The Split: Law Firm Compensation Structures

It should be the first piece of advice every articling student gets, printed in huge capital letters on the first page of the recruitment or orientation brochure: AT ALL COST AVOID CONTACT WITH PARTNERS DURING "THE SPLIT." The multiple meetings that take place during this period, which in most firms take place in March, determine each partner's share of the firm's profits-in other words, professional compensation-for the year. This share, in turn, effectively determines the firm's pecking order for the next 12 to 24 month period, at which point the entire torturous exercise takes place again.

As Canadian law firms have grown larger and larger, the stress associated with determining individual partner compensation has risen accordingly. As recently as 30 to 40 years ago, a law firm's two or three senior partners split the pot amongst themselves, usually according to a ratio set out in a decade (or more) old partnership agreement. Then there was the benevolent (or not) dictator model, where the managing partner-undeniably the first among equals-told everyone what they were getting, and they either put up and shut up or left to set up their own little dictatorship across the street.

Splitting the pot today, among upward of 300 partners, is substantially more difficult. It's a toss up who has it worse: the immensely profitable firms where the stakes are really high, or the firms struggling through a bad year (or strategically flawed decade) when every dollar is precious. Consensus, however, does exist regarding one factor: how a firm approaches compensation tells you more about the firm's culture and real philosophy and values than anything its brochure and website proclaim. Unfortunately, most people don't fully grasp the intricacies of their firm's compensation system until 10 or so years after admission to the partnership.

"There are some large firms that are disasters, and I'm sure their partners don't know it, as to how everyone is getting paid," says Hugh MacKinnon, managing partner of the Toronto office of Bennett Jones. At partner level the firm's Toronto office is staffed primarily with mid- and senior-level laterals, a situation that gives MacKinnon unique insight into how compensation works-or doesn't-at most of Toronto's major firms.

According to MacKinnon, "People at the large firms assume all the other firms are just like theirs. Partners assume everyone is like them-their $100 is calculated the same way as my $100 and it's distributed the same way. For a junior trying to figure out exactly what's going on, it's impossible. Even some senior partners in those firms don't know what's going on."

And no wonder. Splitting significant revenue fairly between hundreds of differently performing partners while, at the same time, adequately financing the firm is a Herculean task. At most firms, it is shouldered by a group of five to eight people-the executive/management committee, an independent compensation committee, or a hybrid of the two. In some firms, the process is further closeted by the closed compensation system-a system in which each partner's share of the profits (usually determined by a partner "point" system) and ultimate dollar worth is known only to the compensation committee. But even in firms with the much more common open system model, in which every partner knows what the others are making, the process can be so complex and so discretionary, knowing the numbers does not immediately translate into understanding how they came to be.

"It's rough justice," says Hugh MacKinnon. "How do you value client origination compared to the guy who's working around the clock? How do you value the superstar compared to the critical second chair? It's all judgement calls and relativities."

Even the one quantifiable number every law firm relies on heavily-the billable hour-requires qualitative analysis. "In a vacuum, billable hours don't always mean a lot," says Norman Bacal, co-managing partner of Heenan Blaikie. "High billable hours may mean horrible delegation ability." Worse, particularly in firms that want to encourage teamwork, they may be an indication of file hoarding. And then, there's the fact that not all billable hours are equal. In purely financial terms, as Bacal puts it, "2000 hours at $250 an hour is not worth as much as 1500 hours billed at twice that rate."

That's not to say billable hours don't matter. As pointed out by Trevor Bell at McCarthy TÃ©trault in Vancouver, "Billable hours are obviously significant because in our business billings produce the revenue, and there's probably a closer relationship between hours and revenue than anything else." Bell is the firm's national professional resources leader and a corporate finance/M&A partner.

But these days, most major firms consider a combination of quantitative and qualitative factors, with a view to creating a compensation system that fosters behaviours considered desirable by the firm. The "holistic look at people's contributions" at McCarthys, as Bell puts it, includes criteria such as contribution to strategic objectives, business development, client relationship management, leadership, and firm building behaviour. And, of course, personal financial performance.

