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Professional Firm Economics, or Those $1000+ an Hour Lawyers

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I’m remiss in not seeing and commenting till now on a Felix Salmon post (hat tip Adam Levitin) earlier this month on law firm billing rates. Felix misses the real driver of law and other professional firm economics in his piece. In referring to top law firm partners who earn as much as $5,000 an hour, he says:

Of course, at these levels, you’re not (just) being paid for the direct work you do for clients: what you’re really being paid for is bringing new clients into the firm and getting the firm revenue streams which can reach hundreds of millions of dollars. But there’s still a reason why those clients will follow you to the firm, and that reason is that the clients will expect you to do real work for them.

Nope, this is NOT how high end professional services works.

First, partners aren’t paid for bringing in new clients. They are paid for the amount of billable hours they generate. That can be for keeping extant clients happy and selling them more work OR bringing in new big ticket clients. And from a raw profitability perspective, it is more attractive to increase billings from current clients than to bring in new clients (much less selling time involved). Thus a well run large firm will have norms as to what level of utilization means partners might be at risk of risk of neglecting new business development.

The key to an individual partners’ profits is how much leverage he can achieve, in terms of the number of associates (or even other partners, say, such as tax partners) they can deploy on their account. Large foreclosure mills are hugely profitable to their owners for that reason, since they often have 90 to 100 lawyers or paralegals for every partner.

At white shoe firms (think Sullivan & Cromwell, Davis Polk) with a big corporate clientele, most big potential clients of the firm already either have a partner working on the account or assigned to solicit it. Younger people moving up through the firm work on these accounts and hope to position themselves to take them over, and also to develop business for clients that the firm isn’t currently serving.

What is the economics of this leverage? A rough rule of thumb at major professional law firms and top consulting firms is that non-partner billing rates are set at 3X their cash comp. At McKinsey in my day, that translated into 2.4X fully loaded personnel costs, including benefits, overheads, training, time spent recruiting, etc.

Let’s look at a second misconstruction by Felix: “that reason is that the clients will expect you to do real work for them.” Um, no, the general counsels that engage big ticket law firms and the CEOs that engage McKinsey know full well that the partner is most assuredly NOT “do[ing] the real work.”

I’ve seen at least four motivations for hiring pricey partners at pricey firms. One is that you are hiring a large, established quantity: a machine that turns out product of a high quality quickly and reliably. For certain types of matters (M&A, bankruptcies) there may be only a limited number of firms with the scale of operations and the range of experience to handle your particular issues. So you may already be limited to the universe of sophisticated, large, big ticket firms.

Second is that the professional firm and the client have a long, established relationship. It’s reflex to turn to them. They do a good job, and they know you intimately. It would be work to bring someone new in and get them up to speed, and even then, it would take a while before you had the same level of comfort in their work.

Third is that key executives value the judgment of the partner. This is where trust and personal relationships matter most. It is most operative in services sold to CEOs, since they are by nature isolated within their organizations. At McKinsey, there were quite a few accounts where what the client wanted was a counseling relationship with the partner, and to get that, he had to sign up for enough in studies to get that level of attention. (Conversely, when clients were hiring McKinsey for raw problem solving, it was far from unheard of for clients to tell the firm they wanted to use only the engagement manager, which was the real working oar on the studies, since if the EM was good, they’d be the ones performing the analyses and coming up with the recommendations . Needless to say, those clients would be politely rebuffed).

Fourth is the Giffen goods factor: clients will hire XYZ Big Name firm/partner because he must be really good if he can charge that much. While that may be true, if you are a one-off client that does not have compensating considerations (as in big sexy PR generating situation) you aren’t likely to get much attention. In addition, clients that are not savvy consumers of professional services often don’t recognize there are horses for courses and you need to find a suitable advisor for the matter at hand. For instance, when I sold my second co-op, the buyer had a big name law firm handle the closing. My attorney and I were tearing our hair. The buyer’s attorney had never handled a co-op closing and came pretty close to reinventing the wheel. I shudder to think what the bill was like. Similarly, a Big Name in the fashion business would have a top (as in pricey) entertainment lawyer negotiate her licensing deals. Her intellectual property lawyer would quietly have to script the entertainment lawyer and redo pretty much all of his written work, while also having to go to some effort to look like it was not an effort to undermine him.

