Freaking Legal Economics
By Steven M. Edwards
Freakonomics is a great book. It uses economic theory to explain some of the mysteries of modern life. I am not an economist, but I thought it would be interesting to undertake an amateur economic analysis of the legal business in an effort to understand how it works, including why some lawyers make more money than others, why law firms employ particular business models, and the role that clients play in law firm economics.
A Strange Business
The law is a strange business. There are many lawyers who can’t get jobs, and yet there are many clients who can’t get lawyers. You would think that if supply exceeds demand, all of these people could find each other.
If supply exceeds demand, you would also think that prices and profits would be very low. In the economic model of perfect competition, prices are bid down to economic cost – economic cost roughly being actual costs plus a sufficient return to incentivize people to enter the business to begin with, as opposed to doing something else. Wheat farmers are often given as an example of this. There are so many wheat farmers in the United States, and the competition is so intense, that the price is bid down to economic cost. If a wheat farmer raises his price even a small amount above economic cost, there will be another wheat farmer who is prepared to sell at economic cost.
The law business is very different. Even though the supply of lawyers exceeds the demand for their services in the overall market, there are some lawyers who charge astronomical prices and make astronomical profits. In the recently released American Lawyer 100, the average profits per partner in 2014 were $1.5 million, and ranged from $495,000 at the low end to $5.5 million at the top. What is more, the average profits per partner have risen about 400 percent in the last 30 years, a period in which the consumer price index rose about 130 percent.
It seems clear that legal services are not a homogeneous product. Wheat is a homogeneous product – a bushel of wheat is a bushel of wheat. Lawyers, by contrast, differ markedly in terms of quality and skills. In addition, legal work differs significantly in terms of complexity and risk. At one end of the spectrum, the work is fairly routine and repetitive, and the risk of getting a bad result is relatively low. At the other end of the spectrum, the work is difficult and complex, and the cost of a bad result can be high.
The legal market can be viewed as a continuum, with commodity work at one end of the spectrum and complex work at the other. Most firms have a mix of commodity and complex work, but firms at the low end of the profits per partner scale tend to do more commodity work, and firms at the high end tend to do more complex work. In addition, the service at the commodity end is a homogeneous service in the sense that there are a lot of people who can do it, and the service at the complex end is more heterogeneous and unique in the sense that there are relatively few people who can do it. In other words, in that segment of the market, demand exceeds supply.
As is the case in most markets with homogeneous products, like wheat, the competition for commodity work is fierce and the prices and profits are low. In markets with heterogeneous products, like the market for fine art, prices and profits tend to be high, even though those markets can be competitive too. It seems likely that the firms at the top of the American Lawyer 100 in terms of profits per partner are making gobs of money because they are offering something unique. Clients understand that there are differences in lawyers from a qualitative standpoint. If they treat lawyers as fungible for purposes of complex work, they may get bad results.
What this means is that clients are willing to pay for quality, or what they perceive to be quality. The reality is that it is very difficult for clients, even sophisticated clients, to judge quality. Unless a client goes through the process that a judge goes through in deciding an issue, which includes looking at the evidence and reading the cases, it is hard to tell whether one brief is better than another or whether one lawyer is more capable than another. In judging quality, it seems likely that clients give results in other matters considerable weight. Clients infer that a lawyer or law firm with good results in other matters must be doing high quality work. In a nutshell, they have a good reputation. What clients are really buying when they pay for legal services, therefore, is reputation.
Reputation is hard to come by, and it takes time to create. Reputation is also important because clients prefer to make choices that they view as safe. If something goes wrong or the result is bad, the general counsel wants to be able to tell the board that he or she hired the best. These factors may explain why there is relatively little movement into and out of the top ranks of the American Lawyer 100 – in the last 10 years, only five of the names in the top 25 firms in terms of profits per partner have changed. Reputation can be what economists call a “barrier to entry” in the legal business. Many of the law firms in the American Lawyer 100 have been there a long time and will stay there unless they do something that harms their reputation or otherwise suffer a financial setback.
There nevertheless has been some movement into and out of the American Lawyer 100. A number of firms have been very successful pursuing niche strategies and then expanding from there to build a strong base. Skadden and Wachtel focused on proxy fights in the 1970s and then took on hostile takeovers in the 1980s because the established firms thought that work was beneath them. They quickly grew into two of the most successful firms in the world – in 2014, Wachtel was first in profits per partner and Skadden was thirteenth. More recently, Quinn Emanuel focused on litigation and was willing to do plaintiffs’ work, and it is now second on the American Lawyer profits per partner list.
