Bluechip New York law firms saw their profits slip in 2008. Susan Beck reports

What has the world come to when Cravath Swaine & Moore has a terrible year? The firm that has served for decades as the touchstone for prestige in the profession last year suffered a 13% drop in revenue and a 24% plunge in profits per equity partner (PEP), and has asked incoming first-year associates to delay their start dates.

As Cravath goes, so go New York's top firms?

While most Manhattan-based outfits had a better year than Cravath – only Cadwalader Wickersham & Taft suffered a steeper drop in revenue and profits – the pain was widespread. All but three of the 15 most profitable New York corporate firms (based on 2007 figures) saw their profits per partner fall. The few that had a decent 2008, such as Cleary Gottlieb Steen & Hamilton and Paul Weiss Rifkind Wharton & Garrison, are bracing themselves for harder times in 2009.

The recent boom that made so many on Wall Street so rich has been revealed for what it was: a shiny but fragile bubble kept aloft in part by false assumptions, wild expectations and, in some cases, fraud. During that time, law firms saw revenue and profits rise at an astounding rate. From 2003 to 2007, Cravath's profits per partner rose 59%, Sullivan & Cromwell's 61%, and Debevoise & Plimpton's 82%; Wachtell Lipton Rosen & Katz's PEP nearly doubled, rising 91%.

Looking ahead, the future for these 15 elite firms is as uncertain as the Wall Street world they draw their strength from. Many of their financial institution clients are grievously crippled and slashing expenses, including legal fees. The backlash against Wall Street may create a new regime that curbs the enormous profits that had become the norm, either through regulation, legislation or market forces. This in turn may leave less money for the lawyers. "The big financial institutions are no longer the most desirable clients the way they used to be," says a management-level partner at one of these firms. "They are all sending out letters demanding, not asking, for significant rate concessions." Decisions about legal fees have, at some companies, been taken out of the hands of the more friendly general counsel's office, he says, and are now the province of an alien purchasing department.

As detailed in The American Lawyer's Corporate Scorecard in April, the decline in corporate activity in the US in 2008 was stunning. M&A was down by 52% (measured by value of deals); the number of initial public offerings was down by nearly 85%; high-yield debt offerings were down 67%; and investment-grade debt issues were down 60%. While litigation, the other big driver for New York firms, has not suffered as much, most clients are pushing for discounts.

During the boom times, many firms leveraged their workforce with associates. At one point, Cadwalader, which threw itself into the structured finance arena, had a leverage ratio of 7.5 (determined by dividing the number of associates and non-equity partners by the number of equity partners). After associate layoffs, it lowered that ratio to 5.8, but its leverage is still higher than all the other firms in this group. The next most leveraged firms are Weil Gotshal & Manges (5.5), Paul Weiss (4.7), Schulte Roth & Zabel (4.3), and Cleary Gottlieb (4.2). The firms with the lowest leverage are Davis Polk & Wardwell and Sullivan & Cromwell, at 2.9.

Dozens of firms across the country have laid off associates, but the top New York firms have been loath to take that step. Now some of the most tradition-bound Manhattan shops are reassessing their principles. A management-level partner at an elite firm that has never resorted to layoffs says that this topic is no longer off-limits. "What is different is that we have never seen anything like what is going on in terms of the impact on the financial industry. It is unprecedented," he observes. "While we are saying we never have [made layoffs in the past], and would like to continue to say that [in the future], there is only so long we can maintain this position. At some point you have to be at the right size relative to your business."

What will that right size be?

Last year, only one firm in this group reduced its head count: Cadwalader laid off 131 lawyers. Some firms found themselves on the opposite end of that scale, increasing their ranks as of 31 August, 2008: Davis Polk's rose 13%; Milbank Tweed Hadley & McCloy and Cleary rose 9%; Sullivan and Simpson Thacher & Bartlett went up 8%; and Cravath went up 7%. With attrition near zero – what sane lawyer would leave their job in this economy? – firms will see their numbers climb just by bringing in a class of first-year associates.

At this point, says one partner in management, firms like his have already cut extraneous expenses and are running "very, very leanly". Cutting lawyers is the only significant cost-saving measure that remains. Of course, partners can accept lower profits. But at some point, if profits drop too low for too long, even the most elite firms will worry about losing partners to competitors, or other types of businesses. "If we are significantly less profitable, that is what you do worry about," says this partner. "You see firms unravelling because they have two to three key players leave."

All of the firms in the top 15 still have profits per partner of at least $1.9m (£1.28m), with most still above $2m (£1.35m). But even for those at that lofty level, seeing your income decline is unsettling. And almost everyone expects 2009 to be worse.

Firms that use a lockstep compensation model, where partners are paid according to seniority, may find more stability when there is less money to distribute. At these firms, the financial pain will be spread evenly among the partnership, possibly leading to a sense of shared sacrifice. But at firms that use a performance-based model, management will have to make difficult decisions about who suffers the most. That, in turn, could lead to internal fights, and possibly departures. Stay tuned.