At Heenan Blaikie, says Bacal, factors such as how many clients a partner is responsible for and how much work he or she sends down to others play an important role in determining compensation. "We don't care who sent the bill out or who gets originating file credit. Systems based on numbers and statistics are subject to the games people can play with the numbers. They encourage particular types of behaviour that are not good for the firm."

According to Terry Burgoyne, co-managing partner of the Toronto office of Osler, Hoskin & Harcourt, a compensation system that's balanced "between quantitative and more qualitative measures is important in ensuring you're not motivating bad behaviour." At Oslers, he says, these qualitative indicators include peer reviews of partners by partners and upward reviews of partners by associates and staff. The firm believes there is a clear link between these qualitative peer reviews and its ultimate profitability.

Qualitative consideration of qualitative and quantitative factors has become more important as large law firms, maturing as businesses and organizations, recognize that "what gets measured is what gets done"-and that ain't necessarily a good thing. As a result, formula-based compensation systems, which tried to quantify everything, are pretty much dead.

According to MacKinnon, "The change in approach has taken place across North America. There used to be a lot of formula law firms, and a lot of Toronto firms would track credits for originating a file, file responsibility credits, they'd have these big formulas. Hardly anyone does that anymore." Most firms, including Bennett Jones, do try to keep track of such information, but its use is limited. As MacKinnon notes, "We don't try to quantify to a cent who originated what. It's impossible. You introduce me to somebody at a cocktail party, I bring in a file, turns out most of the work is in a different practice area, I pass it on. The guy listened to you because of his past experience with you-who gets credit? If you try to get as precise as some of the formula-based firms did, you'll tear your firm apart."

Another approach that has been dropped by most of the top-tier firms is the "eat what you kill" system, in which personal financial performance-partner contributed 5 per cent of the firm's revenues, therefore gets 5 per cent of the profits-is the end-all and be-all of partner compensation. As firms have grown and transformed from collections of sole practitioners to large business organizations with strategic goals and long-term ambitions, the advantages of that system-simple to calculate, simple to explain-have been eclipsed by the realization that it takes more than lone wolves to build a firm.

"Not a lot of the large firms are on the 'eat what you kill' or formulaic system," concurs Trevor Bell. "Such systems are really not consistent with firm-first behaviour and teamwork."

What systems are there? Despite a certain convergence in views within the higher echelons of the profession-formulas evil, lockstep almost as bad, firm-building behaviours highly desirable-there remain as many compensation structures as there are firms. Trevor Bell suggests that at most firms the compensation system "is the result of firm history, something that has evolved over time." The new, nation-wide compensation system implemented at McCarthys two years ago is built on the foundations of the historical compensation systems of each of the 1989/90 pre-merger firms (McCarthy & McCarthy in Toronto, Clarkson TÃ©trault in Montreal, Black and Company in Calgary, and Shrum, Liddle & Hebenton in Vancouver). It should have come as no surprise that it was the office that had to make the biggest adjustment from its historical system-Calgary-that experienced the most "havoc" as a result of the changes. (See "Single-Profit Pools: Money and Power," Lexpert, February 2004).

For partners at Ogilvy Renault, a closed compensation system is a defining feature of the firm's culture and philosophy. As explained by Ava Yaskiel, co-managing partner of the Toronto office, "It is an example of how we support our firm philosophy, which is built on trust and a team approach. We support collegiality, file sharing, and we want to focus our competitive juices externally." The only people at the firm who know what everyone's making-and why-are the members of the executive committee (EC). In contrast to the model now pursued by most major firms, in which EC members are elected for short, generally two-year terms, the EC at Ogilvy is selected by consensus for an indeterminate period of time.

