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The race to the bottom

Cover Story
|Written By Luis Millan
The race to the bottom
Illustration: Matt Roussel

Some law firms are so determined to attract new business they will go to lengths that confound even the most seasoned legal observers. Perhaps one of the most extreme examples took place last year when an Am Law 50 firm successfully undercut — by a staggering 80 per cent — a bid made by an similar sized competitor firm, tentatively agreeing after tough negotiations to provide substantial litigation services for a mere US$350,000.

The implausible situation prompted Dan DiPietro, chairman of the law firm group at Citi Private Bank, to ask his interlocutor to repeat the numbers to make sure he did not miss a digit. Certain law firms have gone even further, and reportedly submitted bids of zero dollars in auctions to obtain work for insurance giant Marsh & McLennan Companies.

The current legal marketplace, characterized by lethargic growth, too many lawyers, and a buyer’s market, has driven some law firms to literally conduct fire sales.

Offers to work for free are atypical. But seemingly more prevalent are cases where law firms aggressively chase work, offering rates so low they almost certainly will lead to an unprofitable engagement or at best result in a write-down. Legal consultant Bruce MacEwen morbidly but aptly describes it as “suicide pricing.” It is a phenomena Edmonton-based legal consultant Patrick McKenna, whose clients are exclusively American law firms, has seen all too often. “There are many firms that are doing it in very limited ways, regrettably in practices they shouldn’t be in in the first place because they are not a major player and so try to get some work by being silly about pricing,” says McKenna.

Though more widespread in the U.S., there are some Canadian law firms engaged in deep discounting. Shahir Guindi recalls seeing on a couple of occasions law firms taking very aggressive and “frankly very ridiculous” positions to land a contract, and it backfired. “It’s clear that those relationships or those ‘investments’ have not borne any fruit,” remarks Guindi, managing partner of the Montreal office of Osler Hoskin & Harcourt LLP.

The practice is based on an enduring but fallacious presumption in the legal profession that by getting a foot in the door it will eventually lead to higher-value mandates. It simply does not work, says Ottawa-based legal consultant Jordan Furlong, a view unreservedly shared by all legal players. “This idea that lawyers have that if we do this for a very low rate but it will be of such high quality and value that the clients will be blown away and happily come back for more is a mistaken assumption because most firms are indistinguishable from each other in terms of the work that they do,” says Furlong, a partner with global consulting firm Edge International. “Having done it for a quarter of the price, why would the client come back to pay the regular price?” Besides devaluing the work performed by lawyers, it can end up disparaging a firm’s brand and stigmatize it with the damning label of being a low-cost producer.

More fundamentally, it betrays an abysmal misunderstanding of the market forces at play. There is no doubt the lasting and unforgiving economic climate has triggered a crisis that arguably was already in the making in the legal market before the 2008 financial crisis. Last year was yet another of modest growth as law firms continued to struggle with the interrelated impacts of sluggish demand for legal services, declining productivity, falling realization rates, and austerity measures intended to preserve profitability, according to a report on the state of the legal market recently published by the Center for the Study of the Legal Profession at the Georgetown University Law Center. A report conducted jointly by DiPietro’s Citi Private Bank and Hildebrandt Consulting LLC echoed those same findings.

It’s no secret demand for legal services has dipped over the past couple of years. In the U.S., the demand compound annual growth rate was a robust 3.7 per cent between 2004 and 2007, a figure that actually declined by 0.4 per cent in the 2008-2012 period, according to the Citi study. More specifically the demand for legal services in 2012 grew by a paltry 0.5 per cent, as tracked by the Thomson Reuters Peer Monitor database. Demand for legal services also has been marked by skimpy growth in the United Kingdom and mainland Europe; only Asia and Latin America, driven by high-growth economies, saw demand on the uptake.

Productivity, as measured by the total number of billable hours recorded by a firm divided by the total number of lawyers in the firm, also suffered in 2012 just as it essentially did in the three preceding years. In 2012, the number of lawyers in U.S. firms grew by two per cent while demand registered only 0.5-per-cent growth. That meant productivity took a hit in 2012, remaining negative at 1.5 per cent.

Just as telling is the dramatic decrease over the past couple of years in realization rates, the percentage of work performed at a firm’s standard rates that are actually billed to and collected from clients. Though law firms have not shied away from raising rates, realization rates continued their downward trend. In 2012, law firms raised their rates by an average of 3.4 per cent, but realization rates fell to a historic low of 83.6 per cent due to client resistance. Am Law 100 firms fared even worse, achieving realization rates of 82.8 per cent, according to Peer Monitor. In stark contrast realization rates stood at 92 per cent before the financial crisis in 2007.

