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Fannie Mae GC: The Law Firm Profit Structure Is Broken

  • Fannie Mae GC: Call Me When I’m Not Sending You Work
  • Before he was hiring law firms, Fannie Mae’s General Counsel Brian Brooks was helping run one — from 2008 to 2011, he served as managing partner in O’Melveny & Meyers’ Washington, D.C., office.

    Not surprisingly, he has some well-formed opinions on the law firm business model.

    In the second installment of a three-part interview with Big Law Business, Brooks argues that, because clients increasingly refuse to pay for expensive associate work, the law firm profit model — which depends on “leverage,” or the difference between associate and partner hours on a matter — is broken.

    The solution, Brooks proposed, is for law firms to approach associate staffing much, much differently.

    “Do what you want with the senior partner rates, but you need to not only hold steady on associate rates, you need to dramatically reduce associate rates if you want to stimulate demand,” said Brooks. “I actually don’t think it’s as tough as most law firm managers think.”

    The Federal National Mortgage Association, or Fannie Mae, is headquartered in Washington, D.C., and is the leading source of residential mortgage credit in the U.S. secondary market, where newly originated mortgages are packaged into mortgage-backed securities and sold to investors.

    Brooks, a graduate of Harvard University and the University of Chicago Law School, has been GC at Fannie Mae since 2014.

    Read Part I of the interview here.

    Part II Excerpts:

    The profit structure of law firms is really broken. The rates of the most senior partners at the best law firms have gone up and up and up. [But] the problem for law firms is that the rates of the mid-level lawyers and associates have gone up and up and up, even faster than the rates of the senior partners, and their value add isn’t the same.

    If you’re going to raise associate rates so fast that there’s not that much of a gap between associates and partners, I’d rather have a hundred percent of the partner’s time, and none of the associate’s time.

    I can’t justify paying seven hundred dollars an hour for a mid-level associate. I just can’t do it. To me, the lack of a gap between associates and partners creates a perverse incentive that law firms need to wake up and recognize.

    It’s all leverage, so you’d be better off having lower rates for associates to induce demand at the associate level. Until you do that, you’ve missed the point.

    Below is an edited transcript of the second installment of the interview.

    Brooks_B08764_highres photo from omm_greybackground

    Brian Brooks (Courtesy of Fannie Mae)

    Big Law Business: What will firms have to do to succeed, in the next decade or so, in light of how law practice is changing?

    Brooks: The first thing I would say is if you just look at the shakeout in the number of elite law firms over time, it’s a pretty sobering story.

    When I came out of law school more than twenty years ago, everyone talked about the Am Law 200. There were these two hundred big law firms, and every city in America, big and small, had its three or four large, elite law firms.

    Ten years ago, nobody talked about the Am Law 200 anymore. People were talking about the Am Law 100. You asked yourself, “Where did all the big firms in Denver and Des Moines and Oklahoma City go?” They all got acquired by bigger firms, or they went under, or they merged locally.

    Five years ago, nobody talked about the Am Law 100. People started talking about the Global Thirty. Then The American Lawyer started publishing the “A-list” of ten firms.

    It’s similar to what happened in the accounting field, where there used to be the Big Eight, then there were the Big Six, now there are the Big Four.

    What does that tell you? One is that, as legal work gets more and more commoditized, it’s easier for companies to do that work in-house. There was a time when, if I wanted a serious class action defense, the rules of class action were so arcane and so complicated, and the cost of document production was so enormous, that I really had to go hire a big firm.

    Nowadays, I’ve got a great in-house litigation group with a terrific head of litigation. You know what? He could do most of that with his team internally with no incremental cost above overhead. I don’t need to go outside for that anymore.

    There are fewer and fewer areas that either can’t be handled in-house or aren’t commoditized to the point where you can go to small firms to do the work.

