Tuesday, February 07, 2006

Big Firm Economics 101: Why are Associate Salaries so High?

I have blogged a fair bit lately about starting associate salaries at big U.S. law firms. (See my previous posts here and here.) That’s natural, I suppose. It’s in the news, and new associates at blue chip firms certainly make a very good living. But why are starting salaries at big firms so high?

There are a lot of answers one might give. Some of the more popular ones are wrong in many ways, but yet contain a seed of truth. So here’s my modest attempt to help set the record straight.

Three common answers to the money question are:
  1. Big law firms throw money away on junior associates because big firms make money hand over fist.
  2. Those poor associates make their firms a big profit, so they deserve big bucks.
  3. Lawyers have a monopoly on the right to practice law. This reduces competition and means firms can charge their clients more.

Let’s take each one of these in turn.

ANSWER ONE: Big law firms throw money away on junior associates because law firms make money hand over fist.

What’s true about this? That’s easy: big firms make a lot of money. Just look at some recent figures. The top 100 U.S. law firms grossed US$41.7 billion in 2004, with the top four (including my old firm, Baker & McKenzie) raking in over $1 billion each.

That’s astonishing, really. Years ago—say, back in the ancient 1960s and 1970s—being a lawyer was a great way to make a good living, but a hard way to get rich. Being in business was a much better way to strike gold (think Apple and Microsoft in the 1970s, or high tech companies today). But now? Bill Gates still makes a lot more money than even top law firm partners, but there are more opportunities to be a corner office partner than to be the top-dog entrepreneur. So in terms of risk versus payoff, practice at a big law firm is not a bad bet.

What’s false about this? A lot, actually. Law firms do not pay newbie associates tons of cash because they can—they pay them high wages because they have to. Law firms are private enterprises, and they respond to market forces. Sure, like any entity or person they have their cognitive biases that result in incorrect decisions, but overall their economic decisions (accounting for imperfect information or assumptions) are startlingly rational. They pay market rates to attract top talent—and if the market rate is high (which it is), then that is what they pay.

ANSWER TWO: Those poor associates make their firms a big profit, so they deserve big bucks.

What’s true about this? Well, law firm associates do work hard . Take it from me, a veteran of the big law firm trenches.

What’s false about this? Newbie associates hardly ever make their firms a profit.

Think about it. Starting associates get such big salaries, and yet they have no practice experience. Law school is only a three year course of study, and in today’s sophisticated world filled with specialty areas of practice, students learn only the rudimentary basics in law school. I’ve been on all four sides of the matter—(1) as a law student, (2) as a newbie associate, (4) as a seasoned lawyer managing projects and other lawyers, and (4) now as a law professor—so I know what I’m talking about.

So big firm newbie associates rarely pay their own way. With salaries approaching $150,000 and other expenses (office rent and other overhead, benefits, insurance, etc.), newbies cost firms around $250,000 per year. Sure, they bill at $200 per hour, but is all that time collectible, as they learn the ropes and the law? Absolutely not. A solid mid-level associate might collect around 85-90% of her or his billed time (remember that it’s not just about the quality of the work—some clients just don’t pay in full, or get special discount rates from the firm), but newbie collection rates are much lower. They usually don’t break even until their third year of practice.
So it would be better to pay junior associates a lot less, and then increase associate salaries exponentially in year three. But that’s not how it works—which is unfortunate, both for the law firms who pay too much for newbie associates and for the newbie associates who feel too much pressure to be profitable.

ANSWER 3: Lawyers have a monopoly on the right to practice law. This reduces competition and means firms can charge their clients more.

What’s true about this? Well, the practice of law is a monopoly granted by each state. And lawyers should never forget that the privilege to practice law is just that: a privilege, not a right.

We should also bear in mind that aspirational goals (like the obligation of licensed lawyers to do public service and pro bono work) are generally doomed to failure. When push comes to shove between public service and a screaming (and paying) client, the client almost always wins. I’ve been there. Lawyers are in business, and they are rational actors. Clients pay the bills.

What’s false about this? Removing lawyers' monopoly on law practice would not do as much as you might think to reduce lawyer salaries. It would have some impact, to be sure—after all, you can’t go into court as a lawyer unless you are one. But what about other areas of law? Transactional work? Regulatory work? The effect would be minimal in many cases.

First, the assumption that all lawyers are overpaid is premised on the assumption that everything lawyers do requires a law license. That is not true. You do not need to be a lawyer to draft or sign a contract, facilitate a corporate deal, or to provide regulatory advice in many areas of practice (like import/export law, my old stomping ground). Companies can sign their own contracts and structure their own deals, and in some cases (typically in regulatory areas) non-lawyer consultants can represent clients.

Yet lawyers still dominate transactional and regulatory work, at least at the high end of the market. In my experience, law firms often offer more creative and critical thinking—and thus more value. So they are able to charge higher fees, and make more money. Not because they have an unbreakable monopoly—they have no real monopoly at all. Their profitability is because they offer the best quality service. The easier work goes to consultants (and some law firms) who charge less, and that is a good thing—clients pay less for the easier work. But the hard stuff? Big firms do it for a premium—which again is a good thing, since clients get value for their dollar. And that’s no different from any other sector of the economy.

* * *

This is a topic where passions run high. Some people like lawyers, and some do not. Those who like lawyers often defend them come what may, while those who do not typically take the opposite stance. And usually the answer lies somewhere in between. This is my attempt to set out a few of my thoughts on the matter. There's more to be said; I'd like to hear what you think.

2 comments:

RyWalters said...

You wrote:
the practice of law is a monopoly right granted by each state. And lawyers should never forget that the right to call yourself a lawyer is just that: a right, not a privilege.

Huh? Don't you mean that the "right to call yourself a lawyer" is a privilege, not a right? After all, only those granted that privilege by a state's bar (usually after a hundred thousand dollars in law school, exam fees, and bar fees) are legally allowed to practice law.

...the assumption that all lawyers are overpaid is premised on the assumption that everything lawyers do requires a law license. That is not true. You do not need to be a lawyer to draft or sign a contract or put together a corporate deal, or to provide regulatory advice in many areas of practice...

Check out this compendium of state UPL statutes (pdf). In California, the practice of law "includes legal advice and counsel, and the preparation of legal instruments and contracts by which legal rights are secured although such matter may or may not be depending in a court." Other states I skimmed had similar provisions.

Gregory W. Bowman said...

Whoops, Rywalters, you are 100% correct. Being a lawyer is a privilege, not a right. Sorry for the typo. I hope you know what I meant. That's such a big difference in meaning that I am going to switch the original post. Bet you had a laugh about that one.

On the other part of your comment, your reference to the UPL statutes is dead on. But my point was more along the following lines:

First, you can write and sign your own contract without being a lawyer. A company does not need to use lawyers (inhouse or otherwise) to write a contract. And some do not. But frankly, most do. And partly it might be so they can blame someone if things go south, but also they do so because there is expertise there that the non-lawyer does not have. That's what I was driving at.

Second, there are some areas of regulatory practice where you can represent clients as an agent before agencies and NOT be a lawyer. It is by definition not UPL. It's in the federal regs for some agencies, for example, and it includes representation of clients concerning regulatory approvals, civil and criminal penalties, and so on. And there are some non-lawyers who do that for a living--but the big bucks generally go to lawyers, for the reasons I gave in my post.

Thanks very much for your comments, and thanks for keeping me straight on my enormous typo. It wasn't a Freudian slip, I swear.