From Georgetown Law: Creative Destruction and Innovation in the legal industry (with video interviews)

Part of our coverage of “Law Firm Evolution:  Brave New World or Business As Usual?”, a conference held March 21-23, 2010 by the Georgetown Center for the Study of the Legal Profession.  For all our posts on the conference click here.

Reported by:  Gregory P Bufithis, Esq.      Founder,  ThePosseList.com and ProjectCounsel.com  

The panel was composed of William J. Perlstein (Co-Managing Partner, WilmerHale), Mark Chandler (Senior Vice President, General Counsel, and Secretary, Cisco), and Jeffrey K. Haidet (Chairman, McKenna Long & Aldridge).

Presentations were made by David McGowan (Lyle L. Jones Professor of Competition and Innovation Law, University of San Diego Law School, and attorney with Durie Tangri LLP, San Francisco), Bernard Burk (Partner, Litigation Department, Howard Rice Nemerovski Canady Falf & Rabkin), and by Larry Ribstein (Mildred Van Voorhis Jones Chair in Law and Associate Dean for Research, University of Illinois Law School).

The session moderator was James W. Jones (Co-Managing Director, Hildebrandt Baker Robbins; Chairman of the Hildebrandt Institute).

The panel discussed long-established economic principles concerning technological innovation and transaction costs to bear in the context of the elite law firm, where they have been largely overlooked in the commentary to date.  These are helpful in explaining a number of the events observed in recent years.

Professor McGowan teaches and writes about intellectual property (IP), antitrust and legal ethics. He is particularly interested in the economic analysis of IP policy and the intersection of IP laws and competition policy. His IP scholarship addresses topics such as antitrust policy in software markets, the implications of network effects for IP policy, legal problems associated with standard-setting organizations, open-source software development, the Justice Department’s antitrust suit against Microsoft, rules governing website access, patent misuse, the scope of copyright law and the relationship between copyright and free speech policy.

He has applied many of these economic principles to law firms.  We had an opportunity to interview David McGowan before the panel start and he gave us an excellent overview of the panel’s objectives:

During the panel David pointed out that there are long-established economic principles concerning technological innovation and transaction costs to bear in the context of the elite law firm, and they have been largely overlooked in the commentary to date.  These principles are helpful in explaining a number of the events observed in recent years.  He said we need to start out with Schumpeter’s definition of innovation because it helps explain why he associated innovation with disruption of the status quo and why it might be considered the most important element in the contribution economic activity makes to overall social welfare  — and is directly applicable to the law firm marketplace.  Reductions in transaction costs and in the cost of certain key inputs to legal services are helpful in explaining a number of the events observed in recent years. Reductions in transaction costs — notably in the cost to clients of finding lawyers and monitoring their performance — represent the rationalization (that is, the playing out in its own terms) of an existing business model. In other words, smarter and more sophisticated client representatives would cause some of the events we are seeing with or without technological change. Examples include clients’ hopping for a specifically skilled and experienced lawyer to handle a particular problem rather than just relying on a firm to supply one, and the increased use of contract lawyers and non-lawyer specialists whose services are bought at comparatively low rates in spot markets.

He also said that these forces are made stronger by cost reductions caused by technology change in the creation, management and storage of information. These changes have no particular growth-valence on their own—they might allow large firms to get larger, for example—but they do help drive the outsourcing and downsourcing trends discussed during the conference.  They also make it possible for small firms to enjoy significant economies of scale without bearing the high fixed costs commonly associated with such economies. Because of these technological changes, boutiques are easier to set up and can operate at lower cost than larger firms. If clients increasingly are willing to pay only for core services from experienced lawyers, this model may prove more robust than conventional academic analysis has suggested in the past.

