients will select or reject you, at least not on the basis of B work alone. Clients will and do and always have, of course, selected and rejected firms based on their specific treatment at the hands of individual lawyers, but that's not what we'd call a firm strategy. That's the serendipity of having the right, or the wrong, people spearheading your business development and client relationship initiatives. It's not what makes B work "strategic" in terms of billing.

A work is, after all, what we all aspire to, isn't it?

And if so--and if there's only so much of it to go around, which there is--shouldn't we try to price our services for A work creatively?

What I have to offer in terms of creative pricing actually has roots in an extremely old story, but a time-tested one: Shared risk. Shared risk simply means that when the client does well, your firm should do well, and when the client fares poorly, you too should fare poorly. (Need I remind you that the billable hour is a cost-plus model where the law firm makes money no matter what happens to the client?)

Billing for A work could proceed on this premise. Dear Client:

• Pay us a discounted, and fixed, amount on a monthly basis for the life of the matter;
• If it turns out poorly, that's it. We're done, and you have paid in full.
• If it turns out well, pay us more, depending on how well--in your sole discretion--you think it turned out. That "more" could be 1x the discount, to make us whole, or 2x or 3x or 5x, to share the largesse.

The discount is up to you, the firm, to determine, as are the terms of the premium or the bonus on the back-end. This is, by the way, the model that the famous Bartlit Beck uses, and according to this month's American Lawyer, Boies Schiller has also employed it to wonderful effect. 

An example may help.

A friend recently wrote from London that he represents creditors in corporate restructuring and insolvency and that "success fees make so much sense that they make time billing actually seem perverse." He elaborates:

I also act for hedge funds in some of the more junior subordinated debt, who will try and get a "consent fee" of, say, 5, 10 or 20c, to restructure the bonds they bought at 2-10c. The legal advice and management of either strategy is a significant determinant of value, which, if successful, can be incredibly lucrative. Conversely, if the strategy doesn't work, the client will have made close to nothing, but have incurred exactly the same legal expenses.

He contrasts the legal industry's antiquarian pricing model with that of the financial advisors:

All of the financial advisors working in corporate restructuring have done it - the model is a monthly run rate of (say) GBP 250,000, with a several million GBP sucess fee, where success is defined as a restructuring that achieves certain outcomes (often calibrated to post-restructuring leverage: ie, you get to own the company, and we get more if post-reorg debt is say only 2.5 x EBITDA than if it is 3.5x)

Does this seem to you to be "taking advantage" of clients? Not, evidently, so clients would notice. Does it seem "unprofessional?" Since when does doing less well when your client does less well and doing better when your client does better seem unprofessional?

Finally, let me note the consenting adults defense to this type of fee arrangement.

Type A, Type B, Type C work: Should we continue to bill for all of them the same way?   Clients put different values on them, and so should we.

Finally, in the best tradition of Adam Smith himself, consider the dimension of self-interest. 

Under the billable hour revenue model, there are only four variables that matter:

• Rates
• Hours
• Realization
• and Leverage.

What's critical to recognize under this model is that every one of these variables has some intrinsic limit. We can debate what the limits are, but limits there are:

• Rates:  $1,000/hour?  £1,000/hour?
• Hours:  2,400/year?  2,700?  3,000?
• Realization:  100% (the days of 200% are so over)
• Leverage:  As I've argued, leverage is actually decreasing, not increasing.

But the escalating arms race on the PPP front has no intrinsic limit.  We therefore stand a fair chance of witnessing a collision between the marketplace demand for ever-higher PPP numbers and a revenue model that cannot grow to the sky (even if our clients claim otherwise).

Now, are you willing to take another hard look at how you bill for Type A and Type C work? 

If not, what could possibly be stopping you?  And inertia is not an answer.

On the balance sheet of essentially every corporation of any size or degree of profitability appears the line, "Retained Earnings."

I have never seen such a line on the balance sheet of any law firm.

Why not?

More importantly, what should the capital structure of a law firm look like? As incessant as is the attention paid to the income statement, I have yet to read or hear a thoughtful, informed, and knowledgeable discussion of law firm capitalization.

Is this simply because in many ways we are an immature or cottage industry (as a friend of mine characterizes it)? Is it because, as another friend who also happens to be managing partner of an AmLaw 25 says, "when we need more capital, we pass the hat among our friends"?

Can this possibly make sense?

A month or so ago I got an email from a non-law-firm-land analyst trying to understand our industry a bit better, and he asked what should have been a simple question: What is a typical law firm's cost of capital? I was stumped.

Understand that it's easy enough to specify a law firm's assets and liabilities: To construct, that is, its balance sheet. But why does it look the way it does and is it optimal? Sure, I know all about working capital, lines of credit, term loans, the utterly predictable seasonal variations throughout the year as firms pay out partner comp at the start of the year and collect wildly at the end. I know about mandatory partner contributions, whether they're flat or progressive, how they're tied, or not, to total compensation, how they're phased in when you make partner and repaid when you retire, whether or not the firm pays interest on them, and so forth.

That's not what I'm asking.

I'm asking why law firms have the capital structures they do.

This requires addressing some basic questions:

• On the capital-demand side, what are the firm's plans for the capital? Geographic expansion? IT infrastructure? Carrying lateral partners until they become cash-flow positive?
• On the capital-raising side, what is the firm trying to accomplish and what behaviors is it trying to encourage?
  • Is the firm allergic to bank debt on general principles? What are those "principles?"
  • Because the reason all major firms that have failed have finally been forced to turn out the lights is that banks have declared them in default and shut off the money?
• To what extent does the firm simply want partners to have "skin in the game?" Is a non-trivial level of mandatory capital contribution a useful way to advance that goal?
• Conversely, is it "fair" to ask partners, whose entire income stream depends on the firm's prosperity, to also invest a portion of their net worth in the same firm? Isn't this the antithesis of portfolio diversification?
• Should the firm pay any interest or other return on contributed capital? Zero? Below-market? Market? (And what's "market?")
• Finally, is all of this being done in a way that is at least cognizant of tax efficiency?

I do not ask these questions rhetorically or academically.

I find this an area of law firm financial management that has been by and large cloaked in darkness. Most firms' capital requirement practices seem far more rooted in history and experience than logic and financial analysis.

Blood, toil, tears, and sweat are spent on determining annual compensation. Where is even a modicum of attention paid to capital contributions? This strikes me--and perhaps you--as perversely odd. The only rational explanation is that capital contributions, compared to annual income, are de minimis. While that's probably true at most firms, should it be?

I can assure you that in the next few years as private equity investors begin to assess the attractiveness of our industry following the effectiveness of the Legal Services Act, they will expect you to know the answers to some of these questions. Or, at the very least, to understand they're germane to any assessment of your firm as a business.

I invite you to sit down with your executive committee and your CFO and take a good hard "clean sheet of paper" look at your capital structure. Does it make any sense whatsoever?

The news out of Dewey & LeBoeuf--that 66 partners, or about one in five of their 350 partners, have seen their compensation cut over the past 15 months by up to 80%--begs for an explanation, or at least some commmentary. First, what's going on in the firm's own words:

The reductions are meant to weed out less-productive partners, firm Chairman Steven Davis tells The Am Law Daily.

Those affected by the "substantial performance-related reductions to their compensation" represent a wide range of practices, Davis says. The partners include some who have been practicing for 25 or more years.

Of the 66, the more fortunate are now taking home $25,000/month, the standard draw for partners. Lower-tier partners have faced more drastic reductions, with monthly draws of as little as $10,000, or an annual total of $120,000 -- $40,000 less than the starting salary for a 2008 incoming first-year.

Both Davis and executive director Stephen DiCarmine characterize the recent actions as an intensification of the firm's long-term strategy of replacing poor performers with higher-producing laterals. "We have a merit-based compensation system," Davis says. "There are a variety of outcomes that people have experienced. It probably occurred to a greater and enhanced extent due to the merger."

Paying partners less than first-year's? What on earth, you may be asking yourself, is going on here?

To begin with, I have nothing to say about the selection criteria for who's taking these hits and who isn't (or, as the firm puts it, who is "experiencing which outcomes"). I can only take the firm at its word that they are intended to be performance-related and to alter the mix of partners over time.

The point I'm interested in is a larger one. Why would a firm feel compelled to take such drastic measures in order to--at least partially--protect the very high incomes of its other partners?

This brings us to what I call the "profit imperative."

First, required is a small digression into the wonderland that is law firm accounting. Partners (we're talking equity partners) actually wear three different and distinguishable hats, in terms of their economic participation in the firm:

• Workers/producers, in which role their job is to actually bill hours and perform client work. In this role, their appropriate compensation is what the firm would have to pay a non-equity partner to perform the same work.
• Managers/administrators, in which role they help run their practice groups or departments, manage staff, mentor associates, participate in firm committees, and so forth. In this role, their appropriate compensation is what the firm would have to pay nonlawyer executives to perform the same work.
• And last and only last, equity partners, which is to say, owners with a residual claim on the profits of the enterprise after all other expenses and claims have been satisfied--including, if you want to be rigorous about it (and some of us do), paying the first two sums listed above out of operating income.

But of course, in wonderland, partners view themselves as wearing one and only one hat, namely the last one. This means they view their compensation as coming entirely from their role as equity owners. And given the current realities of law firm organization, finance, and accounting, they are entirely right to see it that way, however economically irrational that might be in the abstract.

Why does this matter? Only because, as we're about to see, "profits" in law firm land have a special meaning, and that's why they're imperative.

If equity partners across BigLaw had been raised from 3L status on to understand, internalize, comprehend, and expect that their compensation would consist of those three different components, the last of which is highly variable, profits would not be as imperative as they are. But that's not the world we live in.

So now that we're all agreed on the financial irrationality of partners' compensation being paid entirely out of "profits," and are equally agreed that this is culturally embedded and not about to change in your lifetime or mine, it's a baby step to seeing why profits in a law firm cannot fall precipitously and expect the firm to remain in equilibrium. It comes down to expectations.

Perhaps the simplest way to explain this is to contrast it to a normal company, say, Toyota or GM.

