By Antone Johnson, Former eHarmony VP/global head of Legal
As an economics major, as well as a lawyer who's worked in many different areas of the profession over the past decade and a half, let me take a crack at this one.
- "Sticky" wages. Who likes to get their salary cut? Nobody. Historically, most companies (both in and out of the legal profession) will do anything to avoid cutting salaries, even if that means layoffs. That's changed somewhat in recent years, particularly in highly volatile industries like tech and finance, but the legal profession is one of the slowest to change. This leads to:
- "Sticky" billing rates. Law firm billing rates only go one of two directions: Up or sideways. They never go down. This is insane from an economics perspective. When demand for something evaporates as a result of, for example, the housing meltdown or the dot-com crash, basic microeconomics principles tell us that the price must drop to restore equilibrium (supply = demand). When prices are sticky, this doesn't happen, so you end up with a gap between supply and demand: Overpriced lawyers sitting around doing nothing, and clients not getting served because they can't afford those rates. Classic "lose-lose" situation.
- Limited discounting. Most other industries don't like to cut prices either, in good times or bad. Thing is, if you're Cisco selling routers and switches to corporate clients, and demand plummets with the economy, you can authorize your sales force to offer deeper discounts to the highest-volume customers. In enterprise software and hardware deals, I'm used to seeing discounts as high as 30%, 40%, even 50% on occasion to get/keep the ongoing business of the most desirable customers. That is totally unheard of in the world of business law, where the deepest I've ever seen discounts go is 15-20%. Not nearly enough for the Great Recession. Why is this?
- Obsession with prestige and rankings. Lawyers tend to be hyper-competitive personalities. That helps win cases and negotiate tough deals, but it spells trouble when it leads to irrational decisions. The top large business law firms ("Am Law 100" or "NLJ 250") are perennially obsessed with their respective positions in the pecking order, including the most common metrics (profits per partner, revenue per lawyer, year-over-year growth), as well as qualitative factors (hiring the "best" law school graduates, recruiting the most famous partners). How do they do this?
- Money is viewed as a proxy for prestige. A handful of century-old "white shoe" firms in New York, Boston and DC used to dominate the business law world, but that changed radically in the postwar years as aggressive, entrepreneurial upstarts (often Jewish graduates of top law schools who were marginalized by anti-Semitism at the old firms) started grabbing market share and ultimately became some of the most profitable practices around. Regional firms from other cities also entered the fray, rebranding as "national" firms. How to recruit the most renowned, rainmaking partners? Make your firm as profitable as possible to attract them. How to hire the very best associates? Pay the highest starting salary.
- Associate salaries are not an efficient, free market. The top tier of large law firms is an oligopoly within each regional market. For many years leading up to 1996, when I graduated law school, all of the large New York firms payed exactly $83,000 starting salary, all of the LA firms paid $70,000, and so forth. One of a handful of the largest firms would decide when the time finally came to raise associate salaries (often Cravath or Skadden in New York), and once the new figure was announced, every other firm that wanted to be considered "top-tier" would move swiftly to match. As the most profitable legal market in the country, New York led these changes for decades, until...
- The dot-com boom changed everything. There was a severe shortage of corporate lawyers in Silicon Valley in the late 1990s as the amount of deal work exploded, with record IPO, M&A and VC activity, as well as every other type of deal you can imagine. At the same time, the cost of living in the Bay Area was spiraling upward. To compound the situation, there was an exodus of lawyers (including myself) from top-tier law firms to grab in-house opportunities at Internet companies, lured by potential stock option riches as well as other factors. Firms in SF/SV, as well as LA and other markets outside NY, decided they needed to increase associate pay. It started incrementally, with regional offices matching NY starting salaries ($90-95K), until the "shot heard round the legal world" was fired in early 2000. The name Bob Gunderson became legendary among grateful associates as his Silicon Valley firm, Gunderson Dettmer, pushed through dramatic increases in the entire associate pay scale, beginning with $125K starting salaries (up from $95K the year before), plus bonuses. The herd followed, with all of the major SF/SV/LA firms quickly matching the new pay scale, and of course New York couldn't allow the West Coast upstarts to pay the highest salaries, so the Gunderson scale became the nationwide pay scale for top-tier law firms. Who do you supposed paid for those huge salary increases?
- Law firm overhead consists mostly of compensation. Well, that plus expensive office space in prestigious buildings, lavish summer associate programs, and many other little things that generally reflect an attitude of operating in a "costless" environment. Naturally, partners weren't about to let their profits plummet as a result of higher associate pay. So billing rates went up and up and up, passing on the higher cost of doing business to clients. Billing rates roughly doubled at big SF/SV/LA firms between 2000 and 2010, for the same people doing the same work.
- Back to Econ 101. What happens when you double the price of something? Demand for it decreases. At the margin, buyers seek substitutes, or choose to do less, do it themselves, hire more in-house staff, outsource labor-intensive work to India, etc. Well, not necessarily; in an inflationary period, you might need to increase nominal billing rates to keep the real cost of things constant. But 2000-2010 wasn't exactly a boom period overall, with inflation hovering around 3%.
