EconomicsAs that portion of the legal industry focused on corporations goes through another end of year cycle, it is tempting to say, as I and others have done, that the “large corporate law market” operates outside the normal principles of economics. How can it be that large law firms, facing lower demand for services, keep making more money? In this essay, I take on a thought experiment: are there plausible and rational explanations behind what we see happening in the large corporate law market?

Is the Modern Legal Industry a New Economic Paradigm?

The demand for legal services appears (and we have only apocryphal data to support this) to be increasing. General counsel say regulation and compliance requirements keep going up. CEOs complain that “red tape” is slowing growth. And even the presidential campaign chimed in with jabs at de-regulation.

The response among general counsel, having finally convinced their CFOs that in-house lawyers cost less than law firm lawyers, has been a hiring spree that keeps on rolling. Each in-house hire means an additional 2,080 hours available to the corporation at less than half the cost of a large firm lawyer. Still, the in-house hiring binge is, at best, keeping the regulatory flood waters from swamping the corporate boat. No one is successfully pushing them back.

The demand for legal services from large law firms has declined in recent years (as a whole by about $16 billion, though some firms have felt the impact more than others). We can see this in many ways. The clearest, perhaps, is the decline in average billable hours. The billable hour drives many evils, but if the firms can’t bill the hours then demand must have dropped. Most large law firm leaders acknowledge their firms are overstaffed, with all the political and economic problems that brings.

So far, the economic story makes sense. Demand for legal services is up, corporations respond by hiring more lawyers, more in-house lawyers reduces demand for law firm lawyers, which means that prices drop as the firms compete for business, right? Wrong! The economic paradox is that firms continue to increase prices. In 2016, prices seem to have increased about 3-4% and if predictions hold true prices will go up at least that much in 2017. Demand for services from large law firms is dropping, but thanks to the increases in prices revenue for large law firms has increased.

The laws of supply and demand you carefully studied for that Economics 101 course seem to have been shattered. It is tempting to say this is just another example of how the legal industry is unique (or, using my new favorite term to describe lawyer thinking “collective narcissism”). Resist the temptation. The more likely explanation is that the large corporate law market is going through a period where the laws of supply and demand don’t function normally as the market adjusts to new competitive conditions. In other words, the market is going through a transition.

So how long will the transition last? Of course, no one knows. We could assume that corporations will stay the path and not increase the volume of work they send to law firms. We don’t have much to rely on when making this assumption. When push comes to shove, corporations will get their legal work done and that may mean pushing more out the door to the firms. It seems likely, however, that this would be a temporary fix and corporations will continue looking for ways to reduce their spending on law firms.

We also could assume that the intensity of competition among law firms has not reached the point where firms will decrease prices, but that day will come. This is a more interesting assumption. In the past and still today, public announcements of price increases do not mean every client pays more. Many clients will negotiate rate holds with their law firms, at least for existing matters. In the past, those rate holds eventually expire and rates resume their upward trajectory. But we have not seen rate decreases across the board. Firms seem to understand that once rates drop, their pricing paradigm has changed.

The picture gets more complicated as corporations move to alternative (or value) fee arrangements. A firm may hold the line or increase its hourly rates, but as the percentage of work billed hourly declines, those rates become less important. In a market where few services are standardized, alternative fee arrangements do not create price transparency. It is dicey to compare firms on hourly rates, because the final invoice depends on so much more than rates. With alternative fee arrangements and no standards for things like “merger and acquisition services,” only the corporation will have the information to compare pricing across firms (at least initially).

Other factors will affect the transition period. For example, externalities such as the recession could cause corporations to move to variable staffing (using law firms) or double-down on cost reductions with inside staffing. The incoming presidential administration promises it will bring significant economic growth, which could result in corporations expanding their businesses in ways that require expertise housed in law firms. On the other side of the balance, if globalization declines corporations may rely more on in-house teams as they need fewer resources outside their home jurisdictions.

Once we mix all of these factors together, it seems most likely that we won’t identify the end of the transition period until long after it happens. Hourly rates won’t be the canary in the coal mine telling us the end is near, because they may continue to rise as the percentage of work they cover declines.

Are Large Law and Corporate General Counsel Irrational?

Now that we have looked at whether the market is acting in an unusual or even unique way, we can address the second part of the discussion: given the decline in demand for legal services from large firms, why do the firms continue to raise hourly rates, and why do corporate clients acquiesce to rate increases? Are large law firms acting irrationally and is irrational behavior something unexpected? And are corporate clients acting in some unexpected ways?

Let’s look at the large law firms first. As I’ve just noted, there are plausible and rational arguments for firms raising rates in the face of declining demand. If the percentage of work billed on an hourly basis is declining, then the impact of a rate increase declines. Right now, the assumption is that most firms still do more work on hourly arrangements than alternative fees (the Citi/Hildebrandt Consulting 2017 Client Advisory says alternative fees are holding steady at about 16% of fee arrangements), so rate increases are significant to overall firm revenues. How significant depends on the fee arrangement mix, and that mix will continue to move in favor of rate increases having less impact.

Firms also use rate increases as a signaling mechanism. What firm in its right mind would increase rates if it caused economic harm to the firm? Firms raise rates, in part, to tell they world they can raise rates. The firm is strong, its lawyers in demand, and it still is a player. If competitors of the firm raise rates and it doesn’t, it could signal the market the firm is in trouble. The whisper campaign starts, laterals become reluctant to join, and clients (perversely enough) may question whether they should move their work to a firm that isn’t as shaky. The family on the block that doesn’t buy a new car becomes the family with financial problems, not the family that spends wisely.

