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Law firm bubble was bound to fizzle

April 25, 2009

Was it all just a bubble? The $160,000 starting salary; summer associates paid $3,000 a week; $1,000-an-hour partner billing rates; double-digit increases every year in law firm profits.

Back in May 2008, a law firm economics writer, Bruce MacEwen, warned in his Adam Smith Esquire blog, “There may be a bubble” in profits per equity partner.

 

By Jerry Crimmins
Law Bulletin staff writer

And this month, Glen Ellyn law marketing adviser Larry Bodine wrote, ”When I first heard about lawyers charging $1,000 per hour … it was the sound of a bubble popping.”

Law firms that want to succeed in winning and keeping business from corporate clients above all will need to be flexible, says Jason L. Brown, director of legal affairs for PepsiAmericas Inc. in Schaumburg and president of the Chicago chapter of the Association of Corporate Counsel. Photo by Chris Bernacchi

Law firms that want to succeed in winning and keeping business from corporate clients above all will need to be flexible, says Jason L. Brown, director of legal affairs for PepsiAmericas Inc. in Schaumburg and president of the Chicago chapter of the Association of Corporate Counsel. Photo by Chris Bernacchi

In the April issue of California Lawyer magazine, Michael Roster, former general counsel of Stanford University, wrote, ”The legal profession … created its own economic bubble. Now that bubble has burst.”

As clear evidence, since Jan. 1, 2008, major firms have laid off on the order of 10,000 lawyers and staff workers, with more than three-quarters of the cuts coming in 2009.

The economic crash is in large part to blame.

But a number of observers of American law firms say there’s another key factor: the business model of the American law firm is broken.

”Some people have asked,” noted Gregg R. Melinson, chief marketing partner of Drinker, Biddle & Reath LLP, ”when the economy comes back, will things go back to the way they were? I really couldn’t disagree with that more.

”I really think this is a sea change and opportunity for [corporations and their outside counsel] to reinvent the model,” he said.

If so, what went wrong with the model and what can be done about it?

Roster called the ”pay war” that led top law firms to adopt a starting salary of $160,000 for entry-level associates ”the spiral to hell.”

Roster, a former chairman of the Association of Corporate Counsel, is chairman of the steering committee of the ACC’s Value Challenge, through which corporations seek to engage law firms in a dialogue about rejoining the concepts of ”costs” and ”value.”

Roster cites these other broken parts of the law firm model:

  • Emphasis by legal publications on profits per equity partner, and law firms’ adoption of this as a measure of status.
  • Inflated numbers of associates compared to partners in law firms to expand revenue that is then manipulated into profits per partner.
  • Out-of-control associate turnover long before law firms started laying off lawyers.

Other law firm observers noted that despite law firms’ steadily increasing salaries, the firms maintained profits by raising prices.

Rate hikes have ”been a significant driver of firm profitability” since 2001, Mark Medice, national brand manager for PeerMonitor, said in mid-2008, before the bubble burst.

The compound annual growth rate for law firm rates has been above 6 percent for all timekeepers, mostly lawyers and paralegals, since 2001, Medice said back then. By comparison, the Consumer Price Index for American cities rose only in the range of 4.5 percent annually in the same time frame.

Thompson West’s PeerMonitor Index is an analysis of law firm economic indicators.

At least one study asserts that legal expenses in recent years rose far faster than other business expenses.

A recent report by the Corporate Executive Board found that large-company spending on law firms grew by 49 percent between 2002 and 2005, ”alarming CEOs and CFOs.”

The same report said that while non-law firm costs increased by 20 percent over the past 10 years, large law firms’ prices jumped almost 75 percent.

(The report was said to be based on data from 190 large companies and conversations with more than ”300 general counsel, in-house legal staff, procurement officers and law firm partners.”)

Roster, who formerly was the managing partner of Morrison & Foerster’s Los Angeles office, argues that law firms’ emphasis in recent years on profits per equity partner — or PEP — amounted to ”manipulation of a fraction.”

It led law firms in the good years to avoid discounts and to send out bills involving too many lawyers per matter, he said.

Morever, Roster said, law firms got rid of formerly useful practice areas, such as trusts and estates, because the profit margin was too thin and interfered with PEP.

And a law firm’s ”servicing partner,” who handled most of the informal inquiries from clients and was probably closest to those clients, became ”expendable.”

Servicing partners did not bill enough nor have enough associates under them, so they interfered with PEP, Roster said.

”You and I would think a servicing partner is a good thing,” Roster noted. ”He gives answers. [But] Oh, no.”

Law firms have told Roster that ”we have de-equitized most of our servicing partners,” he said.

During the years that high profits per equity partner became de rigueur among law firms, the bottom of the law firm worker pyramid has greatly expanded and the top shrunk in comparison.

Between 1995 and 2007, the total number of lawyers at large law firms increased by 77.2 percent, but the number of equity partners increased only 31.7 percent, according to Indiana University School of Law Professor William Henderson.

High ”leverage,” or a large group of salaried lawyers working for a small group of equity partners, ”can be a wonderful thing in boom times, but a killer in a down market,” Henderson noted last December.

Even with mass law firm layoffs, ”firms with the most human capital leverage will nonetheless be stuck with vast expanses of Class A office space,” Henderson wrote in the Empirical Legal Studies blog.

On the other hand, the Chicago law firm of Bartlit, Beck, Herman, Palenchar & Scott LLP, which Roster called ”one of the three best law firms in America,” has triple the number of partners (52) as associates (17), the reverse of many top law firms.

