Origins of the modern law firm: Insights and omens

I said to myself, these insights on origins of the modern law firm are even more apt than when Ed first penned them in 2015. In the past week, I have seen first-hand four substantial Australian law firms sliding further into difficulties because they have not fully understood the omens…..

Dialogue is pleased to re-publish ‘Origins of the modern law firm: Insights and omens’. 

If you unlock the cage, the beast often comes out.

The fundamental structure, operation and character of governance in law firms has transformed over the past 45 years. For perspective, consider that in 1970, the largest law firm was Shearman & Sterling, with 164 attorneys. By 1985, Shearman & Sterling had 432 lawyers (i). Today, Baker & McKenzie has over 4,000.

Let’s look at nine important features that characterized most large law firms in 1970, and again in 2015. Several are clauses  central to enabling change, while others are only indicators.

>1 General vs. limited liability part­nership (cause) 

During this period, states adopted revisions to their Uniform Partnership Act enabling law partnerships to elect LLP status. While partners would not be protect­ed from liability to clients for profes­sional errors, there would be liability limits to third parties. Intense per­sonal interest in preserving one’s entire financial worth was reduced, making growth through lateral hir­ing a feasible consideration for both firm and candidate, and for remov­ing involvement in this and many other decisions by partners.

>2 Direct percentage ownership in assets (cause)

Growth in size increased frequency of changes to membership, creating valua­tion and tax issues with every adjustment. Further, challenges to valuations from retiring or withdrawn partners, divorcing spouses, or trustees of deceased or disabled partners posed finan­cial risks to all partners. Most large firms moved to a structure where the partners disclaimed any goodwill valuevalue, and waived direct ownership interest in firm assets. Firms converted to a capital contribution model, the only “equity” stake of owner­ship. This capped the amount of equity investment and return to the capital account, virtually eliminating financial interest in the continuation of the enter­prise after departure.

3> Partner mobility

Lateral mo­bility was limited in 1970. By 2015, the majority of firm part­ners may have been partners at two, three or more firms in their careers. Potential for destabili­zation by key departures puts pressure on firms to compete annually with the market to retain their partners, leading to greater emphasis on ever in­creasing profits, wider compen­sation spreads, borrowing for partner pay and other pressures encouraging over distribution

4> Promotion from within

Still the primary source of partners in 1970, associate ranks become a declining source of partners, with only a small percentage of hires from law school making partner. High attrition rates make  investment  in associate skills development a low prior­ity.

5> Multiple partner classes

Most law firms in 1970 used one “eq­uity” partner class, though com­pensation varied among part­ners. By 2015, the multi-class structure predominated, with non-equity “partners” common.

6> Partner participation

From participation in almost all deci­sions as partners, firms have migrated to a governance and management model much less inclusionary, and sometimes virtually exclusionary outside a small circle of partners, the part­nership within the partnership.

7> Debt

Sourced from third-par­ty lenders, landlords, equipment lessors, vendors or the partners themselves, substantial debt use has become widespread in the operating model of many law firms by 2015. In 1970, debt during the year was small, and distributions came after all ob­ligations to third parties were satisfied.

8> Headcount size

Today’s firms are sizes unimaginable in 1970. 

9> Unfunded retirement plans (cause)

Typically a stream of payments over a term of years, often in amounts arrived at by formula, and capped to the ag­gregate of partner payees in any one year to a percentage of partner profits. These programs took a period of years to vest, and many more years to vest fully — almost an entire career at one firm. Forfeit should a partner leave to compete at another firm, these plans encouraged talent to stay in a firm with a continuing interest in the firm’s long-term financial sustainability.

Why are unfunded retirement plans on the list? Weren’t they a bad idea, or no longer desirable?

History may give a clue why they were created, and what hap­pened after.

When former governor of New York, and name partner Thomas Dewey died in 1971, his passing left his firm and family in a dif­ficult predicament. The leading revenue producer in the firm was gone, his practice was not sustainable by others without him, and the partners were jointly and severally liable per­sonally to buy out Dewey’s large ownership interest.

The firm survived a litigious struggle, but the lesson was clear. The risk of one key partner, or several important partners, ceasing to practice in a short period, could destroy the financial sustainability of almost every law firm. Senior partners with long tenure had significant accrued equity ownership ac­counts. They had invested in the self-financed growth of the firm over decades, essentially via reduced income and the buildup of the only meaningful asset of a law firm: the accounts receivable.

