Editor’s Note: The author of this post is the founder and CEO of Legal Mosaic, a strategic consulting firm and a regular contributor to Big Law Business.

By Mark Cohen, Chief Executive Officer, Legalmosaic

A spate of recent data confirms all but an elite group of law firms are experiencing an unprecedented existential challenge. And while profit-per-partner (PPP) remains high even outside that small band of differentiated firms- thanks to thinning the herd, internal cost-cutting, mergers, and unending lateral cherry picking- their sustainability is in doubt.

There is a legion of causes: the law firm partnership model, disaggregation, the ascendancy of service providers, fierce competition among firms, and incursion by other professions- most notably the Big Four.

The remarkable growth of in-house legal departments- in size and influence- may be the primary reason for managing partners to fret (though their thirty and forty-something partners are the ones who could be left holding the bag or, more precisely, the note).  Corporate legal departments are rapidly claiming larger market share- at the expense of law firms.  They have emerged as formidable competition for the firms they so long sustained and enriched.

This begs the question: are corporate legal departments symptoms or causes of law firm instability? Or are they both?

 

A Quick Look at Recent Market Data

A new graphic titled “How Big is the US Legal Services Market?” created by Legal Executive Institute pegs it at $437 billion. This is larger than most estimates because it includes budgets allocated to corporate legal departments in addition to revenues generated by law firms and legal service providers.

While law firms still represent the lion’s share of the $437 billion dollar US legal pie- far eclipsing the rapidly growing provider total- therealstory is corporate legal departments. They now comprise about $160 billion- over 35 percent- of the market. And their market share is increasing steadily. Still worse news for law firms is that litigation- once exclusively outsourced - is now often handled in-house. Shell, for example, recently established a global in-house litigation team that has undertaken some of the company’s largest litigation matters.

Then there’s disaggregation. Corporate departments no longer outsource exclusively to law firms as they had for so long. More work- both in dollars and complexity- is sourced to service providers. One reason is their DNA more closely resembles corporations than law firms.

The 2016 Report on the State of the Legal Market by Georgetown Law’s Center for the Study of the Legal Profession paints an even bleaker picture for law firms. It introduces the data by likening the traditional firm partner model to Kodak. And we all knowthatstory. The Georgetown study makes a strong case that the partnership model is headed towards a similar unhappy ending.

The study notes law firms are no longer the primary option for outsourced work, much less the only one. And while it’s hardly a revelation that a legal supply chain is maturing, itisnews that the trend lines show steady erosion in law firm market share. Georgetown cites a 2015 Altman Weil survey of over 250 corporate Chief Legal Officers. The conclusion: expansion of in-house departments and retraction of law firm work.

Georgetown also reported that demand for legal services has been flat since 2008 in contrast to a 4-6 percent per year increase before the financial crisis. And Georgetown’s report gets even worse for all but a handful of elite firms: realization is down, and PPP enhancing steps like “pruning the herd,” making equity partnership far more selective, and internal cost-cutting will not sustain current profit levels in light of decreasing demand.

So why are corporate law departments growing so quickly in size, scope, and influence? And is this a symptom or cause of the challenges most law firms are now experiencing?

 

Factors Behind Corporate Legal Department Growth

Economics is the obvious place to start. The financial crisis of 2008 created painful belt synching that has impacted purchasing legal services. Discounted rates, RFP’s, intensified competition, and an uptick in lateral movement and mergers are some of its effects. Procurement Departments are now often involved in legal buying decisions, and Chief Legal Officers (Legal COO’s) are fast turning the page on the “relationship model” of legal retention. These trends coincide with disaggregation, resulting in corporate departments outsourcing more-and increasingly complex- work to service providers instead of firms.

The financial crisis also caused corporations to question seriously whether it is necessary to pay “retail plus” for law firms when they can retain captive counsel “wholesale.” And so, as demand for law firm services has flat lined since 2008, in-house departments have become larger, more powerful, and have expanded the breadth and scope of what they do. This has paralleled the rise of service providers. The law firm stranglehold on legal delivery- and its partnership model-is ending for a myriad of interconnected reasons.  The common thread: the cost structure required to sustain the traditional law firm partnership model is unacceptable to consumers, and alternative supply sources have demonstrated legal work- even complex, high-value matters- need not be delivered by law firms. And as for high-volume, lower-value matters and tasks, law firms are increasingly unable to compete with service providers.

What’s the common denominator? Corporate legal departments and service providers have corporate structures, not partnership models. Both are client-centric in ways traditional firms are not. And both seem to recognize that legal service is now a three-legged stool comprised of legal expertise, business process, and technology. They are structured to meld these disciplines and to invest in them. And they give an equal seat at the management table to technologists and process experts. Law firms, in contrast, must retrofit technology and process into a culture that has been exclusively legal-centric. This is a difficult process, especially when it is accompanied by rapid growth via acquisition.

But it’s not just cost that accounts for law firms losing ground to corporate legal departments. Some additional reasons why in-house departments are expanding include: (1) superior knowledge of the client’s business; (2) relevant legal expertise; (3) unnecessary to hire law firms to handle an entire matter- expertise can be retained on a discrete basis; (4) better integration with client’s technology and business processes; (5) improved responsiveness; (6) maturation of legal supply chain (disaggregation); and (7) myth that law firms- and only firms-deliver “bespoke” services has been debunked.

 

Cause or Symptom?

So, is the growth of corporate law departments a symptom or cause of law firm instability? My vote is “both.”

The ascendancy of corporate legal departments is symptomatic of the monolithic partnership model’s bloated rate structure and emphasis on PPP, not client satisfaction. Case in point: how many firms have responded meaningfully to the Association of Corporate Counsel (ACC) “Value Challenge” launched in 2008? Had there been viable, scalable options to the law firm partnership model that provided high-quality legal service at substantially reduced and predictable price-points, perhaps the current law firm crisis would have occurred more gradually. More firms would have jettisoned their partnership models earlier on and created a more client-centric, efficient, transparent, and cost-effective delivery systembecause they would have had to.And in-house departments would have had market options to an internal ramp-up.

At the same time, the growth of corporate departments has had a profound effect upon law firms. Large legal consumers realize that their legal departments can provide benefits beyond cost when compared to law firms. For example, it avoids conflicts, reduces redundancy, provides greater budget predictability, and sends a clear message to law firms that their retention is no longer a necessity in most cases. Translation: it’s a buyer’s market.

 

Conclusion

The days of the law firm monopoly on legal delivery are over. While a handful will continue to be retained for “bet the company” and other high value matters on a premium fee basis, most firms will not enjoy the luxury of maintaining their current structures, PPP, and SOP much longer.

The partnership model that yielded such reliable and robust financial returns had a long run. But it is no longer sustainable for most firms. That is not to say that law firms will go out of business, of course. But to remain competitive, firms must implement change- in structure, price, delivery, and client orientation. And if they don’t, they might confront a Kodak fate. Mergers- of which there have been many- will not resolve the underlying structural defect of the partnership model.

When will firms reconfigure themselves? There’s an internal financial conflict between partners who are “running the table” ‘til retirement and younger ones who have many years of practice ahead of them. How will this play out?

As Richard Susskind said, “It’s hard to convince a room full of millionaires that they’ve got their business model wrong.”