As noted by Yaskiel, "It is possible for a person to be on the executive committee for five to 10 years. So it's never a large group who has all that information." Additionally, "We instil the confidentiality of compensation early with our associates, right after first year. It's a closed compensation system; you just don't talk about it."

The firm's 1996 entry into the Toronto market, and the creation of an office staffed primarily by laterals used to open systems, posed a challenge. Meighen Demers, with which the firm merged in 2000, had a "completely open system," recalls Yaskiel. "Closed compensation systems are unusual now. People who come here from the other top-tier firms can have trouble adjusting."

However, once they've been through the exercise says Yaskiel, "The Toronto people become the biggest converts. I don't think most of them would want to go back to an open system. I hear of colleagues who have to produce memos detailing how much they have done over the past year. It's basically 'explain to me why you're better than your colleagues.' Nobody has to do that here, and nobody misses that. The closed system takes stress away from looking at things that aren't helpful. You don't compare yourself to your partners, you look at yourself, what you did, and ask, is it fair for me? For 99 per cent of the partners, the answer is yes."

Sean Weir, national managing partner of Borden Ladner Gervais LLP (BLG), the only other major Canadian law firm to maintain a closed compensation system, agrees. "When I talk to partners who are in charge of remuneration at open system firms, they don't spend time talking to partners about what the partner makes, the partner asks them why am I getting paid X while Sally is getting paid Y. Tell me why I'm different. And that's a very negative thing."

As explained by Weir, compensation criteria at BLG include business development, status of collections, the quality of work, the type of practice, the lawyer's reputation and contribution to firm reputation, as well as what the partner is doing for the firm in terms of mentoring, recruitment, or management. "So you take all that and you say, George should get paid this and Sally should get paid this. And George says, I billed about 1800 hours and Sally billed 1800, my rate's the same as her rate, why is she making $40,000 more than I am? Well, it may be that Sally is in a strategic area of practice. It may be that Sally's a much better lawyer. She may be doing a hell of a lot more for the firm."

Weir goes on to point out that, "The only way you can satisfy George is to tell him why he's not measuring up to Sally, which is not good. George's practice may be quite good for what it is. Sally's performing at a different level as far as the firm is concerned, eight years from now she's going to be one of the leaders at the bar, she's got greater client acceptability, etc. etc. Look, George, she's better than you are! So how does George feel when he goes out of that meeting?"

Like crap, but at an open system firm like Bennett Jones, George's hurt feelings are the price for transparency-something highly valued by most firms. Hugh MacKinnon acknowledges that, "There are good arguments for both closed and open systems. Closed systems reduced envy." But, MacKinnon is quick to point out that, "You may have situations where people are fencing with windmills, because you have people surmising maybe he's getting more, I think he's getting more-at the end of the day, you just don't know, but that doesn't stop people from guessing. On the other hand, when a system's wide open, maybe it encourages internal competition. It certainly encourages people to work hard."

The compensation system at Calgary-based Bennett Jones is as open as open gets. "We distribute the statistics we collect every month," says MacKinnon, and partners know what "intangibles" come into play at split time.

As part of the open system at Oslers partners can sign on to the firm Intranet and view online all the quantitative and financial information considered by the compensation committee. Additional communication takes place through a mixture of meetings and written information when the split is made. In contrast to Bennett Jones, Ogilvy, BLG, Heenan Blaikie, and McCarthys, which do the split every year, Oslers goes through its allocation exercise once every two years.

You can't win. As noted by Terry Burgoyne at Oslers, "In my experience, firms that do it every year wished they did it every two years, and firms that do it every two years think that maybe they should do it every year." In the biannual system, theoretically at least, partners stress about their performance and compensation once every 24 months instead of every 12. But the onus on the compensation committee to get the numbers right is even higher-if they make a mistake, whether they hi-ball or low-ball a partner, it'll be two years before they can fix it. For young partners who are rising fast, suggests MacKinnon, two years is a long time to feel unappreciated and underpaid.

