We now know that Dewey issued guarantees to many laterals — not at all unusual — and to many incumbent partners — extremely unusual. Based on public reports, many of these guarantees had the following characteristics:
- They ran for more than one year; and
- They were not tied to the firm’s performance, nor so far as Dewey has disclosed, to the individuals’ performance.
Now it’s worth stepping back for a minute to ask whether this sort of compensation arrangement has any analogues in the financial world.
I’d like to suggest that what the Dewey partners with guarantees had negotiated with the firm was essentially a contract that not only fixed their compensation at a very generous level, but simultaneously permitted them to opt out of their financial involvement with the firm’s performance (and possibly their own). If this were the financial markets, what these partners have functionally done is buy a “put” option on Dewey itself. (Yes, yes, I know the analogy isn’t exact; that’s why it’s an analogy. But stick with me here.)
A put option gives the owner the right, but not the obligation, to sell an underlying asset at a specified price on or before a date certain. Importantly, should the buyer of the put option choose to exercise it, the seller of the put option is obligated to purchase the underlying asset at the specified price regardless of its actual price in the market on the exercise date.
In a nutshell, the buyer of the put is purchasing insurance against the value of the asset declining while the seller is wagering the asset will maintain or increase its value. Thus:
- Dewey partners with guarantees have the right
- To collect their specified compensation
- On a date certain
- Regardless of the financial performance of the firm (or the partner personally).
Courtesy of Wikipedia, here are the generic strategies of buyer and seller of puts in a nutshell:
The put buyer either believes that the underlying asset’s price will fall by the exercise date or hopes to protect a long position in it. [...]
The put writer believes that the underlying security’s price will rise, not fall. The writer sells the put to collect the premium.
So: Dewey partners with guarantees (put buyers) wanted to protect their position even if Dewey itself suffered reverses or underperformed. Dewey itself (the put writer, as it were) was willing to assume the risk that the firm would underperform in order to gain the marquee names of partners with guarantees or else to protect its investment in existing partners (which was rational from the firm’s perspective since it didn’t believe material underperformance was a realistic possibility).
Now let’s see how asymmetric the payoff calculations are for these two positions.
The following two charts are apropos puts on equities, but extrapolate in your imagination. Consider the horizontal access not “share price at maturity” but “fair market value of partner’s services when the guarantee is due”; that’s fairly straightforward. Figuring out what the “premium” represents in Law Land is a bit more problematic, but if you care to make the heroic assumption that all involved are behaving rationally, it is a stand-in for the amount of compensation sacrificed by the partner receiving the guarantee in order to negotiate the guarantee.
This makes sense: I should be willing to sacrifice some portion of my probable but otherwise uncertain compensation simply in order to lock in for certain what I’m going to get. From the firm’s side it makes equal sense: It’s hard to justify guaranteeing a partner the highest compensation he/she could earn if everything goes perfectly. The firm can and should rationally expect to get “a break” from that best-of-all-possible worlds compensation level in exchange for issuing the guarantee.
Of course, it’s at least equally likely that firms and partners don’t negotiate this way with each other at all, and if you prefer to believe that, then the “premium” is arguably much closer to zero than the graphs indicate. This does not vitiate the analysis in the slightest.
Here’s the schematic payoff for the put buyer (the partner with a guarantee):
And the payoff for the put writer (the firm):
To call the payoff matrices asymmetric is to belabor the obvious.
Why, you may be asking yourself by now, would the two parties enter into such an arrangement? Frankly, their intent is irrelevant to the analysis: This is simply meant to portray and help explicate the nature and potential consequences of the bargain.
But if you care to speculate, the most logical explanation is probably that no firm (certainly senior management of no firm) expects the firm’s fortunes to decline; the risk of being “short” the put is presumed to be imaginary. The partners’ motivation is presumably more straightforward, acquiring an insurance policy against disappointment.
What matters is that this whole exercise of deconstructing the consequences of puts on equities in the financial markets is an analogy and only that. Shareholders are presumed (certainly under the efficient markets hypothesis) to have no ability whatsoever to influence share price, so it’s the unseeing and unfeeling operation of the market that determines who’s pleased and who’s sorry that they entered into one side or the other of the put transaction.
This is quite the opposite of partners, particularly significant rainmaking partners, in a law firm; decoupling their financial fortunes from the firm’s performance would seem to violate the very spirit of what partnership should mean. Many observers argue the original sin of investment banks was going public, eviscerating the notion of partnership, and substituting the infamously named “OPM” in its place: Other People’s Money. We could do worse than to take a lesson from that sorry, expensive, and checkered history.
Why External Hires Get Paid More, and Perform Worse, than Internal Staff [Knowledge@Wharton]