The recovery position

In the first half of a two-part article, three leaders in professional development consider some of the key management decisions law firms should be taking as economies around the world slowly emerge from a damaging recession.

By Stephen Armstrong, John Claydon and Norman Letalik

To weather the current precarious economic climate, many law firms have had to be aggressive in cutting costs and shifting resources among practice areas. But the shock of the recession, which has overcome the legal profession’s usual resistance to change, provides a perhaps unprecedented opportunity to improve your firm in the long run by transforming it into the firm it would like to be once better times have returned. Seizing that opportunity may require, for example, making long-term changes to cost structure; revising strategy, and therefore, approach to business development; finding new ways to strengthen relationships with existing clients; and re-thinking career tracks, compensation, and training of professionals – all improvements that can often be neglected when work is plentiful and the firm is busy.

This article suggests what firms can do to emerge from the downturn stronger than ever, and this first part focuses on firm economics. Its second part will later consider the ‘people’ dimension, both internally within the firm and externally, involving clients and prospective clients.

An assumption that forms the basis of many of these suggestions is that lawyers at both large and small firms in this period should focus on a broad array of practice-management issues, not only the issues that the recession forces on them. They should do so not simply because they may have time while work is slow, but more importantly, to ensure that they emerge from the recession in the best possible position to take advantage of the rebound. If it turns out that the downturn is shorter than anticipated,
it is all the more important for firms to act quickly before work pressure erodes available time for putting in place the changes necessary to prosper in a world that is likely to be very different from the world before the recession.

A fiscal foundation for the future

Imbed fiscal discipline

As the lay-offs and other drastic cost-cutting measures among the largest and most leveraged firms have demonstrated, economic crises are no time for half measures in making financial decisions. At this point, almost all the hardest-hit firms have taken steps to cut their costs in the short and medium term, and many have contingency plans in place for further reductions if their businesses do not rebound. Even among these firms, however, few have gone on to permanently imbed the financial discipline they will need to put the firm on sound footing for the future. This step should be taken by all firms, even those lucky enough to be surviving the recession relatively easily. As firms turn to this task, they can draw lessons from the experience of firms that have had to cut costs most aggressively:

Controlling costs and allocating resources wisely are not tasks suited to slow consensus building. Leaders need a mandate to make the tough decisions. That mandate does not relieve them of the obligation to consult broadly and to communicate clearly, and often, about the reasons for their decisions, but they should be able to act quickly, to make decisions that have broad effects, and to impose the procedures and rules that fiscal discipline requires. If a firm’s governance structure or culture is preventing these decisions from being made and implemented, it may be time to re-think how the firm is governed – especially if its governance also prevents the firm from being decisive about strategy and investments.

A piecemeal approach to controlling expenses, looking carefully at item after item to see which can be cut, seldom does good. The firms that have been most effective at reducing costs have typically told their cost centres to cut their budgets across the board, excepting only areas where the firm has a strategic need to invest (opening a new office, for example, or upgrading its technology).

Firms have found that some cuts in overheads and staffing seem to have had almost no effect on the firm’s performance. Clearly ‘fat’ had built up over the boom years. These cuts should stay in place, even after the recession ends, especially as that boom is unlikely to return. It will be easier to maintain that discipline, however, if the foundation is laid now, by communicating with the firm about the cost structure the firm wants to maintain going forwards. For firms that have not had to undertake major cuts, there may be a lesson from the experience of the harder-hit firms. In some areas, you can probably take a significant slice off your expenses without damaging the core of your practice.

Controlling costs means much more than cutting them occasionally. It also requires having the metrics and the processes in place to monitor expenses closely and frequently, and to hold those who spend the money accountable for overruns. If your firm does not yet track expenses closely enough to identify overruns in detail each month, now is the time to create that system. Your financial staff or finance committee should be meeting monthly with administrative and practice leaders to review their expenditures, category by category. You should also have a process for ensuring that those who ‘own’ budgets do not find creative ways to spend unused money as your year-end approaches.

The best-managed firms have not simply created a single lean budget. They have developed a number of budget scenarios based on different assumptions. For example, they would have a worst-case projection, anticipating a longer-lasting major decline in revenue; a less-than-worst- case decline; zero-based, contemplating no growth; and an optimistic scenario, anticipating a return to pre-recession profitability. That approach should not be limited to tough times. Firms should be prepared to change from one budget to another if their revenue projections for a year turn out to be over-optimistic.

Be disciplined about investment decisions

Fiscal discipline means more than a rigorous approach to controlling costs, however. It also means having the courage to invest, but doing so with the same discipline. A piecemeal approach, simply responding to requests for more money as they come up, almost guarantees wastage, as opposed to a disciplined approach – perhaps based on an annual strategy review, re-visited every quarter – to making only the investments that will pay real dividends.

These investment decisions may include resisting the temptation to cut some costs that seem easy targets. Although expanding staff tops the list of what you do not want to do, some hirings – for example, of laterals who are indispensible for filling in gaps in your practice – are as good an investment now as they would be in better times. Another good investment may be to accept a short-term operating loss in a practice area to retain key people if necessary. It may also be wise to resist the temptation to reduce the number of equity partners you elect, even if they will be under-employed for a while. They can help to generate revenue later, and it may prevent you losing them to other firms in a year or two.

