UGLINESS INSIDE THE AM LAW 100 — PART I

Every spring, the eyes of big firm attorneys everywhere turn to the American Lawyer rankings — the Am Law 100 — and the contest surrounding its key metric: average profits per equity partner (PPP). But if the goal is to obtain meaningful insight into a firm’s culture, financial strength or profitability for most of its partners, those focusing on PPP are looking at the wrong ball.

Start with the basics

For years, firms have been increasing their PPP by reducing the number of equity partners. American Lawyer reports that cutbacks in equity partners, when done correctly, are “a solid management technique, not financial chicanery.” But as firms are now executing the strategy, it looks more like throwing furniture into the fireplace to keep the equity house warm.

Since 1985, the average leverage ratio (of all attorneys to equity partners) for the Am Law 50 has doubled from 1.76 to more than 3.5. It’s now twice as difficult to become an equity partner as it was when today’s senior partners entered that club. Between 1999 and 2009, the ranks of Am Law 100 non-equity partners grew threefold; the number of equity partners increased by less than one-third.

Arithmetic did the rest: average partner profits for the Am Law 50 soared from $300,000 in 1985 ($650,000 in today’s dollars) to more than $1.7 million in 2012.

The beat goes on

Perhaps it’s not financial chicanery, but many firms admit that they’re still turning the screws on equity partner head count as a way to increase PPP. According to the American Lawyer’s most recent Law Firm Leaders’ Survey, 45 percent of respondent firms de-equitized partners in 2012 and 46 percent planned to do so in 2013.

But even when year-to-year equity headcount remains flat, as it did this year, that nominal result masks a destabilizing trend: the growing concentration of income and power at the top. In fact, it is undermining the very validity of the PPP metric itself.

An unpublished metric more important than PPP

The internal top-to-bottom spread within the equity ranks of most firms doesn’t appear in the Am Law survey or anywhere else, but it should, along with the distribution of partners at various data points. As meaningful metrics, they’re far more important than PPP.

Even as overall leverage ratios have increased dramatically, the internal gap within equity partnerships has skyrocketed. A few firms adhere to lock-step equity partner compensation within a narrow overall range (3-to-1 or 4-to-1). But most have adopted higher spreads. In its 2012 financial statement, K&L Gates disclosed an 8-to-1 gap — up from 6-to-1 in 2011. Dewey & LeBoeuf’s range exceeded 20-to-1.

This growing internal gap undermines the informational value of PPP. In any statistical analysis, an average is meaningful if the underlying sample is distributed normally (i.e., along a bell-shaped curve where the average is the peak). But the distribution of incomes within most big firm equity partnerships bears no resemblance to such a curve.

Cultural consequences

Rules governing statistical validity have real world implications. Growing internal income spreads render even nominally stable equity partner head counts misleading. Lower minimum profit participation levels make room for more equity partner bodies, but what results over time is Dewey & LeBoeuf’s “barbell” system. A handful of rainmakers dominates one side of the barbell; many more so-called service partners populate the other — and they rarely advance very far.

As Edwin B. Reeser and Patrick J. McKenna wrote last year, in Am Law 200 firms, “Typically, two-thirds of the equity partners earn less, and some perhaps only half, of the average PPP.” Statisticians know that for such a skewed distribution, the arithmetic average conveys little that is useful about the underlying population from which it is drawn.

Why it matters

For firms that don’t have lock-step partner compensation, the PPP metric doesn’t reveal very much. For example, consider a firm with two partners and an 8-to-1 equity partner spread. If Partner A earns $4 million and Partner B earns $500,000, average PPP is $2.25 million — a number that doesn’t describe either partner’s situation or the stability of the firm itself. But the underlying details say quite a bit about the culture of that partnership.

Firms with the courage to do so would follow the lead of K&L Gates and disclose what that firm calls its “compression ratio” and then take it a step farther: reveal their internal income distributions as well. But such revelations might lead to uncomfortable conversations about why, especially during the last decade, managing partners have engineered explosive increases in internal equity partner income gaps.

A future post will consider that topic. It’s not pretty.

