Big Law as Legal Fiction and the Lack of Innovation

We often come across the concept of “legal fiction” in law: corporations, survivorship, adoption, real property, etc. In particular, large law firm partnerships are a legal fiction, and the fiction becomes paramount when one views the decision-making processes involved in keeping a firm viable under today’s changing ground rules. Decisions that would be in the best longterm interest of an organization are often different than those actually made by individuals within it, due to factors such as ambiguity, temporal impacts, repetition, and conflicts (see, e.g. Organizational Decision Making). In particular, though, is the issue of individual incentives. In the case of “Big Law”, these varying incentives may well be a primary cause for the slow pace of implementing the changes that are increasingly being demanded by the market.

How do law firms make decisions?

While the corporate legal fiction has well-studied organizational decision-making quirks, law firm partnerships are perhaps quirkier. The corporate hierarchy can address many of the reasons that individual decision-making is not always aligned with the best interests of the organization. For example, it can work to minimize ambiguity by changing communication models or by bringing in more project management. It can address repetition and decisional lock-in by building and empowering innovation teams (a la Innovator’s Dilemma). It can even incentivize long-term thinking via variances in (deferred) compensation and ISO’s. But how much of this is inherently more difficult to address within a standard law firm model, and why?

I’ve asked several CIOs, managing partners, and law firm consultants about whether long-term viability and related strategic planning are given due consideration at law firms, and, if not, why not. I get a variety of answers. But I think there’s a consensus that a focus exists on short-term partner profits and that the firms really addressing the changing market and the role of innovation are quite the exception. Assuming this is true, it’s not because the partners aren’t intelligent. It’s also not because they don’t understand the problems facing law firms today. It’s more likely a result, at least in part, of a misalignment between the organizational and individual goals, resulting from the firm structure and processes that provide the incentives for individual or (managing) partner decision-making.

Do we care if one or another law firm fails?

There seems to be an assumption that law firm failures are a bad idea. But I think it’s worth asking the question – if that’s true, why and for whom is it a bad idea?

As a potential alternate perspective, for example, one may argue that associates may join large firms to get the brand on their resume, and want to stay only long enough to pay off loans and/or to show that they left on their own. I don’t think it’s a surprise that many associates simply don’t like their job. And given the decreasing numbers of associates that make partner, the potential long-term financial incentive is lacking. One consultant told me that law firms expect that most of the associates from the top schools aren’t expected to stay for many years given how, well, boring the day-to-day work is; they’re hired at least in part because it’s important to have the pedigrees in the firm’s associate portfolio. So perhaps most associates these days don’t really care if one or another law firm fails (assuming that the failure wouldn’t happen too early in their tenure). My understanding from talking with members of Big Law HR staff is that associates do not in general feel a strong sense of loyalty to their firm. If associates don’t care, perhaps partners do.

Among partners, lateral hires are common these days. (I won’t discuss the statistics, or pros and cons of this at any length here, but there is plenty of research on this available to interested readers.) Some partners or rainmakers may move to get better compensation. If most lawyers are simply able to move to a new firm for equal or better compensation, does (or should) it matter to them if one or another firm fails?

I tried to get statistics on the average change in compensation for partners resulting from a law firm failure, including for example six months prior to a failure, when the writing may already be on the wall. I couldn’t find anything. My intuition is, not surprisingly, that partners do worse on average after moving due to their firm’s failure. After all, if they found that they could get substantially better compensation or an otherwise better environment elsewhere, they would have moved earlier. And as one managing partner told me, lawyers “commonly test the market and find that they are better off where they are.  (Actually, a meaningful percentage of Big Law lawyers make more money than they could possibly make elsewhere because of the outmoded compensation systems firms maintain.)” Another one stated, “my intuition is that partners, on average, remain at about the same level of comp. If there is a big rush to find jobs, they are generally happy to get what they were paid previously. There is also a difference between free agents and groups. An attractive free agent can do quite well by having a headhunter find the best opportunity for him or her. When a group moves, the partners at the top of the group often sacrifice some incremental income in order to convince the hiring firm to take the entire group.” In any case, in asking consultants, managing partners, and academicians, I heard several strong arguments for why lawyers should care if their firm fails, beyond their own compensation.