As is exhaustively known, GM has been bleeding cash and losing money hand over fist for most of this young Century, yet it continues to exist. The fact that it may not continue for too much longer, and that its pleas for help from Washington may be rewarded, only speaks more strongly of its durability. As for Toyota, it's been coining money during the same period and, even though it may suffer its first loss in its 70 years of operations, there is absolutely zero doubt about its continued viability as a global industry leader.

And the point would be?

• Law firms cannot survive a single year with zero profits.
• That, as we know, is all that partners have to take home.
• If partners have nothing to take home, they will be gone.
• And the firm will be no more.

This may provide perspective on the drastic measures Dewey has taken. There are, of course, other examples of unprecedented Hail Mary's techniques being employed:

• Norton Rose is floating the notion of a four-day work week;
• CMS Cameron McKenna is asking partners to "volunteer for de-equitization" (no, I'm not making this up);
• 92% (92%!) of City of London partners recently polled by Legal Week predicted a drop in profits of more than 15%;
  • 65% predicted it would be more than 20%;
  • 47% predicted it would be more than 25%; and
  • 17% predicted more than 30%.
• And the drastic cuts being implemented far and wide are, at the moment, unavoidable:  "Tony Williams, former managing partner of Clifford Chance and the co-founder of Jomati consultancy [and a good friend of mine—Bruce], said: "You always have to look forward. Cutting people has not just been a knee-jerk reaction [to falling profits]. You have to take the appropriate decision at the appropriate time.""

The point?

Simply that noisy protestations about how firms are cutting people loose in wholesale numbers—be those protests boisterous and cynical or heartfelt and agonized—miss the point that a reasonable level of profitability for a law firm is not a luxury and not an option.  It is as required for survival as oxygen is to us.

Well, that'll teach me...

The volume of commentary following my publication earlier this week of "The Great De-Leveraging" has been unprecedented.  Depending on your attitude, that is either deeply gratifying or almost overwhelming.  As one who takes the positive view by default, I choose option A.

Therefore, I wanted to recap and respond to some of the very thoughtful remarks I've received.  First, a few quick preliminaries:

• "Comments" on "Adam Smith, Esq." are broken.  Yes, I know, I know.  This is a technical issue and not an editorial decision.  We have a complete revamp of the site in the works--currently under wraps--but my devout hope is that that will cure this issue.
• I have attempted to keep the identity of all commenter's scrupulously anonymous, and I hope I have succeeded.
• Without exception--even where people disagreed with my original piece--the remarks and observations have been thoughtful, reflective, and generous.
• I have, as editor-in-chief, reserved the right to condense comments.

Without further ado.

First, "Regular Guy" takes issue with my description of the non-equity position to begin with:

One of my friends forwarded to me your article on The Great De-Leveraging. She was particularly interested in a section in which you wrote "Non-equity lawyers don't have to beat their brains out.  So they don't.  Their deal--again, a perfectly rational one, to them--is that, premised on good behavior, they have a job essentially for life at, say, $350,000 to $450,000/year, adjusted for inflation.  If you think that's not an attractive deal, I suggest you immediately take the elevator down to the street and ask the first ten people you encounter if they'd like such a job."

I am a non-equity partner in Philadelphia, but there's almost nothing in the quoted section which rings true. I (and my friends who are non-equity partners in Philly, DC and in NY) are under incredible pressure to bring in new business and to meet billable hours requirements. And we do it (at least in Philly) for substantially less than $350,000. And on top of it, we get to pay for our own benefits out of pocket. I agree: if we ever had the deal you describe, it would be perfectly rational to do it forever. But I don't know anyone at any firm who ever collected $350,000 to $400,000 for good behavior. I'll be on the lookout for it, though . . .

Frankly, I'm not quite sure what to make of this, since it was an "outlier" in terms of reactions.  Clearly different firms operate at  different economic levels and for some paying a non-equity the amounts I mention might not make sense within their overall compensation structure or not be feasible financially, so I don't doubt that "Regular Guy" is describing his world accurately. 

My point was that, regardless of the exact level of the numbers, they're quite respectable incomes in the US economy as a whole--indeed, according to our President, you'd almost certainly qualify as "wealthy" and worthy of paying additional taxes.

Next up, we have a commenter at  Legal OnRamp who provided a remarkably thorough canvas of the non-equity partner landscape.  I've highlighted key points.

Some excellent data.

Some conclusions I would respectfully differ with.

Nonequity partners, properly applied, are more profitable than associates, notwithstanding their lower production of hours, for a number of reasons. Firstly, they are considerably more experienced and efficient, and thus a higher proportion of their hours worked are billed and collected.

Secondly, their billing rates are higher, and every hour worked has a higher margin as against the allocation of fixed overhead to them as timekeepers.

Thirdly, they tend to have some book of business, just not enough to justify a full equity partnership position. This provides some breadth and stability to the enterprise business base.

Fourthly, they tend to have some real expertise and help out in landing new cases.

Fifthly, they tend to contribute to the administration and partnership duties, from recruiting, mentoring new associates, all manner of committees, etc., thus spreading the burden among a wider group.

Sixthly, it tends to be very easy to project based on years of past experience what the contribution to the bottom line of the firm will be, and their compensation and benefits packages are correspondingly tailored so that the firm makes a profit spread from every one of them.

So....you do not as a manager need to have them working 2,000 hours (though you would like that!). You get 1600 hours at $500 collected from a service partner and she puts $800,000 into the kitty. Salary and benefits at $400k, overhead allocation $150k, net to the firm $250k. Bonus structures encourage more work and there is often generous sharing for it. But it is not required because there are all these other reasons not to force them out if you are making a quarter million a year from their efforts and they carry all these other burdens that would have to be borne by your equity partners otherwise.

Contrast that with an associate doing 1900 hours at $300 per hour, but a fairly typical post billing write down of 6% on hours...or 120. Net collected 1780. All in salary and benefits is $200k, less the overhead allocation of $150k and you net $114k. But, there is great variability in associate productivity. Many will work 2,000 hours or more, but the pre-billing write-offs can amount to 15% for the first two years. Frankly, if you can collect 1600 solid hours off an associate in each of the first two years, you are not doing all that badly. And that alas means that you are about at zero net contribution. Maybe.

Additional partner time is spent reviewing work product, much of which is not billed to the client. Associates in the first three to four years have little ability to carry administrative and other burdens, at least not to the extent of the service partners. And certainly they have no real expertise in the first few years. And there is the element that large numbers of them are going to leave to pursue other directions than big law, after a couple of hundred thousand dollars of sunk costs in recruitment, summer programs etc. per person, whereas the income/service partner has become a long term participant on the team.

There are other elements that merit consideration. The income partner position is also one that allows the firm to flex with people of talent that have issues in "life" that you want to accommodate. A disabled partner who can only work 1200 hours a year, or a partner that wants to dial down the demands while she raises three young kids, would be only two of dozens of examples of ways that the firm will "park" a valued talent that is not in a position to churn and burn like an equity partner must.

It is also an "incubator" position where young associates that the firm has picked out as the "best of the best" are made partner, or are lateraled in for a term to prove themselves. The ambition is to get them up to equity partner performance numbers, because by definition that is where the real economics happen. But obviously not all of them will make it. Not uncommonly there will be some in this class that are an "investment" and will be expected to generate more business, with a few less hours (say 1750 instead of 1950 but with a slug of development hours and activities in accord with a formal business plan).

And, partner culture notwithstanding, this is a class that is effectively "at will". There may be procedures and niceties, if you don't cut it you are out. There are no illusions about this. Whereas at the equity partner level, the protections and practices of the past make the process difficult and painful when they have to be implemented. But there is some stability and comfort in that too.

There is much more to it than just this, but I respectfully suggest that this income or service partner quadrant of the firm is not a wasteland of inattention and losers in a major firm. Yes, there are some that need to be looked after and in some cases counseled out. But the fact is, most of them are PROFITABLE and contributing in myriad ways that associates cannot and do not.   And that is but one reason why as the firm looks inward to decide where and how to cut....that it will not fall on the income partner ranks as heavily as you may suggest it should.

In a nutshell, I think many of these are valid points, especially the initial ones about billable rates and realization ratios being strongly superior to those of junior associates. 

But partly, I submit, this is simply a result of every junior person being at a natural and understandable disadvantage in terms of clients' willingness to pay.  Once associates reach their middle, and certainly their senior, years, their rates and realization rise to very comfortably profitable levels.  It's hard to imagine a world where lawyers vault magically from 3L grads to 4th or 5th years with nothing in-between.  Until we can invent a time machine that warp-bypasses those years, I'm not sure how having a larger cohort of non-equity partners helps alleviate the inevitable waiting-and-training game.  How did those non-equities get where they are, after all?

So it strikes me that those points may be less cause to celebrate non-equities than cause to be grateful that junior associates finally do acquire experience and talent, as costly as it may be to watch them do it.

The point about non-equities being able to assume "administrative and partner duties" including recruiting and mentoring is one I violently disagree with.  Indeed, part of the dysfunction I perceive in firms with large non-equity tiers is precisely that they act as a buffer and "sound insulation" between the partners and the associates.  This is neither healthy for associate development nor for partners' getting to really know the rising young talent pool--not to mention associates' prospects for partnership when that day finally comes.

This would also be the occasion for me to mention--as I did not in the original article--that a common complaint about non-equities is that they hoard work, depriving associates of essential training, implicitly overbilling clients for unnecessary seniority, and gumming up the discipline of proper staffing ratios.  To observe that this is an especially severe problem in this environment would be stating the gruesomely obvious.

Likewise, the points about "life" issues frankly echo one theme I tried to address, perhaps inarticulately, in my initial column on this topic.  

Let me hasten to confess that one reason I may not have been pellucidly clear about this issue is its potential for being viewed as politically incorrect, but here I'll say it: 

I do not believe that a law firm can be simultaneously a "lifestyle" or "work-life balance" firm and an uncompromising, bet-the-ranch, "go to" firm for only the highest-value and most prestigious work.

There, I've said it.  You have a choice, and both choices are eminently defensible and rational.  But I believe you must choose.