Fiscal discipline should also apply to the revenue side of the firm. If a particular matter conflicts you out of a larger assignment in the future, or will consume resources better used elsewhere, or does not align with your strategy, should you take it on? In firms where business intake is left primarily to individual partners or practice areas, this discipline might require more energetic oversight by the firm’s leaders, such as a partner or committee named for that purpose. And again, that discipline should become a permanent part of the firm’s business model.

Re-think staffing and compensation structure

The crisis also provides an opportunity to change your staffing and compensation structure to better serve your clients and improve your economic foundation. In the expectation that the market for lawyers will be a buyer’s market for several years, some firms have not only held salaries steady (and in a few cases, reduced them), but they are also establishing the expectation that their salary scale will continue to be less rich even after the recession ends. Some firms have also made structural changes to control their compensation costs – for example, by establishing or expanding a category of lawyers (often called ‘staff attorneys’ in the US) that are billed and paid at lower rates, or by lengthening tracks to partnership without providing significant salary raises for every year of the track. A few firms are also contemplating ‘profit-based’ compensation, even for non-partners, with compensation tied to the average billing rates and profitability of a practice area or office. Many firms that have so far used a ‘lockstep’ approach to salaries, giving everyone at each level of seniority an automatic raise every year, are now moving towards some version of performance-based compensation. As the second part of this discussion will cover, these approaches often divide associates
into ‘levels’ rather than years, with promotion from level to level dependent on skill and expertise, not simply seniority. The benefits of this approach go far beyond its effects on overall compensation – effects that may be modest – but the approach can provide a tool for gaining more control over compensation costs.

Revisit overhead costs

While the overwhelming cost of running a law firm is in the form of salaries and partner draws, there are other significant costs that can also be cut. If the cost of office space equivalent to yours has gone down or is projected to do so, leases can be extended in exchange for an immediate lowering of rents. Increasingly, law firms are outsourcing word processing; accounting and payroll; IT services; copying and printing; cateringl; public relations; and even some elements of business development. Firms need to determine which office functions can be outsourced to save costs while still keeping service at acceptable levels. Even where services are not outsourced, they can be moved to locations where costs are lower, either in the same city, or, where a firm has multiple offices, to the office where costs are the lowest. Why not have your IT development and programming take place in the office where the cost for IT specialists is lowest?

Insurance, meanwhile, particularly errors and omissions insurance, is also becoming an increasingly large cost for law firms. Pooling with other law firms, particularly for excess of loss insurance above a certain level, is likely to yield significant reductions in the cost of premiums.

Prepare for alternative fee arrangements

Even before the recession, corporate and other institutional clients were becoming increasingly aggressive in their pursuit of lower legal fees and in their complaints about the hourly billing model, which they regard as an incentive to inefficiency and make it difficult for them to predict their legal costs. The recession has accelerated this trend, and more law firms are indicating their willingness to move from the billable hour model – in part, because the continued pressure to discount their hours-based bills is cutting significantly into their profits.

The trend suggests that most firms will need to become more flexible with respect to their fee arrangements, even if they are not being strongly pressed to do so yet. In addition to flat fees for relatively routine work, law firms will increasingly be asked to take a disciplined, sophisticated approach to budgeting even complex matters – an approach that allows costs to be predicted for segments of the matter and avoids catching clients by surprise when changing circumstances affect the cost. In other situations, clients may want firms to share the risk, perhaps by accepting lower hourly rates in exchange for success fees for a transaction or litigation.

The most forward-looking firms are beginning to embrace these changes. Not only are they taking the lead in discussing alternative fee arrangements with their clients, but they are also putting in place the financial and project-management processes that will allow them to manage these arrangements effectively. When managed properly, the arrangements can be a win-win for both the client and the law firm. Clients like them because they force lawyers to become more efficient, reduce legal costs, and make those costs more predictable. Law firms should like them because they allow them to avoid the wear and tear on client relationships of constant arguments about discounts. Although these arrangements will lead to reduced fees for some matters, they also provide opportunities for profits that firms are now forgoing – for example, the ability to charge more for high-value work that does not consume many hours. In addition, these arrangements can improve the morale of a firm’s lawyers, because the focus shifts to the professional value of their work, not the hours they accumulate.

Discussions can also take place with clients about saving expense by outsourcing certain routine legal matters to low-cost service providers. Commonly outsourced services include due diligence for legal transactions; review of documents for discovery, particularly e-documents; and basic legal research (for example, for multi-jurisdiction reviews of regulatory or compliance laws). This form of outsourcing was gaining prominence before the downturn, and will likely be a permanent feature of the legal-services model that emerges from it. Also, the client’s in-house lawyers can manage this type of work directly, allowing its law firm to concentrate on higher-value work.

