Part II of this article appears in the July 2004 issue, and Part III appears in the Augsut 2004 issue of The Metropolitan Corporate Counsel.Corporations attempt to avoid corporate waste by controlling legal costs. Seeking accountability, corporations institutionalized the billable hour, imposing complex rules and auditing. Law firms, however, play a cat-and-mouse game with billable hours, hoarding productivity gains and saddling clients with both cost and outcome risks. Seeking "discounts" from hourly rates, large corporations fractured their "spend" over hundreds of law firms and created their own internal "law firms" - bringing nearly half of their legal work in-house. This has led to the creation of inefficient bureaucracies to manage legal work.
eLawForum offers an alternative to the billable hour. Competitively sourcing legal work for a growing number of large corporations, eLawForum makes fixed-fee deals for large aggregations of legal work. This new competitive legal market shifts risk from the company to the law firm, realigns incentives and creates dramatic savings. An analysis of eLawForum's competitions demonstrates that the best law firms are the most cost-effective, that fixed fees work for significant and complex assignments and that corporations choose to stay with their current legal providers about half of the time. By changing the relationship between quality and price, eLawForum has the potential to transform the legal services industry.
The Corporate Legal Market
Law firms are incredibly profitable businesses. Since 1987, the weighted average operating margin for firms in the Am Law 100 is at least twice that of America's 100 largest publicly traded corporations.1 The 14,867 partners in these law firms divided $10.1 billion in profit among themselves in 2002.
Leading law firms are extremely adept marketers. Focusing attention on high-stakes cases or major acquisitions, they emphasize the relative cost of their services to the potentially high cost of the outcome. Success or failure in a "bet-the-company" litigation or a multi-billion dollar acquisition dwarfs the law firm bill. What is overlooked is that most law firm work falls outside this category. In the parlance of disruptive innovation theory, corporations are "overserved" when they pay top-firm rates for routine matters.
Corporations have reacted by fragmenting their legal spend in two ways. Going "down-market," they use smaller law firms that charge lower hourly rates. Bringing routine work in-house, they have built large in-house law departments. Fragmentation, however, erodes the corporation's market power, creates layers of bureaucracy to administer the multitude of firms and increases the corporation's fixed costs.
Specialization is the way law is practiced in the corporate legal market. Law departments would not dream of hiring employment lawyers to litigate commercial disputes any more than asbestos counsel would be trusted to handle securities class actions. Law is just as specialized as medicine.
The demographic explosion in lawyers has accelerated specialization. The number of lawyers practicing in the U.S. has tripled during the last 30 years. Today, more than 1 million lawyers practice in the U.S.
With specialization, most corporate legal work does not involve complex problem-solving. The right experience enables specialists to easily recognize patterns and apply familiar tools without "reinventing the wheel." Pattern recognition dramatically increases efficiency. Hourly rates assume everything requires complex problem-solving and enable law firms to hoard cost savings instead of passing them along to corporations
The Sole-Source Market
The billable hour is a relatively recent invention. Before World War II, law firms weighed a number of factors in deciding what to charge their clients: The significance of the matter, the skill required, the work done and the result.2 Law firms provided little information on the time spent because they attempted to price on the basis of value. In the pre-billable hour era, corporations outsourced most of their legal work and used fewer law firms than they do today.
After World War II, law firms and corporate law departments moved to hourly billing as a way to more accurately measure the value of legal services. The billable hour became the standard system for overseeing and compensating outside counsel. In lawyer-like fashion, strict rules were imposed, specifying in minute detail what could appear on bills. Law department and law firm compensation inevitably became skewed towards those who excelled at the cat-and-mouse game created by the billable hour.
"Make" vs. "Buy"
The billable hour fragmented the corporate legal spend. Against the yardstick of hourly rates, to hire in-house lawyers was cheaper than outside counsel - to "make" rather than "buy." Without taking the fully allocated cost of in-house legal staff into account, outside counsel appear to be twice as expensive.3 Corporations arbitraged this differential by expanding their in-house law departments, eventually taking over approximately half of corporate legal work. Competing with outside suppliers of legal services, these in-house legal departments have reduced the market for law firms.
Going Down Market
The explosive expansion of law departments was not the only way corporations fragmented their legal spend in reaction to the billable hour. After asking incumbent law firms for discounts from their standard hourly rates, general counsel took the further step of searching for lower hourly rates among firms they had not used before. The move "down-market" meant giving more routine work to smaller law firms charging lower hourly rates. The search for lower hourly rates fractured the "spend" of Fortune 500 corporations over hundreds of law firms.
Wasting Corporate Assets
Corporations have reacted to the fragmentation of their legal spend. To regain their corporate market power, they have provided volume commitments to a few "pe-approved" law firms in exchange for hourly rate discounts.4
Simply aggregating demand in the sole-source/billable hour/cost-plus market does not save money. Reducing the number of firms - what law departments call "convergence" - in return for a 10 or 20 percent discount does not translate into legal service cost reductions. Using "pre-approved firms" is a form of command-and-control that cements the sole-source relationship.
Finally, the "beauty pageant" has also failed to contain costs. The four or five law firms invited are too few to ensure the best representation for a significant litigation. The winning firm is compensated using the billable hour.
Wasting corporate assets is extremely difficult to avoid in the sole-source/billable hour/cost-plus market. Although law firms give discounts on hourly rates to their largest clients, they negate them by raising the base hourly rates to which the discounts are applied and increase the number of hours billed to do the same work. Law firms are masters of the cat-and-mouse game of the billable hour. As long as the procedures mandated by the law department are respected, any attempts at cost reduction can be circumvented by controlling the two key variables - the base rate and the number of hours spent.
