The recession has challenged businesses everywhere.  Law firms have been more profoundly affected by these extraordinary times then any I can remember.  Unfortunately these changes have disrupted lives and livelihoods — significant associate layoffs, associate pay reductions, reductions in first-year class size and starting salaries, and deferrals of employment start dates, among others.  However, the news is not all bad.  Law firms are also making changes that actually make associate careers better, such as moves away from traditional lockstep compensation and a return to real apprenticeship programs.  How well these changes take hold depends on many variables.

Join us on Tuesday October 27  at 1:00 ET for a 90 minute webinar to explore the strategic and financial implications of these changes.  For more information, visit Leverage, Lockstep and the Changing Associate Model.

Paul Lippe, Founder of Legal OnRamp, wrote an interesting commentary, Welcome to the Future: Time for Law School 4.0.  In it he advocated a change in direction for the nation’s law schools including an accelerated curriculum, more practice orientation in teaching, better use of technology, a more empirical approach to practice, a move back to mission-centered management and a long term commitment to skills development.  Worth considering as law schools consider how best to respond to a changing legal and education marketplace.

I was recently asked about my views on open or closed partner compensation programs.  Here is my response.

 Law firms predominantly have open programs; about 80% to 85% are open; 3% to 5% semi-closed (either management compensation is disclosed or certain statistics reflecting the decisions are published, but not individual decisions) and the balance closed.  Traditional professional partnership values support an open program as consistent with partners entitled to see the books and records and their desire for a transparent partnership.  It also greatly aids the ability of partners to determine the degree to which they believe that the program is a fair meritocracy.  This is critical to ensure the overall success of a compensation program that is dependent upon it being widely accepted as a fair meritocracy.  Internal comparisons are the prime evidence in such an evaluation.  And as a practical matter, in most firms the decision makers change leadership roles over time so the closed nature of the program deteriorates over time.
 
Firms that embrace a closed program generally advocate the practice as a means to focus each partner solely on his/her performance and pay.  And accordingly reduce the intra-partner bickering and competition that can result in an open program.  A number of compensation committees in closed firms have indicated that it gives them more freedom to make the decisions they believe are in the best interests of the firm — a dangerous slope to be on when the judgment is limited to a select few. 
 
Others have stated that it makes it easier to bring laterals into the firm.  Our assessment is that firms have frequently overpaid laterals as an enticement to make the deal and then in many cases those same laterals did not quickly produce the business and benefits that were the stated basis of their compensation.  Admittedly it is not an easy task, even for the lateral, to really know how much of his/her practice is portable or how quickly it can or will transition to the new firm.  That scenario also indicates firms are likely paying more for lateral talent then they would pay their own partners.  That can breed resentment and disrupt a collegial/collaborative environment.
 
For a closed program to work the firm must have a very high degree of trust, especially for leadership.  It also must develop other means to ensure that the partners feel that the program is fair and a meritocracy.  The best closed programs have been firms with a strong benevolent founder who had unassailable credibility and who remained in control for many, many years.
 
Transitioning either way is a major change and will likely alter the firm’s culture and intra-partner dynamics.  Even if the decisions were well done in a closed program it will likely be unsettling when partners are first exposed to the reality.  We have found it difficult to close an open program without a major catalyst such as a merger of equals or some traumatic “life-changing” event.

While not as bad as the 4th quarter of 2008 and the 1st quarter of 2009, credit markets continue to be less friendly.  Credit limits are often lower as banks modify their ratios.  Loan covenants are more onerous and banks are more strictly enforcing them.  Those friendly waivers are harder and more expensive to obtain.

The latest trend appears to be line of credit facilities are commonly being written with variable rates tied to some benchmark rate plus a rate floor (”at no time will the rate be less than…….).

This article is a good summary of how the recession affected the accounting firms.  It may all sound a bit unsettling as I found myself easily substituting “law firm” for “accounting firm” and finding it spot on the money.

 A couple of quotes deserve special attention.  This first quote is about getting closer to your clients and getting work.  Gary Boomer said, “The clients out there need you more than ever.  You just need to go talk to them and ask them what’s keeping them up at night and listen.  Not go out on a sales call, but go out and find out what’s making them tick.  If you talk to a client and sit there and listen for a while, you can find a lot of new work.”  This is so perfectly stated, but often not as well executed.

 The second quote is more about the perils of not making tough decisions when they should be made.  Addressing the cutbacks that were made during the recession, Gary Shamis said, “If we had done what we needed to do when we should have done it, we would have released them into a better environment.  I think the recession was good.  It forced us to be more proactive and look at workflow.”  Unfortunately, this is a lesson that is taught during each economic downturn.

 I was also quite interested in the changing dynamic in partner compensation as described by Allan Koltin at the end of the article.  Allan said, “The “new school” train of thought instead asks, ‘Who did you recruit to the firm last year?’  ‘On the upward evaluation, how many identified you as the reason they are with the firm?’ and ‘How many current and future partners would identify you as their sponsor?’” 

Beware of the troubled landlord who is not maintaining their properties, paying property taxes or are late on its mortgages.  This CNN Money article on commercial real estate mortgages identifies the worrisome trends — declining rental rates, increasing vacancies as well as delinquency rates four times higher then they were in the 2nd quarter of 2007.  The article focuses on the issue as it relates to banks.  However, tenants do not want or need the hassle of a landlord in financial distress either.  Much more careful due diligence of landlords and the underlying investors is warranted if you are considering a move or even a lease extension or renewal. 

Interesting post on the Legal Watercooler yesterday that demonstrates the tension between making sharp business decisions and doing right by people.  We see this play out in a variety of ways from firm to firm.

