Wouldn’t most people assume that the experienced in-house lawyers of a company would do most of its legal work? That they would only spend money occasionally on outside counsel?
Not so! Out of a typical law department’s total budget, 40 cents of every dollar is spent inside while the larger share, the other 60 cents, is spent on outside counsel. Why is that, and what are some insights regarding that well-established ratio?
Before we comment on the ratio, let’s understand our key terms. As to “inside spend,” three-quarters of a typical law department’s budget is related to the pay of lawyers, paralegals and other staff (base, bonus, benefits) while the rest goes to supporting them — facilities charges, software and hardware, cross-charges for services from other corporate functions, travel, CLE, publications and so forth. Bear in mind that some of a company’s expenses that benefit the inside legal team (but that law firms cover for their staff) may not hit the law department’s budget: Security guards, infrastructure, severance or the value of granted options and restricted stock may stay in other budgets.
As to “external spend,” law firm fees and disbursements account for perhaps 90 percent of it. The remainder goes to expert witnesses, electronic-discovery service providers and others.
“Total legal spend” adds those two amounts: inside spend plus external spend. The total does not include payments made by companies for damage awards, settlements or fines. As to those outlays, a study in 2008 found them to be on the order of one-fourth of total legal spending as used in this article. If so, for every $1 million spent internally and externally by a law department, a normal company pays out something like $250,000 more on legal resolution costs.
This important benchmark figure, the so-called 40/60 ratio, leads to a number of observations. The remainder of this column discusses 11 of them.
1. Consistent ratio over time. For years the ratio has bobbed along nearly the same. A 1993 law department survey, for example, lets us compare its ratio with that of a successor survey 14 years later. Both surveys had a similar methodology and mix of U.S. law departments. Inside legal spending as a percent of revenue dipped a tiny amount, from 0.14 percent in 1993 to 0.13 percent in 2007, while outside counsel spending as a percent of revenue did also, from 0.21 to 0.19 percent.
In short, during that entire period, the ratio of the two expenses (0.14/0.21) stayed strikingly close to 40/60. Stated pithily, the make-buy balance hadn’t shifted. If companies had been building internal legal resources and substituting their hours for outside hours, the ratio would have shifted toward 50/50 or beyond.
2. Significant spend with litigation law firms is inevitable. Litigation typically accounts for more than 50 percent of the external spend by U.S. law departments. A law department needs law firm assistance because litigation practice is in a world of its own, in-house lawyers may not be admitted readily in some courts, litigation triggers spasms of intense work (think of the total immersion just before and during a trial) and the court’s calendar is not controllable by the inside lawyer.
3. Nonlitigation specialties account for the remaining spend. Until a company reaches some level of size, there is not enough work to keep a full-time specialist busy. Hence, a company uses outside counsel for environmental, patent and employment issues, to name some notable areas. These are vast bodies of law marked by national legislation, court decisions and continual changes in regulatory schemes.
In a sizeable U.S. law department, specialist lawyers constitute approximately half the lawyer head count. By contrast, the other half, the lawyers who support business transactions and business units and are considered commercial generalists, rarely turn outside for assistance. They can handle the flow of contracts and agreements to draft, review, negotiate and interpret; they can guide on compliance; and they can answer day-to-day legal questions that arise. If reliable data were available to benchmark the ratio by practice area, we would likely see that for commercial generalists it might be 90-10. On the other hand, for litigation the ratio may reverse.
4. One internal lawyer hour for each external hour. Assuming 1,800 “chargeable” hours per year for each inside lawyer of a U.S. law department, the fully loaded cost per hour of their time is roughly $200. Each lawyer would have to recover (charge) from their internal clients that amount to cover the operating costs of the full legal team.
The effective, blended rate of typical law firms in the United States — the total of their bills divided by the total of their lawyer hours — is in the range of $300 or so per hour. So, if the inside lawyer meter runs around $200 an hour, and outside around $300, that is 50 percent higher outside, which perhaps not coincidentally is exactly the ratio of 40 to 60. This suggests in broad strokes that for each inside lawyer hour consumed by a typical U.S. company it consumes an outside lawyer hour.
5. Head count and general and administrative expense restrictions. Companies want to staff and spend inside sufficiently to handle the valleys of work, so that even if the flow of legal work dips, employed lawyers are gainfully occupied. This inevitably means that some outside counsel will be needed for peaks of work. As economists might describe it, the employee lawyer is a fixed cost, the law firm lawyer is a variable cost, and that difference in overhead — the ability, at least in theory, to turn the external spigot on or off at will — justifies part of the variable partners’ higher hourly costs. Economically rational lawyers willingly pay more for expenses they can control more, ergo, 40/60.
6. Political forces within the company tip the scales. A forceful director might push for the use of a particular law firm, or perhaps another firm has embedded itself as the trusted adviser of a powerful business executive. Then too, when careers are on the line such as a major merger or a proxy fight, in-house lawyers seek the judgment, backup and brand protection of a well-known firm (“blame them, not me, that the joint venture collapsed”). Crucial legal decisions argue for second opinions from outside counsel.
7. The globalization and geography effect. The more a company buys and sells in other countries, the more it needs to retain local counsel. Languages, time zones and different legal systems and cultures all push toward retention of local legal talent. The ratios of companies doing business around the globe probably tilt more toward outside spending.
8. Variance on either side of the ratio is immaterial. It doesn’t really matter if your law department has the reverse ratio: 60 percent of total legal spending inside. Anywhere in the range between 40 and 60 is acceptable. The ratio can swing mostly due to year-to-year fluctuations in outside spend. Partly it moves around because the lines can blur between what is treated as inside spending, such as outsourcing, temporary staffing services or the vagaries of when a law department chooses to pay a cost as a law firm disbursement or as a direct charge.
9. A significant management challenge. The ratio speaks to the management load on law departments to oversee aggressive and savvy partners at law firms. More is said about outside-counsel management than about all the other operational issues of law departments combined. Deservedly so, because with half the spending or more of a law department at stake externally, general counsel naturally look first for cost savings there that do not require terminating co-workers or reducing their resources.
10. Legal departments compared with other staff groups. Not only do law departments have the highest proportion of highly paid employees but they also spend a greater portion of their budget outside the company than any other staff function. Paradoxical, isn’t it, that well-paid resources spend so handsomely on higher-paid resources!
11. 40/60 as a Darwinian optimum. In the course of decades, thousands of general counsel in the United States have done their best to strike the right balance. As with Darwinian survival of the fittest, law departments have arrived at what may be a “best practice ratio.” In the past three years of the General Counsel Metrics benchmark survey, hundreds of U.S. companies produced 39/61 as the median for this ratio.
The 40/60 ratio is prevalent, fundamental and stable, and the points made above explain some of the fundamental forces that push law departments toward it. Cost control, corporate overhead, specialized needs, management decisions of general counsel, business models — all nudge toward the commonly seen 40/60 ratio.