Large law firms and Ponzi Schemes

This article first appeared on July 16 on The Future of the Law Blog and is reproduced with kind permission. The traditional large law firm model has often been likened by its detractors to a Ponzi Scheme – a giant pyramid structure in which those at the top of the pile benefit unfairly from the hard work of the junior lawyers who are building up from the bottom.

Ponzi Schemes of course are fraudulent, and whilst the description therefore unfairly applies to law firms, there are elements of truth in it. The polite and more correct description for the large law firm business model has included the word “leverage”. At the start of their careers, junior lawyers have traditionally worked their fingers to the bone in the hope that their efforts will be rewarded in future years and that one day they in turn will benefit from the endeavours of lawyers more junior than them.This model relies on three essential features, all of which are under challenge now. The first is that the model can only work if law firms grow at a sufficient rate to allow career progression and for the leverage structure to be rebuilt under each promoted partner as he or she moves up the pyramid. Hence a firm with a leverage ratio of five lawyers for every partner essentially needs to continue to grow at the rate of five lawyers for every young lawyer that it adds to its partner complement. This means that a firm growing from ten partners (and 50 non-partner lawyers) to 20 partners will therefore need to become a 120 lawyer firm in order to preserve its leverage structure and, thereby, its profitability. This worked well until the early part of this century when we saw a huge growth in partner numbers, but this growth trend has now been reversed as law firms started to shed partners and reduce staff rather than add them.The second essential feature of the leverage structure is that the firm’s business model requires most of its profits to be generated from the hard work of its young lawyers, through building a portfolio of clients and work that enables large parts of client engagements to be delegated. This has worked well in the past, as larger firms have been able to charge out their associates and juniors at outrageously high rates that allowed large profits to be made. Sadly (for the legal profession but not for society) clients are no longer prepared to pay these high rates where the work can be done cheaper through in-house teams, outsourced solutions or commoditised processes.The third feature of the leverage model is that young lawyers should be career-dedicated, prepared to work long hours, and to buy into the “jam tomorrow” hope of big profits in future years. It seems that today’s young lawyers are less partnership-focussed, and not as prepared to work on this basis as prior generations.It is not a completely one-way downward trend – there are of course some balancing factors. In the first place, there is an oversupply of lawyers – there are still more new aspiring entrants to the profession in the UK and US than there are places for them. Second, in an increasingly complex world, the demand for legal services still continues to grow despite both economic woes and increasing client-side price pressures.  Third, the power of the big brand seems to indicate that the market share of well-regarded firms of all sizes will continue to grow at the expense of those that are less well organised.So what might all this portend both for firms and tomorrow’s lawyers? First, the growth of larger law firms will almost certainly continue with the aid of a more flexible and less people-leveraged model. Outsourcing, process-improved solutions, project management skills, better use of knowledge management and the increased use of paralegals will all help to make the service offering more efficient and cost effective for large corporate clients, and assist forward-looking firms to make acceptable profit returns. Second, there will no doubt be a continued growth of highly specialised boutiques offering pragmatic and innovative solutions in sectors and technical areas of law; deep know-how, impressive past experiences and muscular bench strength will be key – superficial knowledge of an industry or practice area will not be enough. Third, I think there will be an increase in the number and variety of firms offering societally-based services on a not-for-profit or low profit based. These firms will be staffed by lawyers whose motivation is based more on helping people and sectors of society than on the making of large profits. I am not talking here just about social welfare firms or those focussed on minorities, but also firms on the traditional High Streets.Firms need to re-examine their business models in the light of these challenges. Equally, young lawyers need to question their career motivation and try to fit their working styles, intellectual capabilities and values to the type of firms that may best suit them.