One compelling issue that comes up with law firm failures is, of course, how a firm’s bankruptcy impacts the partners. The partner clawback rules mean that even lawyers who left many months prior to the failure are still on the hook to return compensation to pay off creditors, even if they were unaware of any accounting issues – correctly audited or not. As an extreme example, in the case of Dewey & LeBoeuf, the clawback period was over four years. In fact, one of the potential issues arising from this particular failure is whether or not lawyers should stay with their firm in the face of signs of financial distress, as highlighted in the Schnader discussion:

The bankruptcy court’s holding that law firm partners are strictly liable to repay compensation while ignoring the fees the partner’s efforts generated for the firm bestows an enormous windfall on creditors, who now get to retain the value of the fees generated, and, at the same time, recover the entire compensation paid to partners for their efforts in generating those fees.  The decision incentivizes productive, hard-working partners in NY LLPs to abandon their law firms at the first sign of financial distress rather than staying on to attempt to save the ship.  John [Altorelli]’s decision to stay at Dewey and help it through its financial difficulties only prolonged his exposure, and prevented him from moving to a new firm where he could have been compensated for his efforts.  John’s [personal] bankruptcy filing underscores the danger of remaining loyal to the firm to help it survive through times of trouble.

But this begs the question – given that even senior partners were unaware of the financial distress, let alone the rank-and-file partner – how would one know the right time to leave, or know that a potential new firm doesn’t have the same problems? The laterals that came into Dewey in the years before the failure certainly weren’t in great shape afterward. As pointed out by a managing partner,

“in addition to the clawback issue, there are other important one-time but substantial hits: (1) a partner would lose any capital account, (2) a partner may have to pay income taxes on any partnership debt that is forgiven as part of the reorganization (the cancellation of indebtedness income flow through the partnership to the individual partners) and (3) the partner may lose entirely benefits under certain types of retirement plans. This all could be devastating before you even get to the clawback issue.”

Another issue with law firm failure is that, all other things being the same, it’s simply disruptive and inefficient for all parties involved, including lawyers, staff, and clients. While clients may well follow some lateral moves (apparently, in particular, when the move involves groups or whole practice areas), it still requires a non-trivial amount of work on the client side. It also dismantles inter-practice-area networking, as post-move attorneys need to iron out new internal relationships at a new firm. This can slow down work for the client, or even disrupt some work if the new firm doesn’t contain the same practice areas. As the post-move attorney is working out the kinks, it presents an opportunity for other, well-greased, firms to move in. And all this ignores the issue of imputed conflicts that may require some work to be excluded. Another reason for lawyers to stay is the steady stream of workflow – their income is relatively secure.

Even in a Darwinian model that “the market” benefits when inefficient firms fail, it’s difficult to argue that law firm failures benefit clients, who would be better off if firms adopted increased efficiency and value more smoothly.¹ It certainly doesn’t seem to benefit individual attorneys. I would argue that decision-makers and stakeholders of law firms are simply better off if their firm adopts a strategy for long-term viability.² Assuming that this is true, however, doesn’t mean that individuals make decisions that bear this out.

Fad or trend? – indications of a changing market

If it’s true that there’s a sea change for Big Law, one in which the billable hour model becomes less of a standard and AFA’s become more common, then we might expect that those firms that don’t embrace some degree of change should lose business, and new-model firms should gain. One technology director of a large firm told me a couple of years ago that they thought that Richard Susskind‘s work, portending a radical shift in legal service delivery, is “full of sh–”. While the point the director was making might have validity to some degree for a few of the top law firms, it doesn’t mean that Susskind, Christensen, and others aren’t foretelling a likely scenario for most of the larger firms. At one conference, I was told that the AmLaw 100 and second 100 don’t change very frequently. But one can look at the composition of any stock index, like the DJIA, to see how the economy has changed over time – very few companies stay members for many decades. What kind of turnover do we see in the AmLaw firms, and do we see any indication there that the turnover rate is increasing? If not, it might simply be the case that the composition of the AmLaw 100/200 is a trailing indicator. According to Christensen, we would look at other factors to see if change is coming, as leading indicators.

