We closed Part 1 by looking at how the law firm partnership model fosters destructive behavior through the fiction of ownership. Today let’s look at how it encourages individuals to place their individual interests ahead of the firm, and how it distorts financial reporting.
Indeed, the partnership form profoundly distorts the reported earnings of law firms since “profits” are calculated, in essence, before senior management (i.e., the partners) are paid. Among other things, this infuriates clients and reinforces the extreme short-termism endemic among firms.
The lawyer or the law firm?
You have all heard the tiresome brain-teaser posed by people who think they’re being cute but are actually revealing their obtuseness: “Do clients hire the lawyer or the law firm? [Vocalized or implied, “A-ha!”]” The only mature answer is, “both, of course.” But to the extent one can assign a priority ranking, the partnership model reinforces putting the lawyer first, while the corporate model would reinforce putting the firm first. Loathe as we are to cast any shadow over the unique and sui generis talents of each and every individual Big Law lawyer (all 150,000 or so of them), recent history in our industry has taught us that free agency among lawyers can be a menace to enduring institutions. And our assignment for today, lest you forget, is to hypothesize about the ideal design for the law firm of the future.
This debate has been nothing if not long-running. And at this juncture we have little to add other than to reiterate our view, which seems breathtakingly obvious (although perhaps only to us) that, essentially, the answer is “Both” and “It depends.” (For confirmation see this column by a former AmLaw 25 partner, now GC of one of the world’s largest insurance companies.)
…We’re tasked to design the ideal law firm of the future, and from the perspective of the firm as an institution, there’s no question the corporate form beats the partnership form hands-down.
But whatever the answer to the question, it doesn’t really matter for today’s purpose, recall. Today we’re tasked to design the ideal law firm of the future, and from the perspective of the firm as an institution, there’s no question the corporate form beats the partnership form hands-down. You may appreciate that BMW, for example, has great engineers and designers, but you’re not likely to follow any one of them over to Audi for your next new car if they move. Your loyalty is to the firm, the product, and the brand. And that’s the way it should be.
Distorting financial reporting
No, I’m not going to go rehash the exhausted topic of the value of AmLaw-reported numbers. Not only have we all heard and some of us have participated in that debate ad nauseum, but I think the verdict is in and the issue is frankly settled. At this point any thoughtful observer can conclude that they’re not reliable, not comparable, invite gamesmanship, and purport to prominently measure things that don’t mean what they seem to mean. Which is not to say they aren’t an engrossing guilty pleasure.
Rather, the problem with partnership accounting is two-fold.
First, as universally practiced by law firms, but contrary to economic and management reality, profits of the enterprise are calculated before partners are paid. I don’t know how to say it much more directly (and we’ve written about this before), but this is bizarre from a number of angles:
- Partners perform at least three roles, including laboring as hourly-billing lawyers, participating (some of them, anyway) in firm management, and then and only then being residual owners of the enterprise. Logically:
- They should be paid for their labor as an ongoing operating expense of the firm, analogous to what non-equity partners are paid for their labors;
- They should be paid for management also as an ongoing operating expense, analogous to what business professionals are paid for similar functions; and
- then and only then should they be entitled to the residual profit of the enterprise.
- Failing to recognize and distinguish among these three roles produces chronic and large over-statements of law firms’ profits compared to what those profits would be if accounted for on an economically rational basis.
Second, the requirement that partners are liable for income tax on their proportionate share of earnings whether or not actually distributed to them has served as an all but absolute bar to firms’ retaining income for future investment. Of course, all the tax laws say is that the tax is due on the partner’s entire share, not that it has, in fact, to have been distributed. But I’d be shocked if you’d be invited back to any partners’ meeting where you bring up that distinction and suggest the firm actually has an important choice to make about paying out something less than 100% of earnings.
You may appreciate that BMW, for example, has great engineers and designers, but you’re not likely to follow any one of them over to Audi for your next new car if they move. Your loyalty is to the firm, the product, and the brand.
I said at the outset that this series would read as one of naked advocacy, and I hope at this point you would say I’ve been as good as my word. Now it’s your turn.
Time and again I’ve heard the virtues of partnership sung, whether it’s to serve as cultural glue, to bring out people’s most energetic and dedicated efforts, to encourage seamless collaboration, to inspire loyalty, or to provide a clutchless transmission between firm performance and individual recompense. And I’m sure there are other supposed linkages out there. All these goals are undoubtedly essential, and beyond that are worthy and even aspirational for a sophisticated professional services firm.
So I invite you to make the case why the partnership form is indispensable, or optimal, for their achievement. Because I look at global consulting firms, investment banks, architectural and engineering firms, and more—all full of Type-A individuals playing on some of the world’s great canvasses—and I see no shortfall in cultural glue, energy and dedication, collaboration, loyalty, or the ability and the recognized imperative to pay market-rate.
If you prefer, consider the corporations operating in the four-dimensional space of innovation, customer passion, employee engagement, and financial power, where (even if you might not do it exactly the same way) absolutely everybody is ravenous to know how they do it—Amazon, Apple, Facebook, Google, Tesla. Not a partnership to be found.
Why must law be different?