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February 10, 2009 5:30 AM

Welcome to the Future: The 2011 Scenario and The End of Leverage

Posted by Paul Lippe

I just got back from London, where I met with my friend "Dave" from the legal department of "GlobalBank," which operates in Europe, North America, and Asia. In 2007, GlobalBank spent around $700 million on legal costs, making it likely one of the ten biggest clients in the world. In 2009, no one really knows, but spending will be more like $250-300 million, notwithstanding a bump in restructuring, layoffs, and investigations. According to Dave, "we have been through four rounds of layoffs so far. In addition to half of my team and several of my peers, my boss, my boss's boss and boss's boss's boss all have been let go. We expect the recession to last through all of 2009 and most of 2010, but then hopefully things will start to get better."

A mere 11 months ago--a lifetime in meltdown years--a group of industry experts published the Legal Transformation Study. The study outlined four scenarios for the evolution of the legal industry by 2020. The folks behind this are offering a free Webinar to introduce scenario thinking.

Let me offer my own 2011 scenario in the simplest possible terms.

As Dave and others are now saying, the recession will last through 2010. Law firms will use this period to substantially restructure, and beginning in 2011, things will start growing again. While there's a lot of detail and nuance around the form this restructuring will take, it can be described in simple terms.

A typical law firm bill in January 2011 will generate the same dollars for partner work as it does today, but it will generate half the revenue for associate work. Consider a bill in July 2008 for $1,000,000, representing $450,000 of partner contribution, $500,000 of associate contribution, and $50,000 of 'other'; in January 2011, the bill for an essentially identical project will be $800,000, reflecting $450,000 of partner contribution, $250,000 of associate contribution, and $100,000 of 'other.'

Whether this is accounted for as hourly billing or "value billing" is not particularly strategic, except that to measure differently will of course incentivise firms to be more thoughtful about how to structure work.

Where will those dollars go?  Four places.

1. Clients will just flat out spend less, drive harder bargains, and get more for their money.
2. Some work will go to outsourcers, whether onshore or off.
3. More work will go to contract lawyers or proto-associates not on any kind of partnership track.
4. Some associate time will get replaced by technology.

Why am I so confident that this will happen?

First, associate time is a pricing mechanism, not an indicator of value. Like so much in the modern law firm model, the explosion in associate hours, rates, and leverage began with the Cravath IBM antitrust defense in the 1970s and 1980s, when the firm discovered that in the quintessential "bet the company" case IBM would willingly pay full freight for associate time on massive and pretty routine document review, and that in turn would drive up Cravath's profits dramatically. Since this wasn't particularly compelling work for the associates, the firm had to raise salaries to hold onto folks, triggering the great associate salary escalation.

Second, clients have always recognized that associate time is overpriced. Every client I know views associate time as the price for getting access to partner time and to the firm "brand." In truth, there are two billable hours: the partner's, which should reflect deep expertise and judgment about the client, the law, and best practices, and the associate's, which is generally spent on some form of information processing, which clients recognize as relatively poorly managed compared to other arenas of information processing. As Susan Hackett, general counsel of the Association of Corporate Counsel, recently put it, "I don’t have a problem with the $1,000-an-hour lawyer, but the $350-an-hour junior associate isn't worth it."

Third, as individual partners follow the example of Fred Bartlit and others and spin out of big firms with an "anti-leverage" model, they will be able to charge substantially less than traditional firms. While some sliver of work will still require the very large firm, enough won't, so that firms will have to largely match the boutiques for efficiency gains, or they'll have to shrink radically if they want to do just "high end" work.

For you math majors out there, you will have noticed that the 2011 scenario locks in a 20 percent drop in firm revenues. That's right. So firms will have to find ways to cut at least 40 percent of overhead to maintain profits (more on that in a subsequent column).

In another London meeting, a very able head of knowledge management for a Magic Circle firm quoted the Nobel Prize winning physicist, Sir Ernest Rutherford. "Gentlemen, we have run out of money. It is time to start thinking."