What could be done to strengthen a law firm so it could survive the otherwise guaran­teed crisis of succession, and to do it affordably yet fairly? Eliminating direct ownership interest in assets would do it, but what about the already existing ownership shares, especially for senior partners?

One popular solution became the unfunded pension plan, contractually embedded in the partnership agreement. A vari­ety of approaches to them was available to apply flexibility to each law firm’s unique needs. Basically, firms prepared a cur­rent estimation of all partner equity ownership shares, and a years-to-retirement and vesting formula. Then an allocation of current income to retired part­ners could be made each year to retired partners, to avoid double taxation on the consideration compared to a direct purchase. The payout stream was without interest, and received over a term of years taxed at lower rates to the retired partners. A cap on current income to be applied was often included, to keep the burden manageable. Affording all partners a similar arrangement became a strong incentive to stay.

Thus, a mechanism to allow withdrawal of wealth share cre­ated by partners was created. The Dewey crisis of 1971 was “Exhibit A” to the industry of why something had to be done to avoid winding up like Dewey. (A theme that returned for different reasons in 2012.)

But for active lateral markets, the unfunded plan becomes a barrier to hiring top talent. Firstly, the candidate forfeits her benefits at her current firm, and the new firm may have to offer a financial package that replaces that value. Secondly, the candidate may be obliged to tithe from 5 to 10 percent of annual income to support the plan for retired partners, but her seniority virtually assures she will never be a partner long enough to vest a meaning­ful benefit from that plan, so she won’t come, or demands a “premium” compensation to net out the distribution she wants. This unequal pay for equal per­formance is difficult to justify. Compensation transparency becomes a problem, as does in­formed partner participation in decisions on hiring, compensa­tion and ultimately even basic operations. So it disappears.

The plans are unwound because they impede lateral growth

Unwinding the unfunded plan removes all financial interest in a legacy to the firm beyond one’s own tenure. All financial rewards are made on a current basis, and capital return is limited to the amount contributed. Once re­moved, this last incentive to firm sustainability contributes to the appetite to distribute on a cur­rent basis as much as possible, and pressure to borrow money, or to demand increased capital from partners to make distribu­tions becomes acute.

Adverse financial consequenc­es to a firm by a departing part­ner are not usually shared un­less they are so great as to cause the collapse and bankruptcy of the enterprise, triggering “claw­ backs” of distributions. To date, the actual claw-backs achieved relative to over-distributions made have not balanced out to arrest the practice of passing out monies yet to be collected. The lateral market has shown that forfeiture of substantial capital is often perceived as a prefer­able cost to pay for a departing partner to leave a struggling firm and continue earning high pay, rather than stay and invest through lower pay for years for an uncertain outcome.

Partnership compensation from highest to lowest paid partners widens as firms feel pressure to pay market rate compensation for some part­ners that might leave, while the firm overall cannot afford to do so, and thus reallocates it from lower ranks of equity partners to higher ranks. Profits per equity partner (PPEP) goes up, partner headcount goes down, median partner income falls, the ratio of partners making as much as PPEP falls.

There are other dynamics at work, which can’t be covered in such a short piece. Consider this an introduction. Reflect on how we have arrived at where we are. And if we don’t make positive changes, where this inevitably leads us.

For a profession branded as reluctant to engage in change, law has changed a lot over this period.

Several of these features are causes central to enabling change, while others are only indicators.

(i) For perspective, in 1970 the largest U.S. law firm was Shearman & Sterling with 164 attorneys. By 1985 Shearman & Sterling had 432 lawyers. (Source: Abel, Richard L., American Lawyers (1989) Oxford University Press).

This post is reprinted with permission of Edwin B. Reeser and The Daily Journal Corp, © 2015.

Author

Edwin B. Reeser is a business lawyer in Pasadena specializing in structuring, negotiating and documenting complex real estate and business transactions for in­ternational and domestic corpo­rations and individuals. He has served on the executive commit­tees and as an office managing partner of firms ranging from 25 to over 800 lawyers in size.

You can connect with Ed on LinkedIn and email him at Edwin.reeser@att.net.