Did we serenely pass a tipping point?

As my kids used to say, “Made you look”! Remember, we rarely know a tipping point until we have passed it. We see them while looking back. We realize the world changed as we watched another cute cat video. For the record, I prefer the video of Professors Collins and Stone talking with Judge Posner. The Judge shares some provocative thoughts about the Supreme Court.

As Kovalan says, law firm leaders have blamed “more for less” and decreasing budgets for pressure on firm revenues. Data suggests, however, law departments have different motivations. They pull work in-house because they can. Recently, general counsel added another reason. They said they will trim law firms that seem to be on shaky ground. This move was inevitable. It could hasten the demise of some firms without resources to survive the departure of major clients.

We may have serenely watched general counsel realizing they can live without outside counsel. Are they changing their Facebook statuses from “in a relationship” to “alone and loving it”?

Why Do Law Firms Exist

As clients reduce the number of law firms they use, we should revisit a basic question: why do law firms exist? In 2011, Jordan Furlong published a nice essay taking a look at this question. He came up with one clear reason. Law firms exist to reduce transaction costs. Lawyers would face higher costs if they practiced separately. Re-reading his essay, it is hard to fault his logic. And, Furlong’s conclusion is consistent with the development of law firms over the past 150 years.

After the Civil War, solo practitioners started joining together into firms of two or three lawyers. The main motivation as best we can tell was to save transaction costs. A few firms, such as New York City firms representing corporations, needed more attorneys. They handled complex legal work. The rest saved money by partnering.

In the 1900s, the volume of regulatory work grew. Legal work also became more complex and it took more lawyers to do the manual labor of law. All of this led to some law firm growth. But,  saving on transaction costs was the main driver.

Furlong argues that technology replacing labor drives transaction costs lower. It decreases the justification for large law firms. Transaction costs fall below what firms can get by banding lawyers together.

I think he has a good argument, with one exception. A segment of the large law firm cohort—the superrich law firms—thrive. Twenty large law firms increase revenue and profits each year despite all the challenges facing law firms. Experts claim these firms provide legal services that weather cost cutting efforts. They provide specialized services in high-risk areas and command premium prices for their work. The lawyers in these firms band together because doing so supports lucrative businesses.

These firms don’t feel the challenges other firms do. Competition and technology do not have the same effect on them. Clients with high-risk work are not cost sensitive. Clients demanding specialized and sophisticated work will pay for the “best” to avoid failure.

If we slice off the top 20 firms, we have 180 firms left in The American Lawyer 200. They need to show why they exist. Lowering transaction costs is not sufficient. I am not arguing all but the top 20 law firms will disappear in a decade. But, I believe we will see continued firm consolidation. The gap between the top 20 and the remaining firms will grow. Today, we see a law firm size distribution resembling a two-humped camel. It has a bulge at the right end, one at the left end, and a trough in between. I think we will see a similar distribution in the right end bulge. That is, two humps with a trough in the middle. A camel on a camel?

Large law firms carved up the middle market firms years ago. Today, the 180 law firms in The American Lawyer 200 have become the new middle market firms. They face just as much risk as their predecessors. The live in a trough. That trough holds the firms that have trouble answering “why do you exist?”

A Late Bloomer

In many respects, this firm size evolution reflects broader trends. When I was young, mid-size department stores populated retail malls. Today, those stores have gone away. We have a few large stores, but the others merged or folded. We can go through industry after industry and see the same trend. Why should law firms be different?

We also see competitors entering many of these industries. Amazon? The legal industry is remarkable for having held on so long before living these changes. The tipping point has come (if it has come) late to law.

What Now

Assume we did see a tipping point in 2016 and in 2017 the remodeling pace in the legal industry will accelerate. What does that mean? I think it means a lot for clients. As I’ve said before, I’ll leave the firms to fend for themselves.

Clients need to get serious about understanding their supply chain and how to structure it. We hear that clients use alternative legal services providers more frequently and pull more work in-house. Those changes don’t show supply chain understanding and remodeling. They show clients swapping higher cost for lower cost in an existing supply chain.

