(Illustration by Miguel Ordonez)

Consider two workers at the same company. They have the same title. They bill clients at the same rate. But one is paid a third of what the other’s paid. You might suggest that the lower-paid worker engage the services of an employment lawyer and that their clients be tipped off to the trick. Except that the workers are lawyers—at most Am Law 100 firms, in fact, where profits per equity partner are, on average, $1.47 million, compared with $451,801 for nonequity partners.

Not only is the practice business as usual, it’s fallout from the biggest firm management trend of the past two decades—the creation of the two-tier partnership. Twenty years after The American Lawyer began to track nonequity partners, we decided to take a tape measure to the ever-expanding tier and consider its consequences for law firm health.

A fat middle has become the norm, according to a study of the Am Law 100 firms for which there is reliable nonequity census data over the past two decades. The undeniable effect is to alter the profit picture, and perhaps to distort firm priorities.

The two-tier concept can be traced to Chicago more than 30 years ago. “Nonequity partnership originated as a way of increasing leverage but keeping ambitious people happy,” says the veteran Chicago-based law firm consultant Joel Henning, of Joel Henning & Associates. “It offers a wider variety of career opportunities for good lawyers who want to stay at a firm but temporarily or permanently don’t belong as equity partners.” Skeptics define it more succinctly as second-class citizenship. Love it or hate it, the model has proved nearly irresistible to law firms.

In 1994, the first year for which we gathered full nonequity data, most Am Law 100 firms were equity-only partnerships. Today the one-tier club is down to 17: 11 of the wealthiest New York firms and a half dozen old-line firms from Washington, D.C., and Boston. The average number of nonequity partners at an Am Law 100 firm has gone from 19 to 141, with 816 at DLA Piper alone. In 1994, three firms—Chicago’s Winston & Strawn and Katten Muchin & Zavis and New York’s Anderson Kill Olick & Oshinsky—were the only majority-nonequity partnerships. Today there are 31. At nine firms, there are at least twice as many nonequity partners as equity partners. On the extreme, the nonequity partners at Lewis Brisbois Bisgaard & Smith outnumber their equity partners 4 to 1.

In 1994, the first year of full data, the average (and hypothetical) Am Law 100 firm was composed of 35 percent equity partners, 5 percent nonequity partners and 60 percent nonpartners. Everyone knows that leverage has increased since then. But leverage has not increased because the base of the pyramid—the nonpartners—has widened. Rather, the pinnacle of the pyramid—the equity partnership—has shrunk to make room for a middle tier. Among the two-tier partnerships in today’s Am Law 100, the average firm is still 60 percent nonpartner—but the pinnacle as a percentage of the firm has shrunk to 21 percent, and the middle slab has grown to 19 percent.

Stated another way, the average Am Law 100 partnership in 1994 was 7-to-1 equity to nonequity. Today, there are nine income partners for every 10 equity partners among the two-tier partnerships in The Am Law 100. Financially, the mean two-tier partnership has profits per equity partner of $1.35 million and compensation–all partners (both equity and nonequity) of $926,000. The closest real-life example, with a few nips and tucks, is Winston & Strawn, which, aptly, helped to pioneer the model.

The throwback one-tier, equity-only partnership is a completely different animal. At such firms, associates outnumber partners 2.6 to 1 and profits per partner average $2.3 million. In a snapshot, the average one-tier partnership is a slightly bigger version of Deb­evoise & Plimpton.

Income partners in The Am Law 100 are profitable because they earn nonpartner compensation while billing at partner rates, or at least something close to that. If we conversatively posit an effective billing rate of $455 an hour, then everything a nonequity partner bills after 1,000 hours goes straight to the owners’ bottom line. “The nonequity partner group has emerged as a profit center,” says law firm commentator and former Kirkland & Ellis partner Steven Harper. “It’s extraordinarily lucrative.”

Managing partners long ago discovered that increasing the size of the nonequity tier was a way to goose profits per equity partner (PPP), boosting the ability to compete in the market for high-end lateral talent. But the boundaries between the nonequity and equity categories are fluid. At most modern law firms, partners fall somewhere along a spectrum of pay and control, with a few dozen senior equity partners enjoying vastly greater amounts of both than other partners of any title. That makes it easy to game nonequity numbers, and hard to compare heavy nonequity users with those who abstain from the practice. It also raises the question of whether PPP still measures anything meaningful.

