The Reckoning

By Michael Roster

Most attorneys practicing law today - in-house, at law firms, or in other capacities - believe the legal profession is in the midst of profound change. Some of the change is being driven by the recession, but the crisis has far deeper roots.

Forty years ago Elisabeth Kübler-Ross, author of On Death and Dying, examined the process by which people deal with catastrophic change. I'm not suggesting the demise of the legal profession, but the stages Kübler-Ross identified - denial, anger, bargaining, depression, and acceptance - are remarkably applicable to what I see my colleagues going through and what I think lies ahead for our profession.

Denial
By now it's apparent we are in a financial meltdown exceeding anything since the Great Depression. Stock values have declined by up to two-thirds, unemployment in California is in double digits, corporate earnings continue to plunge, and there seems to be no turnaround in sight.

In the meantime, most law firms reported 2008 profits that were flat or down by 20 percent or more. Revenue growth for the first nine months of 2008 was the weakest since U.S. law firms have been monitoring it. Two major California firms - Heller Ehrman and Thelen Reid & Priest - dissolved almost overnight. In late December a 160-year-old Wall Street firm, Thacher Proffitt & Wood, announced its closure. We read daily about attorney and staff layoffs, rescission of existing offers to new hires, elimination of bonuses, associate salary freezes, and the loss or modification of long-standing bank lines of credit.

Still, the number of new lawyers at U.S. firms reportedly increased by 5 percent in 2008, because firms couldn't shut off the pipeline of recruits fast enough. Historically, natural attrition is 17 to 18 percent; currently, it is near zero. That is, no one is leaving voluntarily.

Yet some leading legal professionals and consultants were quoted recently as saying that they'd never heard of a firm lowering rates and that many firms were going to continue their tradition of annual rate increases.

This may be nothing more than spin for internal and marketing purposes. Even so, such comments eventually come back to CEOs, CFOs, and other senior managers, who then ask their general counsel how it is that law firms can be so insulated from everyone else's realities.

In-house lawyers know firsthand that American companies and their suppliers have been relentless in reducing costs during the past 20 years while simultaneously improving quality and value. They were concerned about escalating legal costs well before the current economic crisis, because the only outliers on the expense side seemed to be the law firms.

Last May, American Lawyer reported a "Law Firm Golden Age," extending from 2003 to 2008, for the 100 top-grossing law firms in the country. During that period the average revenue per lawyer increased by $205,000 and profits per partner jumped by $438,000, to an average of $1.3 million. Nineteen firms had profits per partner of $2 million or more. Similar increases were being reported for the second 100 firms.

At the same time, it was widely reported that salaries for first-year associates were being raised to $160,000 and that top hourly rates were going to exceed $1,000. This is in contrast to the ongoing pressures for general counsel to demonstrate better management and control of legal costs.

At least until recently, a certain amount of denial came from in-house lawyers. It was in-house lawyers who said they wanted time-based computer printouts to be their bills. (See, "We Haven't Always Done It This Way," page 36.) It was in-house lawyers who said they hired the lawyer, not the firm. Most telling, it was in-house lawyers who, when offered an alternative fee system, typically opted for a discount and the old hourly system because that was safer.

The biggest danger, however, is that neither side seems ready to make the radical changes that are necessary.

Anger
Currently, the Association of Corporate Counsel (ACC) has 25,000 members from more than 10,000 companies worldwide. In late 2007 - well before the financial meltdown - ACC members and other in-house counsel became more vocal than ever about the disconnect between the cost of outside counsel and the value of the work provided. The discussions led to the launch last September of the ACC Value Challenge, of which I am the steering committee chair.

Our first step was to convene off-the-record meetings in New York, Chicago, Houston, and San Francisco, with approximately 20 law-firm representatives and 20 in-house leaders at each. These sessions were designed to promote frank discussion, with the understanding that any solutions had to come from true dialogue and a willingness to change on both sides. And once the participants opened up, we heard them express a great deal of frustration and even anger.

In-house lawyers consistently admonished outside counsel to:
- Stop reinventing the wheel when you've done similar work before. Use knowledge-management tools to drive down costs, and pass along at least some of the savings to the client.

- Staff assignments leanly, using only attorneys who have the proper training and expertise.