Felix attempts to raise the question of “value” in legal services, but he treats it as if the lawyer acts in isolation. Yes, there are very good attorneys you can hire for considerably less than the top billers that Felix cites. But there are two complicating issues. First is that value really is in the eye of the beholder. Per the list above, there are good and not so good reasons why someone might pay more than what he would be required to fork over elsewhere for ostensively the same services. But a second issue is that the caliber of servicers rendered has a fair bit to do with how the client manages the attorney, as in how organized the client is, whether he knows how to maintain a productive level of engagement, and whether he puts parameters in place to make sure the attorney does not expand his mandate (whether out of a misguided sense of professionalism or more venal motives).

Now if you are a general counsel at a big company, you are (or should be) an astute consumer of legal services. You likely started out in a well known law firm and between your experience there and on the corporate side, have an idea of how to manage inquiries and cases so that hours don’t get out of control, and also have a good sense of when it’s worth hiring the blue chip firms v. boutiques and mid-tier firms that bill at lower rates. But mere mortals are seldom good judges of the adequacy of the attorney they’ve hired and whether he is value for the money. As with doctors, they tend to go on proxies (bedside manner, professionalism of staff) which give them confidence but may not always be valid indicators of the caliber of the legal thinking and end product. Thus while there are no doubt cases where one can point to overpriced and undervalued professional servicers providers, there is also so much subjectivity and inability to judge alternatives (gee, could that guy you turned down have won your case?) that the idea that you could have objective notions of value seems awfully fraught

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34 comments

  1. d cortex

    The more expensive the chap (or gal) is, the more familiar the firm is with the loopholes in the legal system exploited so only those in the know or of the same gargantuan size can earn while ignoring statute.

    1. jake chase

      Actually, what the major law firms excell at is selling themselves, presenting, acting like they know things. Often, the top partners have been out of touch for years and are totally reliant on nameless underlings trapped at their computer terminals, grinding out largely repetitive documents and analyzing the latest putrid bilge from one political hack after another pretending to be a judge. The work is numbingly boring, yet fraught with danger. My God, suppose I’m wrong! The young lawyers trapped inside these firms have gained their position through fifteen years of regurgitating nonsense on tests, and that is often their only skill, which is the reason they unerringly fuck up simple transactions like a house closing when turned loose in the real world to do their stuff. These prestigous firms are largely responsible for greasing the skids on the American economy which has been going on now since VJ Day. A collection of rich smooth amoral bastards who are perfect candidates for the first circle of Dante’s hell, and the consulting firms are if anything worse since their only product is horseshit confirming CEO prejudices. Who cares about their firm economics?

      1. Up the Ante

        ” .. and the consulting firms are if anything worse since their only product is horseshit confirming CEO prejudices. ”

        Exactly who is Deloitte’s real CEO ? Paying their piper, are they ?

        Normally one would expect upon entertaining the question above someone like Bill Black or Yves to fill in some detail on Control Fraud Deloitte’s history, instead, silence.

  2. CB

    Yves:

    In the last few years, I’ve read a couple of articles about hiring companies getting more astute about outside legal work and requiring firms to bid for work. True?

    1. run75441

      CB:

      Chrysler did such with one large Litigation Firm in Chicago. From the mass of business being offered, they command the price and will move it.

      1. CB

        When I worked for what was then the second largest bank in PA, I had a discussion with an officer about bank size and customer size. We agreed that big banks are for big accounts and small banks are for small accounts. That was many years ago and banking has changed so much since then, I don’t think the axiom holds anymore. But more recently, I worked in IT and I can certainly advise that big IT companies are for big accounts and small IT companies are for small accounts. It’s a matter of leverage in pressing your case.