THE LATERAL BUBBLE

Most big law leaders say that they have to keep pushing equity partner profits higher to attract and retain rainmakers. They have repeated that mantra so often and for so long that the rest of the profession has accepted it as an article of faith.

Perhaps it’s true, but two items in the February issue of The American Lawyer prompt this heretical question:

What if the lateral hiring frenzy is creating a bubble?

Victor Li’s “This Time It’s Personal” describes the state of play: lateral hiring is way up. Law firm management consultants, including my friend Jerry Kowalski, predict more of the same for 2012 as firms counter revenue losses from departing partners to prevent the death spiral that can result. Such fear-driven behavior can easily lead to overpayment for so-called hot lateral prospects that turn out to be, well, not so hot.

As I’ve observed previously, the reasons for the lateral explosion have much to do with big law’s evolution. Its currently prevailing business model encourages partners to keep clients in individual silos away from fellow partners, lest they claim a share of billings that determine compensation. Paradoxically, such behavior also maximizes a partner’s lateral options and makes exit more likely. In other words, the institutional wounds are self-inflicted.

But the article quotes several firm leaders who emphasize that, while money was important in motivating some of the partners they acquired, the search for a global platform also mattered. Frank Burch, cochair of DLA Piper, acknowledges that enticing a lateral hire requires that the money offered be comparable. But he also says that his firm “did a lot of hiring from firms that reported higher profits per partner” than DLA Piper. The article cites four: Paul Hastings; Skadden, Arps, Slate, Meagher & Flom; White & Case; and Morgan, Lewis & Bockius.

Except “Crazy Like a Fox” by Edwin B. Reeser and Patrick J. McKenna (also in The American Lawyer February issue), makes the correct observation that a firm’s average PPP is not all that informative. The authors’ focus principally on the growing cohort of non-equity partners in a climate where clients are unwilling to pay for first- and second-year associates. But they make a telling point on a seemingly unrelated topic: the income gap within equity partnerships has exploded.

They note that a few years ago the equity partner pay spread was typically three-to-one; some places it’s now ten-to-one or even twelve-to-one:

“Over the last few years there has been a dramatic change in the balance of compensation, to a large degree undisclosed, in which increasing numbers of partners fall below the firm’s reported average profits per equity partner (PPP)…Typically, two-thirds of the equity partners earn less, and some earn only perhaps half, of the average PPP.”

(Trying to justify this trend, some firm leaders have offered silly explanations, such as geographical differences.)

Now apply this learning to Li’s article. A firm’s average PPP isn’t luring high-powered lawyers; the money at the top is. Perhaps the desire to provide clients with a better global platform plays a role in some laterals’ decisions, but most of the firms experiencing the highest number of lateral partner departures in 2011 are already worldwide players. In fact, four firms — DLA Piper, K&L Gates, Jones Day, and SNR Denton — are simultaneously on both the most departures and most hires list.

Consider an example. Last year when Jamie Wareham became big law’s highly public $5 million man, did leaving Paul Hastings for DLA Piper improve his ability to serve clients? Doubtful. But the bubble question is far more important to the firm: Has Wareham been worth it? Only he and his new partners know for sure.

That leads to a final heretical question: Where a lateral bubble develops, what happens when it bursts or, perhaps more pernicious, develops a slow profitability leak? Nothing good. For the answer, ask those who once worked at HowreyHeller Ehrman or one of the many other now-defunct firms whose leaders thought that acquiring high-profile laterals offered only upside.

THE LAW SCHOOL QUANDARY

Law school deans are getting conflicting advice. Let’s sort it out.

“Provide more practical training” has become the latest mantra. At the recent annual meeting of the Association of American Law Schools, Susan Hackett, a legal consultant and former general counsel of the Association of Corporate Counsel, argued for a year of executive-style classes covering business topics and skills. Here’s a better suggestion: students seeking a business school education should attend business school.

Meanwhile, according to the National Law Journal, Peter Kalis, chairman of K&L Gates, said that some current law school criticism is misplaced: “I believe law schools should concentrate on the education of law students from the perspective of acculturating them in the rule of law. Law students should spend that time being immersed in and becoming familiar with common law subjects.” More fee simple, anyone?

