Law firms as Ponzi/MLM schemes?

I spent some time on Thursday morning in a courtroom full of very expensive lawyers. The associates were few and far between, as were the women (but that’s a different story). Later that afternoon, I spoke with a former officemate of mine from when we were both second-years at a large NYC law firm. These got me thinking again about this task buried in my to-do list: Write humorous article comparing law firm economics to pyramid schemes or MLM.

Among the topics of most intense interest for associates at large law firms (and even more intense interest for second-year law students, which is funny considering how remote the issue really is) is the partnership track. True, most associates learn quickly that until they get to at least fifth-year status, the brass ring of partnership, which has moved about 4 months back a year, on average, since I was a law student (7 years then, 8 at the biggest NYC firms, to a solid 10 years now), is relatively meaningless from any reasonable day-to-day perspective.

But, several big things in the world of professional service firm partnerships have changed since 1997. Goldman Sachs went public, turning senior managing directors into hundies (that’s over $100m) and probably created the intense increase in compensation thereafter (although I would have to do some research to track down the numbers. With nothing saved up in terms of equity in the firm, bankers wanted to see their money, in cash. (Or, of course, in stock that could be sold for cash – it’s mostly the same.) Also, Andersen Consulting, now Accenture, did the same thing. While it wasn’t quite as profitable as Goldman (what is?), consulting partners extracted a substantial amount of wealth from the firm. What both these firms did, however, was take away the “vested” (not in the technical sense, of course) interest of associates of all ranks in staying to make partner/MD. Without the big pot of gold at the end of the rainbow, associates became mere employees, and they realized that they needed more short-term compensation to make up for the lack of the back-end opportunity and, more importantly, they realized that the partners didn’t really care about them and were willing to sell off the future that some of those associates had been working towards.

Now, this hasn’t happened in the law firm context, in the US, because of something known as fee-sharing. It is unethical, in terms of there being specific ethical rules in each state, that prohibit lawyers from sharing legal fees with non-lawyers. In simple terms, my friend Mike can’t be a partner in my law practice because he’s not a lawyer; the concern is that the non-lawyer, not bound by the ethical rules that constrain lawyers and protect clients and the courts, might exert inappropriate influence over the lawyer and cause the lawyer to do something wrong. (Of course, spouses, children, college bursars, vendors, the IRS, clients, opposing counsel, and the government all exert these influences too, but they’re not looking to a share of bigger legal fees as the justification for their behavior. Except maybe spouses.)

What I’ve often wondered is whether a law firm really works as an independent business, if it can stay up on its own feet without the constant influx of “free talent” at the bottom of the pyramid that is paid off at the partnership level years later. Indeed, every associate that leaves (partners call that attrition) has benefited the firm by not getting the implicit value of that extra work that wasn’t compensated on an annual basis. Firms without associates generally have much lower profits per partner. Some of that is from the leverage that is gained from having employees and charging three times their salary for legal work (historically, the rule of thumb is that of billings, 1/3 goes to salary, 1/3 to firm overhead, and 1/3 to firm profits).

If an investment firm needs new people at the bottom to keep coming in and investing, so that the people who came before can get paid, we put those people in jail. That’s what we call a Ponzi scheme, and it’s considered illegal because the real value is being extracted from the new investors, not created by the company. Now, law firms do indeed do work, but how much is really extracted from the new investors, the ones that hope their name will reach the top of the chain letter?

Or, in a slightly less cynical view, are law firms more like MLM companies, where each associate is brought in at the lowest level and slowly moves up, eventually getting to bring someone else in underneath, until the threshold is crossed and profits start to roll in just from what the folks downstream are doing? Law is sort of like this, but there are no profit shares until you cross the Partner line. However, some firms do have practice-group specific bonuses, and so in those circumstances, some mid-level associates might actually be gaining from the efforts of the juniors.

I write this post because I realize that I don’t have time to turn this into a humorous article or even sponsor an undergraduate senior project to perform the actual economic analysis and compare the various professional services models, pre- and post-partnership, to law firms, to pyramid schemes and MLM systems. If someone would like to take up the topic, please let me know, and I’ll be happy to publish it here.