IN THIS ISSUE:

The economic problems impacting law firms are prompting a wealth of predictions about the future: Some say the profession is about to undergo a dramatic and profound restructuring and life for lawyers will never be the same. Others say this is a minor economic hiccup, like so many before, and all will be well by midyear. The truth lies somewhere between the two extremes, but it is clear that as with most recessions, some structural changes will result. Just how much change largely depends on the duration of the downturn.

Is This Recession Different? The term recession is defined as two consecutive quarters of negative economic growth, but the impact of each recession varies greatly. Some are geographically localized, some are confined to certain industries, and some are severe downturns, while others are largely noticed only on paper. The range of recessionary effects is likewise wide and varied for law firms. Recessions prior to the 1990s were largely cash flow problems for law firms rather than events prompting layoffs. The 2001–2002 recession was severe but relatively short lived and had vastly differing effects on law firms depending on location, size, and practice mix.

This recession, however, appears to be different due to the depth and breadth of the economic contraction:

• According to the Institute for Supply Management (ISM), new manufacturing orders have contracted for 13 consecutive months and are at the lowest level since January 1948. This isn't a recession focused on a few industries, but rather, is a widespread downturn across all 18 industries routinely monitored by the ISM.
• As of January 2009, unemployment in the United States was at 7.6 percent. While unemployment has reached higher levels at various times in the past, the real lesson is in how long it takes employment to recover. While some dream of a quick economic turnaround, a review of historical unemployment data shows that a 1 percent improvement in unemployment from current levels takes an average of 16 to 24 months to achieve, and that's only once unemployment has peaked.
• The Organisation for Economic Co-operation and Development (OECD) reports that the 30 market democracies making up its membership are now in negative growth and are projected to continue contracting until the middle of 2009. This isn't just a U.S. recession; it is a worldwide problem.

Some mid-market firms have closed out 2008 with profits higher than 2007, with a few proclaiming immunity to the recession due to their "lower billing rates" or "more practical approach to legal work." While the facts about their price or staffing may be true, they have little to do with the widespread downturn in the economy or the sinking demand for legal services. The recession hit the large capital markets firms first and hardest, but it is clearly showing up across most other practices and regions. Some mid-market firms are likewise predicting they will begin displacing the major capital market firms as clients seek lower-cost legal providers. While we agree that there is greater opportunity for mid-market firms to compete for complex work than at any time in history, it would be foolish to assume tens of thousands of partners in national/international firms will simply sit idle on the sidelines while mid-market competitors rush for their clients.

So what will change in the profession? There are at least four prominent trends, most foreshadowed by other industries that are likely to take hold in the legal profession:

1. Decline in the Use of Lockstep Compensation for Associates. The legal profession is one of the last industries to utilize lockstep compensation for its professional employees. Most industries learned long ago that lockstep compensation is an appropriate vehicle only for the first year or two of a professional's work life, but, after that, true merit compensation systems produce stronger employees, a more competitive cost structure, and higher profits, and help enforce more constructive feedback.
   
   So why has the legal profession hung on to lockstep for so long? There are several reasons:
   • It is easy to administer. A law firm can essentially look up what its competitors are paying and then match it. Sure, a firm could differentiate itself and blow out the pay scale for a temporary advantage, but with the advent of e-mail such a temporary advantage is measured in days rather than years.
   • Rigorous reviews aren't nearly as critical (at least for compensation purposes) as under a merit system.
   • It is what the majority do ... and law firms are notorious for wanting to be innovative but only as long as they aren't the only ones to do so.
   The downside risk to a lockstep compensation system is that it tends to overpay some associates, but when an industry experienced extraordinary demand and produced record profits every year, who cared?
   
   So who will blink first? While merit compensation systems have become common among smaller and mid-market firms, their use in AmLaw 200 firms is almost unknown. There are now a few such firms investigating the change to a merit system. Such change will likely come from a large, progressive, national firm with profits just below those of the 25 most profitable firms in the United States, as they have the most to gain in profits and the least to lose. They will likely keep lockstep for first- and second-year associates, but let associate compensation float on a true merit basis beginning in the third year, with the potential that a star fourth-year associate could earn as much or more than a mediocre sixth- or even seventh-year associate. What is the challenge in making this transition? Conducting meaningful and impartial performance reviews so that weak partners don't simply rank every associate as outstanding in every category. Fortunately that is a problem we solved years ago.