Pretty good advice.

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Paul, you're spot on. The next two years look to be catastrophic for the traditional law firm business model.

Here's something else that might not survive: the law firm associate. As leverage declines, so too does the need to develop and maintain vast grazing herds of associates within firms. Partners are going to have to start thinking seriously about what purpose associates serve when they no longer constitute the bottom two-thirds of the profitability pyramid. If you can't sell the billable hours they've been churning out, what will become of them?

Are associates really future partners in training, as the recruitment brochures maintain? Then you need to actually train them, you need a better system for identifying, assessing and hiring them, and you need to calculate how many future partners will actually come up through your own ranks, as opposed to coming through lateral hiring.

Many associates, unfortunately, are hired to be billing machines, not partners in development. Should the machine stop working, then everyone will have some hard decisions to make.

Brilliant analysis. The world economy's tanking requires massive restructuring. To stay alive, law firms will have to do what the article describes.

This is an excellent analysis and the prediction seems right. But the future of law firms, regardless of the economic model, requires engaged and well-trained younger lawyers who aspire to do what partners do. The challenge will be to come up with a model that elicits, supports and rewards that kind of drive.

A big question will be how to give new lawyers the experience, learning and attention they need to advance their professional abilities and interests. Ages ago, Steve Brill (I think) floated the idea of an internship period. After all, almost every other profession has a post-graduate-supervised-training requirement. But not surprisingly, this idea died quickly; maybe it should be reconsidered now. Some firms, like Ford & Harrison, have turned the first year of practice into a learning rather than billing year for associates. There are many other possibilities for firms willing to be innovative. That has been a very small group until now, but as Jordan notes via Sir Rutherford, the lack of money may lead to some serious and creative thinking.

Ida –

Excellent points.

My daughter is heading off to Mississippi soon as part of Teach For America. The level of rigor with which TFA approaches preparing newly-minted college grads for the classroom is light years ahead of what firms do with newly minted associates. In any high-performance organization, it is all about people.

Those $1000/hour lawyers were once $350/hour associates. If associates don't exist at firms there won't be any partners in the future (no lateral ones either). I am a fourth year associate at a large law firm. I have always thought that law firm associates do a lot of the "heavy lifting" - they do the research, the review, the drafting and the memo writing (the law after all changes and while experience does have significant weight it is not everything) that often allow partners to give the .2 billable hour answer. At the same time, I have seen a significant amount of time wasted on tasks that could have been handled by a non-lawyer.

I think efficiency is key. Because of minimum billable hours, no one is rewarded by coming up with the best contract or brief in 3 hours if it could have taken them 9 hours. As lawyers we have to, and most of desire to, give the "best" answer or product but young associates should be encouraged to do so efficiently and to understand the cost/benefit analysis to a client.

This does not mean that a firm will not be able to make money but it will mean that it will need many more clients and many more matters to make the same amount of money. But should not high quality, tempered by efficiency, bring in new clients? If the market asks for it maybe it will finally happen.

While it is a fair guess that firms may become less leveraged and more legal work will be done inhouse or outsourced to document review shops, it is also true that future partners will not be recruited from the ranks of contract lawyers and Indian document review staff. There will be associates in the future. While it is understandable that 21 minutes of partner time valued at $1,000/hr is somehow more palatable than 1 hour of associate time at $350, it is also important to realize that with fewer associates, the partner would have to do more work herself. At the end of the day, leverage is not the clients' enemy, inefficiency is. What is more likely to happen is that more firms will charge 'for services rendered' rather than by the hour, at least with respect to work of a more recurring and competition exposed nature.

Great points, Paul. More fuel for the argument that value alone won't cut it in this market.

John

Paul,

I've posted a response at my blog, linked via my name. Although I agree with your central conclusion, I think the first and second points you made are contradictory and gloss over one of the central causes of the leverage model, which is the internal dynamic of a large corporation.