One indicator is stagnation among existing providers. While some of the top firms have done well, there is a growing dichotomy, and I’ve been told that things have been flat for a while:

While the top-tier firms prospered, the annual American Lawyer list found that three-quarters of the 100 firms expanded at a slower growth rate, with average profit per partner inching up just 0.2 percent, to $1.47 million. As the legal industry becomes more finely segmented, partners in the top-tier firms earned twice as much as other firm partners in the rankings.

Compare this to the growth experienced by some of the new players, such as LegalZoom and Rocket Lawyer, who don’t seem to be experiencing stagnation at all – quite the contrary. While these companies are an example of lower margin work, it follows the trend across industry after industry in classic Innovator’s Dilemma fashion. New entrants start with lower margins, more efficiency, and higher value at the low end, and move up market. A cursory glance at legal startups on Angel List, or just a simple Google search, indicates that legal services outside the standard model of Big Law are abundant and thriving (“the market for legal startups is booming” says one commentator). They are ignored at the peril of the established players.

In addition to stagnation and new (low-margin) entrants, another indicator that the industry is changing comes from Big Law clients. Whether it’s tech giants, such as Cisco and Google, or banks such as Bank of America, recent presentations at, for example, Thomson Reuters panels, indicate that corporate legal departments are increasingly using and demanding quality metrics and new financial metrics that allows them to measure ROI on their legal spend. Corporate legal departments are no longer excused from the metrics used across the rest of the company just because their work falls under “legal” (except perhaps for high-stakes bet-the-company litigation). Cisco pays 80% of its law firms under an AFA (generally flat-fee) model. Under these circumstances, efficiency (without loss of quality) is paramount, even under a billable hour structure. Moreover, new entrants that take componentized chunks of work abound far beyond what is now common practice for document review.³ The point is not simply whether clients are dramatically reducing their legal spend, but where they’re spending it and what kind of ROI they expect for it:

“The larger the firm the higher the cost,” said Don H. Liu, general counsel for Xerox Corp. While he uses elite law firms for critical transactions, he helps keep the company’s legal bills in check by sending other work to smaller law firms in St. Louis and other low-cost locations. “Big law firms don’t have a monopoly on talent,” he says.⁴

All things considered – stagnation, new players, changing client values – it’s simply unlikely that these market changes are a fad, or that they aren’t indications of a need for serious change for all but perhaps the very top law firms. Moreover, even at the top, it’s difficult to argue that between two exceptional lawyers, all else being equal, the one who uses technology well doesn’t offer greater value. They can deliver higher quality work product at less cost. Not even the best attorney uses a quill; it’s not a question of “if” as much as a question of “when” various technologies will surface at any and all law firms. Incorporation of technology and efficient delivery require rethinking the standard model of Big Law. It requires innovation, as described, for example, in Christensen and Raynor’s Innovator’s Solution.

The current climate of inaction

Let’s assume that it’s in lawyers’ interest that their firm doesn’t fail, and that market conditions are undergoing a transformation that requires various types of innovation. The next question is how well law firms are doing at incorporating innovation into their long-term strategic planning. There are some well publicized examples of law firm innovation awards and rankings, such as ILTA and the Financial Times. Prof. William Henderson of Indiana University Law School describes the 2014 ILTA Big Law innovation winners: Bryan Cave (realistic financial performance data, integrated technology training), Seyfarth Shaw (client-focused interdisciplinary R&D), and Littler Mendelson (workflow optimization and client-available KM). “It is time to put down the broad brush used to paint BigLaw as inefficient and out of touch,” he says. “As it turns out, BigLaw has on balance a surprisingly good hand to play. Many will thrive, but at the expense of taking market share from the rest.” However, there are also commentaries (e.g. by Ron Friedmann) explaining that so-called innovation at many/most law firms might be best described as the uptake of technology or methodologies that have been common in other industries for years. As Henderson says, “what is missing at some firms, but clearly not all, is the will, courage, and leadership to seize the opportunity.” In fact, he estimates that only 10-15% of large law firms have embarked on strategic initiatives that take into account the “New Normal”. While this pattern of trend-setters and laggards is normal in the adoption of technology and innovation (see, e.g. Crossing the Chasm), the reasons likely vary sector by sector.