Some firms have gone head-to-head against the established firms and have advanced based on reputation alone. David Boies was a well-known litigator when he started Boies Schiller, but he decided he could enhance his reputation further by agreeing to handle the Microsoft case for the government for a reported $140 an hour. He won the case and now his firm is twelfth in the American Lawyer 100 in terms of profits per partner. Paul Weiss has been relentless in its pursuit of quality and reputation, hiring the best law school graduates and bringing in laterals like Ted Wells, Mark Pomerantz, and Beth Wilkinson. Paul Weiss is now third in the American Lawyer 100 in terms of profits per partner.
Some notable firms have exited the market. Donovan Leisure was regarded as one of the best litigation firms in the country, but it could not survive a bad outcome that tarnished its reputation. Howrey collapsed when it expanded too quickly as the market contracted in the wake of the financial crisis of 2008. Dewey LeBeouf grew its practice by offering lateral partners guarantees, borrowing heavily to cover those guarantees and then imploding when it could not service the debt.
There are 26 firms in the American Lawyer 100 with profits per partner of more than $2 million. It is interesting that 20 of those firms are either headquartered in New York or have their largest office in New York. It is also interesting that a significant number of those firms pursue business models where compensation is either lockstep or based on factors other than originations, while the business models of the firms farther down on the list tend to be based on originations. Why is that?
For firms at the top of the list, the name of the game is to keep their clients by providing great service and maintaining their reputation for high quality legal work. The lockstep business model works for them because it encourages partners to stay with the firm since they will make more money the longer they stay. It also incentivizes them to share the work because a firm with a lockstep business model will make more money if everyone is busy.
For firms farther down on the list, which obviously would like to move up on the list, the name of the game is to increase revenue by encouraging business generation. An originations business model encourages business generation. For those firms, the ability to generate business may be more important than sheer legal skill – although the two are not mutually exclusive and, indeed, they may be related – and lateral hiring is an important component of their strategy.
This strategy is not without its shortcomings. Firms that grow through lateral hiring often find themselves in situations where they are paying the laterals too much money, so they must cut costs to maintain profitability. The best way to achieve that is to eliminate the most costly partners who generate the least business and replace them with less costly partners or associates. The originations business model can also discourage sharing. All other things being equal, partners in an originations environment will make more money if they keep matters for themselves and staff them with associates, as opposed to handing the matters over to other partners in order to keep them productive. As a result, some partners become expendable, and there is a lot of movement into and out of those firms.
That is not to say that everything is rosy in the lockstep firms. Partners in those firms often become unhappy if they feel that their contributions, relative to their peers, are not recognized. They may demand adjustments or become the prime targets of originations-based firms that are looking for laterals, although very few actually leave. Lockstep firms may lose clients if partners, who are entitled to receive a certain level of compensation no matter what they do, become lazy or fail to do a good job. As a result, there may be a level of mistrust and concern about whether everyone is carrying their weight in a lockstep firm.
The lockstep model is also hard on associates. The model works best if the associate to partner ratio is high, so it is important to minimize the number of associates who are invited to become partners. Furthermore, the firm does not want the associates to take the clients with them when they leave, so decisions on partnership are traditionally made before the associates are capable of doing that – generally after seven or eight years.
Firms farther down on the American Lawyer profits per partner list typically have lower associate to partner ratios. In the past, those firms tried to compete for associates by convincing law school graduates that it would be easier for them to make partner even though their profits per partner were lower than the most profitable firms. More recently, with the emphasis on business generation, it has become harder to make partner, and originations-based firms are taking longer to make the partnership decision.
The Hybrid System
As the profession has evolved, many firms have adopted a hybrid system, with elements of both business generation and factors other than business generation in their compensation formulas, including the idea of creating a “star system” of highly compensated partners to service the firm’s clients. Interestingly enough, a completely unscientific survey suggests that firms moving up in the world will sometimes incorporate factors other than business generation into their compensation systems, presumably to keep assets in place, while firms that feel they are slipping will embrace originations. In addition, many firms are employing lawyers as counsel, senior attorneys, or contract attorneys, suggesting that there is less concern that they will walk off with the firm’s clients, which in turn makes it easier to maintain the firm’s business while making fewer partners.
As a result, lawyers are consumed with uncertainty even though profitability in the American Lawyer 100 appears to be relatively stable compared, for example, to the profitability of the Fortune 100. That is pretty extraordinary when one considers the capital costs of law firms compared to major companies, further demonstrating that reputation can be a barrier to entry. The willingness of firms to keep lawyers on for more than 10 years without making them partner suggests that those firms see little risk that those lawyers will jump ship and form their own firms, taking the clients with them.
The Impact of Clients
Recent trends with clients have added to the mix. Clients are up in arms over legal costs and are coming down hard on lawyers in an effort to lower their costs. They are attempting to create competitive bidding wars by sending out RFPs; they are establishing “panels” of law firms that are willing to work at lower rates; and they are demanding alternative fee arrangements such as fixed fees and blended rates. One wonders whether this will have any real impact in the long run.