Next comes an observer who takes issue with The American Lawyer's definition of "non-equity partner," and who therefore concludes that my entire ratio calculation is askew and fundamentally uninformative. 

While I don't doubt that he has done has research assiduously, as noted in my original piece, I took the "TAL" data at face value as having at least the virtue of a consistent metric.

One failing of using the NEP to Partner ratio is that a number of the firms with low or zero ratios just use a different title--counsel, senior attorney whatever--to hide the economic equivalents of NEPs.  As you point out in the productivity chart, counsel are even less productive than NEPs--meaningfully so in the "more profitable" firms. 

Using Skadden as the first example--mostly because I know their web address off hand--they have 236 partners and 96 counsel (not counting "of counsel" or European, regional or pro bono counsel, but including "special counsel") for a ratio of 0.406.  This takes Skadden way, way out of your circle of cultural stalwarts, which is a much more select group than the NEP:P ratio implies. 

What follows is my quick counting of website listings [and he proceeds to conduct a similar analysis across another dozen or so firms]

[...]

Anyway, very interesting post.  Thank you.

I shall re-direct his critique to Aric Press.

Next, we have a very thoughtful, even soulful, response, gracefully outlining the pressures  generated when a high-performance culture collides with the life of a mere human (highlights mine).

I would agree with you that some of those non-equity partners, senior counsel, etc. are drags on the system.  But it is profoundly difficult to make that out from just the "hours" figure.  The very deal in becoming a senior counsel is that you have something the firm wants to keep, but you aren't willing to accept as remuneration the currency that they are willing to give you for it -- equity partnership. 

As you noted, it is obvious these days that the life of an equity partner is no better than that of an associate - you just get paid more.  Eventually.  After you have paid off your buy in.  In my firm, new partners made considerably less than 8th or 9th year associates, yet had rainmaking responsibilities, etc.  Lousy deal, and increasingly, talented people noticed.  Indeed, because of all the additional time doing client development, etc. etc., the equity partners who really WORK, carrying the load for those old guys who don't, have a terrible deal these days.  You'll make a nice corpse in your expensive coffin.

So what do the talented people do?  The ones who would be offered partnership, but frankly aren't sure that they want it?  Believe it or not, those people do exist.  A lot of them are women.  And at least for a few key, biologically-driven years, they want and need to dial back on the soul-killing hours.  And if one is HONEST, billing 2500 hours is soul-killing because you worked so many more hours than that.

I was offered, and did not take, a non-equity position.  I would have been on reduced hours (work 40 rather than bill more than 40 was the deal), I could be paid on a 1/3 eat what you kill. 

I was a talented antitrust litigator capable of running cases and capable of very complex analysis.  The clients liked me.  There was a core cadre of women with this deal at my firm who were routinely offered equity partner status every few years.  Typically nobody took equity status because the extra money wasn't worth the price.  This is because we were in control of our own hours (because successful participants under this system have their own clients who are loyal and trust their work), our conversion rates billed/collected were spectacular, and we represented niche practices that were not easily replaced.  Why do you think that the firm was willing to make these deals with us in the first place? 

So yes: in a world where only the raw number of hours billed matters, these people are less profitable for the firm.  But if our conversion rate is extremely high, we're critical to the relationship with some long-term clients, your "diversity" numbers plummet and there is no one to mentor new female talent coming up, and we're a straight 1/3 pay with risk borne by the non-equity, I would argue that these people are one of the very best deals in law firms.  Indeed, the fact that the firm was willing to think outside the box to keep some of these folks tells you that there is profit there.

The bottom line of my little screed is that the raw hours worked numbers don't tell the story of a person's value to the firm.  A senior counsel (other non-equity) has a deal whereby they work fewer hours for less pay.  If the deal doesn't work for both sides, the senior counsel gets canned.  In litigation, senior counsels are sometimes called non-equity partners so that one's card will say what the client wants to see.  But really: this is a strategy for holding onto talent that has decided that working even more hours than one worked as an associate is not worth the price.

Hard to argue with.  So I won't try. 

I told you it was soulful--and deeply appreciated by me.  Next:

Bruce,

A very interesting post.  One comment to consider regarding the relative value of income partners to associates.  At least [in my non-US country], most income partners feed themselves, in the sense that they have direct client contacts that send them enough work that keeps their plates full. 

It is not enough work to keep a pyramid of associates busy beneath them, hence they are not equity partners.  Clients prefer experienced lawyers to inexperienced lawyers because they get more value from them, despite higher hourly rates.  Clients hate paying for 1st year lawyers who contribute relatively little to a file when compared with their hourly rates. 

In my experience, until associates have 2-3 years experience under their belts, they are rarely more useful than a good quality paralegal, whose hourly rates are much lower.  [Here's the same point our second commenter made, so you can mentally reprise the same reaction I had then.--Bruce]  We need junior associates only because we need a future stream of partners.  As you point out, not a very high percentage of those we bring in make it to even income partnership, let alone equity partnership. 

If you agree with Richard Susskind, as I do, that law has much work to do on refining legal work process, then there will be even less work for associates to do in the future, as, organized properly, more work can be done by paralegals, or outsourced to contract lawyers or lawyers in lower cost centers.  Yes, we will continue to need the future partners, but does it make economic sense to pay crazy wages when only one in ten or twenty will make partner. 

The cost of associates is not only in their wages, but also in the time, effort and money to recruit them, and then train them when they come on board.  The best case scenario is that when they leave, they go in-house to a client, and if you have treated them well and have a good alumni program, they may become your client. 

In the worst case scenario, you have to pay to off ramp them.  For a very large percentage, I doubt that their cost is ever re-covered by the firm.  That is why firms hold onto those with experience who can feed themselves, and give good advice to clients.  If they work fewer hours, they are compensated less.  The key is that they are generally good lawyers who are valued by clients.  I'll admit that if they can't feed themselves, then you have to ask, do you keep them on board for what they are paid relative to what associates are paid, who don't bring in any work.  When you add up the real cost of a 1-3 year associate in New York vs. an income partner who completely or largely feeds him or herself, then the economics becomes very different.

Thoughtful and, if I had to bet, penned by someone with a fair degree of exposure to economics in their background.

Next, we have an opinion about how non-equity partners' willingness to work for (relatively) less could threaten the position of equity partners in the longer run:

Your rant [Was it a rant?!?--I thought it was pretty reasonable.  Bruce] about Non-Equity partners could be dead on if you are an equity partner worrying about how to protect your $2 million draw. However, the prevalence of non-equity partners is indicative of another unpleasant reality.

There are many many lawyers who are perfectly competent to do the work and are happy or willing to do so for less money. As we all know, not everyone is a rainmaker. Most of the horned rim types engaged in the securitization mill are technical geniuses but clumsy back slappers. One way or another the redeployment of these people in the legal market place is going to put pressure on big firm economics. Particularly in world with bankers capped at $500,000.

Keep up the great blogging.
(former Big Firm equity partner happy to have left the law)

And finally, this piece from a BigLaw partner who's a regular reader (highlights, again, mine):

        Your last piece, the Great De-Leveraging Article -- is really one of your recent best analyses on the current law firm model.  Well done. 

        As you will recall, you and I corresponded a little over a year ago, when I said that I believed there was a "bubble" in law firm "stock prices" in the form of profits per partner.  The then-existing model could not continue to sustain its growth in profits per partner at the historic rate.  All the available revenue levers -- leverage, rates, utilization -- had all been taken close to their logical maximum points.  Moreover, the drive to continue increasing those profits was leading to poor business practices that would bite firms when they could no longer be increased.  For example, the increased reliance on leverage, in large part through parking associates in the income partner spot, would not be sustainable over the long term and leads to an underinvestment in new talent.  Similarly, the constant increase in rates, particularly for junior associates, was starting to alienate clients.

        As we now are starting to see, the bubble for law firms is popping.  They cannot maintain the profits per partner at the historic rates.  In an effort to prevent a free-fall in partner profits, law firms are now "de-leveraging."  And many firms who could not (or are currently not) doing this fast enough, are starting to fall apart (e.g. Heller, Thelen, etc.) because the collapse of the PPP sends the rain makers to other firms, leaving the firm to collapse of its own weight.

        I think you are right that this is the time that firms need to start afresh -- Andy Grove style -- to figure out their strategy.  But, I believe that the firm leadership in only a few firms actually understand the dramatic nature of the strategic decisions they should be contemplating.  Most firms will consider whether to downsize, and if so in which practice areas.  They'll take some actions, and those in the top quartile may even align those actions so that the resulting firm structure is aligned to those practice areas where the firm sees opportunity in the future.  But, I think the choice is much more fundamental, and most firms do not yet see it (or do not want to see it).  I think firms need to think through fundamentally what their competitive advantages are, what markets they are targeting, and as a result, they need to decide what their firm business model is going to look like. 

        A couple examples may suffice:  Some of the highly profitable, NY firms (who are listed in your article as having few, or no income partners), generally tend to generate work through the big deals and the big litigations.  Those deals are large enough that the clients become price insensitive, and they can be staffed with large teams of lawyers paying attention to every legal detail.  For those firms, the model of high fees and lots of leverage continues to work.  While they may also be able to get premium pricing structures, they don't typically have to take any risk to get those premiums.  Those firms can continue to use the "Cravath" model, where they churn through the best and brightest of law school graduates, and are left with the brightest (and most "durable") lawyers who become partners.  That model will probably continue to produce $2-$4 million PPP. And while the growth in those profits may be difficult, given the amount of those profits, the model will likely still be successful.