2. The Profession Will Continue to Subdivide. We have long talked about segmentation in the profession: Growing divisions among "the haves" and the "have-nots." Unfortunately, law firms have struggled to figure out what it is that the "haves" really have, with too many confusing size with success or breadth with depth. The key elements of the most successful firms have always been:
   • depth of expertise, rather than breadth
   • capital to invest, and the willingness to risk it wisely
   • tough quality standards for their partners
   • effective teamwork and internal cooperation (autonomy is sacrificed for success)
   The truth is that despite their public image as close-knit partnerships, many law firms are only loose coalitions of lawyers who cooperate on little more than substantive expertise. And most of that cooperation only occurs when prompted by the clients. These firms are noteworthy because they
   • are highly mixed in terms of the quality of partners they admit.
   • rarely market together ("hunting in packs," using a team approach to get the best work for a broad variety of lawyers rather than just the practice of the best marketers).
   • leave the assignment of client work up to the discretion of whoever brought in the work, rather than ensuring work is distributed according to the best interests of the client or the firm.
   • rarely exercise any form of peer review of work or behavior, unless of course a blatant malpractice issue exists.
   These firms rarely consciously use their collective strengths to offset their acknowledged weaknesses (and every firm has partner weaknesses, whether it wants to admit them or not). It is these loose coalition firms that will likely face a period of stagnating or declining profits.



3. Billing Rates and Market Forces—They Actually Work. There has been a strong outcry from clients for the last six years about the outrageous increase in billing rates charged by law firms. Yet, despite all the rhetoric, the market forces have largely worked. Here's why:
   • The real problem has been that this was an unusual period during which the demand for many (but not all) legal services has outstripped the supply of quality lawyers, and as a result, billing rates continued to rise.
   • At the same time there were other practices for which there was an overwhelming supply of lawyers, and clients were routinely moving work in order to get better deals, often for equivalent expertise.
   • The real problem in the legal profession is that pricing changes occur much more slowly or less frequently than in the consumer goods market, which can be highly frustrating for clients.
   • Some clients have been equally frustrated due to their own impatience, or perhaps unrealistic attitudes. Some clients were outraged by their existing lawyers who refused to lower their prices. After all, why would a law firm facing extraordinary demand for its services arbitrarily cut its fees (other than to a de minimis amount to placate clients) when there was a ready supply of work to replace it at full price? As my niece so frequently tells me after giving her worldly advice, "Well, duh!"
   • But there is one glaring problem in this market theory of billing rates: While most law firms have had some practices facing overwhelming demand, they generally invoked across-the-board rate increases. In effect, they attempted to raise the price of low demand practices along with high demand practices. Those are the practices that will face the most significant, and fastest, rate pressures in the coming months.



4. Project Pricing Is the Real Future of Alternative Pricing. The legal press has been filled with articles on alternative pricing arrangements for years, but with little in the way of constructive arrangements that satisfy both buyers and sellers of legal services. Most such arrangements have conflicting goals. The law firm wants an arrangement with the potential for higher prices, while the client wants one with the potential for lower prices, but each side is generally unwilling to accept proportionate risk. As a result, we hear of inane pricing schemes involving ever more complicated rules and conditions that really only favor one side or the other.
   
   Clients tend to want more predictability and better alignment of incentives (something other than the more hours you bill on my matter the more you earn). Law firms tend to want some potential to participate in the risk and rewards when their own efficiency or ability produces extraordinary results that are not reflective of their fees.
   
   So what's the real solution? It is exactly what law firms in other parts of the world and other professional service firms do on a daily basis: project pricing. Project pricing means that at the outset of a project the firm provides an estimate of price based on a mutually agreed upon set of assumptions. And yes, you will never get all of the assumptions right ... but both clients and law firms get better at predicting them over time. If the assumptions change, there will be the potential for a change order. Such arrangements are increasingly common throughout the legal profession in Asia and Europe, and are increasingly used by pharmaceutical companies in their litigation. Will project pricing work for every practice? No, but it may well work for 80 percent of the legal work in the United States.
   
   The trends described above are less about predicting the future than identifying the seeds of current change. The combination of the downturn in the economy and the actual experiences of other professions that have evolved through the same structures as the legal profession makes it relatively easy to identify changes that will impact the profession. No matter what happens in the next year, it is important to keep some perspective. The legal profession is still a terrific way to earn a living; it is just changing and becoming more competitive. But what business or industry never changes or becomes more competitive? Still, relative to the risks involved, and the investment of time and capital, there are few other professions that provide as much intellectual freedom and income as the legal profession.

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