A primary long-term strategy for a lot of U.S. law firms is the establishment and growth of an office in the U.K. or continental Europe.  But such global aspirations are becoming much more expensive and risky as the value of the U.S. dollar falls against the British pound and the euro.  For firms looking to enter Europe, the question will be whether the opportunity is good enough to justify the dollars at risk.  For the 120 or so U.S. firms that already operate offices in the U.K. or Europe, the question is whether they will be able to hang on to what they have already accomplished.  For firms with partners situated in China, it also gives us a preview of what is coming late next year when the renminbi is revalued against the dollar. And, should the U.S. slide into a recession – particularly if it occurs faster in the U.S. than in Europe – the impact on partner compensation on both sides of the Atlantic could be the undoing of some firms.

The problem starts with the partner compensation system of the firms.  U.S. firms pay their European partners in either dollars or their local currency – either British pounds or euros.  If compensation is calculated in dollars, the risk of currency fluctuation is borne by the partner.  That is, if the value of a dollar goes up, the partner enjoys increased purchasing power in the country where he lives.  If the dollar goes down, the partners’ compensation isn’t worth as much.  On the other hand, if the partner is paid in local currency, then the firm takes the risk because it must pay in dollars to purchase the local currency to pay the partners.

This, of course, is not a new issue.  Currencies constantly fluctuate against each other.  The difficulty is that the value of the U.S. dollar is at a 26 year low against the pound.  Partners in the UK and Europe who are paid in dollars are screaming as they stand to lose $100,000 or more this year due to the conversion.  Back across the pond, U.S. partners of firms that pay in pounds or euros are screaming because their profits take a hit in order to make up the exchange difference for the European partners.  And when partners are unhappy, they begin to consider their options.

The problem for firms paying foreign partners in their local currently hasn’t hit the radar screen of many firms yet.  The UK and European partners are happy because they are being paid what they expected to be paid and because the number of U.S. partners is, for most firms, so much larger than the number of foreign partners that the impact of the increased cost of buying the necessary pounds and euros has not become apparent on the firm’s financial statements.

But the issue is front and center for UK and European partners who are paid in dollars – and they are very unhappy!

To get a better feel for the magnitude of this problem and the way U.S. firms are dealing with it, we interviewed a number of large firms with extensive overseas operations.  While we can’t share the names of the firms, we can share what we found to be four basic approaches to the issue being used:

1.  Ignore the problem.  This is not as hardhearted or as short-sighted as it may seem.  For firms that have traditionally paid in dollars, a change could be both politically difficult and expensive.  U.S. partners would point out that for years foreign partners benefited from the strength of the U.S. dollar and were effectively paid more than they would earn at a domestic law firm where they would be paid in local currency.  For firms whose European operations have not yet turned the profitability corner, the politics among partners back home may make this the only available option.

2.  Take a bullet for the Brits and the Europeans.  Having the foresight to see this problem coming, some firms have sought to relieve the risk from the European partners.  There are several common ways of doing this with differing levels of risk for the firm.
• Set an exchange rate at the beginning of each year based on the current rate at year end or by using a three or five year rolling average.  This provides some protection for the partner (and a win when the exchange rate goes the other way) without having to accommodate the volatility of currency markets.
• Establishing a collar and cap – a range of positive or negative fluctuation outside of which there is adjustment by the firm, e.g., the conversion rate is adjusted only if the fluctuation is more or less than five percent.
• Paying at the prevailing rate each time a distribution is made.  This is among the most common means of providing protection, but it is also the most risky for the firm.  Because, in many firms, large amounts of compensation are paid out in the latter part of the calendar year, the cost to the firm for a rapidly declining dollar could be daunting.
• Use subjective bonuses to cover partners’ currency fluctuation losses.

3.  Develop a hedge.  A number of firms have traditionally provided a hedged investment to at least partially protect partners from currency fluctuations.  Typically, participation is voluntary and in most firms few partners have taken advantage of the vehicle because, with a strong dollar, it has historically worked against their interests.

