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In Lean Times, Law Firms Reconsider Two-Tier Partnership

Aug. 11, 2015, 5:20 PM

In the 1990’s and accelerating into the 2000’s, a number of major law firms adopted a two-tier partnership structure, mainly for economic reasons, legal experts said.

A class of non-equity partners on top of partners with an ownership stake created a win-win scenario, it seemed: the firms found a place for talented senior lawyers who may not have the business of a senior rainmaker, while a partnership with fewer equity members provided higher profits.

Recently, though, that model has been coming under pressure.

“When the market went in the downturn, firms found themselves with a lot of non-equity partners who had very little incentive to actually go out and get business, who were being paid a lot of money,” said David Wilkins, a professor at Harvard Law School who has studied the legal profession.

“I remember asking my students,How many of you are going to law firms, and how many of you want to be partners?’” Wilkins continued. “This number has been declining over time. But when I said, ‘What if you found out that you could make $400,000 a year and not [have to] generate business?’... A lot of hands went up.”

But while non-equity partners who occupy such middle-tier positions have little incentive to generate new business for the firm, he said, they have all the incentive in the world to hog client relationships and deprive up-and-coming associates from business opportunities that could lead to their promotion [up] the ranks.

“To keep those people in that limbo status has become much more complicated than many firms thought,” said Wilkins.

The complication laid out by Wilkins, and several other legal experts interviewed by Big Law Business, came to the fore on Monday when Above the Law reported that BakerHostetler had become the latest in a series of law firms to consider doing away with its two-tier partnership structure. The 930-lawyer firm, founded in Ohio, declined to comment on the possibility of the shift, but confirmed the authenticity of a memo leaked to the legal blog.

BakerHostetler Details Partnership Plans

“The firm is operating in an increasingly competitive and dynamically changing environment,” said BakerHostetler chairman Steven Kestner, in the July 1 memo to his firm’s partners. “The firm’s current two-tier structure was put in place in 1992 when we had 480 lawyers across eight offices. Today, we have 930 lawyers in 14 offices, with a significant amount of that growth in recent years.”

Kestner continued that in light of the firm’s growth and market trends, his firm’s policy committee at a February meeting examined partnership structures in place by other firms and authorized a restructuring committee to be formed to take a look at whether an alternative partnership “may be desirable for the firm.”

A BakerHostetler spokeswoman said in a statement: “It is still under discussion and has not yet been put to a partnership vote, which is still some weeks away. It’s therefore premature to have further discussion about the issue at the present time.”

Wilkins, who speaks with law firm leaders regularly, said he has no personal knowledge of BakerHostetler’s decision, but other consultants in the industry confirmed his observations and said that they have seen other firms implement similar changes.

Gretta Rusanow, senior client adviser in Citi Private Bank’s law firm lending group, said, “While we haven’t collected hard data on this, we are aware of more than a few firms who’ve re-equitized partners.”

Rusanow said that firms are mainly doing it to build capital investment to finance the firm’s operations, and to retain lawyers who aren’t as easily recruited to competitors with a hefty chunk of their money sitting at the firm.

Other Law Firms Pressured to Switch

There have been other reports of law firms that moved to a single-tier partnership. In 2013, Akin Gump Strauss Hauer & Feld revamped its partnership to switch to an all-capital system. Before that, in 2012, DLA Piper carried out a similar change to its international offices having already made the change in 2008 in its U.S. branch.

“We were in the midst of the financial crisis, so one certainly would take the position to do everything one could to create a larger cushion to protect the enterprise,” said Roger Meltzer, co-chair of DLA Piper, of the impetus of its initial 2008 move to create a single-tier partnership in the U.S.

Meltzer added that a one-tier partnership results in an alignment of interests: “And honestly, from my point of view, everyone who is considered a partner in the firm ought to have skin in the game.”

The global financial crisis pushed firms toward the single-tier partnership, experts said.

Before that, in 2006, a study by law professor William Henderson of Indiana University Maurer School of Law, reported that as many as 80 percent of the 200 largest firms in the country carried two-tier partnerships.

A two-tier structure provided benefits to firms because they could simultaneously offer clients senior experienced lawyers, and not have to pay the partners an equity interest. Some increased their profits per partner as a result, the study found.

That changed after the financial crisis. With less work around, non-equity partners created an impediment to associates’ advancement to partnership; and secondly, the financial toll of keeping a large number of unproductive partners around, even if they didn’t have an equity stake, became too costly.

Regardless of the reversal, there appear to only be a few firms that have actually changed their whole partnership structures as a result. One lawyer noted that it would be difficult to switch from two tiers to one because a firm would have to lay off or push out all of its non-equity partners, or promote them to equity status to shed its second tier of a two-tier partnership.

“How are you going to deal with that?” said one lawyer who requested anonymity.

Some Law Firms Consider, But Don’t Change

In a recent interview with Big Law Business, K&L Gates chair Peter Kalis said his own firm recently re-visited its “up-or-out” policy, by which lawyers are allowed to hold non-equity partner status for only a certain period of time before being pushed out or promoted to equity partner.

A firm with nearly 500 of its 900 partners designated non-equity, K&L Gates has opted not to take this approach, but has recently reconsidered it, Kalis said. He noted, however, that the firm ultimately decided that no change was necessary.

K&L Gates’s two-tier partnership, according to Kalis, has resulted in a high amount of turnover this year. More than 90 partners have departed the firm since the beginning of the year, and the overwhelming majority of them, he said, have been non-equity partners who received performance evaluations in late 2014 and early 2015.

Kent Zimmermann, a law firm consultant, said that he’s encountered several managing partners who are considering whether to shrink the rank of non-equity partners in their firm.

“Many firms that want to enhance their financial performance and their cultures are taking a hard look at their income partner pool and deciding to what extent they want to shrink that pool,” he said. “Some are deciding to tighten up what it takes to get into that pool in the first place, and to remain in that pool.”

He said he speaks with a lot of managing partners who “are coming to the conclusion that they have too many income partners.”

“At some firms, it becomes a dumping ground for people who can’t cut it as an equity partner,” Zimmermann said. “And, it often happens that firms don’t have the stomach to counsel people out who aren’t going to cut it as an equity partner, and it’s just easier to make them an income partner, and some firms have large groups who grow in that pool in their career.... It’s not good for the firm, or the income partner’s career.”

Does the Client Care?

Wilkins, the Harvard professor, noted that additional arguments have been made against the use of the non-equity partner, and some have even come from the client’s side.

“I used to ask clients whether they asked law firms about which partners were non-equity, and they said, ‘No, that’s an internal law firm question,’” he said. But recently, the response has been changing.

"[Clients] might care about the fact that a non-equity partner might not have the ability to get the best associates to work on the matter,” he said, and noted that a client would prefer to give their most important work to an influential firm partner.

Yet other lawyers and legal observers remained skeptical about the premise that clients actually cared. Brian Cadwallader, general counsel of Johnson Controls, for one, said through a company spokesman that it has never been an issue for him. And Brackett Denniston, general counsel of General Electric, said by email that his company looks for the best lawyers, regardless of equity status.

“Equity partnership in many firms is based in significant part on the ability to attract business,” said Denniston. “That is not the reason we hire lawyers, though there is a correlation between the ability to attract business and leadership.”

“An imperfect one,” he added.

(UPDATED: This article has been updated with additional comment from Brackett Denniston, general counsel of GE)