           A second model probably applies to many mid-tier firms  (AmLaw 20-60).  These firms will need to adopt what I would call the "production" model.  Their target markets tend to be Fortune 1000 clients.  In litigation, they may not get the "bet the company" cases, but they will get significant cases within the firm's areas of specialty.  In deal work, they may become specialists in certain types of deals (the equivalent of what securitizations work provided for much of the last 7 years).  In both categories, clients are increasingly fee sensitive.  And in both categories, the work, while not "commoditized" is certainly of a type where sophisticated firms could bid on the work on a fixed rate basis.  Those firms who can figure out how to do this -- and this requires an incredible control over internal information within the firm to ensure that projects are properly bid and managed -- will have a chance of keeping up with the NY firms in terms of profits (though I doubt they will maintain the same high level).   This "production" model requires an ingrained systematization of process controls, teams of lawyers who are deep experts, and leaders who are risk takers (for bidding purposes) and project managers (for execution purposes).  It may still be a leveraged model, but the leverage probably will not look the same as in current firms. There may still be a place for income partners, but those partners skills are now to bring deep expertise and extensive project management skills.  Think of this firm like large construction firms.  The principals take significant risk, have the potential for significant reward, but only if the team executes flawlessly.

        A third model is what I consider the "boutique" model.  These firms have very talented senior lawyers in practices that are often difficult to leverage (think of Regulatory work, Appellate practices, perhaps some IP litigation, Tax advisory work, etc.).  These firms will likely have difficulty maintaining significant leverage.  A 1:2 partner-associate leverage may be the most that can be maintained (if that).  To the extent these firms can command premium rates, they may support significant profits per partner, but probably never at the level of the large NY firms.  The question will be whether these firms can offer a culture that compensates partners in a non-financial manner that makes up for the lost profits they might earn at larger firms.  One could imagine a fairly idyllic life -- less pressure to generate business, more time engaging in the practice of law. 

        As you note in your article, most firms currently don't really know "who" they are or what their strategy is.  Strategies have focused on either "bigger, more revenue," or "focused, more profits," but I don't sense that most firms have really considered what makes the firms a cohesive entity, how the firm differentiates itself, what innovative services it might provide, or how the firm can leverage its strategic assets.  The result is behemoth firms that keep getting bigger, with shrinking equity partnership ranks in order to keep the PPP at acceptable levels, and layers of "associates," "income partners," "counsel" and "others" who largely become cogs in an indiscriminate entity.  Loyalty to those firms is at an all-time low, because all the firms basically look the same, so partners defect when they see a chance to increase income.  Clients have a hard time telling firms apart, so success in client marketing focuses mostly on the personal relationship because there are very few other differentiating factors (to be sure, personal relationships will always be important). 

        Most firms are following the crowd like lemmings, breathing a sigh of relief that now, given Latham's large layoffs, it is now "ok" to really cut into lawyer staffing levels.  When the markets return, the pecking order for law firms will probably stay the same, though mid-tier firms may be at even a greater competitive disadvantage, having lost even more of their rain-makers to higher-tier firms.  A few smart mid-tier firms might realize that downturns are opportunities.  In good times, it can be hard to rock the boat; In downturns, there is a burning platform where partners can be galvanized to take action, if a good roadmap is provided.  Firms with strong leaders will take the opportunity to "right-size" and "right-structure" their firms.  They'll adopt new business practices, invest in training on those skills critical to the firm's differentiated success (e.g., project management, or substantive expertise) (after all, their idle lawyers now have more time to attend these trainings), institute systems to track costs on the types of matters they want to focus on in the future, they will start partnering with clients now (when clients may be eager to take risks to reduce costs, and law firms may have excess capacity in their system) to find ways to take risks together to find a better long-term model. 

           The bubble has popped.  The market is in a downturn, and businesses are being reinvented.  Some law firms will keep doing the same old thing (and for some, like the NY firms, that's probably a good model).  A few well-managed firms will use this time to determine "who" they are, and how they want to compete; assess what sort of PPP they really need and want, develop a strategy that builds on their strengths to differentiate themselves from other firms, and develops a structure and set of expertise to execute that strategy. 

        But then again, for most firms, they'll just hunker down, cut costs, and hope their relative standing somehow improves when the market returns.  Good luck to them.

A fascinating roundup of responses--and all, Dear Readers, thanks to you.  As they used to say somewhere in the lost mists of collective media memory, "keep those cards and letters coming."

What, finally, then, do I think about the remarkable growth over the last decade of the non-equity tier, and of the advisability of same?

As Tolstoy famously wrote in the opening of Anna Karenina, "Happy families are all alike; every unhappy family is unhappy in its own way."  I would paraphrase, or mangle, that to observe that "single tier firms are all alike; every two-tier firm is two-tier in its own way."

By that I mean there is no template, no equivalent of the Cravath Model, for what being "two-tier" means.  We as an industry continue to experiment on this front (as we are experimenting, abruptly and unwillingly, on many other fronts, of a sudden in this environment).

But I continue to believe that the burden of proof is on those who would argue for the expansion and not the contraction of the non-equity tier.  Economic reasons, as I noted in my original piece, are the least of it--which, ironically, is at odds with the gravamen of most of my interlocutors above who argued for the non-equity tier on economic grounds.

The core of the debate, in my mind, is all about culture.  Many are the reasons to have a substantial  non-equity tier, and many are the reasons, as I have argued, to strictly limit it.  But do not, under any circumstances, pretend that you are not making a decision with vast cultural implications.

Just as I was thinking it was about time to publish a column on the topic of "leverage" at law firms (roughly speaking, the associate to partner ratio, although there's more than one way to calculate something that people will call "leverage"), here comes a slew of pieces on the topic, including:

• Prof. Larry Ribstein on "the over-leveraging and over-regulation of the legal profession:"
  

  In the longer run, we now see very clearly that running law firms as thinly capitalized worker cooperatives is not an equilibrium solution in this market.

  The answer, as I've said many times before, is dropping regulatory restrictions on law firm structure and letting them be run like real businesses. This particularly includes permitting non-lawyer capitalization and perhaps even public ownership, as well as enabling firms to hold onto their intellectual property through non-competition agreements.

• A piece in, of all places, The Atlantic's blog called "There's leverage everywhere!" with this pregnant introduction to our system:
  

  But let's work the argument a little further. It surely is true that unlike their current incarnations, the old Wall Street partnerships did not destroy the world with excessive leverage. But in the pre-credit-boom era, no one else was incurring much leverage either. It might be worth considering whether there are entities that are structurally similar to the old Wall Street firms (i.e., partnerships in which a substantial portion of the partners' net worth was tied up in their employer, and could not easily be removed from same) and see whether they have taken on significant leverage in the modern age of easy credit.

  As it turns out, there are such entities. We call them "big law firms." And their example is instructive.

  and
  
  
• More than one of these new pieces has referenced something that ours truly wrote about "Leverage:  Friend or Foe? (Or Noncombatant?)" back in December 2005, where I said:
  
  Common sense would tell you that in a labor-intensive service industry, where revenue is driven primarily by sheer tonnage of hours worked, the higher the ratio of associates (and non-equity partners) to (full equity) partners, the higher the revenues and thus the profits per partner. Right? It turns out this is one of those cases where it's not as simple as it seems.
  
  [...]  Then there's the evil twin of high leverage: Low utilization. It doesn't help that your leverage ratio is through the roof if nobody's busy; indeed, welcome to the worst of both worlds.

What has changed?

For starters, the whole world is now aware of the perils of leverage.  Let me throw a few charts into the discussion for starters.  By and large, I would like to believe, they speak for themselves.

Finally, here's one that leaves you wondering whether to laugh or cry—and it's seriously out of date at this point.

It's a chart showing the large global banks' market capitalization as of the 2nd quarter of 2007 (large blue-grey circles) and then as of October 20, 2008 (small green circles). 

In order, left to right and top row to bottom, they are:  Morgan Stanley, RBS, Deutsche Bank, Credit Agricole, Societe Generale, Barclays, Unicredit, UBS, Credit Suisse, Goldman Sachs, BNP Paribas, Santander, Citigroup, JP Morgan, and HSBC:

Update (8 March 2009):  A very helpful reader, who chooses anonymity, pointed out within hours of my publishing this that the chart above is seriously misleading.  Why?  Because the circles, being two-dimensional, invite us to visually compare their areas rather than their diameters—and the latter is what the chart-drawer actually chose to represent. 

Take Citigroup:  Its market cap went from $255B to $82B in the period in question.  Now that you look at it closely, you can see that's how the chart was drawn.  But were the circles drawn to scale appropriately in terms of their area, it's clear that it would take only 3.11 of the small green circles to fill the large blue circle (since 255/82 = 3.11).  Your eyes tell you in a flash that the green circle as drawn is far too small, in fact.  (Full explanation here.)

While I apologize for this mental and visual hiccup, all I can offer in defense is that I'm not the only one:

Pretty scary, eh?  It's a chart showing the deterioration of major bank market caps since 2007.  Prepared by someone at JP Morgan based on data from Bloomberg, this chart flashed across Wall Street and the financial world a few days ago, filling thousands of e-mail in boxes.  Putting a face on the current banking crisis it really brought home to many people on Wall Street the critical position the financial industry finds itself in.

Too bad the chart is wrong.

[...] So it's a typo: no big deal, right?  Yeah, but what a typo!  It got past Bloomberg and JP Morgan and pretty much all of Wall Street before someone said, "Hey, this makes no sense!"

Here's a proper chart.  While the players are somewhat different, that's more than made up for by the fact that it's far more current:  Comparing the market cap as of March 30, 2007, with the market cap as of February 20, 2009—barely two weeks ago:

Still not great performance, to be sure, but if there are degrees of horrendous-ness, this is at least less so.  Plus truthfully representative.

Thank you, Dear Reader.  Thus concludes the update.

While there are many reasons for these breathtaking declines, surely a proximate cause was the sky-high assets to equity ratios of many of these institutions.  20 to 1, 35 to 1, and even 50 to 1 were not unheard of in the palmy days.  Suffice to say that business model is, as I heard someone remark recently here in New York, "so last August."

So other parts of the economy (shockingly large parts!) may have gone crazy.  What does this have to do with us, necessarily?

If there are analogies to be drawn across professional service sectors, leverage is out for the investment banks and leverage is out for us as well.  For the I-banks, as noted, it was (in retrospect and even, to some more astute observers at the time) outrageous ratios of assets to equity, and for us it may be the high ratio of lawyer leverage.