Billable Hours Jeopardize Results
Billable hours foster an adversarial environment that leads to higher settlements. At the outset of litigation, the corporate defendant has access to more information to evaluate the case than the plaintiff. Yet the billable hour encourages suspension of judgment and exhaustive discovery. This educates the plaintiff and may lead to surprises that expose the corporation to additional liability. The "scorched earth" policy of refusing to negotiate settlement until after the close of discovery and filing of summary judgment motions hardens positions and escalates the plaintiff's costs that must be factored into any settlement.
The Fixed Fee Alternative
General counsel are recognizing the pitfalls of the billable hour.5 In 1993, Dan Hapke, then Chairman of the American Corporate Counsel Association (ACCA), pointed out that hourly billing pressures lawyers to pad their bills, perform needless work and engage in similar unprofessional conduct. Lawyers are encouraged to stretch out their time rather than seek early results.6
Alarmed by the unending drive for billable hours, Robert Hirshon made it the focus of his American Bar Association presidency. In 2002, the ABA released a comprehensive study indicting the billable hour as "a counter-intuitive measure of value."7 According to a partner of Bartlit Beck Herman Palenchar & Scott, "the only way lawyers made more money was to bill more hours as opposed to doing a better job."8
Highlighting the need for an alternative way of pricing legal services, the ABA study recommends the fixed fee. "Lawyers should be at least as capable to set fixed fees for most engagements as auditors, construction contractors and even car mechanics are. All of these other jobs have substantial risks of cost overruns due to unexpected difficulties."9
The eLawForum Model
eLawForum is replacing the sole-source/billable hour/cost-plus market with a competitive-source/all inclusive fixed fee/total cost market. By shifting risk, aligning incentives, aggregating demand and basing compensation on results, eLawForum delivers dramatic results.
At the heart of the eLawForum process is a "quality competition." Highly qualified law firms compete and provide their services at very substantial savings. Over the past four years, the business model - built upon the quality competition - has evolved through four stages.
In its first stage, eLawForum did not require law firms to propose fixed fees so that hourly rates remained the dominant compensation structure. Moreover, the cost-plus model allowed the law firms to continue charging for their expenses as well as their fees. Hourly rates do not enable corporate clients to know their legal service cost in advance, nor do they provide a basis for cost comparison. In the end, savings from the discounted, capped or partially fixed compensation schemes were uncertain.
The second stage saw the introduction of the fixed fee requirement. Making fixed fee arrangements mandatory in all competitions, it became possible to compare the legal service cost (fees and expenses) of competing proposals. Corporations could budget legal service costs with the confidence of a fixed fee and achieve significant, measurable savings.
In the third stage, in addition to high-stake single matter assignments, eLawForum began to leverage a corporation's market power by aggregating various legal matters into the same assignment. eLawForum developed sophisticated prospectuses and data sets to assist the law firms in analyzing the complex structures of these new aggregation deals. Aggregating legal matters typically yielded a 50 percent cost reduction. The 2002 ABA study noted the tremendous success eLawForum has enjoyed with aggregating demand for fixed fees.
The fourth stage added a new focus on management for total cost - liability cost as well as legal service cost. While competition drove the fixed fee down to break even, a share in the savings over historic liability costs offered the winning firm the potential to profit. Through close communication with the competing law firms, eLawForum identified and priced each risk factor separately and became a strong advocate in selling the deal. In the fourth stage, legal service cost savings grew to two-thirds as winning firms bet on reducing liability costs by 25 to 50 percent.1The American Lawyer publishes an annual survey of the revenue and profitability of the largest law firms. The Am Law 100 has maintained nearly 40 percent margins since the survey began in 1987. The operating margins of America's 100 largest publicly traded corporations hovered around 12 percent during the same period. Some argue that the Am Law margins appear high because Am Law 100 partners receive no salaries, while the cost column of publicly traded companies includes salaries paid to executives and management. However, assuming the average partner's salary is roughly $200,000, the Am Law 100 would still have profit margins approaching 30 percent.
2 Herbert M. Kritzer, "Lawyer's fees and the Holy Grail: Where should clients search for value?" Judicature, 77:4, Jan.-Feb. 1994, p. 187.
3 By PriceWaterhouseCoopers' estimate, outside counsel cost at least 56% more than inside counsel. PriceWaterhouseCoopers, "Law Department Spending Survey Trends Analysis Report," 1999, p.20.
4 Zoë Baird, "A client's experience with implementing value billing," Judicature, 77:4, Jan.-Feb. 1994, p. 199.
5 By 2001, a study by the BTI Consulting Group found that nearly three-quarters of companies were dissatisfied with their outside counsel. The Strategic Review and Outlook for the Legal Services Industry, p. 69. "Clients...see no substantial difference between any of the law firms out there. Quality is good, but clients can find it in virtually any firm." Id. At 18.
6 Daniel S. Hapke, Jr., "Professionalism, Quality, and Hourly Billing... Are They Compatible?" American Corporate Counsel Association Docket, 11:3, pp. 30-38.
7 American Bar Association, "ABA Commission on Billable Hours Report," August, 2002, p.ix.
8 Id.at p. 36.
9 Id. at p.16.
Clayton M. Christensen is a Professor at Harvard Business School and Scott D. Anthony is a Partner of Innosight, LLC. Republished in part from Innosight, LLC's monograph, eLaw Forum-Transforming Legal Services. Copyright 2004 Innosight, LLC.