4.  Provide COLA.  Some firms with offices in a variety of locations (both in the U.S. and globally) provide partners with a cost of living allowance which partially offsets a loss of purchasing power for partners in expensive locations (including partners in New York and San Francisco).

The Real Problem
Aside from the knotty problem of keeping partners happy with their compensation, the current fluctuation issues are the tip of what may become a very large iceberg.  For years firms have accounted for the difference in the cost of living among U.S. cities with the logic that different cities permitted different billing rates, and those rates roughly tracked the cost of living in the city.  For example,  New York City is about half again as expensive a place to live and do business as Kansas City (or at least that’s what the economic statisticians tell us) and New York City billing rates are at least 50 percent greater for comparable lawyers than in Kansas City.  The result for a firm with offices in both Kansas City and New York City is that the New York lawyer will have larger statistical performance fueled by the higher rates and earn a proportionately higher share of profits from the firm.  And, in the greater scheme of things, it all balances out.

A lot of U.S. firms carried this same logic with them when they opened offices in other countries.  Partners in less prosperous countries had lower economic performance and got paid less.  Partners in expensive places like London had much higher performance and were paid more.  The value of what partner compensation will buy all comes out about the same – the famous “Big Mac Index.”

Unfortunately, two problems are impacting on this neat little system.  The first is the volatility of currency and the fact that the value of what currencies will buy is changing much faster than the core economics of an office that drives changes in partner performance.  That is, increases in billing rates can’t keep up with the devaluing of dollars, causing a disruption in the value of performance compared to the value of compensation.

The other problem is that law firms really have become global organizations.  Work moves around the system to the extent that the location of the client, the responsible partner and the lawyers doing the work may be on different continents.  If the balancing of differences in the value of work performed and compensation ever really did work internationally, it likely won’t for very much longer.

There are two results – a long-term and short-term.  The short-term is that UK and European law firms will enjoy a buyers market in the lateral acquisition of lawyers.  The dollars involved are so large for partners with a healthy portfolio who are paid in dollars that the most disgruntled will walk across the street to work with domestic firms and be paid in local currency or join another U.S. firm that offers an effective currency hedge.  Back at home, the losses for overseas operations will look even larger with the exchange rate and, with the loss of some of the laterals that firms paid so highly to get in London, many firms will become much more bullish in implementing their European growth strategies.

At the same time, UK firms, for which the risk of U.S. expansion and New York partner compensation has been too great to make serious inroads into the America legal scene, will find the U.S. among their least expensive growth options.  Freed from the lengthy notice periods common for lawyers moving laterally among firms in Europe and with pockets full of cheap dollars, expect British firms to go on a shopping spree in New York and, perhaps, elsewhere.

What can U.S. firms do?
1. Take a hard look at U.K. and European offices and understand the value that the office brings and who provides that value.  This is not the time to continue the expense of bad decisions that no one has the nerve to admit.
2. Take reasonable steps to make foreign partners whole through a bonus or indexed compensation program.  Install a hedging program through an international bank and force foreign partners to use it.  This is one of those times when you have to protect partners from themselves.
3. Weigh your strategic options.  Make sure your foreign initiatives are clearly articulated and have measurable goals, including the risk/reward of currency fluctuation.
4. Drive implementation separately from strategy.  If the strategy is to follow your client base to Europe, it does not necessarily mean an office in Munich.  Consider alliances or joint ventures to reduce the dollars at risk in foreign investment.
5. Make sure your firm has the banking relationship and internal management horsepower to deal with currency issues.

The business of hedging risk involves precisely understanding what the risk is and then deciding what reward is necessary to justify the risk.  Law firms are risk adverse organizations but, if they are to compete globally, they are going to have to learn to accept and deal with risk.  The typical legal reaction is to move slowly and cautiously but, as the old saying goes, “It doesn’t work to leap a twenty-foot chasm in two ten-foot jumps.”   This may be a defining moment for the legal industry globally.  It will be interesting to see what happens.