I said at the outset that there are different definitions of "leverage" in our world, and I want to take some time and spend a little bit of effort breaking them out, because I believe the subtle differences matter.

Courtesy of The American Lawyer, here are the top 25 most leveraged firms from the AmLaw 100 and the bottom 25 least leveraged firms.

Top:

And bottom:

These figures are calculated by dividing the total number of lawyers at the firm (full time equivalent) by the number of equity partners.  For example, using firm #100 here, Faegre & Benson has 424 total lawyers and 255 equity partners, so 424/255 = 1.89.

Again, we can debate whether this is the ideal measure of leverage or not; my own preference is to divide all lawyers who are not equity partners by equity partners, but the results would be directionally similar. (Using Faegre & Benson as an example, again, the number of "lawyers who are not equity partners" would be 424-255 = 169, and dividing that by the number of equity partners yields 169/255 = 0.66.)

Why does leverage matter? For starters, as I noted in my 2005 column I quoted at the outset, leverage is your best friend in good times and your worst enemy in bad times. While we've heard the drumbeat of client complaints about paying for useless junior associates for years, this is suddenly the kind of environment where it will grow sharp teeth and bite hard. Either: (a) massive litigations will not be pursued because they're too complicated, uncertain, protracted, and expensive; and/or (b) if they must be pursued, contract attorneys, staff attorneys, and outsourcers will provide the human throw-weight needed for massive document review; and/or (c) corporations will simply insist that document review be completed for flat fees of $X/unit [$1.00/page? $0.50/page?]. In any event, no one I talk to--absolutely no one--believes that the litigation "factory" model with one partner overseeing half a dozen or more associates who are billing 'til the cows come home will be a predominant source of revenue going forward.

All well and good, but I think a more interesting calculation compares the ratio of non-equity partners to equity partners.  The charts and calculations that follow are premised on The American Lawyer's conventions, which denote someone an equity partner if they receive a K-1 and a non-equity partner if more than half of their income is guaranteed.  This is not the place to debate that methodology; the point for present purposes is that all firms are hewing to the same metric. While the raw data is courtesy of The American Lawyer, the calculations and the sorting are my own.

Here are the firms where the non-equity to equity partner ratio is greater than 1.00:

And here are the firms where that ratio is less than 0.25:

Note that I've drawn lines segregating the 11 firms with a non-equity to equity ratio between 0.00 and 0.25, simply because—depending on what may be special circumstances unique to each firm—arguments could probably be made that they don't "really" have non-equity partners as they see it; they just have to report this way based on The American Lawyer definitions.   Also note that I alphabetized the listing, by firm name, of all those reporting 0.00 ratios.

Why does this matter?  Aren't all the firms reporting layoffs reporting exclusively layoffs of associates and staff, not partners.

Yes, but those reports reflect actions taken to date, and I want to essay a little vision into what we may be seeing in the future, and to set the stage I think the two charts above are most informative.

First, why have no firms announced partner layoffs?  Isn't this the worst kind of cronyism, safeguarding one's peers, taking it all out on the "little people," and demonstrating lousy business judgment to boot, when the cost savings realized by offing (say) 10 associates could probably be realized by tossing a single partner overboard.  (Such, to paraphrase, is how it has recently been expressed to me, in tones ranging from outrage to derision to glum resignation.)

The issue, as so often is the case, is more complex than that.

Simply put, it takes time to get rid of partners.  They are not employees at will, as associates and staff.  They must be cajoled, "spoken to," almost certainly offered incentives to walk gently towards the door.  Note, importantly, that this is almost universally true of non-equity as well as equity partners.  (Off the top of my head, essentially every partnership agreement I've seen that addresses the issue at all treats non-equity and equity partners alike on the topic of termination—that is to say, it's hard to accomplish without cause.)

And there's more.  More and more non-equity partners, that is.  This chart shows the percentage of all lawyers at AmLaw firms who are not equity partners, from 2000 through 2006.  The big red bars are of course associates, ranging from 82% of the total in 2000 to 75% in 2006.  The light grey slices are "income" partners, growing from 9% to 13%, and the darker grey slice at the very top, growing from 9% to 12%, are "other non-equity lawyer" (don't ask me about the terminology; I'm just the reporter here). The chart is courtesy of last year's Citibank/Hildebrandt Client Advisory.

Now—bear with me—one more data point. 

Here's the "productivity," measured by annual hours billed, of (a) equity partners; (b) income partners; (c) associates; and (d) other non-equity lawyers, at "higher profit" and at "lower profit" firms:

What it shows with conspicuous graphic clarity is that income partners and other non-equity lawyers are systematically the least productive lawyers in these firms.  Associates work the hardest, but equity partners work almost as hard.  (At higher profit firms, the associates record a negligible 2.5% more hours than equity partners.)

From both a human and an economic perspective, this is all perfectly logical. Non-equity lawyers don't have to beat their brains out.  So they don't.  Their deal—again, a perfectly rational one, to them—is that, premised on good behavior, they have a job essentially for life at, say, $350,000 to $450,000/year, adjusted for inflation.  If you think that's not an attractive deal, I suggest you immediately take the elevator down to the street and ask the first ten people you encounter if they'd like such a job.

What else do we know about non-equity lawyers?

They are the most expensive form of leverage.  They make more than associates, to state the obvious, and have also "maxed out" on any variable benefits one needs a certain period of tenure to earn, such as 401(k) matches, etc.

This, frankly, is the least of it. The real issue is cultural.

Go back and take a look at the firms with non-equity to equity partner ratios < 0.25. Better yet, focus on those where the non-equity tier is either nonexistent (0.00) or de minimis and probably only an artifact of The American Lawyer's reporting system.

What do they have in common?

Indeed: An unusually high combination of cultural cohesion and readily articulable strategy. Just a sampling proves the point:

• Cleary, Cravath, Davis Polk, Debevoise, Paul Weiss, Simpson Thacher, Skadden, Sullivan & Cromwell, Wachtell.

Like them or not, you can say of each of those firms that they stand for something, and that achieving partnership there is dependent on several dimensions beyond that of being a mighty rainmaker.

Vs. those with the non-equity to equity ratio > 1.00: Without (re-)naming names, it must be said of that group that their strategies are extremely diverse and, in some cases, as yet unproven. Additionally, many of the firms in that group have high proportions of relatively new lateral partners.

But back to culture. I submit that firms with high proportions of non-equity partners have changed their culture. They may not have intended to, they may not have foreseen it, but change it they have.

Thirty or twenty years ago and even pretty much today, at least in New York-based firms, the reality is truly up or out. This attracts a certain cohort of hard core Type A people who (as I felt at that time) have never been anywhere other than at the top of their classes and who don't intend to be anywhere else now. As a managing partner said to me last week, "We've all heard the statistics that only one in 25--or whatever--starting associates at Cravath will make partner. But you know what? All the Cravath on-campus interviews are hugely oversubscribed! Everybody thinks they're going to be the one in the 25."

He has a point.

So how does the introduction, and more importantly the perpetuation, of a material cohort of non-equity partners change the culture of a firm?

Let me editorialize about a few consequences:

• The culture shifts from "excellence or else" to "good enough."
  • I don't think that "good enough" is sustainable in this environment.
    
    
• In the palmy days of 2001--2007, having a flexibly extensible non-equity tier served as a crutch for firms that wanted to avoid making difficult decisions about people or having awkward conversations with them.
  • I don't think that those difficult decisions and awkward conversations can be postponed in this environment.
    
    
• One of the reasons we're seeing widespread associate layoffs--apart from the pure economic imperative to cut costs in order to match revenues to capacity--has to do with morale. It's dreadful to morale to walk the halls seeing a bunch of your colleagues with too little to do, who are then guiltily sneaking out at 5:30.
  • The non-equity tier, with nothing to aspire to and perhaps (psychological speculation on my part, which I am shockingly unqualified to offer) feeling themselves ever so slightly "damaged goods" only exacerbate this.
  • None of us, none of our firms, have room for morale-busting zombies in this environment.
    
    
• The ranks of the non-equities grew not by design but by happenstance and, frankly, inattentiveness. While it may be true, as Oliver Wendell Holmes famously remarked, that "the life of the law has not been logic, it has been experience," it's time to apply some analytic logic, some serious and rigorous strategic evaluation, to the weed on steroids that has been the growth of the non-equity tier in too many firms over the past palmy period.
  • And no, we cannot afford to do otherwise in this environment.

We read, finally, that firms are drastically cutting back their summer programs and dialing back first-year offers, postponing start dates, offering semi-paid sabbaticals, and so forth. All well and good and relatively innovative examples of rising to this dismal occasion.

The pipeline of new talent must be kept as full as anticipated demand warrants. Law firms live and die on their talent, and they cannot short-change their investment in it based on next quarter's or next year's depressing projections, although they can certainly try to size it to better approximate the new reality.

But the talent that may not be carrying its weight, that needs profound re-examination, is that of the non-equity tier.

If you were starting your law firm today, would it look as it does in terms of non-equity partners?

Better yet, or more realistically yet, perform Andy Grove's famous thought (and reality) experiment when Intel was a low-end maker of commodity DRAM chips, having their lunch eaten in the late 1970's by the voracious and talented Japanese, threatening Intel's very existence.

I paraphrase: Grove said to his top management team, "If we don't turn things around in a very serious way, the Board will fire us. So why don't we 'fire' ourselves. Let's march out of this conference room and march back in assuming we're the new team the Board has hired. What would we do then?"

They performed the exercise, decided to abandon DRAM's and invest in microprocessors. The rest is history, and it's history residing under your desk or in your lap.

I'm suggesting you perform a "Grove Intervention" on your firm. And if you've read this far, you know where I think you might start.

When non-lawyers ask what's happening in the world of law these days (i.e., what ATL is covering), our first response is usually one word: layoffs. It's been a dominant theme in our coverage since the fall.

—Above The Law (today)

While I might nominate that quote for Understatement Of The Season, I cite it for an entirely different purpose:  Are there any alternatives to layoffs?

Actually, I don't believe there are any "pure" alternatives to layoffs, at least not in the economic sense of "substitutes," for firms under serious financial stress.  But I'd like to suggest there are "complements" (economic sense) to layoffs. 