No surprise then that annual profits per equity partner, the most commonly used measure for law firm success and financial health, have taken a beating. While compound annual growth rate for PPEP in the U.S. stood at six per cent between 2004 and 2008, it plunged to 1.7 per cent for the period of 2008 to 2012, reveals the Citi study. That has proven to be hard medicine to swallow for partners who experienced healthy profit margins during good times, according to Citi, remarking many are still clinging to the expectation profitability will revert back to the levels before the financial crisis struck.

The boom years that law firms enjoyed preceding the global financial crisis debatably masked a business model that was slowly beginning to unravel. The signs were there; no one was really paying attention. Even before the economic downturn in 2008, productivity growth was essentially flat in categories such as equity partners, income partners, and associates — signs that too many lawyers were chasing not enough work. More revealing, the financial success of law firms rested on a house of cards: annual rate increases prior to 2008 averaged six to eight per cent per year at a time when the U.S. inflation rate never exceeded four per cent, points out the Georgetown Law report.

“Truth be known, between 1985 and 1995, irrespective of any law firm’s strategic plan, the overall strategy in the legal business was to bill more hours and to work harder so they got partners and associates to put in more hours,” notes McKenna. “From 1996 to 2007, irrespective of what the strategic plan said, every year firms automatically raised their fees — and the client paid. Then in 2008, the shit hit the fan. Now you can’t raise your fees without a great deal of client pushback and you can’t get any leverage because you are de-equitizing [partners] and there’s more lawyers than demand for legal services. So how do you make money?” asks McKenna rhetorically.

Therein lies the conundrum. Moreover, things are not expected to get much better in the near future. “We think it is time to let go of any lingering notion that the industry will revert to the boom years before the Great Recession anytime soon,” predicts the Citi report. “With profit growth and other financial indices reaching lower set points in the past four years, we anticipate that the current state of the industry will remain the norm for the foreseeable future.”

But what about the Canadian legal marketplace? Has it coped better than its American or European counterparts? Is the future of Canadian lawyers and Canadian law firms just as bleak? Nobody really knows. In what has proved to be a sore spot for those who study the Canadian legal marketplace — and perhaps a blessing for Canadian law firms — hard figures are non-existent. There is not a single consulting firm or organization that examines or tracks the Canadian legal scene with the same depth as the Americans. “It would be really nice to have the same kind of data so that you can objectively evaluate this marketplace,” remarks lawyer Mitchell Kowalski, author of Avoiding Extinction: Reimagining Legal Services for the 21st Century. “So we’re stuck with anecdotes and best guesses. That, in turn, allows the marketplace to be even more non-reactive to any kind of change because there is no one out there with data that says there’s a problem here.” Furlong concurs: “We are hampered by the fact that there is almost no publicly available information about mid-sized to large firms in Canada in terms of their profitability and revenue,” says Furlong. “The only rankings of Canadian law firms that you will find anywhere is based on the number of lawyers. So we are working in the dark.”

Nevertheless, it is widely assumed because the Canadian economy was relatively unscathed by the 2008 financial crisis, the financial impacts on Canadian firms were not nearly as severe as their American and European counterparts. Nor does it appear the wholesale bloodletting still taking place in the U.S. in a bid to shave costs and maintain profitability has occured or is about to occur to the same extent in Canadian firms. In the U.S., associates and support staff have been laid off in droves. Partners too are under the gun. De-equitization, which really took off three years ago, will continue unabated, says the Georgetown Law report. Approximately 15 per cent of some 120 firms surveyed by Wells Fargo Private Bank’s Legal Specialty Group said they intended to cut partners in the first quarter of this year. Another survey conducted by American Lawyer revealed 55 per cent of 113 managing partners and firm chairs planned to ask one to five partners to leave the firm in the coming year.

Though little quantifiable information about the Canadian legal marketplace is available for public consumption, Canadian law firms readily concede the market has changed. “Although Canada has been more resilient than the U.S. and Europe, the research findings apply in full measure,” says Les Viner, managing partner of Torys LLP. “The legal marketplace is fundamentally different. There are several reasons that is so, but the number one driver is Economics 101: supply and demand.”

André Vautour, chairman of the board at Montreal law firm Lavery de Billy LLP, acknowledges the market is flat, and would be surprised if it grew greater than the rate of the economy over the next couple of years. “We’re not that different from the U.S. and European markets but, on the other hand, I don’t think we have been affected as much as they have been,” says Vautour. “We’re not seeing a big fall on realization rates for instance. Our hourly rate increases, however, have been much more modest compared to before. Our productivity has decreased but it is marginal in our case. It has meant though that we have not hired as much as we did in the boom years but we haven’t made a conscious decision to reduce our payroll or reduce the number of our lawyers.”

