Friday, July 18, 2008

How the "Cravath System" Created the Bi-Modal Distribution

[posted by Bill Henderson, crossposted to ELS Blog]

Nalp_2006 The bi-modal distribution (graphic to the right, originally posted at ELS) continues to generate interest in the blogosphere.  See, e.g., Greg Mankiw, Right Coast, Broken Symmetry. The  chart summarizes the starting salaries for lawyers who graduated from law school in 2006.  One reason the bi-modal structure is so jarring is that it demonstrates that measures of central tendency, such as average or median, are not necessarily reliable guides for law students' future earning power.  In conventional labor markets, that disconnect is rare.

NALP recently dug into its archives to determine whether this stratification is a persistent feature of the entry level law market. See NALP Bulletin (Jan. 2008). It turns out that 15 years ago, the market followed a much more traditional distribution.   The chart below summarizes the salaries for the class of 1991.


The 1991 graph is right skewed but bears some resemblance to a normal curve.  Below is the graph for 1996:


The rightward skew is a bit more pronounced and the area under the $75K to $85K range is becoming more substantial.  A more seismic shift is seen in 2000 (below) with the emergence of a second mode at the $125K price point. 


At the height of the Internet boom, a remarkable 14% of all entry level lawyers took jobs at the $125K level.  According to NALP, "never before had a single salary so dominated the landscape."  Under the 2006 bimodal distribution (see chart above), 44% of graduates received entry-level salaries in the $40K to $60K range; yet, the second mode moved further to the right ($135K to $145K) and grew to 17% of all graduates.

What are the market forces that have created this peculiar salary structure?  In my working paper, "Are We Selling Results or Résumés?: The Underexplored Linkage Between Human Resource Systems and Firm-Specific Capital," I posit that the runaway $160K mode is a confluence of two factors: (1) the continued growth in the corporate legal services market, primarily due to the growing scale and scope of transnational corporate activity; and (2) law firms' nearly universal adherence to the "Cravath system," which purports to hire the best graduates from the best law schools and provide them with the best training.  More after the jump. ...

The New York firm of Cravath Swaine & Moore created and refined this system during the early 20th century.  The emphasis on educational credentials was initially an attempt to establish a distinctive brand of legal services that could differentiate the firm from other Wall Street competitors. Now, ironically, it has become a uniform industry practice utilized by every large law firm that claims to provide first-rate services. [Virtually all firms mimic the Cravath system without understanding its logic.  In the paper, I draw upon a unique study of engineers at the renown Bell Labs to suggest that Cravath's superior client service has less to do with credentials than an organizational structure and ethos that aligns the interests of associates, partners, and clients.  Paul Cravath's theory is laid out in Robert Swaine's history of the firm.  I will discuss his profound disconnect in a subsequent post.]

On one level, law firms' reluctance to tinker with the Cravath system makes perfect sense--it has produced large incomes and huge profits margins for decades.  Further, 30 or 40 years ago, the vast majority of  firms that would eventually become the Am Law 200 were, in fact, "white shoe" firms within an overwhelmingly regional corporate legal market.  In particular, places like Cleveland, Detroit, Pittsburgh and St. Louis garnered their share of elite law school graduates.  In the early 1960s, sociologist Jack Ladinsky found that 73% of Detroit lawyers working in law firms (i.e., not in solo practice) went to one of five national schools:  Harvard, Yale, Columbia, Chicago, or University of Michigan.  See Ladinsky, Careers of Lawyers, Law Practice, and Legal Institutions, 28 Am. Sociology Rev. 47, 49 (1963).  You can bet this pattern is radically different today.

As these regional law firms morphed into the Am Law 200, their partners remained psychologically wedded to their own perceptions of eliteness.  In the ensuing salary wars, these firms slavishly paid the prevailing rate rather than signaling to the market that the firm had become "second rate" (a term used by a Proskauer Rose partner in rationalizing the higher pay). In turn, the laws of supply and demand produced the bi-modal distribution.

The Results or Résumés paper draws upon two pieces of market data to demonstrate that a large proportion of large corporate law firms have to re-evaluate their business models:  (1) stunning uniformity of associate entry level salaries amidst large, growing disparities in profits per partner; and (2) evidence that firms are becoming stratified by premium versus non-premium practice areas.

Regarding the disconnect between associate and partner pay, the bar chart below compares associate starting salaries with profits per equity partner at the 25th, 50th, 75th, and 95th percentile breakpoints in the Am Law 200.

