Bloomberg Law
Free Newsletter Sign Up
Bloomberg Law
Advanced Search Go
Free Newsletter Sign Up

The Cravath Pay Raise: Challenges and Opportunities for Law Firms (Perspective)

June 14, 2016, 3:11 PM

Editor’s Note: The author of this post chaired a major law firm for 15 years.

And so it begins. Last week, Cravath announced a material move in their associate compensation scale, increasing starting salaries from $160,000 to $180,000. Predictably, a swath of firms announced matching compensation scales over the next few days, a pattern that will likely continue over the coming weeks. After all, playing follow-the-leader is a time-honored tradition in the industry. And once again, Cravath leads the way, at least in terms of associate compensation.

The last time the industry made material changes in the associate compensation scale was in 2006 and 2007, just as the storm clouds were gathering for the Great Recession. Before that it was 2000 — literally just before the dot-com crash. Perhaps there is no causal relationship between associate compensation and crashes but, still, stock pickers should take note of recent changes. Go short.

Is this our Bernie Sanders moment?

Pundits have engaged in significant discussions about the cost impact on firms based on their leverage model, bandying about numbers anywhere from $6 million to $15 million per firm. True enough — the math is what it is. The underlying assumption, however, is that the industry is having a Bernie Sanders moment — i.e., this is simply a redistribution of wealth from partners to associates.

Given the compensation levels at play, one can certainly make the argument that redistribution is precisely what should happen. Cravath, for example, reported average partner compensation of $3.6 million. Even if the funding for the increases in associate compensation comes 100% from the pockets of the partners, it’s hard to feel sorry for them. In fact, the decision to reinvest in the organization’s talent pool is precisely what it means to be the owner of a business.

Redistribution of wealth is not the historic modus operandi of the industry. Certainly partners have carried some of the burden by moderating their level of compensation increases rather than actually giving associates raises. It is fair to say that neither compensation move in the 2000’s was a pure transfer from partners to associates.

Rather, firms found ways to cover material portions of the expense in other ways: passing the cost to clients via higher rates, reducing expenses elsewhere in the organization, raising (often silently) expectations on associates or being quicker to cut expenses (and people) in the face of declining demand.

Associate raises have big implications for firms with lower partner compensation

This time is different. Not because Big Law has moved into some form of corporate socialism, but because circumstances have changed. As power has shifted to buyers of legal services and the options for legal service delivery have expanded, the idea that firms will be able to shift some or all of the cost of associate compensation to rate increases seems almost inconceivable. Over a period of years? Perhaps. From the start? Not likely. As Bloomberg Big Law’s Casey Sullivan noted in an articlediscussing the odd way in which the industry sets compensation, he quotes Craig Silliman, the General Counsel of Verizon:

“…to the degree that the firms are raising salaries across the board and they try to push through these pay increases in higher billing rates, then it simply encourages me to look for alternatives, whether moving the work in-house or moving work to lower-price firms.”

Similarly, this new generation of attorneys is less receptive than prior generations to increased workload expectations. And for firms that have been on cost-reduction efforts since 2008, the easy gains are now gone. Finding off-setting levels of cost savings is simply not realistic for them.

The fact is, the industry is facing a redistribution of wealth scenario whether one likes it or not. The question now becomes, how far down into Big Law will the compensation change go? If history is any guide — and history is a pretty good predictor in this industry — the compensation adjustments will ultimately permeate most of the AmLaw 100. There will certainly be hold-outs. And there will likely be modifications to the scale in various cities and firms. Nevertheless, history predicts an industry-wide move to increase starting associate salaries.

For firms at the top of the partner compensation table, the impact will be modest. Yes, partners will make less money than they otherwise would have made and they will not be happy about it. But with the right level of communication and partner buy-in, it will ultimately be a non-event. After all, most of the other firms will have moved as well so, even if you don’t like it, what are you going to do?

For firms at the lower end of the partner compensation table, however, it won’t be easy to be sanguine about the move. It’s one thing for a firm with average partner compensation of $4 million to absorb this cost (irrespective of leverage). It is quite another for a firm with average partner compensation of $800,000 to absorb a similar level of cost increase. Remember, the additional compensation for associates flows through to compensation for non-equity partners, counsel or other categories of lawyers.

Seize the opportunity to reassess law firm business models

The decision to raise associate salaries should not be a reflexive response to the market. Instead, this move should cause firms at the lower end of partner compensation to have a hard look at their business model and their value proposition. Yes, the competition for talent is intense and opting out of the scale increase can put firms at a continual disadvantage in attracting top law students. But top law students aren’t the only people who can handle client problems.

A firm considering opting out of the move, therefore, must have an honest evaluation of its business proposition: in an increasingly stratified industry, where does the firm want to play? Where can it play? What is the value proposition being offered to clients? Where is the talent for those client needs? If the firm chooses to opt out of this compensation move, it needs to be able to answer these questions.

For those that choose to move their associate compensation scale, they face other challenges other than the obvious cost problem.

First, in this hyper-competitive market, it’s more important than ever to be brutally honest with partners about the competition for talent and the cost of acquiring it that will be borne by the partners. Because the owners of the business are being required to reinvest in their firm’s talent, they are entitled to know the scale of that investment and why it is being made. Retaining talent at the partner level is also important and communication is critical.

Second, compensation changes will accelerate the change in staffing models already well underway in the industry. While historic cost recovery tools may not be available, associates are not the only people creating client value in law firms. Contract attorneys, flex-time attorneys, staff attorneys, and hybrid legal professionals such as project managers and technologists all provide valuable services at lower cost. The rising cost of associates will place additional pressure on firms to correct staffing levels and will push the industry toward a matrixed workforce. Many law firms simply are not ready for this and have not yet begun putting the structure in place to support it. In the face of this compensation move, they risk being caught flat-footed.

Simply put, firms that have already begun moving toward a more matrixed workforce will absorb this associate compensation increase more easily into their business model. Those firms still using a more traditional structure will experience this compensation increase as the first domino in a cascade throughout all fee earners, putting immense pressure on future performance and the health and stability of the firm.

And what if a recession does come? With the financial markets near all-time highs, it’s something that law firms following Cravath’s lead should consider.