Paying your way

Any adjustment in remuneration policy is likely to be one of the thornier issues for management to grapple with in response to the economic downturn.

By Fergus Payne, partner and joint head of the partnerships and LLP team, Lewis Silkin LLP

The boom times for law firm profits are over for now. After years of firms announcing record profits and being on a seemingly upward trend, a large number of firms currently have financial-management issues to address as clients look to slash their legal expenditure budgets in this difficult trading climate. Firms are having to deal with the issues of falling workloads, retaining star performers, protecting profits so far as they are able, and, in extreme cases, simply survival.

It is no wonder that we are seeing swingeing cuts in overheads, most obviously in relation to staff costs, leading to rounds of redundancies, particularly in departments where workloads have been hardest hit and (perhaps earlier than previously seen in an economic downturn, and certainly in larger numbers now) partner departures and de-equitisations. All of this means law firm managers are facing new challenges and difficult decisions in relation to partner remuneration. The effect is being felt across the board, for salaried, fixed-share and, in particular, equity partners, whose reward can be the most elastic of all, forming the final part of the profit matrix.

Model merits

One assumes that most firms will be eyeing the publication of the 2009 property per equity partner (PEP) figures with some trepidation, being keen to know how peer and rival firms have fared.

So, how well equipped for the current economic climate are the typical models for partner remuneration? Most firms operate either a traditional lockstep system at one end of the spectrum, or a purely merit or performance-based system at the other. ‘Eat what you kill’ is this at its most extreme. The traditional full lockstep allows for the partners to achieve a full profit share in equal steps over a pre-determined number of years, and time served is the only requirement. A merit or performance-based system means that a partner’s profit share is determined solely with reference to performance; typically with a high emphasis on his or her personal performance. Of course, there are now many variants operated in practice; particularly variations on the traditional lockstep system. A hybrid lockstep follows the traditional lockstep, but with the flexibility to accelerate or moderate the speed or size of steps to achieve a full profit share, based on individual assessment. Partial lockstep adds a performance element to the conventional lockstep so that the basic profit share will follow full lockstep, but with any additional profit share dependent on individual or departmental performance. Increasingly, law firms have begun to use ‘bonus pools’ to address issues both of underperforming partners, and the retention and reward of high-performing partners.

Within their own remuneration model, firms might also include other provisions such as a decrease from plateau profits once a partner has achieved a specific age, or one that is linked to underperformance. Safety nets are sometimes used to ensure that the partners’ base profit share does not fall below a specified figure.

Clearly one of the most significant challenges in the current economic downturn is how to properly reward partners where some parts of the business are thriving and others are not, either because of market forces or through genuine partner performance (or lack of it). Often this can go right to the heart of a firm’s partnership ethos and culture. There was a time that partners experiencing a recession would have accepted that some parts of the business will not perform as well as others and just lived with the financial consequences of this. Arguably, firms are now far more business focused, however, and a desire to maintain margins and partner profits have taken on greater significance. With this recession, it appears to be the case that there is a greater disparity between the higher and lower-performing departments at firms than has previously been seen.

Another factor is the widespread inclusion of provisions in partnership and LLP members’ agreements permitting the partners on a specified majority, or even the management committee, to require a partner to leave for no cause. Little wonder then that one has read of so many partner redundancies and de-equitisations in recent months.

However, it is unlikely that there will be much appetite outside a firm’s management team for any wholesale changes to remuneration structures in partnership or LLP members’ agreements in the current economic climate. Although some firms are contemplating, or have already implemented, limited structural changes, the majority of partners are unlikely to view such changes with anything other than suspicion.

Drawing in

Clearly some action can and, in the case of some firms, must be taken in relation to payments to partners, if not necessarily through structural changes to the remuneration system. The most obvious of these is to reduce or control the partners’ monthly drawings. This may be badly received where partners have begun to treat their drawings like a salary and are reliant on the payment for regular outgoings and will face a detrimental effect on their living standards. For many firms with a drawings policy closely aligned to regular distributions of prior year profit, this will also necessitate a rigorous analysis of the firm’s current cashflow forecasts. Inevitably, this is then going to lead the firm’s management to address working capital management issues and the need to generate fees and collect cash as quickly as possible. In many ways cash collection will take on a greater emphasis than ever, with the need to ensure that clients with ailing businesses don’t simply become bad debt statistics. One might anticipate that the trend in recent years for firms to link drawings and distributions to the collection of client debts will gather more momentum.

It would be an imprudent firm that continues to pay drawings without real regard for the firm’s annual budgeted profits. This is likely to be less of a problem where a firm has a policy of paying relatively modest monthly drawings but aims to make regular distributions of prior-year profit and/or further payments on account of the current year’s anticipated profit based on achieving specified financial targets. In the current climate, any drawings policy will need to be operated having very close regard to the firm’s cashflow forecasts.

The potential knock-on effect of all this is that it may become difficult for some firms to pay out prior-year profits, with pressure already on regular expenditure including partner’s monthly drawings. The danger is that these unpaid sums become, in effect, partnership capital if locked in on an indefinite basis. A firm’s bankers may also have their own views on appropriate levels of distributions to partners in situations where the firm’s trading has deteriorated.

Firms may also need to consider whether there has been any potential overdrawing in the previous financial year, and whether they were slow or did not address declining profits early enough in the relevant trading period. The potential issues in this situation are twofold. First, a partner may find that his or her current account is overdrawn, and depending upon terms of the firm’s partnership LLP members’ agreement, may be required to make a cash repayment. Second, overdrawing may constitute a breach of a firm’s banking covenants.

Difficult departures

Another area that may affect a firm’s approach to partner remuneration is the obligations the firm assumes in relation to the departure, or de-equitisation, of partners. Individual partners may negotiate compensation and/or accelerated payments of undrawn profits and capital, which could, in some circumstances, place additional strain on the firm’s cash resources.

The flip side of this is reaching agreement with some of the remaining partners, either to accept de-equitisation, which leads to them taking a reduced profit share, or working less time with a commensurate reduction in their profit share. This latter approach reflects the more enlightened approach to overcapacity at associate level, where an increasing number of firms have introduced flexible-working patterns, sabbaticals and other measures that reduce overheads but also avoid redundancies.

As well as seeking increased facilities from their banks, firms may need to look at persuading equity partners to contribute additional capital, assuming that their banks are willing to advance new loans on acceptable terms.

Another management tool may simply be the promotion of fewer partners in the annual cycle. The announcements of partner promotions by firms with a financial year ending on 31 March or 30 April 2009 would tend to suggest that this is already happening.

In truth, a combination of all the above measures are most likely being adopted at present, without necessarily bringing much peace of mind for management teams in the short term. It should become clearer over the next six to 12 months what the effect of such measures has been, and possibly which measures some firms have adopted and how successful they have been individually. Until that time, with trading conditions continuing to be difficult, firms will need to decide on, and implement, the measures they believe will work for them as quickly as possible.

Fergus Payne is a partner at Lewis Silkin. He can be contacted at fergus.payne@lewissilkin.com