Finally, a Northwestern University law professor and a first-year Kirkland & Ellis associate offered a dramatic solution to the shortage of attorneys. You probably didn’t know there was one. Although the U.S. already leads the world in lawyers per capita, the authors concluded that allowing colleges to offer undergraduate law programs would: 1) reduce law school tuition to zero (for such students); 2) produce more lawyers; 3) cause some attorneys to charge lower fees; and 4) assure broader access to legal services for lower- and middle-income Americans. While not prohibiting law schools from offering today’s $150,000 J.D. degree programs, the plan would put most law schools out of business.

Where to begin? One reason the United States has too many lawyers is that law school has long been a default solution for college students. But when youthful expectations clash with the harsh reality that most attorneys endure, career dissatisfaction results. Allowing poorly informed undergraduates to pursue a law degree right out of high school would be exponentially worse — for them and the profession. (Commenters to the on-line version of the article destroyed the authors’ cavalier comparison of their scheme to the UK system. If you’re wondering why The Wall Street Journal editorial board published such a flawed piece, you’re not alone.)

What do students think?

At the same time, today’s law students like the education they’re getting. According to the recently released 2011 Law School Survey of Student Engagement of 33,000 current students at 95 law schools in the U.S. and Canada, 83 percent of respondents said that their experience in law school was “good” or “excellent.” Eighty percent said they definitely or probably would attend the same law school if they could start over again. Maybe most of these students will join the ranks of unhappy scambloggers when they can’t get jobs to repay their loans, but for the moment they’re satisfied.

But the same study revealed that 40 percent of students felt that their legal education had so far contributed only some or very little to their acquisition of job- or work-related knowledge and skills. In other words, some like their law school experience, even if it’s not equipping them in a practical way for positions they hope to obtain.

A final point may resolve this apparent contradiction. When students seek their first law jobs, curriculum makes little difference. Candid big firm interviewers admit that, except insofar as a particular course might give a recruit something interesting to discuss in an interview, subject matter is irrelevant. In fact, dramatic curriculum innovation is underway at many schools and, however worthwhile it otherwise may be, affected students haven’t become more desirable to prospective employers:

“There’s no employer out there right now — not law firms, not the Department of Justice, not the ACLU — that are seeking out these graduates,” Indiana University Maurer School of Law Professor William Henderson observed at the AALS meeting. “These programs haven’t affected hiring patterns. It’s still all sorted out with credentials. It’s based on the brand of the law school.”

If the vast majority of students are happy with the law school experience and changing it won’t improve their job prospects, perhaps the legal academy and its critics should consider focusing attention elsewhere. Here’s an idea: Provide prospective law students better information about the real life that most lawyers lead. For too many of them, it comes as an unpleasant surprise. Forewarned is forearmed.

HUMBLE LEADERSHIP

Over a year ago, I considered the then newly-named dean of the Harvard Business School, Nitin Nohria. He’s been an outspoken critic of MBA curriculum that fosters short-term thinking at the expense of ethics and long-term values.

Nohria’s appointment came after the economic collapse of 2008 caused many to rethink what I call the MBA mentality of misguided metrics. Business school faculty worried that they’d taught too narrowly — emphasizing the need to maximize short-term profits at the expense of important but less easily measured values. Some suggested that business management should become more like a profession, such as medicine or, ahem, law.

Unfortunately, the most visible and powerful segment of the legal profession — big law — had already evolved to mimic some of the business world’s worst features. Nohria would have to look elsewhere for guidance.

So I read with interest his recent Q&A in the Wall Street Journal. Ethics has been a centerpiece of his curriculum overhaul at Harvard. But he’s even more concerned that this new classroom emphasis won’t stick once students return to the workforce.

“[T]here seems to be a big difference between people’s understanding of their responsibilities as business leaders and their capacity to live up to those when faced with pressure or temptation,” he told the Journal.

Because those achieving power have more difficulty retaining their moral compasses, Nohria’s new mission is cultivating humility.

“Abraham Lincoln said people think that the real test of a person’s character is how they deal with adversity,” Nohria told the Journal. “A much better measure of a person’s character is to give them power. I’ve been more often disappointed with how people’s character is revealed when they’ve been given power.”

