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

[posted by Bill Henderson, crossposted to ELS Blog]

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.