- Bring turnover under control. For example, ACC calculations show that a large firm typically has hired 200 first-year associates annually, at a cost of $250,000 to $400,000 per recruit. But by the sixth year, up to 85 percent of those lawyers are gone. No other business would waste such critical resources.

- Reduce overhead. Sell the artwork, move to less costly campuses, cut internal costs, and pass along the savings to clients.

- Budget work carefully, and then stick to the budget. If other contractors can work at a fixed price, don't tell us you can't.

Another of the most common complaints was directed primarily at the legal press: Stop using profits per partner as a metric. Profits per partner may be great for bragging rights, but the numbers can be easily manipulated by eliminating "servicing partners," reducing the number of associates who make partner, or raising billing rates.

Ironically, servicing partner has become a pejorative term for lawyers who actually answer client inquiries and work with only a few, highly qualified associates. These are precisely the attorneys corporate counsel want working on their matters. But because servicing partners may draw substantially less than higher-billing colleagues, they drag down average profits per partner and are thus expendable.

Focusing on profits per partner also leads to ever-increasing billing rates. In a January 2009 client advisory, Hildebrandt and Citi Private Bank stated, "[E]ven during the period of record economic growth from 2001 to 2007, the only driver of profitability that was working consistently to support revenue and PPEP [profits per equity partner] was the ability of firms to raise their rates significantly every year." As a result, clients no longer can afford to give the firm basic work, which once was used to help train junior lawyers and foster long-term attorney-client relationships. Finally, maintaining profits per partner through high associate-to-partner ratios results in visible overstaffing - again, at the client's expense.

Likewise, law-firm representatives told in-house counsel to:
- End the widespread use of requests for proposals. They're costly for firms to administer, and they produce only marginal results. More important, if you want more value, we need a longer-term and more predictable relationship. Only then can our firm assume more risk with fixed rates, assign associates dedicated to your matters, and bring other efficiencies to bear. Retain us for a portfolio of work and we can achieve even greater efficiencies.

- Let junior associates participate in meetings, court appearances, and other activities. As associates become more involved in matters, they learn faster and will be more committed to you, the client.

- Stop the nit-picky audits of legal bills. We must add staff to respond to them, and your net savings are nil. If you have a problem with a bill, tell us and we'll almost always adjust it.

To law firm managers, one of the most annoying in-house adages is, "We hire the attorney, not the firm." This focus on individual performers ignores the substantial differences in the way law firms are structured and, in turn, in the value of the work clients receive. Firms that pay high premiums to rainmakers, for instance, reduce incentives for the attorneys actually doing the work. Worse, relating only to high-profile partners encourages them to hoard work at the expense of the firm's next generation, and to sell their "book of business" (meaning the client) in the lateral hiring market.

Bargaining
The economic crisis has forced law firms to do a lot of internal bargaining. Should they retain as many associates and partners as reasonably possible, even if senior partners need to push more of the income downward? Or should they seek to maintain a high profits-per-partner ratio, and then adjust billing rates and staffing to achieve that result?

Likewise, firms are debating whether to freeze billing rates and salaries, or to raise rates but give clients a larger discount. Raising rates ensures that premium work still commands a premium price; firms worry that otherwise, if and when the economy recovers, they'll have lost out on several years of rate increases.

Many clients are bargaining in a different direction. For example, Wal-Mart and other companies have announced they won't accept any billing rate increases, including hikes for attorneys who move up the ladder. And some clients are demanding reduced fees to accommodate their constricted legal budgets. If corporate lawyers can't get better value from the firms, they are bringing more work in-house.

At our planning sessions we also heard that many companies are shifting a sizable portion of their legal work to regional and boutique firms. Many in-house lawyers reported that these firms showed equal or greater expertise, gave much more practical advice, and were much more responsive - all at less cost. Indeed, in its 2008 Chief Legal Officer Survey, Altman Weil found that 77.5 percent of the respondents believed that medium-size law firms (100 to 349 lawyers) have a strong future.

Further bargaining promises to be a significant development this year, both within firms and between firms and their clients. The question is, will the bargaining lead to better results, or will it produce only short-term fixes that put off the day of reckoning?

Depression
The economic crisis has put a strain on everyone. Partners find they are working harder than ever but seem to be less appreciated. With the implied threat of removal to nonequity status, their relationship to the firm feels more like year-to-year tenancy. Associates, meanwhile, look at senior lawyers and say, "We don't want to be like them" - referring to their hours, their lifestyles, and even the type of work they are doing.

