Continued Decline in Law Firm Profits Seen for '09

Karen Sloan

02-03-2009

It is the roughest market the legal industry has seen in at least 17 years, and there is no quick fix or recovery on the horizon.

That point is but one of the many sobering predictions offered in the latest client advisory from Hildebrandt International and Citi Private Bank (pdf). The advisory concludes that profits-per-partner in 2008 generally spanned from flat to a 10 percent decrease compared with the previous year.

Profits are likely to fall even further in 2009, with average profits-per-partner declining by 5 percent to 15 percent, and perhaps more at certain law firms, according to the advisory.

Much of the sour news can be traced back to the faltering economy, which has been in an official recession since December 2007.

"To find a more analogous situation to the present downturn in the legal market, you would have to go back to 1991 and the economic problems triggered by the savings and loan crisis. But even in 1991, the recession was not as deep or broad as the current one, and the impact across the legal markets was not as severe," the advisory reads.

Even the downturn that followed the bursting of the technology bubble in 2001 was much shorter and more limited in scope, it notes.

The advisory predicts that recent moves by law firms to rein in expenses -- including reducing bonuses, freezing associate salaries, postponing new initiatives, instituting layoffs, weeding out unprofitable partners and slowing distribution schedules -- are likely to continue throughout 2009. Additionally, firms will not be able to rely on rising billing rates and growing demand for their services to generate record profits. Instead, they will need to reconsider changes to several key aspects of their business model. That includes everything from adjusting associate compensation structures and being more flexible with professional staff to offering alternatives to the billable hour model.

"The big message is that it's going to be a bit of a bumpy ride, but it's an opportunity to do things that probably should have been done before," said James Jones, a vice president of Hildebrandt International. "I think we've never had a more compelling set of reasons to [make significant changes to law firm business practices.]"

One of the primary problems facing law firms is declining demand for legal services, which has left attorneys in certain practice areas largely idle.

In contrast to historical growth in demand prior to the downturn, firms saw demand virtually stagnate in the first nine months of 2008, according to one survey. Yet another survey showed that demand actually fell by 2.6 percent during the course of the year, with corporate, mergers and acquisitions and litigation showing the biggest drop compared with 2007. At the same time, firm head count grew by 5.5 percent during the first three quarters of the 2008. The disconnect between falling demand and rising head count was likely a byproduct of the traditionally long lead-up time to associate hiring, as well as exceptionally low attrition throughout the year, Jones said. Thus, it's not surprising that many firms instituted staff and attorney layoffs in the fourth quarter of the year. The advisory projects that law firm demand will continue to be flat throughout 2009, and that more firms will face layoffs.

A broad economic recovery is unlikely to happen before 2010, but there is some good news for law firms. The legal industry tends to be one of the first to recover from tough financial times, and it can rely on countercyclical practices to help get through. The client advisory predicts increases in work related to new government regulations on financial institutions, legal issues tied to the Obama administration's economic stimulus package, litigation, bankruptcy and reorganizations. Some economists also are predicting that mergers and acquisitions will pick up.

Still, those countercyclical practices won't be enough to make up for shrinking demand for legal services, and the advisory predicts that law firm debt will grow in 2009.

"Citi Private Bank has reported its outstanding loans to law firms are up by 30 percent from a year ago, and its loan commitments are up by even more," the advisory reads.

But law firms should use the economic downturn as an opportunity to make some significant changes in their business models.

A firm should have a clear strategy that addresses how it will weather the economic downturn and what role it will play when the economy comes out of its slump. That strategic plan should involve identifying the firm's core practices, as well as its unprofitable practices.

Additionally, firms should move away from lockstep associate compensation models and instead consider competency-based models, the advisory suggests. Jones said that instead of increasing compensation by class year, an alternative model is to separate associates into three or four levels, determined by their specific skill sets. Associates then would move up the next level only after they acquired certain skills. Rising to the next level would trigger an increase in compensation.

"The legal profession is one of the last industries still to cling to this outmoded seniority based method," the advisory reads.

Firms should also focus on getting rid of lawyers who consistently underperform, and should consider expanding the use of contract attorneys and other nonpartner attorneys such as of counsel and staff attorneys. That could improve firm leverage and give the firm added flexibility.

Finally, the advisory recommends that law firms get serious about alternatives to the traditional hourly billing model. Corporate legal departments are clamoring for discounted fees or fixed fees as well as for more efficiency from law firms. Firms should address those concerns by reallocating people and resources to centers in lower cost areas and using contract attorneys, among other things.

Jones acknowledged that some firms will have a difficult time making the changes recommended in the client advisory.

"Most law firm leaders I've spoken with are concerned [about the economy]. They are in a mode where they have to hunker down and go back to some of the fundamentals," Jones said. "We've gone through a period where everyone got used to growth and expansion. People haven't really had to look at doing more with less."