This is the sixth in a series of Client Alerts on thorny issues faced by General Counsel and Corporate Secretaries. Previous Alerts have focused on issues in the context of Board and Committee meetings such as when a matter needs to be taken to the Board, the length and scope of Board and Committee minutes, Directors' use of corporate or charter aircraft to attend meetings, who should be in the meeting room, and words and phrases to avoid when making a presentation. This Alert deals with management of the Legal Department and the issues a General Counsel faces when the Chief Executive Officer or Chief Financial Officer asks:
Why Does Our Legal Function Cost So Much?
Few issues create heartburn for the General Counsel as does being challenged to justify the expense of the organization's legal function. The issue may arise in the fall in connection with the organization's annual budgeting process, or as a result of a high-profile litigation (most often, following a loss), or in connection with recognizing an unusual increase in the litigation reserve as a charge to quarterly earnings. However the issue may arise, the General Counsel is immediately put on the defensive and begins a frantic mental search for an appropriate response. This Alert discusses some ways a General Counsel might think about the issue and some potential responses.
The first requirement in answering the question of why the organization's legal function is so expensive is knowing what the organization's legal function actually costs. By this, I mean both the all-in cost of the internal legal department plus the outside counsel spend. Not included are payments made to settle or amounts of judgments entered in litigation matters. Presumably, these are charged to the applicable business line. Different organizations will account for the expense of the internal legal department differently, but whatever accounting approach the organization uses, it is critical that the General Counsel have at his or her fingertips a single number that represents his or her best estimate of the annual cost of the internal legal function. This includes the cost of the legal function at all subsidiaries and at all operations around the world, and all indirect expenses such as employee benefits, imputed office rental charges, travel and entertainment, library services, etc. One cannot begin to justify the expense of the organization's legal function without first knowing the annual cost of the internal legal function. If the General Counsel has to say to the CEO or CFO, "I'll get that number and be back to you," he or she is immediately on the defensive. That number should be at his or her fingertips.
The external legal spend should, at least in theory, be an easier number to obtain. Again, it doesn't matter if the external legal spend is budgeted to the legal department or to lines of business and control functions (e.g., HR). The General Counsel should have at his or her fingertips both the annual budgeted amount for the current year and a good estimate of the actual spend to date. Two factors can make these numbers a bit tricky. The first is the vagaries of the litigation process and the aggressiveness of the opposing side. The second is the presence of contingent "alternative fee arrangements" that can produce higher or lower actual payments, depending on the outcome of a matter. The best a General Counsel can do here is make a most-likely case estimate of what the fees will be. And of course, part of justifying the organization's legal expense is being able to say to the CEO and CFO that the General Counsel has negotiated fee arrangements with law firms and other vendors (whether traditional or alternative) that deliver maximum value for the dollar.
One factor that will likely impact the cost of the legal function is the ratio of outside counsel/ inside counsel spend. This is a complex subject that will likely be the subject of its own Client Alert, but the accepted wisdom is that an organization saves money by bringing more work in-house. I would not argue with the accepted wisdom to the extent that one is measuring incremental cost for a given unit of work, but I would only suggest that the presence of additional inside counsel leads to increased use of outside counsel as more issues are identified and dealt with. I would argue that this is to the long-term benefit of the organization but at a short-term cost.
External factors will significantly impact the absolute cost of the legal function. Large organizations will spend more than smaller ones. International operations, large numbers of employees, multiple lines of business, being in a regulated industry and being subject to new and complex regulations, will also add to costs. One way to neutralize, at least in part, the impact of these variables is to express the cost of the legal function in terms of pennies per dollar of revenue. That is, it is useful to be able to say that for every dollar of the organization's revenue, one cent or two cents (or whatever the actual number is) of every revenue dollar is required to support the organization's legal function. This permits (in a pie chart sense) the legal expense to be compared with the cost of other of the organization's functions.
Inevitably, the CEO or CFO will ask at some point whether "our" legal function costs more or less than that of our peers. Expressing costs in terms of pennies per dollar of revenue helps in doing this comparison. The problems here, however, are two. First, there is an issue with finding true peers. If publicly traded, the organization will have identified peers it uses for HR and total shareholder return-performance graph purposes, but somehow there are always some significant differences among these peer companies. Second, even after peers have been identified, there is a question of whether one is getting comparable numbers for one's peers. By definition, you know how your numbers have been computed, but you don't know whether the comparison with peers is "apples to apples." If the organization's costs are lower than those of its peers, the General Counsel now has an easy answer for the CEO or CFO, although I would suggest this result might lead to some introspection as to whether the organization may be a bit underlawyered. It seems that more frequently, however, the organization's numbers are higher than its peers. As a result, the General Counsel may feel somewhat at a loss as to how to explain this difference to the CEO and CFO because he or she honestly believes that a lower level of lawyering would represent unacceptable risk to the organization.
At this point, the analysis moves from the objective to the subjective. One of the most important functions performed by the General Counsel is translating the risk tolerance of the organization as defined by the CEO and the Board to the real-world operation of the Legal Department. If the organization has defined for itself a lower risk tolerance (or if, for example, in a regulated industry, the organization has had a lower risk tolerance defined for it by its regulator(s)), it will require more lawyering (whether internal or external) to achieve that goal. Part of the General Counsel's answer to the CEO and CFO as to why its legal function costs what it does is that it reflects progress toward achievement of the broader organization goal of risk reduction. Second, I think a safe assumption is that all General Counsel have as a primary goal the delivery to the organization of true substantive value and outstanding client service. Achievement of that goal requires high-quality, dedicated and engaged internal counsel, and top-quality outside counsel, and, in short, that "doesn't come cheap." If the General Counsel has been successful and over the years the Legal Department has earned a reputation for delivering value and excellent client service, the CEO and CFO are quite likely to be tolerant of a numbers gap with peer organizations. If not, they are more likely to focus just on the numbers.
The answer to why an organization's legal function "costs so much" is a combination of objective and subjective factors. In addition to the importance of monitoring the internal and external spend numbers on a continuing basis, a General Counsel can feel confident that his or her focus on outstanding client service and delivering value to the organization will pay significant dividends if and when the cost of the legal function is challenged.
This article is presented for informational purposes only and is not intended to constitute legal advice.
