William Henderson on Are We Asking the Wrong Questions About Lawyer Regulation?

totmauthor —  19 September 2011

The TOTM Unlocking the Law Symposium is designed to raise a host of questions surrounding lawyer regulation, including ending lawyer licensure requirements and the ban on non-lawyer investment.

My thesis, for better or worse, is that we may be asking the wrong questions.  Despite the stringent regulations placed on lawyers, ingenious entrepreneurs—most of them non-lawyers—are finding ways to get into the legal services business.  Nobody needs to unlock the front door for them to enter.  They are climbing through the first floor windows, scaling down our chimneys, and seeping through our basement walls.  In ten years, much of the deregulation agenda will come to pass without any formal deregulation.  U.S. consumers and businesses are already voting with their feet.

Before getting into specific examples of how non-lawyer innovators are gaining a foothold in the legal services industry, and will eventually reap enormous financial rewards, let’s review the baseline numbers.  Despite the perceived linkage between the Lehmann Brothers collapse in the fall of 2008 and the decline in law firm employment, the high water mark for law firm jobs was actually 2004 (1,123,000 wage earners).  According to the County Business Patterns dataset, which is based on the universe of U.S. wage earners rather than a sample, employment in law offices has been trending downward since 2004 (see chart below). Between 2004 and 2009, total law office employment declined by over 2% (-26,106).

In contrast, the catch-all category of “all other legal services” seems to be undergoing a boom.  Between 1998 and 2009, this sector more than doubled, increasing from 9,800 to 21,600 jobs.  As shown in the above graph, both law offices and all other legal services were growing from 1998 to 2004.  But after 2004, when law offices jobs starting moving sideways, the all other legal services sector continued to pick up steam.

It is fair to observe that “all other legal services” is still a fly speck compared to the 1 million plus jobs in law firms.  But I would add to two caveats to that observation.

First, these data are current as of March 2009.  Since that time, we know that law firms have not yet regained their bearings and that legal process outsourcers – one of several niche businesses surely being included in the catch-all category—have gained considerable traction.  (For example, Thomson Reuters bought Pangea3 in 2010).  So the fly speck is almost certainly getting bigger.

Second, if the U.S. Census Bureau had been tracking payrolls at the turn of the 20th century, horse carriage production would have been a major category of employment. In contrast, so-called horseless carriages would have been in the “all other land transportation” category.  The world changes.  Citizens and businesses want their problems solved as cheaply and effectively as possible.  If those problems have a legal component, a substantial number of buyers don’t care if the solution involves the input of a licensed U.S. lawyer.  They only care about cost, quality, and convenience.

Now that we have covered that basic marketplace data, it is worth asking what businesses are in the “all other legal services” category.  Over the last two years, I have talked with principals at three companies that likely fall into this niche.

Novus Law LLC.  This company conducts electronic document review for complex litigation and corporate due diligence.  The company was funded by very patient non-lawyer angel investors, and it’s controlled by non-lawyer managers.  The founders of Novus are MBAs with over two decades of experience in the business process engineering for Fortune 500 clientele.  Drawing upon this expertise, Novus Law created decision tree systems maps for all of permutations of discovery and due diligence (nearly 1,000 discrete steps).  In turn, it re-engineered the processes to cut out all redundancy, eliminate errors, speed up delivery time, and develop fact theories that traditional law office methods would have near zero chance of uncovering. Although Novus uses some Indian labor, its competitive advantage is entirely based on the Novus process, which has been certified by Underwriters Laboratories.  I learned about Novus when the founders visited by Project Management class.  I cannot imagine a scenario in which the innovations of Novus Law get ignored.

Clearspire.  Another innovator is Clearspire, which has a unique two-company model that draws a sharp line between the practice of law and cutting edge technology and business processes.  Clearspire PLLC provides legal services to corporate clients.  Clearspire LLC, which is financed and run by business people, provides Clearspire PLLC with its technology and support services—the key ingredient for increasing quality and driving down costs.  Clearspire began with a massive investment to create its own state-of-the-art technology platform—the type of investment few law firms are willing to make.  This platform enables the PLLC to focus exclusively on the practice of law; in turn, the LLC generates the client base.  The Clearspire model is potentially revolutionary because the model can be scaled for very large legal service organizations, accelerating both innovation and profits.  Clearspire currently has five Practice Areas and will soon have seven more.  The financial returns for the legal support company (Clearspire LLC) are potentially extraordinary.