In explaining the “arc of law firm development” and the “arc of legal services” David went on to say that  law firms allowed clients to economize on transaction costs by offering “one-stop shopping” for a particular engagement, thus saving the client the time, effort and expense of locating and assembling its constituent pieces from disparate sources. But a “rational economic actor” (the client) should use one law firm for a full bundle of the constituent services necessary to complete a particular project unless the sum of (1) the cost of some constituent service(s) from one or more different providers (factor costs), plus (2) the cost of finding the cheaper provider(s) (search costs), plus (3) the cost of coordinating use of the cheaper provider(s) for some services and the law firm for the rest (coordination costs) is less than what the law firm will charge for all the services except the cheaper one(s) the client decides to carve out and hand to someone else. 

These principles go a long way toward explaining some widely observed changes in the market for legal services over the last 30 years.  Back in the “golden age” circa 1960, many companies did not have in-house lawyers at all, or had only a few. Those lawyers tended to be relatively unsophisticated about issues integral to the effective functioning of a modern law department—how to find the right people for particular kinds of tasks, and how to coordinate their efforts with the client company, with one another and with outside counsel. Instead, they chose to hand whole tranches of legal work over to their outside general counsel, who were quite good at finding and hiring good people, assigning appropriate people to particular tasks, and coordinating the efforts those involved to produce the desired work product.

In this brief post I cannot do justice to all the issues David addressed, or his brilliant paper.  For a detailed explanation see David’s paper Coase, Schumpeter, and the Future of the (Law) Firm by clicking here.

Larry Ribstein discussed why Big Law’s business model is inherently fragile and why it’s crumbling under pressure.   He began his analysis by noting there’s a certain unresolved tension between partners’ role as workers and their role as owners:  as workers, lawyers’ self-interest is to cultivate their own individual human capital, including client relationships; but as owners, lawyers’ ultimate success depends on enhancing the firm’s expected earnings, which requires them to invest in building the firm.

This dynamic intersects with another one, which goes back to the question of why large, diversified law firms exist to begin with.  One plausible explanation (subscribed to by Bruce McEwen) is that diversification across practice groups and geographic regions insulates lawyers from the effects of downturns in their own areas of expertise. 

Larry said a new model needs new types of law firm property but that ethical rules impede this development.  But, he said, markets will challenge these rules.   These pressures on the “equilibrium” can be summarized as follows: 

▪Short term economic climate (client demand)

▪Rise of in-house counsel (information asymmetry)

▪Technology and markets (reducing size advantage)

▪Increased leverage (reducing monitoring and bond)

▪Changing clientele (and peak load demand)

▪Limited liability (reducing monitoring and bond)

▪Global competition (client demand)

▪De-professionalization (client demand)

▪Decline of hourly billing (effect of reduced bond, reduces profitability) 

It is why we are moving toward the new law firm.  Firms want outside equity capital because: 

▪Lawyers are inefficient risk-bearers

▪Revenues and expenses don’t match

▪For incentive compensation and promotion 

But the supply of outside equity capital: 

▪Depends on firms’ risk-adjusted ROI

▪Which depends on their business model 

So what we have in terms of economic analysis is a situation where lawyers must be able to rationally conclude that their expected gains from investing in the firm’s reputation and brand outweigh those from building their own clientele.  This can be an eminently reasonable wager if all of one’s partners are equally committed to putting the firm first.  The obvious risk is that you may create what Larry describes as a “prisoner’s dilemma coordination problem,” meaning that there are perverse incentives for individual lawyers to “grab and leave” even if it would end up leaving everyone worse off than they could be in a highly functioning, coordinated, collaborative firm.

To this Larry adds the inarguable observation that over the past 20 or so years, the associate:partner leverage ratio has increased materially in many (not all) firms.  As Bruce McEwen has commented “Human capital leverage is no different in its consequences than financial capital leverage:  It’s your best friend in good times and your worst enemy in bad times (paraphrasing the US Marines)”. 

To round out this dismal picture add the ingredients of relative U.S. decline in an era of globalization, erosion of the cost-plus pricing model of the billable hour, and the still-nascent but inarguable threat of outsourcing.