As the paper documents, over the last several years, profits are going up at all levels of the Am Law 200; they are just going up much faster for high PPP firms. Obviously, when firms at the top of the heap (95th percentile) pay higher salaries and bonuses, it is quite a stretch for firms at the 25th percentile to match.  The money has to come from somewhere.  If it comes out of the draw of a rainmaking partner, he or she has a strong incentive to seek greener pastures.  That is risky; but to the majority of the partnership, departing from the Cravath model seems equally perilous. Over the last decade, virtually all large firms have adapted by increasing leverage (i.e., the ratio of total lawyers to equity partners).  But higher leverage can also undercut associate morale and loyalty.  So for firms at the bottom of the PPP distribution, the salary wars are one hell of a vise, particularly as the economy heads south and they are stuck with a $160,000+ cost structure.

Yet, for many firms, there is second trend that is much more troubling.  Based on a dataset of lateral partner mobility within the Am Law 2000, it is possible to tease out a relative hierarchy of practice areas.  The table below, which covers the 2000 to 2005 time period, orders legal specialty by differential profits per equity partner (PPP) between the firm a partner left and the firm he or she joined.

The trends are straightforward. Partners in marquee practices like white collar crime, securities enforcement, M&A, private equity, emerging markets, and intellectual property litigation are disproportionately moving upstream to more profitable firms. Partners specializing in regulatory compliance, real estate, public finance, project finance, and trust & estates are disproportionately moving downstream.  A similar analysis using multivariate regression, which controlled for year and city, found that labor & employment was also associated with downward (i.e., lower PPP) movement. (See regression table.)

In the long-run, firms without a optimal mix of premium practice areas will have a hard time sticking with the Cravath system.  Increasingly, corporate clients are refusing to have their cases staffed by expensive first- or second-year associates who don't know very much and tend to leave.  Hence, the training the clients are allegedly paying for has little or no future payoff.   

In other words, for many large law firms, the wheels of their hallowed business model are falling off.  During this period of denial, every firm's short term strategy is to work harder, promote fewer lawyers to equity partner, and de-equitize as needed.  Marc Galanter and I chronicle the unremitting nature of modern large firm practice in our forthcoming Elastic Tournament article.  If you have any doubt about the inevitability of change, read this seminal speech by Cisco GC Mark Chandler.

Fortunately, the Results or Résumés paper lays out a solution for any law firm willing to try something new.  The psychological barriers, however, are much larger than the logistical or financial.  I will blog on this topic in a subsequent post.

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Your premise is interesting. However, it misses what is probably the single most significant point in the distribution model and the flaw in the "Cravath System."

The firms may be paying the salaries, but they aren't doing the training. Today's associates are being thrown into the pool and told to sink or swim. Firms that used to value the development of their attorneys now treat them as fungible billing units. Associates are expected to learn by doing, and not to waste their time or the firm's doing so.

The incredibly large rate of turnover and the burnout factor bear witness to this. Today's law students need to understand that they are gambling on a very small number of prizes, and that the price of winning is selling their souls.

Posted by: New Diarist | Jul 20, 2008 1:28:51 PM

To New D:
I think the issue you correctly raise in your first two paragraphs is well taken and also one that I have heard Bill H address in the larger project that this is part of: the extent to which the old Cravath Model of training associates through work is also sustainable anymore. In a presentation Bill made at LAS in Montreal, I recall that he had evidence that clients are resisting paying for the training, now that the rates of newbies is so high, and actually demand that only third or fourth years or above work on their cases.

The hands-on training which law firms used to pride themselves on (whether or not it worked before under cheaper labor rates) may no longer be sustainable, and that would be another problem to address in the current bimodal reality. I think Bill has, but I also look forward to his dealing with that issue some more, and I appreciate your raising it here.

Posted by: Alan Childress | Jul 20, 2008 4:53:29 PM

I wonder if the training issue doesn't augur for some kind of "residency" model along the lines of medical training. If the firms can't bill the time that junior associates spend, it might make sense for the associates to have to go through a period of lower salaries. One apparent obstacle could be the cost of living in places like NYC: there's a limit to how little they can pay juniors. Though obviously hospitals in places like NY, Boston, L.A. etc. handle this.