The Bartlit firm ”doesn’t believe in leverage,” Roster said. ”They believe it’s a stupid idea.”

The attrition rate of associates, Roster contends, has been another key malfunction in the modern law firm.

Before the current economic crash, associate attrition in large law firms had been ”up to about 20 percent” annually, Roster said, compared to what he estimated it was in 1973, about 12 percent.

Total associate attrition in recent years has been a whopping 85 percent before a few survivors of the associate class make partner, he said, based on his interviews with law firm leaders.

The result is ”the missing middle.”

”Where are the middle to senior associates?” Roster asked before the bubble burst. He said middle to senior associates were the ”people who really know the subject well and are very enthusiastic about their work. But the law firm pressures drive them out.”

The other serious effects of high associate attrition are very high recruiting and training expenses to constantly replace them.

”It costs $250,000 to $400,000 for every single recruit,” Roster estimated in a recent interview, ”to get them in the door. Then it takes a year or two … before they really know how to practice law.

”Up to now, firms got away with passing these costs on to clients,” Roster continued. ”Increasingly, clients are saying, ‘We can’t do this any more.’ ”

So what should law firms do?

First, law firms need to be more flexible, says Jason L. Brown, director of legal affairs for PepsiAmericas Inc. in Schaumburg.

”The complaint I hear the most” from other corporations and corporate counsel ”is that some law firms are not flexible,” Brown said in an interview.

Some law firms, he said, are agreeable, and ”will say, OK, is there a better way we can do this? Can we work on this billable hour thing? Can we work on a different mechanism to handle these matters?”

But other law firms are ”so kind of steeped in their ways of doing things,” Brown said, ”that the mere discussion about how to change is met with immediate tension.”

Brown is also president of the Chicago chapter of the Association of Corporate Counsel.

Corporations want to be able to make new deals with law firms to reduce corporate legal expenses. According to Brown, corporate departments that buy raw materials or other resources ”are able to make deals.”

For instance, information technology vendors, who represent a much younger enterprise, are quick to offer new service and pay arrangements when a client asks, Brown noted.

”I think it’s difficult for a law firm across the board to try to slash their billable hours,” he continued, ”but there may be more creative ways to do it.”

Brown suggested:

  • Avoid charging the rates of mid-level associates for legal services ”that could easily be done by paralegals,” or in other cases, have those services performed far faster, and thus more cheaply, by a partner.
  • Out-source document review and production and organization of documents for litigation or due diligence to a staffing company, or assign these tasks to a law firm’s own contract lawyers ”at a much cheaper rate.”
  • Charge different rates for the same attorneys or senior paralegals, depending upon the type of work to be done.

And while variable rates may be appropriate under some circumstances, Roster said, flat fees also can be a useful tool.

Roster suggested that law firms could could agree to do all of a corporation’s work in a given legal category for one annual, flat fee.

”That’s what I did at Stanford years ago,” he said. ”I gave firms portfolios to do counseling and litigation for a fixed price: labor, environmental, medical center… My costs went down 25 percent. My litigation went down by half after five years.”

Roster was general counsel at Stanford from 1993 to 2000.

Similarly, Ivan K. Fong, chief legal officer at Cardinal Health in Dublin, Ohio, said in November, ”Rather than having hourly rates, we are increasingly negotiating flat fees or fixed fees or success fees.”

And then there is the matter of attrition.

Except for layoffs, the associate attrition rate at U.S. law firms is now about zero, since there are no alternate jobs available, according to Roster and others.

But in the good years, excess attrition was a highly avoidable expense, according to Roster and the ACC.

The ACC hired an economist, Dr. John H. Johnson IV, president of Criterion Economics LLC, to build a computer model of a modern law firm with numerous variables, including associate attrition.

According to Johnson, by adding only a 5 percent increase in associate attrition into the model, profits drop substantially (recruiting costs are high. The lost profits in the model can be replaced by raising rates, cutting overhead to the bone, or getting associates who remain to do far more work.

The ACC offers the model online for law firms to use.

”In one test,” according to Roster, ”we reduced the incoming class of associates for a typical large firm by half, and we reduced the attrition rate to what it had been a decade ago. While it may seem counter intuitive, firm profits actually increased by nearly 30 percent.

”This approach,” Roster adds, ”would almost certainly allow for better training and mentoring of associates, a happier work environment for associates and partners alike, greater continuity in staffing and a far more valuable work product from the client’s perspective.”

Corporations often tell the ACC they don’t want to pay to train new law firm associates.

The law firm computer model and user manual is available at the ACC online.

Brown of Pepsi and spokespersons for ACC argue that they are not trying to lower law firm profits.

Instead, Roster says, clients ”prefer less turnover of their [outside] lawyers, greater training and mentoring, leaner staffing of matters, rewarding so-called servicing partners who actually answer our questions with little wasted effort, and, most important, rewarding efficiences and outcomes.”

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One Comment leave one →
  1. April 27, 2009 6:43 pm

    It is absolutely right that chasing PPP (which is the more common way to describe profits per equity partner) was a fool’s game and became an obsession. However, it was running in parallel with the crazy leverage encouraged by government housing and tax policy (which many people warned was inevitable). As asset and credit deleveraging blew up the market, it was obvious law firm deleveraging would happen in tandem. It may be one of the few silver linings in this market.

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