Axiom.  A third innovator is Axiom, which was founded by a former Davis Polk associate who was astonished at the extraordinary mark-up on associate labor.  Axiom’s value proposition is very simple.  Enable corporate clients to contract directly with former BigLaw associates and partners, effectively cutting out all the costly overhead associated with Class A office space in major global markets.  If you visit Axiom’s website, it looks like a very hip global law firm.  But technically it is a brokerage service for over 300 highly qualified and experienced lawyers who want the ability to control their schedules.  Axiom was also launched with non-lawyer equity funding.  Axiom has the potential to eventually go public.

Some might argue that these innovators are all in violation of the fee-splitting ban embodied in Model Rule 5.4.  But each has structured their business to be either a provider of a legal input (Novus) or a support service (Clearspire and Axiom).  Further, the entire rationale behind Rule 5.4 is to avoid the abrogation of lawyer independence to the detriment of clients.  But these corporate clients are incredibly sophisticated – they would readily sign an affidavit in court that they are being harmed by the lack of innovation endemic to the traditional time and materials model.  A legal challenge to their business models was just one of risks the founders and investors considered before launching their businesses.  The expected value was (far) in excess of the expected cost.  This is capitalism 101.

These three companies are merely illustrative.  In the personal service sector, Legal Zoom is becoming a household name.  Although a U.S. District Court Judge recently ruled that the company’s logic-driven legal forms violated Missouri’s ban on the unauthorized practice of law, minor modifications in the company business practices will likely avoid any significant curtailment in the Legal Zoom’s long term economic prospects.  Many lawyers, it turns out, use Legal Zoom to better assist their clients.  Legal Rocket, which just took in funding from Google Ventures, has a similar business model.  Much more sophisticated business forms, with annotations and learning tools, are being created and sold by the Practical Law Company, which was founded by former partners of elite global law firms.  PLC is selling directly to in-house legal departments, effectively undercutting the perceived state-of-the-art transactional documents generated by the marquee U.S. and U.K. law firms.  What, exactly, needs to be unlocked?

Every company I have described has entered the market because they see enormous profit-making opportunities by being better, faster, or cheaper than the supposedly protected legal guild.  This scenario exactly fits Clayton Christiansen’s “Disruptive Technology” paradigm.  As shown in the chart below, incumbent firms are not worried by new entrants because they enter at a low point in the value chain.  Yet, these new entrants are not hindered by the fixed ideas that tend to accompany decades of financial prosperity.  Further, these companies tend to be capital intensive, so they have to innovate to survive.  This fosters a culture—and eventually a competitive advantage—of rapid learning.

Among Fortune 500 executives, the Innovator’s Dilemma is well known.  Because big incumbent companies find it difficult to stay at the cutting edge of innovation, a very common strategy is to buy promising start-up businesses before they become your competitors.  For example, Microsoft has aggressively pursued this strategy for nearly 20 years, using some very hardball tactics for get innovators on board.  But here is the brutal irony in law—the incumbent law firms retain no earnings and therefore have minimal capital available for substantial acquisitions.  So when Axioms, Clearspires, Novus Laws, and PLCs obtain greater allegiance among the incumbents’ client base, the incumbent’s market share will erode very rapidly, inducing panic and, for some, economic failure.

What should law schools be doing to prepare for this new world order?  We are embarrassingly flat footed on these topics.  But that is topic for another day.

11 responses to William Henderson on Are We Asking the Wrong Questions About Lawyer Regulation?

  1. 

    Of course, the individual rate for insurance is much lower when the individual is part of a law firm. Additionally, a large law firm handling maters of great financial significance needs to acquire insurance and reinsurance covering potential claims in the hundreds of millions dollars. The cost of these policies is completely prohibitive if purchased by individual lawyers. Moreover, because of principals of respondeat superior, an attorney supervising the work of a another lawyer within his or her firm is personally responsible for the negligence or other malpractice of the supervised attorney. Some lawyers do elect to go “bare.” Most bar associations require that clients be informed in writing that a lawyer does not have malpractice insurance.

    However, as I noted elsewhere, since 1988, 30 major law firms have dissolved or gone in to bankruptcy. I don’t know of a single instance in which a large law firm was driven into dissolution because of a malpractice or negligence claim.

  2. 

    It looks like the growth in legal services jobs is close to the decline in law jobs— about 10,000 compared to about 20,000. Do you have the exact figures from the governmetn data?

  3. 

    Another question on malpractice insurance: Why do law firms buy it? The alternative is to be judgement-proof. Individual lawyers will still be exposed, but they could buy insurance on their own (or is it a matter of getting a group rate?)

    Is it that the law firm wants to be able to pay for its members’ malpractice as part of committing to do a good job?