The suppliers in the legal industry may change, but the supply change structure remains the same. A client hires a law firm. Everything is transactional, with little or no integration. Even when that client goes back to the law firm for help, each matter is transactional without integration. This is an old supply chain model. To the client’s detriment, it favors the supplier, not the buyer.

In 1980, Harvard Business School professor Michael E. Porter published the Five Factors Model. We use it to analyze an industry’s structure. We consider: 1) bargaining power of suppliers, 2) bargaining power of buyers, 3) threat of new entrants, 4) threat of substitutes, and 5) industry rivalry. Based on the analysis, we can measure the intensity of competition in an industry. Intense competition means suppliers earn lower profits.

When we look at the legal industry, the model shows low competition. Suppliers can earn outsized rewards at the expense of buyers. As competitors have entered the legal industry, the results shift a bit. But, the structure favors suppliers earning outsized rewards. This is one reason law firms can raise rates each year.

The structural shift that makes sense for the legal industry goes counter to the direction clients have taken. Jeffrey Dyer and Harbir Singh call it the “relational view”and described it in a 1998 article.

Under the relational view, suppliers and buyers integrate processes. This creates seamless, cost effective, higher quality workflows. The automotive industry is a visible example of this approach. An assembler integrates with Tier 1 suppliers, who integrate with Tier 2 suppliers, and so on. Before you say “lawyers don’t assemble cars,” I’ll point out that some clients and law firms use this same approach. The supplier and buyer work for mutual advantage rather than winner takes all.

How does this work? The supplier and buyer think long term. Working together, they set a goal. Then, they examine and integrate their existing processes. They design a value stream that flows through the entities. Value streams in the old model start and stop at each entity’s door. They build and invest in a relationship and in each other. They develop trust and expect the relationship to continue.

That relationship means the supplier will invest in innovation that benefits both it and the buyer. It means it won’t try to maximize the return on each matter. Instead, it will maximize the return on the relationship. It means the buyer will return to the supplier rather than shop every matter. The buyer invests in the supplier. Studies show that using the relational view, suppliers and buyers both do well. The supplier has a continued relationship at lower profit per transaction. But, that is better than higher profit per transaction and constant churn.

Finally, external competition keeps the parties on their toes. If a buyer stops investing, innovation will drop off. That in-house law department will be less competitive than departments in other companies. The corporation has a competitive disadvantage. If a supplier stops investing, the buyer will leave for a stronger relationship. We see that today. Buyers report they already have dropped many firms and plan to continue the trend.

Today, corporate law departments still use the transaction view for supply chain structure. They do not build competitive advantages, just temporary cost benefits. Law firms do not invest, because they have no incentives to do so. The transaction view drives low innovation, higher cost for the buyer, and higher revenue for the supplier.

Conclusion

Buyers have more alternatives today to get their legal needs serviced. They understand this and have decreased their reliance on law firms. Law firms struggle to respond and keep the benefits of the current supply chain structure. That is, law firms still want outsized profits. Buyers perpetuate the transaction structure that helps law firms. Swapping one supplier for another does not change the structure.

Both buyers and suppliers will do better over the long run by changing the supply chain structure. Moving from a transactional view to a relational view balances benefits to both parties. We have seen instances in the legal industry of this move. The client and the firm prosper with stronger relationships. Innovation increases. Buyers should consider a new supply chain structure. Otherwise, they will replicate the current system with different players, which is not real change.

References

1. Jeffrey H Dyer & Harbir Singh, The relational view: Cooperative strategy and sources of inter-organizational competitive advantage, 23 Academy of Management Review (1998).
2. Lawrence M. Friedman, A History of American Law (Simon and Schuster. 1973).
3. Steve Kvalan, Your Clients Just Aren’t That Into You, Law.com(2016), available at http://www.law.com/sites/ali/2016/11/13/your-clients-just-arent-that-into-you/.
4. Tony Mauro, Judge Posner Slams “Stupid” Decisions by Chief Justice Roberts, “Silly” Stances by Scalia, Law.com(2016), available at http://www.law.com/sites/almstaff/2016/11/30/judge-posner-slams-stupid-decisions-by-chief-justice-roberts-silly-stances-by-scalia/.