This article is reprinted with permission from the January 2010 Law Firm Partnership and Benefits Report of the American Lawyer Media. © 2010 ALM Properties, Inc.
Economic problems impacting law firms are prompting a wealth of predictions about the future. What structural changes may result from the current economic downturn for law firms and the practice of law? The following is an updated version of an article first published by Blane Prescott, Vice President with Hildebrandt, in the closing months of 2008.
The economic problems impacting law firms are prompting a wealth of predictions about the future:
- Some say the profession is undergoing a dramatic and profound restructuring and life for lawyers will never be the same.
- Others say this is just another economic downturn, like so many before, and all of the reactionary changes being announced by law firms will fall by the wayside once the economy recovers.
The truth is probably somewhere between the two extremes, but it is clear that as with most recessions, some more permanent structural changes will result. Just how much change largely depends on the duration of the downturn.
IS THIS RECESSION DIFFERENT?
The term "recession" is defined as two consecutive quarters of negative economic growth, but the impact of each recession varies greatly. Some downturns are geographically localized (e.g., the Asia crisis of the late 90s), some are heavily centered around certain industries (e.g., the dot.com bust of 2001), while others are measurable but largely unnoticed. The range of recessionary effects on law firms is wide and varied. Recessions prior to the 1990s were largely cash flow problems for law firms rather than events prompting layoffs. The 2001 recession was surprisingly short and light, but had vastly differing effects on law firms depending on location, size, and practice mix.
This recession, however, is far different due to the depth and breadth of the economic contraction.
According to the Institute for Supply Management (ISM), new manufacturing orders contracted for 16 consecutive months as of Spring 2009 and were at the lowest level since January 1948. This isn't a recession focused on a few industries, but rather, is a widespread downturn across all 18 industries routinely monitored by the ISM.
As of June 2009, unemployment in the United States was at 9.4%. Unemployment reached higher levels only one other time since World War II, but the real concern is in how long it normally takes employment to recover once rising above 7%. While some dream of a quick economic turnaround, a review of historical unemployment data shows that the last time unemployment reached this level it took 53 months before it fall back below 7%, a level that many economists feel is the upper limit of a healthy economy.
The IMF expects global GDP to shrink by 1.4% this year, with rich countries' economies contracting 3.8%. This downturn isn't a regional phenomenon, but a world wide downturn that will force many countries to dig their own way out of their economic problems.
Many mid-market firms closed out 2008 with profits higher than 2007, with a few proclaiming immunity to the recession due to their "lower price" or "more practical approach to legal work." While such firms may indeed have pricing/staffing advantages over their big firm/higher profit brethren, those advantages won't insulate them from the downturn. The recession hit the large capital markets firms first and hardest, but is rapidly showing up across other practices and regions. Some mid-market firms are likewise predicting they will begin displacing the major capital market firms as clients seek lower-cost legal providers. While we agree there is greater opportunity for mid-market firms to compete for complex work than at any time in history, it would be foolish to assume tens of thousands of partners in national/international firms will simply sit idle on the sidelines while mid-market competitors rush for their clients.
So what will change in the profession? There are at least four prominent trends, most foreshadowed by other pro-fessions and common business practices, that are likely to take hold in the legal profession:
DECLINE IN THE USE OF LOCKSTEP COMPENSATION FOR ASSOCIATES
The legal profession is one of the last industries to utilize long-term, lockstep compensation for its professional em-ployees. Most industries learned long ago that lockstep compensation is an appropriate vehicle only for the first year or two of a professional's work life, but, after that, true merit evaluation and compensation systems produce more valuable and happy employees, a more competitive cost structure, higher profits, and help enforce more constructive feedback.
So why has the legal profession hung on to lockstep for so long? There are several reasons:
- It is easy to administer. A law firm can essentially look up what its competitors are paying and then match it. Yes, a firm could differentiate itself and blow out the pay scale for a temporary advantage, but with the advent of e-mail such a temporary advantage was diminished to days rather than years.
- Rigorous reviews aren't nearly as critical (at least for compensation purposes) as under a merit system.
- It is what the majority do ... and law firms are notorious for wanting to be innovative but only as long as they aren't the only ones to do so.
The downside risk to a lockstep compensation system is that it tends to over-promote and overpay, but when an industry experienced an extended sellers' market and produced record profits every year, who cared?
The leak in the dam is building momentum: While merit promotion/compensation systems for associates have be-come more common among smaller and mid-market firms in the last ten years, their use in AmLaw 100 firms was rare. But in recent months at least 12 firms have announced the introduction of such programs and numerous others are investigating either full or partial merit systems. Such change will likely be embraced by large, progressive, na-tional firms with profits just below those of the 25 most profitable firms in the United States, as they have the most to gain in profits and the least to lose. Most will keep lockstep for firstand second-year associates, but let associate compensation float on a true merit basis thereafter, with the potential that a star fourth-year associate could earn as much or more than a mediocre sixthor seventh-year associate. What are the challenges in making this transition? Developing meaningful criteria for promotion and conducting constructive and impartial performance reviews so that partners don't simply rank every associate as outstanding in every category. Fortunately these are problems we solved years ago.
