It might not feel like it to some, but the economic environment for large law firms has been benign for a long time. It has been difficult not to make money. According to Legal Business, the top 100 UK law firms (that is, less than 1% of the 10,000 or so in the UK), still manage to gross over £17.5 billion, even in these supposedly tough economic times. That’s at least 50% of the total value of the legal economy. And for the more than 8,000 equity partners in those firms, this produced an average net profit share (PEP) of almost £650,000. By most people’s reckoning (even in the world of clients), that’s a lot of money for a lot of people – and it is only an average. It’s not so much the size of any individual reward that’s the issue (the range is reported as £138,000 to £1,840,000 – and it’s no longer Slaughter and May, or any other Magic Circle firm, at the top): rather, it’s the sheer number of people who are able to extract this level of averaged reward in a reactive service market that is dependent on client activity.

Let me put this in a different context: I would doubt that the number of buyers of legal services who control that £17.5 billion spend in aggregate earn more than £5.4 billion, or on average earn £650,000. These buyers might historically have been relatively loyal to their choice of law firms and lawyers, allowing these levels of return to be earned. But pretty well across the market (whether in the commercial, financial, or public sectors; and whether large, medium or small organisations) the quest is now ‘more for less’. As we move further into the immediate 21st century, the quest is also likely to become ‘even more for even less’. Many law firms seem reluctant to take up this challenge.

These levels of lawyers’ rewards – aided and abetted, let’s be honest, by clients – have also driven a market that has doubled its numbers of solicitors, and trebled its turnover and profits, over the past 20 years.

I have had the temerity to suggest for a number of years that the market has too many lawyers, too many law firms, and too many equity partners. I used to be challenged regularly for this: how could a market possibly be described as over-supplied when it remained difficult to recruit good people and was so conspicuously successful (at least in PEP terms)? Interestingly, I now hear the challenge less often; indeed, these days I’m more likely to hear others adopting the over-supply view – including the leaders of the largest law firms. The reason is that over-supply typically leads to greater competition, predatory pricing, consolidation, and ultimately a squeeze on profits. (By ‘consolidation’, I mean the creation and emergence of increasingly larger firms as lawyers join or merge, rather than, necessarily, the disappearance of small firms.) It also exposes the underlying weaknesses of a model that works in good times of rising turnover and profits, but which has been built on foundations of shifting (quick)sand. Over-supply is therefore a symptom, not a cause, of even more fundamental issues. These are that law firms delude themselves into thinking that their structure and approach are basically sound, merely temporarily buffeted by forces largely beyond their control that must be endured before the sunny times return.

So here are the principal elements of the Grand Delusion.

First, partnership is sought and awarded on ‘the L’Oreal principle’ (with apologies to that great brand). Even now, very few firms truly subscribe, and stick, to the notion of a business case for the admission of a new equity partner that shows that the practice area, and firm as a whole, needs and can afford another profit-taker. The top 100 firms have just shy of 1,000 more equity partners in 2012 than they had in 2011. What logic in the present climate makes that sustainable? Nor is the admission debate firmly focused on what the new partner can do for the firm (other than to keep at least the same level of fee income flowing in from personal productivity). Too often, the issue is decided on the foundation that the candidate has served his or her time and is a good (or, at least, good enough) lawyer and so, in some inchoate way, ‘because they’re worth it’. No wonder so many firms struggle with employee-minded owners who think that rising incomes are a given and a right because they have made financial commitments that they might not otherwise be able to sustain.

Second, net profit as a reward. I have written elsewhere about the distorted and distorting nature of PEP (net profit per equity partner). The simple truth is that the net profit of virtually every law firm is neither meaningful nor accurate as a measure of true economic return to the business. It utterly confuses the returns to owners, managers, financiers, and workers. It utterly confuses capital and income returns, by ‘bundling up’ what would otherwise be an accumulation of capital value over time into a current-year income. It utterly confuses short-term and longer-term returns – unfortunately nudged in this direction by the taxation of partnerships, which encourages immediate extraction rather than investment or the creation of ‘rainy day’ funds. Amid this confusion, it also seriously distorts individual and entity behaviour, by encouraging the pursuit of personal or short-term gains at the expense of collective effort and reward over a sustained period.

Third, partnership generally (or at least our firm in particular) is a collegiate, long-term institution. This is the expected response to my second point, intended to show how little I understand professional partnerships. The whole notion of joint and several unlimited liability, combined with close, personal relationships over time and ethical responsibility for one’s advice, encourages collegiality and pulling together. I’ll admit it does in theory. I’m even prepared to concede that it probably used to be like this ‘in the good old days’ – and even still is in some firms. But usually, when partners are vocal about their collegiality, in my experience, it’s the empty barrel syndrome.