For matters that are still billed by the hour, and despite the intense pressure from clients to cut rates, meanwhile, partners should be instructed to defer the decision about a discount to a partner or committee with firm-wide responsibility for making these decisions. Such a process will prevent a firm from losing revenue unnecessarily because some partners give in to pressures to discount more easily than others. It will also insulate the partner from appearing to resist the client’s proposal, and at the same time ensure that the law firm takes a consistent approach with all clients. In-house counsel are more sophisticated than ever in comparing notes about the cost of legal services, in part as a result of networking sites such as Legal OnRamp. This additional transparency makes it imperative that all clients are treated in a consistent and fair manner.

Diverse fee arrangements are now becoming so common that many observers believe there can be no return to the tyranny of the billable hour. If these arrangements are to prove profitable for law firms, they will have to take two steps: educate their partners about how to predict and manage a matter’s profitability, and institute better project management.

Analyse and manage matter profitability

Most partners do not have a sophisticated understanding of a matter’s profitability, nor of how that profitability can be affected by how it is staffed and managed (for example, by how the work is divided among lawyers with different profit margins). If your firm does not have the financial tools that allow partners to understand, not simply a matter’s billable hours and realization, but also its actual profitability, it should create these tools and train partners to use them. In addition to helping partners staff matters with an eye to their profitability, the tools enable the firm to understand, at a quite granular level, which types of matters are likely to be the most and the least profitable. The tools will also allow the firm to identify and train partners who consistently staff or manage matters so they are less profitable than similar matters managed by other partners.

Focus on project and team management

Although law firms have largely only begun to embrace the discipline of project management, the trend is accelerating. The change is driven in part because clients are reviewing bills closely and refusing to pay for what they regard as inefficiencies, and in part because alternative fee arrangements can easily become unprofitable if the lawyers running them lack necessary project-management skills. Project management means organising all significant matters so that clients and other stakeholders know what needs to be done, what milestones must be achieved, who will be working on what elements of the project, when critical decisions must be made and what happens when unforeseen events occur. As a result, project or matter management not only provides a road map for the client and all other stakeholders; it also provides a planning device and a communications template that includes getting approval from key stakeholders at pre-determined intervals. Although project-planning tools can be applied to any matter on a one-off basis, they work best if a firm systematically collects and organises information about types of matters and creates resources for each type. Partners then have a head start when they set out to organise a similar matter.

Project management has several advantages, all of which will put a firm in a better position to serve its clients effectively:

Over time, the more matters that are subject to project management discipline, the easier it becomes for law firms to determine the cost of doing a certain type of project more accurately. As project plans are constantly updated as they are carried out, those using project management discipline will soon learn where difficulties tend to arise and what external factors are likely to increase a project’s cost or length. As a result, a firm will be better able to predict costs for a client, even if it still relies on a billable hour approach to fees.

Project management can help lawyers with poor organisational skills to become more disciplined. It also allows all professionals working on a project to know what their respective roles are, what expectations have been set for their performance, and when they need to complete a task.

Especially, when combined with financial modeling that allows partners to understand the effect of different staffing and leverage models on a matter’s profitability, project management can help firms better allocate their internal resources because they will have a clearer understanding of the work to be done on each matter.

Unsurprisingly, clients enjoy the transparency of a project plan, and much of the mystery of what occurs in a transaction or case is dissipated. If problems occur, they are also recognised sooner. Where a process is taking too long, the project plan draws attention to the impediments and forces those involved to re-evaluate and streamline their processes.

Reassign and retrain

Even if your firm has not been forced to lay off lawyers or reassign them, the current situation affords an excellent opportunity for firms and practice groups to assess which practice areas are likely to remain challenged in the near, medium and longer terms, and which are likely to prosper, or at least climb out of the downturn earliest. There is a strong case to be made that associates and partners should be trained in areas that are likely to thrive in the future wherever possible, rather than being made redundant while the growth areas hire expensive laterals. The exception is investing in laterals who bring reputation, expertise or business that it would take too long to develop in-house. The business case for retraining includes the following:

It reinforces firm morale if professionals are re-tooled, as it shows that the firm values its professionals and is willing to invest in their development;
The cost of hiring expert laterals is likely to be greater than the cost of retraining lawyers, given the premium that must be paid for experts in hot areas, the considerable expense involved in direct recruitment, the cost of the ramp-up period while laterals are integrated into the firm’s culture and learn its policies and procedures, and the risk that they will fail to perform as the firm expects;
Re-training broadens the skill set of your professionals, enhancing their long-term ability to become trusted advisors to their clients;
It keeps client knowledge within the firm, rather than losing it to potential competitors;
It allows professionals within your firm to get to know one another better than if they stayed in practice silos. This interaction will pay dividends in cross-selling practice areas going forwards.

As the phrase that has now become a cliché runs: “A crisis is a terrible thing to waste.” No firm should undertake changes in all the areas this article has addressed of course, but every firm should be thinking about how to take advantage of the openness to change that the recession has created. Five years from now, the most successful firms are likely to be the ones that have had the discipline and courage to make changes for the long term, even when they could survive in the short term with a less innovative approach.

John Claydon is director of professional development for Lex Mundi. Norman Letalik is a partner and managing director of the professional excellence program at Borden Ladner Gervais. Stephen Armstrong is the principal of Armstrong Talent Development. John Claydon can be contacted at: jclaydon@lexmundi.com