Knowledge of what needs to be done to capitalize on the changing market is abundant. Beyond standard texts like Innovator’s Solution, there is a plethora of consultants eager to help law firms exploit innovation. Henderson highlights the three requisite drivers:

1. Substantial investments of money and time
2. Substantial expertise from non-lawyer professionals
3. Skillful and determined leadership to communicate and support the change initiative

Yet, he points out that law firm partners “have been waiting for proofs of concept from peers.” He goes on to say that “obtaining partner buy-in remains a Herculean task.” The issue is, then, why is it so difficult to get partners on board? The answer, in part, comes back to the standard model of law firm organizational structure and the misalignment between the individual incentives and organizational objectives.

Carrots and sticks: how to incentivize innovative decision-making

Christensen discusses quite eloquently how to motivate various stakeholders in the corporate setting. For managers, use the stick; for innovators, use the carrot. He stresses, for example, how important is it for managers to see the pending doom and rising competition from disruptive innovators. Similarly, he views it as crucial that the innovation team understand the opportunity – to ignore the initial small size of the new market and recognize the growth potential. This is, however, even more straightforward for sustaining innovation. That is, rather than needing to establish new markets, much of law firm innovation can focus on making current practice (much) more efficient. For this to work, though, managers are assumed to make decisions that are in the best interest of the firm.

From an organizational perspective, law firm “shareholders” are also management, and the principal-agency model of a corporation doesn’t work. Whether or not corporations execute their charge effectively, their managers are tasked with increasing long-term shareholder value. But Big Law managers and decision-makers are also the key shareholders, and the annual payout of all profits doesn’t provide an incentive for long-term future shareholders like non-equity partners or associates. Decision-makers may still care for various reasons, such as reputation.⁵ But the question is whether that’s enough to motivate a loss in personal income, in order to reallocate revenue to innovation initiatives, in order to keep a firm viable for decades to come; how much personal, current, income is one willing to sacrifice for (potentially someone else’s) future income?⁶

One managing partner pointed out several reasons for partner hesitancy to adopt innovation within the firm’s strategic planning. First and foremost may be that they simply don’t understand how innovation helps (and thus be willing to delay innovation projects until it’s too late to catch up). This problem may be amplified by junior partners who understand the nature of the business less than senior partners. Another potential issue is that some partners hope to hold onto the status quo until they’re able to retire. A third reason is that the partners don’t see a lot of movement among the majority of their peers. And finally, the classic Innovator’s Dilemma argument: “we’ll just move up market – we don’t want to do that low margin work anyway.” In addition, Ron Friedmann points out reasons like the negative incentives to try out new ideas; what might be called the “if it ain’t broke don’t fix it” syndrome; fear of looking stupid; the difficulty of taking responsibility; the (real or imagined) negative response of clients; etc.

Thus, under Christensen’s model, the stick of company failure works only inasmuch as the managing partners are either young enough to worry about their own future income, don’t think that they can easily move to another more viable firm, or care about other incentives (for example, a belief that their personal reputation is tied to that of the firm’s future success). That is, the firm’s failure may be somewhat unimportant, and thus not a motivator. For the senior partner – managing, equity, whatever – the trade-offs between personal, short-term income and long-term firm viability might be very different than what a 30-something junior partner might prefer. This may be rational as viewed from the perspective of a senior partner.

