The Paradox of the Client-Driven Market

We all take for granted that the business of law is changing and that clients are now in the driver’s seat. But does it follow that corporate counsel know where the legal market is headed?

This question came to mind following my recent participation at the annual meeting of the Corporate Counsel Institute at Northwestern University Pritzker School of Law. I was part of a panel on the changing economics of the business of law. During the day and half that preceded us, the 250-plus in-house lawyers in attendance covered a dizzying array of topics, including changes in regulatory law, compliance programs, hot topics in labor and employment, practicing law in the digital age, the role of the general counsel in board-related matters, enabling legal to operate at the speed of business, lawyers as leaders and lessons in corporate crisis management.

As that agenda suggests, the daily work demands placed on corporate counsel leave little time to reflect upon the changing economics of the business of law. Yet, paradoxically, the small decisions that these lawyers make on a daily or weekly basis, when aggregated together, are the primary drivers behind the changing market.

As a law professor who focuses on the business and economics of the legal market, I am not immersed in the details of substantive law. Yet, I can provide a broad narrative on how the legal market is changing and, to some extent, flag key issues that general counsel and in-house lawyers ought to be thinking about.

The abstract of our business of law session asked four very good questions about the changing economic landscape. Below are my answers:

What are the changing law firm economics and the implications on in-house practice?

Law firm economics are changing because clients are changing how they buy legal services.

The biggest change—by a very wide margin—is the growing ranks of in-house lawyers. Over the last 20 years, in-house legal departments have grown 7.5 times faster than lawyers employed in private practice, from less than 35,000 in 1997 to more than 105,000 in 2016. There are now more lawyers working in-house than there are working in domestic offices of Am Law 200 law firms. Remarkably, since the mid-2000s, government legal jobs have been growing twice as fast as law firm lawyers. (see data here.)

These changes are occurring because legal complexity is increasing faster than overall economic growth and, thus, the growth of legal budgets. To stay within budget and still get their work done, legal departments have grown, replacing work done by law firm associates and partners with work done by salaried in-house lawyers.

The in-sourcing of legal work means that the composition of legal work going to law firms is more specialized than in the past. Corporate clients see the value of senior lawyers with extensive experience and expertise in complex areas of law. They see a lot less value, however, in inexperienced junior associates. Hence, it has become relatively common to implement billing guidelines that refuse to pay for first- or second-year associates.

Because firms are doing more specialized work with fewer associates, their leverage model has become more reliant on counsel and non-equity partners. The client doesn’t push back on paying these lawyers, as they are already trained and knowledgeable. In the short term this is workable; in the long term, however, it creates an imbalanced model with no reliable mechanism for replenishing talent.

Because clients are in-sourcing work that was previously done by associates, law firm revenues are flat. Thus, most law firms are seeking to grow by taking market share, including client acquisition through the lateral partner market. This approach is driving up compensation for partners who control client relationships, leaving a proportionately smaller share for other firm lawyers. There is also precious little left over for long-term strategic investments in training, personnel and technology.

This situation is the logical endpoint of the client mantra, “we hire the lawyer, not the firm.” Both clients and law firms have much to gain through creative collaboration that aligns long-term interests.

What current structures predominate within law firms, and how does each impact service?

There are many different structures in law firms that impact service that are seldom obvious to clients unless they ask the right questions and are very discerning. To keep things simple, let’s discuss two ends of the compensation continuum.

At one end of the spectrum is what might be called the “billing and origination model,” where partners are given “credit” for bringing in and or managing the client relationship. The partner is also evaluated based on billings and collections from that client (the partner’s billings plus all other timekeepers).

Because the partner’s livelihood is substantially determined by originations and billing/collections, the client can expect very solicitous service from the relationship partner. The partner, after all, is trying to preserve and grow his or her book of business.

The downside of this system, however, is that partners can and do become very territorial regarding who interacts with “their” client. If the loyalties switch to another lawyer (for example, a senior associate trying to build his or her own client base by delivering a track record of great service), then movement to another firm by someone on the team may cause the partner to lose the business. Further, it is often not the partner’s self-interest—either in the current year’s compensation or preserving client loyalties—to consistently delegate work to the most qualified or cost-effective person in the firm.

Finally, to keep up their billing and the collections during times of scarcity, some partners will do work that should be done by associates or staff attorneys.

At the other end of the spectrum are a smaller number of firms that have avoided or scuttled origination credits. The overwhelming reason for eliminating credits is to increase collaboration and team work. Many of the most profitable and prestigious firms operate on this model, compensating on a lockstep or modified lockstep basis.

This model is often much better for both clients and lawyers because there is no scorekeeping that could undercut client focus. However, this system works best when the firm already has top-of-the-market clients and thus can attract, retain and mold very high-quality junior talent. (In fact, this tends to the type of firm that retains sufficient market power to charge high billing rates for junior lawyers.)

Within the current legal market, it is an open question whether a firm that scuttles billing and origination credits can outperform rival firms that continue to emphasis individual partner production. Remarkably, there are a few large firms out there trying to find out. Their logic is compelling—“if I were the client, this is the type of work environment I would want because it delivers the greatest value.” Further, the internal competition of the billing and origination model chafes against their sense of professionalism. They hold out hope that there is a different and better way.

How often do corporate clients ask about internal compensation systems? I ask because it is integrally related to what they say they want from law firms.

How are these structures likely to change with disruption?

Continued flat market demand is going to result in significantly more consolidation among law firms. Bigger law firms make law firm leaders less dependent on individual partners. The bigger size and scale can also cost-effectively fund technologies, services and add-ons that institutionalize client relationships.

This is where the legal industry is headed, though we’re all going to live through a messy transition period that could last a half a generation or more.

I am hopeful that enlightened corporate counsel will speed this process up by seeking out firms that have the right internal incentive structures and are willing to invest in the client relationship.

What is the impact of change on the quality of legal services, the cost of legal services and the market for legal talent?

The big issue here is who is going to “own” talent development. In the short to medium term, we are likely to see more entry-level employment in large legal departments, primarily because these lawyers are cheaper to train right out of law school and they don’t have to unlearn Big Law habits that are out-of-synch with modern in-house practice.

During times of stress, practicing lawyers often suggest that more training and preparation get built into the three years of law school. However, I can say with 100 percent certainty that law schools will not make significant in-roads unless employers—law firms and legal departments—recruit from the change agent law schools. At present, we have a dysfunctional labor market where elite schools are rewarded for admitting high LSAT students and the change agent law schools have few interested customers.

If we want to have a better future for the legal industry, there needs to be collaboration across the entire legal market. In the year 2017, the one stakeholder group that can bring everyone else to the table are large corporate legal departments.

Thus, my message to corporate counsel is simple—you may not realize it, but you’re driving this market. Where do you want to go?

 

William D. Henderson is professor of law and Stephen F. Burns chair on the legal profession at Indiana University Maurer School of Law. He is also editor of Legal Evolution, an online publication that focuses on successful legal industry innovation.