Finally, and perhaps the simplest reason of all, if a firm can raise rates and get the higher rates to stick, it can offset decline in demand. The firm may see a shift in the mix of services corporations request. Corporations could take in-house those services that are routine, that require less specialized knowledge, or that require more frequently used skills (a corporation is less likely to pull in environmental work done infrequently than basic commercial work). The work corporations still send to law firms has higher value attached to it, though lower volume. Firms respond by increasing rates, which corporations pay for the higher value services they ask firms to provide (and, because the system is imprecise, they also pay those higher rates for lower value work). Firms do less work, but their work commands higher prices. Corporations send out less work, but are willing to pay more for the work because it has higher value to the corporation.

We would expect the firms to adjust to lower demand by reducing headcount. We know that most large law firm managing partners acknowledge they need to reduce headcount given lower demand levels. Some firms have followed through, either by reducing the total number of lawyers, or in many cases by pushing lawyers down the totem pole (the firm de-equitizes partners, moves income partners to of counsel, and so on). Most firms admit they have much more to do to balance lawyer supply and client demand. So why aren’t firms reducing their headcounts?

Again, we can find many reasons. In some cases, it is difficult to overcome firm culture. Many partners still believe that “once a partner, always a partner” should rule. It isn’t cricket to make someone a partner and then drop them just because times get tougher. Other firms do not have strong leaders—managing partners who will pull the trigger when necessary.

But, we can find other, perhaps more complex, reasons. Some partner portfolios may consist mostly of complex matters, the type that corporations still want to send to law firms. Most partners have portfolio mixes, with some complex matters sprinkled among many ordinary matters. At one time, a firm could shove out the door those partners who had few if any complex matters. Most of that shoving was done years ago. That leaves many partners with a mix of matters and the lucky few who have predominantly complex matters.

Picking which partners to let go (de-equitize, etc.) can be tricky given the portfolio mixes. Firms must consider substantive areas (keep the tax partners, let go of the corporate partners?), politics (let go of the environmental partner who has a weak portfolio mix, though the higher value work from his clients goes to litigation enhancing that department’s portfolio?), and timing (practice areas that are dead today may become hot tomorrow). Finally, remember that a firm aggressively reducing headcount may be seen as a failure rather than a success. A firm that goes from $500 million in revenue and 30% profit margin to $450 million in revenue and a 35% profit margin may have made a smart economic move. But, potential lateral hires, the legal industry, and even clients may see that move as indicating a firm with problems, starting a negative chain reaction.

Given the reticence many firms show about dropping partners, these and other factors give plenty of reason to hold off from reducing headcount. The result: firms roll forward with productivity dropping. In other words, we can put together plausible and rational explanations for the behaviors we see today in the  large corporate law market.

Our final question focused on clients: why do they continue to pay higher hourly rates (even assuming they get a discount off the published rack rates)? Again, we can find plausible and rational reasons. First, many corporations are not ready to reduce their dependance on law firms. The general counsel may not feel his team can handle more work, more complex work, or riskier work. Some general counsel don’t want the hassle of taking on more work. Some have not increased their department’s headcount. Some need the expertise a firm can provide. The world is not ready for all legal work to move away from large law firms.

Second, there is a convenience factor. Each firm added to the roster for a corporate law department adds some burden to the law department. Managing a portfolio of law firms takes time, and the smaller the department the greater the burden (e.g., small departments do not have dedicated business managers, so the general counsel manages outside law firms). Just like the rest of us, general counsel will pay something for convenience—in their case the convenience of using fewer firms. General counsel also can face some external pressure to reduce the number of firms they use (I would hear regularly from the audit firm that the “best practice” was to have 80-90% of the department’s outside spend concentrated on 10 or fewer firms).

The number of high quality smaller firms seems to grow every day. In many of those firms, the service quality is higher than what you would get at a large law firm, and the cost is lower. But, finding those firms takes time. Those firms also may have a limited range of matters they can handle, which means the corporation must add to its roster of law firms to get services across the full range it needs. And, of course, hanging in the background is the maxim that “no general counsel ever got fired for hiring [name of large law firm].” The last reason may not be great, but it still exists.

So again, there are plausible and rational reasons for corporations to stick with large law firms and pay increased rates. We may disagree with that approach and we may believe our reasons for doing things differently overpower the reasons for holding the course, but that doesn’t mean a general counsel has gone off the deep end by paying higher rates to a large law firm.

Do You Feel Lucky?

The economics of the large corporate law market have not received much attention or rigorous study. This post is largely a thought experiment and not a summary of solid research. I have attempted to show that, without resorting to wild ideas or claims that lawyers have gone crazy, we can construct arguments for what is happening in the large corporate law market that are consistent with what we have observed. They also could support the argument that the market will not change significantly in the absence of an outside force disrupting the market. That force could be technology, a new business model, or large scale client dissatisfaction.

Eventually, without such a force, we should expect the market to move through this transition phase and we should see normal economic principles play out. That may take years or even (less likely) decades. Each time I go through one of these exercises, the same final question comes up. We have seen client dissatisfaction growing. Will the time it takes the market (and here, we could extend the discussion beyond the large corporate law market to the entire industry) to move through this transition be too long for clients? Will the dissatisfaction grow to the point where clients will take matters into their own hands? As I and many others have asked, will lawyers become irrelevant? We should never underestimate dissatisfaction. It is a powerful force that can disrupt the status quo—you don’t have to look any further than the recent U.S. presidential election to see an example of the theory in action. It will require some hard work and luck to transition the legal industry from its lawyer-centered, inefficient model to a client-centered, efficient model. The question is, to borrow a phrase, “do you feel lucky”?

References

Citi and Hildebrandt Consulting LLC 2017 Client Advisory.