[Jargon digression:  In economics, "substitutes" are goods or services that people can trade off between without drastic disruption or deprivation, such as coffee and tea, bagels and muffins, or red and white wine.  As you can tell from these examples, there are rarely perfect substitutes—we all have our preferences—but if our favorite is unavailable or exorbitantly expensive, we will make do with the alternative and carry on.  "Complements," by contrast, are goods or services that tend to go together.  Think coffee and sugar, bagels and cream cheese, or red wine and bread.]

In the land of law firm layoffs, it's all too easy to understand why so many firms are resorting to them in this unprecedented environment. 

Forgive me if what follows strikes you as simplistic (good for you if it does!), but I find myself explaining this to people with a frequency that suggests it's not widely understood.  Consider hypothetical BigLaw firm in 2008 and 2009:

Obviously, these numbers are simplistic and you can quibble with the details and assumptions, but the message is powerful:  Law firm P&L's are highly leveraged. In the good times, this is your best friend:  Every additional dollar of revenue drops almost intact to the bottom line.  But in the bad times, this is your worst enemy.  A 1% drop in revenue can--all else equal--lead to a 3% drop in profits.

What, then, to do?  As the famous advice has it, "Follow the money."  The money, in this case, is associate and staff compensation.  Together they are to a law firm's expenses as Social Security and Medicare are to the federal government's budget:  Enormous.  If you need to cut a lot of expense at a law firm, you don't have many alternatives but to look there.  (I'm assuming all your office leases are long-term and not readily renegotiable, especially in this environment.)

The bad news, of course, is that cutting associates and staff used to be viewed as being as untouchable as trimming Social Security and Medicare would be. But not any more. If we've learned nothing else from the drumbeat of layoffs in the US and the UK, it is that there is no stigma attached to them today.

While we're at it, let's not limit the casualties to associates and staff. Everybody ought to share the pain, including equity and (if you have them) non-equity partners. It cannot be true that every single person in category X (say, partner) is irrebuttably indispensable while everyone in category Y (non-equity) is subject to scrutiny. Note to those keeping score at home: Cutting partner ranks will also distribute the diminished profits over a smaller pool, making the hit to your PPP less, percentage-wise, than the hit to your total P.

So if the base case for the inevitability of resorting to layoffs has been made, how can we do it more intelligently? How can we be more intelligent and less reactive, more scalpel and less meat-axe, more humane and less brutal?

Let's go back to "complements."

I suggest there are a variety of techniques you can employ, not as "substitutes" for layoffs, but to enhance their cost-saving impact and trigger other savings. Let me add that, with some degree of consternation, I don't see very many firms implementing these "complements." If this column has no other purpose, it's to change that myopic behavior.

• Reduced hours for reduced pay. Forgive me, but this strikes me as blisteringly obvious. We've heard bellyaching throughout the boom years about "work/life balance" and so forth, usually to imperceptible effect, but now we have an opportunity we can embrace with gusto. Of course, the reaction of associates invited to partake of this bonanza may suddenly be less than enthusiastic. "Be careful what you wish for?" Still, you should think about it.
  
  
• Sabbaticals. Whether paid, unpaid, or inbetween, consider granting (requiring?) people to take a period of time off. Don't permit them to do nothing, however; make sure the expectation is that they will do something related to broadening themselves, learning, professional or cultural or emotional or even artistic development. You might be surprised at the new imaginations they'll return with. And in the meantime you'll have economized while maintaining loyalty.
  
  
• Shared jobs. As with our first suggestion, this is one that was oft requested and rarely honored during the boom: "Impractical and unworkable." "Clients won't stand for it." "Shirking by another name." "How entitled do they think they are?" Permit me to suggest the world has changed. Think about this again.
  
  
• Salary freezes. Been there, done that, and how shocked are you that the reaction has been so placid? Which brings me to:
  
  
• Salary cuts. I don't know if you read it here first, but it matters not where you did. Economists famously and widely insist that wages are "sticky downwards," which is their awkward formulation of the highly common-sensical notion that people hate to see their pay (at the same employer) actually drop. But these are not ordinary times, and there are ample reasons to think that people would be surprisingly amenable to this revolutionary concept:
  • Today, a job--almost any job, much less a highly respectable one at BigLaw--beats no job. Enough said.
  • There's value in shared sacrifice. Taking a hit, collectively and communally, to preserve the firm's community, is not a hard stretch or leap of the imagination for people today.
  • Dollars go farther than they did 18 months ago. Have you noticed that housing has gotten cheaper? That cars can't be given away? That "70% off" is the minimum required to get people off the street and in the door? That everyone is suddenly very very negotiable on price?
    

I'm not suggesting my list is exhaustive; it's meant to be suggestive and (we can always hope) creative.

Now's the time to innovate. Given what a straight-line extrapolation of current reality would look like, somebody better.

Update:  23 February.  I received the following correspondence from a 1L at a top ten law school.

Greetings from Law Student Land.

What an intense time to be a 1L. Just thought I'd share a few thoughts and reflections, especially as they relate to your latest column.

First, never have any doubt about the attention paid to Above the Law at the student level. Personally I have serious misgivings about that site's position as the main conduit of information between associates and management. However, looking around my Crim class the other week on that famous thursday and watching everyone tick off the layoffs as they happened, I was struck again by the power of the instant press on firm recruiting and retention.

Secondly, and building on my first comment, note this story: ( http://abovethelaw.com/2009/02/nationwide_layoff_watch_mckee_1.php ) for an example of the sort of press that will make a difference in July, when my class at [*****] begins bidding for interview slots at firms. As I'm sure firms are aware, students aren't going to be able to exclude all of the firms that have made layoffs from our job search.

However, the process by which firms lay off their associates is a chance for us to "look under the hood" at the interaction between management and associates at different firms. I am certain that firms who conducted "stealth layoffs" or that swung the scythe heavily through the first-year ranks will be penalized come recruitment time. Which is not to even mention the debacle over at Pillsbury last week.

Lastly, I note with satisfaction your mention of work/life balances issues in your latest column as a way to trim firm expenses. Sadly, it seems that though firms have realized they will need to adapt to a changed business environment, they have so far acted with the lumbering (be-suited) herd mentality that so regularly characterizes their behavior.

Someone has told them that layoffs are ok, and so they are going to attempt to cut staff numbers until their profit margins return to normal. While wages are surely sticky, they are not stuck. I am lucky enough to have secured an associateship with a firm this summer. The firm I am headed to pays its associates below the "New York rate" but in a secondary city. I am told that associates work around 50 hours a week. This strikes me as a fair bargain, and one that many of my classmates would willingly make. It seems to me that even firms that are known as "sweatshops" could create a 75% work schedule in which pay is cut in relation to the chosen billable hour requirement. The idea of a sabbatical seems like an ingenious way to temporarily de-equitize partners until work picks back up.

All of which is just to say that I think your concept of where the general mood of the lowest rung of the ladder is these days is fairly accurate. Keep up the good work.

[After I asked my correspondent whether I could have permission to republish his thoughts:]

I have no problem with being anonymously quoted. I think this is clear from my comment, but just to be sure, the scheme I am advocating is less hours for less pay, as opposed to a straightforward pay cut. I don't think this would be too much of a problem, as I am under the impression that there aren't enough hours to go around at the moment. I'm also generally not in favor of having an across the board pay cut in exchange for a promise of no layoffs. Obviously, this would reward under-producers at the expense of the hardest working associates. I think generally we as students expect firms to approximate the level of attrition that they have in good times, and therefore be prepared for our class when we come aboard in 2011.

Thoughtful commentary indeed. 

Why would it not make sense for firms to offer a tradeoff between hours and pay or, perhaps more audaciously, a tradeoff between the investment made in professional development and training, and pay? 

What I'm suggesting in the latter thought experiment is simply this: If a firm is going to work you to death and skimp on training and professional development (they're non-billable), then shouldn't you expect to be paid handsomely for your pains? Conversely, if another firm is willing to devote significant resources in time and money to an intense training effort, shouldn't you rationally be willing to accept a lower salary, recognizing that you're investing for your future in a non-monetary way?

The remarkable thing is that it seems to work in other industries—witness the old joke about how the publishing industry is a wonderful place to get training "if your parents can afford to send you there."

Find out my thoughts on the matter here.

When The New York Times features it on the front page, it must be real, right?

I'm referring to Billable Hours Giving Ground at Law Firms, which features Evan Chesler flatly arguing that "This is the time to get rid of the billable hour." Unfortunately, if you're looking for real insight into the issues underlying the stress on the billable hour, this is not the article to read--unless, as I perhaps suspect, the article was pitched to an audience oblivious to the entire issue prior to picking up that day's Times.

Shall we review the bidding on this topic?

Pro the billable hour:

• It's familiar, both to lawyers in private practice and to their inhouse lawyer clients. It's been the dominant revenue model since the 1960's which, for all practical purposes, is the professional lifetime of anyone working today.
  
  
• It's measurable. David Wilkins of Harvard says:
  
  "Does this make any sense?" said David B. Wilkins, professor of legal ethics and director of the program on the legal profession at Harvard. "It makes as much sense as any other kind of effort to measure your value by some kind of objective, extrinsic measure. Which is not much."
  
  David (a friend) is of course right, but the alternative to an "objective, extrinsic measure" is some variant of subjective and judgmentally laden approximation, which requires trust.
  
  
• Clients--this is my theory, at least--have been largely bluffing this past decade or more when they've moaned and complained about the billable hour. After all, from their perspective, it has some indisputable virtues:
  • They can say to their financial green eye-shade types, "Well, look, they actually did the work. Says so right here."
  • And, for that matter, they can say that they negotiated the "most-favored nation" rate and, on top of that, got a 15% discount; so don't argue that we didn't get value for money.
    
    
• Again, clients might not be too comfortable with the alternatives. Why is $375,000 "for services rendered" the right number? How does one defend that internally against the purchasing agents and cost accountants? (And don't assume their instinct will be to ask why it's not a higher number.)