    2. GeorgeNYC

      Corporations are certainly getting more savvy about their use of legal services. The risk for most lawyers now is that they are becoming a “commodity” as to certain more routine legal services. However Yves’ insight that management uses certain “big” firms more for their partner’s trusted advice certainly holds true. I often see “big” firms handling cases that others can handle for a fraction of the cost. However, clearly these firms have deeper relationships. Thus the firm is used for certain cases knowing full well that they are overcharging for those because the firm is needed for its special contacts in other areas.

      For example, years ago I recall a case where a “white shoe” Washington firm, used by a bank for its lobbying contacts, was assigned to deal with a routine recovery case. We were monitoring for a client. The file was “pristine.” But the bill almost exceeded the potential recovery. Clearly they were more concerned about the firm’s expertise in other areas.

    3. Yves Smith Post author

      Yes, Wal-Mart appears to have led that trend. They also push their law firms to have more minority partners.

      1. skippy

        “They also push their law firms to have more minority partners.”

        Cough… bringing in a young and dynamic zeal to the market sector…

        Conversely… empty vessels which can be filled at half the cost, if not more!

        Skippy… the shining beacon – on (mounted) – the worlds hill… Hay… I didn’t know microwaves were visible.

  3. Middle Seaman

    My experience coincides well with Yves’ points. As an expert witness for and against large companies represented by large and distinguished law firms, one sees the close relationships between client and the firm, the ability of large law firm to produce the “best looking” products, etc. You work with associates and with partners and the results will correlated badly with size and cost. Still, the big dogs hire the big barkers almost invariably.

  4. rik

    Partners are judged (and paid) on several issues. Personal turn over (hours), turnover team, average term of payment, billed/written, paid/billed, billable not billable, hours (tot) worked; new clients, growth in present clients, liability issues, dealing with staff, development of juniors.
    My experience as long as a proper profit is made (both firm and partner) it doesnot matter much. First when things go wrong or look to go wrong attention is given to the relavant points. Proper staff running away, dealing with staff becomes a major one. Economy down, payment terms and actually hours paid for. New investments cash flow becomes an issue.

    Billable own hours are a major but a) more for junior folks, ones who are running a complete office you are judged mainly by other things. Furthermore it looks to move away somewhat from the billable hours. Gets also more riskmanagement (especially for lawyers), qualitymanagement, sales, H&R in it.

    Hourly rate the 3.0 factor looks simply to go up. Costs have risen faster than turnover.
    Costs are in general higher in ‘hourshops’ than in ‘dayshops’ (like McKinsey), mainly you need a better office and better office services to run that.

    In my experience lawfirms donot give worse services as you only use the manager. I simply always like to do that as it reduces costs and often they know more technically than the partners. And at the end of the day you mainly need them and own councils for info so you can make a proper decision.
    However most companies work differently.
    However advisor costs have become a real P&L issue, combined you really need to control them.
    Different in law than say with McK. You donot need often somebody of boardroom level to talk to and test your ideas. You simply need info in most cases (unless of course you’re dealing with an IPR dispute with Apple or so).
    Only liability issues can make that impossible.

    In my experience the 2 other main reasons to go for a big law firm are network but especially internationally. Complicated issues have often an international dimension you want to be assured as possible that things are done right in say Sao Paulo when there is a major legal problem overthere.
    Also ‘cover your own ass’ is often an important issue. A mistake made by a small law firm in a big case will simply be a negative for the manager responsible for hiring them.
    Next to the quality (they have specialists, and the max resources,often the best people, reliable on deadlines).

    Sort of advisor is relevant (audit and tax have the furthest developed firms, rest is a bit behind but catching up). Daily or hourly.