Author Jonah Lehrer made a similar observation in a WSJ article discussing one study’s conclusion that nice people have a better chance of advancing:

“Now for the bad news, which concerns what happens when all those nice guys actually get in power. While a little compassion might help us climb the social ladder, once we’re at the top we end up morphing into a very different kind of beast.”

What does this have to do with lawyers? Plenty, especially most of those who run big firms where power has become concentrated increasingly at the top.

“Before the recession,” one management consultant observed, the top-to-bottom ratio within equity partnerships “was typically five-to-one in many firms. Very often today, we’re seeing that spread at 10-to-1, even 12-to-1.”

Several months ago, one big firm leader offered the Journal this spin:

“Pay spreads widen as firms become more geographically diverse, operating in cities with varying costs of living, said Peter Kalis, chairman of K&L Gates. The firm’s pay spread rose from about 5-to-1 to as much as 9-to-1 in the past decade as it expanded. ‘Houses cost less in Pittsburgh than they do in London,’ Mr. Kalis said.”

It’s a nice soundbite, but for reasons I’ve outlined before, not particularly persuasive. (E.g., Are there no top-of-the-range equity partners at K&L Gates’ Pittsburgh headquarters?)

But here’s the larger point: K&L Gates ranked 105th out of 126 firms in The American Lawyer  2011 Mid-Level Associate Survey. The firm scored well below the national averages in morale, collegiality, associate relations, training and guidance, family-friendliness, and overall rating as a place to work.

Kalis deserves praise for inviting recruits seeking jobs at his firm to ask tough questions. They won’t pose this one, but any leader should consider it:

While those at the top of big firms have consolidated their wealth and power, does true leadership — measured by the positive energy that everyone else in the place exudes — seem absent in a lot of them?

If Nohria is correct that the test of character comes when a person gains power, many at the top of some big firms could do better. Then again, it all depends on the metrics by which they’re measured.

LOCATION, LOCATION, LOCATION?

In “Greed Atop the Pyramids,” I observed that the internal spread between the top and the bottom within large firm equity partnerships has grown dramatically in recent years. No one feels sorry for those at the low end, but the compensation for many top partners has reached staggering heights. My title suggested an explanation.

K&L Gates Chairman Peter Kalis — whom I’ve never met — has offered another reason: It’s not greed; it’s geography. His photograph appeared with The Wall Street Journal article on Jamie Wareham, “The $5 Million Dollar Man.” According to the Journal, at K&L Gates “top partners earn up to nine times as much as other partners. Pay spreads widen as firms become more geographically diverse, operating in cities with varying costs of living, said Peter Kalis, chairman of K&L Gates. The firm’s pay spread rose from about 5-to-1 to as much as 9-to-1 in the past decade as it expanded. ‘Houses cost less in Pittsburgh than they do in London,’ Mr. Kalis said.”

Let’s consider that proposition. It’s certainly true that London is more expensive than New York, and New York is more expensive than Pittsburgh. It’s also true that some firms consider cost-of-living differences when setting compensation; some apply formulaic across-the-board geographical adjustments. But the issue involves the top of a widening range, not the relative cost of comparable talent across offices.

Here’s how to test the hypothesis that geography accounts for this relatively new phenomenon: Are all of a firm’s top equity partners located in the city of the firm’s most expensive office? I doubt it. Or try it from the other side: Are any of the biggest paydays going to partners working in less expensive cities? Almost certainly.

I don’t know how much Kalis makes, but he might even be a useful example. His K&L Gates website biography page shows a commendable involvement in a number of Pittsburgh-area civic organizations. In addition to his Pittsburgh office, the page also lists a New York phone number, but his only bar admission is Pennsylvania. He’s certainly not headquartered in the most expensive cities where K&L Gates has offices — Tokyo, Moscow, Hong Kong, Singapore, Beijing, London, or Paris. My hunch is that, as Chairman and Global Managing Partner, he’s not at the low end of his firm’s equity partner compensation range, either. So why the superficially appealing but ultimately unpersuasive “houses are cheaper in Pittsburgh” line to explain away a pervasive big law trend?