Con the billable hour:

• It provides, obviously and somewhat tendentiously, an incentive for firms to run the clock rather than solve problems. I say "tendentiously" because this assumes lawyers put their own very short-sighted self-interest ahead of professional responsibility, ahead of a satisfied client, and ahead of simple integrity in their professional dealings. In my experience, to the extent time-sheets did not reflect utter reality to the second decimal place, it was because lawyers engaged in self-administered haircuts on the time they'd actually spent, fearing they'd look inexperienced or simply making an on-the-spot judgment about what the activity they'd performed "was really worth."
  
  
• It starts from "cost of production" rather than "value to client." This, to me, is its core economic failing. To be sure, no firm can long sell its products or services at less than "cost of production," but unless you're in an absolutely commmoditized industry, that is the merest of starting points.
  
  
• It's dehumanizing, reducing talented and highly educated professionals to fungible units as factors of production. Worse, it contains no rewards for brilliance, insight, judgment, or even plain old efficiency. Lawyers have every incentive to work day and night, and no incentive to recharge their batteries, take in a performance of "Trovatore," read "The Merchant of Venice" or The Federalist Papers, or simply enjoy a moment outdoors in the sunshine. We can debate whether, in the long run, this will produce pale and narrow automatons or whether utter and uncompromised dedication to a profession, 24/7, is the only route to serious excellence, but the point is that decision should be made by each individual with free will unfettered by the hands of a stopwatch.
  
  
• Ultimately, it limits law firms' revenue. (Clients--you can skip this paragraph.) Each of the variables that goes into revenue under the billable hour model has intrinsic limits: Rates, hours, realization, and leverage. This is worth a separate column, or more, of its own, so I'll go no further here.
  
  

Are we, then, about to witness in some grandiose fashion the "death" of the billable hour, much less its dropping back into the shadows of small-beer practices or quaint and creaky backwaters?

As you can tell by how I phrased the question, I see no such incipient revolution. And the primary source of life-support I would cite is clients, not law firms. Indeed, if there's a single remark in the Times article that's wrong-headed at best and offensive at worst, this is it:

[There's a] risk to law firms experimenting with other payment arrangements: If lawyers set too low a price, they lose money. Many lawyers may not be good enough businessmen to pick the right price, said [Frederick] Krebs, [President] of the Association of Corporate Counsel.

"The difficulty is, we don't really know what it costs us to do something," he said.

Wrong on the count that we don't really know what things cost, and wrong on stilts that lawyers aren't good enough businessmen to set a fair price.

First, if you believe that actuarial science has continued to survive and thrive for centuries for a reason, and that statistics, while subject to abuse for rhetorical or polemical means, are fundamentally a powerful tool, then you subscribe to the notion that we can tell "what things cost."

Second, if you believe lawyers can't set a price that both profits their firms and continues to win loyal clients, I would ask you to explain how the share of GDP going to lawyers, as well as the total percentage of lawyers as a component of the workforce, have continued to grow essentially unabated (well, until the last six months...) throughout our lifetimes.

So where, then, do I think the future of the billable hour lies?

As the old political joke has it, "You can't beat somebody with nobody," and part of the billable hour's durability to date has been a failure of imagination in nominating "somebody" to run against it.

But for the first time in awhile, "somebody," in various guises, are appearing. Here are just a few suggestions:

• Flat fees for a large portfolio of litigation over time and space.
  • Imagine you could handle all of Wal-Mart's employment litigation west of the Mississippi for three years (a made-up example). With the help of some of our good friends the actuaries, you could put a reasonable, albeit approximate, price on that.
  • But beyond that, imagine how landing that contract would change our firm's behavior the day after signing: All of a sudden, your incentive would not be to let Wal-Mart slide carelessly into court, ramping up your billable hours, but precisely the contrary--to keep them out of court, because going to court costs you dearly against your fixed-price contract.
  • Wouldn't you, then, embark on a campaign of employment-law compliance counseling at Wal-Mart?
  • And did you notice how this aligns the client's and the firm's interests? All of a sudden there's genuine risk-sharing: The more the client is sued (unpleasant and expensive), the harder the law firm has to work and the less profitable it is (unpleasant and expensive).
    
    
• An 80/120 deal.
  • With a willing and innovation-friendly client, agree that such and such a matter should cost, say, $1-million, but ask them to pay your firm as progress fees just 80% of that as the matter proceeds.
  • When it's done, the client gets--in its sole discretion--to evaluate how successful the outcome was for them. If they don't like it very much, they've paid your firm 80% and the matter is closed.
  • But if they like the result a lot, they pay you 120%.
  • And of course, 99% of the time, they pay you more than 80% but less than 120%.
  • What do you wager that the average recovery your firm would make on deals like that would exceed 100%? I would happily take that bet, as everyone working on the matter at our firm will know that this is a client they have to please.

There are surely other models inventive minds can think of.

The billable hour is dead. Long live the billable hour.

Perspective.

It's time for some.

A friend of mine who's the lead financial reporter for one of the original three networks prompts these thoughts. Not that he/she subscribes to the view that it's time for some "perspective"--au contraire. To paraphrase their view: "We're in a severe recession. This is not the time to be sanguine, it's the time to be alarmist. [And] In terms of investments, it's time to go to CD's; if you've already lost 40% in equities, you want to get out; you don't want the 40% to become 60%."

Now, we all react in our individual ways to once-in-a-career times like these, and if my job were to report on deadline every weeknight to a national television audience about the state of the economy and the financial system, I'd probably not be writing this piece. I'd be writing about how this time is different, and not for the better: That this time is more akin to the Great Depression than to the 70's staglation and OPEC oil price spike, the 80's Volcker-induced shock therapy to stamp out inflation, or the 90's dotcom meltdown. I would, in other words, be writing alarming things.

Since we're still in the middle (the beginning?) of this economic episode, we of course can't know. My call for "perspective" may be delusional and this may be one of those pieces ruefully quoted back to me months or years hence. But I'll go out on a limb.

This chart shows the US per capita GDP in 2000 dollars from 1870 to 2004 (ratio scale), and comes from the new textbook Macroeconomics by Charles Jones:

The trendline is 2%/year growth, and the only real deviation visible to the naked eye is the 1929-1933 Great Depression--and even after that, the trendline quickly returned to normal. Every other recession appears as little more than a blip or a rounding error.

What does this tell us?

It scarcely "proves" that this time is nothing to worry about, but it does suggest that, my friend the financial reporter's views to the contrary notwithstanding, the "animal spirits" of capitalism (John Maynard Keynes' felicitous phrase) will arise again. Assets will be bought and sold. Companies will be started, grow, and decline. Capital will flow from country to country and industry to industry. New financial instruments will be created. New regulatory structures will govern. Globalization will not cease.

In all of these activities, lawyers and law firms will be enablers, facilitators, innovators, brokers, handmaidens, and creators.

I'm not gainsaying the challenges, and for those of you in leadership positions in firms these days, this is surely the time you'll earn your keep. What I'm saying is:

• Be not apocalyptic.
  
  
• Manage your partners' expectations. If next year is tantamount to a return to 2003, we'll all live.
  
  
• Recruit carefully, prudently, assiduously, but keep recruiting. Talent is your lifeblood. Do not shut if off.
  
  
• Communicate, communicate, communicate, to your partners, associates, and staff, about how the firm is doing. (Yes, some of it will hit "Above The Law" in a nanosecond, but that's a topic for another day.)
  
  
• Communicate with your clients. They're anxious as well; let them know you're in the same boat. A little bit of sympathy about cost-cutting pressures wouldn't hurt as well.

It all depends, perhaps, on your perspective. If it's the nightly news, it's one thing. If it's the arc of a career, it's another. Stay true to which is yours.

Beyond continuing to hypothesize duelling views of future realities, let's look at the historical record (with help from McKinsey).

Financial crises, to begin with, are not that rare:  On average, they occur every decade to one major economy or another.  And while this promises to be among the more severe, a lesson from the 20th Century is that how bad things will get depends largely on the governmental response. 

At this point (December 2008), according to Bloomberg, US financial instiutions have taken total credit-crisis related write-offs of almost $1-trillion.  McKinsey estimates the total required amount of writeoffs will be between $1.4 and $2.2 trillion, or 10—15% of US GDP.  Historically, in the past century that level of writeoffs was exceeded only three times:

• During the early 1990's banking crisis in Japan that initiated its "lost decade;"
• In the Asian financial crisis of the late 1990's;
• And of course in the Great Depression.

In the first two, writeoffs in the affected banking sectors were 15 and 35% of GDP respectively; in the Great Depression, about 20%.

But from the perspective of the functioning economy, the real question for companies is not what's happening in the banking sector but what's happening to the availability of credit:

How long it takes an economy to emerge from a downturn depends heavily on what kind of cleanup and stimulus package governments employ--especially in repairing the banking system's ability to provide credit efficiently and restoring confidence among companies and consumers. On average, countries have needed two years to emerge from past recessions after major banking crises and up to twice as long to return to trend growth. Only in two cases did a downturn last substantially longer: in Japan during the lost decade, as a result of counterproductive government policies, and in the Great Depression, when the government was far less able to mount a coordinated response than it is today.

And with respect to stock markets—the high-profile indicator that everyone including our financial reporter friend pays attention to—we are also, apparently, in a quite well-precedented downturn:

Equity markets are the most visible and dramatic indicators as crises unfold. At the end of October 2008, the S&P 500 index had fallen by 46 percent from its peak a year before (October 9, 2007, to October 27, 2008). By late November 2008, the US equity market had given up almost all of its gains since the 2001-02 dot-com bust. Although nobody knows if the market has reached bottom, the fall so far isn't unusual by historical standards. Japan's Nikkei 225 fell by 48 percent from peak to trough (December 29, 1989, to October 1, 1990) during the banking crisis, though the market has subsequently fallen still further; at the end of October 2008, it retained less than 20 percent of the peak value reached in 1999. During the Asian financial crisis, the equity markets of Indonesia, South Korea, and Thailand fell by 65, 72, and 85 percent, respectively, in local-currency terms. In the United States, the S&P 500 index fell by 49 percent from March 24, 2000, to October 9, 2002, after the tech bubble burst.