Typically, partners are confusing collegiality with friendliness and sociability. Collegiate organisations make decisions in the long-term best interests of the firm, they are collaborative, and no individual is more important than the firm. What I hear described, though – most often in firms that claim to be collegiate – is an environment where personal and local interests are usually pursued in preference to the firm’s objectives. Work-hogging, and a refusal to cross-sell, are prevalent, fed by a personal billing and client origination culture. These firms are often low-trust partnerships, where it is not unusual for high billers to hold the firm to ransom or to throw their toys out of the pram when it looks as though they might not get their own way. This is collegiality?

As for long term, many law firms show a marked reluctance to be strategic in their thinking and planning, or to invest in a war chest, rainy day fund, or seriously in professional management. Nor is there much sense of return on investment beyond the term of personal ownership (or even, in some cases, beyond the end of the current financial year). The sense of stewardship or custodianship for future generations that used to characterise the more collegiate of firms has been sacrificed on the daily altar of chargeable time and client billings. For a provocative view on this, see Mitch Kowalski’s book, Avoiding Extinction: Reimagining Legal Services for the 21st Century. He writes (or rather one of his principal characters says) that “the partnership model has no room for any element of custodianship, teamwork or collaboration”. I might not be quite so forceful in my denunciation of partnership – not least because I have seen some wonderfully collaborative partnerships – but it is true that, all too often, partners tolerate behaviour that is diametrically opposed to the ‘collegiate’ intention and ethos that they espouse.

Before we write off this critique of partnership as itself delusional, it would be worth observing that an increasing number of law firms now appear to agree. Last week, the Solicitors Regulation Authority published data showing that, of the solicitors’ firms that are not sole practitioners, only 41% of them are partnerships. And before we assume that the emerging structure of choice is the LLP, this is in fact the choice of only 21% of firms: the truly staggering statistic is that almost twice that number – 38.5% – are fully incorporated. Even so, I would dare bet that, still in too many cases, within the corporate structure the ‘collegiate’ delusion is still prevalent.

Fourth, the notion of being an ‘international law firm’. Large law firms have often claimed to be following their clients as they open offices in other parts of the world; in truth, more often than not they have simply been following their competitors. There has not been enough independent thinking, or integration of the ‘international offices’. These offices are too often expected to be stand-alone businesses (no surprise, then, that they don’t integrate well and rarely receive work from, or refer work to, other offices), to be as profitable as London (few places are, and almost never on the back of only local clients and business), and to ‘send money back to HQ’. This is not internationalisation; it is imperialism. It is not following a market: it is a solution looking for a market.

Fifth, “we must be good businesses: look at the money we make!”. Law firm management has undoubtedly improved in the past 20 years – but only relative to its own market. I have critiqued the broken business model before, but in summary:

• too many firms are still wedded to cost-plus, time-based, input-driven billing: there is not enough thought about or action towards creating value for clients and charging accordingly;
• there is too much use of qualified lawyers, coupled with demeaning treatment of ‘non-lawyers’ and resistance to project management and outsourcing;
• reluctance to admit new partners and deal with under-performers, combined with a tougher borrowing climate and professional restrictions on financing, have imposed self-limiting barriers to effective capitalisation and investment; and
• the misallocation of rewards, and the recognition of the wrong forms of contribution and behaviours, the wrong people, and the wrong timescale, have driven expectations and costs to unsustainable levels.

Compared to most other forms of large commercial endeavour, law firms are still lagging in terms of effective governance and management.

The Grand Delusion that all is well in the land of law (and BigLaw in particular) is blinding many firms to the need for reconstruction. There is still time for law firm governance and management structures to address this delusion before the weaker firms are sucked under the quicksand. The challenge is not that partnership, profitability, collegiality, globalisation, and good business management are not legitimate or worthy objectives. It is that they are pursued in ways that are too often, at best, lax and, at worst, misguided. Unfortunately, too many people have a vested interest in the old model continuing to work; but the Emperor’s clothes are nevertheless increasingly being seen for what they are.

The issue is not what firms and their partners want; it is not even about what they are capable of doing. It is about what the market will expect and allow. To expect to make a lot of money on the basis of business practices that are not as tight, efficient or as valuable to clients as they could be is surely to invite scrutiny, at least. The conundrum remains: if law firms can have achieved so much in spite of themselves, just imagine what could be achieved if they really turned their attention to their fundamentals. The absence of delusion would be a sound starting point. The future is not what it used to be.