- Things sucked for a couple years, but another bubble came along. The dot-coms died a grisly death, but the housing bubble was ready to take investors for a similar ride; we all know how that turned out. During those years, there was plenty of corporate work for the big firms to do, especially in New York, securitizing mortgages, creating all kinds of funky new derivatives, and so forth. In good times, investment bankers basically pay whatever bill the law firm throws their way, so in the mid-2000's housing boom years, it was raining money in those areas. Bankruptcies of the Enron-WorldCom nature also kept large numbers of lawyers busy in the early-mid-2000s, as well as a boom in IP litigation corresponding with the rise of the patent troll industry. Only after the housing crash and the related carnage on Wall Street did things really cool off for big law firms. The deep freeze began around 2008.
- At large law firms, salaries and billing rates are the same across departments. As a matter of morale, prestige and camaraderie, this makes sense. As a matter of economics, it's nuts. Again, thinking of efficient markets, when demand for something (e.g., securitization of sub-prime mortgages) dries up, the price charged for that work should drop. When demand for something soars (e.g., corporate bankruptcy), rates for that work should rise. Nope. For the most part, a 4th-year associate in every practice area bills out at the 4th-year associate rate, and so forth. Again, why does this matter? Go back to the points about sticky billing rates and sticky salaries. Both are likely to go only one direction -- up -- as long as any major area of the firm is doing well and can afford to raise rates along with demand. This works out pretty well for the firm, because different practice areas are cyclical or counter-cyclical and that helps stabilize their finances, but it's not so great for the clients.
So where does this leave us? I've addressed the question of why (large, top-tier) law firm billing rates are so high: Enormous overhead, sticky billing rates and salaries, and a general institutional insensitivity to costs until clients kick and scream about them. But what about that bimodal distribution and all of those out-of-work lawyers?
- In placement, law schools and students focus on the large, top-tier firms to the exclusion of most other opportunities. This is because they pay the highest starting salaries and are prestigious names to have on the resume at the beginning of a legal career (see "obsession with prestige and rankings"). This isn't just about greed and status; student loan burdens can be huge (another subject) and recent graduates are rightly concerned about earning enough to pay them off. Particularly at top-tier law schools, there's a big push to land jobs at the big firms, and in good times, a large proportion of each class gets those jobs. (In bubble times, there's a bidding war over a fixed supply of perceived "top students" -- as they say, only 10 schools can be in the Top Ten, and only 25% of the class can be in the top quarter of their class.) It's always been the case that smaller firms, government jobs, judicial clerkships and public interest jobs for lawyers pay much less than the big firms. But with demand shriveling up for new grads to staff the big, top-tier firms (perhaps related to the fact that said firms seem to think it makes sense to bill out rookie lawyers at $250+ an hour), that pushes everyone down the pecking order. Small and mid-sized firms usually hire a small number of associates, particularly at the junior level. They hire only when necessary, based on immediate needs, vs. planning ahead for whole "classes" of new associates as the big firms do.
- The middle is missing. There used to be a class of mid-sized regional firms with billing rates and salaries significantly lower than the big national/coastal firms, but significantly higher than most small firms. That's mostly gone now, as during the good years, many of those firms merged with megafirms as part of the pursuit of ever-higher profits (justified by the need to keep those profits growing to attract/retain the best partners).
- People are catching on. None of this is new in 2011. The legendary, late Craig Johnson (no relation) founded Virtual Law Partners in 2008 based on the idea that law firms could do top-tier work for corporate clients at significantly lower rates by cutting overhead and operating more efficiently. (Shocking, I know.) As Craig famously said in an interview:
"The thing that makes it almost a slam dunk is the incredible price umbrella from the big firms," Johnson said. "When you charge $400 an hour and have clients think it's a bargain, how could you not succeed?"
See http://www.law.com/jsp/article.j... for the whole story, which is worth reading. So before stepping down off the soapbox, here's the upshot:
- The legal industry is in the midst of a once-in-a-generation disruption. From the perspective of one who has served as a general counsel in recent years, paying $3 million a year in outside law firm bills, we (or "they" now that I've switched teams) are fed up with large firms' endlessly escalating billing rates and cost insensitivity. With many talented, experienced lawyers having left big firms (voluntarily or involuntarily), and technology making it easier than ever to set up shop as a new solo practice or small firm, Craig's point is compelling. I started my own firm, Bottom Line Law Group, with a similar philosophy of low overhead and an awareness of clients' cost sensitivity, in large part because I want to serve early stage startups and other clients who couldn't afford me if my billing rate were $650/hour. (See http://bll.la/55 for a manifesto of sorts.) Firms like mine, and those founded by many of my colleagues in the last couple years, are the wave of the future. It's such an obvious win-win -- or slam dunk, as Craig said -- that I think it's inevitable. In much the same way that startups seize opportunities that large corporations aren't nimble enough to pursue, "startup" law firms will rush to meet the market need that's currently unmet. The only way I see that not happening is if the megafirms move to slash overhead (meaning compensation, not layoffs) and billing rates. With all of the incentives and institutional traits that I've described above, I think the probability of that happening in the near future is near zero.
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