Creative Destruction In the Legal Industry

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Over the past eight months nearly every industry in the US has begun a transformation to reform in the face of greater competition and weakening demand. From the automotive industry to financial services, Wall Street to Main Street, small companies to Fortune 500’s, business models are changing and in some cases being turned upside down. Yet somehow the legal industry remains resistant to reform a key area of its own vulnerability – the billable hour.

In part, this failure can be blamed on the fact that law firms weathered the initial economic storm fairly well compared to other industries. The top 100 US law firms saw only a 4% drop in per-partner revenue on average and incurred minor layoffs in 2008. And the last decade has seen rapidly rising profitability and growth within the industry.

But these numbers do not reflect the pain that is now coming. Most industry observers predict a precipitous drop in revenues by the end of 2009, likely in the 15% to 30% range. This will lead to significant downsizing even within some of the most storied and profitable practices. Latham & Watkins, the second largest US firm by total revenues, just recently announced a 21% decline in its client business from the previous year and outlined plans to lay-off 190 attorneys in 2009. More extreme are the cases of Wolfe Block and Heller Erhman, who were forced to close their doors permanently. Similar stories are fast becoming the standard.

To be fair, not much can be done by firms to counteract weakening demand for legal services. It is being driven by market forces largely beyond their control. But what is making some firms more vulnerable than others is the rigidity in their billing structures. Right now clients have all of the leverage in the system to shop for better services and cost. But unlike previous downturns in the economy, the unusual severity of the distress ripping through the nation is creating newfound demand for lasting alternatives that go beyond the basic billable hour methodology. And because the motivation for change is coming from the client side, not the attorney side, there is a unique opportunity for consumers of legal services (and especially general counsel’s of major US businesses) to create the solutions that best fit their objectives.

Law firms caught off guard by this shifting paradigm should be concerned, but not surprised. A major report published by the American Bar Association in 2002 (ABA 2001-2002) sounded the alarm on the billable hour by citing its tendency to produce spiraling per hour costs, overbilling, loss of client control over work-product, misalignment of interests, lack of collaboration and mentoring between attorney’s, as well as upset in the work-life balance. Six years later these risks are deeply rooted in the system, so much so that prominent senior practitioners are joining the chorus for change.

Evan Chesler, the presiding partner at Cravath, Swaine & Moore, told BusinessWeek in an interview last month that he is on a “mission to make the billable hour irrelevant,” even for lawsuits. Chesler’s comments are significant not just for their content, but also because of the pressure they place on New York-based and other elite law firms to follow his firm’s example. Chesler argues that the move to alternatives isn’t just recession driven, but rather a reality of where the industry is going longer-term.

This shifting paradigm is offering clients their greatest opportunity yet to bring systemic change to billing structures, which if done properly, should result in better legal services at the same or lower cost to businesses. This should be welcome news to executives struggling to make ends meet with fewer and fewer resources. Achieving this outcome, however, will require at least two key weaknesses of the current billable hour to be addressed by clients.

First, clients need to ensure that new billing structures have better quality control mechanisms. Success fees, even if only representing 10% to 20% of the total compensation in a client matter, more closely tether the objectives of the client with the attorney’s work-product. It also confronts the soft logic that effort by itself, even if unsuccessful, merits equal compensation.

Second, clients need to use billing alternatives as a way to control spiraling costs. Pricing inefficiencies today are rooted in the perverse incentives created by the billable hour, which often lead to work-product that goes beyond a client’s needs or desires. As a standard practice, firms write-down 15% to 25% of the bill at the end of a case to avoid client outrage. This type of institutionalized overbilling is uncommon within professional industries such as the law and clients need to respond to it by demanding cap and flat fee alternatives. The protection afforded by these alternatives not only will ensure that lawyers do more with less, but that longer-term cost spiraling tendencies are keep in check when markets correct.

When economic bubbles burst, there is chaos and distress. One of the few positive developments to rise from the ashes has typically been innovation and opportunity. New business ideas – and new ways for running old businesses -- are informed by what went horribly wrong in the past. Customers of legal services have just as much right to benefit from this process of creative destruction as customers of any other industry. Ensuring that this occurs will be a positive step for businesses on their path to economic recovery.

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