The changing landscape of the legal business

December 2014 | EXPERT BRIEFING | LITIGATION & DISPUTE RESOLUTION

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Change is in the wind in the legal profession. Some law firms are regularly downsizing and others going out of business altogether. The firms that do survive are separating into increasingly well-defined tiers. The paradigm of ever increasing billing rates and profits per partner is under attack like never before. Law firms need to adapt in order to survive. The law firms that succeed in the new environment will be those that clearly align their interests with those of their clients and provide high quality, cost efficient, value added legal advice that is informed by a better understanding of their clients’ businesses.

Law is now a big business. The Am Law 100 produced gross revenues of $77.4bn in 2013. Yet in many ways the legal profession continues to be run in an old fashioned way. The business is by and large still conducted through large private partnerships that at times find change difficult. The market for legal services, however, is becoming more efficient and law firms need to become more efficient to survive and prosper.

Alignment of interests and cost efficiency

The biggest challenge facing law firms today is that clients are demanding more transparency and efficiency. Clients need to understand the potential costs of any legal project for which they are considering retaining outside counsel. They also need to ensure that they are hiring lawyers who have the relevant subject matter expertise. Clients increasingly hire individual lawyers, not law firms. Law firms, on the other hand, need to drive profitability in order to be able to retain and maintain the highest level of legal talent. Despite the growing publicity around the challenges facing the legal industry generally and law schools in particular, there remains fierce competition for talent at the high end of the market.

Law firms play a very valuable role for clients but they need to evolve to a new way of thinking about their business. Predictability and accountability need to replace the “it is what it is” system that has historically defined pricing in the legal industry. In order to do this we need to identify the fundamental underlying problem. The real conflict is the disintermediation between clients and the lawyers who do the bulk of the work, i.e., associates. Law firms reward associates for the number of billable hours that they log annually. Associates whose hours exceed 2000 hours can earn handsome bonuses. Yet these associates are largely removed from the ongoing discussions between lawyers and their clients as to legal costs and value.

So what to do? Get associates involved in the billing process? Reduce associate rates or at least stem the tide of increase? All good ideas, but they don’t go far enough. The answer lies in doing the same thing any good business manager does when running a P&L. Create a system of expectations and accountability. The first step in every legal engagement should be a discussion of cost. What is the scope of the assignment? What is its timeframe? What sort of expertise is required? What functions can the client do internally and where do they need outside support? This conversation should not be done in the abstract or as in a quick conversation. It needs to be done in conjunction with finance people on both sides. A financial model should be built and agreed upon for all legal engagements of a significant size.

As a practical matter, the first step in increasing law firm profitability is to use the financial model developed with the client as a budget for the legal work. Instead of having carte blanche on a particular matter, associates should be given a budget and need to learn to work within that budget to achieve the necessary result. This is how every other business on the planet works. At first this might make associates uncomfortable as they could understandably be afraid that it could lead to long, unrewarded hours at the office. The flip side, however, is that if the associates view themselves as building lasting relationships with clients, they will be more inclined to take a long-term view. Just as importantly, they will be in a position to communicate both internally and with the client when the actual requirements of a project are moving away from the agreed scope. Associate bonuses should be based more on realisation rates than pure hours. This is a better measure of alignment with the firm’s clients.

A more transparent and sophisticated budgeting process is just the starting point. Where the real alignment of interests occurs is when law firms create teams that truly embrace their clients’ legal requirements. Law firms often preach that associates need to develop the trust of the firm’s key clients in order to advance towards partnership. This is a noble objective but one that often gets cast aside in the race to reach the billable hour plateau that equates to bonus eligibility. Associates need to be reoriented to invest in clients. They need to view every assignment as an opportunity to deepen their connection with important businesses and their principals and advancement should be measured on the basis of relationships rather than short term profitability.

Taking a long term view

Some firms have addressed the tension between controlling costs and maintaining quality by structuring alternative fee arrangements. While appropriate in certain circumstances, AFAs are not a panacea. A number of clients who have experimented with AFAs have expressed concern about the quality of work produced thereunder. The argument from both sides (more frequently from the law firms) is that AFAs are fundamentally risky. One can never tell, the argument goes, just how much work a legal project will or even should entail. AFAs are a useful tool, but only to the extent that they create predictability and transparency. Lawyers who accept an alternative fee arrangement and will work vigorously until they approach the fee cap and then do as little as possible to finish the job are missing the fundamental point. It’s not about this assignment; it’s about developing the trust of important clients. We need to fundamentally reset the mindset.

Associates tend to look at their practice on a task basis. We need to reorient them to focus on building relationships. The dialogue needs to change from “I am working on a merger for Jones and Co.” or “I have to do XYZ’s 34 Act filings” to “I am working for Mr. Jones at Jones and Co. on a merger. We really need to do a great job to see if we can really cement our relationship with Jones and Co.” or “I am doing 34 Act filings which I hope to do efficiently so I can market this service to other similarly situated issuers.”

Most law firms have more than enough experience to deliver high quality legal work. Although I wouldn’t say that legal services have become a commodity, they certainly are trending that way. What clients really notice are service levels. How long did it take to get a return call? Did the law firm hit its deadlines? Did the lawyers take the extra steps to make the transaction easier or, heaven forbid, more enjoyable? If the associates become more engaged with the firm’s clients and understand the firm’s strategy moving forward, then everyone wins.

Value added

It is almost a cliché for law firms to say that they provide ‘value added’ advice. It is the message that many firms deliver in their marketing campaigns to differentiate themselves from their competitors. Just saying so doesn’t make it so. Again, the mindset is important. The CEO of a client calls up his attorney and is worried about an environmental issue that is slowing down an acquisition. At issue is a complicated release of hazardous substances. Some firms refer the CEO to an environmental specialist who has the relevant subject matter expertise. The specialist goes into great detail explaining the problem and range of solutions. The CEO gets lost in the jargon. He does not want a primer on environmental 101. What he really needs is to be advised what he should do. The relationship partner upon whom he has come to rely needs to be on that call and offer his business judgment on the matter.

As the law business gets more and more competitive it becomes increasingly important for lawyers to understand their clients’ businesses. Lawyers need to regularly visit their clients’ facilities and see firsthand what is going on. They need to reach out proactively to clients to learn where their businesses are headed, what new products they are launching and what risks they are worried about. Lawyers need to go to industry events, trade shows and any other place where they can deepen their knowledge about the industries in which they work. They need to read trade journals and spend more time at their clients’ place of business. Law firms should regularly secund their attorneys to their clients and pay attention to what they learn there. Well rounded commercial advice needs to be based upon not only sound judgment and experience but also a solid understanding of the legal and business risks that clients are facing in their day-to-day businesses. The common theme here is investing in your clients’ business.

So where are we headed? The law business is in the process of being restructured. Only firms that develop and stick to a strategy that has an eye to the new legal order will prosper or even survive. The top tier international firms will continue to do large transactions, multi-jurisdiction, complex litigation and specialised regulatory work. Mid-size firms that stick to their knitting can carve a niche in the middle market as long as they keep their pricing in check. The balance of the legal market is likely to become completely commoditised. As with many things in life, the key is knowing who you are.

Gene T. Barton, Jr. is a partner at Pepper Hamilton LLP. He can be contacted on +1 (617) 204 5169 or by email: bartong@pepperlaw.com.

Gene T. Barton, Jr.

Pepper Hamilton LLP