    What that means is that the demand for large numbers of lawyers at law firms gets smaller and smaller. Now, the demand for a small number of elite partners in those firms might continue to be strong. But for the rank and file lawyers, they have to justify why it’s worth their rate for me to hire them as opposed to just hire a full-time body in-house.

    That brings me to another key point: the profit structure of law firms is really broken. The rates of the most senior partners at the best law firms have gone up and up and up.

    And you know what? I’m perfectly willing to pay it, because for the best partners at the biggest law firms, their value add is enormously high.

    That’s not the problem for law firms. The problem for law firms is that the rates of the mid-level lawyers and associates have gone up and up and up, even faster than the rates of the senior partners, and their value add isn’t the same.

    Since the way law firms make money is based on leverage, which is the difference between the number of partner hours and the number of associate hours on a matter, if you’re going to raise associate rates so fast that there’s not that much of a gap between associates and partners, I’d rather have a hundred percent of the partner’s time, and none of the associate’s time.

    That’s the incentive that you’ve created for me as the client. Do what you want with the senior partner rates, but you need to not only hold steady on associate rates, you need to dramatically reduce associate rates if you want to stimulate demand.

    I can’t justify paying seven hundred dollars an hour for a mid-level associate. I just can’t do it. To me, the lack of a gap between associates and partners creates a perverse incentive that law firms need to wake up and recognize.

    Big Law Business: It’s tough though for firms, isn’t it, if the firm’s profits are dependent on those associate rates?

    Brooks: I actually don’t think it’s as tough as most law firm managers think. I say that in two respects. First of all, as associate rates have gone up, what have companies done in response? What they’ve done is say to their law firms, “We will not pay for first-year or second-year associates at all.”

    Ironically, when you started going through these various fee levels, it’s not that companies have paid those increasing rates. Those rates have been effectively falling to zero, because no one will pay any rate.

    It might’ve been different had those lawyers been charged at a lower rate. Ironically enough, at x hundred dollars an hour, you can actually sell some of that time, but at 2x hundred dollars an hour, you can sell none of that time.

    The second irony is: people think law firms make money on the billable hour, but when you sit down with the business consultants of the world, and you really delve into the numbers, you find out they don’t make money on the billable hour. They make money on leverage.

    Law firms have a small number of partners who take the profits, and a large number of associates who work on salary. There’s no amount that you could charge out the partners at that would make them profitable.

    You could pick any number of thousands of dollars an hour, and there is no level at which you can sustain partner profits based only on their own billings. It’s all leverage, so you’d be better off having lower rates for associates to induce demand at the associate level. Until you do that, you’ve missed the point.

    Big Law Business: Is part of this about loyalty, and investing in a relationship? Is it about companies saying, “give us those lower rates, and you’ll profit from that in the long run”?

    Brooks: I think that’s part of it. But it’s really a mathematical issue. It’s not, I think, at the end of the day, a loyalty issue. I mentioned the firms we work with. We love these firms. They’ve gotten great results for us over a long period of time.

    I think what you see over time is more and more of that work has migrated to the partners we know and trust, and we have done much more management on the number of associate hours and the identity of the associates we allow to staff those.

    There would’ve been a time twenty years ago when no general counsel’s office would’ve paid any attention to who the third-year associates were. Now that they’re so expensive, we don’t want anybody working on our matters who isn’t going to be on them for the long term, when we’re capturing the value of their learning curve and everything else.

    I think it’s because the compression between associate rates and partner rates has gotten so great.

    Just to be clear, I’m not suggesting that firms should lower their rates. It would be great if they wanted to lower their rates, but what I’m suggesting is you can’t raise partner rates and associate rates in tandem, because the value proposition for those two kinds of people is different.

    The more you compress those rates together, the less you’re going to be able to get leverage on your matters. That’s why significant numbers of law firms are either failing or retrenching or consolidating. It’s because they can’t sell their associate time anymore.

    In Part III of the interview, Brooks will discuss the “usual suspects” problem, and law firm diversity.

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