A broader alternative measure of success—effectively gauging how much a law firm pays all its partners—is average compensation–all partners, or CAP. “CAP backs out a kind of manipulation of the numbers, and allows you to compare apples and apples,” says James Jones of the Center for the Study of the Legal Profession at Georgetown Law. “PPP is simply misleading the market as to the underlying economic facts. If I were a lateral moving to a two-tier firm, I’d be much more interested in seeing CAP.” (In fact, in our description of the CAP metric, we have long called it the most complete assessment of partner pay.)

When The Am Law 100, ranked by PPP, is reranked by average CAP, the order is scrambled. Thirty-one firms on The Am Law 100 shift by 10 ranking spots or more. Two firms that appear superwealthy by PPP—Kirkland and Boies, Schiller & Flexner—topple out of the top 10, to 19th and 26th, respectively, because they rely on a large nonequity tier. Suddenly Kirkland’s peer is no longer Cravath, Swaine & Moore, but Hughes, Hubbard & Reed. With one stroke on a spreadsheet, Boies moves from the company of Gibson, Dunn & Crutcher, with PPP in the vicinity of $3 million, to that of Weil, Gotshal & Manges, with CAP in the vicinity of $1.6 million.

For an even more dramatic effect, consider the two firms at the Am Law 100 median for profits per partner. Ranked by PPP, Greenberg & Traurig just edges out Arnold & Porter, at $1.35 million. Ranked by CAP, the equity-only Arnold & Porter leapfrogs nonequity-heavy Greenberg Traurig by 31 spots, as Greenberg pays its two tiers of partners an average of $705,000.

Notwithstanding the well-publicized bankruptcy of Dewey & LeBoeuf alumnus Gregory Owens, income partners aren’t poor, and few feel oppressed. “It’s frustrating sort of being on the cusp, but I’m happy to have a decent job making decent money,” says a young nonequity partner at a big midwestern firm who still hopes to make equity partner and requested not to be identified. “Depending on your hours and lifestyle, this may not be a bad permanent gig, especially for those of us who went through 2009 and saw lots of people laid off. Up-and-out is not the best thing if you’re out.”

But some market observers believe that the two-tier model is an inferior institutional design. “I don’t care how you sugarcoat it,” says Harper. “If you take people who have succeeded at everything in their lives and make them permanent second-class citizens, that can’t have a positive effect on morale.”

“Income partners have by far the lowest productivity of any lawyers in their firms,” says Jones. Last year, they worked an average of about 200 hours less, according to Thomson Reuters Peer Monitor. “That to me suggests there are people in this category who should have been asked to leave their firms,” he says. In particular, Jones suspects the numbers hide a sizable group of partners who are disgruntled because they’ve been deequitized.

Henning grants that the nonequity tier shouldn’t be a dumping ground or an excuse to defer hard decisions. But a well-managed firm, he says, will hold out as partners only those lawyers it is proud to call partner. Managed right, he says, nonequity status helps both law firms and lawyers.

“I cannot think of any other profession where the career options are so limited,” says Henning. “Nonequity partnership is a good alternative because there are some terrific lawyers who, for whatever reason, either because of their own preference or the firm’s, are not owner material—maybe because they have family obligations or they’re writing the great American novel, probably because they’re not rainmakers or don’t want to work so damn hard.”

Email: mgoldhaber@alm.com.

SIDEBAR TEXT:

An Asterisk to the Cravath Model

Technically, the firm that invented the one-tier partnership has joined the two-tier bandwagon—at least for now.

In 2013 John White became the first and only nonequity partner in Cravath, Swaine & Moore’s 195-year history. But the chair of Cravath’s corporate governance and board advisory group was not deequitized for missing his hours target. Nor will he be going bankrupt anytime soon.

John White was deequitized to avoid any conflict of interest when Cravath argues before the U.S. Securities and Exchange Commission, which is chaired by his wife, Mary Jo White. Like most nonequity partners, White continues to be held out to the world on the firm website by the word “partner,” unmodified.—M.D.G.