  5. rik

    A point I didnot stress enough. The major cases get into the spotlight and get all the attention, but most legal etc work (obo money spend) is done at a lower level. Labor disputes, clients not paying, basic legal info or products. In my experience it works best (and cheapest) to have that managed by a manager/junior partner at the lawfirm (providing the guy or girl can manage, often an issue with lawyers, simply demand another one if not up to the job, but not many people do that) and get big guns and specialists in for the difficult stuff. Same in a company (of a certain size) daily contact with lawyers is done basically by in house legal people.

    However specialism is often an issue, in the way that basically all lawyers are specialists in some firms. You will often need (more senior) partners as they are the only ones with some general knowledge and experience (and subsequently able to manage the total job coming from your company). Otherwise your own organisation has to manage what should be done by the law firm (and also in house lawyers often donot have much talent for organisation).

  6. DANNYBOY

    Yves,

    Read the article because #1 daughter does such Law Work. Thanks for your insights. And, as long as I’m writing, you may wish to edit the spelling of ‘their’, in your last paragraph, to ‘there’.

    Thank you.

    1. JD

      A judge who rules against biglaw or the kind of institutional litigants they represent is not just deciding a case; he is repudiating an entire way of life, turning the world upside down. No wonder judges just about never do it, no matter what the law is.

      Don’t forget that most Judges come from the big firms to begin with, and/or are looking for somewhere to land once they are off the bench. Hence, they want to play nice with their former/future employers.

  7. John Regan

    What an entirely different world “biglaw” is.

    Truth be told, big firms are no more likely to be right “on the law” than any other lawyer. Pretenses aside, most legal issues are not intellectually difficult and have a straightforward resoltion. But as you can see from this post, there is (unfortunately) a lot more going on than “the law”.

    There are careers, institutional concerns, an entire culture of influence peddling and status seeking that is far more observed than any concerns about the law, which by comparison are relegated to little more than trivialities.

    A judge who rules against biglaw or the kind of institutional litigants they represent is not just deciding a case; he is repudiating an entire way of life, turning the world upside down. No wonder judges just about never do it, no matter what the law is.

    It should go without saying that this is a terrible state of affairs for a “justice” system.

    1. grayslady

      That’s my observation, as well. Judges are always running for re-election. In the big cities, they’re going to favor the firms who most influence their re-election chances. You’re more likely to receive “justice” in the collar counties where individual law firms aren’t as influential in the proceedings.

      1. charles 2

        Ooooh, I see !

        The terse reply get-educated-in-economics-before-posting-to-this-blog,-I-have-a-Harvard-education-and-you-don’t style…

        Should you have taken the pain of actually reading the article you refer to, you would have noticed the following sentence “a Giffen good should not be confused with products bought as status symbols or for conspicuous consumption (such a situation would indicate a Veblen good).”

        1. Yves Smith Post author

          Funny how you project motives. Did it occur to you that I’m on vacation and trying to avoid spending time on the blog?

          I don’t see how these are Veblen goods, since it is businesses that hire big name firms (eliminating the Veblen conspicuous consumption/bragging rights motivation which is THE driver of Veblen goods). Here, price is seen as a proxy for quality. And even though the normal analysis of Giffen goods contends that the only type of goods that could be Giffen goods are “inferior” goods, the fact is that there are no substitutes for legal services, and if someone has been connned into thinking that there are no substitutes for a PARTICULAR CALIBER of legal services (as in he needs a lawyer of a certain caliber to handle his work or he will be fucked over), the consumer will hew to a Giffen goods consumption pattern. I see the essence of a Giffen good as necessity (and when you need a lawyer, you need a lawyer) and perceived lack of substitutes (as in reasons for not hiring cheaper lawyers).