Perhaps it’s because reality is sometimes harsh and unflattering. Citing a former pay consultant for law firms, the Journal article noted, “A majority of big law firms have begun reducing the compensation level of 10% to 30% of their partners each year, partly to free up more money to award top producers.”

I don’t know if that has happened at K&L Gates, but other law firm management consultants have suggested that the need to attract and retain rainmakers in a volatile market has widened the top-to-bottom equity partner range in many firms:

“Before the recession, [the top-to-bottom equity partner compensation ratio] was typically five-to-one in many firms. Very often today, we’re seeing that spread at 10-to-1, even 12-to-1.”

Finally, the Journal article itself provides additional evidence that something other than geography is at work: “A small number of elite firms, such as Simpson Thacher & Bartlett LLP and Cravath, Swaine & Moore LLP, still hew to narrower compensation bands, ranging from 3-to-1 to 4-to-1, typically paying the most to those with the longest service….”

Cravath has a London office. Simpson Thacher has offices in Beijing, Hong Kong, London, Los Angeles, New York, Palo Alto, Sao Paolo, Tokyo, and Washington, DC. Yet they have avoided the surging top-to-bottom equity partnership pay gaps that Kalis attributes to geography.

To understand what has really happened recently inside big firms — and why — read The Partnership.

There is, indeed, greed atop the pyramids — even in Pittsburgh.

CULTURE SHOCK

On December 30, K&L Gates Chairman Peter Kalis sent an email that recently reached the legal blogosphere. Bluntly, he reminded fellow partners to get their outstanding client bills paid before the firm’s fiscal year-end. Above the Law reproduced it [complete with typos purportedly from the original]:

“Let me be clear about a couple of things. First, partners and administrators at this law firm are expected to run through the tape at midnight on December 31. Many of you came from different cultures. I don’t care about your prior acculturation. We didn’t conscript you into service at this law firm. You came volunatrily [sic]. What we are you are as well.

“And that brings me to my second point. We are a US-based global law firm. US law firms operate on a cash basis of accounting. Our fees must be collected by midnight within the fiscal year in which they are due. You don’t get to opt out of this feasture [sic] because it doesn’t appeal to you. Again, I couldn’t care less whether it appeals to you. It is who we are and therefore it is who you are. Get us paid by tomrrow [sic].” (http://abovethelaw.com/2011/01/the-two-faces-of-kl-gates/)

The message demonstrates three things — from the predictably banal to the inadvertently profound.

First, although the tone is a bit harsh, the substantive content doesn’t surprise any big law partner. Most lawyers aren’t particularly good businessmen. Reminding them that aging invoices require follow-up isn’t evil or wrong; it’s necessary. No attorney enjoys nagging clients about an overdue receivable. Presumably, the December 30 message was just the final step in a sustained year-end drive asking partners to complete a task that they’d otherwise avoid (as I did).

Second, email is perilous. Speedy communication can be great, but it’s fraught with danger. In less than a minute, you can address, type, and send a message to an entire group (and eventually reach many more blog readers). If you don’t take the time to proofread for typos, much less reflect on how others might later analyze your statements, no one will stop you from hitting the send button. Once released, the words assume a life of their own and context disappears. Every trial lawyer who has sought to explain away a client’s unflattering email message understands the problem. Surprisingly, some of those same lawyers fail to apply the lesson to their own writings. Next time, Kalis will probably prepare a script and deliver his thoughts via voicemail.

The third point has nothing to do with substance — that is, chiding partners to get client bills paid. Rather, the message acknowledges an unintended consequence of the prevailing big law business model: It has produced unprecedented lateral partner mobility that, in turn, erodes distinctive firm cultures. Two sentences make the point:

“Many of you came from different cultures. I don’t care about your prior acculturation.”

Six months ago, I praised Kalis for encouraging prospective associates to put interviewing partners on the spot when he urged: “[Recruits] should ask searching questions. How practice has changed over the years and how you deal with the changing demands. And how hard it is to reconcile your life at work with the rest of your life…I don’t believe lawyers should bow to icons. I want them to look me in the eye and ask tough questions.”  (http://thecareerist.typepad.com/thecareerist/2010/06/kl-gates-likes-them-sassy.htmlhttp://thebellyofthebeast.wordpress.com/2010/07/09/summer-associates-take-note-inadvertent-revelations/)

Although they probably won’t pose them, recruits now have more tough questions for him and other big law attorneys: As partners lateral into equity partnerships, what does the culture of the receiving firms become? Does it coalesce around the common denominator of maximizing current-year profits? Or is there room for other, non-monetary values that have traditionally defined the profession? If it’s the latter, how does the firm encourage them?