THE PROFESSION WILL CONTINUE TO SUBDIVIDE
We have long talked about segmentation in the profession: Growing divisions among the "haves" and "have-nots." Unfortunately, law firms have struggled to figure out what it is that the "haves" really have, with too many confus-ing size with success or breadth with depth. The key elements of the most successful firms have always been:
- Depth of expertise, rather than breadth;
- Capital to invest, and the willingness to risk it wisely
- Tough quality standards for their true equity partners; and
- Effective teamwork and internal cooperation (autonomy is often sacrificed for firm success).
The truth is that despite their public image as close-knit partnerships, many (cynics might even say most) law firms are only loose coalitions of lawyers who cooperate on little more than substantive expertise. And most of that coop-eration occurs primarily when prompted by clients. These loose coalition firms are noteworthy because they are highly mixed in terms of the quality of partners they admit:
- They rarely market together ("hunting in packs," using a team approach to get the best work for a broad variety of lawyers rather than just the practice of the best marketers);
- They leave the assignment of client work up to the discretion of whoever brought in the work, rather than ensur-ing work is distributed according to the best interests of the client or the firm; and
- They rarely exercise any form of peer review of work or behavior, unless of course a blatant malpractice issue exists.
These firms rarely use their collective strengths to offset their acknowledged weaknesses (and every firm has part-ner weaknesses, whether it wants to admit them or not). The real difference in firms is that the stronger ones are more prone to address their weaknesses. But these loose coalition firms will likely face a prolonged period of stag-nating or declining profits that extends well beyond the downturn.
BILLING RATES AND MARKET FORCES ACTUALLY WORK
There has been an outcry from clients for the last ten or more years about the outrageous increase in billing rates charged by law firms. Yet, despite all the rhetoric, the market forces have largely worked. Here's why.
The real problem has been that this was an unusual period during which the demand for most (but not all) legal ser-vices has outstripped the supply of quality lawyers, and as a result, billing rates continued to rise due to that demand.
At the same time there were other practices for which there was an overwhelming supply of lawyers, and clients were routinely moving work in order to get better deals, often for equivalent expertise.
Pricing changes occur much more slowly or less frequently than in the consumer goods market, which can be frus-trating for clients. What may take many law firms by surprise is that pricing evolution typically accelerates during a downturn, and the law firms that try to ignore such change will likely face a prolonged period of catch up as their peers adapt more quickly.
Many clients have been frustrated due to their own impatience, or perhaps unrealistic attitudes about creating pric-ing change. Some clients were outraged when their existing lawyers refused to lower their prices. But should this really be a surprise? Why would a law firm facing extraordinary demand for its services arbitrarily cut its fees (other than by a de minimis amount to placate clients) when there was a ready supply of work to replace it at full price?
But there are glaring problems in this market theory of billing rates: While most law firms have had some practices facing overwhelming demand, they generally invoked across-the-board rate increases. In effect, they attempted to raise the price of low demand practices/lawyers along with those in high demand. Just as these firms were able to achieve broad based price increases in the good times, they may be surprised by the broad based pricing stagnation in the down times.
PROJECT PRICING IS THE REAL FUTURE OF ALTERNATIVE PRICING
The legal press has been filled with articles on alternative pricing arrangements for years, but with little in the way of actual examples being used on a broad basis. The challenge has been in matching up the conflicting goals of law firms and clients: Law firms typically want an arrangement with the potential for profits at or above that produced by standard billing rates, while clients want pricing models with the potential for lower prices. But each side is often unwilling to accept proportionate risk. As a result, we hear of inane pricing proposals involving ever more compli-cated rules and conditions that only favor one side or the other.
Clients tend to have four priorities in their pricing schemes: More predictability of fees, better value for the price, control over their total legal spend and better alignment of incentives (something other than the more hours you bill on my matter the more you earn). Law firms tend to want some potential to participate in the risk and rewards when their own efficiency or ability produces extraordinary results that are not reflective of their fees.
So what's the real solution? It is exactly what law firms in other parts of the world and other professional service firms do on a daily basis: fixed or project pricing. Project pricing means that at the outset of a project the firm pro-vides an estimate of price based on a mutually agreed upon set of assumptions, and then bills that fixed price. And while no one will ever get all of the assumptions right both clients and law firms will get better at predicting them over time. If the assumptions change, there will be the potential for a change order.
Such fixed-price arrangements are increasingly common throughout the legal profession in Asia and Europe, and are increasingly used in some litigation in the U.S. But that shouldn't be a surprise, since fixed or project pricing is the basis on which most companies buy all of their goods and services worldwide. Will project pricing work for every practice? No, but it may well work for 50% of the legal work in the U.S. Will the billable hour finally suffer the long predicted death by so many pundits? It is highly unlikely in any of our lifetimes, since it is a mechanism that lends itself to many types of short term service projects.
The trends described above are less about predicting the future than identifying the seeds of current change. It would be foolish to think that pricing in the legal profession will never evolve beyond the hourly rate model used so extensively for the last 40 years. The combination of the downturn in the economy and the historic experiences of other professions that have evolved through the same structures as the legal profession make it relatively easy to identify changes.
No matter what happens in the next year, it is important to keep some perspective. The legal profession is still a terrific way to earn a living; it is just changing and becoming more competitive. But what business or industry never changes or becomes more competitive? Still, relative to the risks involved, and the investment of time and capital, there are few other professions that provide as much intellectual freedom and income as the legal profession.