Larry went on to discuss regulatory impediments, pressures on regulation and the effects of the death of Big Law.  For his full presentation The Death of Big Law click here.  He expanded on his thoughts in this interview:

Note:  In January 2007, Mark Chandler, general counsel of Cisco Systems, announced in a speech at Northwestern Law School that his company was moving away from paying outside counsel by the hour for most of the company’s legal work. Chandler would instead pay a flat rate for various legal services, describing the profession’s reliance on the billable hour to be “the last vestige of the medieval guild system.”  In his speech, he argued that flat rates would help Cisco’s bottom line, partly because ending the billable hour would cut attrition rates at large law firms, which, in turn, would reduce the cost of legal services.

At the Georgetown conference Mark said that “looking at firms that fail does not tell us that much. Silicon Valley is sustained by California law that makes non-competes void”.   He said firms invest a lot in nurturing relationships.   For him “cross-selling is about revenue enhancement, not capitalizing on your reputation”.  Mark uses the 2×2 matrix as part of the Cisco legal department strategy.  The matrix provided a common and acceptable vocabulary that allows a group to talk through an issue and to be able to move on to considering alternative solutions.  For a look he provided a PowerPoint which you can see by clicking here.  This is all critical for a company like Cisco which became the largest manufacturer of networking equipment in the world by retaining vital functions while partnering to attain speed and scale in other areas. To keep pace with cutting-edge engineering, Cisco has purchased a steadystream of start-up companies with promising technologies.  New companies are integrated quickly, with special attention given to recognizing and rewarding staff efforts. Capital-intensive processes in areas such as manufacturing, logistics, and distribution are treated as noncore and better suited to best-of-breed strategic partners. 

Other points made by the panel:

Bernard A Burk:  we need to look at economic models of BigLaw to help understand their evolution and thereby know how to change law firm structure.   He made the point that as firms got large “they became not so much fragile as brittle”.  They were stymied (or helped, depending on how you look at it) by lateral partner moves.   It was all about “Reputational Capital theory” but that no longer works.  As firms became large, it was too hard to monitor and the simple truth was/is clients shop for lawyers, not firms, so firm reputation does not have much value.

So, this is the conundrum – what explains large firms then? Why do firms keep growing?   There are dis-economies of scale that create friction. In this environment, partners have personal brands that attract clients. To make most of personal capital, you surround yourself with peers to both refer business to and gain business from.  This provides some explanation for why a firm might get large.  But as firms get too big, referrals are harder because partners can’t really know which partners are reliable and which will refer business back to them. 

Partners want to move upstream and work with those who have the most reputational capital. It explains why the model is “brittle” and why with personal and individual capital belonging to the individual, and not the institution, that this IP easily transfers across law firms.

Jeff Haidet:  Recession is not the cause of this paradigm shift.  The forces have been at work a long time.  The ACC value challenge had roots in 2007 before crash and Laura Empson in her work Managing the Modern Law Firms had raised many issues we are seeing today.

Bill Perlstein:  It is clear that it is the law firm managers and the client general counsels who are the ones who believe change is imminent.  His fear is that “most in the market we will go back to the old normal”.   And that is a period in time “that will never be repeated”.    This was all accelerated by a set of unique factors at the start of the century –” the dot-com crash, major scandals such as Enron, the rise of e-discovery in huge volumes, etc.  He said “money was almost free” given the rush of transactions and deals.  But these growth drivers will not be present in the future.

And it is a mistake to view BigLaw/AmLaw 200 as this simple monolith.  The top NYC firms such as Cravath and Wachtell are in a far different business — they are doing the highest-stake cases.   We have at the other end of the spectrum firms like Quinn Emmanuel which have a much narrower focus.  And in the middle you have many large, multi-office firms.  And that’s the issue:  these firms have trouble differentiating.