    • 

      Eric,

      One possible reason for the “firm buys” as opposed to the “individual lawyers buy” model is partnership liability (which is both joint and several).

      All partners in a traditional partnership form of law firm are secondarily liable for the professional negligence of their fellow partners. If partner A has elected to practice “bare” (i.e., without professional liability insurance) and commits a costly malpractice, and then turns out to be personally insolvent (i.e., judgment-proof), the victim of the malpractice has legal recourse for compensatory damages to partner A’s fellow partners.

      Having the partnership (i.e., the law firm as a whole), rather than individual partners, secure malpractice insurance avoids the potential uncovered liability problem attendant in the case of the individual partner who intentionally “defects” (prisoner’s dilemma) from the individual insurance coverage scheme, or who, for whatever reason, otherwise fails to secure sufficient professional liability insurance to cover his or her professional negligence.

      When the firm secures the insurance on behalf of all of the firm’s practitioners, the “worst” that happens when any individual partner becomes insolvent (i.e., goes bankrupt) is that the cost of his insurance premium for the year in question (and the cost of any necessary insurance “tail”) must be allocated among (i.e., “eaten by”) the remaining partners.

      But if the law firm follows an individually-acquired coverage model, and an individual partner goes both “bare” and “bankrupt,” then the potential “joint and several” liability exposure of the other individual partners of the firm, in the aggregate, is equal to whatever the uninsured liability of the “bare-bankrupt” partner was/is — which typically is going to be an amount far in excess of what the “bare-bankrupt” partner’s unpaid annual professional liability insurance premium would have been.

      Herb Detrick

  4. 

    Attorneys Liability Assurance Society (http://www.alas.com/about.shtml ), is a mutual insurance company owned by its 233 law firm members and provides insurance for some 58,000 lawyers, primarily from BigLaw. ALAS offers coverage of $75,000,000 per claim and $150,000,000 in the aggregate. Law firm risk managers typically arrange for reinsurance most often on the London Market at limits in the hundreds of million dollars, depending on the nature of risks typically taken by the particular law firm.

    A law firm’s investment in ALAS is considered an asset of the law firm, and upon withdrawal from ALAS, the law firm receives a return on its equity investment in ALAS.
    Since 1988, 30 major law firms have dissolved or gone in to bankruptcy. I don’t know of a single instance in which a large law firm was driven into dissolution because of a malpractice or negligence claim.

    While it is true that law firms do not typically retain earnings and are theoretically disadvantaged in investing in new acquisitions, we obviously still see law firm growth in adding to its ranks with new laterals. Those acquisitions are either funded by bank credit lines, most often provided by Citibank, Wells Fargo and sometimes Bank of America. In addition, law firm growth is further funded by increased capital requirements from the law firm’s partners.

    In my opinion, continued lateral growth will not be funded by private equity investment. http://kowalskiandassociatesblog.com/2011/04/27/alternative-business-structures-here%e2%80%99s-a-great-idea-let%e2%80%99s-get-some-private-equity-funds-to-invest-in-large-commercial-law-firms-and-we%e2%80%99ll-all-make-a-ton-of-money/

  5. 

    “But here is the brutal irony in law—the incumbent law firms retain no earnings and therefore have minimal capital available for substantial acquisitions.”

    Great post. Could you expand on this point? I wonder about it, because I just was blogging on the WilmerHale legal malpractice case, where that firm may have to be $115 million in damages (besides the $99 million from its malpractice insurance) http://g406.blogspot.com/2011/09/dog-ate-my-homework-bill.html . So, how much can a big law firm come up with if it needs to?

  6. 

    Bill –

    While I am not holding any brief for any of the alternative providers of legal services, the record should be made clear that Legalzoom.com apparently settled the Missouri litigation and also just announced that it is providing direct legal counseling by lawyers on its web portal. These updates are listed in my post at http://kowalskiandassociatesblog.com/2011/08/11/are-law-firms-going-to-be-replaced-by-internet-based-providers-of-legal-services/

    Another new model is http://www.rimonlaw.com , which is certainly worth noting.

    I personally spent a great deal of time with Clearspire and their technology platform is light years ahead of anybody else in the pack. Quite clearly, Clearspire has the platform to provide extraordinary returns, as you noted, but, in addition, it also can and does seem to deliver high quality legal services at a small fraction of BigLaw pricing, with the overwhelming number of engagements it enters into with clients are at very attractive fixed fees, with an extraordinary “money back” guarantee: If Clearspire concludes a project under the fixed fee projection, it refunds a portion of the saving to the client, while if it goes over budget, Clearspire alone eats the difference.

    All of these folks will be eating a lot of other folks’ lunches.

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