Measuring the source of new work for purposes of remuneration decisions continues to challenge law firms.  Clearly when a partner or team of partners bring a new client to the firm there is measurable origination.  And there is at least implied agreement that origination should be shared when multiple individuals hold meaningful relationships within a client organization and those relationships draw work to the firm.  I say ‘implied’ because there is very little sharing taking place — it appears that fewer then one-quarter of the clients in law firms are shared for origination purposes; with a sizable portion of firms not sharing at all (Compensation Systems in Private Law Firms, 2009).  Now one might say that only the largest clients at large law firms may present realistic opportunities for multiple relationships.  And we can see from surveys, larger firms, which have correspondingly larger clients, exhibit a greater degree of sharing.  Still this issue of getting lawyers to sell and service clients collectively challenges leadership.  It is a critical issue in succession programs, as well as for remuneration.  Even if clients are not large enough to support multiple relationship partners, some thought should be given to creating a team that will ensure relationship continuity over time. 

When tracked, small law firms are least likely to reallocate origination.  Large law firms, while more likely to reallocate origination credits, engage in individual partner negotiation as the primary method to determine when and how origination will be adjusted.  Large firms are also more likely to focus on the current client relationships when discussing origination reallocation.  Many firms do not track origination because of the fear that a corrosive internal competition will result.  This does not mean that those firms do not consider this contribution when making compensation decisions.  Origination reigns supreme as the most critical partner compensation factor.  This metric, more then any other, determines whether a lawyer becomes – and remains - an equity owner in a law firm.  And it may well be a determining factor in when and how lawyers exit the firm in their senior years.  So not tracking origination says more about culture and operating philosophy then it does about its importance.  

Unfortunately, tracking origination is very much like trying to maintain a mailing list.  You work hard to keep it updated only to find it is 30% wrong whenever you go to use it.  Such it is with the tracking methods for origination.  Going to matter level tracking aids is a more current and hopefully realistic tracking method.  If done well it can provide real-time assessments specific to each matter and should reflect evolving relationships over time.  The best origination records still require compensation decision makers to make inquiries of practice leaders and other partners so that informed adjustments can be made.  

Getting this wrong can cause all kinds of havoc.  Example, Partner Paula is not given recognition for origination of a $1.5 million portfolio of a $5 million client where she has worked hard to build a trusted advisor relationship with the business unit CEO.  She leaves her firm and takes $1 million of work with her.  Clearly she was off in her estimate of $1.5 million, but the firm was also off in not recognizing the possibility of the $1 million.  The new firm recognizes the $1 million as Paula’s origination.  This scenario plays out in firm after firm, year after year.  This is why leaders in many firms are constantly reinforcing organization and team values.  It is also why the compensation decision makers work hard to get behind the numbers to understand, as well as anyone can, how work gets to the firm.  

Maybe this time the profession is serious about associate pay changes.  I’ve been a bit skeptical because the clamor for change is not new.  What is new is the breadth of the realignment of pay scales and the corresponding announcements of apprenticeships (the boldest moves to address client resistance to hiring newly minted lawyers), training programs and other activities.  All of these are positive steps.

However, associate compensation still appears out of line.  The reductions announced so far are about half of what is probably required (i.e. going from $160,000 to $145,000 should probably go much further to $125,000 or even $100,000); thus resetting the wage scale by a decade.  This is a painful reality and one that surely will fire up emotions.  But the tide has changed; clients are moving quickly and assertively to reduce legal spend.  This goes beyond alternative fee arrangements (AFAs). Costs of outside legal bills are going to come down, and from the early signs — down dramatically.  Services will be competitively bid, outsourced, off shored, converged, internalized, re-engineered, and even forgone.  Now add the AFAs to create greater certainty regarding total cost along with a healthy measure of risk transfer from the client to the law firm.  All of this will bring the major line item in any law firm — the cost of people — under assault.  This will affect total employment, wage scales and job expectations.  The pace of the salary change is directly affected by the pace of change in what clients will pay for legal services.

Once the scale is in line, what’s next?  Pay packages are likely to be less generous on the upfront money (say goodbye to signing bonuses), with reduced salaries and more modest benefits.  Bonuses, possibly semi-annually or quarterly, will ease some of the pain.  But expect the eligibility performance thresholds to be rigorous.  There is likely to be more emphasis on skills and competencies, particularly as they relate directly to delivering valued advice and counsel to clients.  But do not for a minute think that those criteria will overshadow revenue generation.  It’s where the money to pay associates comes from.  There is also going to be a concerted effort at looking beyond what associates know and do to how they conduct themselves.  All three (skills/competencies, revenue, behavior) will be expected.

To do this firms will define what they want from an associate over many years, build metrics and methods to grade performance, and determine what that performance is worth.  Hopefully this will set milestones for career progression and even multiple career paths.  Time to rethink up or out, tiered ownership and the array of tactics deployed over the past twenty years.  The trade-off for associates — lower remuneration hopefully mitigated by better career development and opportunity.

Firms wrestling with alternative fee arrangements (AFAs) often raise the question about how these arrangements will affect compensation decisions.  They raise concerns about how to recognize performance if hours are no longer indicative of contribution.  But hours are not the primary consideration in most owner compensation programs in US law firms.  We know that fees collected as working and originating lawyer are the top two performance metrics for compensation purposes.  This is not likely to change in the short term. 

But in the context of AFAs, the affect of the initiative on profitability is as key a consideration as winning the engagement and generating the revenue.  Determining an effective means to assess profitability is critical.

AFAs are likely to involve risk, innovation and possibly some trial and error to ultimately bring a successful approach to market.  All three (risk, innovation and trial/error) are appropriate to consider in compensation decisions along with the profits and fees ultimately created.