"Generally speaking, while our system is not perfect, it has been developed and refined to the point where it is broadly accepted as fair," counters Burgoyne. "That does not mean that everyone is happy every time in how they have done in regard to others, but people are happy with the process. People have to believe the process is fair even if they disagree with an individual result. There are always people who are surprised, both positively and negatively, and there is a process for appeals."

The 190 partners at Oslers are compensated at a "controlled number of levels," a practice increasingly familiar as large firms now freely admit that setting 200-300 different levels of compensation is a nightmare. McCarthy TÃ©trault, for example, slots its partners into 15 different grids nation-wide. At Heenan Blaikie, partners go up and down by sizable sums. "We've discovered that, psychologically, partners cannot distinguish small distinctions," says Norman Bacal. "How do you determine this partner contributed $5,000 more or $7,250 less than that partner? So we work with ranges of $30,000 to $50,000."

Other firms, including Ogilvy Renault and Bennett Jones, respectively at 200 and 120 partners, continue to assess each partner an individual share of the profits. But whether they end up with 175 levels of partner compensation or 13 ranges, none of the major Canadian firms use the "l" word-lockstep.

The lockstep system used by some US firms and particularly prevalent among the major UK firms, has lawyers-associates and partners both-move up in income as a peer group determined by seniority. As Terry Burgoyne puts it, "You're on an escalator, you get to the top at 15 years, and you stay there."

Toronto's lockstep compensation systems, fairly common among the top firms as late as the mid-1990s, shattered, first at the partner, and now, for the most part, at the associate level, as a result of increased competition for talent. Canada's last lockstep systems, belonging to Montreal firms, died during the national and Toronto-Montreal wave of law firm merger during 1999 and 2000.

The "fairness" of the lockstep system, laudable in theory, has limited appeal in practice, particularly for star lawyers. "To have that system requires an enormous rigour in selecting ensure that they will contribute the same as everyone else," says Burgoyne. And, lockstep only works in a market where everyone else is doing it, so your superstar can't cross the street for a bigger chunk of change.

The aversion of lawyers in New York to lockstep is understood to be one of the key obstacles to further trans-Atlantic mergers. Notably, London-based Clifford Chance, as part of the merger deal it struck with New York-based Rogers & Wells in 2000, agreed to temporarily grandfather the higher incomes of some of the New York firm's star performers. When Clifford Chance started bringing the income of New York lawyers in line with its seniority system, some partners faced pay cuts of more than 50 per cent. Despite bonuses and concessions that star US partners be paid at levels higher than the top of the lockstep system, many of the highest paid New York performers have left, including antitrust superstars Kevin Arquit and Steven Newborn who were compensated outside the lockstep system.

Increased partner mobility goes hand in hand with the war for talent that brought down lockstep. This mobility has changed compensation structures in a number of important ways. Earlier systems were usually retrospective: that is, the law firm first made the money and then the partners split it. Heenan Blaikie is one of a diminishing number of law firms to continue to split profits retrospectively. Most major firms do the split prospectively: in the first quarter of 2004, based on the projected 2004 budget, they set the 2004 compensation levels. They split the money before they make it and, if they manage their cash flow well, they distribute most of the profit as they make it.

The reason for the popularity of the prospective system among potentially mobile partners is obvious. The retrospective system allows firms to penalize partners who leave during the course of the year. If a partner leaves a firm during 2004, and the majority of his or her compensation for that year isn't calculated and paid out until 2005, that compensation may turn out to be somewhat less than anticipated. Most prospective systems don't have that club-although, depending on the firm's partnership agreement, the firm may take up to five years to pay out whatever moneys it owes the departing partner.

Even most firms with prospective compensation systems end up owing the partner somewhere between 15 and 30 per cent of his other take at year's end. At BLG, explains Sean Weir, "We will distribute a percentage of the draw on a monthly basis, and quarterly as well." The quarterly distribution is partially intended to help partners-considered self-employed by the Canada Customs and Revenues Agency-to make their quarterly tax payments. "We hold a percentage back in case we don't make our budget," and that last draw is distributed by April 30th, when "partners will have a chunk of tax cash due April 30. It's nice to be able to give them money to deal with that, or use it to pay down a debt or whatever."