No one ever has to apologize for hiring Cravath, DPW or S&C, blowing seven or eight figures, and losing. They're the best, it's a sign of strength to the other side, it deters people in the future, blah, blah, blah.

No amount of theoretical economics will dissuade companies from that thinking -- they will need to be simply unable to afford it. Not 'worry about its value,' but flat-out not be able to meet the bills.

One of the ways I know this is quite simple: there has been a huge, thriving "boutique" market for years, with thousands of excellent lawyers available at a fraction of the price of BigLaw. And, still, BigLaw has thrived. The downturn will not change that psychology overnight.

Paul: great piece. Do you have a perspective on how clients are reacting to the ongoing layoffs at firms? Are they applauding efforts made by firms to reduce costs, a reduction that will eventually translate to lower fees and increased efficiency? Or are they asking themselves why firms only focus on reducing costs when partner profits are affected? How are they going to react when firms eliminate millions of dollars of staff expenses without lowering fees?

Law education in the US is too expensive. Many law graduates take on jobs as lawyers afterwards just to pay the student loan.

An associate's complete lack of value to a client is also a consequence of the poor training you receive as a lawyer in the US.

Most law schools are even fairly incapable of preparing you for the bar.

Let's hope that law schools are going to feel some competitive pressures to improve quality.

A massive scaling back in associate time spent on large matters may seem like something clients want, but in practice, I just don't think that the clients are going to find the cost cutting you suggest appealing.

Doc review, for example, is a big expense and it is rightly considered to be fairly dull and menial work. But the reason there is so much associate participation in reviews is because the documents being reviewed are very sensitive, and errors can have consequences that are very serious.

Delegating more responsibility to contract attorneys is riskier than paying for associate time, and delegating this task to lawyers in a foreign sweatshop is extremely dangerous.

If big clients try to cut their litigation costs by outsourcing document review, three things are going to happen.

The first is that privileged and damaging documents are going to start getting accidentally produced to the opposition with much greater frequency, negatively impacting litigation outcomes.

The second is that confidential client documents are going to get leaked. When the documents being reviewed contain valuable information and the clients hand them to people who are paid peanuts, some of the information is going to get sold. Some of it is likely to end up on the Internet. The harm caused to clients from such leaks could be significant.

The final likely event is that embarrassing personal information about document custodians is likely to be disclosed. Document review in major litigations involves reviewing the e-mail records of prominent people, and these e-mails often contain personally sensitive information.

While inadvertent disclosure of privileged docs can sometimes be corrected by clawing back the docs, once a personally embarrassing document gets out into the world, little can be done to limit the damage.

I don't think the cost savings for clients will be worth the risks associated with transmitting confidential information to people who cannot be trusted.

Additionally, it seems unlikely that outsourced reviewers will be able to identify significant documents, so firms that work with these providers may find themselves embarrassed when confronted with damaging documents.

It may be that clients will be more willing to negotiate less cumbersome discovery in the interest of reducing costs, for example, by reducing the relevant time period of searches, or agreeing to only review documents that contain search terms rather than demanding review of every item.

But agreeing to such limitations still carries a risk that an important document will somehow fail to appear in the search, impacting the outcome of the litigation.

Clients driving harder bargains will force law firms to produce efficient work. That means good work at the lowest cost. Alternative pricing and deep discounting does not argue for a de-emphasis of leverage as a driver of profitability. While most firms are cutting headcount through associates and staff, we believe that the smarter firms are the ones who are taking this opportunity to deal with underperforming partners as well.

You assert that “associate time is a pricing mechanism, not an indicator of value.” While I don’t disagree, it seems fairly clear that all fee earner time is a pricing mechanism within an hourly billing system, and that the market itself is the indicator of value. For you and other proponents of the argument that law firms are on the brink of “the end of leverage” I'd be very interested to learn how firms will maintain, or grow, profitability without the use of leverage, which we've seen in studying hundreds of firms as the second biggest driver of profitability, behind revenue per lawyer.

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