The article “Pay Gap Widens at Big Law Firms as Partners Chase Star Attorneys,” published in The Wall Street Journal last week, reported on the increasing spread in partner compensation at large law firms, setting many in the industry talking.  In fact, the article understates the extent of the spread, the factors driving it and the impact that spread is having on both the firms in question and throughout the industry.

As discussed in my CCM audio conference on partnership compensation trends last month, the spread 10 years ago at most firms was 3 or 4 to 1, with partners moving up the pay scale based either on performance or tenure or some combination of the two.  That spread has grown in the last few years to over 20/1 at some firms, more than twice what the WSJ cites, which obviously didn’t find any firms with record spreads willing to fess up publicly.  Unfortunately, many times, thanks to lack of transparency, the partners themselves don’t realize the extent of the spread and therefore aren’t able to tattle. 

Why the increase?

Yes, geographical expansion has prompted some firms to make a quasi-cost-of-living adjustment—Cleveland vs. Tokyo–when setting compensation.  But we are not talking about millions of dollars in variances here, Peter.  And yes, some changes in compensation systems have driven some of the increases in spread.  I recommend, and many firms have adopted, the practice of holding a sizeable bonus pool to reward profitability.  I suggest that that pool be divvied up throughout the firm based on firm-wide, departmental and individual profitability, using sophisticated metrics that truly capture the various drivers of profitability.  But many firms simply shovel the bonus pool to those designated the top revenue producers, creating ever more dramatic variations in pay.  

But the biggest factor producing large increases in spread is the advent of the free-agent market.  (See The Lateral Lottery.)  Lawyers with books that may or may not materialize are courted by firms for great and not-so-great reasons with out-size pay—sometimes guaranteed, sometimes paid in advance, often completely unrelated to the revenue the lateral eventually brings in.  (See The $5 Million Dollar Man, where the recent pay deal with litigator Jamie Wareham, just hired by DLA Piper, for $5 million a year, a significant raise from his top-of-the-heap pay at Paul, Hastings, Janofsky & Walker, shows how irrelevant his likely firm revenue is to that number–his team would have to bill 20,000-40,000 hours and beyond a year just for the firm to approach breaking even.)

The punch line is that somewhere in the vicinity of half to 2/3rds of these laterals will not pan out, leaving firms with an even higher attrition rate than they have with first year associates (about whom much less information is available) and significantly higher sunk costs.  

While  pay gaps in US firms have traditionally been larger than at the big English firms–where there is often 2-to-3/1 lockstep spreads–the English are realizing they have to pay competitively to keep top partners both in and from the US. Coincident with that pay change has come, as night follows day, the elevation of their lateral partner attrition rates. See Revealed:Lateral Partner Hiring Doesn’t Work.

DLA Piper’s Burch is quoted in the WSJ article as saying that he tries to minimize tensions created by different pay levels by talking to partners about the importance of paying "at market in every area of our practice." Of course, bringing partners into a consensus about the perceived advantages of admitting one of these 800-lb gorillas would be ideal.  But what is stunning about that statement is the admission of the firm’s estimation of the worth of all those legacy partners left several multiples behind. 

And that of course is the crux of the matter—these kinds of star deals make existing partners take second looks at their prospects of getting such a megadeal from their own firm.  And not surprisingly lead them to see what some other firm will offer.  And certainly those highly-paid laterals won’t hesitate to leave when an even richer carrot is dangled in front of them.  So both the lower-paid disgruntled partners and the higher-paid greedy partners pull at the fragile fabric that holds a firm’s partners together until eventually you have a Finley Kumble or a Howrey on your hands. 

That is consistent with "Big But Brittle: Economic Perspectives on the Future of the Law Firm in the New Economy," a research paper, noted in the last entry, by University of San Diego Law professor David McGowan and fellow Bernard Burk of the Center of Corporate Governance at Stanford, which concludes that firms are getting larger, but the larger firms are also more prone to rapid collapse.  Firms are able to use high compensation packages to attract lawyers with big networks of high-paying clients, but particularly with the current stagnating demand, those lawyers are the very ones who can find an even sweeter pay deal elsewhere and whose departure can destabilize the firm they leave. 

The WSJ article includes a list of the 10 firms with the highest profits per partner for 2009.  Orrick and other savvy firms have already renounced PPP as an outmoded measure of a firm’s financial health and perhaps also foresaw it as a barometer likely to cause trouble in a spread-widening world.  The outsized pay of a few lawyers at the top make the PPP averages worse than meaningless– they entice young law graduates and associate laterals with expectations that are unlikely to be realized and they graphically illustrate to lower-paid partners how much less valued they are.  

The latest mid-level associate survey confirmed that IN SPITE OF the fact that those associates are the lucky ones who have a job and over 70% of them think they are securely on the partnership track, 2/3rds are looking to leave their firms within the next 5 years.  Partnership is simply not so attractive when they get a good look at it up close. 

Across the industry, the stagnant demand is going to heighten the Darwinian struggle not only for each partner’s share of a diminishing firm pie (see  "Why Partner Compensation Will Go Down") but also for each firm’s share of the industry pie.  How well has that get-more-profits-by-growing-bigger-by-buying-big-talent strategy been working for the large firms?  According to the latest data from Citi Group, it is the firms smaller than the AmLaw 200 whose profits are growing at the fastest pace. 

What is missing in all of this is a discussion of what the research says about whether these big pay packages actually motivate higher profitability or simply constitute the only metric by which competitive lawyers can distinguish themselves.  But here’s a hint:  that don’t bode well for the usefulness of big spreads either.

Don’t fall prey to the lemming approach to increasing profitability. With the right advice, you can structure a sane, cost-efficient, culture-stabilizing compensation system that incents and rewards profitability without putting your firm in jeopardy.