For Hugh MacKinnon at Bennett Jones, how a firm distributes money is a crucial component of its compensation structure-and a key indicator of its culture. "What we do, and there are not many firms that do this, is clear out the till every month. After expenses, whatever is in the till at the end of the month, we distribute, based on everyone's share of the profit. This is not by accident. This reflects a real core cultural approach. This is done by firms that are not paternalistic. The notion that somebody has discretion over when you're going to get your money is not tolerated. Pay the expenses, but when that's done, I want my money."

"There's value in getting your money today," MacKinnon continues. He understands why firms make use of quarterly and year-end holdbacks-they want partners to make their tax payments and they want to have the extra cash on hand as "working capital to finance the firm." But, "that paternalistic approach to managing your something that in a firm like ours is just not tolerated. We can manage our own money, and most of us do a good job of it, so mind your own business. That reflects our entrepreneurial culture. All this means is that our cheques vary month to month. If people are not billing and collecting, guess what? You have a smaller cheque. Our approach reinforces the fact we are in business with our clients, because if we are not doing what we're supposed to be doing, it's a thin month on the 30th."

Such an approach requires strong cash flow, and it was one of the reasons Bennett Jones used to do its split based on cash in hand only. Most law firms calculate their revenue the same way they do their taxable income: on a modified accrual basis, which is based on cash and the year-over-year increase in accounts receivable (AR). A few firms used the full accrual method, which included cash, AR, and work in progress (WIP).

A cash only number is lower than a modified accrual number, which, in turn, is lower than a full accrual number. Or, to put it another way, the $100 a partner in the cash- in-hand system is actually more than the $100 a partner in the modified accrual system is making, and the partner in the full accrual system never actually sees his entire $100. The full accrual system, obviously, ends up with the most inflated revenues. Ironically, when the accounting firms made their foray into the legal services market, it was the full accrual system they used, causing considerable confusion and ultimately disappointment among their law firm recruits.

For most partners, the three systems are major arcana, and, as they compare their $100 (or million) to that of their competitors, they assume both are calculated the same way. "We had the anomalous situation where someone would say, I'm making a $100, if I went across the street I could make $105, but calculated the way everyone else did, they were making $120 but didn't know it," says MacKinnon. In 2003, Bennett Jones moved to stating income on the partial accrual basis, like every other firm on Bay Street.

The firm's concession to the prevailing Bay Street standard, which, over the last five years, has become the national standard, underscores the impact the war for talent and partner mobility have had on compensation systems. Although the minute intricacies of their systems are jealously guarded by many firms as one of their "competitive advantages," the compensation negotiations that form such a crucial part of lateral recruitment have "opened up" most of these secrets and led to a certain degree of convergence among major firms.

For many partners, the issue is not "Am I being treated fairly within the firm?" The real issue is "How do I compare to the competition?" It is that attitude and the availability of comparative information-not all of it, mind you, accurate-that killed lockstep. The awareness of partners that they may very well change firms at some future point in their careers is killing the retrospective split. And the move of firms like Bennett Jones from stating earnings on a cash-in-hand basis to modified accrual illustrates how, in the war for talent, the thing that's often talking the most is money.

The firms that continue to adhere to the closed compensation system face similar issues. While their partners can't compare themselves to each other, they do compare themselves to the market. And that makes the burden of the split harder, especially when rewarding top performers is crucial to the long-term success of the firm. "The onus on us to do the right thing is much greater than in an open compensation system," says Ava Yaskiel at Ogilvy Renault. "We better get it right."

If they don't, split time may take on an entirely new meaning.

Marzena Czarnecka is a Lexpert staff writer.