If the stick won’t work, then perhaps a carrot will. The problem that Christensen describes is that the opportunity of a new market is in general so small to an established player that management finds it difficult to invest the resources to pursue it. But as I mentioned, there is a lot of room in Big Law for sustaining innovation. However, if the payout of an innovation program is past the retirement horizon of the decision-makers, they have less incentive to go along with it.⁷ One potential carrot here is to consider extending the payout of key innovation decisions for some extended period as those decisions become fruitful. I’ve been told that this type of deferred compensation, extending beyond the active employment of a partner, is simply a non-starter – perhaps due to the constraints of a partnership, or just the standard mentality of a participating attorney. But if some form of longer-term payout is the only way to get needed resources allocated to such new programs, it is in the interests of more junior stakeholders to go along with it. And, in fact, such a model works in the favor of the junior staff in any case, as they inevitably become senior and get rewarded for their own long-term decision-making post departure. If the only motivation to embrace innovation is pending doom, it’s already too late to fix the problem, and in fact, based on failures like Dewey, it’s too late to leave.

Timing is everything: if not now, when?

Henderson’s “From Big Law to Lean Law” is mandatory reading for anyone trying to understand the current market of Big Law. As he has said in the past, there’s a train wreck coming in the next few years. In fact, he estimates that within the next 5-10 years, following the typical pattern of Innovator’s Dilemma, alternative delivery mechanisms will be providing the necessary range of service required by Big Law clients that the current model will simply be superfluous for most Big Law firms. Yet, in speaking with Big Law consultants and managers, there seems to be quite a hesitancy among partners to adopt necessary changes. Perhaps changes are necessary, but isn’t it rational to wait until we see firms falter due to the standard model? When and how much of real dollars today should partners give up in order to accommodate a restructuring whose progression is unclear? And while it’s easy to see that lawyers have adopted changes like using computers for word processing, how are they supposed to know how far to go?

As an engineer first and lawyer second, this is an odd perspective for me. In the hi-tech world, it’s more of an innovate-or-die mentality. Competition isn’t based on factors like reputation per se, but on the features available and the relative cost. This isn’t just true for services based on advertising revenue such as from Google or Facebook – it’s equally true for services such as games, office tools, accounting, project management, and on and on. In separating the role of shareholder and manager, managers ostensibly hold back paying dividends and invest in the R&D necessary to keep a firm viable. If what might make sense to a Big Law firm if it were viewed as a corporation isn’t happening due to the partnership structure, then it seems to imply that the partners are conflating their dual roles as managers and shareholders. Today’s take-home pay is at least in part a dividend that only makes sense after a reasonable investment is made in the R&D investments for long-term viability.

Mixed into the argument that partners want to wait until they see other firms falter is the conception that the non-faltering firm either won’t be theirs or that they’ll have time to take action once they see the failures. But the rationale behind this reasoning seems risky to me. Perhaps it’s coming from skepticism about there being fundamental changes occurring in the market, as opposed to being one of timing. I’d argue that that’s simply wishful thinking that goes against well-established economic theory and data of how innovation and technology enters new sectors. If it’s one of timing, I’d argue that, first of all, revenues of Big Law as compared with alternates such as LPO’s and startups have put the writing on the wall already. Second, there’s simply no reason or need to wait.

Finally, flipping things around, in trying to answer the question as to why Big Law is NOT doing more to innovate, I haven’t heard a single rational argument. It might be different if innovation in process, structure, and technological delivery diminished the final work product. But what quality data exists, as far as I can see, indicates that Big Law clients are simply better served via innovation, regardless of practice area.⁸ That means that partners are arguing that they don’t want to deliver a better, less expensive product – solely to benefit their individual short-term profits. That mentality doesn’t seem to be a recipe for a quality law firm that bases its market share on “reputation”.

Conclusion

Where compensation is a key incentive for individual decision making, which it rationally is, it has to be addressed in a way that takes into account the legal fiction of the organizational decision-making of a Big Law firm, and the non-fiction that decision-makers are, ultimately, individuals.

Ongoing research

Along with mapping Innovator’s Dilemma to the legal space, our work at Stanford Law School’s Center on the Legal Profession also explores some of the innovation approaches that might be successful from a Big Law perspective.

Notes