The situation is equally depressing for in-house counsel, who must make substantial cuts in their own staffs while under pressure to obtain immediate and major cost savings from outside counsel. The general counsel and what is left of the in-house staff then face increasing workloads, including high-risk legal issues brought upon their companies because of the financial meltdown, at the same time they see their stock options and retirement funds vastly diminished. The disparities in incomes and costs between in-house operations and law firms thus become even more glaring and, frankly, depressing.

In many ways, the problem law firms face is of their own doing. Attorneys have achieved income levels that may exceed the value of their work, both to their clients and to society. Worse, in recent years many lawyers, consultants, and legal publications have promoted the idea that the law isn't really a profession but simply a business. So it shouldn't be surprising when clients ask law firms to accept the realities of running a business: wide swings in revenue and profits, price cutting and cost cutting in times of oversupply, loss of trusted relationships to competition, and the real possibility of failure and dissolution.

Ironically, when I talked with various law partners a year ago about their income expectations, they said their peers believe they are comparable to CEOs and thus deserve similar compensation. That belief reveals extraordinary naïveté about what it takes to run a business with a workforce in the thousands, quarterly analyst meetings, supply and production problems, environmental and regulatory burdens, and the like. But even so, C-level executives live with the risk of significantly reduced incomes, including in the value of their company stock and options. Where is there similar acceptance of risk by senior partners for significantly reduced compensation? And where is their willingness to put the future of their law firms first and assure the development and financial security of more junior lawyers?

Acceptance
There is a certain inevitability to the crisis now before us. In many ways the legal profession - overleveraged and raising rates out of proportion to value - created its own economic bubble. Now that the bubble has burst, most lawyers are far more accepting of the need for change.

Fortunately, many in-house counsel and outside lawyers are focused on positive responses to the crisis in the profession. In the various discussion sessions ACC has held, we've seen a remarkable similarity in the responses of participants. During the first hour, lawyers on both sides sat with their arms folded. Even if they weren't saying it out loud, they were thinking, "Here we go again - same whining, same result." But by the second hour, lawyers on each side had begun offering recommendations they might previously have felt had no chance of being accepted.

Within the next few months, ACC's 49 chapters will host their own sessions with in-house and law-firm attorneys to discuss ways to achieve value. The ACC website (acc.com) has a tool kit for this project that is open to anyone. It includes forms, articles, and other items that suggest ways to better align the interests of clients and their outside lawyers.

ACC also has retained a major economic consulting firm to build a Microsoft Excel?based model in which firms and practice groups can modify variables - such as turnover of associates, billing rates, recruiting costs, and overhead - to see how different alternatives affect profitability. In one scenario I tested, profitability increased nearly 30 percent at a typical 1,000-attorney firm by cutting the size of the incoming associate class in half but then applying an attrition rate more in line with the historical average.

ACC has developed a one-page Covenant of Counsel for clients and outside lawyers (available on its website) that sets out basic principles for delivering value. ACC also is urging the trade press to stop promoting profits per partner and instead to develop metrics that more meaningfully indicate efficiency and value. ACC itself is in the process of developing a value index with which in-house counsel can rate lawyers, practice groups, and firms according to the value they provide, taking into account results, responsiveness, and innovation.

Probably ACC's most important recommendation is to use a process it calls Meet, Talk, Act. It works like this:
- Pick your three best firms or clients and schedule a two-hour brown-bag lunch with each to address a single question: Working together, how can we improve the value of legal services?

- Talk frankly about what new approaches might be tested, and about what changes might be needed on both sides.

- At the end of the meetings, don't over-lawyer the concepts but instead agree to try some of the ideas, even on a small scale, and then expand those that work well.

Time for Rethinking
For most lawyers, these are challenging times. And mere tinkering at the edges of the relationship between corporate clients and outside counsel is unlikely to achieve long-term benefits. But where there is a willingness to rethink the legal function, both sides are likely to discover ways to achieve true and sustainable benefits.

Most important, focus on value in your discussions, and everything else will fall into place.

Michael Roster, steering committee chair of the ACC Value Challenge, is a former managing partner of Morrison & Foerster's Los Angeles office and cochair of its financial services practice group. He subsequently was general counsel of Stanford University and of Golden West Financial.

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