As noted above, clients are willing to pay higher prices for higher quality work. The ability of some firms to deliver high quality work (recognizing that quality may actually be the perception of quality as inferred from reputation) gives them what economists call market power – i.e. the ability to charge a price above economic cost. Even though those firms have market power, competition in their market segment – what some economists call monopolistic competition – may be intense. If economic theory is correct, that competition should result in a market price, and changing the unit of measurement should not cause a significant change in the overall wealth transfer from clients to lawyers for legal services. Whether you charge by the bushel or the pound, unless there are economies of scale or savings in transaction costs, the cost of wheat should be the same. The same should also hold true for a heterogeneous product like legal services, assuming market forces are operating and firms are not engaging in price fixing.
Alternative Fee Arrangements
Alternative fee arrangements may yield transitory savings as firms opportunistically take advantage of the new regime. For example, firms with low utilization rates will try to keep their lawyers busy by offering special deals; firms may be willing to offer special pricing for commodity work, while continuing to do complex work for standard rates. But firms will continue to take advantage of whatever market power they have to obtain total payments from clients that are commensurate with the quality of work they perform. Legal costs will continue to go up because the amount of legal regulation is increasing and the work is becoming more complex. This is why profits per partner in the American Lawyer 100 continue to rise notwithstanding alternative fee arrangements, which have been in existence for some time.
There is also some risk for clients in the alternative fee approach. After an initial period of adjustment, smart firms will use their market power to calibrate alternative fee arrangements in a way that protects them from the downside. Clients may end up paying more for work done on a fixed fee basis than they would if they paid hourly rates. Law firms may assign more junior lawyers to matters where there are blended rates in order to minimize opportunity costs. Alternative fee arrangements also make the market more heterogeneous. Comparison shopping is more difficult when products are priced in different ways. It may be very difficult to determine whether a fixed fee is more economical than an hourly rate when the controlling factors are the duration and complexity of the case, which are often difficult to predict.
When you think of it, the hourly rate is an elegant way of measuring the value of legal services because clients pay for exactly the amount of time and experience level that they get. In the days of Abraham Lincoln, most matters were handled on a fixed fee basis. At the outset of a case, the lawyer got a retainer, which he kept even if he got a quick result. The hourly rate was considered to be an improvement that protected the client by requiring it to pay only for the time actually spent and protected the lawyer by ensuring that the lawyer was appropriately compensated even if the matter took more time than originally anticipated. With alternative fee arrangements, there is a risk of overpayment or underpayment. Rational law firms will use their market power to avoid underpayment if they can.
Hourly rates make some clients uncomfortable because they are concerned about padding and overbilling. A busy lawyer has no incentive to do that. If anything, a busy lawyer has every incentive to do the work as efficiently as possible and then move on to the next matter because that will increase the lawyer’s base of clients and enhance the lawyer’s reputation for doing good work. A lawyer who is less busy may have some incentive to take more time than is necessary on a matter, but alternative fee arrangements are a somewhat blunt instrument for dealing with the problem. A far better solution is simply to change lawyers, which clients do all the time.
I predict that, after a period of experimentation with alternative fee arrangements, clients will return to hourly rates. (In the meantime, I am perfectly happy to explore alternative fee arrangements and readily admit that I may be wrong about them.) If I am right, the emphasis will shift back to hourly rates and savings from discounts on standard hourly rates. Law firms may react by increasing the discounts while also increasing the standard hourly rates, turning the standard hourly rate into a list price. But at the end of the day, the market price will be the market price, regardless of the unit of measurement.
Costs Will Increase
If legislatures pass more laws, regulators adopt more regulations and courts recognize more legal rights, clients’ legal costs will increase. As more lawyers enter the profession, they will look for new and inventive ways to earn a living, increasing clients’ costs. One is reminded of the Abraham Lincoln story of the town with one lawyer who could barely earn a living, but things changed when a second lawyer moved into town and they both became very wealthy. That was great for the lawyers, but probably not so great for the clients. Consumers are never happy about escalating costs, so I’m sure that clients will continue to be frustrated about their ever-increasing legal spend.
The pressure from clients, the emphasis on business generation, and lateral hiring and firing have created an atmosphere of fear, uncertainty, and doubt throughout the legal community. Many lawyers that I know are absolutely miserable even though they are making more money than they ever dreamed they would. They complain that the practice of law has turned into a crass business that is no longer as professional or collegial as it once was. This is a complaint that I first heard more than 40 years ago when I started practicing law. Maybe things were different in the days of Abraham Lincoln. I don’t know.
The important thing to remember is that people in the legal profession haven’t really changed over the years – suddenly becoming nasty, brutish, and short (or at least short tempered). They are simply rational economic actors who are responding to market forces. They always have been. It is market forces that have changed, and they are likely to continue to change in the future. It helps to understand the economic conditions that create this environment, even if it does not make it any more pleasant.