Andrew Fleming, managing partner of the Toronto office of Norton Rose Canada LLP, points out Canadian law firms “are not immune” to the trends that have taken hold in other jurisdictions.Indeed, Canadian law firms are grappling with the underlying market forces that emerged even before the financial crisis of 2008, though some believe the crisis accelerated its evolution. The drive towards the commoditization of legal services, the emergence of non-traditional service providers, and the changing roles of in-house counsel and corporate law departments are all disruptive forces forcing Canadian law firms to take a hard look at how they operate. It’s not as if they have much of a choice because the combination of all of these forces has led to a pivotal shift in the legal services market.

In a word, it has become a buyer’s market. Clients are taking a much more hands-on approach, and are driving all the critical decisions over the structure and delivery of legal services. They are also holding lawyers far more accountable than ever before, and expecting — if not demanding — efficient and cost effective services delivered on a timely basis. “Before you get retained, clients want a dialogue upfront,” says Oslers’ Guindi. “Clients want to control who is participating in the file. They want to have an understanding on the risk tolerance or materiality levels that are going to apply throughout the course of the mandate. They want constant dialogue, and most of all they don’t want surprises when it comes down to the issues they are going to face, the bill, the people on the file.”

The shift from the seller’s market that traditionally dominated to a buyer’s market should mean purchasers can drive a much harder bargain. In today’s highly competitive market, discounts are almost a given. That is certainly the case in the U.S. With too many clients chasing too little work, the Citi study notes pricing concessions have become a fact of life. “Clients . . . are using their newfound bargaining power with alacrity,” it says. In turn, many firms have given in, offering discounts because they feel it is “better to keep lawyers’ plates full with lower-billing work rather than half-full with full-priced work.” But playing the heavy discount game can lead to bittersweet results, warns McCarthy Tétrault LLP partner Matthew Peters, who is responsible for the development of the firm’s overall approach to the marketplace and clients. “We have seen this in circumstances with other firms where they are loading up,” he says. “There is no barrier to scraping up hours. Their view is that it’s such a low rate we better rack up the hours in order to increase the top-line revenues.”

As importantly, adds Peters, providing hefty discounts does not address clients’ needs as it can have a detrimental impact on the quality of the service they receive if only because it can be far more difficult to get the right people working on the file. “The client’s issue is what’s the total bill that I get in the mail, and deep discounts don’t address that problem because you haven’t addressed how many hours you spent to get the matter done,” says Peters. Fleming adds another proviso; clients no doubt have the upper hand in the current economic clime but savvy in-house counsel recognize “you can get further ahead by having a happy partner with you in the provision of legal services than if you have a disgruntled partner.”

Corporate Canada seems to have bought into that line of reasoning. Discussions around pricing certainly hold centre stage but Canadian corporate clients and in-house counsel are not nearly as aggressive or forceful as their American and European counterparts in efforts to obtain steep discounts, says Furlong. “Clients are kings who really don’t realize they are on the throne,” he says. Geoffrey Creighton, past chairman of the Canadian Corporate Counsel Association, has a different take. The senior vice president and general counsel at IGM Financial Inc. is not entirely convinced the legal market is as “radical” in Canada as some people would like to think. Canadian corporate counsel are far more inclined to focus on obtaining value for the money they spend on outside legal services than enter into tough negotiations over price, says Creighton. That doesn’t preclude them from haggling. Au contraire. Besides negotiating over value adds such as free onsite continuing legal education and lawyer secondees at deeply discounted rates or even no cost, in-house counsel and corporate law departments are progressively flexing their muscles and demanding law firms use low-cost alternatives such as legal process outsourcers to perform commodity work. That largely accounts for the success of ATD Legal Services PC. A Toronto-based no-frills LPO, ATD performs e-discovery and document review services and due diligence at a fraction of the hourly rate, around $100 an hour, that Big Law charges. Most of its clients are other law firms, says Andrea Taylor, ATD’s director of operations. “Law firms don’t have a choice because clients are demanding it. It’s a necessity they have come to accept.”

Since in-house counsel and corporate law departments are increasingly doing more of the legal work themselves, and using external lawyers only for specialized advice, clients have in some respects become the main competitors of outside law firms, observes Furlong. Not only are in-house counsel increasingly displacing outside lawyers as the primary trusted legal advisers, they also deprive them of a previously steady supply of activity and revenue. It’s in the interest then of the supplier to be efficient and cost effective. “There are more in-house counsel, which means there are more educated consumers that can be more precise about the specifications about what they need and getting overkill,” says Creighton. “Like in any market, that is going to drive more efficient conduct by the supplier.” A sure-fire way for a law firm to lose a client is by making the client feel they were taken advantage of, he says, which in large part explains why Canadian law firms are now scrambling in pursuit of the new Holy Grail of the profession — so-called value billing.