The answers matter because Kalis’s email emphasizes (twice): “What we are you are as well.”

I don’t know about K&L Gates, but what passes for culture in too many big firms is his message’s final exhortation: “Get us paid by tomrrow [sic].”

WHO REMEMBERS FINLEY KUMBLE?

“I just don’t see the need to cram two firms with around a thousand lawyers [each] together. It made no sense,” one Akin partner reportedly told the National Law Journal shortly after the collapse of Akin-Orrick merger talks.

The number of law firm mergers in 2010 is down from recent years, but look at the headliners: Sonnenschein – Denton; Hogan & Hartson – Lovells; Reed Smith – Thompson & Knight; Orrick and anyone. An earlier consolidation wave produced K&L Gates, DLA Piper, Bingham McCutcheon and others.

How much of this activity proceeds from the simplistic premise that bigger is always better?

When I was a young partner in my large firm, Finley Kumble became a disaster that struck fear in the hearts of big firm expansionists. During the early 1980s, Finley rocked the legal world as it signed up high-profile figures and raided other firms’ superstars, some of whom earned the then-staggering sum of $1 million annually. From only 8 lawyers in 1968, Finley became the nation’s second largest firm by 1985.

It promoted itself as a national powerhouse run on principles of meritocracy. The more business a lawyer generated, the more money he or she took home. Money was the glue that held the partnership together. Does that sound familiar?

But Finley grew too fast, assuming debt for office expansions and promising outsized paychecks to big name lateral hires. As revenue dollars dwindled, the firm disintegrated. With more than 650 attorneys at the time of its dissolution in 1987, it was still one of the nation’s largest firms.

The ghost of Finley Kumble haunted Biglaw leaders for years. Some saw its end as confirming that even large, diverse firms possessed their own identities. Mixing cultures through aggressive recruitment of name players with portable practices was a mistake. Others concluded that senior attorneys and their egos couldn’t survive as a single cohesive unit if their sole point of intersecting common purpose was greed. Still others saw the failure as an inevitable consequence of unrestrained growth. Finley proved that there was a limit on the size that any healthy large law firm could attain. No one knew the outside boundary with certainty, but crossing it was fatal.

What did today’s Biglaw managers learn from the lessons of Finley Kumble’s demise? Probably very little. After all, lawyers excel at distinguishing away precedent that undermines their preferred positions.

In that respect, modern proponents of growth through merger and high-profile lateral acquisitions can point to many differences between Finley and today’s firms. For example, the use of MBA-type metrics that focus on short-term profits at the expense of non-monetary values is now pervasive throughout Biglaw. In that respect, the earlier potential for cultural clashes has diminished as  current year equity partner profits have become the universal coin of the realm. Likewise, lateral movement at all levels — especially among rainmakers who were Finley Kumble’s signature recruits — has become commonplace. Indeed, the legal world has become more hospitable to Finley’s central mission and modus operandi.

It would be interesting to hear from former Finley attorneys on the question of how today’s large firms differ from what their old firm once was. Perhaps Finley was just ahead of its time. Or perhaps some major players in Biglaw law are about to see their times change. Or maybe the large firm segment of the profession is proceeding toward the same countdown that big accounting firms have already experienced: From Big 8 to Big 6 to Big 5 to Big 4 — and the race is on to be one of those few.

Here’s the key question: Who benefits in the long run from the rise of mega-firms? Management consultants embrace strategic fits producing scale economies that supposedly benefit clients and equity partners. Perhaps they are correct. But who considers whether hidden costs include undermining community, exacerbating attorney dissatisfaction, or imperiling broader professional values?

Personally, I enjoyed the time when I recognized most of my equity partners at the firm’s annual meetings. Who is willing to develop or consider a metric by which to measure that?