Another thought: how much do newbies demand training, at least from their assigning attorneys? Even when I started at a big Wall Street firm in the 1980s for about 25% of what 1st-years now are making, I had to bug partners for training; but when I did so, I got it. The head of my firm (with whom I worked directly) even came in on a Saturday to help me. Last time I was at a big firm was during the Internet boom, but at the time many juniors seemed to believe that since they'd gotten the job and the exorbitant pay, they must be so smart that they knew what they were doing a priori. Had they asked me for help, I'd have been happy to give it. But few did, and some even ignored what I took the initiative to offer. There's more to the interaction of high salaries and training than just the sustainability issue.

Finally, a comment about the graphs. I think the use of a solid line may be inappropriate, since this suggests a continuous distribution. The triangular peak around the $125K mark in the Class of 2000 graph is a case in point. The text suggests that there should be a sharp, singular peak at this particular dollar value. Was there really such a perfectly symmetrical distribution at all increments in the $120K-$130K range? If so, this would be a phenomenon that needs explanation. (Cf. how the fact that spectral lines were often broadened, rather than singular, led to the discovery of some interesting physics in the 19th Century, e.g. Lorenz broadening.) If lawyers are going to use statistics, charts, economic arguments, etc., please be more careful. A bar chart would probably have been the more appropriate display.

Posted by: A.J. Sutter | Jul 20, 2008 8:29:00 PM

A few quick thoughts on "Results or Resumes" and "Law Firms, Ethics, and Equity Capital":

@ Since many firms are global, the issue is not only state ethical rules. I don't think allowing firms to choose a home jurisdiction is a good idea -- if you want to play everywhere, you should have to play by all the pertinent rules. I have to do that even as a California lawyer in Japan, and I think Japan is right to make me do so.

@ Bruce MacEwan comments that "[T]he primary reason the Anglo-Saxon common law tradition has become the de facto international law of business is its malleability and extensibility." IMHO this does not justify Anglo-Saxon hegemony over rules of the legal profession. Not all societies are as in thrall to liberal capitalist dogma as the US, and their conceptions of roles of lawyers in society are different as well. Another argument against the home jurisdiction point.

@ I would think that the news today gives enough examples of the disastrous results of liberal capitalist financial innovation triumphalism (e.g., the subprime crisis) to make people think twice about pushing it again. What Marx said is false, viz. that when history repeats itself it's first time as tragedy, second time as farce. Tragedy can hit more than once.

@ As for the alignment of capitalism and the public good, people made the same arguments about for-profit HMOs. How did that turn out?

@ There's also a comment in one or both of the papers about how financial growth opportunities are needed so that partners don't move to other firms. Yet financial incentives don't seem to restrain movement in corporations so much, especially after people are fully-vested. Why would this work differently?

@ Apropos of the analogy to the Bell Labs study: how good is the analogy between the "client" pool for Bell labs researchers and that for law firms, do you think? BTW, you refer to an HBR study from 1993; Bell Labs' role within Lucent was considerably downgraded in the post-2000 era, leading in a mass exodus from many groups. There was also a rather spectacular case of scientific fraud there in 2002, the Jan Hendrik Schön case, which included retractions of a Nature paper that had been featured on the cover and a "breakthrough of the year" in Science, indeed retractions of 21 papers in Science, Nature and Physical Review Letters. The Bell Labs culture is not necessarily a good one for export.

@ The analysis in the Regan&al. paper, concerning a derivative interest, seems if anything more conservative than your proposal about involving a private equity firm. You don't mention any safeguards about the PE firm not being involved in firm management. What's your intention?

I have no vested interest in the prevailing business model of law firms, and won't shed a tear if it collapses under its own weight. But I'm not sure that relaxing professional ethical constraints is likely to be the right way to start improving things. Real evolution is when you adapt to the environment as it is, rather than lobbying the environment to make it easier for you to make money. Your first proposal, about a spin-out based on a fixed-fee approach, sounds more reasonable. So might instilling (does it date me to say restoring?) an enhanced awareness of social responsibility in young lawyers. For that, you law profs are the first line of intervention.

Posted by: A.J. Sutter | Jul 21, 2008 8:28:15 AM

hey, I found it interesting. That's a very good analysis you do in here. But, are 100% positive about it? And one more thing, not much newbies demand some training. They seem looks too arrogant and think because they can be hired by big law firm, so they must be too good to be hired. So, they feel like knowing everything. But, the truth, they just know very little thing.

Posted by: united states bankruptcy court | Nov 9, 2009 6:31:54 AM

Interesting analysis but I'm not sure I completely agree with your conculsion.

Posted by: bankruptcy discharge papers | Nov 29, 2009 6:54:23 PM

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