Here, as well, are some fascinating and troubling statistics on the housing market.

But reasons for hope still remain, and they're all tied to how the underlying economy is—or isn't—isolated from the financial services sector blow-up.  For example, in the early 1980's S&L crisis, 258 US banks failed or required FDIC assistance and during the entire decade of the 1980's 750 failed and more than 1,500 required assistance (vs. 35 during the entire decade of the 1970's), yet corporate investment continued to increase at an annual rate of 4.5% in the 1980's. How well prepared are we today?  Surprisingly well:  US industrial companies have higher interest coverage and lower leverage than they did going into the dot-com bust or the S&L crisis.

By contrast, one reason the Depression was Great was that business investment fell by more than 75% from 1929 to 1933 because capital had almost nonexistent cross-border mobility and even the soundest of corporate credits couldn't obtain long-term debt financing.  That happening again today appears exceedingly unlikely.

So where does this leave us? 

As we've just all learned, the famous PG Wodehouse character had it right when he said, "never confuse the unlikely with the impossible."  Now that we've all seen shockingly unlikely events unfold, including the end of Wall Street as we knew it, what should we actually be doing?

Your answer depends on how uncertain you feel about the future.

If you feel that what we're going through is a "normal," albeit severe and protracted, recession, we know how to deal with that. Pull in your horns, sit tight, control costs rigorously, and wait for the legal industry (a lagging industry) to pull out after the real economy does.

If on the other hand you feel that we're experiencing a generational or once-in-a-career change in the way high-end legal services are bought and sold, then you need to stand on tiptoes, rather like a sprinter entering the blocks at the starting line of a race, prepared to bolt forward as soon as there's clarity enough (in your mind) to think the starter's pistol has fired. This does not mean you need to be inattentive to costs, any more than sprinters are inattentive to weight, or complacent about your current exalted standings. At the starting line, you have no standing; all are equal, at 0:00.

This is where I actually think we are. We are all about to begin running a new race, one where incumbency will count for far less than it used to, and where a premium will be put on agility, speed, and foresight. Because this race, once the starter's pistol fires, will be run in heavy fog, with visibility just yards down the track and the positions of your competitors, be they ahead of or behind you, difficult to discern moment to moment. But the time to start training, to make your firm more agile and alert and responsive, is now.

"Reports of my death have been greatly exaggerated."
—Mark Twain, in a cable from London to US publishers, who had mistakenly printed his obituary.

And so, for the entirety of my career, has it been the case with predictions of the demise of the billable hour.  If the best predictor of what will happen is what just has happened, then the billable hour is here for keeps.  But I wonder.

If you can say nothing else about what's going on now, you can say that the volume of the dialogue about alternatives to the billable hour has never been higher.

Last month the Association of Corporate Counsel announced their "Value Challenge," through, among other venues, an interview with Susan Hackett, their GC. Some of her comments included:

Value from the corporate perspective means receiving a solution that addresses the client's problem-for an appropriate cost. [...] Take a look at the cost of legal services and the fact that they've been rising 6, 7, 8 percent a year, for as long as anyone can remember. But the services remain pretty much the same. And at the same time that outside firms' costs are rising, the in-house law departments are getting better at their efficiencies and at lowering their costs. [...]

We also want to measure whether people are starting to do more of their work on a non-hourly basis. It¹s one metric. I¹m not saying billable hours is the entire project, but it¹s one good way to look at this. [...] You would see a lot less work done on the billable-hour basis, but I don¹t know what alternative billing will look like.

I don't know about you, but it sounds like "billable hours is the entire project."

Consider another perspective: The dehumanization that comes with the billable hour. And dehumanization it is, is it not? Doesn't it tell people that they're fungible commodities? To be sure, their hourly rates vary, but they're all and every reducible to cogs in the machine. No rewards for specific insight, no discounts for slogging through it, no premiums for remarkable efficiencies. You are your watch.

Or consider the perspective of the intersection of the core years to partnership tournament with the key family formation and child-bearing years. At the moment, these two critical life trajectories tend to overlap in people's lives. Both are intensely time-consuming. Their intersection is, for many people, unsustainable; they are forced to choose one or the other.

Don't misunderstand; I'm not suggesting that the pressures of the path to partnership years--and the partnership years themselves--can be substantially ameliorated, minimized, or underestimated. There is no substitute for hard work if one wants to achieve professional performance at the level partnership entails. But what I am suggesting is that the billable hour model exacerbates the tension between familly and work precisely at the time it matters most. Without it, contributions could be more readily recognized "on the merits," without the quota of hours in the office or on the BlackBerry.

Two other perspectives are, I believe, more important and will be more consequential. One results from the tsunami of changes in the complexion of the financial services industry in the last year and the other results from an inherent structural problem with the billable hour model for firms themselves.

Financial Services

The industry is unrecognizable from its form a year ago. Bear Stearns, Lehman, Merrill Lynch, gone, and Morgan Stanley and Goldman Sachs essentially far different from what they were. Balance sheet leverage ratios of 30:1 or 40:1 are ancient history. New regulations, of forms we can't yet predict, are certain. Old forms of regulation may go by the wayside, but the net result, to be sure, will be an overall increase in oversight.

Which brings me back to the billable hour: If financial services comprise a substantial part of your clientele, look forward to their being more heavily regulated than before. With congressional oversight. Care to explain to, say, Barney Frank, why $1,000/hour is a fair and economically justified rate? Wouldn't you far prefer to explain why (say) $750,000 as a flat fee on a $50-million transaction is reasonable?

Also, Bank of America buys legal services very differently than did Merrill Lynch. RFP's, beauty contests, bakeoffs, diversity quotas, expectations about first and second year associates (don't bother putting them on the bill), and so forth: It will be a new world.

Structural Issues

I have long predicted that the demise of the billable hour will only come about when law firms find it in their own self-interest to call a halt, and perhaps at last the stars are beginning to align. Consider the four variables that determine your firm's revenue and profitability under the billable hour model:

• Rates;
• Hours;
• Realization; and
• Leverage

Faithful readers will know that I've pointed out that all four of these variables have intrinsic limits:

• Rates: $1,000/hour? £1,000/hour? At some point there is a limit to clients' stomach for it.
• Hours: 2,200/year, 2,600. 3,000? At some point the body rebels, and the talent pool capable of sustaining these super-human schedules thins out.
• Realization: >100%? I think not.
• Leverage: At what point do associatesl look at the odds and simply check out?

But on the profitability side of the ledger, there are no intrinsic limits.  How high is "too high" for PPP?  Sarah Palin Joe Six-pack probably thinks $2-4-million/year would do just nicely, but when you're a partner at BigLaw regularly rubbing shoulders with hedge fund managers and private equity folks—or plain old Fortune 500 CEOs—you're a piker by comparison. Consider also the baffling silence over the fact that corporate execs get equity in the form of stock, restricted stock, or options.  Lawyers, even the best of them, toil for ordinary income.  Yes, you can make a very respectable income and if you sock it away prudently (we Scotch Presbyterians can give you advice on this if you'd like), you'll end up with a very comfortable nest egg.  But it will have been gained by the sweat of your brow and not the true alchemy of returns on capital.  So we have, under the billable hour model, inherent constraints on revenue but no inherent constraints on the desire for ever-increasing profits.

This brings me to the point: Won't firms find it in their own self-interest to get beyond the billable hour in the pretty darned near future?

Do not, I hasten to add, be afraid. "Alternative billing" is not code for "reduced revenue."

Indeed, we have every reason to expect that getting away from the billable hour will lead to less micro-management of billing, fewer he-said/she-said spats about whether this, that, or the other micro-activity was justified, and less general embarrassment over tiny charges for faxes, messengers, and other costs of doing business.

I'll suggest another reason more potent than "embarrassment" for ditching the billable hour:  Doesn't it fundamentally reflect a lack of trust between your firm and your clients?  Rather than being able to say "For professional services rendered...." and have confidence that hte client will trust you to have put a fair price on things, the billable hour reflects a green eye-shade mentality, notoriously subject to auditing (now, even by bespoke software programs designed to ferret out inconsistencies and discrepancies of the most minute and trivial nature).  The billable hour, I believe, starts from a relationship of mistrust:  "See, we can prove we actually did the work!"  And the GC or other inhouse counsel can, in turn, tell their finance department, "Yes, see, they really did the work." 

This is not the premise from which mature relationships of trust and confidence arise. 

At the risk of piling on, I'll suggest yet another reason the billable hour disserves our profession:  Economically, it begins life with "cost of production" rather than "value to client."  Except for the rawest and most basic of commodities, "cost of production" should have virtually nothing to do with price.  (OK, before the microeconomists in the audience start piling on, permit me to issue the immediate caveat that, in a  perfectly competitive marketplace, price will equal marginal cost of production, but I stoutly question the assumption that the marketplace for services of BigLaw is remotely "perfectly competitive.")

To be sure, firms need to meet their costs and then some to make a profit, permit reinvestment in their businesses, and appropriately reward their owners and investors.  In this technical sense, then, "cost of production" is clearly a relevant variable when determining price.  Price best exceed cost of production by a reasonable margin if the firm is to survive as a going economic entity.  But for price to be mathematically determined to the second decimal place by "cost of production" is flatly irrational.  Worse, it ignores (again) what the perceived value of the services is to the client.

Now, don't pretend you can't put a value on those services.  We value complex baskets of goods and services all the time, and markets for those goods are highly liquid.  Why is a haircut at "Frederic Fekkai" on East 57th Street worth hundreds and hundreds of dollars while one with Sal the barber on Upper Broadway is worth $30 including a hefty tip? 

Finally, a failure to bill "for professional services rendered" represents, I must believe in my heart of hearts, a failure of courage.  Do you mistrust what your services are worth?  Do you mistrust whether your client agrees with your perception of their value?

If that is the root cause of the continued dominance of the billable hour, then we have far more work to do than turning off "timeslips elite."  But for the health of our profession, for our self-respect, and for the benefit of clients, turn it off we ultimately must.