Legal Business Blogs

Comment: Marking your own homework, Dentons and a defence of PEP

It would almost be too easy to pick holes in the letter that Dentons has supplied to the media to justify its attempt to withhold its profits on the basis of Olympian high principle. But I won’t let that stop me.

The letter, authored by Dentons’ chief executive Elliott Portnoy and chair Joe Andrew, sets out a number of arguments why Dentons won’t disclose basic information on the profitability and the margins on which it operates. Without exception they lack substance, though to varying degrees. Indeed, it’s notable that Dentons largely fails to make any of the credible arguments for not supplying figures on profit per equity partner (PEP).

The rationale for withholding PEP focuses on four key areas. In relative terms, the most convincing is the first – that for heavily globalised law firms, PEP is a mis-leading comparison point against rivals concentrated in high-cost areas like London and New York.

Given that non-lockstep firms, especially those with multiple profit centres, will typically offer far higher packages than the firm-wide average in those developed markets, you can argue that a single number deceives. But not as much as claimed. For one, high-margin markets like London are also high-cost and highly competitive – so it’s not easy to make a sizeable profit in them without being very good. Likewise, the sheer size of these markets will typically drag up a firm-wide PEP – offsetting the downward drag of smaller, lower-cost branches. In other words the average won’t be that mis-leading and a firm could easily offer a firm-wide and ‘core market’ figure anyway. This issue also illustrates a genuine strategic dilemma for law firms – international expansion is expensive and is fiendishly difficult to execute without punishing your bottom-line.

The second pitch from Dentons is that reporting law firm financials is a tradition of Western markets and disclosing such results would be ‘merely another sign of a law firm that is governed by the standards and expectations of the US or the UK and not the best interests of a truly global, polycentric firm’. Well, the claim that a US or UK-bred global law firm should go lowest common denominator on disclosure and transparency towards the less sophisticated and well-regulated markets it operates in is, to me, bordering on the distasteful.

However, it is the third and fourth rationales that hit the low point. The third is that Dentons is withholding basic profit information for the sake of clients, with Portnoy and Andrew writing: ‘We believe our clients see reporting of profits as yet another example of law firms being concerned more about themselves than about serving the clients. Industry experts have cited the laser-sharp focus on profits as a leading factor when measuring client dissatisfaction…How many of our clients have told us how upsetting it is that outside lawyers they hire make so much more than the lawyers they have on their own teams?’

Where do you start with that? Clients may well be unhappy about the high margins and profits of their advising law firms – I would always argue they should be more focused on what they are charged rather than the profits of suppliers – but I find it hard to see that clients are bothered with the basic concept of an industry having several recognised measures of profitability, as pretty much all sizeable ones do. Would clients prefer to have no idea that their advisers, on which they rely, may be operating on such margins as to be at risk of failure?

This is also to confuse clients being irritated by the reporting of high profits rather than resentful of the existence of high profits. It is also strange to assert that because a firm won’t be openly disclosing its profitability that there won’t be an internal ‘laser-sharp’ focus on profitability that will be driving behaviours and charging policies that may aggravate clients. The argument that the solution is less transparency certainly flies in the face of general trends in regulation and governance.

Likewise, I would argue that clients are well served to at least know that there could be a link between the 30%-50% margin being achieved by their suppliers and excessive charges. It may be upsetting to clients that external counsel earn more – at least armed with the knowledge they have the information to instruct suppliers whose bottom line offends them less.

And what of the final point, basically the old chestnut that PEP is a poor indicator of quality? As someone who has crunched these numbers for years I totally reject that claim. Providing basic common sense deployed in using counter-balancing indicators, along with obvious adjustments for business model and chosen markets – PEP is a highly accurate indicator of the calibre of a law firm. And compared to earnings per share or price-earnings ratio, for example, PEP is a shining beacon of practical applicability, corresponding as it does closely to what the partners are taking home. PEP also speaks to how law firms actually structure their business – some law firm leaders may wish that cat was not out of the bag but it is.

In the final section – Dentons decides to take the marking of its own homework to new levels by pre-judging criticism of its stance by concluding that its policy is a sign of its trailblazing vigour: ‘Dentons is a new firm dedicated to challenging the status quo, and as such, we question all the old ways of doing things.’

Quite apart from the fact that I would struggle to identify in what way Dentons has challenged the legal industry status quo in general, its policy looks suspiciously like a watered down version of that fellow pioneer Slaughter and May, except Slaughters actually is best in class and has the decency to adopt its approach more completely and without the fuss of portentous prose.

Why bother write on such a missive at all? Well, Dentons has issued only the latest in a long line of self-serving pitches from law firms over the years on this topic. The concept that those being reported on should be able to cherry-pick their own benchmarks has always offended me, speaking as it does to the bizarre notion that the legal industry should continue to operate as some kind of half-baked cottage industry without defined metrics and measures of success.

What about claims that law firms routinely fiddle their own numbers? There is an element of truth in the US, where there is more tolerance of sharp practice. Despite claims that Dentons is breaking new ground, in reality a sizeable number of major American law firms already don’t disclose financials, they just don’t dress that policy up as principle. It should also be noted that some of the institutions like Citi’s law firm team who talk down the accuracy of the AmLaw figures are mounting a sales pitch. There are some discrepancies between Citi’s numbers and AmLaw but the supposed major differences have always looked over-done to me. And much of this debate about transparency is US-centric – years of reporting on these results has led me to believe that the UK profession has been remarkably honest in self reporting, even before the introduction of limited liability partnerships. That transparency and integrity does the UK profession considerable credit in my book.

For all the talk about gaming indicators in law, judging a law firm’s financials is easy. You take revenue, PEP, revenue per lawyer and leverage and cross-reference them on a one, three and five-year basis. I could teach my mother to do it in five minutes and if that test can easily be gamed I’ve never seen how.

That isn’t to say that there isn’t a more thoughtful critique to be mounted of PEP specifically and the extent that it has changed the profession, led to spiralling ‘wage inflation’ and a damaging star culture in law firms.

But down-playing PEP itself cannot reasonably mean not looking at profitability and margins on some agreed measure – at least for anyone looking for a grown-up view of the industry. It may well be in future as the structure of the industry changes – and the dominance of partnership in legal services fades – that there is a move away from PEP. But that day has yet to come. The reason PEP hasn’t been super-ceded lacks mystery: it still delivers and no one has offered a convincing alternative.