          And we have seen an expansion at the very high end of legal services……

          1. charles 2

            I have crossed many executives with their insecure ego inflated by the fact that they were in the league of “I am doing a strategic review with McKinsey/BCG”. There are like the guys who buy Porsches to believe that they drive like a race pilot. Note that is not to say that Porsches are bad cars or McKinsey studies are junk…

            Your understanding of the essence of the Giffen good is very different to what you would find in any economic textbook or in Wikipedia for that matter. To quote again the latter in http://en.wikipedia.org/wiki/Veblen_good :

            “The Giffen goods theory is one for which observed demand rises as price rises, but the effect arises without any interaction between price and preference—it results from the interplay of the income effect and the substitution effect of a change in price.”

            Please enjoy your vacations, you can check this when you are back. Blogging shouldn’t be slavery !

          2. charles sereno

            Speaking for myself, and, in fact, many others, I’m sure, like charles 2, I, too, have crossed a number of inflated, insecure egoes, and there are like Harvard guys with Porsches, who don’t read economic textbooks, or even Wikipedia, and, thus, come to different essences of things, and, so, drop names. Whew! Thank goodness our Yves is not like that. Happy vacation , Yves.

  8. Tio Pedro

    It’s career risk management for those doing the selection. Hire Skadden or McKinsey, and you’ve got a built-in excuse when/if things go wrong – “But we hired Skadden!”. Take a chance on a smaller name, and you don’t have that excuse. Sure, they may charge less, but those savings don’t end up in the hiring manager’s paycheck, and it’s all OPM anyway for him. A smaller firm gives the hiring manager, personnally, no upside, and all the downside.

  9. Expat

    A fifth motivation, perhaps, for clients is precluding their adversaries from hiring the firm. If in fact the first four motivations are true, then this fifth makes the deal. Charge what you like because your clients will pay.

  10. kevinearick

    so, you have two poles on a battery, and the ground is a black hole, with a semi-conductive intermediary…

    funny, no one questions the bill until after you pull their a- out of the fire, and then they jump right back in, thinking it’s a competition…it’s not about money. money isn’t real. it’s about the illusion of control, shared in a demographic ponzi to maintain the illusion of a status quo.

  11. curlydan

    I’d edit your third reason for hiring to say “key executives value the [indepedent or non-political] judgment of the partner”. Bascially, any internal analytics or finance group can do the work of a McKinsey, Bain, BCG, etc does, but giving recommendations to a CEO based on an _internal_ study would involve a lot of politics and supsicions of bias.

    So the CEO goes out and hires a McKinsey type firm, the imported twenty-something consultants hole up in a hotel learning about the industry about which they know nothing, strip mine the internal knowledge from key company leaders, and propose a solution that they’ve already lobbed off on a previous client or that they stole from somebody internal. Then they submit the multi-million dollar invoice and DONE. But at least the CEO didn’t have to deal with the internal politics because he got an unbiased viewpoint.

    Two years down the road, switch consulting companies, and lather, rinse, and repeat.

    Believe me, I’ve been down this path.

  12. Donnor

    In my experience, relationships are the primary driver of which big firm is selected. For example, the CEO is friends/social circle of partner so they hang together thus trust. The other is you pat my back and I will pat yours. For example, big law firms will send a key lawyer to fill a general counsel job to lock-in the business for the firm. On the flip side, a general counsel develops close ties to powerful partner(s) and in return for locking in a lot of the business those partner(s) will in turn ensure the general counsel lands on his/her feet if they find they lose their jobs due to change of control event, etc.

  13. Procopius

    Another demonstration that the “magic of the marketplace” doesn’t really work in the real world. This is one of the points Yves made in her critique of neoclassical economics in ECONned, and I wish this point would be made more often and in every publication. The economic theory depends on various assumptions which many people don’t know about. No barriers to entry of suppliers or consumers. No supplier is able to influence price. Product is undifferentiated; all suppliers provide exactly the same product. Perfect knowledge of both present and future conditions on the part of both suppliers and consumers, so fraud is detected and punished by the market. It would be nice if we could make every voter understand the lies under the “free markets are the answer” scam. And I’m not saying these distortions are caused by malice, or even greed, just that this is the way the world really works and the rational expectations hypothesis is as real as the confidence fairy.

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