Not all are going about it in the same way. Some firms have sought a competitive advantage through consolidation in the belief a comprehensive footprint is needed to serve international clients. It was a popular strategy as there were a record number of 96 cross-border mergers announced last year, including the likes of Norton Rose with Calgary-based MacLeod Dixon; Fasken Martineau with Johannesburg-based Bell Dewar; and announced last year but officially launched a couple of months ago, the creation of Dentons from Salans LLP, Fraser Milner Casgrain LLP, and SNR Denton.

Other law firms are putting a lot of effort towards re-thinking their delivery systems to enhance efficiency and service while being able to stare down the pressures of operating in today’s business climate. Nearly four years ago, after sensing clients’ expectations were shifting, McCarthy Tétrault introduced legal project management at a time when many major North American law firms were just beginning to explore the discipline. Today, it is taking a step further and has just introduced legal service process mapping, a system designed to clearly lay out the steps required over the life of a matter to improve efficiencies by identifying best practices and examining whether others such as paralegals or LPOs could perform the task. “The traditional approach has been to look at discounts but clients are telling us that they are looking at the number of hours spent,” explains Peters. “This is a whole issue of efficiency and how services are delivered. If you can examine the number of hours, the staffing profiles, and just how services are delivered, you can actually impact the total bill as well. In many respects, it is a much more effective way because you are not jeopardizing quality and you are dealing with the whole issue of the total bill.”

Alternative fee arrangements such as fixed fees, flat fees, or performance-based arrangements are supposedly on the uptick, and something many law firms offer. It turns out, however, in-house counsel are not exactly enamoured with them, according to the 2013 In-House Counsel Barometer Survey conducted by Vision Critical in collaboration with the Canadian Corporate Counsel Association and Davies Ward Phillips & Vineberg LLP. “There is a general lack of knowledge surrounding alternative fee arrangements,” admits Creighton. “It might work in certain contexts but in others I don’t know how you’d make an alternative fee arrangement work really well if it is a big complicated transaction. I still think the traditional billable hour is appropriate for many more complex matters if you have a good trusting relationship.”

Other alternatives, such as new law firm models like Cognition LLP, a Toronto-based legal services provider that rents out hired guns, is seemingly gaining growing acceptance from corporate law departments and in-house counsel. Managing and controlling costs of outside counsel is a priority in today’s competitive business world, says Jill Schatz, general counsel and vice president law at Primus Telecommunications Canada Inc. “The use of alternative legal service provider models such as the virtual law office practice offered by Cognition is an invaluable tool to help contain costs,” says Schatz. Cognition’s co-founder Joe Milstone believes the legal services market is on the cusp, “if not already beginning and into it,” of fundamental change. “I temper that by saying that the Canadian market is actually even more conservative and slower to respond and, in some ways, lagging other markets such as the U.K. and the U.S.”

That is a viewpoint shared by legal consultants and “futurists.” Kowalski likens the current Canadian marketplace to a monopoly where there is very little incentive to change. Allowing non-lawyers to own an equity interest in law firms, as is the case in Australia and the U.K., would force Canadian law firms to become more innovative. As it stands, says Kowalski, there is a perception among some law firms they have “ridden the storm fairly well so why change.” He believes it would be in firms’ interest to focus on processes, invest heavily in knowledge and information technology systems to “really help them drive” efficiencies, and provide better client service. “Just drop the billable hour right off the bat and that would force them to be more efficient by having to work on a budget.”

  • RE: The race to the bottom

    BCReed
    Great Article! Although I don't agree with all the analysis it is great to see information being shared and analysis being done on the business of law.

    With the suicide pricing, there should be more emphasis and analysis placed on the margin and business operations rather than the price reductions. It is quite feasible for firms to lower prices if they can maintain or increase their margins through efficiency investments, overhead reduction, and work volume increases. Its suicidal if they choose not to change the operations and just lower their prices.

    As for ABS's I don't foresee that as the way to dramatically change the profession either. Although the industry itself is profitable their are many conditions present which dissuade investment. Just because the industry is open to investment doesn't mean its an attractive investment. The partner model, regulatory restrictions, use of the legal system as a competitive tool make the industry unattractive.
  • Price Fixing

    james
    Its hard to tell whether this article is overtly endorsing price fixing or just implying that its the best strategy
  • RE: Price Fixing

    Jerry
    Are you confusing fixed fees (or flat fee billing) with price fixing? These are not the same concepts. Price fixing would be an agreement between law firms to sell their services at a artificially fixed price instead of market rates. A fixed fee agreement is between a law firm and a client in which both parties agree that the firm provides legal services for a fixed amount.

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